UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

NASTECH PHARMACEUTICAL COMPANY INC.

Registrant’s telephone number, including area code: (425) 908-3600

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

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

Title of each class

Common Stock, $.006 par value

Preferred Stock Purchase Rights, $.01 par value

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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.   [   ]

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-5 of the Act). Yes  [X]   No   [   ]

The aggregate market value of the voting stock held by non-affiliates of the Registrant as of June 30, 2003 based upon the closing price on that date, on the Nasdaq National Market, was approximately $106,155,553.

As of March 4, 2004, there were 11,912,961 shares of the Registrant’s $0.006 par value common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Definitive Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after the end of the Registrant’s fiscal year 2003 are incorporated by this reference into Part III of this Form 10-K.

Table of Contents

NASTECH PHARMACEUTICAL COMPANY INC.

Table of Contents

FORWARD-LOOKING STATEMENTS

     This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect our current views with respect to future events or our financial performance, and involve certain known and unknown risks, uncertainties and other factors, including those identified below, which may cause our or our industry’s actual or future results, levels of activity, performance or achievements to differ materially from those expressed or implied by any forward-looking statements or from historical results. In some cases you can identify forward-looking statements by terminology such as “may,” “will,” “could,” “would,” “should,” “believe,” “expect,” “plan,” “anticipate,” “intend,” “estimate,” “predict,” “potential” and other expressions which indicate future events and trends.

     The following factors, among others, could cause our or our industry’s future results to differ materially from historical results or those anticipated:

	•		our ability to obtain additional funding;
	•		our efforts to find a collaborative partner for apomorphine nasal spray, calcitonin nasal spray, interferon beta, morphine gluconate nasal spray, oral abuse-resistant opioid, peptide YY (3-36) nasal spray or other programs;
	•		the success or failure of our research and development programs;
	•		the advantages and disadvantages of pharmaceuticals delivered nasally;
	•		the need for improved and alternative drug delivery methods;
	•		our efforts to collaborate with other pharmaceutical and biotechnology companies that have products under development;
	•		our ability to successfully complete product research and development, including preclinical and clinical studies and commercialization;
	•		our ability to obtain required governmental approvals, including product and patent approvals;
	•		our ability to successfully manufacture the products of our research and development programs and our marketed products to meet current Good Manufacturing Practices (“cGMP”) and to manufacture these products at a financially acceptable cost;
	•		our ability to attract and/or retain our key officers and employees and manufacturing, sales, distribution and marketing partners;
	•		costs associated with any product liability claims, patent prosecution, patent infringement lawsuits and other lawsuits;
	•		our ability to develop and commercialize our products before our competitors; and
	•		the projected size of the drug delivery market.

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     These factors and the risk factors described in this document are the important factors of which we are currently aware that could cause actual results, performance or achievements to differ materially from those expressed in any of our forward-looking statements. We operate in a continually changing business environment, and new risk factors emerge from time to time. Other unknown or unpredictable factors also could have material adverse effects on our future results, performance or achievements. We cannot assure you that projected results or events will be achieved or will occur. These statements are not guarantees of future performance and actual actions or results may differ materially. These statements are subject to certain risks, uncertainties and assumptions that are difficult to predict, including those noted in the documents incorporated herein by reference. We have no obligation to update or revise publicly any forward-looking statements as a result of new information, future events or otherwise, unless required by law. Readers should, however, carefully review the risk factors included in this Annual Report on Form 10-K under the caption “Risk Factors” and in other reports or documents filed by us from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

PART I

ITEM 1. BUSINESS

Overview

     Nastech Pharmaceutical Company Inc. (“Nastech”, the “Company” or “We”) is an emerging pharmaceutical company developing products based on applying proprietary drug delivery technologies, with approximately 195 patents and applications filed. We are developing molecular biology-based technologies for delivering both small and large molecule drugs by nasal administration, along with an extended release oral delivery technology. Our intranasal drug delivery technology may lead to greater drug efficacy, speed of action, safety, and patient compliance. We are developing a diverse product portfolio across multiple therapeutic areas, including products targeted for the treatment of sexual dysfunction, obesity, pain management, osteoporosis, and multiple sclerosis.

     We are building a pharmaceutical company leveraging our unique drug delivery capabilities and technologies as the means to develop commercial products – initially with partners, then on our own. The key elements of our business model are to:

	•		develop proprietary active delivery molecules from our tight junction and siRNA technologies;
	•		focus on molecules where our portfolio of technologies will offer significant clinical advantages;
	•		conduct preclinical, clinical and manufacturing steps to generate validated clinical leads and products;
	•		partner to complete or assist us to complete development and commercialization; and
	•		provide turn-key commercial manufacturing of nasal delivery products.

     We are a leader in molecular-biology based drug delivery, which involves the pharmaceutical manipulation of “tight junctions”. Tight junctions are the cell-to-cell connections that comprise various tissues of the body and that regulate the transport and passage of therapeutic drugs across these natural barriers. We also have expertise in formulation science, a systematic approach to drug development using biophysics, physical chemistry and pharmacology to maximize therapeutic efficacy and safety, which sometimes involves a change in route of administration. Our drug delivery technology is essential in designing an optimized, customizable dosage form and in delivering proteins and large molecule drugs that can currently only be delivered by injection or other non-optimized routes.

     Our core technical competency in molecular-biology based drug delivery involves the research, development and manufacture of nasally administered prescription pharmaceuticals. We investigate the commercial weaknesses of pharmaceutical products currently available in oral, injectable or other dosage forms, and we determine the advantages an alternative drug delivery system, such as intranasal, would have for the same drug in the market place. For example, while the oral route of drug delivery is the most popular and least expensive method of delivery, gastrointestinal and liver metabolism can reduce an oral drug’s effectiveness. Generally, a nasal delivery system will provide faster absorption into the blood stream than an oral product thereby resulting in faster onset of action. Other advantages of this therapy may include lower drug doses, fewer side effects, greater safety and efficacy, greater convenience to the patient, better patient compliance of prescribed drug therapy and lower overall health care costs for the patient when compared to established methods of delivery. Pharmaceuticals that are currently injected can also be candidates for nasal delivery.

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     We were incorporated in Delaware in 1983 and our principal executive offices are located at 3450 Monte Villa Parkway, Bothell, Washington. We relocated our headquarters to Bothell, Washington, in 2002, and we operate a drug manufacturing facility in New York. We have research laboratories in Hauppauge, New York and in Bothell, Washington.

Business Strategy

     Our current business strategy seeks to broaden applications of our commitment to tight junction technology and formulation science, allowing drugs to be safer and more effective in patient treatment, with particular emphasis on the applications for nasal drug delivery in the prescription and over-the-counter markets.

     Focus Research and Development Efforts on Molecules Where Our Portfolio of Technologies will Offer Significant Clinical Advantages. Our core technical competency in molecular-biology based drug delivery involves the research, development and manufacture of nasally administered prescription pharmaceuticals. We believe that by focusing our research and development activities in this way, we may enter into collaborative alliances with pharmaceutical companies and bring to market new, improved therapies.

     Establish Collaborative Arrangements. Using tight junction technology and formulation science, we seek to establish domestic and international relationships with major pharmaceutical companies for the early stage introduction of nasal dosage forms of drug delivery as a viable alternative to injectable therapy. Ideally we would focus our efforts on an innovator company’s new chemical entity in Phase II clinical development where a drug’s safety and efficacy have been determined. Our proprietary formulation, delivered via nasal route of administration, would be the product approved for commercialization and marketed by the collaborative partner. This approach allows us to devote our resources to the further development of our technology while leveraging the established product development, sales and marketing capabilities of our collaborative partners in significant markets.

     Protect and Expand Our Intellectual Property Rights. We have and will continue to seek patent protection for our formulations and other technology in the United States and key international markets. We have filed U.S. patent applications, as well as corresponding patent applications outside the U.S., relating to our technology. As specific formulations are developed and clinically tested, we intend to file for additional patent protection.

     A cornerstone of our business strategy is to work with collaborative partners to develop and commercialize drugs for intranasal delivery. In an ideal collaboration, our partner will support the application of our technology to a particular drug by providing the drug, funding clinical development, and marketing the resulting commercial product. We ideally will supply the intranasal formulation delivery system and receive research and development and progress payments during development, receive revenues from manufacturing, and royalties from sales of any commercial products.

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Programs

     The following chart summarizes our programs under development:

     (1) See the section of Item 1 entitled “Government Regulations” for a description of the different stages of development.

Programs Under Development

     Apomorphine Hydrochloride – Sexual dysfunction. Apomorphine Hydrochloride is a centrally acting dopamine agonist. We believe that a nasal dosage form of apomorphine may allow for patient-friendly self-administration and provide a rapid systemic absorption of the drug with reduced side effects for the treatment of sexual dysfunction. We completed a Phase II clinical trial in November 2001 in 184 men with erectile dysfunction (“ED”). On February 1, 2002, we granted Pharmacia exclusive, worldwide rights to develop and market intranasal apomorphine for the treatment of male and female sexual dysfunction, and Pharmacia agreed to manage and fund all future development in these indications. In August 2002, we were granted a U.S. patent entitled “Nasal Delivery of Apomorphine.” The patent contains 13 claims and is directed to compositions of apomorphine or a chemically modified equivalent or pharmaceutical salt and to methods of treating sexual dysfunction, including erectile dysfunction. In January 2003, the U.S. Federal Trade Commission (the “FTC”) mandated as part of the Pfizer/Pharmacia merger that Pharmacia divest apomorphine. As a result of the FTC mandate, we entered into a divestiture agreement with Pharmacia under which we reacquired all the product and intellectual property rights to the intranasal apomorphine product that we had originally granted to Pharmacia in February 2002. See “Collaborative Arrangements—Pharmacia & Upjohn Company” under this Item 1 for a further discussion of our former relationship with Pharmacia. In March 2004, we announced the successful completion of a maximum tolerable dose study for this program.

     Calcitonin – Osteoporosis. Calcitonin is a hormone produced by the thyroid gland that acts primarily on bone. Bone is in a constant state of remodeling, whereby old bone is removed by cells called osteoclasts, and new bone is laid down by cells called osteoblasts. Calcitonin inhibits bone removal by osteoclasts, and promotes bone formation by osteoblasts. A currently approved and marketed intranasal calcitonin has been shown to increase spinal bone mass in postmenopausal women with established osteoporosis. Human calcitonin has a very short half-life in the blood stream and therefore the longer acting salmon calcitonin is used therapeutically. In December 2003, we filed an Abbreviated New Drug Application (“ANDA”) for Calcitonin-Salmon Nasal Spray for osteoporosis with the U.S. Food and Drug Administration (“FDA”).

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     The osteoporosis pharmaceutical market is currently $7 billion and is expected to grow to $14 billion by 2011¹. The only currently available formulation of calcitonin has worldwide sales of nearly $400 million, of which the U.S. accounts for approximately $240 million².

     Interferon Beta – Multiple Sclerosis. Interferons are a family of naturally occurring proteins and glycoproteins classified as cytokines. They are produced by cells in response to viral infection and other biological inducers and mediate antiviral, antiproliferative and immunomodulatory activities. Interferon beta is currently administered by injectable dosage form only. We believe that a nasal dosage form would increase patient compliance and possibly efficacy and have fewer side effects than an injectable product. In March 2002, we reported positive interim results from the Phase I clinical trial in healthy male subjects which showed elevations in the same biologic markers produced by the intramuscular product, suggesting a pharmacological effect. In 2003, we continued optimizing the intranasal formulation of this product. We are in continuing discussions with potential collaboration partners regarding further development of this product.

     Morphine Gluconate – Pain. Morphine is a well known opioid analgesic currently marketed in multiple dosage forms including those for injectable, oral and rectal administration. Breakthrough pain can occur in chronic pain patients treated with long-acting opioid agents. However, only one agent is currently approved for treating breakthrough pain, a transmucosal oral fentanyl product, limited to opioid-tolerant cancer patients. We believe a nasal dosage form of our patented morphine gluconate, an enhanced bioavailability form of morphine, will allow for patient-friendly self-administration and will provide a rapid systemic absorption of the drug for fast pain relief, particularly among sufferers of breakthrough pain. In December 2002, we announced positive results from a Phase II clinical trial indicating that intranasal morphine gluconate was rapidly absorbed and produced meaningful pain relief. The onset of pain relief occurred at an average of 2.2 minutes following dosing and none of the patients needed to take another rescue medication for breakthrough pain within 30 minutes. There were no serious adverse events reported. We are in continuing discussions with potential collaboration partners regarding further development of this product.

