INHALE THERAPEUTIC SYSTEMS INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549
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FORM 10-K

/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER
31, 1999 OR

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

COMMISSION FILE NO. 0-23556
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INHALE THERAPEUTIC SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

DELAWARE 94-3134940
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

150 INDUSTRIAL ROAD, SAN CARLOS, CA 94070
(Address of principal executive offices and zip code)

(650) 631-3100
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act: NONE

Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK,
$0.0001 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 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 approximate aggregate market value of voting stock held by
non-affiliates of the Registrant, based upon the last sale price of the Common
Stock on March 1, 2000 as reported by Nasdaq National Market was approximately
$1,860,035,885. Determination of affiliate status for this purpose is not a
determination of affiliate status for any other purpose.

20,588,388

(Number of shares of common stock outstanding as of March 1, 2000)
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DOCUMENTS INCORPORATED BY REFERENCE

Portions of Registrant's definitive Proxy Statement to be filed for its 2000
Annual Meeting of Shareholders are incorporated by reference into Part III
hereof.

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INHALE THERAPEUTIC SYSTEMS, INC.
1999 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

PAGE
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PART I
Item 1. Business.......................................... 1
Item 2. Properties........................................ 26
Item 3. Legal Proceedings................................. 27
Item 4. Submission of Matters to a Vote of Security
Holders................................................. 27
PART II
Item 5. Market for Registrant's Common Equity and Related
Shareholder Matters..................................... 27
Item 6. Selected Financial Data........................... 30
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations..................... 31
Item 7A. Quantitative and Qualitative Disclosures about
Market Risk............................................. 35
Item 8. Financial Statements and Supplementary Data....... 35
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure..................... 35
PART III
Item 10. Directors and Executive Officers of the
Registrant.............................................. 36
Item 11. Executive Compensation........................... 39
Item 12. Security Ownership of Certain Beneficial Owners
and Management.......................................... 39
Item 13. Certain Relationships and Related Transactions... 39
PART IV
Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K..................................... 40
SIGNATURES.................................................. 43

PART I

ITEM 1. BUSINESS

OVERVIEW

Inhale Therapeutic Systems, Inc. ("Inhale") is creating a drug delivery
system to easily and painlessly deliver a wide range of drugs, including
peptides, proteins, nucleic acids and other molecules, by inhalation to the deep
lung for treatment of systemic and respiratory diseases. Inhale is using this
system principally to enable non-invasive delivery of protein drugs currently
administered by injection. Inhale's most advanced program, which is sponsored by
Pfizer Inc. ("Pfizer"), is inhaleable insulin. Pfizer commenced dosing for its
Phase III clinical trials in June 1999. In addition to its insulin program with
Pfizer, Inhale has development collaborations with Biogen, Inc., Aventis Behring
L.L.C. (formerly Centeon L.L.C., a joint venture of Hoechst AG and Rhone-Poulenc
S.A., which have now merged to form Aventis S.A.), and Eli Lilly & Co. Inhale
also has early stage feasibility and research collaborations with several other
companies and has tested seven drugs in clinical trials.

Currently there are approximately 35 macromolecule drugs marketed in the
United States and about 120 other such drugs in clinical trials. Sales of the
top 15 genetically engineered protein drugs (a subset of macromolecule drugs)
were estimated at $14 billion worldwide in 1997. Most of these drugs are
currently delivered by injection. Injections are undesirable for numerous
reasons including patient discomfort, inconvenience and risk of infection. Poor
patient acceptance of, and compliance with, injectable therapies can lead to
increased incidence of medical complications and higher disease management
costs. Alternatives to injection such as oral, transdermal and nasal delivery
have to date been commercially unattractive due to low natural
bioavailability--the amount of drug absorbed from the delivery site into the
bloodstream relative to injection. As an alternative to the invasiveness of
injection, Inhale believes a deep lung inhalation delivery system could expand
the market for protein drug therapies by increasing patient acceptance and
improving compliance and may enable new therapeutic uses of certain protein
drugs.

Inhale is creating a proprietary platform integrating customized
formulation, dry powder processing and packaging with a proprietary inhalation
device to enable efficient, reproducible delivery of drugs for systemic and
local lung indications. For specific drug products, Inhale formulates and
processes bulk drugs supplied by collaborative partners into dry powders which
are packaged into individual dosing units referred to as blisters. The blisters
are designed to be loaded into Inhale's device, which patients then activate to
inhale the aerosolized drugs. Inhale has developed an inhalation device that is
being used several times per day for several months in outpatient trials for
insulin. In addition, Inhale has demonstrated room temperature stability of a
year or more for a number of protein drugs, and has scaled-up its powder
processing and packaging for late stage clinical trials and small scale
production for certain drugs.

As an alternative to invasive delivery techniques, Inhale believes that a
deep lung delivery system could potentially expand the market for protein drug
therapies by increasing patient acceptance and improving compliance, which in
turn could decrease medical complications and the associated costs of disease
management. Additionally, deep lung delivery may enable new therapeutic uses of
certain protein drugs. Inhale is focusing development efforts on applying its
pulmonary delivery system primarily to drugs for systemic and local lung
diseases that either have proven efficacy and are approved for delivery by
injection or are in late stage clinical trials.

A cornerstone of Inhale's business strategy is to work with collaborative
partners to develop and commercialize drugs for deep lung delivery. In a typical
collaboration, Inhale's partner will support the application of Inhale's
technology to a particular drug by providing the drug, funding clinical
development, and marketing the resulting commercial product. Inhale typically
will supply the delivery system and receive research and development and
progress payments during development, and receive revenues from powder
manufacturing, device supply, and royalties from sales of any commercial
products.

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In addition to Pfizer's sponsorship of the inhaleable insulin program,
Inhale has active development programs with several other corporate partners.
Inhale's most recent collaboration is with Biogen for pulmonary delivery of
Interferon-Beta-1a, sold under the trade name AVONEX-Registered Trademark-, the
leading drug worldwide for the treatment of Multiple Sclerosis. Inhale is also
engaged in development collaborations with Aventis Behring on alpha-1 proteinase
inhibitor for genetic emphysema, and with Lilly for an undisclosed protein drug.
Inhale is also engaged in early stage feasibility and research programs with
respect to other compounds. Inhale anticipates that any product that may be
developed would be commercialized with a collaborative partner and believes its
partnering strategy will enable it to reduce the investment required to develop
a large and diversified potential product portfolio.

In late 1999, Inhale completed the sale of approximately $108.5 million
aggregate principal amount of 6 3/4% Convertible Subordinated Debentures due
October 13, 2006. In early 2000, the Company entered into agreements with
certain holders of these outstanding debentures to convert their debentures into
common stock in exchange for a cash payment. To date, the Company has agreed to
make cash payments of approximately $16.2 million in the aggregate in connection
with agreements that provide for the conversion of approximately $94.2 million
aggregate principal amount of outstanding debentures into approximately
2.9 million shares of common stock. Such amounts will be reflected as a charge
to interest expense in the first quarter of 2000.

In February 2000, Inhale received approximately $222.4 million in net
proceeds from the issuance of $230.0 million aggregate principal amount of
convertible subordinated notes to certain qualified institutional buyers under
Rule 144A of the Securities Act of 1933, as amended. Interest on the notes will
accrue at a rate of 5.0% per year, subject to adjustment in certain
circumstances. The notes will mature in 2007 and are convertible into shares of
Inhale's common stock at a conversion price of $76.71 per share, subject to
adjustment in certain circumstances.

Upon completion of the issuance of the February 2007 notes and the exchange
of the October 2006 debentures, the Company expects to net approximately
$206.2 million cash.

OPPORTUNITY FOR PULMONARY DRUG DELIVERY

MACROMOLECULES

Innovations in biotechnology and recombinant techniques have led to a large
increase in the number of macromolecule drugs over the last several years. These
drugs, which are identical or similar to the body's natural molecules, are
enabling new therapies for many previously untreated or poorly treated diseases.
Currently, approximately 35 biotechnology drugs are approved for marketing in
the United States and approximately 120 additional biotechnology drugs are in
clinical trials, many for chronic and subchronic diseases. Sales of genetically
engineered protein drugs were estimated at $14 billion worldwide in 1997.

There are five typical routes of administration of drugs, four natural and
one which bypasses natural barriers to entry of molecules into the body. The
four natural routes are through the digestive tract (oral), the skin
(transdermal), the mucosal surfaces (nasal and sublingual), and the lung
(inhalation). Penetration of the skin by injection (subcutaneous, intramuscular,
or intravenous) bypasses the major natural barrier to prevent molecules from
entering the body.

Oral delivery is a common method of delivery for many small molecule drugs.
However, macromolecules are typically extremely vulnerable to digestion and
therefore are very poorly delivered by an oral route. In addition, Inhale
believes that dosage reproducibility for oral delivery of macromolecules may be
very poor because of their low oral bioavailability. While several companies are
working on oral delivery for macromolecule drugs, no commercially viable system
is currently being marketed.

The size of most macromolecules makes penetration of the skin inefficient or
ineffective. Passive transdermal delivery using "patch" technology has not been
successful to date since the skin is less

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naturally permeable to macromolecules than the gastrointestinal tract. No
macromolecule drugs have been approved for marketing in the United States
utilizing patch technology. Certain peptides and proteins can be transported
across the skin barrier into the bloodstream using high pressure "needle-less"
injection devices. The devices, which inject proteins like insulin through the
skin into the body, have been available for many years. However, Inhale believes
these devices have not been well accepted due to patient discomfort and
relatively high cost.

The nasal route of drug administration has been limited by low and variable
bioavailability for proteins and peptides. As a result of these limitations,
penetration enhancers are often used with nasal delivery to achieve higher
bioavailability. These enhancers may cause local irritation to the nasal tissue
and result in safety concerns with long-term use. Only a limited number of
peptides have been approved for marketing in the United States utilizing nasal
delivery. Inhale believes these same obstacles will affect sublingual drug
delivery, which also relies on the penetration of similar tissue in the mouth.

The principal practical and efficient route of administration of
macromolecules, particularly recombinant proteins, has been injections.. Drug
injections administered in hospitals or doctors' offices can be expensive and
inconvenient to patients. Many patients find self-injectable therapies
unpleasant. As a result, such therapies for many chronic and subchronic diseases
meet with varying degrees of patient acceptance and compliance with the
prescribed regimens. Poor acceptance and compliance can lead to increased
incidence of medical complications and potentially higher disease management
costs. In addition, some elderly, infirm or pediatric patients cannot administer
their own injections and require assistance, thereby increasing both
inconvenience to these patients and the cost of therapy.

Delivery of drugs to the lungs via inhalation (pulmonary delivery) has the
potential to be a much more effective route of administration of macromolecules,
with a relatively higher absorption into the bloodstream (bioavailability) than
all alternative routes except injection. As an alternative to the invasiveness
of injection, Inhale believes a deep lung inhalation delivery system could
increase patient acceptance and improve compliance and may enable new
therapeutic uses of certain macromolecule drugs. Pulmonary delivery is already
in use for a variety of small molecule drugs.

Existing pulmonary drug delivery systems such as metered-dose inhalers
("MDIs"), dry powder inhalers and nebulizers, are used primarily to deliver
drugs to the upper airways of the lung for lung diseases. Approximately 35 drugs
are approved for marketing by the FDA for delivery into the respiratory tract,
but none of these pulmonary drug delivery devices were designed to optimize drug
delivery to the deep lung for absorption into the bloodstream. MDIs, dry powder
inhalers and nebulizers typically deliver only a fraction of the drug to the
deep lung, with most of the drug being lost in the delivery device or in the
mouth and throat. Consequently, Inhale believes that the total efficiency of
such systems is generally not high enough to be commercially feasible for
systemic delivery of most macromolecule drugs.

In addition, pulmonary drug delivery devices currently do not provide the
dosage reproducibility and formulation stability generally needed for
commercially viable systemic macromolecule drug delivery. Inhale believes that
many MDI and dry powder systems do not provide the deep lung dosage
reproducibility necessary for many systemic applications because the patient
must coordinate the breathing maneuver with the generation of the aerosol.
Further, Inhale believes that many macromolecules currently cannot be formulated
for use in MDI systems, since macromolecule drugs could be denatured by the MDI
formulating ingredients. In addition, Inhale believes that some macromolecules
may be inactivated by nebulization and that many dry powder systems do not
provide the protection needed for long-term stability that may be needed for
macromolecule formulations.

Inhale believes that an efficient and reproducible deep lung delivery system
for systemic macromolecule drugs used in the treatment of chronic and subchronic
diseases represents a significant commercial opportunity. Such a system could
improve patient acceptance of systemic macromolecule drug therapy and compliance
with prescribed regimens, thereby improving therapeutic outcomes and reducing

3

the costs of administration and treatment of disease. Additionally, pulmonary
delivery may enable new therapeutic uses of certain macromolecule drugs.

Inhale also believes that opportunities for a deep lung delivery system
exist in the delivery of macromolecules for local lung diseases due to the
limitations of current pulmonary devices. Biotechnology and pharmaceutical
companies are developing new macromolecule drugs for pulmonary diseases such as
asthma, cystic fibrosis, emphysema, lung cancer, pneumonia and bronchitis.
Pulmonary delivery is the preferred route for treating most lung diseases since
application of the drug directly to the site of action (lung) requires much less
drug than systemic administration, thereby potentially reducing systemic side
effects.

OTHER MOLECULES

In addition to developing a deep lung delivery system for macromolecules,
Inhale is investigating opportunities for leveraging its technology for
application to small molecules where there is a clear, demonstrable need for an
alternative drug delivery system and where Inhale's existing technology can be
applied without significant modification. Examples include molecules that
require rapid systemic absorption for efficacy (i.e., analgesics and
antiemetics), molecules that undergo massive first pass metabolism by the oral
route or molecules used for local lung delivery for diseases such as asthma that
are currently delivered by sub-optimal aerosol systems.

MDIs, existing dry powder inhalers and nebulizers have been used primarily
to deliver drugs to the upper airways of the lung for local lung applications.
Some of the problems associated with traditional small molecule aerosol delivery
systems include poor reproducibility, low efficiency, low drug payload per puff,
poor moisture barrier and, in the case of wet systems, long dosing time and
potential for microbial growth.

Inhale believes that its technology could be used to address these problems
by providing efficient dispersion of the drug into the lungs resulting in the
reproducible delivery of a consistent amount of drug into the bloodstream.
Inhale further believes its technology could potentially be applied economically
in market segments where it is essential that significant drug doses reach the
lung. Large amounts of drugs taken orally or through inefficient inhalers can
result in side effects which could be avoided or reduced through more efficient
and better targeted pulmonary delivery.

STRATEGY

Inhale's goal is to become the leading drug delivery company in the field of
pulmonary delivery of macromolecules. In addition, Inhale is leveraging its
technology base for other applications where its system can provide significant
market advantages. Inhale's strategy incorporates the following principal
elements:

- DEVELOP A BROADLY APPLICABLE PULMONARY DELIVERY SYSTEM. Inhale is
developing its non-invasive deep lung drug delivery system to be
applicable to a wide range of peptides, proteins and other molecules
currently delivered by injection or poorly delivered by inhalation or
other routes. Inhale intends to develop effective non-invasive delivery
alternatives that can: (1) expand market penetration for existing
therapeutics currently delivered by injection, infusion or other routes;
(2) commercialize new indications by using deep lung delivery as a new
route of administration; and (3) extend existing patents or seek new
patents to gain important competitive advantages for Inhale and its
partners.

- BUILD COMPETITIVE ADVANTAGE THROUGH AN INTEGRATED SYSTEMS APPROACH. Inhale
is developing a commercially viable deep lung delivery system through an
integrated systems solution. Inhale combines its expertise in pulmonary
physiology and biology, aerosol science, powder science, chemical
engineering, mechanical engineering and product design, protein
formulation, fine powder processing and filling to build a proprietary,
fully-integrated system for pulmonary delivery of therapeutic

4

drugs. Inhale believes that building expertise in technology across
several disciplines provides it with a significant competitive advantage.

- PARTNER WITH PHARMACEUTICAL AND BIOTECHNOLOGY COMPANIES.Inhale's strategy
is to market its proposed products through collaborative partners. Inhale
is seeking to work with partners that have significant clinical
development and marketing resources, and currently has collaborations with
several large pharmaceutical and biotechnology companies. For patented
drug products, Inhale intends to partner with owners or licensees from the
outset of the project. For drugs that are off-patent or licensed-in,
Inhale may perform initial feasibility screening work, formulations
development and early stage clinical trials before entering into a partner
relationship for further development. Inhale believes this partnering
strategy enables it to reduce its cash requirements while developing a
large and diversified potential product portfolio.

- FOCUS ON APPROVED OR LATE STAGE DRUGS. To date, Inhale has focused
primarily on drugs that either have proven efficacy and are approved for
marketing or are in late stage clinical trials. Inhale believes that
working primarily with drugs with demonstrated efficacy reduces the
technical risk of its projects. In the future, Inhale anticipates working
on drugs at earlier stages of development.

- EXPAND MANUFACTURING CAPABILITY. Inhale intends to formulate, manufacture
and package dry powders for most of its drugs and to subcontract
manufacturing of its device. Inhale believes that this strategy will
provide manufacturing economies of scale across a range of therapeutic
products and expand capacity for additional partnerships and commercial
scale production.

INHALE'S DEEP LUNG DRUG DELIVERY SYSTEM

Inhale believes that the following criteria are necessary for a commercially
viable non-invasive deep lung drug delivery system:

- SYSTEM EFFICIENCY/COST: The system must attain a certain minimum
efficiency in delivering a drug to the bloodstream as compared to
injection. Bioavailability (the percentage of drug absorbed into the
bloodstream from the lungs relative to that absorbed from injection) is
the most important element of system efficiency. Total system efficiency
is critical due to the high cost of macromolecule drugs. Total delivery
system efficiency is determined by the amount of drug loss during
manufacture, in the delivery device, in reaching the site of absorption,
and during absorption from that site into the bloodstream. Inhale believes
that for most systemic macromolecule drugs, a non-invasive delivery system
must show total delivery system efficiency of at least 5% to 25% compared
to injection for the system to be commercially viable.

- REPRODUCIBILITY: The system must deliver a consistent and predictable
amount of drug to the lung and into the bloodstream.

- FORMULATION STABILITY: Formulations used in the system must remain
physically and chemically stable over time and under a range of storage,
shipping and usage conditions.

- SAFETY: The system should not introduce local toxicity problems during
chronic or subchronic use by a wide population of patients.

- CONVENIENCE: The system must be convenient to the patient in terms of
comfort, ease of operation, transportability and required dosage time.

Inhale approaches pulmonary drug delivery with the objective of maximizing
overall delivery system efficiency while addressing commercial requirements for
reproducibility, formulation stability, safety and convenience. To achieve this
goal, Inhale's delivery system integrates customized drug formulations and
packaging with its proprietary inhalation device. Inhale combines an
understanding of lung biology, aerosol science, chemical engineering, mechanical
engineering and protein formulations in its system development efforts. Inhale
believes that this interdisciplinary capability provides an important
competitive advantage.

5

Inhale has chosen to base its deep lung delivery system on dry powders for
several reasons. Many proteins are more stable in dry powders than in liquids.
In addition, dry powder aerosols can carry approximately five times more drug in
a single breath than typical MDIs and, for many drugs, at least 25 times more
than currently marketed liquid or nebulizer systems. Inhale believes that a dry
powder system for drugs requiring higher doses, such as insulin and alpha-1
proteinase inhibitor, could decrease dosing time as compared with nebulizers.

Inhale takes bulk drugs supplied by partners and formulates and processes
them into fine powders that are then packaged into individual blisters. The
blisters are designed to be loaded into Inhale's device, which patients activate
to inhale the aerosolized drugs. Once inhaled, the aerosol particles are
deposited in the deep lung, dissolved in the alveolar fluid and absorbed into
the bloodstream. Although Inhale is in the advanced stages of developing its
system technologies, there can be no assurance that Inhale's products will ever
be successfully commercialized.

FORMULATIONS

Each macromolecule drug poses different formulation challenges due to
differing chemical and physical characteristics and dosing requirements. This
requires significant optimization work for each specific drug. Inhale has
assembled a team with expertise in protein formulation, powder science and
aerosol science and is applying this expertise to develop proprietary techniques
and methods that it believes will produce stable, fillable and dispersible dry
powder drug formulations. Inhale has developed several protein powders which
remain stable at room temperature in excess of one year. Through its work with
numerous macromolecules, Inhale is developing an extensive body of knowledge on
aerosol dry powder formulations, including knowledge relating to powder flow
characteristics and solubility within the lung, as well as physical and chemical
properties of various excipients. Inhale has filed and expects to continue to
file patent applications on several of its formulations and, through strategic
acquisitions, has acquired rights to certain U.S. and foreign patents and patent
applications relating to stabilization of macromolecule drugs in dry
formulations.

POWDER PROCESSING

Inhale is modifying standard powder processing equipment and developing
custom techniques to enable it to produce fine dry powders with particle aerosol
diameters of between one and five microns without degradation or significant
loss of expensive bulk drug. Inhale has scaled up powder processing to levels
sufficient for producing test powders for late stage clinical trials and small
volume marketed products. Inhale is in the process of further scaling up its
powder processing systems in order to produce quantities sufficient for
commercial production of products Inhale believes it will need to supply in high
volumes, such as insulin. However, there can be no assurance that Inhale will be
successful in further scaling up its powder processing on a timely basis or at a
reasonable cost, or that the powder processing system will be applicable for
every drug.