     Oral Abuse-Resistant Opioid– Pain. CC-109 is a new agent for treating pain. Like Purdue Pharma’s OxyContin, a controlled-release narcotic painkiller with annual sales exceeding $1.5 billion, CC-109 is a long-acting, orally administered opioid. OxyContin has diversion problems in which drug abusers crush the sustained release tablets, releasing oxycodone, the active opioid. The crushed tablets can be dissolved and misused either systemically or orally, leading to narcotic highs and in some cases death. In contrast to OxyContin, CC-109 is a chemically-modified opioid that cannot be abused by simply crushing a tablet since it is not merely a physically based sustained-release formulation of oxycodone. CC-109 when taken orally, is metabolized by gastrointestinal enzymes, resulting in release of opioids over time. If FDA approved and commercially available, it is believed that CC-109 could not simply be crushed to release oxycontin; hence it is designed to have less abuse potential for diversion than OxyContin and other oral opioid formulations. In 2003, we advanced the preclinical program for CC-109 including the initiation of pharmacodynamic and safety studies, developed a regulatory strategy and refined the manufacturing process.

     Peptide YY(3-36) – Obesity. Peptide YY(3-36) (“PYY”), a high affinity Y2 receptor agonist, represents a new class of obesity drugs. It is a hormone naturally produced by specialized endocrine cells (L-cells) in the gut in proportion to the calorie content of a meal which is believed to reduce appetite and food intake by modulating appetite circuits in the hypothalamus. Results from a study conducted by Dr. Stephen R. Bloom and colleagues published in The New England Journal of Medicine (September 4, 2003, Volume 349, Number 10, Pages 941-948), demonstrated a 16.5% calorie reduction in obese subjects for the 24-hour period following a single intravenous injection of PYY, based on diary recorded food intake. Obese subjects were found to have lower levels of PYY both pre- and post-dose, suggesting that PYY levels might be causally related to obesity and that PYY supplementation might have therapeutic benefit. We have developed a proprietary formulation of PYY and have filed patent applications throughout the world containing over 350 claims. We are currently in Phase I clinical trials with this program.

     Obesity is a chronic condition that affects millions of people and often requires long-term or invasive treatment to promote and sustain weight loss. A study published in the January 1, 2003 issue of the Journal of the American Medical Association (“JAMA”), reported that the prevalence of obesity among U.S. adults climbed to 20.9 percent in 2001. According to the U.S. Department of Health and Human Services, obesity among adults has doubled since 1980,

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while overweight among adolescents has tripled and approximately 300,000 U.S. deaths a year currently are associated with obesity and overweight¹. The total direct and indirect costs attributed to overweight and obesity amounted to $117 billion in 2000¹. Additionally, in the U.S., more than $33 billion is spent annually on weight-loss products and services².

Other Programs and Research Activities

     In addition to the programs contained in our product development pipeline, we are frequently presented with opportunities to evaluate the feasibility of a given compound for nasal delivery and to develop new product concepts. In this regard, our ongoing research activities focus on the utilization, optimization or modification of our core nasal drug delivery technologies for use with specific drugs or therapies.

     We also intend to leverage our core technologies by collaborating with other pharmaceutical and biotechnology companies that have products under development that may benefit from nasal delivery. Such collaborative development projects will be initiated only to the extent that we believe that the project is feasible; the potential product resulting from the development program would have significant market potential; and favorable economic arrangements can be obtained. We will generally seek milestone payments based upon the development cycle, payment of certain expenses incurred by us, manufacturing rights, if applicable, and royalties.

Tight Junction Technology Platform

     Tight junctions are the connections between cells that comprise various tissues of the body such as epithelial and endothelial layers and that regulate the passage of molecules across these natural barriers. As part of the body’s normal activity, tight junctions selectively open and close in response to various signals inside and outside of cells allowing the passage of large molecules or even entire cells across the tight junction barrier.

     Tight junctions are found in all tissues, but the tight junctions containing tissues that are of particular relevance to drug delivery are found in nasal tissue, intestinal tissue, blood vessels, and the blood-brain barrier. The blood-brain barrier is a specialized layer of endothelial cells that line the inner surface of blood vessels in the brain, which excludes many drugs from passing into the brain. Drugs, particularly large molecular weight drugs, need to pass through these tissue barriers in order to get to their sites of action.

     Tight junctions consist of proteins, such as claudins, occludin and junctional adhesion molecules that are anchored in the membranes of two adjacent cells and interact with each other to hold the cells together and prevent other molecules from passing between them.

     The goal of our tight junction biology program is to understand the structure and function of these tissue barriers and to identify active compounds that can transiently open the tight junction, thus permitting drugs to pass through. We have genetically engineered and produced many of the key tight junction proteins and are using them as targets to identify peptides and small molecules that can significantly improve drug delivery by temporarily opening tight junctions. We call such peptides and small molecules tight junction modulators.

     By improving our understanding of the structure and function of tight junctions in the nasal epithelial barrier, we expect to continue to make significant improvements in the delivery of both small and large molecules for an increasing number of therapeutic applications. Nasal drug delivery has several benefits including: delivery of a wide range of therapeutics (small molecules and larger molecules such as peptides, proteins, and nucleic acids); a rapid onset of adequate blood levels; more flexible dosing schedules; and control of drug effects. Nasal delivery is non-invasive compared to injections, can result in less drug degradation and toxicity, and has the potential for direct delivery to the brain.

     Through our tight junction technology, we have identified compounds that directly and specifically affect the tight junctions between cells in the nasal tissues in a manner mimicking natural processes (for example, the effects are reversible) and result in increasing drug permeability through the tight junction barrier. Based on these approaches, we

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have developed formulations for improving the delivery of promising new classes of drugs such as PYY for the treatment of obesity. We were the first to demonstrate delivery of PYY by a non-injected route.

     Our tight junction technology has significant potential applications outside of nasal drug delivery, particularly for improving oral drug delivery (through the gastrointestinal tract), pulmonary drug delivery (through the lungs by inhalation), intravenous drug delivery (through blood vessel walls into tissues), and drug delivery through the blood-brain-barrier (through the blood to the brain) for the treatment of diseases. All of these tissue barriers have tight junctions which, although distinct, have properties in common that can be manipulated by the technology we are developing.

     RNA interference (RNAi) is an important tool we are using to analyze tight junction function and to determine the importance of individual tight junction proteins in affecting drug delivery. Small interfering RNAs (siRNAs) are double-stranded RNA molecules 20-22 nucleotides in length that are able to silence a specific gene and reduce the amount of the protein the gene produces. We have developed siRNAs against a number of the tight junction proteins and determined the resulting effects on the tight junction. For example, we can determine whether siRNA inhibition of specific tight junction proteins increases tight junction permeability. These types of studies help to identify which tight junction components are the most appropriate targets to affect in order to improve the passage of drugs through tissue barriers.

Collaborative Arrangements

     Our collaborative arrangements ideally provide for a development project to be followed by commercialization pursuant to a licensing agreement. Our current collaborative arrangements are as follows:

     Questcor Pharmaceuticals, Inc. — In June 2003, we completed the sale of certain assets relating to our Nascobal® brand products, including the Nascobal® (Cyanocobalamin USP) nasal gel, to Questcor Pharmaceuticals, Inc. (“Questcor”). We have filed the New Drug Application, and will continue to prosecute the pending U.S. patents, in each case for the Nascobal® nasal spray product on behalf of Questcor. Nascobal® is a registered trademark of Questcor Pharmaceuticals, Inc.

     Under the terms of the Asset Purchase Agreement with Questcor, Questcor paid us $9.0 million at closing, $3.0 million on September 30, 2003, and approximately $2.2 million on December 31, 2003. Questcor has also agreed to make payments of $2.0 million contingent upon FDA approval of a New Drug Application for the Nascobal® nasal spray product; and $2.0 million contingent upon issuance of a U.S. patent for the Nascobal® nasal spray product.

     In the year ended December 31, 2003, we recognized a gain of $4,236,000 on the sale of the assets. The gain was calculated as $14.0 million in non-contingent proceeds, less the net book value of the assets of $8.1 million, less costs and fees. At the time of the sale, approximately $1.0 million of the gain relating to the fair value of work to be completed on the filing of the NDA for the Nascobal® nasal spray product was deferred and was recognized later in 2003 as license and research fee revenue.

     Under the terms of a supply agreement between the parties, subject to certain limitations, we are obligated to manufacture and supply all of Questcor’s requirements and Questcor is obligated to purchase from us all of its requirements for the Nascobal® nasal gel and upon FDA approval the Nascobal® nasal spray. In addition, we terminated an agreement entered into in March 1990 with Questcor (as successor in interest to RiboGene, Inc., Rugby Laboratories, Inc., and Darby Pharmaceuticals, Inc.), under which Questcor, as successor in interest, purchased our Metoclopramide HCl patent and other related proprietary information (the “Metoclopramide Agreement”). The Metoclopramide Agreement provided for certain minimum royalties through October 2004 and other fees payable to us if and when nasal Metoclopramide HCl is approved for marketing and commercialized. We received $100,000 in each of the years of 2002 and 2001 as minimum royalties pursuant to this agreement.

     Cytyc Corporation — On July 16, 2003, we entered into an agreement with Cytyc Corporation (“Cytyc”) pursuant to which Cytyc acquired patent rights to our Mammary Aspirate Specimen Cytology Test Device (“MASCT”). Under the terms of the agreement, we received a license fee, and have the potential to receive milestone payments and royalties. In March 2004, we announced the issuance of a second U.S. patent for this product entitled, “Methods and Devices for Collecting, Handling and Processing Mammary Fluid Samples for Evaluating Breast Diseases, Including Cancer.”

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     Our recent collaborative arrangements, now ended, are as follows:

     Pharmacia & Upjohn Company — On January 24, 2003, we entered into a divestiture agreement (the “Divestiture Agreement”) with Pharmacia & Upjohn Company (“Pharmacia”), under which we reacquired all rights to the intranasal apomorphine product that was the subject of the collaboration and license agreement that we and Pharmacia entered into in February 2002 (the “Pharmacia Agreement”). The Divestiture Agreement was the result of the FTC’s consideration of the merger between Pfizer Inc. and Pharmacia (the “Pfizer-Pharmacia Merger”). The divestiture was intended to address concerns of the FTC’s staff that the Pfizer-Pharmacia Merger could inhibit innovation and competition in the sexual dysfunction marketplace. In April 2003, the Pfizer-Pharmacia Merger closed. Effective upon the closing, the existing Pharmacia Agreement and the related Supply Agreement dated February 1, 2002 were terminated and we reacquired from Pharmacia all product and intellectual property rights granted to Pharmacia under the Pharmacia Agreement. In addition, Pharmacia granted us an exclusive, royalty-free license to utilize, for the treatment of human sexual dysfunction, any Pharmacia patents and know-how that relate to the intranasal apomorphine product currently under development and transferred to us all information relating to the development, commercialization, and marketing of this product. Also effective upon the closing of the Pfizer-Pharmacia Merger, Pharmacia and Pfizer covenanted not to sue us for the infringement of certain patents by reason of its development or commercialization of the current product, or in certain instances, other intranasal apomorphine products, for human sexual dysfunction. Pharmacia has further covenanted that, for a period of one year following the closing of the Pfizer-Pharmacia Merger, neither it nor Pfizer will develop or commercialize an intranasal apomorphine product for the treatment of human sexual dysfunction. Pfizer will divest itself of the 250,000 shares of our common stock that it purchased in connection with the Pharmacia Agreement in accordance with an agreed-upon timeframe and process.

     Upon the signing of the Divestiture Agreement in January 2003, Pharmacia made a cash payment to us of $13.5 million consisting of a $6.0 million divestiture payment, $7.0 million in research and development funds and $500,000 for reimbursement of expenses of the divestiture transaction. During the year ended December 31, 2003, we recognized $13.0 million in license and research fees and $500,000 of legal expense reimbursements relating to the $13.5 million payment.

Patents and Proprietary Rights

     We intend to seek appropriate patent protection for our proprietary technologies by filing patent applications in the United States and certain foreign countries. We have 16 issued or allowed United States patents and approximately 42 pending United States patent applications. When appropriate, we also seek foreign patent protection and to date have 42 issued or allowed foreign patents, and approximately 95 pending foreign patent applications.

     Our financial success will depend in large part on our ability to:

	•		obtain patent and other proprietary protection for our inventions;
	•		enforce and defend patents once obtained;
	•		operate without infringing the patents and proprietary rights of third parties; and
	•		preserve our trade secrets.

     Our patents and patent applications are directed to composition of matter, methods of use and methods of manufacturing, as appropriate.

     We apply for patents covering our discoveries and technologies as we deem appropriate. However, we may fail to apply for patents on important discoveries or technologies in a timely fashion or at all. Also, our pending patent applications may not result in the issuance of any patents. These applications may not be sufficient to meet the statutory requirements for patentability, and therefore we may be unable to obtain enforceable patents covering the related discoveries or technologies we may want to commercialize. In addition, because patent applications in the United States are maintained in secrecy for approximately 18 months after filing, other parties may have filed patent applications relating to inventions before our applications covering the same or similar inventions. Any patent applications filed by third parties may prevail over our patent applications or may result in patents that issue alongside patents issued to us, leading to uncertainty over the scope of the patents or the freedom to practice the claimed inventions.

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     Although we have a number of issued patents, the discoveries or technologies covered by these patents may not have any therapeutic or commercial value. Also, issued patents may not provide commercially meaningful protection against competitors. Other parties may be able to design around our issued patents or independently develop products having effects similar or identical to our patented product candidates. In addition, the scope of our patents is subject to considerable uncertainty and competitors or other parties may obtain similar patents of uncertain scope.

     Third parties may infringe our patents or may initiate proceedings challenging the validity or enforceability of our patents. The issuance of a patent is not conclusive as to its validity or enforceability. Challenges raised in patent infringement litigation we initiate or in proceedings initiated by third parties may result in determinations that our patents have not been infringed or that they are invalid, unenforceable or otherwise subject to limitations. In the event of any such determinations, third parties may be able to use the discoveries or technologies claimed in our patents without paying licensing fees or royalties to us, which could significantly diminish the value of these discoveries or technologies. Also, as a result of such determinations we may be enjoined from pursuing research, development or commercialization of potential products or may be required to obtain licenses, if available, to the third-party patents or to develop or obtain alternative technology. Responding to challenges initiated by third parties may require significant expenditures and divert the attention of our management and key personnel from other business concerns. In addition, enforcing our patents against third parties may require significant expenditures regardless of the outcome of such efforts.

     In addition, third parties may independently develop intellectual property similar to our patented intellectual property, which could result in, among other things, interference proceedings in the United States Patent and Trademark Office to determine priority of invention.

Competition

     The biopharmaceutical industry is subject to rapid and substantial technological change. Competition is intense and based substantially on scientific and technological factors. These factors include the availability of patent and other protection of technology and products, the ability to commercialize complex, unpredictable technological developments and the ability to obtain governmental approval for testing, manufacturing and marketing. We face, and will continue to face, intense competition in the development, manufacturing, marketing and commercialization of our product candidates from academic institutions, government agencies, research institutions, biopharmaceutical companies and drug delivery companies in the United States, Europe and elsewhere.

Manufacturing and Raw Materials

     We currently have manufacturing facilities located in Hauppauge, New York. The manufacture of our product candidates for clinical trials and commercial purposes is subject to cGMP and other agency regulations.

     We attempt to remain apprised of the financial condition of our suppliers, their ability to supply our needs and the market conditions for these raw materials. A material shortage, contamination, and/or recall could adversely affect the manufacturing of our products.

Research and Development

     Our research and development spending was $17.1 million, $11.6 million and $6.6 million in 2003, 2002, and 2001, respectively.

Government Regulation

New Drug Development and Approval Process

     Regulation by governmental authorities in the United States and other countries is a significant factor in the manufacture and marketing of pharmaceuticals and in our ongoing research and development activities. All of our product candidates will require regulatory approval by governmental agencies prior to commercialization. In particular, all of our drug candidates are subject to rigorous preclinical testing and clinical trials and other premarketing approval requirements by the FDA and regulatory authorities in other countries. In the United States, various federal, and in some cases state statutes and regulations also govern or affect the manufacturing, safety, labeling, storage, record keeping and

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marketing of such products. The lengthy process of seeking required approvals and the continuing need for compliance with applicable statutes and regulations require the expenditure of substantial resources. Regulatory approval, when and if obtained, may significantly limit the indicated uses for which our products may be marketed.

     The steps required by the FDA before our drug candidates may be marketed in the United States include, among other things:

	•		the performance of preclinical laboratory and animal tests, and formulation studies;
	•		the submission to the FDA of an Investigational New Drug application (“IND”) which must become effective before human clinical trials may commence;
	•		the completion of animal pharmacology and toxicology studies and demonstration of the ability to manufacture under related cGMP guidances;
	•		the completion of adequate and well-controlled human clinical trials to establish the safety and efficacy of the drug; and
	•		the submission and FDA approval of a new biologics license application (“BLA”) for biologic products or a new drug application (“NDA”) for drug products.

     The testing and approval process requires substantial time, effort and financial resources and we cannot be certain that any approvals for any of our proposed products will be granted on a timely basis, if at all.

     Prior to commencing a clinical trial, we must submit an IND to the FDA. The IND becomes effective 30 days after receipt by the FDA, unless within the 30-day period, the FDA raises concerns or questions with respect to the conduct of the trial. In such a case, we must work with the FDA to resolve any outstanding concerns before the study can begin. The submission of an IND may not result in FDA authorization to commence a clinical trial. Further, an independent institutional review board at the medical center or centers proposing to conduct the trial must review and approve the plan for any clinical trial before it commences.

     Human clinical trials are typically conducted in three sequential phases that may overlap:

	•		PHASE I: the drug is initially introduced into healthy human subjects and tested for safety, dosage tolerance, absorption, metabolism, distribution and excretion.
	•		PHASE II: involves studies in a limited patient population to identify possible adverse effects and safety risks, to determine the efficacy of the product in patients with specific targeted diseases and to determine optimal dosage.
	•		PHASE III: when Phase II evaluations demonstrate that a dosage range of the product is effective and has an acceptable safety profile, multi-center Phase III trials are undertaken to evaluate clinical efficacy and safety at a specific dose or doses in an expanded patient population to determine the language for the product label.

     We cannot be certain that we or any of our collaborative partners will successfully complete Phase I, Phase II or Phase III testing of any compound within any specific time period, if at all. Furthermore, the FDA or the study sponsor may suspend clinical trials at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk.

     The results of product development, preclinical studies and clinical trials are submitted to the FDA as part of an NDA or BLA. The FDA may withhold approval for an NDA or BLA if the applicable regulatory criteria are not satisfied or may require additional clinical data. Even if such data is submitted, the FDA may ultimately decide that the NDA or BLA does not satisfy the criteria for approval. If approved, the FDA may withdraw product approval if compliance with regulatory standards is not maintained or if problems occur after a product reaches the market. In addition, the FDA may require testing and surveillance programs to monitor the effects of approved products, and the FDA has the power to prevent or limit further marketing of a product based on the results of these post-marketing programs.

     Satisfaction of the above FDA requirements or similar requirements of state, local and foreign regulatory agencies

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typically takes several years and the actual time required may vary substantially, based upon the type, complexity and novelty of a product or indication.

     Government regulation may delay or prevent marketing of potential products for a considerable period of time and impose costly procedures upon our activities or the activities of our collaborative partners. The FDA or any other regulatory agency may not grant any approvals on a timely basis, if at all. Success in early stage clinical trials does not assure success in later stage clinical trials. Data obtained from clinical activities is not always conclusive and may be susceptible to varying interpretations, which could delay, limit or prevent regulatory approval. Even if a product receives regulatory approval, the approval may be significantly limited to specific indications and dosages. Further, even if regulatory approval is obtained, later discovery of previously unknown problems with a product may result in restrictions on the product or even complete withdrawal of the product from the market. Delays in obtaining, or failures to obtain regulatory approvals may have a material adverse effect on our business. In addition, we cannot predict what adverse governmental regulations may arise from future United States or foreign governmental action.

     Any products manufactured or distributed by us or our collaborative partners pursuant to FDA approvals are required to be manufactured under cGMP guidances, and are subject to continuing regulation by the FDA, including record-keeping requirements and reporting of adverse experiences with the drugs. Drug manufacturers are required to register their establishments with the FDA and certain state agencies, and are subject to periodic unannounced inspections by the FDA for compliance with cGMP, regulations which impose certain procedural and documentation requirements upon us and our contract manufacturers. We cannot be certain that we or our present or future suppliers will be able to comply with the cGMP regulations and other FDA regulatory requirements.

     Steps similar to those in the United States must be undertaken in virtually every other country comprising the market for our product candidates before any such product can be commercialized in those countries. The approval procedure and the time required for approval vary from country to country and may involve additional testing. There can be no assurance that approvals will be granted on a timely basis, or at all. In addition, regulatory approval of prices is required in most countries other than the United States. There can be no assurance that the resulting prices would be sufficient to generate an acceptable return to us.

Employees

     As of February 29, 2004, we had 82 full-time employees, of whom 66 were engaged in research and development. The balance of our employees are engaged in administration and support functions.

     None of our employees are covered by a collective bargaining agreement or are represented by a labor union. We consider our relationships with our employees to be satisfactory.

RISK FACTORS

Risks Related to Our Business

We will require additional financing in the future, and if additional capital is not available, we may have to curtail or cease operations.

     Our business currently does not generate the cash that is necessary to finance our operations. Subject to the success of our development programs and potential licensing transactions, we will require additional capital to complete the research and development activities we currently contemplate and to commercialize our proposed products. In addition, we may need to raise additional capital to fund more rapid expansion, to develop and commercialize new products, to enhance existing services, to respond to competitive pressures, and to acquire complementary businesses or technologies. Our future capital needs depend on many factors, including:

	•		the scope, duration and expenditures associated with our current research and development programs;
	•		continued scientific progress in these programs;
	•		the outcome of potential licensing transactions, if any;
	•		competing technological developments;

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	•		our proprietary patent position, if any, in our products;
	•		the regulatory approval process for our products; and
	•		other factors which may not be within our control.

     We may not be able to obtain additional financing at these times on terms favorable to us, if at all. General market conditions may make it very difficult for us to seek financing from the capital markets. Without additional funding, we may have to delay, reduce or eliminate one or more research or development programs and reduce overall overhead expenses. This action may reduce the market price of our common stock.

If we fail to negotiate or maintain successful collaborative arrangements with third parties, our development and commercialization activities may be delayed or reduced.

     In the past, we have entered into, and expect to enter into in the future, collaborative arrangements with third parties who provide us with funding and/or who perform research, development, regulatory compliance, manufacturing or commercialization activities relating to some or all of our product candidates. If we fail to secure or maintain successful collaborative arrangements, our development and commercialization activities may be delayed or reduced.

     These collaborative agreements can be terminated under certain conditions by our partners. Our partners may also under some circumstances independently pursue competing products, delivery approaches or technologies. Even if our partners continue their contributions to our collaborative arrangements, they may nevertheless determine not to actively pursue the development or commercialization of any resulting products. Also, our partners may fail to perform their obligations under the collaborative arrangements or may be slow in performing their obligations. In addition, our partners may experience financial difficulties at any time that could prevent them from having available funds to contribute to these collaborations. In these circumstances, our ability to develop and market potential products could be severely limited.

Because of significant research and development and other costs, we have never been profitable on an annual basis, and we may never become profitable.

     We incurred net losses in each of the last three years as follows: $9.2 million in 2001, $13.5 million in 2002 and $2.1 million in 2003. As of December 31, 2003, we had an accumulated deficit of $54.8 million. The process of developing our products requires significant research and development efforts, including basic research, preclinical and clinical development, as well as FDA regulatory approval. These activities, together with our sales, marketing, general and administrative expenses, have resulted in operating losses in the past. We may never achieve profitability. As a result, the market price of our common stock could decline.

Because our operating results are subject to significant fluctuations and uncertainties, we may not be able to meet any of our future expense obligations, and our failure to meet public market analysts or investors’ expectations regarding earnings may cause our stock price to decline.

     Our operating results are subject to significant fluctuations and uncertainties due to a number of factors including, among others:

	•		the timing and achievement of licensing transactions, including milestones and other performance factors associated with these contracts;
	•		the time and costs involved in patent prosecution and development of our proprietary position;
	•		continued scientific progress and level of expenditures in our research and development programs;
	•		the cost of manufacturing scale-up and production batches, including vendor provided activities and costs;
	•		the time and costs involved in obtaining regulatory approvals;
	•		changes in general economic conditions and drug delivery technologies;

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	•		the expiration of existing patents and related revenues; and
	•		new products and product enhancements that we or our competitors introduce.

     As a result of these factors and other uncertainties, our operating results have fluctuated significantly over the last three years resulting in net losses of $9.2 million, $13.5 million and $2.1 million in the years 2001, 2002 and 2003, respectively.

     Our revenues and operating results, particularly those reported on a quarterly basis, may continue to fluctuate significantly. This fluctuation makes it difficult to forecast our operating results. Therefore, we believe that quarterly comparisons of our operating results may not be meaningful, and you should not rely on them as an indication of our future performance. Also, our operating results in a future quarter or quarters may fall below the expectations of public market analysts or investors. If this were to occur, the price of our stock could decline.

If we are unable to adequately protect our proprietary technology from legal challenges, infringement or alternative technologies, this inability will hurt our competitive position.