POWDER FILLING AND PACKAGING

Powders made up of fine particles that do not behave in a granularly flowing
way, are generally compressible, and hence require handling that is different
than for powders comprised of larger particles. Currently available commercial
filling and packaging systems are designed for filling powders of larger
particle size and therefore must be re-engineered to dispense finer powders
accurately and in the small quantities often required. Initially, during early
stages of development, powder filling was performed manually. Inhale has since
developed and qualified a proprietary automated filling system suitable for use
in production of clinical trial supplies and commercial quantities for certain
products. Inhale is further developing a high through-put system for use with
products whose market requirements dictate increased capacity.

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INHALATION DEVICE

Inhale's proprietary pulmonary delivery device is designed to provide deep
lung delivery of therapeutic powders in a reproducible, safe and efficient
manner. The first of a series of patents applied for covering the device was
granted in the United States in October 1995. To achieve its objectives, Inhale
has designed its pulmonary delivery device to perform the following:

- EFFECTIVELY DISPERSE FINE PARTICLES INTO AN AEROSOL CLOUD. Fine powders
have different dispersion requirements or characteristics than large
powders. Most current dry powder inhalers use larger powders and are not
efficient in dispersing powders with aerosol diameters of one to five
microns. Inhale has developed and is refining its dispersion system for
its device specifically for fine powders. Inhale's device has been
designed to efficiently remove powders from the packaging, effectively
break up the powder particles and create an aerosol cloud while
maintaining the integrity of the drug.

- EFFICIENTLY AND REPRODUCIBLY DELIVER THE AEROSOL CLOUD TO THE DEEP LUNG.
Inhale is developing a proprietary aerosol cloud handling system in its
device that is intended to facilitate deep lung powder deposition and
reproducible patient dosing. The handling system design is intended to
enable the aerosolized particles to be transported from the device to the
deep lung during a patient's breath, reducing losses in the throat and
upper airways. In addition, the aerosol cloud handling system, in
conjunction with the dispersion mechanism and materials used in the
device, is designed to reduce powder loss in the device itself.

- ELIMINATE THE USE OF PROPELLANTS TO AVOID ASSOCIATED ENVIRONMENTAL
CONCERNS AND FORMULATION DIFFICULTIES. Unlike MDIs, the Inhale device does
not use propellants. The oily surfactants required to stabilize propellant
formulations can cause aggregation of macromolecules. Current
chlorofluorocarbon propellants, which are used in most commercial MDI
systems, are being phased out in many countries due to environmental
concerns.

The success of Inhale's deep lung drug delivery system for any drug will
depend upon Inhale achieving sufficient formulation stability, safety dosage
reproducibility and total system efficiency (measured by the percentage of bulk
drug entering the manufacturing process that eventually is absorbed into the
bloodstream relative to injection for systemic indications, or the amount of
drug delivered to the lung tissue for local lung indications). The initial
screening determinant for the feasibility of pulmonary delivery of any systemic
drug is pulmonary bioavailability, which measures the percentage of the drug
absorbed into the bloodstream when delivered directly to the lungs. In addition,
a certain percentage of each drug dose may be lost at various stages of the
manufacturing process, (e.g., in drug formulation, dry powder processing, or
powder filling and packaging) and in moving the drug from a delivery device into
the lungs. Excessive drug loss at any one stage or cumulatively in the
manufacturing and delivery process would render a drug commercially unfeasible
for pulmonary delivery. Formulation stability (the physical and chemical
stability of the formulated drug over time and under various storage, shipping
and usage conditions) and safety will vary with each macromolecule and the type
and amount of excipients, that are used in the formulation. Dose reproducibility
(the ability to deliver a consistent and predictable amount of drug into the
bloodstream over time both for a single patient and across patient groups)
requires the development of an inhalation device that consistently delivers
predictable amounts of dry powder formulations to the deep lung, accurate unit
dose packaging of dry powder formulations and moisture resistant packaging.
There can be no assurance that Inhale will be able to successfully develop such
an inhalation device or overcome such other obstacles to reproducible dosing.

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CLINICAL STATUS SUMMARY

The following table sets forth, for both Inhale's partner development
programs and Inhale's programs available for partnering, the drug currently in
development, the indication(s) for the particular drug, its present stage of
clinical development and, with respect to Inhale's partner development programs,
the identity of Inhale's corporate partner for such drug.

PARTNER DEVELOPMENT PROGRAMS

DRUG INDICATION(S) CLINICAL STATUS(1) PARTNER
- ---- ------------------ ------------------ ---------------

Insulin................................. Type 1 and 2 Phase III Pfizer
Diabetes

Alpha-1 Proteinase Inhibitor............ Genetic Emphysema Phase I Aventis Behring

AVONEX-Registered Trademark-............ Multiple Sclerosis Preclinical Biogen

Undisclosed Protein..................... Not Released Preclinical Lilly

PTH..................................... Osteoporosis Phase I Lilly

PROGRAMS AVAILABLE OR EXPECTED TO BE AVAILABLE FOR PARTNERING

DRUG INDICATION(S) CLINICAL STATUS(1)
- ---- -------------------------------- ------------------

Calcitonin.................................... Osteoporosis, Bone Pain, Paget's Phase I
Disease

Interleukin-1 Receptor........................ Asthma Phase I/II

Undisclosed Non-Protein, Non-Peptide.......... Not Released Phase II

Undisclosed Non-Protein, Non-Peptide.......... Not Released Phase I

Undisclosed Non-Protein, Non-Peptide.......... Not Released Preclinical

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

(1) Clinical Status means:

Phase III - large-scale out-patient clinical trials conducted to obtain
information regarding specific patient groups conducted following encouraging
Phase II trial results.

Phase II - clinical trials to establish dosing and efficacy in patients

Phase I - clinical trials in healthy subjects to test safety, and for drugs with
systemic applications, to test bioavailability compared with injection.

Preclinical - formulation development and animal testing in preparation for
human trials

INHALE'S PARTNER DEVELOPMENT PROGRAMS

In general, Inhale's partnership arrangements provide funding for
development, payments upon the achievement of certain milestones and royalty and
manufacturing revenues upon the commencement of commercial sales. The
arrangements are cancelable by the partner at any time without significant
penalty.

INSULIN PROGRAM

Insulin is a protein hormone naturally secreted by the pancreas to induce
the removal of glucose from the blood. Diabetes, the inability of the body to
properly regulate blood glucose levels, is caused by insufficient production of
insulin by the pancreas or insufficient use of the insulin that is secreted.
Over

8

time, high blood glucose levels can lead to blindness, loss of circulation,
kidney failure, heart disease or stroke. Insulin is currently marketed only in
injectable form. Insulin is supplied by various manufacturers, including Lilly,
Novo-Nordisk A/S and Aventis.

According to the United States Centers for Disease Control and Prevention,
approximately 16 million people in the United States have diabetes
(10.3 million are diagnosed with diabetes; another 5.4 million have undiagnosed
diabetes) and 798,000 new cases are diagnosed each year. All Type 1 diabetics,
estimated at between 5% and 15% of all diabetics, require insulin therapy. Type
1 diabetics require both a baseline treatment of long-acting insulin and
multiple treatments of regular, or short acting, insulin throughout the day.
Type 2 diabetics, depending on the severity of their case, may or may not
require insulin therapy. Type 2 diabetics who use insulin are best treated with
regular insulin and sometimes require long-acting insulin as well. Because of
the inconvenience and unpleasantness of injections, many Type 2 patients who do
not require insulin to survive, despite the fact that they would benefit from
it, are reluctant to start treatment.

Regular insulin is generally administered 30 minutes before mealtimes and
generally is given only twice a day. A ten-year study by the National Institutes
of Health ("NIH"), however, demonstrated that the side effects of diabetes could
be significantly reduced by dosing more frequently. The NIH study recommended
dosing regular insulin three to four times per day, a regimen which would more
closely mirror the action of naturally produced insulin in non-diabetics.
Because of the risk of severe hypoglycemia, this course of treatment is not
recommended for children, older adults, people with heart disease or with a
history of frequent severe hypoglycemia. In addition, many patients are
reluctant to increase their number of daily doses because they find injections
unpleasant and inconvenient.

Pursuant to a collaborative agreement originally entered into in
January 1995, Inhale and Pfizer are developing an inhaled version of regular
insulin that can be administered in one to three blisters per dose using
Inhale's deep lung delivery system. Inhale believes that its delivery system
could provide increased user convenience and result in greater patient
compliance by eliminating some injections for Type 1 and Type 2 patients and all
injections for some Type 2 patients. In addition, Inhale believes that pulmonary
delivery could yield medical advantages by providing a more rapid acting insulin
than most currently marketed injectable products.

Through its collaboration with Inhale, Pfizer conducted Phase I and Phase
IIa clinical trials which indicated that pulmonary insulin was absorbed
systemically, reduced blood glucose levels and provided the same glycemic
control as injected insulin. In October 1996, Pfizer initiated a multi-site
Phase IIb outpatient trial to include up to 240 diabetes patients, the results
of which were announced in June 1998. In 70 Type 1 diabetics treated with either
inhaled or conventional injected insulin therapy for three months, blood levels
of hemoglobin A1c, the best index of blood glucose control, were statistically
equivalent. Virtually identical results were obtained in a group of Type 2
diabetics. In September 1998, Pfizer released additional Phase IIb data which
indicated that results from 56 to 69 patients in a three-month trial showed that
individuals with Type 2 diabetes can markedly improve their glycemic control
without insulin injections by combining Inhale's pulmonary insulin with oral
diabetes agents.

In November 1998, Pfizer and Aventis announced that they entered into
worldwide agreements to manufacture insulin and to co-develop and co-promote
inhaleable insulin. Under the terms of the agreement, Pfizer and Aventis agreed
to construct a jointly owned manufacturing plant in Frankfurt, Germany. Until
its completion, Pfizer will provide Inhale with biosynthetic recombinant insulin
for powder processing from Aventis's existing plant. Inhale will continue to
have responsibility for manufacturing powders and supplying devices and will
receive a royalty on inhaleable insulin products marketed jointly by Pfizer and
Aventis. In November 1998, Pfizer held a meeting for 117 Phase III sites of the
inhaleable insulin trials and in June 1999, Pfizer began dosing for the Phase
III clinical trials.

In January 1995 and October 1996, Pfizer made two $5 million equity
investments in Inhale at a 25% premium to the market price of Inhale stock at
the time of each investment.

9

ALPHA-1 PROTEINASE INHIBITOR PROGRAM

In January 1997, Inhale entered into a collaborative agreement with Aventis
Behring to develop a pulmonary formulation of alpha-1 proteinase inhibitor to
treat patients with alpha-1 antitrypsin deficiency, or genetic emphysema.
Alpha-1 proteinase inhibitor is approved in the United States and several
European countries for augmentation treatment of alpha-1 antitrypsin deficiency.
Current treatment is given by systemic intravenous infusion on a weekly basis.
This "replacement therapy" consists of a concentrated form of alpha-1 proteinase
inhibitor derived from human plasma. Under the terms of the collaboration,
Aventis Behring will receive commercialization rights worldwide excluding Japan
and Inhale will receive royalties on product sales, an up-front signing fee and
up to an estimated $15 million in research and development funding and milestone
payments.

The two companies have completed preclinical work that indicates Inhale's
dry powder formulation of Aventis Behring's alpha-1 proteinase inhibitor has the
potential to significantly improve the efficiency of delivery compared with
current infusion therapy. Inhale believes its pulmonary delivery system could
significantly reduce the amount of drug needed for genetic emphysema therapy
since alpha-1 proteinase inhibitor could be delivered directly to the lung.
Aventis Behring is currently negotiating to secure rights under patents that
have been granted in Europe directed to aerosol formulations for the treatment
of the lung containing serine protease inhibitors, including alpha-1 proteinase
inhibitor. In December 1999, patient dosing began for Phase I clinical trials.

AVONEX-REGISTERED TRADEMARK- PROGRAM

In February 1999, Inhale entered into a collaborative agreement with Biogen
to develop an inhaleable formulation of Biogen's proprietary Interferon-Beta-1a,
marketed as AVONEX-Registered Trademark-, for the treatment of Multiple
Sclerosis. Multiple Sclerosis is believed to be the most common chronic
neurological condition of young adults in North America and Europe. It is
estimated that over 250,000 people in the United States are currently affected
by Multiple Sclerosis and that approximately 10,000 new cases are diagnosed
annually in the United States. Under the terms of the agreement, Inhale will
receive royalties on product sales, an up-front signing fee, and up to an
estimated $25 million in research and development funding and potential progress
payments. Biogen will provide bulk AVONEX-Registered Trademark- to Inhale for
formulation into a dry powder which is stable at room temperature. Inhale will
manufacture and package the dry powder and supply inhalation devices. Biogen
will be responsible for clinical trials, marketing and commercialization.

PROPRIETARY MOLECULE PROGRAM WITH LILLY

In January 1998, Lilly and Inhale entered into a collaborative agreement to
develop an inhaleable formulaton for an undisclosed protein product based on
Inhale's deep lung drug delivery system. Under the terms of the agreement,
Inhale will receive funding of up to $20 million in research, development and
milestone payments. Lilly will receive global commercialization rights for the
pulmonary delivery of the products with Inhale receiving royalties on sales of
any marketed products. Inhale will manufacture packaged powders for, and supply
inhalation devices to, Lilly.

PTH PROGRAM

In January 1997, Inhale entered into a collaborative agreement with Lilly to
develop pulmonary delivery for parathyroid hormone (PTH 1-34) with the target
indication of treatment and prevention of osteoporosis. At this time,
osteoporosis was estimated to affect approximately 25 million Americans, mostly
women. If not prevented or left untreated, osteoporosis can progress painlessly
until a bone breaks. As many as 35,000 people die each year from a cause
associated with hip fractures, primarily due to complications that result from
surgery or from being confined to bed.

In late 1998, unexpected observations from a long-term test in rats of the
injectable version of this PTH 1-34 led Lilly to suspend further clinical
development of the injectable and pulmonary versions of this

10

drug pending further analysis. Inhale is maintaining a minimum development
effort in its pulmonary program pending further direction from Lilly. Depending
on the continued evaluations by Lilly, this inhalation program could be
re-initiated, suspended for an extended period, or possibly terminated. Inhale
does not currently believe that this program will be re-initiated by Lilly in
the near future, if at all.

INHALE'S PROGRAMS AVAILABLE OR EXPECTED TO BE AVAILABLE FOR PARTNERING

CALCITONIN PROGRAM

Inhale is funding a proprietary program to develop a pulmonary formulation
of calcitonin for the treatment of osteoporosis, bone pain and Paget's disease.
Calcitonin is a peptide hormone secreted by the thyroid gland that inhibits bone
resorption and lowers serum calcium. Calcitonin is available in two forms, fish
and human. Calcitonin is administered daily or every other day by injection in
the United States. In the United States, salmon calcitonin is approved for the
treatment of postmenopausal osteoporosis, Paget's disease, hypercalcemia of
cancer and bone pain. Human calcitonin is approved for Paget's disease and bone
pain. Paget's disease is a chronic disorder of the adult skeleton, in which
localized areas of bone become hyperactive and are replaced by a softened and
enlarged bone structure. About 3% of Caucasians in the United States over age 60
have Paget's disease. Hypercalcemia occurs as a result of excessive serum
calcium levels caused by hyperparathyroidism and malignancy. It occurs in
approximately 10-20% of cancer patients.

In April 1997, Inhale announced the successful completion of Phase I trials
to investigate the tolerability and bioavailability of pulmonary delivery of a
dry powder, aerosolized form of salmon calcitonin as a potential treatment for
osteoporosis, Paget's disease, hypercalcemia and other bone diseases. The
single-dose study conducted in the United Kingdom with a total of 36 fasted
healthy subjects indicated that the drug was systemically absorbed when
delivered by the pulmonary route with Inhale's system. Inhale is continuing work
on this program while it seeks a partner for further clinical development.

INTERLEUKIN-1 RECEPTOR PROGRAM

Interleukin-1 is a cytokine that helps initiate the inflammatory response to
foreign pathogens and is believed to be a causative factor for asthma. The
interleukin-1 receptor is a molecule which can block the inflammatory action of
Interleukin-1. Inhale collaborated with Immunex to develop a pulmonary
formulation of interleukin-1 receptor as a therapeutic product for asthma.
Initial formulation development and animal toxicology have been completed, and
the two companies successfully completed Phase I/II trials demonstrating
pulmonary delivery. This program is awaiting further work and/or licensing by
Immunex.

MOLECULE PROGRAMS FORMERLY PARTNERED WITH BAXTER

In March 1996, Inhale entered into a collaborative agreement with Baxter
International Inc. to use Inhale's dry powder pulmonary delivery system as a
technology platform for developing and launching therapeutic products. In
connection with the collaboration, Baxter made a $20 million equity investment
in Inhale at a 25% premium to the market price of Inhale stock at the time of
the investment. At that time, Baxter received worldwide commercialization rights
for four non-protein/peptide drugs in exchange for up to an estimated
$60 million in research and development funding and progress payments.

In April 1998, Inhale announced that the first two compounds from its
collaboration with Baxter had successfully completed Phase I and Phase II trials
respectively. In addition, it was announced that the program would focus on the
product that had completed Phase I as it was the product with the most
commercial potential. The technology from one of the three remaining products
was returned to Inhale, leaving the development of the other two compounds on
hold. In October 1998, Inhale announced that it had reached an agreement with
Baxter to amend their collaborative agreement to facilitate signing a new
corporate partner to fund further development and commercialization of the
undisclosed compound that

11

had been their focus since April 1998. Baxter's obligations under that amendment
expired in September 1999. As a result, rights to the compounds reverted to
Inhale and are now available for other partnering opportunities.

OTHER PROGRAMS

In addition to the above mentioned programs, Inhale has conducted and
continues to conduct feasibility studies with respect to additional drug
formulations both for its own account and in cooperation with potential
partners. Inhale will continue to pursue these and other feasibility programs to
determine the potential for collaborative development programs with respect to
these drugs. Included among such studies is initial research on a long-acting
inhaleable insulin. Some diabetic patients require a long-acting insulin to
maintain baseline insulin levels. A long-acting, inhaleable form of insulin
could be used by these patients as a supplement to short-acting, mealtime
inhaleable insulin. This program is part of a broader sustained release program
announced by Inhale in January 1999.

MANUFACTURING

Inhale generally plans to formulate, manufacture and package the powders for
its deep lung delivery products and to subcontract the manufacture of its
proprietary pulmonary delivery devices. Under its collaborative agreement with
Pfizer to develop inhaleable insulin, Inhale will manufacture insulin powders
and Pfizer will be primarily responsible for filling blisters. The terms of the
collaborative agreement with Pfizer provide that prior to the commercialization
of its first products, Inhale must build and have validated a powder processing
facility and must have validated a device manufacturer or manufacturers. Inhale
believes its manufacturing strategy will enable it to achieve the following:

- provide economies of scale by utilizing manufacturing capacity for
multiple products;

- improve its ability to retain any manufacturing know-how; and

- allow its customers to bring pulmonary delivery products to market faster.

Inhale has built a powder manufacturing and packaging facility in San
Carlos, California capable of producing powders in quantities sufficient for
clinical trial. This facility has been inspected and licensed by the State of
California and is used to manufacture and package powders under current good
manufacturing practices. Inhale is expanding its facility to meet its future
commercial manufacturing commitments.

Inhale is working to further scale-up its powder processing to a larger
production scale system and to further develop the necessary powder packaging
technologies. Fine particle powders and small quantity packaging (such as those
to be used in Inhale's delivery system) require special handling. Current
commercial packaging systems are designed for filling larger quantities of
larger particle powders and therefore must be modified to dispense finer
particles in the small quantities required by Inhale. Inhale has developed and
validated a proprietary prototype automated filling system which Inhale believes
is capable of supporting its requirements through Phase III trials and into
commercial production for some products. Inhale is developing a higher capacity
automated filling unit capable of filling blisters on a production scale for
moderate and large volume products. Inhale faces significant technical
challenges in developing an automated, commercial-scale filling system that can
accurately and economically handle the small dose and particle sizes of its
powders. There can be no assurance that Inhale will be able to develop or
acquire the technology necessary to develop successfully any such system in a
timely manner or at commercially reasonable cost. Any failure or delay in
developing such technology would delay product development or bar
commercialization of Inhale's products and would have a material adverse effect
on Inhale.

Inhale's proprietary inhalation device has been developed for commercial use
and is being used in the Phase III insulin and other trials in 2000. Inhale
plans to subcontract the manufacture of its pulmonary delivery device before
commercial production of its first product. Inhale has identified contract
manufacturers that it believes have the technical capabilities and production
capacity to manufacture its devices

12

and which can meet the requirements of current good manufacturing practices.
There can be no assurance that Inhale will be able to obtain and maintain
satisfactory contract manufacturing on commercially acceptable terms, if at all.
Inhale's dependence upon third parties for the manufacture of its inhalation
device may adversely affect Inhale's cost of goods and its ability to develop
and commercialize products on a timely and competitive basis.

GOVERNMENT REGULATION

The research and development, manufacture and marketing of pulmonary drug
delivery systems are subject to regulation by the FDA in the United States and
by comparable regulatory agencies in other countries. These national agencies
and other federal, state and local entities regulate, among other things,
research and development activities and the testing, manufacture, safety,
effectiveness, labeling, storage, record keeping, approval, advertising and
promotion of Inhale's products.

The process required by the FDA before a pulmonary drug delivery system may
be marketed in the United States depends on whether the compound has existing
approval for use in other dosage forms. If the drug is a new chemical entity
that has not been approved, the process includes the following:

- extensive preclinical laboratory and animal testing;

- submission of an Investigational New Drug application ("IND");

- adequate and well-controlled human clinical trials to establish the safety
and efficacy of the drug for the intended indication: and

- submission to the FDA for approval of a New Drug Application ("NDA") with
respect to drugs or a Biological License Application ("BLA") with respect
to biologics.