     We specialize in the nasal delivery of pharmaceutical products and rely on the issuance of patents, both in the United States and internationally, for protection against competitive drug delivery technology. Although we believe that we exercise the necessary due diligence in our patent filings, our proprietary position is not established until the appropriate regulatory authorities actually issue a patent, which may take over three years from initial filing.

     Moreover, even the established patent positions of pharmaceutical companies are generally uncertain and involve complex legal and factual issues. Although we believe our issued patents are valid, it is possible that others may nevertheless challenge our issued patents, that our issued patents will not withstand review in a court of competent jurisdiction, and that a court will hold our issued patents to be invalid. Furthermore, it is possible that others will infringe or otherwise circumvent our issued patents and that we will be unable to fund the cost of litigation against them. We also cannot assure you that others have not filed patent applications for technology covered by our pending applications or that we were the first to invent the technology. There may be third party patents or patent applications relevant to our potential products that may block or compete with the technologies covered by our patent applications.

     In addition, we may not be able to protect our established and pending patent positions from competitive drug delivery technologies, which may provide more effective therapeutic benefit to patients and which may therefore make our products, technology and/or proprietary position obsolete.

     If we are unable to adequately protect our proprietary technology from legal challenges, infringement or alternative technologies, we will not be able to compete in the pharmaceutical delivery business.

Because intellectual property rights are of limited duration, expiration of intellectual property rights and licenses will negatively impact our operating results.

     Intellectual property, such as patents, and license agreements based on those patents, generally are of limited duration. Our operating results depend on our patents and intellectual property licenses. Therefore, the expiration or other loss of rights associated with intellectual property and intellectual property licenses can negatively impact our business. For example, in the past we received significant revenues from royalties related to the sale of Stadol®NS™. The underlying patents on Stadol®NS™ expired in August 2001 in the United States and in April 2002, internationally, resulting in the discontinuance of royalties from Bristol-Myers Squibb, the licensee. This event has adversely affected our revenue and contribution to operations.

If the commercial opportunity for nasally-administered products is limited, this limitation will impact our anticipated future revenue growth.

     The physical and chemical properties of a drug affect our ability to develop a method of delivering it intranasally. Although we continue to explore the feasibility of nasally delivering drugs that are large, more complex molecules, we have more expertise in nasal delivery of smaller, less complex molecules. The universe of nasal products that qualify as small molecules and are available for commercialization may be limited. Accordingly, we may be subject to intense competition in these potential products, which can affect our anticipated future revenue growth. Although we

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need to accelerate our research of the intranasal delivery of larger molecules, it is possible that we will not be successful in this area. If we are not successful in this area, our future revenue may not grow at all or as quickly as anticipated.

Our product development efforts may not result in commercial products.

     We intend to continue our aggressive research and development program. Successful product development in the biotechnology industry is highly uncertain, and very few research and development projects produce a commercial product. Product candidates that appear promising in the early phases of development, such as in early human clinical trials, may fail to reach the market for a number of reasons, such as:

	•		a product candidate is not effective in later or broader trials in humans;
	•		a product candidate is not safe in later or broader trials in humans;
	•		regulatory bodies, such as the FDA, do not approve a product candidate for an intended use, or at all;
	•		a product candidate is not economical for us to manufacture and commercialize or could not be made at all;
	•		third parties have proprietary rights to a product candidate, and do not let it be sold on reasonable terms, or at all; or
	•		a product candidate is not financially successful because of existing therapeutics.

     As a result, there can be no assurance that any of our products currently in development will ever be successfully commercialized.

The FDA is required to approve our product candidates before they can be marketed and we cannot assure you that they will approve these product candidates, the failure of which will prevent the receipt of revenue and adversely affect our stock price.

     Many of our research and development programs are at an early stage. Clinical trials are long, expensive and uncertain processes. Clinical trials may not be commenced or completed on schedule, and the FDA may not ultimately approve our product candidates for commercial sale. Further, even if the results of our preclinical studies or clinical trials are initially positive, it is possible that we will obtain different results in the later stages of drug development or that results seen in clinical trials will not continue with longer term treatment. Drugs in late stages of clinical development may fail to show the desired safety and efficacy traits despite having progressed through initial clinical testing. For example, positive results in early Phase I or Phase II clinical trials may not be repeated in larger Phase II or Phase III clinical trials. All of our potential drug candidates are prone to the risks of failure inherent in drug development. The clinical trials of any or all of our drug candidates, including apomorphine nasal spray, calcitonin nasal spray, interferon beta, morphine gluconate, oral abuse-resistant opioid dosage, and peptide PYY (3-36) nasal spray could be unsuccessful, which would prevent us from commercializing the drug. Our failure to develop safe, commercially viable drugs would substantially impair our ability to generate revenues and sustain our operations and would materially harm our business and adversely affect our stock price.

We are subject to extensive government regulation that may cause us to cancel or delay the introduction of our products to market, or may have a negative impact on our products’ sales performance after introduction.

     Our research and development activities and the clinical investigation, manufacture, distribution and marketing of drug products are subject to extensive regulation by governmental authorities in the United States and other countries. Prior to marketing in the United States, a drug must undergo rigorous testing and an extensive regulatory approval process implemented by the FDA under federal law, including the federal Food, Drug and Cosmetic Act. To receive approval, we or our collaborators must, among other things, demonstrate with substantial evidence from well-controlled clinical trials that the product is both safe and effective for each indication where approval is sought. Depending upon the type, complexity and novelty of the product and the nature of the disease or disorder to be treated, that approval process can take several years and require substantial expenditures. Data obtained from testing are susceptible to varying interpretations that could delay, limit or prevent regulatory approvals of our product candidates. Drug testing is subject to complex FDA rules and regulations, including the requirement to conduct human testing on a large number of

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test subjects. We, our collaborators or the FDA may suspend human trials at any time if a party believes that the test subjects are exposed to unacceptable health risks. We cannot assure you that any of our product candidates will be safe for human use. Other countries also have extensive requirements regarding clinical trials, market authorization and pricing. These regulatory schemes vary widely from country to country, but, in general, are subject to all of the risks associated with U.S. approvals.

     If any of our products receives regulatory approval, the approval will be limited to those disease states and conditions for which the product is safe and effective, as demonstrated through clinical trials. Even if regulatory approval is obtained, later discovery of previously unknown problems may result in restrictions of the product, including withdrawal of the product from the market. Further, governmental approval may subject us to ongoing requirements for post-marketing studies. Even if we obtain governmental approval, a marketed product, its manufacturer and its manufacturing facilities are subject to unannounced inspections by the FDA and must comply with the FDA’s cGMP regulations. These regulations govern all areas of production, record keeping, personnel and quality control. If a manufacturer fails to comply with any of the manufacturing regulations, it may be subject to, among other things, product seizures, recalls, fines, injunctions, suspensions or revocations of marketing licenses, operating restrictions and criminal prosecution. Other countries also impose similar manufacturing requirements.

     The United States Drug Enforcement Agency (“DEA”), regulates controlled drug substances, such as morphine, oxycontin, the active ingredient in CC-109, and other narcotics. Establishments handling controlled drug substances such as morphine must be registered and inspected by the DEA and may be subject to export, import, security and production quota requirements. In addition, advertising and promotional materials are, in certain instances, subject to regulation by the Federal Trade Commission. There can be no assurance that we will not be required to incur significant costs to comply with such laws and regulations in the future or that such laws or regulations will not have a material adverse effect upon our business.

Because we have limited experience in marketing or selling our proposed products, these products may never be successful.

     Even if we are able to develop our products and obtain necessary regulatory approvals, we have limited experience or capabilities in marketing or commercializing any of our proposed products. We are dependent on our ability to find collaborative marketing partners or contract sales companies for commercial sale of our products. Even if we find a potential marketing partner, we may not be able to negotiate a licensing contract on favorable terms to justify our investment or achieve adequate revenues. In addition, a licensing transaction with a marketing partner does not assure a product’s success, which is dependent upon patients’, physicians’ or third-party payers’ acceptance of the product.

     Our products may prove to be unsuccessful if various parties, including government health administration authorities, private health care insurers and other health care payers, such as health maintenance organizations and self-insured employee plans that determine reimbursement to the consumer, do not accept our products. We cannot assure you that reimbursement will be available at all or at levels sufficient to allow our marketing partners to achieve profitable price levels for our products. If we fail to achieve adequate reimbursement levels, patients may not purchase our products and sales of these products will be absent or reduced.

We may be required to defend lawsuits or pay damages for product liability claims.

     Product liability is a major risk in testing, marketing and manufacturing biotechnology and pharmaceutical products. We face substantial product liability exposure in human clinical trials and for products that we sell, or manufacture for others to sell, after regulatory approval. Product liability claims, regardless of their merits, could be costly and divert management’s attention, and adversely affect our reputation and the demand for our products.

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We may be unable to compete successfully against our current and future competitors.

     Our competitors are numerous and include, among others, major pharmaceutical companies, biotechnology firms, universities and other research institutions. Our competitors may succeed in developing technologies and products that are more effective than the nasal delivery technology we are developing or that will cause our technology or products to become obsolete or noncompetitive. In addition, our potential products, if approved and commercialized, will compete against well-established existing products. For example, Pfizer has already successfully commercialized Viagra, a competitor of our product candidate, intranasal apomorphine.

     Many of our competitors have substantially greater financial and technical resources and production and marketing capabilities than we have. They also may have greater experience in conducting preclinical testing and clinical trials of pharmaceutical products and obtaining FDA and other regulatory approvals. Therefore, our competitors may succeed in obtaining FDA approval for products faster than we can. Even if we commence commercial sales of our products, we will also be competing against their manufacturing efficiency and marketing capabilities, areas in which we have limited or no experience. We also face and will continue to face intense competition from other companies for collaboration arrangements with other pharmaceutical and biotechnology companies.

     Although we believe that our ownership of patents for our nasal delivery products will limit direct competition with these products, we must also compete with other promising technologies such as controlled release, target organ or site release, pumps, polymers, microemulsion, monoclonal antibodies, inhalation, ocular, liposomal, implants, transdermal passive and transdermal electrotransport. Our competitors may develop other products using these or other delivery alternatives that may be as or more effective than our products and proposed products. In addition, we may not be able to compete effectively with other commercially available products or drug delivery technologies.

If we have a problem with our manufacturing facility, or if we or our suppliers fail to comply with applicable regulations, we may not be able to market our products or conduct clinical trials.

     Generally, we manufacture all of our products for clinical and commercial use at our principal manufacturing facility located in Hauppauge, New York. Although it is our intent to have multiple suppliers for materials and components of our manufactured products, we cannot ensure that this will occur. In addition, we must produce these products in compliance with federal and state regulations. These authorities also subject our facilities to inspection. In addition, some of our key suppliers are also subject to regulatory compliance. If we have a problem at our manufacturing facility, or if we or our suppliers fail to comply with federal and state regulations or otherwise fail to perform their respective obligations in a timely fashion or not at all, these problems or failures could cause a delay in clinical trials or the supply of product to market. Any significant delay or failure to perform could also jeopardize our performance contracts with collaborative partners, result in material penalties to us, and jeopardize the commercial viability of our products.

Changes in the healthcare industry that are beyond our control may be detrimental to our business.

     The healthcare industry is changing rapidly as the public, government, medical professionals and the pharmaceutical industry examine ways to broaden medical coverage while controlling the increase in healthcare costs. Potential changes could put pressure on the prices of prescription pharmaceutical products and reduce our business or prospects. We cannot predict when, if any, proposed healthcare reforms will be implemented, and these changes are beyond our control.

If we lose our key personnel, or if we are unable to attract and retain additional personnel, then we may be unable to successfully develop our business.

     If we are unable to retain one or more of our corporate officers, Dr. Steven C. Quay, President, Chief Executive Officer and Chairman of the Board, Dr. Gordon C. Brandt, Executive Vice President Clinical Research and Medical Affairs, Dr. Paul H. Johnson, Senior Vice President, Research and Development and Chief Scientific Officer, Gregory L. Weaver, CPA, MBA, Chief Financial Officer and Corporate Secretary, David E. Wormuth, Senior Vice President, Operations or any of our other key managers or key technical personnel, our business could be seriously harmed. Although we generally execute employment agreements with key personnel, this is not a guarantee that we will be able to retain them or that we will be able to replace any of them if we lose their services for any reason. Competition for these managers and technical personnel is intense. Failure to retain these key personnel, could, among other things:

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	•		compromise our ability to negotiate and enter into additional collaborative arrangements;
	•		delay our ongoing discovery research efforts;
	•		delay preclinical or clinical testing of our product candidates;
	•		delay the regulatory approval process; or
	•		prevent us from successfully commercializing our product candidates.

     In addition, if we have to replace any of these individuals, we will not be able to replace the significant amount of knowledge that they have about our operations.

Risks Related to the Securities Markets and Ownership of Our Common Stock

We cannot assure you that our stock price will not decline.