If the drug has been previously approved, the approval process is similar,
except that certain preclinical tests relating to systemic toxicity normally
required for the IND and NDA/BLA application may not be necessary.

Preclinical tests include laboratory evaluation of product chemistry and
animal studies to assess the potential safety and efficacy of the product and
its formulation. Pulmonary drug products must be formulated according to current
good manufacturing practices, and pre-clinical safety tests must be conducted by
laboratories that comply with FDA good laboratory practices regulations. The
results of the pre-clinical tests are submitted to the FDA as part of an IND
application and are reviewed by the FDA before clinical trials begin. Clinical
trials may begin 30 days after receipt of the IND by the FDA, unless the FDA
raises objections during that period.

Clinical trials involve the administration of the drug to healthy volunteers
or to patients under the supervision of a qualified medical investigator.
Clinical trials are conducted in accordance with protocols that detail the
objectives of the study, the parameters to be used to monitor participant safety
and efficacy or other 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 ("IRB"). The IRB will consider,
among other things, ethical factors, the potential risks to subjects
participating in the trial and the possible liability of the institution.

Clinical trials are typically conducted in three sequential phases, but the
phases may overlap. In Phase I, the initial introduction of the drug into
healthy human subjects, the product generally is tested for tolerability,
pharmacokinetics, absorption, metabolism and excretion. Phase II involves
studies in a limited patient population to:

- determine the efficacy of the product for specific targeted indications;

- determine dosage tolerance and optimal dosage; and

- identify possible adverse effects and safety risks.

13

After Phase II trials demonstrate that administration of the drug by the
pulmonary route is effective and has an acceptable safety profile, Phase III
trials are undertaken to evaluate further clinical efficacy and safety within an
expanded patient population at geographically dispersed clinical study sites.
The FDA, the clinical trial sponsor, the investigators or the IRB may suspend
clinical trials at any time if any one of them believe that study participants
are being exposed to an unacceptable health risk.

The results of product development, pre-clinical studies and clinical
studies are submitted to the FDA as an NDA/BLA for approval of the marketing and
commercial shipment of the pulmonary drug product. The FDA may deny an NDA/BLA
if applicable regulatory criteria are not satisfied or may require additional
clinical testing. Even if such data are submitted, the FDA may ultimately decide
that the NDA/BLA does not satisfy the criteria for approval. Product approvals
may be withdrawn if compliance with regulatory standards are not maintained or
if safety concerns arise after the product reaches the market. The FDA may
require post marketing testing and surveillance programs to monitor the effect
of pulmonary drug products that have been commercialized, and has the power to
prevent or limit future marketing of the product based on the results of such
programs.

Each domestic drug product 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.
Establishments handling controlled substances must be licensed by the United
States Drug Enforcement Administration ("DEA"). Domestic manufacturing
establishments are subject to biennial inspections by the FDA for compliance
with current good manufacturing practices compliance. Inhale is also subject to
U.S. federal, state and local regulations regarding workplace safety,
environmental protection and hazardous and controlled substance controls, among
others.

Many of the drugs with which Inhale is working are already approved for
marketing by the FDA. Inhale believes that when working with approved drugs, the
approval process for delivery by pulmonary drug products may require less time
and fewer tests than for new chemical entities. However, Inhale expects that its
formulations often will use excipients not currently approved for pulmonary use.
Use of these excipients will require additional toxicological testing that may
increase the costs of, or lengthen the time in, gaining regulatory approval. In
addition, regulatory procedures applicable to Inhale's products may change as
regulators gain experience in the area of macromolecules, and any such changes
may delay or increase the cost of regulatory approval.

For the products currently under development, Inhale's device is considered
to be part of a drug/ device combination for deep lung delivery of each specific
molecule. Prior to submission of an IND, the FDA Center and division within the
FDA Center responsible for the review of the IND and NDA/BLA will be identified.
In the case of Inhale's products, either the Center for Drug Evaluation and
Research or the Center for Biologics Evaluation and Research, in consultation
with the Center for Devices and Radiological Health, could be involved in the
review. However, one Center is designated as the Center which has the lead
responsibility for regulating the product. The jurisdiction within the FDA is
based on the primary mode of action of the drug and is identified in the FDA's
intercenter agreement.

Inhale expects that its partners generally will be responsible for clinical
and regulatory approval procedures, but Inhale may participate in this process
by submitting to the FDA a drug master file developed and maintained by Inhale
which contains data concerning the manufacturing processes for the product. The
clinical and manufacuturing development and regulatory review process generally
takes a number of years and requires the expenditure of substantial resources.
Inhale's ability to manufacture and sell products developed under contract
depends upon the partner's completion of satisfactory clinical trials and
obtaining marketing approvals. Inhale may prepare and submit an IND application
and perform initial clinical studies before licensing the product to a partner.
Inhale's business strategy contemplates performing more of these studies in the
future.

14

Sales of Inhale's products outside the United States are subject to local
regulatory requirements governing clinical trials and marketing approval for
drugs and pulmonary delivery systems. Such requirements vary widely from country
to country.

Prior to marketing a new dosage form of any drug, including one developed
for use with Inhale's pulmonary drug delivery system, the product must undergo
rigorous preclinical and clinical testing and an extensive review process
mandated by the FDA and equivalent foreign authorities regardless of whether or
not such drug was already approved for marketing in another dosage form. These
processes generally take a number of years and require the expenditure of
substantial resources. None of Inhale's proposed products has been submitted to
the FDA for marketing approval. Inhale has no experience obtaining such
regulatory approval, does not have the expertise or other resources to do so and
intends to rely on its partners to fund clinical testing and to obtain product
approvals.

PATENTS AND PROPRIETARY RIGHTS

Inhale's policy is to apply for patent protection for the technology,
inventions and improvements deemed important to the development of its business.
Inhale also relies upon trade secrets, know-how, continuing technological
innovations and licensing opportunities to maintain and further develop its
competitive position. Inhale plans to defend aggressively its proprietary
technology and any issued patents.

Inhale expects that its integrated system for pulmonary delivery of both
large and small molecule drugs will yield innovations in dry powder
formulations, powder processing, powder packaging and device design. It is
Inhale's strategy to build proprietary positions in each of its technological
areas. Inhale's success will depend in part upon its ability to protect its
proprietary technology from infringement, misappropriation, duplication and
discovery. Inhale has filed patent applications covering certain aspects of its
device and powder processing technology and powder formulations and pulmonary
route of delivery for certain molecules, and plans to file additional patent
applications. There can be no assurance that any of the patents applied for by
Inhale will issue, or that any patents that issue will be valid and enforceable.
Even if such patents are enforceable, Inhale anticipates that any attempt to
enforce its patents could be time consuming and costly.

Inhale currently has 49 issued U.S. and foreign patents covering certain
aspects of its technology and has a number of patent applications pending. The
United States Patent and Trademark Office (the "PTO") has issued the following
patents to Inhale:

- Patent No. 5,458,135 (October 17, 1995) for certain claims covering the
use of its device in a method for delivering aerosolized (including
powder) formulations of drugs to the lung.

- Patent No. 5,607,915 (March 4, 1997) for pulmonary delivery of active
fragments of parathyroid hormone (PTH) 1-34.

- Patent No. 5,654,007 (August 5, 1997) for a system and methods for
processing fine dispersible powders for easier processing.

- Patent No. 5,740,794 (April 21, 1998) for a method and means to access a
packaged drug, to break up a dry powder drug into particles with
compressed air (aerosolize), and to transport the aerosolized drug into a
holding chamber.

- Patent No. 5,775,320 (July 7, 1998) for a method and means for dispersing
a dry-powder or liquid drug, and transferring the drug in its aerosolized
"cloud" form to a holding chamber where it is held until a patient is
ready to inhale, as well as a method and means to pull in atmospheric
"chase" air following the initial inhalation to help push the drug into
the deep lung.

- Patent No. 5,780,014 (July 14, 1998) for methods and means for pulmonary
delivery of dry powder alpha1-antitrypsin, a proteinase inhibitor, for
administration to a patient.

15

- Patent No. 5,785,049 (July 28, 1998) for approximately 50 claims directed
to methods and means for aerosolizing dry powders through use of a high
pressure gas stream to draw dry powder from a receptacle such as a blister
pack and for which Inhale utilizes the design described therein to achieve
efficient aerosolization of fine dry powders to enable deep lung delivery
for systemic absorption.

- Patent No. 5,814,607 (September 29, 1998) for pulmonary delivery of active
fragments of parathyroid hormone of between 34 and 38 amino acids in
length.

- Patent No. 5,826,633 (October 27, 1998) relating to Inhale's powder
handling technologies, including the process of transferring fine powder
particles into blister packs in an un-compacted state so that they can be
easily dispersed in Inhale's pulmonary delivery system.

- Patent No. 5,922,354 (July 13, 1999) for a method for preparing fine
particles by agglomeration.

- Patent No. 5,928,469 (July 27, 1999) for a method for preparing storage
stable compositions. In this method, a material to be stored and a glass
forming substance are spray-dried to form stable particles.

- Patent No. 5,976,574 (November 2, 1999) for a process for spray-drying
hydrophobic drugs in organic solvent suspensions.

- Patent No. 5,985,248 (November 16, 1999) for a process for spray-drying a
hydrophobic drug and a hydrophilic excipient in an organic solvent and
compositions formed by the process.

- Patent No. 5,993,783 (November 30, 1999) for a respirable
alpha-1-antitrypsin dry powder having an areodynamic diameter of less than
5 Microns.

- Patent No. 5,994,314 (November 30, 1999) for dry powder nucleic acid
compositions and methods for their preparation.

- Patent No. 5,997,848 (December 7, 1999) for pulmonary administration of
dry powder insulin which is rapidly absorbed through the alveoli into the
systemic circulation.

- Patent No. 6,001,336 (December 14, 1999) for a process for spray drying a
hydrophobic drug in an aqueous suspension with a hydrophilic component.

In November, 1999, Inhale acquired from Alliance Pharmaceutical Corp. its
PulmoSpheres-Registered Trademark- technology and other related assets for
particle formulation and powder processing, subject to the terms and conditions
of an asset purchase agreement. The PulmoSpheres-Registered Trademark-
technology utilizes an emulsification process to produce a powder having
characteristics that Inhale believes may improve efficiency and reproducibility
for drugs delivered to the lung through alternative technologies such as MDIs as
well as potentially improve drug delivery through Inhale's proprietary deep lung
drug delivery system. The assets acquired included Alliance's intellectual
property portfolio for PulmoSpheres-Registered Trademark- consisting of, among
other things, several patent applications. With respect to applications of the
PulmoSpheres-Registered Trademark- technology outside the respiratory field,
Inhale has licensed the technology back to Alliance. While Alliance has made
several representations in its agreement with Inhale regarding its ownership
rights of the PulmoSpheres-Registered Trademark- technology, it is possible that
third parties might assert claims challenging Alliance's rights, and thus
Inhale's rights. Even if Inhale can defend its rights successfully, the
uncertainty regarding the status of its rights during the time any such
litigation is pending may prevent Inhale from using the underlying technology.

In March 1998, Inhale and Initiatech Inc. signed an agreement under which
Inhale licensed technology, intellectual property, and patents for protecting
biologically active compounds in the dry state. Inhale intends to use this
technology to expand its current technology base in stabilizing dry powder
aerosol formulations for peptides, proteins, and other macromolecules at room
temperature. Inhale's license is exclusive for the fields of respiratory
delivery of pharmaceutical products and for any delivery form of insulin. The
license includes rights to two issued U.S. patents and a Canadian patent
covering the

16

protection of biological materials from degradation in the dry state. Initiatech
has licensed exclusive rights to this technology from the Boyce Thompson
Institute for Plant Research, Inc.

In June 1997, Inhale acquired the intellectual property portfolio of the
BioPreservation Division of Pafra. This portfolio includes issued U.S. and
foreign Letters Patent and pending applications relating to the stabilization of
macromolecule drugs in dry formulations. An application for reissue of the
original U.S. patent included in this portfolio is pending in the PTO. There can
be no assurance that Inhale will be successful in obtaining a reissued patent. A
second U.S. patent from this portfolio issued to Inhale on July 27, 1999 and is
noted above. A granted European patent included in this portfolio was the
subject of an opposition proceeding before the European Patent Office. The
opposition hearing was held on December 16, 1999. Inhale successfully defended
the patent and its method claims relating to glass stabilization technology
against four opposing parties. In addition, in late 1999, based on claims of
this granted European patent, Inhale filed an infringement action in the courts
of the United Kingdom against Quadrant Healthcare plc. There can be no assurance
that any of the other Pafra patent applications will be held to be valid and
enforceable. The inability to obtain or defend the Pafra patents could have a
material adverse effect on Inhale.

Inhale has obtained license rights to certain know-how and patent
applications owned by Genentech, Inc. covering formulations, powder processing
and pulmonary delivery of certain molecules, which it believes could be
important to the development of its business. These license rights are
worldwide, nonexclusive, sublicensable and royalty free. In 1997, Genentech
successfully defended an opposition proceeding involving a pending European
patent licensed to Inhale. Recently, this decision was upheld on appeal. The
pending patent covers the pulmonary delivery of cytokines and growth factors.

The patent positions of pharmaceutical, biotechnology and drug delivery
companies, including Inhale, are uncertain and involve complex legal and factual
issues. Additionally, the coverage claimed in a patent application can be
significantly reduced before the patent is issued. As a consequence, Inhale does
not know whether any of its patent applications will be granted with broad
coverage or whether the claims that eventually issue will be circumvented. Since
patent applications in the United States are maintained in secrecy until patents
issue, and since publication of discoveries in scientific or patent literature
often lag behind actual discoveries, Inhale cannot be certain that it was the
first inventor of inventions covered by its issued patents or pending patent
applications or that it was the first to file patent applications for such
inventions. Moreover, Inhale may have to participate in interference proceedings
declared by the PTO to determine priority of invention, which could result in
substantial cost to Inhale, even if the eventual outcome is favorable. An
adverse outcome could subject Inhale to significant liabilities to third
parties, require disputed rights to be licensed from or to third parties or
require Inhale to cease using the technology in dispute.

Inhale is aware of numerous pending and issued U.S. and foreign patent
rights and other proprietary rights owned by third parties that relate to
aerosol devices and delivery, pharmaceutical formulations, dry powder processing
technology and the pulmonary route of delivery for certain powder formulations
of macromolecules. Inhale cannot predict with any certainty which, if any,
patent references will be considered relevant to its technology by authorities
in the various jurisdictions where such rights exist, nor can Inhale predict
with certainty which, if any, of these rights will or may be asserted against it
by such third parties. There can be no assurance that Inhale can obtain any
license to any technology that it determines it needs, on reasonable terms, if
at all, or that Inhale could develop or otherwise obtain alternate technology.
The failure to obtain licenses if needed would have a material adverse effect on
Inhale.

Inhale also relies upon trade secret protection for its confidential and
proprietary information. No assurance can be given that others will not
independently develop substantially equivalent proprietary information and
techniques or otherwise gain access to Inhale's trade secrets or disclose such
technology, or that Inhale can meaningfully protect its trade secrets.

17

Third parties from time to time have asserted or may assert that Inhale is
infringing their proprietary rights based upon issued patents, trade secrets or
know-how that they believe cover Inhale's technology. In addition, future
patents may issue to third parties which Inhale's technology may infringe.
Inhale could incur substantial costs in defending itself and its partners
against any such claims. Furthermore, parties making such claims may be able to
obtain injunctive or other equitable relief which could effectively block
Inhale's ability to further develop or commercialize some or all of its products
in the United States and abroad, and could result in the award of substantial
damages. In the event of a claim of infringement, Inhale and its partners may be
required to obtain one or more licenses from third parties. There can be no
assurance that Inhale or its partners will be able to obtain such licenses at a
reasonable cost, if at all. Defense of any lawsuit or failure to obtain any such
required license could have a material adverse effect on Inhale.

Inhale's ability to develop and commercialize its technology will be
affected by its or its partners' access to the drugs which are to be formulated.
Many biopharmaceutical drugs, including some of those which are presently under
development by Inhale, are subject to issued and pending United States and
foreign patent rights which may be owned by competing entities. There are issued
patents and pending patent applications relating to the pulmonary delivery of
macromolecule drugs, including several for which Inhale is developing pulmonary
delivery formulations. Inhale intends generally to rely on the ability of its
partners to provide access to the drugs which are to be formulated for pulmonary
delivery. There can be no assurance, however, that Inhale's partners will be
able to provide access to drug candidates for formulation for pulmonary delivery
or that, if such access is provided, Inhale or its partners will not be accused
of, or determined to be, infringing a third party's rights and will not be
prohibited from working with the drug or be found liable for damages that may
not be subject to indemnification. Any such restriction on access or liability
for damages would have a material adverse effect on Inhale.

It is Inhale's policy to require its employees and consultants, outside
scientific collaborators, sponsored researchers and other advisors who receive
confidential information from Inhale to execute confidentiality agreements upon
the commencement of employment or consulting relationships with Inhale. These
agreements provide that all confidential information developed or made known to
the individual during the course of the individual's relationship with Inhale is
to be kept confidential and not disclosed to third parties except in specific
circumstances. The agreements provide that all inventions conceived by an
employee shall be the property of Inhale. There can be no assurance, however,
that these agreements will provide meaningful protection or adequate remedies
for Inhale's trade secrets in the event of unauthorized use or disclosure of
such information.

COMPETITION

Inhale believes that products developed using its technology will compete on
the basis of system efficiency, dosage reproducibility, safety, patient
convenience and cost. There is intense competition to develop a solution to the
non-invasive delivery of drugs from several drug delivery and pharmaceutical
companies, many of which are much larger and have far greater resources than
Inhale. These include companies working on developing systems for other
non-invasive routes of delivery, such as oral, transdermal, bucal, nasal, and
needle-less injections, as well as companies working on pulmonary delivery
systems. In addition, several companies are working on sustained release
injectable systems. While these latter systems involve injections, the lower
number of injections could be competitive with Inhale's pulmonary delivery
technology in certain applications. Inhale believes its technology and
integrated pulmonary delivery systems approach provides it with important
competitive advantages in the delivery of drugs compared with currently known
alternatives. However, new drugs or further developments in alternative drug
delivery methods may provide greater therapeutic benefits for a specific drug or
indication, or may offer comparable performance at lower cost than Inhale's
proprietary deep lung drug delivery system.

18

With respect to pulmonary delivery, several companies are marketing and
developing dry powder, MDI, liquid and nebulizer devices that could have
applications for drug delivery, including Dura Pharmaceuticals, Inc. and Aradigm
Corporation, which also have collaborative arrangements with corporate partners
for the development of pulmonary delivery systems for insulin. Several of these
companies may have or may be developing dry powder devices that could be used
for pulmonary delivery of proteins and other macromolecules. There can be no
assurance that competitors will not introduce products or processes competitive
with or superior to those of Inhale. Inhale intends to monitor competitive
device activities and continue to focus its activities on those products for
which Inhale believes it has and can maintain a competitive advantage. If a
device is developed that is superior to Inhale's for certain applications,
Inhale may seek to obtain a license to allow Inhale's partners to use such
device with Inhale-developed powders, although there can be no assurance that
Inhale would be able to do so.

Inhale's success depends upon maintaining a competitive advantage in the
development of products and technologies for pulmonary delivery of
pharmaceutical drugs. If a competing company were to develop or acquire rights
to a better system for efficiently and reproducibly delivering macromolecule
drugs to the deep lung, a non-invasive drug delivery system which is more
attractive for delivery drugs to the deep lung, a non-invasive delivery system
which is more attractive for the delivering of drugs than pulmonary delivery, or
an invasive delivery system which overcomes some of the drawbacks of current
invasive systems for chronic or subtonic indications (such as sustained release
systems), Inhale's business would be negatively impacted.

Inhale is in competition with pharmaceutical, biotechnology and drug
delivery companies, hospitals, research organizations, individual scientists and
nonprofit organizations engaged in the development of alternative drug delivery
systems or new drug research and testing, as well as with entities producing and
developing injectable drugs. Inhale is aware of a number of companies currently
seeking to develop new products and non-invasive alternatives to injectable drug
delivery, including oral delivery systems, intranasal delivery systems,
transdermal systems, bucal and colonic absorption systems. Several of these
companies may have developed or are developing dry powder devices that could be
used for pulmonary delivery of macromolecules. Many of these companies and
entities have greater research and development capabilities, experience,
manufacturing, marketing, financial and managerial resources than Inhale and
represent significant competition for Inhale. Acquisitions of competing drug
delivery companies by large pharmaceutical companies could enhance competitors'
financial, marketing and other resources. Accordingly, Inhale's competitors may
succeed in developing competing technologies, obtaining FDA approval for
products or gaining market acceptance more rapidly than Inhale. Developments by
others may render Inhale's products or technologies noncompetitive or obsolete.

EMPLOYEES AND CONSULTANTS

As of December 31, 1999, Inhale had 339 employees, of which 252 were engaged
in research and development (including manufacturing) activities and 87 in
general administration and business development. One hundred twenty-five of the
employees hold advanced degrees, of which 88 are Ph.D.s. Inhale employs
scientists and engineers with expertise in the areas of pulmonary biology,
aerosol science, powder technology, mechanical engineering, protein chemistry
and chemical engineering. None of Inhale's employees are covered by a collective
bargaining agreement and Inhale has experienced no work stoppages. Inhale
believes that it maintains good relations with its employees.

To complement its own expertise, Inhale utilizes specialists in regulatory
affairs, pulmonary toxicology, process engineering, manufacturing, quality
assurance, device design, clinical trial design and business development. These
individuals include certain of Inhale's scientific advisors as well as
independent consultants. See "Management."