     The market price of our common stock could be subject to significant fluctuations. Among the factors that could affect our stock price are:

	•		changes in revenue estimates or publication of research reports by analysts or the decision of analysts to drop coverage of the Company;
	•		failure to meet analysts’ revenue estimates;
	•		speculation in the press or investment community;
	•		strategic actions by us or our competitors, such as acquisitions or restructurings;
	•		actions by institutional stockholders;
	•		low average daily trading volumes due to relatively small number of shares outstanding;
	•		general market conditions; and
	•		domestic and international economic factors unrelated to our performance.

Additionally, numerous factors relating to our business may cause fluctuations or declines in our stock price.

     The stock markets in general and the markets for pharmaceutical stocks in particular, have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our common stock.

We expect to sell shares of our common stock in the future, and these sales will dilute the interests of other securityholders and may depress the price of our common stock.

     As of March 4, 2004, there were 11,912,961 shares of common stock outstanding, and there were outstanding options to purchase 3,087,750 shares of our common stock and warrants to purchase 1,098,752 shares of our common stock. On December 18, 2003, we filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission (“SEC”), pursuant to which we may issue common stock and warrants from time to time, up to an aggregate of $30.0 million. The shelf registration statement was declared effective by the SEC on January 14, 2004. We may also issue additional shares in acquisitions, financings or in connection with the grant of additional stock options to our employees, officers, directors and consultants under our stock option plans. We have not entered into any agreements or understanding regarding any future acquisitions and cannot assure that we will be able to identify or complete any acquisition in the future. The issuance or even the potential issuance of shares in connection with any other additional financing or acquisition, or upon exercise of warrants, options or rights will have a dilutive impact on other stockholders and could have a negative effect on the market price of our common stock.

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The anti-takeover provisions of our stockholder rights plan may entrench management, may delay or prevent beneficial takeover bids by third parties and may prevent or frustrate any stockholder attempt to replace or remove the current management even if the stockholders consider it beneficial to do so.

     We have a stockholder rights plan designed to protect our stockholders from coercive or unfair takeover tactics. Under the plan, we declared a dividend of one preferred stock purchase right for each share of common stock outstanding on March 17, 2000. Each preferred stock purchase right entitles the holder to purchase from us 1/1000 of a share of Series A Junior Participating Preferred Stock for $50. In the event any acquiring entity or group accumulates or initiates a tender offer to purchase 15% or more of our common stock, then each holder of a preferred stock purchase right, other than the acquiring entity and its affiliates, will have the right to receive, upon exercise of the preferred stock purchase right, shares of our common stock or shares in the acquiring entity having a value equal to two times the exercise price of the preferred stock purchase right.

     The intent of the stockholder rights plan is to protect our stockholders’ interests by encouraging anyone seeking control of our company to negotiate with our board of directors. However, our stockholder rights plan could make it more difficult for a third party to acquire us without the consent of our board of directors, even if doing so may be beneficial to our stockholders. Furthermore, the anti-takeover provisions of our stockholder rights plan may entrench management and make it more difficult for stockholders to replace management even if the stockholders consider it beneficial to do so.

Available Information

     We file annual, quarterly and special reports, proxy statements and other information with the SEC. The public may read and copy any documents each company files at the SEC’s Public Reference Room at 450 Fifth Street N.W., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. SEC filings are also available to the public from the Securities and Exchange Commission’s Internet website at http://www.sec.gov.

     We make available through our website at http://www.nastech.com our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish such material to the SEC.

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ITEM 1A. EXECUTIVE OFFICERS OF THE REGISTRANT

Our executive officers are as follows:

     Executive officers hold their office until their successors are chosen and qualify, subject to earlier removal by the Board of Directors.

     Set forth below is a biographical description of each of our executive officers, based on information supplied by each of them:

     Dr. Steven C. Quay. Dr. Quay has been employed by us since August 2000 as Chairman of the Board, President and Chief Executive Officer. In 1999, Dr. Quay founded and was Chairman, President and CEO of Atossa HealthCare, Inc., which focused on the development of a proprietary platform of diagnostics and treatments related to breast cancer risk assessment and therapeutics and other women’s health care products. Atossa was acquired by Nastech in August 2000. In 1991, Dr. Quay founded Sonus Pharmaceuticals, Inc., a company engaged in the research and development of drug delivery systems and oxygen delivery products based on its emulsion and surfactant technology, where he served as Chief Executive Officer, President and a director until June 1999. In 1984, Dr. Quay founded Salutar, Inc. to develop contrast agents for magnetic resonance imaging. Two pharmaceuticals, OmniScan® and TeslaScan®, were invented by Dr. Quay at Salutar and are now FDA-approved for sale in the United States and other countries. Dr. Quay has authored more than 100 papers in diagnostic imaging, oncology and biochemistry and has received 48 U.S. patents. Dr. Quay graduated from the University of Michigan Medical School, where he received an M.A. and Ph.D. in Biological Chemistry in 1974, and 1975, respectively and an M.D. in 1977. Dr. Quay did post-graduate work in the chemistry department at the Massachusetts Institute of Technology, and received his residency training at the Massachusetts General Hospital, Harvard Medical School. From 1980 to 1986, he was a faculty member at Stanford University School of Medicine.

     Dr. Gordon C. Brandt. Dr. Brandt joined us in November of 2002. In his position of Executive Vice President Clinical Research and Medical Affairs, he oversees the drug development process from preclinical through clinical testing. Prior to joining Nastech, Dr. Brandt held senior positions at Sonus Pharmaceuticals, Inc., where as Vice President, Clinical and Regulatory Affairs, he was involved in managing all aspects of design and implementation of early and late stage clinical trial programs and submissions to regulatory authorities. Dr. Brandt graduated from Yale University, received an M.D. degree from the University of California, San Francisco, and completed a residency in internal medicine at Kaiser Hospital, San Francisco. Dr. Brandt is an author on numerous scientific papers and abstracts and holds one U.S. patent.

     Dr. Paul H. Johnson. Dr. Johnson has been employed by us since September 2003 as Senior Vice President, Research and Development and Chief Scientific Officer. Prior to joining Nastech, Dr. Johnson was Vice President, Research and Development and Chief Scientific Officer at EpiGenX Pharmaceuticals, Inc., a privately-held company focused on the development of epigenetic-based strategies to treat cancer and infectious diseases. Previously, Dr. Johnson served as the Head of the Cell and Molecular Biology Department and Principal Scientist in the Cancer

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Research Department at Berlex Biosciences in Richmond, California, the U.S. Research and Development Center for Schering AG in Germany. Prior to Berlex, he was the Director of the Cell and Molecular Biology Laboratory at SRI International (formerly the Stanford Research Institute) and Professor of Biochemistry at Wayne State University Medical School. Dr. Johnson received a B.S. in Biological Sciences from the State University of New York, Buffalo, and a Ph.D. in Biochemistry from the Roswell Park Cancer Institute (SUNY). Dr. Johnson is an author on numerous scientific papers and abstracts.

     Gregory L. Weaver. Mr. Weaver has been employed by us since May 2002 as Chief Financial Officer. Prior to joining Nastech, Mr. Weaver held the positions of Vice President, Strategic Development, and Vice President & Chief Financial Officer of Ilex Oncology, Inc., an oncology-focused biopharmaceutical company. During his tenure at Ilex Oncology, Mr. Weaver was involved in a series of strategic financings and pharmaceutical product and company acquisitions. Prior to Ilex, Mr. Weaver held several senior financial management positions, including Vice President & Chief Financial Officer of Prism Technologies, a medical device company, and Chief Financial Officer of a division of Fidelity Capital Publishing. Mr. Weaver received a Master of Business Administration degree in Finance from Boston College, and a Bachelor of Science degree in Accounting from Trinity University in San Antonio. He also served in the United States Air Force. He is a Certified Public Accountant.

     David E. Wormuth. Mr. Wormuth has been employed by us since March 2001 as our Senior Vice President, Operations. Prior to joining Nastech, Mr. Wormuth was President of David E. Wormuth & Associates, a consulting firm providing expert consultancy to the pharmaceutical industry in the areas of manufacturing and quality control. From 1992 until 1997, Mr. Wormuth served as Vice President of Operations for Sonus Pharmaceuticals, Inc. Prior to joining Sonus, Mr. Wormuth spent 5 years in various operational/manufacturing positions with Kabivitrum, a Swedish firm, specializing in emulsion technology and the development of amino acids for LVP applications. Prior to Kabivitrum, Mr. Wormuth spent 13 years with Abbott Laboratories in various manufacturing roles until 1987. Mr. Wormuth graduated from Newberry College, Newberry South Carolina in 1967, where he received a Bachelor of Arts degree in History and Political Science and also served in the United States Marine Corps.

ITEM 2.- PROPERTIES

     For the first half of 2003, we leased approximately 27,700 square feet for our research and development (“R&D”) activities and administrative offices in Bothell, Washington (“Bothell Facility”) and 10,000 square feet for our manufacturing activities in Hauppauge, New York (“Hauppauge Facility”), and we subleased approximately 14,000 square feet for our R&D activities in an additional facility in Hauppauge, New York (“Adams Avenue Facility”).

     Effective July 1, 2003, we amended our lease for the Bothell Facility to lease an additional 9,300 square feet to be used for R&D activities. On February 17, 2004, we amended our lease for the Bothell Facility to lease an additional 14,000 square feet effective January 1, 2005. The February 17, 2004 amendment also extended the lease for the existing space in the Bothell Facility by three years to 16 years such that the new termination date is now January 16, 2016 for the entire 51,000 square feet leased in the Bothell Facility.

     Effective February 14, 2003, we entered into the following agreements with respect to the Adams Avenue Facility (1) with the landlord to terminate the lease for the Adams Avenue Facility and (2) with the new tenant of the Adams Avenue Facility to sublease approximately 14,000 square feet of the facility through the end of June 2003. As a result of the termination of our Adams Avenue Facility lease, we recorded, in December 2002, a charge of $595,000 which is comprised of the net book value of the leasehold improvements and costs incurred to vacate the Adams Avenue Facility, offset by the deferred rent liability related to the Adams Avenue Facility.

     During 2003, we leased office and laboratory space on an annual basis at the State University of New York at Stony Brook for the conduct of clinical trials. The lease expired on June 30, 2003 and was not renewed. We also leased space in Edmonds, Washington as a result of the merger with Atossa HealthCare, Inc. in 2000. Effective October 1, 2003, we sublet approximately 70% of the space in Edmonds to a third party, and effective February 1, 2004, we sublet all of the remaining space in Edmonds to the same third party. The Edmonds lease expires May 31, 2004.

     The lease for the Bothell Facility expires January 16, 2016, and the lease for the Hauppauge Facility expires June 30, 2005. Future minimum lease payments are approximately $21,660,000 during the lease terms. Annual lease expenses will be approximately $1.7 million in 2004 and approximately $2.1 million in 2005 and thereafter. We are also responsible for all utilities, maintenance, security and property tax increases related to our properties.

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     We believe that our existing facilities are adequate to meet our current needs and that suitable additional or alternative space will be available in the future on commercially reasonable terms, as needed.

ITEM 3. LEGAL PROCEEDINGS

     On July 22, 2003, we served pleadings on G. Pohl-Boskamp GmbH & Co. (“Pohl-Boskamp”) to initiate litigation captioned Nastech Pharmaceutical Company v. G. Pohl-Boskamp GmbH & Co., in the High Court of England and Wales, Chancery Division, Patents Court, claiming that Pohl-Boskamp breached a license agreement (the “License Agreement”) between us and Pohl-Boskamp by wrongfully repudiating the License Agreement and by failing to pay fees due to us for obtaining patents in various countries within the territory covered by the License Agreement. The dispute was settled by the parties in January 2004, with Nastech recovering all patent rights licensed under the License Agreement, and with each party releasing the other from further claims.

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

     There were no matters submitted to the vote of security holders through the solicitation of proxies or otherwise, during the last quarter of the fiscal period covered by this report.

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PART II

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

     Our common stock trades on the NASDAQ National Market under the symbol NSTK. The following table sets forth the range of high and low closing prices for our common stock as reported by the NASDAQ National Market for the last two years. These quotations represent inter-dealer prices, without adjustment for retail mark-ups, markdowns or commissions and do not necessarily represent actual transactions.

     As of March 1, 2004 there are approximately 6,500 beneficial holders of our common stock, including several brokerage firms holding shares in street name for beneficial owners.

Dividend Policy

     We have not declared any cash dividends on our common stock for the two most recent fiscal years. In addition, we have no current plans to pay any dividends on our common stock and intend to retain earnings, if any, for working capital purposes. Any future decision to pay dividends on our common stock will depend upon our results of operations, capital requirements, our financial condition and other factors that the board of directors deems relevant.