19

RISK FACTORS

THE FOLLOWING RISK FACTORS SHOULD BE READ CAREFULLY IN CONNECTION WITH
EVALUATING INHALE'S BUSINESS. ANY OF THE FOLLOWING RISKS COULD MATERIALLY
ADVERSELY AFFECT INHALE'S BUSINESS AND OPERATING RESULTS OR FINANCIAL CONDITION.

WE DO NOT KNOW IF OUR DEEP LUNG DRUG DELIVERY SYSTEM IS COMMERCIALLY FEASIBLE.

We are in an early stage of development. There is a risk that our deep lung
drug delivery technology will not be commercially feasible. Even if our deep
lung delivery technology is commercially feasible, it may not be commercially
accepted across a range of large and small molecule drugs. We have tested seven
deep lung delivery formulations in humans, but many of our potential
formulations have not been tested in humans.

Many of the underlying drug compounds contained in our deep lung
formulations have been tested in humans by other companies using alternative
delivery routes. Our potential products require extensive research, development
and pre-clinical (animal) and clinical (human) testing. Our potential products
also may involve lengthy regulatory review before they can be sold. We do not
know if and cannot assure you that, any of our potential products will prove to
be safe and effective or meet regulatory standards. There is a risk that any of
our potential products will not be able to be produced in commercial quantities
at acceptable cost or marketed successfully. Our failure to achieve commercial
feasibility, demonstrate safety, achieve clinical efficacy, obtain regulatory
approval or, together with partners, successfully market products will
negatively impact our revenues and results of operations.

WE DO NOT KNOW IF OUR DEEP LUNG DRUG DELIVERY SYSTEM IS EFFICIENT.

We may not be able to achieve the total system efficiency needed to be
competitive with alternative routes of delivery. Total system efficiency is
determined by the amount of drug loss during manufacture, in the delivery
device, in reaching the site of absorption, and during absorption from that site
into the bloodstream. Deep lung bioavailability is the percentage of a drug that
is absorbed into the bloodstream when that drug is delivered directly to the
lungs as compared to when the drug is delivered by injection. Bioavailability is
the initial screen for whether deep lung delivery of any systemic drug is
commercially feasible. We would not consider a drug to be a good candidate for
development and commercialization if its drug loss is excessive at any one stage
or cumulatively in the manufacturing and delivery process or if its deep lung
bioavailability is too low.

WE DO NOT KNOW IF OUR DEEP LUNG DRUG FORMULATIONS ARE STABLE.

We may not be able to identify and produce powdered versions of drugs that
retain the physical and chemical properties needed to work with our delivery
device. Formulation stability is the physical and chemical stability of the drug
over time and under various storage, shipping and usage conditions. Formulation
stability will vary with each deep lung formulation and the type and amount of
ingredients that are used in the formulation. Problems with powdered drug
stability would negatively impact our ability to develop and market our
potential products or obtain regulatory approval.

WE DO NOT KNOW IF OUR DEEP LUNG DRUG DELIVERY SYSTEM IS SAFE.

We may not be able to prove potential products to be safe. Our products
require lengthy laboratory, animal and human testing. Most of our products are
in preclinical testing or the early stage of human testing. If we find that any
product is not safe, we will not be able to commercialize the product. The
safety of our deep lung formulations will vary with each drug and the
ingredients used in its formulation.

20

WE DO NOT KNOW IF OUR DEEP LUNG DRUG DELIVERY SYSTEM PROVIDES CONSISTENT DOSES
OF MEDICINE.

We may not be able to provide reproducible dosages of stable formulations
sufficient to achieve clinical success. Reproducible dosing is the ability to
deliver a consistent and predictable amount of drug into the bloodstream over
time both for a single patient and across patient groups. Reproducible dosing
requires the development of:

- an inhalation device that consistently delivers predictable amounts of dry
powder formulations to the deep lung;

- accurate unit dose packaging of dry powder formulations; and

- moisture resistant packaging.

We may not be able to develop reproducible dosing of any potential product.
The failure to do so means that we would not consider it a good candidate for
development and commercialization.

WE DEPEND ON PARTNERS FOR REGULATORY APPROVALS AND COMMERCIALIZATION OF OUR
PRODUCTS.

Because we are in the business of developing technology for delivering drugs
to the lungs and licensing this technology to companies that make and sell
drugs, we do not have the people and other resources to do the following things:

- make bulk drugs to be used as medicines;

- design and carry out large scale clinical studies;

- prepare and file documents necessary to obtain government approval to sell
a given drug product; and

- market and sell our products when and if they are approved.

When we sign a collaborative development agreement or license agreement to
develop a product with a drug company, the drug company agrees to do some or all
of the things described above. If our partner fails to do any of these things,
we cannot complete the development of the product.

WE MAY NOT OBTAIN REGULATORY APPROVAL FOR OUR PRODUCTS ON A TIMELY BASIS, OR AT
ALL.

There is a risk that we will not obtain regulatory approval for our products
on a timely basis, or at all. Our product must undergo rigorous animal and human
testing and an extensive review process mandated by the United States Food and
Drug Administration ("FDA") and equivalent foreign authorities. This process
generally takes a number of years and requires the expenditure of substantial
resources; although the time required for completing such testing and obtaining
such approvals is uncertain. We have not submitted any of our products to the
FDA for marketing approval. We have no experience obtaining such regulatory
approval.

In addition, we may encounter delays or rejections based upon changes in FDA
policy, including policy relating to good manufacturing practice compliance,
during the period of product development. We may encounter similar delays in
other countries.

Even if regulatory approval of a product is granted, the approval may limit
the indicated uses for which we may market our product. In addition, our
marketed product, our manufacturing facilities and Inhale, as the manufacturer,
will be subject to continual review and periodic inspections. Later discovery
from such review and inspection of previously unknown problems may result in
restrictions on our product or on us, including withdrawal of our product from
the market. The failure to obtain timely regulatory approval of our products,
any product marketing limitations or a product withdrawal would negatively
impact our revenues and results of operations.

21

WE DO NOT KNOW IF OUR TECHNOLOGIES CAN BE INTEGRATED SUCCESSFULLY TO BRING
PRODUCTS TO MARKET.

We may not be able to integrate all of the relevant technologies to provide
a deep lung drug delivery system. Our integrated approach to systems development
relies upon several different but related technologies:

- dry powder formulations;

- dry powder processing technology;

- dry powder packaging technology; and

- deep lung delivery devices.

At the same time we must:

- establish collaborations with partners;

- perform laboratory and clinical testing of potential products; and

- scale-up our manufacturing processes.

We must accomplish all of these steps without delaying any aspect of
technology development. Any delay in one component of product or business
development could delay our ability to develop, obtain approval of or market
therapeutic products using our deep lung delivery technology.

WE MAY NOT BE ABLE TO MANUFACTURE OUR PRODUCTS IN COMMERCIAL QUANTITIES.

POWDER PROCESSING. We have no experience manufacturing products for
commercial purposes. We have only performed powder processing on the small scale
needed for testing formulations and for early stage and larger clinical trials.
We may encounter manufacturing and control problems as we attempt to scale-up
powder processing facilities. We may not be able to achieve such scale-up in a
timely manner or at a commercially reasonable cost, if at all. Our failure to
solve any of these problems could delay or prevent late stage clinical testing
and commercialization of our products and could negatively impact our revenues
and results of operations.

To date, we have relied on one particular method of powder processing. There
is a risk that this technology will not work with all drugs or that the cost of
drug production will preclude the commercial viability of certain drugs.
Additionally, there is a risk that any alternative powder processing methods we
may pursue will not be commercially practical for aerosol drugs or that we will
not have, or be able to acquire the rights to use, such alternative methods.

POWDER PACKAGING. Our fine particle powders and small quantity packaging
require special handling. We have designed and qualified automated filling
equipment for small and moderate quantity packaging of fine powders. We face
significant technical challenges in scaling-up an automated filling system that
can handle the small dose and particle sizes of our powders in commercial
quantities. There is a risk that we will not be able to scale-up our automated
filling equipment in a timely manner or at commercially reasonable costs. Any
failure or delay in such scale-up would delay product development or bar
commercialization of our products and would negatively impact our revenues and
results of operations.

INHALATION DEVICE. We face many technical challenges in further developing
our inhalation device to work with a broad range of drugs, to produce such a
device in sufficient quantities and to adapt the device to different powder
formulations. In addition, we are attempting to develop a smaller inhalation
device, which presents particular technical challenges. There is a risk that we
will not successfully achieve any of these challenges. Our failure to overcome
any of these challenges would negatively impact our revenues and results of
operations.

22

For late stage clinical trials and initial commercial production, we intend
to use one or more contract manufacturers to produce our drug delivery device.
There is a risk that we will not be able to enter into or maintain arrangements
with any potential contract manufacturers or effectively scale-up production of
our drug delivery devices through contract manufacturers. Our failure to do so
would negatively impact our revenues and results of operations.

WE DEPEND ON SOLE OR EXCLUSIVE SUPPLIERS FOR OUR INHALATION DEVICE AND BULK
DRUGS.

We plan to subcontract the manufacture of our pulmonary delivery device
before commercial production of our first product. We have identified contract
manufacturers that we believe have the technical capabilities and production
capacity to manufacture our devices and which can meet the requirements of good
manufacturing practices. We cannot be assured that we will be able to obtain and
maintain satisfactory contract manufacturing on commercially acceptable terms,
if at all. Our dependence on third parties for the manufacture of our inhalation
device may negatively impact our cost of goods and our ability to develop and
commercialize products on a timely and competitive basis.

We obtain the bulk drugs we use to formulate and manufacture the dry powders
for our deep lung delivery system from sole or exclusive sources of supply. For
example, with respect to our source of bulk insulin, we have entered into a
collaborative agreement with Pfizer which has, in turn, entered into an
agreement with Aventis to manufacture biosynthetic recombinant insulin. Under
the terms of their agreement, Pfizer and Aventis agreed to construct a jointly
owned manufacturing plant in Frankfurt, Germany. Until its completion, Pfizer
will provide us with insulin from Aventis's existing plant. If our sole or
exclusive source suppliers fail to provide bulk drugs in sufficient quantities
when required, our revenues and results of operations will be negatively
impacted.

WE DO NOT KNOW IF THE MARKET WILL ACCEPT OUR DEEP LUNG DRUG DELIVERY SYSTEM.

The commercial success of our potential products depends upon market
acceptance by health care providers, third-party payors like health insurance
companies and Medicare, and patients. Our products under development use a new
method of drug delivery and there is a risk that our potential products will not
be accepted by the market. Market acceptance will depend on many factors,
including:

- the safety and efficacy of our clinical trials;

- favorable regulatory approval and product labeling;

- the frequency of product use;

- the availability of third-party reimbursement;

- the availability of alternative technologies; and

- the price of our products relative to alternative technologies.

There is a risk that health care providers, patients or third-party payors
will not accept our deep lung drug delivery system. If the market does not
accept our potential products, our revenues and results of operations would be
significantly and negatively impacted.

IF OUR PRODUCTS ARE NOT COST EFFECTIVE, GOVERNMENT AND PRIVATE INSURANCE PLANS
MAY NOT PAY FOR OUR PRODUCTS.

In both domestic and foreign markets, sales of our products under
development will depend in part upon the availability of reimbursement from
third-party payors, such as government health administration authorities,
managed care providers, private health insurers and other organizations. In
addition, such third-party payors are increasingly challenging the price and
cost effectiveness of medical products and services. Significant uncertainty
exists as to the reimbursement status of newly approved health care

23

products. Legislation and regulations affecting the pricing of pharmaceuticals
may change before our proposed products are approved for marketing. Adoption of
such legislation and regulations could further limit reimbursement for medical
products. A government or third-party payor decision to not provide adequate
coverage and reimbursements for our products would limit market acceptance of
such products.

WE EXPECT TO CONTINUE TO LOSE MONEY FOR THE NEXT SEVERAL YEARS.

We have never been profitable and, through December 31, 1999, we have an
accumulated deficit of approximately $94.5 million. We expect to continue to
incur substantial and increasing losses over at least the next several years as
we expand our research and development efforts, testing activities and
manufacturing operations, and as we further expand our late stage clinical and
early commercial production facility. All of our potential products are in
research or in the early stages of development except for our insulin
collaboration. We have generated no revenues from approved product sales. Our
revenues to date have consisted primarily of payments under short-term research
and feasibility agreements and development contracts. To achieve and sustain
profitable operations, we must, alone or with others, successfully develop,
obtain regulatory approval for, manufacture, introduce, market and sell products
using our deep lung drug delivery system. There is a risk that we will not
generate sufficient product or contract research revenue to become profitable or
to sustain profitability.

WE MAY NEED TO RAISE ADDITIONAL CAPITAL THAT MAY NOT BE AVAILABLE.

We anticipate that our existing capital resources will enable us to maintain
currently planned operations through at least the next 24 months. However, this
expectation is based on our current operating plan, which is expected to change
as a result of many factors, and we may need additional funding sooner than
anticipated. In addition, we may choose to raise additional capital due to
market conditions or strategic considerations, even if we believe we have
sufficient funds for our current or future operating plans. To the extent that
additional capital is raised through the sale of equity or convertible debt
securities, the issuance of such securities could result in dilution to our
stockholders.

We have no credit facility or other committed sources of capital. To the
extent operating and capital resources are insufficient to meet future
requirements, we will have to raise additional funds to continue the development
and commercialization of our technologies. Such funds may not be available on
favorable terms, or at all. In particular, our substantial leverage may limit
our ability to obtain additional financing. If adequate funds are not available
on reasonable terms, we may be required to curtail operations significantly or
to obtain funds by entering into financing, supply or collaboration agreements
on unattractive terms. Our inability to raise capital could negatively impact
our business.

OUR PATENTS MAY NOT PROTECT OUR PRODUCTS AND OUR PRODUCTS MAY INFRINGE ON
THIRD-PARTY PATENT RIGHTS.

We have filed patent applications covering certain aspects of our device,
powder processing technology, and powder formulations and deep lung route of
delivery for certain molecules, and we plan to file additional patent
applications. We currently have 49 issued U.S. and foreign patents that cover
certain aspects of our technology and we have a number of patent applications
pending. There is a risk that many of the patents applied for will not issue, or
that any patents that issue or have issued will not be valid and enforceable.
Enforcing our patent rights would be time consuming and costly.

Our access or our partners' access to the drugs to be formulated will affect
our ability to develop and commercialize our technology. Many drugs, including
powder formulations of certain drugs that are presently under development by us,
are subject to issued and pending U.S. and foreign patents that may be owned by
our competitors. We know that there are issued patents and pending patent
applications relating to the deep lung delivery of large molecule drugs,
including several for which we are developing deep lung delivery formulations.
This situation is highly complex, and the ability of any one company, including
Inhale, to commercialize a particular drug is unpredictable.

24

We intend generally to rely on the ability of our partners to provide access
to the drugs that are to be formulated by us for deep lung delivery. There is a
risk that our partners will not be able to provide access to such drug
candidates. Even if such access is provided, there is a risk that our partners
or we will be accused of, or determined to be, infringing a third-party's patent
rights and will be prohibited from working with the drug or be found liable for
damages that may not be subject to indemnification. Any such restriction on
access to drug candidates or liability for damages would negatively impact our
revenues and results of operations.

OUR COMPETITORS MAY DEVELOP AND SELL BETTER DRUG DELIVERY SYSTEMS.

We are aware of other companies engaged in developing and commercializing
pulmonary drug delivery systems and enhanced injectable drug delivery systems.
Many of these companies have greater research and development capabilities,
experience, manufacturing, marketing, financial and managerial resources than we
do and represent significant competition for us. Acquisitions of or
collaborations with competing drug delivery companies by large pharmaceutical
companies could enhance our competitors' financial, marketing and other
resources. Accordingly, our competitors may succeed in developing competing
technologies, obtaining regulatory approval for products or gaining market
acceptance before us. Developments by others could make our products or
technologies uncompetitive or obsolete. Our competitors may introduce products
or processes competitive with or superior to ours.

INVESTORS SHOULD BE AWARE OF INDUSTRY-WIDE RISKS.

In addition to the risks associated specifically with Inhale described
above, investors should also be aware of general risks associated with drug
development and the pharmaceutical industry. These include, but are not limited
to:

- changes in and compliance with government regulations;

- handling of hazardous materials;

- hiring and retaining qualified people; and

- insuring against product liability claims.

WE EXPECT OUR STOCK PRICE TO REMAIN VOLATILE.

Our stock price is volatile. In the last twelve months, based on closing
prices on the Nasdaq National Market, our stock price ranged from $23.00 to
$126.62. We expect it to remain volatile. A variety of factors may have a
significant effect on the market price of our common stock, including:

- fluctuations in our operating results;

- announcements of technological innovations or new therapeutic products;

- announcement or termination of collaborative relationships by Inhale or
our competitors;

- governmental regulation;

- clinical trial results or product development delays;

- developments in patent or other proprietary rights;

- public concern as to the safety of drug formulations developed by Inhale
or others; and

- general market conditions.

Any litigation brought against us as a result of this volatility could result in
substantial costs and a diversion of our management's attention and resources,
which could negatively impact our financial condition, revenues and results of
operations.

25

THE NOTES ARE SUBORDINATED TO ANY EXISTING AND FUTURE SENIOR DEBT.

The notes are contractually subordinated in right of payment to our existing
and future Senior Debt. As of December 31, 1999, we had approximately
$4.9 million of Senior Debt. Upon the closing of our sale of 6 3/4% Convertible
Subordinated Debentures in late 1999, we incurred additional indebtedness of
approximately $108.5 million. In early 2000, we entered into agreements with
certain holders of such debentures to reduce the principal amount of debentures
outstanding by approximately $94.2 million. The indenture does not limit the
creation of additional Senior Debt (or any other indebtedness). In connection
with the expansion of our facilities, we expect that we may significantly
increase our Senior Debt in the near future. Any significant additional Senior
Debt incurred may materially adversely impact our ability to service our debt,
including the notes. Due to the subordination provisions, in the event of our
insolvency, funds which we would otherwise use to pay the holders of the notes
will be used to pay the holders of Senior Debt to the extent necessary to pay
the Senior Debt in full. As a result of these payments, our general creditors
may recover less, ratably, than the holders of our Senior Debt and such general
creditors may recover more, ratably, than the holders of our notes or our other
subordinated indebtedness. In addition, the holders of our Senior Debt may,
under certain circumstances, restrict or prohibit us from making payments on the
notes.

OUR OUTSTANDING INDEBTEDNESS HAS INCREASED SUBSTANTIALLY WITH THE ISSUANCE OF
THE 5% CONVERTIBLE NOTES.

As of December 31, 1999, we had approximately $113.3 million in long-term
debt. Upon the closing of our sale of 5.0% convertible subordinated notes in
early 2000, we incurred additional long-term indebtedness of $230.0 million. In
early 2000, we entered into agreements with certain holders of the October 2006
debentures to reduce the principal amount of debentures outstanding by
approximately $94.2 million. Upon closing of the offering of the notes, our
long-term debt was approximately $249.2 million. This increased indebtedness has
and will continue to impact us by:

- significantly increasing our interest expense and related debt service
costs;

- making it more difficult to obtain additional financing; and

- constraining our ability to react quickly in an unfavorable economic
climate.

Currently, we are not generating sufficient cash flow to satisfy the annual
debt service payments that will be required as a result of the consummation of
sale of the notes. This may require us to use a portion of the proceeds from the
sales of the notes to pay interest or borrow additional funds or sell additional
equity to meet our debt service obligations. If we are unable to satisfy our
debt service requirements, substantial liquidity problems could result, which
would negatively impact our future prospects.

ITEM 2. PROPERTIES

Inhale currently leases approximately 156,000 square feet in San Carlos,
California, 20,000 square feet in Palo Alto, California and 8,000 square feet in
Belmont, California. The Palo Alto facility is used for research, development
and administration; the lease has a five-year term, and expires on May 31, 2003.
The Belmont facility is used for administration; the lease has a 30-month term
and expires on June 30, 2003.

The San Carlos facility is leased pursuant to a 15-year lease agreement. The
San Carlos facility serves as the Company's corporate headquarters and is used
for research, development, manufacturing and administration. The lease provides
Inhale with an option to lease approximately 69,000 additional square feet in
the same facility. This manufacturing facility operates under current good
manufacturing practices and has been approved and licensed by the State of
California to manufacture clinical supplies for use in clinical trials.

26

In October 1998, Inhale acquired 4.7 acres of land adjacent to its San
Carlos facility. Inhale intends to use this property to expand future
operations. In October 1999, Inhale commenced construction of an 85,000 square
foot facility on this site to expand its administrative offices and research and
development capacity.

ITEM 3. LEGAL PROCEEDINGS

Not applicable.

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

No matters were submitted to a vote of Inhale's shareholders in the quarter
ended December 31, 1999.

PART II

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

PRICE RANGE OF COMMON STOCK

Inhale's Common Stock trades on the Nasdaq National Market under the symbol
INHL. The table below sets forth the high and low closing sales prices for
Inhale's Common Stock (as reported on the Nasdaq National Market) during the
periods indicated.

PRICE RANGE OF
COMMON STOCK
-------------------
YEAR ENDED DECEMBER 31, 1998: HIGH LOW
- ----------------------------- -------- --------

1(st) Quarter............................................... $ 34.250 $25.250
2(nd) Quarter............................................... 34.000 23.125
3(rd) Quarter............................................... 29.875 21.750
4(th) Quarter............................................... 33.375 21.500

YEAR ENDED DECEMBER 31, 1999:
- ------------------------------------------------------------
1(st) Quarter............................................... $ 34.625 $23.875
2(nd) Quarter............................................... 29.688 23.000
3(rd) Quarter............................................... 34.875 23.625
4(th) Quarter............................................... 43.688 26.875

YEAR ENDED DECEMBER 31, 2000:
- ------------------------------------------------------------
1(st) Quarter (through March 9, 2000)....................... $126.625 $41.688

As of December 31, 1999, there were approximately 225 holders of record of
Inhale's Common Stock. Inhale has not paid any cash dividends since its
inception and does not intend to pay any cash dividends in the foreseeable
future.

27

RELATED STOCKHOLDER MATTERS

In February 2000 we issued $230,000,000 aggregate principal amount of
convertible subordinated notes, which are convertible at the option of the
holder, at any time on or prior to maturity into shares of our common stock. The
notes were sold only in the United States to certain qualified institutional
buyers under an exemption from registration provided by Rule 144A of the
Securities Act of 1933, as amended. The notes are convertible at a conversion
price of $76.71 per share, which is equal to a conversion rate of approximately
13.037 shares per $1,000 principal amount of notes, subject to adjustment.
Interest on the debentures will accrue at a rate of 5.0% per year subject to
adjustment in certain circumstances . We will pay interest on the notes on
February 8 and August 8 of each year, beginning August 8, 2000. The notes mature
on February 8, 2007. We may redeem some or all of the notes at any time before
February 8, 2003 at a redemption price of $1,000 per $1,000 principal amount of
notes, plus accrued and unpaid interest, if any, to the redemption date, if the
closing price of our common stock has exceeded 150% of the conversion price then
in effect for at least 20 trading days within a period of 30 consecutive trading
days ending on the trading day before the date of mailing of the provisional
redemption notice. We will make additional payment in cash with respect to the
notes, call for provisional redemption in an amount equal to $13.93 per $1,000
principal amount of notes, less the amount of any interest actually paid on the
notes before the call for redemption. We may redeem some or all of the notes at
any time after February 8, 2003. The notes are unsecured and subordinated to our
existing and future senior indebtedness. Merrill Lynch & Co. served as the sole
bookrunner for the offering and received approximately $7,187,500 in discounts
and commissions.

In October and November of 1999 we issued $108,450,000 aggregate principal
amount of convertible subordinated debentures, which are convertible at the
option of the holder, at any time on or prior to maturity into shares of our
common stock. The debentures were sold only in the United States to certain
qualified institutional buyers under an exemption from registration provided by
Rule 144A of the Securities Act of 1933, as amended. The debentures are
convertible at a conversion price of $32.0075 per share, which is equal to a
conversion rate of approximately 31.2427 shares per $1,000 principal amount of
notes, subject to adjustment. Interest on the debentures will accrue at a rate
of 6 3/4% per year subject to adjustment in certain circumstances . We will pay
interest on the notes on April 13 and October 13 of each year, beginning April
13, 2000. The debentures mature on October 13, 2006. We may redeem some or all
of the debentures after October 13, 2002 at the following prices (expressed in
percentage of the principal amount), together with accrued and unpaid interest
to, but excluding, the date fixed for redemption:

DURING THE TWELVE MONTHS COMMENCING REDEMPTION PRICE
- ----------------------------------- ----------------

October 13, 2002............................................ 103.375%
October 13, 2003............................................ 102.250%
October 13, 2004............................................ 101.125%
October 13, 2005............................................ 100.000%

The debentures are unsecured and subordinated to our existing and future
senior indebtedness. The initial purchasers of the debentures, Lehman Brothers
Inc., Deutsche Bank Securities Inc. and U.S. Bancorp Piper Jaffray Inc.,
received an aggregate of approximately $3,253,500 in discounts and commissions
relating to this offering. On January 26, 2000 a shelf registration statement
for the debentures and the shares of common stock issuable upon conversion of
the debentures was declared effective by the SEC. In early, 2000, we entered
into agreements with certain holders of these outstanding debentures to convert
their debentures into shares of our common stock in exchange for a cash payment
made by Inhale. To date, we have agreed to make cash payments of approximately
$16.2 million in the aggregate in connection with agreements that provide for
the conversion of approximately $94.2 million aggregate principal amount of
outstanding debentures.

On November 4, 1999 we issued to Alliance Pharmaceutical Corp. 180,099
shares of our common stock having a market value of $5.0 million in a private
placement exempt from registration under Section 4(2) of the Securities Act of
1933, as amended. We issued these shares and paid $15.0 million in cash to
Alliance in exchange for acquiring Alliance's PulmoSpheres-Registered Trademark-
technology and other related assets

28

for particle formation and powder processing. Alliance is a sophisticated,
qualified investor and defined as an "accredited investor" under
Rule 501(a) of the Securities Act, as amended, and acquired these shares in the
ordinary course of its business for its own account for investment and not with
a view to, or any arrangements or understandings regarding, any subsequent
distributions. Alliance signed a Stock Purchase Agreement in which it made
certain representations and warranties to us that they met the criteria to be
eligible for this exemption from registration. No underwriters were involved in
this offering and no commissions or remuneration was paid in connection with the
sales of these shares.

On December 9, 1998 we issued 1,200,000 shares of our common stock to two
affiliated entities, Smallcap World Fund, Inc. and American Variable Insurance
Series Growth Fund, which are managed by Capital Research and Management
Company, at a purchase price of $31 per share, for an aggregate amount of
$37.2 million in cash in a private placement exempt from registration under
Section 4(2) of the Securities Act of 1933, as amended. These purchasers of
shares of our common stock are qualified investors and institutions defined as
"accredited investors" under Rule 501(a) of the Securities Act, as amended, and
acquired these shares in the ordinary course of their business for their own
account for investment and not with a view to, or any arrangements or
understandings regarding, any subsequent distributions. These purchasers signed
a Stock Purchase Agreement in which they made certain representations and
warranties to us that they met the criteria to be eligible for this exemption
from registration. Volpe Brown Whelan & Company served as the exclusive
placement agent in connection with this offering and received $1,886,040 in
payment of certain fees and commissions. On February 11, 1999, a shelf
registration statement for these shares of common stock was declared effective
by the SEC.

On April 13, 1998 we issued an aggregate of 5,781 shares of our common stock
to several individuals who are affiliated with Boyce Thompson Institute for
Plant Research, Inc. and Initiatech, Inc. in partial consideration for Inhale
signing an agreement with Initiatech, Inc. under which Inhale licenses
technology, intellectual property, and patents for protecting biologically
active compounds in the dry state. Initiatech has licensed exclusive rights to
this technology from the Boyce Thompson Institute for Plant Research, Inc. These
shares were sold in a private placement exempt from registration under
Section 4(2) of the Securities Act of 1933, as amended. No underwriters were
involved in this offering and no commissions or remuneration was paid in
connection with the sales of these shares.

On February 7, 1997 we issued 1,800,000 shares of our common stock at a
purchase price of $18 per share, for an aggregate amount of $32.4 million in
cash in private transactions exempt from registration under Rule 506 of
Regulation D promulgated under the Securities Act of 1933, as amended to
selected institutions qualified as "accredited investors" under Rule 501(a) of
Regulation D. These purchasers acquired our shares in the ordinary course of
their business for their own account for investment and not with a view to, or
any arrangements or understandings regarding, any subsequent distributions.
These purchasers each signed a Purchase Agreement in which they made certain
representations and warranties to us that they met the criteria to be eligible
for this exemption from registration. Vector Securities International, Inc.
served as the exclusive placement agent in connection with this offering and
received $1,782,000 in payment of certain fees and commissions. On February 7,
1997 a shelf registration statement for these shares of common stock was
declared effective by the SEC.

On June 27, 1997 we sold 28,165 shares of our common stock to Pafra Limited
for an aggregate purchase price of $600,000 in a private placement exempt from
registration under Section 4(2) of the Securities Act of 1933, as amended. We
issued these shares to Pafra in partial consideration for Pafra's assignment to
Inhale of certain of its intellectual property rights, the goodwill and
know-how. Pafra is a sophisticated, qualified investor and defined as an
"accredited investor" under Rule 501(a) of the Securities Act, as amended, and
acquired these shares in the ordinary course of it business for its own account
for investment and not with a view to, or any arrangements or understandings
regarding, any subsequent distributions. Pafra signed an assignment in which it
made certain representations and warranties to us that they met the criteria to
be eligible for this exemption from registration. No underwriters were involved
in this offering and no commissions or remuneration was paid in connection with
the sales of these shares.

29

ITEM 6. SELECTED FINANCIAL DATA

SELECTED FINANCIAL INFORMATION
(IN THOUSANDS, EXCEPT PER SHARE INFORMATION)

YEARS ENDED DECEMBER 31
----------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------

STATEMENT OF OPERATIONS DATA:
Contract research revenue................ $ 41,358 $ 21,795 $ 16,249 $ 6,890 $ 3,445
Operating costs and expenses:
Research and development............... 64,083 35,398 23,645 14,376 9,041
General and administrative............. 7,869 8,387 6,328 4,004 3,232
Acquired in-process research and
development.......................... 9,890 -- -- -- --
-------- -------- -------- -------- --------
Total operating costs and expenses....... 81,842 43,785 29,973 18,380 12,273
-------- -------- -------- -------- --------
Loss from operations..................... (40,484) (21,990) (13,724) (11,490) (8,828)

Interest income (expense), net........... 2,036 3,634 3,741 1,581 1,166
-------- -------- -------- -------- --------
Net loss................................. $(38,448) $(18,356) $ (9,983) $ (9,909) $ (7,662)
======== ======== ======== ======== ========
Net loss per share....................... $ (2.26) $ (1.17) $ (0.72) $ (0.88) $ (0.78)
======== ======== ======== ======== ========
Shares used in computation of net loss
per share(1)........................... 17,008 15,719 13,792 11,207 9,837
======== ======== ======== ======== ========

DECEMBER 31,
----------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------

BALANCE SHEET DATA:
Cash, cash equivalents and short-term
investments............................ $138,185 $ 82,862 $100,173 $ 36,309 $ 19,927
Working capital.......................... 122,239 71,784 83,811 31,304 17,701
Total assets............................. 226,806 134,496 119,762 41,492 23,248
Long-term debt........................... 4,895 4,940 5,102 187 353
Convertible subordinated debentures...... 108,450 -- -- -- --
Accumulated deficit...................... (94,466) (56,018) (37,662) (27,691) (17,770)
Total stockholders' equity............... 86,629 115,881 97,093 35,061 20,182

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

(1) Basic and diluted net loss per share is based upon the weighted average
number of common shares outstanding. All share amounts have been adjusted to
reflect the implementation of FASB Statement No. 128 and Staff Accounting
Bulletin No. 98. See Note 1 of Notes to Financial Statements.

30

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

THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE
RISKS AND UNCERTAINTIES. INHALE'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM
THOSE DISCUSSED HERE. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES
INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED IN THIS SECTION AS WELL AS IN
PART I OF THIS ANNUAL REPORT UNDER THE HEADING "RISK FACTORS".

OVERVIEW

Since its inception in July 1990, Inhale has been engaged in the development
of a pulmonary system for the delivery of macromolecules and other drugs for
systemic and local lung applications. Inhale has been unprofitable since
inception and expects to incur significant and increasing additional operating
losses over the next several years primarily due to increasing research and
development expenditures and expansion of late stage clinical and early stage
commercial manufacturing facilities. To date, Inhale has not sold any commercial
products and does not anticipate receiving revenue from product sales or
royalties in the near future. For the period from inception through
December 31, 1999, Inhale incurred a cumulative net loss of approximately
$94.5 million. Inhale's sources of working capital have been partner fundings,
including milestone payments, from short-term research and feasibility
agreements and development contracts, equity financings, financings of equipment
acquisitions and tenant improvements, and interest earned on investments of
cash.

Inhale has generally been compensated for research and development expenses
during initial feasibility work performed under collaborative arrangements.
Partners that enter into collaborative agreements generally pay for some or all
research and development expenses and make additional payments to Inhale as
Inhale achieves certain key milestones. Inhale expects to receive royalties from
its partners based on their revenues received from product sales, and to receive
revenue from the manufacturing of powders and the supply of devices. In certain
cases, Inhale may enter into collaborative agreements under which Inhale's
partners would manufacture or package powders or supply inhalation devices,
thereby potentially limiting one or more sources of revenue for Inhale. To
achieve and sustain profitable operations, Inhale, alone or with others, must
successfully develop, obtain regulatory approval for, manufacture, introduce,
market and sell products utilizing its pulmonary drug delivery system. There can
be no assurance that Inhale can generate sufficient product or contract research
revenue to become profitable or to sustain profitability.

In late 1999, Inhale completed the sale of approximately $108.5 million
aggregate principal amount of 6 3/4% Convertible Subordinated Debentures due
October 13, 2006. In early 2000, the Company entered into agreements with
certain holders of these outstanding debentures to convert their debentures into
common stock in exchange for a cash payment. To date, the Company has agreed to
make cash payments of approximately $16.2 million in the aggregate in connection
with agreements that provide for the conversion of approximately $94.2 million
aggregate principal amount of outstanding debentures into approximately
2.9 million shares of common stock. Such amounts will be reflected as a charge
to interest expense in the first quarter of 2000.

In February, 2000, Inhale received approximately $222.4 million in net
proceeds from the issuance of $230.0 million aggregate principal amount of
convertible subordinated debentures to certain qualified institutional buyers
under Rule 144A of the Securities Act of 1933, as amended. Interest on the
debentures will accrue at a rate of 5.0% per year, subject to adjustment in
certain circumstances. The debentures will mature in 2007 and are convertible
into shares of Inhale's common stock at a conversion price of $76.71 per share,
subject to adjustment in certain circumstances.

31

RESULTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

Contract research revenue was $41.4 million for the year ended December 31,
1999 compared to $21.8 million and $16.2 million for the years ended
December 31, 1998 and 1997, respectively. Revenue increased 90% in 1999 from
1998 levels and 34% in 1998 from 1997 levels. Costs of contract research revenue
approximate such revenue and are included in research and development expense.

The 90% increase in revenue for the year ended December 31, 1999 as compared
to December 31, 1998 was primarily due to expansion of Inhale's existing
collaborative agreement with Pfizer, and includes activities associated with the
manufacture of Phase III clinical supplies. Pfizer represented approximately 71%
of Inhale's revenues for the year ended December 31, 1999. Revenue for 1999 and
1998 included reimbursed research and development expenses as well as the
amortization of up-front signing and progress payments received from Inhale's
collaborative partners. Recognition of up-front signing and progress payments is
based on actual efforts expended. Contract revenues are expected to fluctuate
from year to year, and future contract revenues cannot be predicted accurately.
The level of contract revenues depends in part upon future success in obtaining
new collaborative agreements, timely completion of feasibility studies, the
continuation of existing collaborations and achievement of milestones under
current and future agreements.

Research and development expenses were $64.1 million for the year ended
December 31, 1999, as compared to $35.4 million and $23.6 million for the years
ended December 31, 1998 and 1997, respectively. These expenses represent
proprietary research expenses as well as the costs related to contract research
revenue and include the salaries and benefits of scientific and development
personnel, clinical manufacturing costs, laboratory supplies, consulting
services, facilities, costs of obtaining intellectual property protection for
Inhale's technologies and expenses associated with the development of
manufacturing processes. The 81% increase in such expenses in 1999 from 1998 was
due to increased spending related to the scale-up of technologies and the
continuing development of global manufacturing capabilities in order to support
Phase III inhaleable insulin clinical trials and commercial production. In
addition, the Company hired additional scientific and development personnel to
handle an increase in the number of development projects and incurred increased
expenses associated with device development and clinical manufacturing. The
largest components of the 1999 increase in research and development were the
increases of $11.8 million in salaries and employee benefits expense, a
$9.3 million increase in research and development supplies and services, and a
$3.8 million increase in facilities and administrative expense allocations
associated with supporting the research and development efforts. The
$11.8 million increase in research and development expenses in 1998 from 1997
was primarily attributable to the development of infrastructure necessary to
manufacture the Company's products on a late stage clinical scale. Inhale
expects research and development spending to increase over the next few years as
Inhale expands its development efforts under collaborative agreements and scales
up its commercial manufacturing facility.

General and administrative expenses were $7.9 million for the year ended
December 31, 1999 as compared to $8.4 million and $6.3 million for the years
ended December 31, 1998 and 1997, respectively. The $0.5 million decrease in
general and administrative expenses in 1999 from 1998 is attributed to an
increased percentage of general and administrative related costs allocated to
research and development operations. The $2.1 million increase in such expenses
in 1998 was due primarily to costs associated with supporting Inhale's increased
research efforts including administrative staffing, business development
activities and marketing activities. General and administrative expenses are
expected to continue to increase over the next few years as Inhale expands its
operations.

Interest income was $4.1 million for the year ended December 31, 1999 as
compared to $3.9 million and $3.8 million for the years ended December 31, 1998
and 1997, respectively. The 5% increase in interest income in 1999 from 1998 and
the 3% increase in interest income in 1998 from 1997 were primarily due to
Inhale maintaining larger cash and investment balances, including the proceeds
of its October, 1999

32

issuance of convertible subordinated debentures which resulted in net proceeds
of $105.2 million. Interest expense was $2.1 million for the year ended
December 31, 1999, as compared to $0.3 million and $0.1 million for the years
ended December 31, 1998 and 1997, respectively. The $1.8 million increase in
interest expense in 1999 from 1998 primarily relates to interest on the
above-mentioned convertible subordinated debentures. The $0.2 million increase
in interest expense in 1998 from 1997 related to increased debt balances,
including the proceeds of the Company's November, 1997 tenant improvement loan.

At December 31, 1999, Inhale had federal and state net operating loss
carryforwards of approximately $92.6 million. These carryforwards will expire
beginning in the year 2000. Utilization of net operating loss carryforwards may
be subject to substantial annual limitations due to the ownership change
limitations provided for by the Internal Revenue Code of 1986. The annual
limitations may result in the expiration of net operating loss carryforwards
before utilization.

ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT

On November 4, 1999, Inhale concluded an agreement with Alliance
Pharmaceutical Corp. to acquire Alliance's PulmoSpheres-Registered Trademark-
particle and particle processing technology for use in respiratory drug
delivery. Under the terms of the agreement, Inhale received the rights to
PulmoSpheres-Registered Trademark- technology, other related assets (including
research materials, laboratory records, and certain equipment that had been used
in the development of PulmoSpheres technology and the manufacturing and testing
of particles using such PulmoSpheres technology), and Alliance stock valued at
$5 million in exchange for $15 million in cash and $5 million of Inhale stock.
Alliance also has the right to additional substantial payments upon the
achievement of certain milestones and royalties on a defined number of products
commercialized using the technology. $15.0 million of the purchase consideration
was allocated to the assets acquired based on their fair value on the date of
acquisition. Approximately $9.9 million of the purchase price was allocated to
in-process research and development and has been charged as an expense in the
year ended December 31, 1999.

The PulmoSpheres-Registered Trademark- technology utilizes an emulsification
process to produce a powder having characteristics that Inhale believes may
improve efficiency and reproducibility for drugs delivered to the lung through
alternative technologies such as metered-dose inhalers ("MDI's"), as well as
potentially improve drug delivery through Inhale's proprietary deep lung drug
delivery system. Inhale evaluates this technology to be in the pre-clinical
stage of development.

The purchased research and development had no alternative future use at the
date of acquisition. It was identified and valued through extensive interviews
and discussions with appropriate management and scientific personnel and the
analysis of data provided by Alliance regarding the
PulmoSpheres-Registered Trademark- technology, its stage of development at the
time of acquisition, the importance of the technology to Inhale's overall
development plan, and the projected incremental cash flows from the projects
when completed and any associated risks. Associated risks include the
uncertainties in overcoming significant technological risks, acquiring FDA
approval and establishing commercial viability.

Inhale does not expect the products which utilize the
PulmoSpheres-Registered Trademark- technology to obtain FDA approval before
2005. Inhale is in process of evaluating which projects will benefit the most
from the PulmoSpheres-Registered Trademark- technology and is estimating the
associated future development costs, which are expected to be substantial
through 2006.

LIQUIDITY AND CAPITAL RESOURCES

Inhale has financed its operations primarily through public and private
placements of its equity securities, convertible debentures, contract research
revenues, interest income earned on its investments of cash and financing of
equipment acquisitions. In its initial public offering completed May 1994,
Inhale raised net proceeds of approximately $14.4 million and raised additional
net proceeds of $7.2 million in its

33

public offering completed in March 1995. In February 1997, Inhale completed a
private placement of its Common Stock, selling 1.8 million newly issued shares
for net proceeds of $30.5 million. In November 1997, Inhale completed a public
offering of its Common Stock, selling 1.725 million newly issued shares for net
proceeds of $40.0 million. Inhale secured a $5 million loan in November 1997 to
finance the purchases of equipment and facility improvements. In December 1998,
Inhale completed a private placement of its Common Stock, selling 1.2 million
newly issued shares for net proceeds of $35.3 million. In October 1999, the
Company received approximately $105.2 million in net proceeds from the sale of
convertible subordinated debentures. At December 31, 1999, Inhale had cash, cash
equivalents and short-term investments of approximately $138.2 million. In
February 2000, Inhale completed the sale of convertible subordinated notes
netting proceeds of approximately $206.0 million. This includes cash payments of
approximately $16.2 million in connection with agreements that provide for the
conversion of approximately $94.2 million of its October 2006 debentures that
were outstanding at December 31, 1999.

Inhale's operations used cash of $15.3 million and $19.2 million, and
provided cash of $5.0 million in the years ended December 31, 1999, 1998 and
1997, respectively. These amounts differed from Inhale's net operating losses in
these periods principally due to increased depreciation expense and fluctuations
in the Company's accounts receivable, other assets, accrued liabilities and
deferred revenue balances. Fluctuations in these balances reflect Inhale's
increased research, development and manufacturing activities, as well as timing
differences in the receipt of cash from Inhale's development partners.
Additionally, in 1999, Inhale, recorded a $9.9 million write-off of acquired
research and development in connection with the acquisition of
PulmoSpheres-Registered Trademark- technology.