Securities Authorized For Issuance Under Equity Compensation Plans

     The information required by this Item is incorporated by reference to the information contained in the section captioned “Securities Authorized for Issuance Under Equity Compensation Plans” of the Registrant’s Proxy Statement to be filed with the Securities and Exchange Commission.

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

     The following selected financial data should be read in conjunction with the financial statements and notes thereto. The following table sets forth our selected consolidated financial data as of and for the years in the five-year period ended December 31, 2003.

(In Thousands, Except Per Share Data)

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

Overview

     The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. These statements include, but are not limited to, statements about the following: (i) our plans to broaden our focus on difficult to formulate drug delivery technologies;(ii) our plans to simultaneously fund multiple research and development projects; (iii) our expected license and research fee revenues; (iv) expected increases in our research and development costs; and (v) the ability of our current cash position to provide adequate working capital through December 2004. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section entitled “Risk Factors” included elsewhere in this Report. You should also carefully review the risk factors set forth in other reports or documents that we file from time to time with the Securities and Exchange Commission, particularly Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K. You should also read the following discussion and analysis in conjunction with our consolidated financial statements and related notes included in this report.

     Nastech Pharmaceutical Company Inc. is an emerging pharmaceutical company developing products based on applying proprietary drug delivery technologies, with approximately 195 patents and applications filed. We are developing molecular biology-based technologies for delivering both small and large molecule drugs by nasal administration, along with an extended release oral delivery technology. Our intranasal drug delivery technology may lead to greater drug efficacy, speed of action, safety, and patient compliance. We are developing a diverse product portfolio across multiple therapeutic areas, including products targeted for the treatment of sexual dysfunction, obesity, pain management, osteoporosis, and multiple sclerosis.

     We are building a pharmaceutical company leveraging our unique drug delivery capabilities and technologies as the means to develop commercial products – initially with partners, then on our own. The key elements of our business model are to:

	•		develop proprietary active delivery molecules from our tight junction and siRNA technologies;
	•		focus on molecules where our portfolio of technologies will offer significant clinical advantages;
	•		conduct preclinical, clinical and manufacturing steps to generate validated clinical leads and products;
	•		partner to complete or assist us to complete development and commercialization; and
	•		provide turn-key commercial manufacturing of nasal delivery products.

     We are a leader in molecular-biology based drug delivery, which involves the pharmaceutical manipulation of “tight junctions”. Tight junctions are the cell-to-cell connections that comprise various tissues of the body and that regulate the transport and passage of therapeutic drugs across these natural barriers. We also have expertise in formulation science, a systematic approach to drug development using biophysics, physical chemistry and pharmacology to maximize therapeutic efficacy and safety, which sometimes involves a change in route of administration. Our drug delivery technology is essential in designing an optimized, customizable dosage form and in delivering proteins and large molecule drugs that can currently only be delivered by injection or other non-optimized routes.

     Our core technical competency in molecular-biology based drug delivery involves the research, development and manufacture of nasally administered prescription pharmaceuticals. We investigate the commercial weaknesses of pharmaceutical products currently available in oral, injectable or other dosage forms, and we determine the advantages an alternative drug delivery system, such as intranasal, would have for the same drug in the market place. For example, while the oral route of drug delivery is the most popular and least expensive method of delivery, gastrointestinal and liver metabolism can reduce an oral drug’s effectiveness. Generally, a nasal delivery system will provide faster absorption into the blood stream than an oral product thereby resulting in faster onset of action. Other advantages of this therapy may include lower drug doses, fewer side effects, greater safety and efficacy, greater convenience to the patient, better patient compliance of prescribed drug therapy and lower overall health care costs for the patient when compared to established methods of delivery.

     Our current business strategy seeks to broaden applications of our commitment to tight junction technology and formulation science, allowing drugs to be more safe and effective in patient treatment, with particular emphasis on the applications for nasal drug delivery, in the prescription and over-the-counter markets.

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     We have an accumulated deficit of $54.8 million and expect additional operating losses in the foreseeable future as we continue our research and development activities. Our development efforts and the future revenues from sales of these products are expected to generate contract research revenues, milestone payments, license fees, royalties and manufactured product sales for us. As of December 31, 2003, we had approximately $25.1 million in cash, cash equivalents and short–term investments. We believe that our current cash position provides us with adequate working capital through at least December 31, 2004. In addition, we are planning to enter into various collaborations to accelerate our R&D programs, and to the extent these collaborations do not occur, we may be required to reduce our research and development activities or raise additional funds from new investors or in the public markets. On December 18, 2003, we filed a shelf registration statement on Form S-3 with the SEC, pursuant to which we may issue common stock and warrants from time to time, up to an aggregate of $30.0 million. The terms of any future offering would be established at the time of the offering. The shelf registration statement was declared effective by the SEC on January 14, 2004. The shelf registration statement will enable us to raise funds from the offering of any individual security covered by the shelf registration statement, as well as any combination thereof, from time to time and through one or more methods of distribution, subject to market conditions and our capital needs. We plan to use the proceeds from any offering under the registration statement for general corporate purposes, including financing our clinical development and research programs.

Critical Accounting Estimates

     We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe that the following discussion addresses our most critical accounting estimates which are those that are most important to the portrayal of our financial condition and results of operations and which require our most difficult and subjective judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We also have other policies that we consider key accounting policies; however, these policies do not meet the definition of critical accounting estimates, because they do not generally require us to make estimates or judgments which are difficult or subjective.

Revenue Recognition

     Most of our revenues are generated from complex research and licensing arrangements. These research and licensing arrangements may include upfront non-refundable payments, milestone payments, royalties, revenue from R&D services performed and product sales revenue.

     Upfront non-refundable fees received under research collaboration agreements are generally recognized over the term of the related research period. Changes in estimated development time or costs of development are recognized prospectively. Any such changes could impact future revenue recognition depending on whether estimated time or costs increase or decrease. Upfront non-refundable fees received under license agreements, which do not require any further research and development activities or other continuing involvement on our part are recognized upon receipt.

     Milestone payments are typically progress payments for specific events of development, such as completion of preclinical or clinical activities, regulatory submission or approval, or manufacturing objectives prior to commercialization of a product. These milestone payments are generally non-refundable and recognized as revenue based on the percentage of actual product research and development costs incurred to date to the estimated total of such costs to be incurred over the development period.

     Royalty revenue is generally recognized at the time of product sale by the licensee.

     Revenue from R&D services performed is generally services performed under collaboration agreements and is recognized at the time the services are performed.

     Product sales revenue is recognized at the time the manufactured goods are shipped to the purchaser and title has transferred.

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Stock-based compensation

     We apply Accounting Principles Board Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees, and related interpretations in accounting for our stock-based employee compensation plans, rather than the alternative fair value accounting method provided for under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, (“SFAS 123”). In Note 2(l) of the Notes to Consolidated Financial Statements, we provide pro-forma disclosures in accordance with SFAS 123 and related pronouncements. Under APB 25, compensation expense is recorded on the date of grant of an option to an employee or member of the Board of Directors only if the fair market value of the underlying stock at the time of grant exceeds the exercise price. In the three years ended December 31, 2003, 2002 and 2001, our stock option grants were based on the closing price of our stock on the date of grant, with the exceptions of grants to our CEO in May 2002, and an extension made in October 2002, of the expiration date of certain stock option grants to members of the Board of Directions, as described more fully in Note 8 of the Notes to Consolidated Financial Statements. In addition, we have granted options to certain outside consultants, which are required to be measured at fair value and recognized as compensation expense in our Consolidated Statements of Operations. We apply the Black-Scholes option-pricing model for estimating the fair value of options, which involves a number of judgments and variables including estimates of the life of the options and expected volatility which are subject to significant change. A change in the fair value estimate could have a significant effect on the amount of compensation expense calculated.

Income Taxes

     A critical estimate is the full valuation allowance for deferred taxes that was recorded based on the uncertainty that such tax benefits will be realized in future periods. To the extent we achieve profitability such deferred tax allowance would be reversed at that time.

Results of Operations

Total Revenue

     Total revenue and dollar and percentage changes as compared to the prior year are as follows (dollar amounts are presented in thousands):

     The following table sets forth information on types of revenue for the years ended December 31, 2003, 2002 and 2001 (dollar amounts are presented in thousands):

     The increase in total revenue in 2003 over 2002 was driven primarily by an increase in license and research fees as a result of the divestiture agreement which we entered into with Pharmacia under which we reacquired all rights to the intranasal apomorphine product and to a lesser extent revenue for services performed for Questcor in filing the NDA for the Nascobal® spray product totaling $1,025,000. The increase in total revenue in 2002 over 2001 was driven primarily by an increase in license and research fees as a result of collaboration and license agreement for intranasal apomorphine with Pharmacia. The following table sets forth information on the license and research fees (dollar amounts are presented in thousands):

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Product revenue and cost of product revenue

     The following table sets forth information on product revenue, cost of product revenue and cost of product revenue as a percentage of product revenue for the years ended December 31, 2003, 2002 and 2001 (dollar amounts are presented in thousands):

     Product revenue consists of sales of Nascobal® nasal gel and royalty revenue from sales of Nascobal® nasal gel. From 1997 until September 30, 2002, we had a license agreement with Schwarz Pharma that granted to Schwarz Pharma exclusive rights to market Nascobal® in the U.S. We recorded revenue from sales of manufactured products to Schwarz Pharma and royalty revenue received from Schwarz Pharma through September 2002. On September 30, 2002, we terminated the agreement with Schwarz Pharma and reacquired rights to Nascobal®. During the time period from October 1, 2002 to June 17, 2003, we earned revenue from our own direct sales of Nascobal® nasal gel to drug wholesalers using a contract sales organization and contract distributor. On June 17, 2003, we completed the sale of certain assets relating to our Nascobal® brand products to Questcor. In connection with the sale, we entered into a supply agreement with Questcor under which Questcor is obligated to purchase from us all of its requirements for the Nascobal® nasal gel and, upon FDA approval, the Nascobal® nasal spray. In 2003, we earned product sales revenue under the supply agreement and, in the future, we expect to receive product sales revenue under this supply agreement.

     The increase in cost of product revenue in 2003 over 2002 was driven primarily by an increase in product revenue as a result of our own direct sales of Nascobal® nasal gel. During this time the cost of product revenue as a percentage of product revenue increased from 21% to 28%. This is due, in part, to $315,000 of royalty revenue in 2002 included in product revenue on which no cost of product revenue is recorded. The decrease in cost of product revenue in 2002 over 2001 resulted primarily from manufacturing efficiencies and from a write-off of costs in 2001 related to a production batch failing product release standards.

Research and development

     Research and development expense consists primarily of salaries and other personnel-related expenses, costs of clinical trials, consulting and other outside service, laboratory supplies, facilities costs, FDA filing fees and other costs. Research and development expense by project as a percentage of total R&D expense and total R&D expense as compared to prior years are as follows (dollar amounts are presented in thousands):

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The increase in 2003 over 2002 resulted primarily from the following costs:

	•		Personnel–related expenses increased 55% to $6.7 million due to an increase in research and development activities for our products under development and development of our tight junctions technology as described in more detail in the Section of Part I Item 1 entitled “Products”.
	•		Costs of clinical trials, consulting, outside services and laboratory supplies increased 39% to $7.1 million due to clinical trials performed for our apomorphine and PYY products under development.
	•		Facilities costs increased 45% to $2.7 million due to rent and related expenses on the Bothell facility offset in part by closure of the Adams Avenue facility.
	•		FDA filing fees in 2003 were approximately $300,000 due to the filing of the NDA for the Nascobal® nasal spray. There were no FDA filing fees in 2002.

The increase in 2002 over 2001 resulted primarily from the following costs:

	•		Personnel-related expenses increased 23% to $4.4 million due to an increase in research and development activities for our intranasal apomorphine product as a result of the execution of the Pharmacia Agreement.
	•		Costs of clinical trials, consulting, outside services and laboratory supplies increased 134% to $5.1 million due to an increase in research and development activities for our intranasal apomorphine product as a result of the execution of the Pharmacia Agreement.
	•		Facilities costs increased 143% to $1.8 million due to occupancy of the Bothell Facility in 2002 and a higher allocation of rent costs to R&D as a result of increase in R&D activities.

     We expect an increase in research and development costs in the foreseeable future as we continue our research and development activities. These expenditures are subject to numerous uncertainties in timing and cost to completion. We test compounds in numerous preclinical studies for safety, toxicology and efficacy. We then conduct early stage clinical trials for each drug candidate. If we are not able to engage a collaboration partner prior to the commencement of later stage clinical trials, we may fund these trials ourselves. As we obtain results from trials, we may elect to discontinue or delay clinical trials for certain products in order to focus our resources on more promising products. Completion of clinical trials by us and our collaboration partners may take several years or more, but the length of time generally varies substantially according to the type, complexity, novelty and intended use of a drug candidate. The cost of clinical trials may vary significantly over the life of a project as a result of differences arising during clinical development, including, among others:

	•		the number of sites included in the clinical trials;
	•		the length of time required to enroll suitable patient subjects;
	•		the number of patients that participate in the trials;
	•		the duration of patient follow-up that seems appropriate in view of results; and
	•		the number and complexity of safety and efficacy parameters monitored during the study.