Inhale purchased property and equipment of approximately $20.5 million,
$34.6 million and $17.3 million during the years ended December 31, 1999, 1998
and 1997, respectively. The decrease in 1999 is primarily due to the increased
expenditures in 1998 for the purchase of land and the build out of Inhale's
manufacturing facility and corporate headquarters located in San Carlos,
California. The Company also invested $15.3 million in the purchase of
PulmoSpheres-Registered Trademark- technology in 1999, in addition to its
non-cash exchange of common stock for shares of Alliance valued at
$5.0 million.

Inhale expects its cash requirements to continue at an accelerated rate due
to expected increases in costs associated with further research and development
of its technologies, development of drug formulations, process development for
the manufacture and filling of powders and devices, marketing and general and
administrative costs. These expenses include, but are not limited to, increases
in personnel and personnel related costs, purchases of capital equipment,
investments in technologies, inhalation device prototype construction and
facilities expansion, including the completion of Inhale's commercial
manufacturing facility and scale-up of device manufacturing with its outside
contract manufacturers.

Given its current cash requirements, the Company believes that it will have
sufficient cash to meet its operating expense requirements for at least the next
24 months. However, the Company plans to continue to invest heavily in its
growth and the need for cash will be dependent upon the timing of these
investments. Inhale's capital needs will depend on many factors, including
continued scientific progress in its research and development arrangements,
progress with pre-clinical and clinical trials, the time and costs involved in
obtaining regulatory approvals, the costs of developing and the rate of scale-up
of Inhale's powder processing and packaging technologies, the timing and cost of
its late stage clinical and early commercial production facility, the costs
involved in preparing, filing, prosecuting, maintaining and enforcing patent
claims, the need to acquire licenses to new technologies and the status of
competitive products. To satisfy its long-term needs, Inhale intends to seek
additional funding, as necessary, from corporate partners and from the sale of
securities. There can be no assurance that additional funds, if and when
required, will be available to Inhale on favorable terms, if at all.

Inhale is currently considering expansion opportunities which would likely
involve the sale and leaseback of land adjacent to its current facilities and
the development of new facilities on such land.

34

Inhale anticipates that its lease obligations relating to this proposal would be
approximately $60.0 million over the term of the lease, which Inhale expects to
extend approximately 15 years.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of Inhale's investment activities is to preserve
principal while at the same time maximizing yields without significantly
increasing risk. To achieve this objective, Inhale invests in highly liquid and
high quality debt securities. Inhale's investments in debt securities are
subject to interest rate risk. To minimize the exposure due to an adverse shift
in interest rates, Inhale invests in short term securities and maintains an
average maturity of one year or less. A hypothetical 50 basis point increase in
interest rates would result in an approximate $291,000 decrease (less than
0.217%) in the fair value of Inhale's available-for-sale securities.

The potential change noted above is based on sensitivity analyses performed
on Inhale's financial position at December 31, 1999. Actual results may differ
materially. The same hypothetical 50 basis point increase in interest rates
would have resulted in an approximate $150,000 decrease (less than 0.185%) in
the fair value of Inhale's available-for-sale securities at December 31, 1998.

Increases in interest rates could adversely affect the fair market value of
Inhale's convertible subordinated debentures, which pay a fixed rate of
interest.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements for the years ended December 31, 1999, 1998 and
1997 are submitted as a separate section of this report. See Item 14.

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

Not Applicable.

35

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Inhale incorporates by reference the information concerning its directors
set forth under the heading "Election of Directors" in Inhale's definitive Proxy
Statement to be filed for its 2000 Annual Meeting of Shareholders.

EXECUTIVE OFFICERS AND DIRECTORS

The following table sets forth the names, ages and positions of the
executive officers and directors as of December 31, 1999:

NAME AGE POSITION
- ---- -------- ------------------------------------------

Robert B. Chess........................... 43 Chairman and Co-Chief Executive Officer
Co-Chief Executive Officer, President and
Ajit S. Gill.............................. 51 Director
Vice President of Finance and
Brigid A. Makes........................... 44 Administration, Chief Financial Officer
Stephen L. Hurst.......................... 44 General Counsel and Secretary
John S. Patton, Ph.D...................... 53 Vice President, Research and Director
Robert M. Platz........................... 48 Vice President, Technology
Mark J. Gabrielson........................ 43 Director
James B. Glavin........................... 64 Director
Irwin Lerner.............................. 69 Director
Melvin Perelman, Ph.D..................... 69 Director

ROBERT B. CHESS has served as Chairman of the Board of Directors since
April 1999 and Co-Chief Executive Officer since August 1998. Mr. Chess served as
President from December 1991 to August 1998 and as Chief Executive Officer from
May 1992 to September 1998. Mr. Chess was elected a Director in May 1992. From
September 1990 until October 1991, he was an Associate Deputy Director in the
White House Office of Policy Development. In March 1987, Mr. Chess co-founded
Penederm Incorporated ("Penederm"), a topical dermatological drug delivery
company, and served as its President until February 1989. He left Penederm in
October 1989. Prior to co-founding Penederm, Mr. Chess held management positions
at Intel Corp., a semiconductor manufacturer, and Metaphor, a computer software
company (acquired by International Business Machines). Mr. Chess holds a BS in
Engineering from the California Institute of Technology and an MBA from the
Harvard Business School.

AJIT S. GILL has served as President since April 1999, as Co-Chief Executive
Officer since August 1998 and as a Director since April 1998. Mr. Gill served as
Chief Operating Officer from October 1996 to August 1998 and Chief Financial
Officer from January 1993 until October 1996. Before joining Inhale, Mr. Gill
was Vice President and General Manager of Kodak's Interactive Systems division.
Mr. Gill has served as Chief Financial Officer for TRW-Fujitsu, Director of
Business Development for Visicorp, and as start-up President for three high
technology companies. He completed a BTech at the Indian Institute of
Technology, an MS in Electrical Engineering from the University of Nebraska, and
holds an MBA from the University of Western Ontario.

BRIGID A. MAKES has served as Vice President of Finance and Administration
and Chief Financial Officer since June 1999. From 1998 until joining Inhale,
Ms. Makes served as Vice President, Chief Financial Officer and Treasurer for
Oravax, Inc., a life sciences company. From 1992 to 1998, Ms. Makes served in
various management positions for Haemonetics Corporation, developer of automated
blood processing systems, including, from 1995 to 1998, Vice President Finance,
Chief Financial Officer and Treasurer. Ms. Makes holds a Bachelor of Commerce
degree from McGill University in Finance and International Business and an MBA
from Bentley College.

36

STEPHEN L. HURST has been General Counsel and Secretary since August 1998.
Mr. Hurst served as Vice President, Intellectual Property and Licensing of
Inhale from March 1994 to August 1998. From July 1990 to February 1994,
Mr. Hurst was in private law practice and consulted with COR
Therapeutics, Inc., a biotechnology company, on intellectual property and
business development issues. From November 1987 to June 1990, he was the Campus
Patent Coordinator for the University of California, San Francisco. He also
worked as an Associate Counsel at Townsend & Townsend, the San Francisco area's
largest intellectual property law firm. He received a BS degree in Environmental
Science from the University of California at Berkeley and his JD from Golden
Gate University in San Francisco.

JOHN S. PATTON, PH.D., a co-founder of Inhale, has been Vice President,
Research since December 1991 and a Director since July 1990. He served as
President of Inhale from its incorporation in July 1990 to December 1991. From
1985 to 1990, Dr. Patton was a Project Team Leader with Genentech, Inc., a
biotechnology company, where he headed their non-invasive drug delivery
activities. Dr. Patton was on the faculty of the Marine Science and Microbiology
Departments at the University of Georgia from 1979 through 1985, where he was
granted tenure in 1984. Dr. Patton received a BS in Zoology and Biochemistry
from Pennsylvania State University, an MS from the University of Rhode Island, a
Ph.D. in Biology from the University of California, San Diego and received post
doctorate fellowships from Harvard Medical School and the University of Lund,
Sweden both in biomedicine.

ROBERT M. PLATZ, a co-founder of Inhale, has served as Vice President,
Technology since August 1990. He also served as a Director of Inhale from
July 1990 to August 1991. From January 1983 to August 1991, Mr. Platz was
employed by SRI International, a contract research company, most recently as
Senior Chemical Engineer, where he headed the pharmaceutical aerosol group.
Mr. Platz received a BS in biology and an MS in Chemical Engineering from the
University of California, Los Angeles.

MARK J. GABRIELSON has been a Director since May 1992. Since January 1991 he
has been a general partner of Prince Ventures, L.P., a venture capital
management firm that serves as the general partner of Prince Venture Partners
III, L.P. Mr. Gabrielson is a Director of several private companies. From 1978
until joining Prince, Mr. Gabrielson served in a variety of marketing and
business development positions with SmithKline Beecham plc.

JAMES B. GLAVIN has been a Director since May 1993. Mr. Glavin is Chairman
of the Board of The Immune Response Corporation, a biotechnology company. He was
President and Chief Executive Officer of The Immune Response Corporation from
1987 until September 1994. From 1987 to 1990, Mr. Glavin served as Chairman of
the Board of Smith Laboratories, Inc. and was President and Chief Executive
Officer from 1985 to 1989. From 1985 to 1987, he was a partner in CH Ventures, a
venture capital firm. From 1983 to 1985, he served as Chairman of the Board of
Genetic Systems Corporation, a biotechnology firm, and as its President and
Chief Executive Officer from 1981 to 1983. Mr. Glavin is a director of The
Meridian Fund and Gish Biomedical, Inc.

IRWIN LERNER has been a Director since April 1999. Mr. Lerner served as
Chairman of the Board of Directors and of the Executive Committee of Hoffman-La
Roche Inc., a pharmaceutical and health care company, from January 1993 until
his retirement in September 1993, and from 1980 through December 1992, also
served as President and Chief Executive Officer. From September 1995 until
present, Mr. Lerner has served on the Board of Medarex, Inc., a monoclonal
antibodies products company and became Chairman of the Board in May 1997.
Mr. Lerner served as the Chairman of the Board of Sequana Therapeutics, Inc., a
biotechnology company, from May 1995 until Sequana merged with Arris
Pharmaceuticals Inc., a pharmaceutical company, to form Axys
Pharmaceuticals, Inc. in January 1998 and has served on the Board of Axys since
then. Mr. Lerner served for 12 years on the Board of Pharmaceutical
Manufacturers' Association where he chaired the Association's FDA Issues
Committee. Mr. Lerner received a B.S. and an M.B.A. from Rutgers University. He
is currently Distinguished Executive-in-Residence at Rutgers University Graduate
School of Management. Mr. Lerner is also a director of Public Service Enterprise
Group Incorporated, a diversified public utility holding company, Humana Inc.,

37

a health care company, Covance, Inc., a contract drug development company, and
V.I. Technologies, Inc., a blood products company.

MELVIN PERELMAN, PH.D. has been a Director since January 1996.
Dr. Perelman spent 36 years at Eli Lilly & Company, most recently as Executive
Vice-President and President of Lilly Research Laboratories, a position which he
held from 1986 until his retirement in 1993. Dr. Perelman served as President of
Lilly International from 1976 until 1993. Dr. Perelman is a member of the Board
of Directors of Cinergy, Inc., DataChem, Inc., Immusol, Inc. and of The Immune
Response Corporation.

SCIENTIFIC ADVISORY GROUP

We have assembled scientific and development advisors that provide us with
expertise in critical scientific, development, engineering, manufacturing and
business issues facing Inhale. The scientific advisory group assists us on
issues related to pulmonary delivery, pulmonary toxicology, aerosol science,
government regulation, product selection and clinical trial design. Its members
are called upon individually as needed and include, among others:

NAME AFFILIATION AREA OF EXPERTISE
- ---- --------------------------------- -----------------------

Joseph Brain, Ph.D............... Professor, Chairman, Department Pulmonary safety
of Environmental Health,
Director, Physiology Program,
Harvard School of Public Health
Peter Byron, Ph.D................ Professor of Pharmacy, Virginia Pharmaceutical aerosols
Commonwealth University, Medical
College of Virginia
Carl Grunfeld, M.D............... Professor of Medicine, University Endocrinology
of California, San Francisco
Michael Matthay, M.D............. Professor of Medicine and Pulmonology
Anesthesiology, University of
California, San Francisco
Gerald Smaldone, M.D............. Professor of Medicine, State Aerosol medicine
University of New York at Stony
Brook

REGULATORY AND DEVELOPMENT ADVISORY BOARD

In August 1999, we formed a regulatory affairs board to assist and advise us
on matters relating to efficient and effective regulatory processing and to
better assist us and our collaborative partners in obtaining regulatory approval
for our products. The board currently includes the following:

NAME AFFILIATION AREA OF EXPERTISE
- ---- ----------------------------- -----------------------------

Carl C. Peck, M.D............ Professor of Pharmacology and Clinical and regulatory
Medicine, Director, Center development strategy
for Drug Development,
Georgetown University Medical
Center
David Savello, Ph.D.......... Executive Vice President and Pharmaceutical research and
Chief Technology Officer, development and regulatory
R.P. Scherer, Inc. affairs
Phillip B. White............. Director, Medical Device Device regulatory affairs
Consulting, AAC Consulting

38

ITEM 11. EXECUTIVE COMPENSATION

Inhale incorporates by reference the information set forth under the heading
"Executive Compensation" in Inhale's definitive Proxy Statement to be filed for
its 2000 Annual Meeting of Shareholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Inhale incorporates by reference the information set forth under the heading
"Security Ownership of Certain Beneficial Owners and Management" in Inhale's
definitive Proxy Statement to be filed for its 2000 Annual Meeting of
Shareholders.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Inhale incorporates by reference the information set forth under the heading
"Certain Transactions" in Inhale's definitive Proxy Statement to be filed for
its 2000 Annual Meeting for Shareholders.

39

PART IV

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

(a)(1) Financial Statements

The Financial Statements required by this item, with the report of
independent auditors, are submitted in a separate section beginning on page F-1
of this report.

(2) Financial Statement Schedules

Schedules have been omitted because the information required to be set forth
therein is not applicable or is shown in the Financial Statements or notes
thereto.

(3) Exhibits

The following exhibits are filed herewith or incorporated by reference:

EXHIBIT EXHIBIT TITLE
- --------------------- -------------

2.1(1) Agreement and Plan of Merger between Inhale Therapeutic
Systems, a California corporation, and Inhale Therapeutic
Systems (Delaware), Inc., a Delaware corporation.

3.1(1) Certificate of Incorporation of Registrant.

3.2(1) Bylaws of the Registrant.

4.1 Reference is made to Exhibits 3.1 and 3.2.

4.2(2) Restated Investor Rights Agreement among the Registrant and
certain other persons named therein, dated April 29, 1993,
as amended October 29, 1993.

4.3(2) Specimen stock certificate.

4.4(3) Stock Purchase Agreement between the Registrant and Pfizer
Inc., dated January 18, 1995.

4.5(9) Form of Purchase Agreement between the Registrant and the
individual Purchasers, dated January 28, 1997.

4.6(10) Stock Purchase Agreement between the Registrant and Capital
Research and Management Company, dated December 8, 1998.

4.7(12) Purchase Agreement among the Registrant and Lehman Brothers
Inc., Deutsche Bank Securities Inc. and U.S. Bancorp Piper
Jaffray Inc., dated October 6, 1999.

4.8(12) Registration Rights Agreement among the Registrant and
Lehman Brothers Inc., Deutsche Bank Securities Inc. and
U.S. Bancorp Piper Jaffray Inc., dated October 13, 1999.

4.9(12) Indenture between the Registrant as Issuer and Chase
Manhattan Bank and Trust Company, National Association, as
Trustee, dated October 13, 1999.

4.10(12) Form of Registration Rights Agreement between the Registrant
and Alliance Pharmaceutical Corp.

4.11(13) Purchase Agreement among the Registrant and Merrill Lynch &
Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated,
Deutsche Bank Securities Inc., Lehman Brothers Inc., and
U.S. Bancorp Piper Jaffray Inc., dated February 2, 2000.

4.12(13) Resale Registration Rights Agreement among Registrant and
Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith
Incorporated, Deutsche Bank Securities Inc., Lehman
Brothers Inc., and U.S. Bancorp Piper Jaffray Inc., dated
February 2, 2000.

40

EXHIBIT EXHIBIT TITLE
- --------------------- -------------

4.13(13) Indenture between Registrant as Issuer and Chase Manhattan
Bank and Trust Company, National Association as Trustee,
dated February 8, 2000.

10.1(4) Registrant's 1994 Equity Incentive Plan, as amended.

10.2(7) Registrant's 1994 Non-Employee Directors' Stock Option Plan,
as amended.

10.3(2) Registrant's 1994 Employee Stock Purchase Plan, as amended.

10.4(2) Standard Industrial Lease between the Registrant and W.F.
Batton & Co., Inc., dated September 17, 1992, as amended
September 18, 1992.

10.5(2) Addendum IV dated April 1, 1994 to Lease dated
September 17, 1992, between the Registrant and W.F. Batton
and Marie A. Batton, dated September 17, 1992.

10.6(6) Amendment Agreement Number One, dated October 20, 1995, to
Lease dated September 17, 1992, between the Registrant and
W.F. Batton & Co., Inc.

10.7(6) Amendment Agreement Number Two, dated November 15, 1995, to
Lease, dated September 17, 1992, between Registrant and
W.F. Batton and Marie A. Batton, Trustees of the W.F.
Batton and Marie A. Batton Trust UTA dated January 12,
1998 ("Batton Trust").

10.8(11) Amendment Agreement Number Three, dated February 14, 1996,
to Lease, dated September 17, 1992, between Registrant and
Batton Trust.

10.9(11) Amendment Agreement Number Four, dated September 15, 1996,
to Lease, dated September 17, 1992, between Registrant and
Batton Trust.

10.10(2) Senior Loan and Security Agreement between the Registrant
and Phoenix Leasing Incorporated, dated September 15,
1993.

10.11(2) Sublicense Agreement between the Registrant and John S.
Patton, dated September 13, 1991.

10.12(5) Stock Purchase Agreement between the Registrant and Baxter
World Trade Corporation, dated March 1, 1996.

10.13(8) Sublease and Lease Agreement, dated October 2, 1996, between
the Registrant and T.M.T. Associates L.L.C. ("Landlord").

10.14(11) First Amendment, dated October 30, 1996, to Sublease and
Lease Agreement, dated October 2, 1996, between Registrant
and Landlord.

10.15(11) Letter Agreement, dated April 9, 1997, amending Sublease and
Lease Agreement, dated October 2, 1996, between the
Registrant and Landlord.

10.16(11) Third Amendment, dated April 16, 1997, to Sublease and Lease
Agreement, dated October 2, 1996, between Registrant and
Landlord.

10.17(11) Fourth Amendment, dated November 5, 1997, to Sublease and
Lease Agreement, dated October 2, 1996, between Registrant
and Landlord.

10.18(13) Sublease by and between Webvan Group, Inc., as sublessor and
Registrant, as sublessee, dated November 3, 1999.

23.1(13) Consent of Ernst & Young LLP, independent auditors.

24.1(13) Power of Attorney. Reference is made to Signature Page.

25.1(13) Form T-1 Statement of Eligibility and Qualification of
Trustee.

27.1 Financial Data Schedule.

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

(1) Incorporated by reference to the indicated exhibit in Inhale's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1998.

41

(2) Incorporated by reference to the indicated exhibit in Inhale's Registration
Statement on Form S-1 (No. 33-75942), as amended.

(3) Incorporated by reference to the indicated exhibit in Inhale's Registration
Statement on Form S-1 (No. 33-89502), as amended.

(4) Incorporated by reference to Inhale's Registration Statement on Form S-8
(No. 333-59735).

(5) Incorporated by reference to the indicated exhibit in Inhale's Quarterly
Report on Form 10-Q for the quarter ended March 31, 1996.

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

(7) Incorporated by reference to the indicated exhibit in Inhale's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1996.

(8) Incorporated by reference to the indicated exhibit in Inhale's Quarterly
Report on Form 10-Q for the quarter ended September 30, 1996.

(9) Incorporated by reference to Inhale's Registration Statement on Form S-3
(No. 333-20787).

(10) Incorporated by reference to the indicated exhibit in Inhale's
Registration Statement on Form S-3 (No. 333-68897), as amended.

(11) Incorporated by reference to the indicated exhibit in Inhale's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1998.

(12) Incorporated by reference to the indicated exhibit in Inhale's
Registration Statement on Form S-3 (No. 333-94161), as amended.

(13) Filed herewith

(b) Reports on Form 8-K.

The following Report on Form 8-K was filed during the quarter ended
December 31, 1999: A Report on Form 8-K dated October 4, 1999 pertaining
to the Registrant's acquisition of Alliance's
PulmoSpheres-Registered Trademark- particle and particle processing
technology and other related assets.

(c) See Exhibits listed under Item 14(a)(3).

(d) Not applicable. See Item 14(a)(2).

42

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized, on the 10th day of March
2000.

INHALE THERAPEUTIC SYSTEMS, INC.

By: /s/ ROBERT B. CHESS
-----------------------------------------
Robert B. Chess
CHAIRMAN AND CO-CHIEF EXECUTIVE OFFICER

/s/ AJIT S. GILL
-----------------------------------------
Ajit S. Gill
CO-CHIEF EXECUTIVE OFFICER,
PRESIDENT AND DIRECTOR

POWER OF ATTORNEY

KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints, Ajit S. Gill as his attorney-in-fact for him in
any and all capacities, to sign any and all amendments to this report on
Form 10-K, and to file the same, with exhibits thereto and other documents in
connection therewith, with the Securities and Exchange Commission, hereby
ratifying and confirming all that the said attorney-in-fact, or his substitutes,
may do or cause to be done by virtue hereof.