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     None of our current pipeline of drug candidates has received FDA or foreign regulatory marketing approval. In order to achieve marketing approval, the FDA or foreign regulatory agencies must conclude that our and our collaboration partners’ clinical data establishes the safety and efficacy of our drug candidates. Furthermore, our strategy includes entering into collaborations with third parties to participate in the development and commercialization of our products. In the event that third parties have control over the development process for a product, the estimated completion date would largely be under control of that third party rather than under our control. We cannot forecast with any degree of certainty how such collaboration arrangements will affect our development plans or capital requires.

     As a result of the uncertainties discussed above, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will receive cash inflows from the commercialization and sale of a product.

Royalties

     In 2002, royalty expenses were $9,000, a decrease of $478,000, or 98%, compared to 2001. The decrease resulted from the decrease in sales of Stadol®NS™ by BMS and the related decrease in royalties payable to UKRF due to the discontinuance of royalties for Stadol®NS™ resulting from the expiration of the U.S. patent on Stadol®NS™.

Sales and marketing

     Sales and marketing expense consists primarily of salaries and other personnel-related expenses, costs of using a contract sales organization and contract distributor for Nascobal® nasal gel, consulting, sales materials, trade shows and advertising. Total sales and marketing expense and dollar and percentage changes as compared to the prior year are as follows (dollar amounts are presented in thousands):

     In October 2002, after we terminated the agreement with Schwarz Pharma and reacquired rights to Nascobal®, we initiated marketing programs to re-launch our own direct sales of Nascobal® nasal gel. The increase in sales and marketing expense in 2003 over 2002 and the increase in 2002 over 2001 were driven primarily due to expenses incurred as part of this re-launch.

     We expect a decrease in sales and marketing costs in the foreseeable future as we do not currently have a product which we are selling directly which would require this same level of expenditure.

General and administrative

     General and administrative expense consists primarily of salaries and other personnel-related expenses to support our R&D activities, amortization of non-cash deferred stock option compensation, professional fees such as accounting and legal, corporate insurance, amortization of intangibles and facilities costs. Total general and administrative expense and dollar and percentage changes as compared to the prior year are as follows (dollar amounts are presented in thousands):

     The decrease in 2003 over 2002 resulted primarily from the following costs:

•

Personnel–related expenses decreased 5% to $2.4 million due to additional costs incurred in 2002

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			associated with relocation of personnel to our Bothell, Washington location.
	•		Amortization of non-cash deferred stock option compensation decreased 66% to $470,000. In 2002, we recorded $773,000 of non-cash compensation expense related to stock options granted to our Chief Executive Officer in connection with the extension of his employment agreement through December 31, 2005, and $612,000 of compensation expense related to extending the expiration dates for all options held by certain members of the Board of Directors, as described further in Note 8 of the Notes to Consolidated Financial Statements.
	•		Costs of legal fees, accounting fees, corporate insurance and other administrative costs decreased 43% to $2.1 million. In January 2003, we entered into a divestiture agreement with Pharmacia under which we reacquired all rights to the intranasal apomorphine product. In contemplation of this agreement, in 2002, we incurred significant legal costs associated with the divestiture. In 2003, as part of the divestiture agreement, we received and recorded a $500,000 reimbursement from Pharmacia for a portion of these legal costs. Patent legal fees decreased by $400,000 due to the addition of in-house patent counsel in 2003.
	•		Facilities costs decreased 41% to $360,000 due to closure of the Adams Avenue facility.
	•		Amortization of intangibles increased 85% to $400,000 due to amortization of the Nascobal® related assets. In June 2003, we completed the sale of certain assets relating to our Nascobal® brand products to Questcor, at which time the amortization of the related tangibles ceased.

     The increase in 2002 over 2001 resulted primarily from the following costs:

	•		Personnel-related expenses increased 31% to $2.3 million due to additional costs incurred in 2002 associated with relocation of personnel to our Bothell, Washington location.
	•		Amortization of non-cash deferred stock option compensation of $1.4 million recorded in 2002 versus zero in 2001. In 2002, we recorded $773,000 of non-cash compensation expense related to stock options granted to our Chief Executive Officer in connection with the extension of his employment agreement through December 31, 2005, and $612,000 of compensation expense related to extending the expiration dates for all options held by certain members of the Board of Directors, as described further in Note 8 of the Notes to Consolidated Financial Statements.
	•		Costs of legal fees, accounting fees, corporate insurance and other administrative costs increased 151% to $3.7 million. In January 2003, we entered into a divestiture agreement with Pharmacia under which we reacquired all rights to the intranasal apomorphine product. In contemplation of this agreement, in 2002, we incurred significant legal costs associated with the divestiture. Patent legal costs also increased by $700,000 due to activities in support of our intellectual property portfolio.
	•		Facilities costs decreased 19% to $605,000 due to closure of the Adams Avenue facility.
	•		Amortization of intangibles increased 278% to $216,000 due to amortization of the Nascobal® related assets which we reacquired from Schwarz Pharma in 2002. In 2001, we recorded $57,000 of amortization of goodwill associated with the acquisition of Atossa. The goodwill amortization ceased as of December 31, 2001 as described further in Note 2 section (e) of the Notes to Consolidated Financial Statements.

     We expect general and administrative expenses to increase slightly in the foreseeable future in support of our research and development activities.

Restructuring charge

     In 2002, a restructuring charge of $595,000 was recorded which resulted from the termination of the lease on the Adams Avenue Facility effective as of February 14, 2003. The restructuring charge is comprised of an $871,000 write-off of leasehold improvements and $86,000 for costs related to vacating the Adams Avenue Facility, which was offset by the elimination of the $362,000 deferred rent liability. There were no restructuring charges in 2003 or 2001.

Interest Income

     The following table sets forth information on interest income, average funds available for investment and average interest rate earned for the years ended December 31, 2003, 2002 and 2001 (dollar amounts are presented in thousands):

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     The decrease in interest income in 2003 over 2002 and in 2002 over 2001 was driven primarily by a decrease in the average interest rate earned on funds available for investment due to a decrease in the prevailing market interest rates.

Interest Expense

     We incur interest expense on our capital leases and our notes payable as described in further detail in Notes 6 and 13 of the Notes to Consolidated Financial Statements. The following table sets forth information on interest expense, average borrowings and average interest rate earned for the years ended December 31, 2003, 2002 and 2001 (dollar amounts are presented in thousands):

     The increase in interest expense in 2003 over 2002 was driven primarily by an increase in the average borrowings, offset by a decrease in the average interest rate. In June 2003, we paid off the note payable to Schwarz Pharma, which had an interest rate of 7.5% per annum, in connection with our sale of Nascobal® to Questcor. In June 2003, we entered into a note payable with Wells Fargo bank with an initial balance of $7.0 million at a rate of LIBOR plus 0.75%. The rate paid on the Wells Fargo note has ranged from 1.875% to 2.0% during 2003. During 2003, we also increased borrowings on our capital leases by approximately $2.4 million at interest rates ranging from 8.3% to 8.6%.

Related Party Transactions

     We pay certain monthly expenses incurred by a company that is owned primarily by Dr. Steven C. Quay, our CEO, in exchange for use of its laboratory facility for certain research and development work. Under this arrangement, during years ended December 31, 2003, 2002 and 2001, we paid rent of approximately $32,300, $36,800 and $29,700, respectively.

     Bruce Thaw, a member of our Board of Directors, provided legal services to us. Fees earned by Mr. Thaw during the years ended December 31, 2002 and December 31, 2001 were $82,750 and $42,000, respectively. As of November 2002, Mr. Thaw ceased to provide legal services to us.

     From 1999 until 2002, we provided split-dollar life insurance for Devin Wenig, our former Chairman of the Board of Directors (who is currently a director) in consideration for services rendered and in lieu of cash remuneration. At the end of 15 years, the premiums we paid were to be repaid to us, with such repayment secured by our collateral interest in the insurance policy. For both years ended December 31, 2002, and 2001, we recognized $40,000 of expense related to this policy. In January 2004, we entered into a termination agreement with Mr. Wenig whereby we have no future obligations with respect to the split-dollar life agreement, we have no right to any of the cash surrender value or proceeds of the life insurance policy and we will forego any existing accounts receivable recorded related to our interest in the life insurance policy through the split-dollar life agreement. In 2003, we expensed approximately $54,000 which was recorded as a receivable for the split-dollar life agreement.

     In October 2003, we entered into a consulting agreement with Dr. Ian Ferrier, a member of our Board of Directors, for the purpose of advising us on our strategic planning. Under the agreement, Dr. Ferrier was paid $45,000 in 2003. The agreement terminates on March 31, 2004, unless extended by the parties.

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Liquidity and Capital Resources

Cash Requirements

     We have financed our operations primarily through the sale of common stock and warrants in private placements and in the public markets, revenues received from our collaborative partners, equipment financing facilities and notes payable. As of December 31, 2003, we had approximately $25.1 million cash, cash-equivalents and short-term investments.

     We have an accumulated deficit of $54.8 million and expect additional operating losses in the foreseeable future as we continue our research and development activities. Our development efforts and the future revenues from sales of these products are expected to generate contract research revenues, milestone payments, license fees, royalties and manufactured product sales for us. As of December 31, 2003 we had approximately $25.1 million in cash, cash equivalents and short–term investments. We believe that our current cash position provides us with adequate working capital through at least December 31, 2004. In addition, we are planning to enter into various collaborations to accelerate our R&D programs, and to the extent these collaborations do not occur, we may be required to reduce our research and development activities or raise additional funds from new investors or in the public markets. On December 18, 2003, we filed a shelf registration statement on Form S-3 with the SEC, pursuant to which we may issue common stock and warrants from time to time, up to an aggregate of $30.0 million. The terms of any future offering would be established at the time of the offering. The shelf registration statement was declared effective by the SEC on January 14, 2004. The shelf registration statement will enable us to raise funds from the offering of any individual security covered by the shelf registration statement, as well as any combination thereof, from time to time and through one or more methods of distribution, subject to market conditions and our capital needs. We plan to use the proceeds from any offering under the registration statement for general corporate purposes, including financing our clinical development and research programs.

Sources and Uses of Cash

     Total sources and uses of cash for the three years ending December 31, 2003, 2002 and 2001 are as follows (dollar amounts presented in thousands):

     Our operating activities used cash of $7.7 million for the year ended December 31, 2003, compared to $6.5 million for 2002 and $7.4 million for 2001. Cash used in operating activities relates primarily to funding net losses and changes in deferred revenue from collaborators, partially offset by non-cash charges related to depreciation and amortization of deferred stock compensation and intangibles. In 2003, we had a non-cash gain on the sale of our product, Nascobal®, of $4.2 million. In 2002, we had a non-cash restructuring charge of $595,000 associated with our exit of the Adams Avenue facility. We expect to use cash for operating activities in the foreseeable future as we continue our research and development activities.

     Our investing activities provided cash of $3.5 million for the year ended December 31, 2003, compared to using cash of $3.8 million for 2002 and $179,000 for 2001. Changes in cash from investing activities are due primarily to purchases of short-term investments net of maturities and purchases of property and equipment. In addition, in 2003, we sold our product, Nascobal® which resulted in a cash inflow of $14.0 million. We expect to continue to make significant investments in our research and development infrastructure, including the purchase of property and equipment to support our research and development activities.

     Our financing activities provided cash of $12.0 million for the year ended December 31, 2003, compared to $7.6 million for 2002 and $13.1 million for 2001. Changes in cash from financing activities are primarily due to issuance of common stock and warrants, issuance of notes payable and proceeds from equipment financing facilities. In September 2003, we completed a private placement of approximately 1.5 million shares of common stock, resulting in net proceeds of approximately $10.0 million as described in further detail in Note 7 of the Notes to Consolidated Financial Statements. We finance property and equipment purchases through equipment financing facilities, such as

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capital leases and our Revolving Line of Credit Note as described in further detail in Notes 6 and 13 of the Notes to Consolidated Financial Statements. On December 18, 2003, we filed a shelf registration statement on Form S-3 with the SEC, pursuant to which we may issue common stock and warrants from time to time, up to an aggregate of $30.0 million. The shelf registration statement was declared effective by the SEC on January 14, 2004. We plan to use the proceeds from any offering under the registration statement for general corporate purposes, including financing our clinical development and research programs. Over the next several years, we are required to make certain payments on our contractual obligations as described below.