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

SIGNATURE TITLE DATE
--------- ----- ----

Chairman and Co-Chief
/s/ ROBERT B. CHESS Executive Officer
------------------------------------------- (CO-PRINCIPAL EXECUTIVE March 10, 2000
Robert B. Chess OFFICER)

Co-Chief Executive Officer,
/s/ AJIT S. GILL President and Director
------------------------------------------- (CO-PRINCIPAL EXECUTIVE March 10, 2000
Ajit S. Gill OFFICER)

Vice President of Finance and
/s/ BRIGID A. MAKES Administration, Chief
------------------------------------------- Financial Officer (PRINCIPAL March 10, 2000
Brigid A. Makes FINANCIAL AND ACCOUNTING
OFFICER

/s/ JOHN S. PATTON
------------------------------------------- Vice President, Research and March 10, 2000
John S. Patton Director

43

SIGNATURE TITLE DATE
--------- ----- ----

/s/ MARK J. GABRIELSON
------------------------------------------- Director March 10, 2000
Mark J. Gabrielson

/s/ JAMES B. GLAVIN
------------------------------------------- Director March 10, 2000
James B. Glavin

/s/ MELVIN PERELMAN
------------------------------------------- Director March 10, 2000
Melvin Perelman

/s/ IRWIN LERNER
------------------------------------------- Director March 10, 2000
Irwin Lerner

44

INHALE THERAPEUTIC SYSTEMS, INC.
INDEX TO FINANCIAL STATEMENTS

PAGE
--------

Report of Ernst & Young LLP, Independent Auditors........... F-2
Balance Sheets at December 31, 1999 and 1998................ F-3
Statements of Operations for each of the three years in the
period ended December 31, 1999............................ F-4
Statement of Stockholders' Equity for each of the three
years in the period ended December 31, 1999............... F-5
Statements of Cash Flows for each of the three years in the
period ended December 31, 1999............................ F-6
Notes to Financial Statements............................... F-7

F-1

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Inhale Therapeutic Systems, Inc.

We have audited the accompanying balance sheets of Inhale Therapeutic
Systems, Inc. as of December 31, 1999 and 1998, and the related statements of
operations, stockholders' equity and cash flows for each of the three years in
the period ended December 31, 1999. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Inhale Therapeutic Systems
at December 31, 1999 and 1998, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 1999 in
conformity with accounting principles generally accepted in the United States.

/s/ ERNST & YOUNG LLP

Palo Alto, California
January 24, 2000

F-2

INHALE THERAPEUTIC SYSTEMS, INC.

BALANCE SHEETS

(IN THOUSANDS, EXCEPT PAR VALUE)

DECEMBER 31,
-------------------
1999 1998
-------- --------

ASSETS
Current assets:
Cash and cash equivalents................................. $ 33,430 $ 24,916
Short-term investments.................................... 104,755 57,946
Accounts receivable....................................... 1,756 1,013
Other current assets...................................... 7,377 665
-------- --------
Total current assets.................................... 147,318 84,540
Property and equipment, net................................. 63,852 49,863
Investment in Alliance Pharmaceutical Corp.................. 6,328 --
Other assets................................................ 9,308 93
-------- --------
$226,806 $134,496
======== ========

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable.......................................... $ 13,374 $ 3,678
Accrued liabilities....................................... 6,849 4,655
Deferred revenue.......................................... 4,811 4,359
Tenant improvement loan--current portion.................. 45 64
-------- --------
Total current liabilities............................... 25,079 12,756
Tenant improvement loan..................................... 4,895 4,940
Convertible subordinated debentures......................... 108,450 --
Accrued rent................................................ 1,753 919

Commitments (See Note 4)

Stockholders' equity:
Preferred stock, 10,000 shares authorized, no shares
issued or outstanding................................... -- --
Common stock, $0.0001 par value; 50,000 shares authorized;
17,226 shares and 16,924 shares issued and outstanding
at December 31, 1999 and 1998, respectively............. 2 2
Capital in excess of par value............................ 181,154 172,847
Deferred compensation..................................... (1,530) (931)
Accumulated deficit....................................... (94,466) (56,018)
Accumulated other comprehensive gain/(loss)............... 1,469 (19)
-------- --------
Total stockholders' equity.............................. 86,629 115,881
-------- --------
$226,806 $134,496
======== ========

See accompanying notes

F-3

INHALE THERAPEUTIC SYSTEMS, INC.

STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE INFORMATION)

YEARS ENDED DECEMBER 31,
------------------------------
1999 1998 1997
-------- -------- --------

Contract research revenue................................... $ 41,358 $ 21,795 $ 16,249
Operating costs and expenses:
Research and development.................................. 64,083 35,398 23,645
General and administrative................................ 7,869 8,387 6,328
Acquired in-process research and development.............. 9,890 -- --
-------- -------- --------
Total operating costs and expenses........................ 81,842 43,785 29,973
-------- -------- --------
Loss from operations........................................ (40,484) (21,990) (13,724)
Interest income............................................. 4,111 3,904 3,807
Interest expense............................................ (2,075) (270) (66)
-------- -------- --------
Net loss.................................................... $(38,448) $(18,356) $ (9,983)
======== ======== ========
Basic and diluted net loss per share........................ $ (2.26) $ (1.17) $ (0.72)
======== ======== ========
Shares used in computing basic and diluted net loss per
share..................................................... 17,008 15,719 13,792
======== ======== ========

See accompanying notes

F-4

INHALE THERAPEUTIC SYSTEMS, INC.

STATEMENT OF STOCKHOLDERS' EQUITY

(IN THOUSANDS)

ACCUMULATED
COMMON STOCK CAPITAL IN OTHER TOTAL
--------------------- EXCESS OF DEFERRED ACCUMULATED COMPREHENSIVE STOCKHOLDERS'
SHARES PAR VALUE PAR VALUE COMPENSATION DEFICIT GAIN/(LOSS) EQUITY
-------- ---------- ---------- ------------- ------------ -------------- -------------

Balance at December 31,
1996....................... 11,835 $ 1 $ 62,839 $ (88) $(27,679) $ (12) $ 35,061
Issuance of common stock in
private placement, net of
issuance costs of $1,940... 1,800 1 30,459 -- -- -- 30,460
Issuance of common stock in
connection with licensing
agreement.................. 28 -- 600 -- -- -- 600
Issuance of common stock in
public offering, net of
issuance costs of $2,885... 1,725 -- 40,024 -- -- -- 40,024
Common stock issued upon
exercise of stock
options.................... 125 -- 798 -- -- -- 798
Issuance of common stock in
connection with exercise of
warrant.................... 29 -- -- -- -- -- --
Deferred compensation........ -- -- 551 (551) -- -- --
Amortization of deferred
compensation............... -- -- -- 101 -- -- 101
Unrealized gain on
available-for-sale
securities................. -- -- -- -- -- 32 32
Net loss..................... -- -- -- -- (9,983) -- (9,983)
--------
Comprehensive loss........... -- -- -- -- -- -- (9,951)
------ ---------- -------- ------- -------- ------ --------
Balance at December 31,
1997....................... 15,542 2 135,271 (538) (37,662) 20 97,093
Issuance of common stock in
private placement, net of
issuance costs of $1,997... 1,200 -- 35,202 -- -- -- 35,202
Issuance of common stock and
stock options in connection
with licensing agreement... 6 -- 284 -- -- -- 284
Common stock issued upon
exercise of stock
options.................... 176 -- 1,514 -- -- -- 1,514
Deferred compensation........ -- -- 576 (576) -- -- --
Amortization of deferred
compensation............... -- -- -- 183 -- -- 183
Unrealized loss on
available-for-sale
securities................. -- -- -- -- -- (39) (39)
Net loss..................... -- -- -- -- (18,356) -- (18,356)
--------
Comprehensive loss........... -- -- -- -- -- -- (18,395)
------ ---------- -------- ------- -------- ------ --------
Balance at December 31,
1998....................... 16,924 2 172,847 (931) (56,018) (19) 115,881
Issuance of common stock to
Alliance................... 180 -- 5,000 -- -- -- 5,000
Common stock issued upon
exercise of stock options,
net of costs............... 122 -- 1,545 -- -- -- 1,545
Compensation in connection
with stock options granted
to consultants............. -- -- 798 -- -- -- 798
Deferred compensation........ -- -- 964 (964) -- -- --
Amortization of deferred
compensation............... -- -- -- 365 -- -- 365
Unrealized gain on
available-for-sale
securities................. -- -- -- -- -- 1,488 1,488
Net loss..................... -- -- -- -- (38,448) -- (38,448)
--------
Comprehensive loss........... -- -- -- -- -- -- (36,960)
------ ---------- -------- ------- -------- ------ --------
Balance at December 31,
1999....................... 17,226 $ 2 $181,154 $(1,530) $(94,466) $1,469 $ 86,629
====== ========== ======== ======= ======== ====== ========

See accompanying notes

F-5

INHALE THERAPEUTIC SYSTEMS, INC.

STATEMENTS OF CASH FLOWS

INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

(IN THOUSANDS)

YEARS ENDED DECEMBER 31,
---------------------------------
1999 1998 1997
--------- --------- ---------

CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES
Net loss.................................................... $ (38,448) $ (18,356) $ (9,983)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization............................. 6,889 3,415 2,337
Amortization of deferred compensation..................... 365 183 101
Issuance of common stock for services..................... 798 -- --
Issuance of common stock and stock options in connection
with licensing agreements............................... -- 284 600
Acquired in-process research and development.............. 9,890 -- --
Changes in assets and liabilities:
Decrease (increase) in accounts receivable, other current
assets, and other assets................................ (8,004) (876) 518
Increase (decrease) in accounts payable and accrued
liabilities............................................. 12,724 (1,546) 7,443
Increase (decrease) in deferred revenue................... 452 (2,327) 3,963
--------- --------- ---------
Net cash (used in) provided by operating activities......... (15,334) (19,223) 4,979
--------- --------- ---------
CASH FLOWS USED IN INVESTING ACTIVITIES
Acquisition of PulmoSpheres-Registered Trademark-
technology................................................ (15,288) -- --
Purchases of short-term investments......................... (122,481) (219,414) (483,247)
Sales of short-term investments............................. 28,658 65,189 80,662
Maturities of short-term investments........................ 47,174 182,309 334,289
Purchases of property and equipment, net.................... (20,502) (34,584) (17,261)
--------- --------- ---------
Net cash used in investing activities....................... (82,439) (6,500) (85,557)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Issuance of convertible subordinated debentures, net........ 104,806 -- --
Payments of loan and capital lease and obligations.......... (64) (181) (168)
Proceeds from tenant improvement loan....................... -- -- 5,000
Issuance of common stock, net of issuance costs............. 1,545 36,716 71,282
--------- --------- ---------
Net cash provided by financing activities................... 106,287 36,535 76,114
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents........ 8,514 10,812 (4,464)
Cash and cash equivalents at beginning of year.............. 24,916 14,104 18,568
--------- --------- ---------
Cash and cash equivalents at end of year.................... $ 33,430 $ 24,916 $ 14,104
========= ========= =========

See accompanying notes

F-6

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

DECEMBER 31, 1999

NOTE 1--ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

ORGANIZATION AND BASIS OF PRESENTATION

Inhale Therapeutic Systems, Inc. ("Inhale", the "Company") was incorporated
in the State of California in July 1990 and reincorporated in the State of
Delaware in July 1998. Since inception, Inhale has been engaged in the
development of a system to deliver drugs to the bloodstream through the lungs by
inhaling a powdered version of the drug. The system is applicable to a wide
range of peptides, proteins and other molecules.

Inhale expects increasing losses over the next several years as research and
development and manufacturing scale-up efforts continue, and as Inhale expands
its facilities for commercial manufacturing. Management plans to continue to
finance Inhale primarily through issuances of equity or debt securities,
research and development contract revenue, and in the longer term, revenue from
product sales and royalties.

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

CASH, CASH EQUIVALENTS AND INVESTMENTS

Inhale considers all highly liquid investments with a maturity from date of
purchase of three months or less to be cash equivalents. Cash and cash
equivalents include demand deposits held in banks and interest bearing money
market funds. All other liquid investments are classified as short-term
investments. Short-term investments consist of federal and municipal government
securities, repurchase agreements or corporate commercial paper with A1 or P1
short-term ratings and A or better long-term ratings with remaining maturities
at date of purchase of greater than 90 days and less than one year. Inhale
limits its concentration of risk by diversifying its investments among a variety
of industries and issuers. Inhale has experienced no material losses on its
investments.

At December 31, 1999, all short-term investments are designated as
available-for-sale and are carried at fair value, with material unrealized gains
and losses, if any, reported in stockholders' equity. The amortized cost of
securities is adjusted for amortization of material premiums and accretion of
discounts to maturity. Such amortization, if any, is included in interest
income. Realized gains and losses and declines in value judged to be
other-than-temporary on available-for-sale securities, if any, are included in
interest income. The cost of securities sold is based on the specific
identification method. Interest and dividends on securities classified as
available-for-sale are included in interest income.

F-7

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 1--ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The following is a summary of available-for-sale debt securities as of
December 31, 1999:

AVAILABLE-FOR-SALE DEBT SECURITIES
-----------------------------------------------
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
-------- ---------- ---------- ----------
(IN THOUSANDS)

Obligations of U.S. government agencies............. $ 81,692 $108 $ -- $ 81,800
U.S. corporate commercial paper..................... 41,081 33 -- 41,114
Repurchase agreements, secured by U.S. Government
securities........................................ 3,845 -- -- 3,845
Other............................................... 7,872 -- -- 7,872
-------- ---- --------- --------
$134,490 $141 $ -- $134,631
======== ==== ========= ========
Amounts included in cash and cash equivalents....... $ 29,822 $ 54 $ -- $ 29,876
Amounts included in short-term investments.......... 104,668 87 -- 104,755
-------- ---- --------- --------
$134,490 $141 $ -- $134,631
======== ==== ========= ========

The following is a summary of available-for-sale debt securities as of
December 31, 1998:

AVAILABLE-FOR-SALE DEBT SECURITIES
-----------------------------------------------
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
-------- ---------- ---------- ----------
(IN THOUSANDS)

Obligations of U.S. government agencies.............. $20,758 $ -- $ -- $ 20,758
U.S. corporate commercial paper...................... 42,773 -- (19) 42,754
Repurchase agreements, secured by U.S. Government
securities......................................... 17,704 -- -- 17,704
Other................................................ 105 -- -- 105
------- --------- ---- --------
$81,340 $ -- $(19) $ 81,321
======= ========= ==== ========
Amounts included in cash and cash equivalents........ $23,375 $ -- $ -- $ 23,375
Amounts included in short-term investments........... 57,965 -- (19) 57,946
------- --------- ---- --------
$81,340 $ -- $(19) $ 81,321
======= ========= ==== ========

The gross realized losses and gains on the sale of debt securities
available-for-sale during the years ended December 31, 1999 and 1998 were not
material. At December 31, 1999 and 1998, the average portfolio duration was
approximately five months and three months, respectively, and the contractual
maturity of any single investment did not exceed eleven months at December 31,
1999 and 1998.

The estimated fair value amounts have been determined by Inhale using
available market information and appropriate valuation methodologies. However,
market data must be interpreted to develop the estimates of fair value.
Accordingly, the estimates presented herein are not necessarily indicative of
the amounts that Inhale could realize in a current market exchange.

F-8

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 1--ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Inhale owns common stock in one technology company. These shares of Alliance
Pharmaceutical Corp. ("Alliance") are accounted for as long-term
available-for-sale securities. Due to restrictions on the sale of this stock,
the Company carries that portion of its investment in Alliance that can be sold
within one year at market value, with material unrealized gains and losses, if
any, reported in stockholders' equity. That portion which cannot be sold within
one year is carried at cost.

PROPERTY AND EQUIPMENT

Property and equipment consist of the following at December 31:

1999 1998
-------- --------
(IN THOUSANDS)

Laboratory and other equipment........................... $ 24,317 $15,012
Leasehold improvements................................... 47,101 36,003
Land..................................................... 7,443 7,443
-------- -------
78,861 58,458
Less accumulated depreciation............................ (15,009) (8,595)
-------- -------
$ 63,852 $49,863
======== =======

Property and equipment are stated at cost. Major renewals and improvements
are capitalized, while maintenance and repairs are expensed when incurred. Other
equipment is depreciated using the straight-line method over estimated useful
lives of four to seven years. Manufacturing equipment is depreciated using the
straight-line method over its useful life estimated to be ten years. Leasehold
improvements and assets acquired under capital leases are amortized using the
straight-line method over the shorter of an estimated useful life of fifteen
years or the term of the lease.

Interest is capitalized in connection with the construction of leasehold
improvements to the Company's manufacturing facility in San Carlos, California.
The capitalized interest is recorded as part of the asset to which it relates
and is amortized over the asset's estimated useful life. In 1999 and 1998,
Inhale capitalized $0 and $203,000 of interest cost, respectively.

COMPREHENSIVE GAIN/LOSS

Effective January 1, 1998, Inhale adopted the Financial Accounting Standards
Board's ("FASB") Statement of Financial Accounting Standards No. 130, "Reporting
Comprehensive Income" ("SFAS 130"). The Company's other component of
comprehensive gain/loss includes only unrealized gains and losses on securities
held as available-for-sale and is shown in the Statement of Stockholders'
Equity. Inhale has no other material components of other comprehensive loss and
accordingly the comprehensive loss is the same as net loss for all periods.

REVENUE RECOGNITION

Contract revenue from collaborative research agreements is recorded when
earned and as the related costs are incurred. Payments received which are
related to future performance are deferred and recognized as revenue when earned
over future performance periods. In accordance with contract terms, upfront and

F-9

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 1--ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
milestone payments from collaborative research agreements are considered
reimbursements for costs incurred under the agreements, and accordingly, are
generally recognized based on actual efforts expended over the remaining terms
of the agreements. Inhale's research revenue is derived primarily from clients
in the pharmaceutical industry. Contract research revenue from three partners
represented 71%, 10% and 9% of Inhale's revenue in 1999. Three partners
accounted for 51%, 22% and 18% of Inhale's revenue in 1998 and 47%, 25% and 21%
of Inhale's revenue in 1997. Costs of contract research revenue approximate such
revenue and are included in research and development expenses.

STOCK-BASED COMPENSATION

As permitted by the provisions of Statement of Financial Accounting
Standards No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"), Inhale
continues 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 option plans. Under APB 25, if the exercise price of
Inhale's employee stock options equals or exceeds the fair market value of the
underlying stock on the date of grant as determined by the closing price of
Inhale's common stock as quoted on the Nasdaq stock market, no compensation
expense is recognized. See Note 5 for pro forma disclosures required by
FAS 123.

RESEARCH AND DEVELOPMENT AGREEMENTS

Inhale performs research and development for others pursuant to feasibility
agreements and development and license agreements. Under the feasibility
agreements, Inhale generally is reimbursed for the cost of work performed.
Feasibility agreements are designed to evaluate the applicability of Inhale's
technologies to a particular molecule and therefore are generally completed in
less than one year. Under Inhale's development and license agreements, the
partner companies receive an exclusive license to develop, use and sell a dry
powder formulation and a suitable delivery device to be developed by Inhale for
one of the partner's macromolecule drugs. Under these development agreements,
Inhale will be reimbursed for development costs and may also be entitled to
milestone payments when and if certain development milestones are achieved. All
of Inhale's research and development agreements are generally cancelable by the
partner without significant financial penalty to the partner.

ACCOUNTING FOR INCOME TAXES

Inhale accounts for income taxes under Statement of Financial Accounting
Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). Under FAS 109, the
liability method is used in accounting for income taxes.

F-10

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 1--ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

NET LOSS PER SHARE

In accordance with Financial Accounting Standard No. 128, basic and diluted
net loss per share has been computed using the weighted average number of shares
of common stock outstanding during the period. Had Inhale been in a net income
position, diluted earnings per share would have included the following
outstanding options, warrants and convertible debentures:

YEARS ENDED DECEMBER 31,
------------------------------------
1999 1998 1997
-------- -------- --------
(IN THOUSANDS)

Warrants............................................. 20 20 20
Options.............................................. 4,553 3,163 2,351
Convertible debentures............................... 3,388 -- --
----- ----- -----
Total.............................................. 7,961 3,183 2,371
===== ===== =====

SEGMENT INFORMATION

Effective January 1, 1998, Inhale adopted the FASB's Statement of Financial
Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and
Related Information" ("SFAS 131"). SFAS 131 superseded FASB Statement No. 14,
"Financial Reporting for Segments of a Business Enterprise." SFAS 131
establishes standards for the way that public business enterprises report
information about operating segments in annual financial statements and requires
that those enterprises report selected information about operating segments in
interim financial reports. SFAS 131 also establishes standards for related
disclosures about products and services, geographic areas, and major customers.

Management has organized Inhale's business in one operating segment which
includes activities related to the development of systems for the pulmonary
delivery of macromolecule drugs. Inhale's operations and all of its assets are
presently located in the United States and the Company derives all of its
revenues within the United States.

RECLASSIFICATION

Certain prior year amounts have been reclassified to conform to the 1999
presentation.

NOTE 2--COLLABORATIVE RESEARCH AND DEVELOPMENT AGREEMENTS

Inhale performs research and development for others pursuant to feasibility
agreements and development and license agreements. Under the feasibility
agreements, Inhale generally is reimbursed for the cost of work performed.
Feasibility agreements are designed to evaluate the applicability of Inhale's
technologies to a particular molecule and therefore are generally completed in
less than one year. Under Inhale's development and license agreements, the
partner companies receive an exclusive license to develop, use and sell a dry
powder formulation and a suitable delivery device to be developed by Inhale for
one of the partner's macromolecule drugs. Under these development agreements,
Inhale will be reimbursed for development costs and may also be entitled to
milestone payments when and if certain development milestones are achieved. All
of Inhale's research and development agreements are generally cancelable by the
partner without significant financial penalty to the partner.

F-11

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 2--COLLABORATIVE RESEARCH AND DEVELOPMENT AGREEMENTS (CONTINUED)
In February 1999, Inhale entered into a collaborative agreement with Biogen
to develop pulmonary delivery for Biogen's AVONEX-Registered Trademark-, a drug
used in the treatment of Multiple Sclerosis. Under the terms of the agreement,
Inhale will receive royalties on product sales, an up-front signing fee, and up
to an estimated $25 million in research and development funding and potential
progress payments. Biogen will provide bulk AVONEX-Registered Trademark- to
Inhale for formulation into a dry powder which is stable at room temperature.
Inhale will manufacture and package the dry powder and supply inhalation
devices. Biogen will be responsible for clinical trials, marketing and
commercialization. The Company recognized revenue of $2.2 million under this
agreement in 1999.

In December 1997, the Company entered into a collaboration agreement with
Eli Lilly and Company ("Lilly") to develop pulmonary delivery for an undisclosed
protein based on Inhale's deep-lung drug delivery system for macromolecules.
Under the terms of the agreement, Inhale will receive funding of up to
$20 million in research, development and progress payments. Lilly will receive
global commercialization rights for the pulmonary delivery of the products with
Inhale receiving royalties on any marketed products. Inhale will manufacture
packaged powders for and supply devices to Lilly. Under this agreement the
Company recognized revenue of $1.2 million in 1999 and $0.9 million in 1998. No
revenue was recognized under this agreement in 1997.

In January 1997, the Company executed a collaboration agreement with Lilly
to develop pulmonary delivery for parathyroid hormone ("PTH"). Under the terms
of the agreement, Inhale will receive funding of up to $20 million of initial
fees, research and development and progress payments. Lilly will receive global
commercialization rights for the pulmonary delivery of the products with Inhale
receiving royalties on any marketed products. Inhale will manufacture packaged
powders for and supply devices to Lilly. Under this agreement, the Company
recognized revenue of $3.8 million and $3.4 million in 1998 and 1997,
respectively. In late 1998, unexpected observations from a long-term test in
rats of the injectable version of parathyroid hormone led Lilly to suspend
further clinical development of the injectable and pulmonary versions of PTH
pending further analysis. Inhale is maintaining a minimum development effort in
its pulmonary program pending further direction from Lilly. Inhale does not
currently believe that the program will be reinitiated in the near future, if at
all.

In December 1996, Inhale entered into a collaborative agreement with Aventis
Behring to develop a pulmonary formulation of alpha-1 proteinase inhibitor to
treat patients with alpha-1 antitrypsin deficiency, or genetic emphysema. Under
the terms of the collaboration, Aventis Behring will receive commercialization
rights worldwide excluding Japan and Inhale will receive royalties on product
sales, an up-front signing fee and up to an estimated $15 million in research
and development funding and milestone payments. Aventis Behring will manufacture
the active ingredient for use in Inhale's delivery device. Inhale will
manufacture and package the dry powder and supply inhalation devices to Aventis
Behring for commercialization and marketing. Under this agreement, the Company
recognized revenue of $3.9 million, $1.6 million and $0.9 million in 1999, 1998
and 1997, respectively.

In March 1996, Inhale entered into a collaboration agreement with Baxter
Healthcare Corporation ("Baxter") to use Inhale's dry powder pulmonary delivery
system as a technology platform for developing and launching therapeutic
products. In connection with the collaboration, Baxter made a $20 million equity
investment in Inhale at a 25% premium to the market price of Inhale stock at the
time of the investment. Baxter received worldwide commercialization rights in
exchange for up to an estimated

F-12

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 2--COLLABORATIVE RESEARCH AND DEVELOPMENT AGREEMENTS (CONTINUED)
$60 million in research and development funding and milestone payments for four
molecules. In October 1998, Inhale announced that it had reached an agreement
with Baxter to amend their collaborative agreement to facilitate signing a new
corporate partner to fund further development and commercialization of the
undisclosed compound that had been their focus since April, 1998. Baxter's
obligations under this amendment expired in September, 1999. As a result, rights
to the compounds reverted to Inhale and are now available for other partnering
opportunities. The Company recognized revenues associated with this program of
$4.3 million, $4.0 million and $4.1 million in 1999, 1998, and 1997,
respectively.

In January 1995, the Company entered into a collaborative development and
license agreement with Pfizer Inc. ("Pfizer") to develop pulmonary delivery for
inhaled insulin based on Inhale's deep-lung delivery system for macromolecules.
Under the terms of the agreement, Inhale will receive funding consisting of
initial fees, research and development and progress payments. Upon execution of
the agreement Pfizer purchased $5.0 million of Inhale common stock. In addition,
in October 1996, Pfizer purchased an additional $5.0 million of Inhale common
stock. Pfizer will receive global commercialization rights for the pulmonary
delivery of the products with Inhale receiving royalties on any marketed
products. Inhale will manufacture inhaled insulin for, and supply devices to
Pfizer. Under this agreement the Company recognized revenue of $29.5 million,
$11.1 million and $7.6 million in 1999, 1998 and 1997, respectively.

Costs associated with research and development activities attributable to
these agreements are expected to approximate the revenues recognized.

NOTE 3--ACQUISITION OF PULMOSPHERES-REGISTERED TRADEMARK- TECHNOLOGY

In November 1999, Inhale concluded an agreement with Alliance Pharmaceutical
Corp. to acquire Alliance's PulmoSpheres-Registered Trademark- particle and
particle processing technology for use in respiratory drug delivery. Under the
terms of the agreement, Inhale received the rights to
PulmoSpheres-Registered Trademark- technology, other related assets and Alliance
stock valued at $5 million in exchange for $15 million in cash and $5 million of
Inhale stock. The purchase price, including $387,000 of acquisition costs, has
been allocated to assets acquired and to in-process research and development,
which has been charged as an expense on the Statement of Operations for the year
ended December 31, 1999. The Company's investment in Alliance and the assets
acquired in connection with the PulmoSpheres-Registered Trademark- acquisition
are recorded at their fair market value at acquisition as follows:

Property and equipment, net................................. $ 200
Acquired in-process research and development charged to
operations at December 31, 1999........................... 9,890
Intellectual property, net.................................. 3,171
Assembled workforce......................................... 96
Goodwill.................................................... 2,030
-------
Total cash purchase consideration......................... 15,387
Common stock of Alliance.................................... 5,000
-------
Total purchase consideration.............................. $20,387
=======

F-13

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 3--ACQUISITION OF PULMOSPHERES-REGISTERED TRADEMARK- TECHNOLOGY (CONTINUED)
Goodwill and other intangible assets are being amortized over seven years.

The purchased research and development was identified and valued through
extensive interviews and discussions with appropriate management and scientific
personnel and the analysis of data provided by Alliance regarding the
PulmoSpheres-Registered Trademark- technology, its stage of development at the
time of acquisition, the importance of the technology to Inhale's overall
development plan, and the projected incremental cash flows from the projects
when completed and any associated risks. Associated risks include the
uncertainties in overcoming significant technological risks, acquiring FDA
approval and establishing commercial viability.

NOTE 4--COMMITMENTS, LONG-TERM DEBT AND TENANT IMPROVEMENT LOAN

As of December 31, 1999, Inhale had $108,450,000 aggregate principal amount
of 6 3/4% Convertible Subordinated Debentures ("the Debentures") which will
mature on October 13, 2006 and are convertible into shares of Inhale's common
stock at a conversion price of $32.0075 per share, subject to adjustment in
certain circumstances. The Debentures are redeemable in part or in all at the
option of the Company on or after October 13, 2002. Interest is payable
semi-annually on April 13 and October 13. The Debentures are unsecured
subordinated obligations which rank junior in right of payment to all of the
Company's existing and future Senior Debt. The Company had approximately
$4.9 million of Senior Debt outstanding at December 31, 1999. Costs relating to
the issuance of the Debentures are recorded as long-term assets and are being
amortized over the term of the debt (see Note 8).

Inhale leases its office and laboratory facilities under several
arrangements expiring through the year 2012. Rent expense was approximately
$2,484,000, $1,777,000 and $1,106,000 for the years ended December 31, 1999,
1998 and 1997, respectively. In November 1997, Inhale received from the landlord
of its facility in San Carlos, California a loan of $5.0 million to fund a
portion of the cost of improvements made to the facility. The loan bears
interest at 9.46% per annum, and principal and interest payments are payable
monthly over the ten-year loan term with a balloon payment of $4.5 million at
the end of the tenth year. The loan is recorded on the balance sheet as a tenant
improvement loan.

F-14

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 4--COMMITMENTS, LONG-TERM DEBT AND TENANT IMPROVEMENT LOAN (CONTINUED)
Future noncancelable commitments under operating leases and the tenant
improvement loan at December 31, 1999 are as follows:

TENANT
OPERATING IMPROVEMENT
LEASES LOAN
--------- -----------
(IN THOUSANDS)

Years ending December 31,
2000................................................. $ 1,841 $ 510
2001................................................. 2,028 503
2002................................................. 2,136 503
2003................................................. 1,792 503
2004................................................. 1,713 503
2005 and thereafter.................................. 14,484 5,974
------- -------
Total minimum payments required........................ $23,994 $ 8,496
======= -------
Less amount representing interest...................... (3,556)
-------
Present value of future payments....................... 4,940
Less current portion................................... (45)
-------
Non-current portion.................................... $ 4,895
=======

NOTE 5--STOCKHOLDERS' EQUITY

COMMON STOCK

EMPLOYEE STOCK PURCHASE PLAN

In February 1994, Inhale's Board of Directors adopted the Employee Stock
Purchase Plan (the "Purchase Plan"). Under the Purchase Plan, 150,000 shares of
common stock have been reserved for purchase by Inhale's employees pursuant to
section 423(b) of the Internal Revenue Code of 1986. As of December 31, 1999, no
shares of common stock have been issued under the Purchase Plan.

STOCK OPTION PLANS

EQUITY INCENTIVE PLAN

Inhale's 1994 Equity Incentive Plan (the "Equity Incentive Plan") was
adopted by the Board of Directors in February 1994. The Equity Incentive Plan is
an amendment and restatement of Inhale's 1992 Stock Option Plan. The purpose of
the Equity Incentive Plan is to attract and retain qualified personnel, to
provide additional incentives to employees, officers, consultants and employee
directors of Inhale and to promote the success of Inhale's business. Pursuant to
the Equity Incentive Plan, Inhale may grant or issue incentive stock options to
employees and officers and non-qualified stock options, restricted stock
purchase awards, stock bonuses and stock appreciation rights to consultants,
employees, officers and employee directors. Options granted to non-employees are
recorded at fair value based on the fair value measurement criteria of FAS 123.

F-15

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 5--STOCKHOLDERS' EQUITY (CONTINUED)

The maximum term of a stock option under the Equity Incentive Plan is ten
years, but if the optionee at the time of grant has voting power of more than
10% of Inhale's outstanding capital stock, the maximum term of an incentive
stock option is five years. The exercise price of incentive stock options
granted under the Equity Incentive Plan must be at least equal to 100% (or 110%
with respect to holders of more than 10% of the voting power of Inhale's
outstanding capital stock) of the fair market value of the stock subject to the
option on the date of the grant. The exercise price of non-qualified stock
options, and the purchase price of restricted stock purchase awards, granted
under the Equity Incentive Plan are determined by the Board of Directors. Stock
appreciation rights authorized for issuance under the Equity Incentive Plan may
be tandem stock appreciation rights, concurrent stock appreciation rights or
independent stock appreciation rights.

The Equity Incentive Plan may be amended at any time by the Board, although
certain amendments would require shareholder approval. The Equity Incentive Plan
will terminate in February 2004 unless earlier terminated by the Board.

NON-EMPLOYEE DIRECTORS' STOCK OPTION PLAN

In February 1994, Inhale's Board of Directors adopted the Non-employee
Directors' Stock Option Plan under which options to purchase up to 200,000
shares of Inhale's common stock at the then fair market value may be granted to
Inhale's non-employee directors. As of December 31, 1999, options on 34,800
shares had been exercised and options to purchase 102,066 shares were
exercisable.

1998 NON-OFFICER EQUITY INCENTIVE PLAN

Inhale's 1998 Non-officer Equity Incentive Plan ("1998 Plan") was adopted by
the Board of Directors in June 1998. The purpose of the 1998 Plan is to attract
and retain qualified personnel, to provide additional incentives to employees
and consultants and to promote the success of Inhale's business. Pursuant to the
1998 plan, Inhale may grant or issue non-qualified stock options, restricted
stock purchase awards, stock bonuses and stock appreciation rights to employees
and consultants who are neither Officers or Directors of Inhale.

The maximum term of a stock option under the 1998 Plan is ten years. The
exercise price of stock options, and the purchase price of restricted stock
purchase awards granted under the 1998 Plan are determined by the Board of
Directors. Stock appreciation rights authorized for issuance under the 1998 Plan
may be tandem stock appreciation rights, concurrent stock appreciation rights or
independent stock appreciation rights. The 1998 Non-officer Equity Incentive
Plan may be amended by the Board of Directors at any time.

F-16

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 5--STOCKHOLDERS' EQUITY (CONTINUED)
A summary of activity under the Equity Incentive Plan, the Non-Employee
Directors' Stock Option Plan and the 1998 Non-officer Equity Incentive Plan is
as follows:

OPTIONS OUTSTANDING
--------------------------------- WEIGHTED-AVERAGE
OPTIONS AVAILABLE EXERCISE PRICE EXERCISE PRICE
FOR GRANT NUMBER OF SHARES PER SHARE PER SHARE
----------------- ---------------- -------------- ----------------
(IN THOUSANDS, EXCEPT PER SHARE INFORMATION)

Balance at December 31, 1996...... 1,774 1,659 $ 0.06-19.25 $ 9.13
Options granted................. (851) 851 0.01-35.25 21.01
Options exercised............... -- (125) 0.06-16.13 6.41
Options canceled................ 34 (34) 0.56-22.75 15.43
------ ----- ------------ ------
Balance at December 31, 1997...... 957 2,351 0.01-35.25 13.48
Shares authorized............... 1,550 -- -- --
Options granted................. (1,069) 1,069 0.01-34.13 28.16
Options exercised............... -- (174) 0.06-22.75 8.69
Options canceled................ 83 (83) 5.56-35.25 21.89
------ ----- ------------ ------
Balance at December 31, 1998...... 1,521 3,163 0.01-35.25 18.48
Shares authorized............... 1,250 -- -- --
Options granted................. (1,575) 1,575 0.01-41.88 27.15
Options exercised............... -- (124) 0.01-34.12 12.60
Options canceled................ 61 (61) 10.01-34.12 26.46
------ ----- ------------ ------
Balance at December 31, 1999...... 1,257 4,553 0.01-41.88 $21.52
====== ===== ============ ======

At December 31, 1999, 1998 and 1997, options were exercisable to purchase
approximately 1,511,484, 1,077,000 and 784,000 at weighted-average exercise
prices of $14.91, $11.36 and $8.17 per share, respectively.

Weighted average fair value of options granted during the year ended
December 31, 1999, 1998 and 1997, was $28.34, $28.42 and $21.89, respectively.
The following table provides information regarding Inhale's stock option plans
as of December 31, 1999.

OPTIONS OUTSTANDING OPTIONS EXERCISABLE
---------------------------------------------------- ---------------------------------
WEIGHTED-
AVERAGE
WEIGHTED- REMAINING WEIGHTED-
RANGE OF AVERAGE EXERCISE CONTRACTUAL LIFE AVERAGE EXERCISE
EXERCISE PRICES NUMBER PRICE PER SHARE (IN YEARS) NUMBER PRICE PER SHARE
- --------------------- -------------- ---------------- ---------------- -------------- ----------------
(IN THOUSANDS) (IN THOUSANDS)

$ 0.01-7.75 595 $ 3.82 5.03 496 $ 4.42
8.88-12.00 454 10.09 5.60 272 10.12
14.25-19.63 743 17.55 6.90 299 16.92
21.88-32.38 2,655 28.01 9.0 409 27.66
34.13-41.88 106 35.19 8.10 35 34.83
------------ ----- ------ ---- ----- ------
$ 0.01-41.88 4,553 $21.52 7.80 1,511 $14.91
============ ===== ====== ==== ===== ======

F-17

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 5--STOCKHOLDERS' EQUITY (CONTINUED)
In 1999, the Company granted 67,100 options to employees and consultants
with exercise prices below the market price of the stock on the grant date. The
weighted-average exercise price and weighted-average fair value of these options
as of December 31, 1999 were $0.01 and $27.87, respectively.

Pro forma information regarding net income and earnings per share is
required by FAS 123, which also requires that the information be determined as
if Inhale has accounted for its employee stock options granted subsequent to
December 31, 1994 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:

1999 1998 1997
-------- -------- --------

Risk-free interest rate........................ 5.6% 4.8% 5.7%
Dividend yield................................. 0.0% 0.0% 0.0%
Volatility factor.............................. 0.600 0.700 0.578
Weighted average expected life................. 5 years 5 years 6 years

The Black-Scholes options valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because Inhale's 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. However, Inhale
has presented the pro forma net loss and pro forma basic and diluted net loss
per common share using the assumptions noted above.

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

YEARS ENDED DECEMBER 31,
------------------------------
1999 1998 1997
-------- -------- --------

Pro forma net loss............................. $(48,077) $(24,325) $(13,168)
======== ======== ========
Pro forma basic and diluted net loss per common
share........................................ $ (2.83) $ (1.55) $ (0.95)
======== ======== ========

Because FAS 123 is applicable only to options granted subsequent to
December 31, 1994, the pro forma effect of the statement will not be fully
reflected until approximately the year 2000.

WARRANTS

In October 1996 Inhale issued two warrants ("the warrants") to purchase a
total of 20,000 shares of Common Stock (10,000 shares each) at a price of
$13.125 per share in connection with a facility lease. The warrants expire in
October 2006 and were both outstanding and exercisable at December 31, 1999.

F-18

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 5--STOCKHOLDERS' EQUITY (CONTINUED)
STOCK COMPENSATION

Inhale recorded deferred compensation of approximately $964,000 during the
year ended December 31, 1999. Deferred compensation of $576,000 had been
recorded in the year ended December 31, 1998. These amounts represent the
difference between the exercise price and the deemed fair market value of
certain of Inhale's stock options granted in these periods and are being
amortized to expense over the three-year vesting period of the options.

RESERVED SHARES

A total of 5,830,108 shares of common stock have been reserved for issuance
at December 31, 1999 for Inhale's equity incentive plans and the warrants.

NOTE 6--INCOME TAXES

As of December 31, 1999, Inhale had federal and state net operating loss
carryforwards of approximately $82,000,000 and $10,600,000, respectively. Inhale
also had federal and state research and other tax credit carryforwards of
approximately $2,000,000 and $2,100,000, respectively. The federal and state net
operating loss and credit carryforwards will expire at various dates beginning
in 2000 through 2019 if not utilized.

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

Significant components of Inhale's deferred tax assets for federal and state
income taxes as of December 31 are as follows:

1999 1998
-------- --------
(IN THOUSANDS)

Deferred tax assets:
Net operating loss carryforwards...................... $ 28,500 $ 16,300
Research and other credits............................ 3,700 2,200
Capitalized research expenses......................... 1,600 1,900
Deferred revenue...................................... 1,900 1,700
Depreciation.......................................... 1,300 --
Other................................................. 2,100 2,500
-------- --------
Total deferred tax assets............................... 39,100 24,600
Valuation allowance for deferred tax assets............. (39,100) (24,600)
-------- --------
Net deferred tax assets................................. $ -- $ --
======== ========

Because of Inhale's lack of earnings history, the deferred tax assets have
been fully offset by a valuation allowance. The valuation allowance increased by
$14,500,000 and $8,900,000 during the years ended December 31, 1999 and 1998,
respectively.

F-19

INHALE THERAPEUTIC SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

NOTE 7--STATEMENT OF CASH FLOWS DATA

YEARS ENDED
DECEMBER 31,
------------------------------
1999 1998 1997
-------- -------- --------
(IN THOUSANDS)

Supplemental disclosure of cash flows information:
Interest paid............................................. $ 470 $270 $ 66
====== ==== ====
Supplemental schedule of non-cash investing and financing
activities:
Deferred compensation related to the issuance of certain
stock options........................................... $ 964 $576 $551
====== ==== ====
Issuance of common stock to Alliance...................... $5,000 $ -- $ --
====== ==== ====
Issuance of common stock and options in connection with
licensing agreement..................................... $ -- $284 $600
====== ==== ====

NOTE 8--SUBSEQUENT EVENTS (UNAUDITED)

In February 2000, Inhale received $222.4 million in net proceeds from the
issuance of $230.0 million aggregate principal amount of convertible
subordinated notes to certain qualified institutional buyers under Rule 144A of
the Securities Act of 1933, as amended. Interest on the notes accrues at a rate
of 5% per year, subject to adjustment in certain circumstances. The notes will
mature in 2007 and are convertible into shares of Inhale's common stock at a
conversion price of $76.71 per share, subject to adjustment in certain
circumstances.

In February 2000, Inhale entered into privately negotiated agreements with
certain holders of its outstanding 6 3/4% convertible subordinated debentures
privately placed in October and November 1999, providing for the conversion of
approximately $94.2 million aggregate principal amount of the outstanding
debentures in exchange for cash payments of approximately $16.2 million in the
aggregate. As a result of these transactions, the $94.2 million of convertible
debentures were converted into approximately 2.9 million shares of Inhale common
stock. Inhale will no longer have interest payment obligations on the debentures
that were converted.

F-20