Contractual Obligations

     We have contractual obligations in the form of facility leases, notes payable and capital leases. These are described in further detail in Notes 6, 10 and 13 of the Notes to Consolidated Financial Statements. The following chart details our contractual obligations (in thousands):

Off-Balance Sheet Arrangements

     As of December 31, 2003, we did not have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Recent Accounting Pronouncements

     In November 2002, the Financial Accounting Standards Board Emerging Issues Task Force issued its consensus concerning Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). EITF 00-21 addresses how to determine whether a revenue arrangement involving multiple deliverables should be divided into separate units of accounting, and, if separation is appropriate, how the arrangement consideration should be measured and allocated to the identified accounting units. The guidance in EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have a material impact on our financial statements.

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Our exposure to market rate risk for changes in interest rates relates primarily to our investment of cash in excess of near term requirements. We have a prescribed methodology whereby we invest our excess cash in debt instruments of U.S. government agencies and high quality corporate issuers (Standard & Poor’s double “AA” rating and higher). To mitigate market risk, securities have a maturity date within 15 months, no category of issue can exceed 50% of the portfolio, and holdings of any one issuer excluding the U.S. government do not exceed 20% of the portfolio. Periodically, the portfolio is reviewed and adjusted if the credit rating of a security held has deteriorated. We do not utilize derivative financial instruments.

     Our revolving line of credit note with Wells Fargo Bank requires monthly payments of interest. The entire note balance is due and payable December 31, 2004. The table below outlines the minimum cash outflows for payments on the note payable and capital lease obligations (in thousands) as described in further detail in Notes 6 and 13 of the Notes to Consolidated Financial Statements.

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ITEM 8. INDEX TO FINANCIAL STATEMENTS

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INDEPENDENT AUDITORS’ REPORT

To the Board of Directors and Stockholders
    Nastech Pharmaceutical Company Inc.:

We have audited the accompanying consolidated balance sheets of Nastech Pharmaceutical Company Inc. and subsidiary (the Company) as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nastech Pharmaceutical Company Inc. and subsidiary as of December 31, 2003 and 2002 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.

Seattle, Washington
February 27, 2004

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NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(In Thousands, Except Share and Per Share Data)

See accompanying notes to consolidated financial statements.

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NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(In Thousands, Except Per Share Data)

See accompanying notes to consolidated financial statements.

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NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the Years Ended December 31, 2003, 2002 and 2001
(In Thousands, Except Share Data)

See accompanying notes to consolidated financial statements.

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NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)

See accompanying notes to consolidated financial statements.

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NASTECH PHARMACEUTICAL COMPANY INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Three Years Ended December 31, 2003

Note 1 — Business and Basis of Presentation

     Business

     Nastech Pharmaceutical Company Inc. (“Nastech”, or the “Company”) is an emerging pharmaceutical company developing products based on applying proprietary drug delivery technologies, with approximately 195 patents and applications filed. The Company is developing molecular biology-based technologies for delivering both small and large molecule drugs by nasal administration, along with an extended release oral delivery technology. The Company’s intranasal drug delivery technology may lead to greater drug efficacy, speed of action, safety, and patient compliance. The Company is developing a diverse product portfolio across multiple therapeutic areas, including products targeted for the treatment of sexual dysfunction, obesity, pain management, osteoporosis, and multiple sclerosis.

     The Company is building a pharmaceutical company leveraging its unique drug delivery capabilities and technologies as the means to develop commercial products – initially with partners, then on the Company’s own. The key elements of the Company’s business model are to:

•		develop proprietary active delivery molecules from tight junction and siRNA technologies;
•		focus on molecules where its portfolio of technologies will offer significant clinical advantages;
•		conduct preclinical, clinical and manufacturing steps to generate validated clinical leads and products;
•		partner to complete or assist the Company to complete development and commercialization; and
•		provide turn-key commercial manufacturing of nasal delivery products.

     The Company is a leader in molecular-biology based delivery, which involves the pharmaceutical manipulation of “tight junctions”. Tight junctions are the cell-to-cell connections that comprise various tissues of the body and that regulate the transport and passage of therapeutic drugs across these natural barriers. The Company also has expertise in formulation science, a systematic approach to drug development using biophysics, physical chemistry and pharmacology to maximize therapeutic efficacy and safety, which sometimes involves a change in route of administration. The Company’s drug delivery technology is essential in designing an optimized, customizable dosage form and in delivering proteins and large molecule drugs that can currently only be delivered by injection or other non-optimized routes.

     The Company’s core technical competency in molecular-biology based drug delivery involves the research, development and manufacture of nasally administered prescription pharmaceuticals. The Company investigates the commercial weaknesses of pharmaceutical products currently available in oral, injectable or other dosage forms, and determines the advantages an alternative drug delivery system, such as intranasal, would have for the same drug in the market place. For example, while the oral route of drug delivery is the most popular and least expensive method of delivery, gastrointestinal and liver metabolism can reduce an oral drug’s effectiveness. Generally, a nasal delivery system will provide faster absorption into the blood stream than an oral product thereby resulting in faster onset of action. Other advantages of this therapy may include lower drug doses, fewer side effects, greater safety and efficacy, greater convenience to the patient, better patient compliance of prescribed drug therapy and lower overall health care costs for the patient when compared to established methods of delivery.

     The Company’s current business strategy seeks to broaden applications of its commitment to tight junction technology and formulation science, allowing drugs to be more safe and effective in patient treatment, with particular emphasis on the applications for nasal drug delivery, in the prescription and over-the-counter markets.

     As of December 31, 2003, the Company has an accumulated deficit of $54.8 million and expects additional operating losses in the foreseeable future as it continues its research and development activities. The Company has funded its operating losses primarily through the sale of common stock in the public markets and private placements and also through revenues provided by its collaborative partners.

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     The Company faces certain risks and uncertainties regarding its ability to generate positive operating cash flow and profits. These risks include, but are not limited to, its ability to obtain additional capital, protect its patents and property rights, overcome uncertainties regarding its technologies, competition and technological change, obtain government approval for products and attract and retain key officers and employees.

     Note 2 — Summary of Significant Accounting Policies and Related Matters

     (a) Principles of Consolidation

     The financial statements include the accounts of Nastech Pharmaceutical Company Inc. and its wholly-owned subsidiary, Atossa HealthCare, Inc. All inter-company balances and transactions have been eliminated in consolidation. The Company operates in one segment and utilizes a platform of drug discovery technologies and development capabilities to discover and develop nasally administered formulations of prescription pharmaceuticals.

     (b) Use of Estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates.

     (c) Cash and Cash Equivalents

     Cash and cash equivalents consist of cash, money market funds, and investments in U.S. Government and Agency Securities and highly-rated investment grade commercial paper with maturities of 3 months or less at date of purchase.

     (d) Investments

     Investments in marketable securities consist of debt instruments of U.S. government agencies and high quality corporate issuers (Standard & Poor’s double “AA” rating and higher) and have been categorized as available for sale and are stated at fair value.

     (e) Inventories

     Inventories are stated at the lower of cost (first-in, first-out basis) or market and consist of raw materials at the Company’s manufacturing facility and for December 31, 2002, finished goods held by the Company’s former distributor.

     (f) Intangible Assets and Goodwill

     Intangible assets consisted of costs associated with the purchase of a license agreement related to the Nascobal® product as is more fully described in Note 15. Such costs were being amortized over a ten-year period from the date of acquisition using the straight-line method. In June 2003, the Company completed the sale of certain assets relating to the Nascobal® brand products to Questcor Pharmaceuticals, Inc. (“Questcor”), at which time the intangible asset was sold. The sale transaction is described more fully in Note 11.

     Goodwill represents the cost in excess of the net assets resulting from the Company’s acquisition in 2000 of Atossa Health Care, Inc. Until December 31, 2001, goodwill was amortized on a straight-line basis over a three-year period. In accordance with SFAS 142, Goodwill And Other Intangible Assets (“SFAS 142”) this amortization ceased after December 31, 2001. Accumulated amortization at December 31, 2001 was $81,000. The pro forma net loss and loss per share for the 12 months ended December 31, 2001, excluding goodwill amortization of $57,000, was $9,175,000 and $1.15 per share, respectively. As required by SFAS 142, the Company will conduct, on an annual basis, an assessment of goodwill impairment.

     As a result of the Company’s R&D programs, the Company has applied for a number of patents in the United States and abroad. Such patent rights are of significant importance to the Company to protect products and processes developed. Costs incurred in connection with patent applications for the Company’s R&D program have been expensed as general and administrative expenses as incurred.

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     (g) Property and Equipment

     Property and equipment are carried at cost and depreciated using straight-line methods over estimated useful lives ranging from 3 to 10 years. Leasehold improvements are carried at cost and amortized using the straight-line method over the lesser of the estimated useful life or the remaining lease term. When assets are sold or retired, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the period. Expenditures for maintenance and repairs are charged to expense as incurred.

     (h) Impairment of long-lived assets

     Long-lived assets including property and equipment are reviewed for possible impairment whenever significant events or changes in circumstances, including changes in the Company’s business strategy and plans, indicate that an impairment may have occurred. An impairment is indicated when the sum of the expected future undiscounted net cash flows identifiable to that asset or asset group is less than its carrying value. Impairment losses are determined from actual or estimated fair values, which are based on market values, net realizable values or projections of discounted net cash flows, as appropriate.

     (i) Revenue Recognition and Accounts Receivable

     Most of the Company’s revenues are generated from complex research and licensing arrangements. These research and licensing arrangements may include up-front non-refundable payments, milestone payments, royalties, revenue from R&D services performed and product sales revenue.

     Upfront non-refundable fees received under research collaboration agreements are generally recognized over the term of the related research period in accordance with guidance rendered in the Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue in Financial Statements, as amended. Changes in estimated development time or costs of development are recognized prospectively. Any such changes could impact future revenue recognition depending on whether estimated time or costs increase or decrease. Upfront non-refundable fees received under license agreements, which do not require any further research and development activities or other continuing involvement on the part of the Company are recognized upon receipt.

     Milestone payments are typically progress payments for specific events of development, such as completion of preclinical or clinical activities, regulatory submission or approval, or manufacturing objectives prior to commercialization of a product. These milestone payments are generally non-refundable and recognized as revenue based on the percentage of actual product research and development costs incurred to date to the estimated total of such costs to be incurred over the development period.

     Royalty revenue is generally recognized at the time of product sale by the licensee. Royalty payments have varied based on the level of sales reported by the licensees, Bristol-Myers Squibb (“BMS”) and Schwarz Pharma. In addition, with the expiration of the U.S. patent covering Stadol® NS™ in August 2001 and the expiration of the international patent in April, 2002, the Company’s royalty revenue from BMS decreased substantially and will not be a significant source of revenue in the future. As of October 2002, the Company no longer received royalty revenue from sales of Nascobal® as a result of its purchase of the license agreement for Nascobal® from Schwarz Pharma as described more fully in Note 15.

     Revenue from R&D services performed is generally services performed under collaboration agreements and is recognized at the time the services are performed.

     Product sales revenue is recognized at the time the manufactured goods are shipped to the purchaser and title has transferred.

     For the year ended December 31, 2003, a substantial portion of revenue was derived from revenue recognized as a result of payments received by the Company as a result of the divesture agreement entered into with Pharmacia & Upjohn Company as described more fully in Note 11. For the year ended December 31, 2002, a substantial portion of revenue was derived from upfront fees, milestone payments and revenue from R&D services performed for Pharmacia and from direct sales of Nascobal® nasal gel. For the year ended December 31, 2001, a substantial portion of revenue was derived from licensing agreements with BMS, Schwarz Pharma, and G. Pohl Boskamp.

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     The Company’s accounts receivable are predominantly from sales of Nascobal® nasal gel as a result of the supply agreement with Questcor.

     (j) Net Loss per Common Share

     Basic and diluted net loss per common share is computed by dividing the net loss by the weighted average number of common shares outstanding during the period. The diluted loss presented excludes the effect of common stock equivalents (stock options and warrants) since such inclusion in the computation would be anti-dilutive. Such options and warrants amounted to 4,109,302; 3,432,752; and 2,329,516; for years 2003, 2002, and 2001, respectively.

     (k) Income Taxes

     Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

     (l) Stock-Based Compensation

     The Company accounts for stock-based compensation using the intrinsic value method in accordance with APB No. 25, Accounting for Stock Issued to Employees. Effective July 1, 1996, the Company adopted the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation, which requires the disclosure of pro forma net income and earnings per share as if the Company adopted the fair value-based method in measuring compensation expense as of the beginning of fiscal 1996.

     The per share weighted average fair value of stock options granted during the fiscal years ended December 31, 2003, 2002 and 2001 was $6.02, $9.53, and $5.26, respectively, on the date of grant using the Black Scholes option-pricing model with the following weighted-average assumptions:

     Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, its net loss would have been reported as the pro forma amounts indicated below:

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