DISCOVERY LABORATORIES INC /DE/ - 10-K Annual Report

Back to GetFilings.com

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

FORM 10-K

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

For the fiscal year ended December 31, 2002

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

For the transition period from to

Commission file number 0-26422

DISCOVERY LABORATORIES, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 94-3171943
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

350 SOUTH MAIN STREET, SUITE 307, DOYLESTOWN, PENNSYLVANIA 18901
(Address of principal executive offices) (Zip Code)

(215) 340-4699
(Registrant's telephone number, including area code)

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

Name of each exchange
Title of each class on which registered
------------------- -------------------

None None

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

Common Stock, $.001 par value

(Title of class)

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 (ss.229.405 of this chapter) is not contained herein, and will
not be contained, to the best of the registrant's knowledge, in definitive proxy
or information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K. |_|

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). |_|

The aggregate market value of shares of voting and non-voting common equity held
by non-affiliates of the registrant computed using the closing price of common
equity as reported on NASDAQ SmallCap Market under the symbol DSCO on June 28,
2002, the last business day of the registrant's most recently completed second
fiscal quarter, was approximately $69 million. For the purposes of determining
this amount only, the registrant has defined affiliates to include: (a) the
executive officers named in Part III of this Annual Report on Form 10-K; (b) all
directors of the registrant; and (c) each shareholder that has informed the
registrant by February 26, 2003 that it is the beneficial owner of 10% or more
of the outstanding shares of common stock of the registrant.

As of February 26, 2003, 32,856,526 shares of the registrant's common stock were
outstanding.

The information required by Items 10 through 13 of Part III of this Annual
Report on Form 10-K is incorporated by reference to the extent described herein
from our definitive proxy statement, which is expected to be filed by us with
the Commission within 120 days after the close of our fiscal year.

ii

Unless the context otherwise requires, all references to "we," "us," "our," and
the "Company" include Discovery Laboratories, Inc. ("Discovery"), and its
wholly-owned, presently inactive subsidiary, Acute Therapeutics, Inc.

FORWARD LOOKING STATEMENTS

The statements set forth under Item 1: "Description of Business" and elsewhere
in this prospectus, including in Item 7: "Management's Discussion and Analysis
of Financial Condition and Results of Operations - Risks Related to Our
Business" and those incorporated by reference herein which are not historical
constitute "Forward Looking Statements" within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934,
including statements regarding the expectations, beliefs, intentions or
strategies for the future. We intend that all forward-looking statements be
subject to the safe-harbor provisions of the Private Securities Litigation
Reform Act of 1995. These forward-looking statements are only predictions and
reflect our views as of the date they are made with respect to future events and
financial performance. Forward-looking statements are subject to many risks and
uncertainties which could cause our actual results to differ materially from any
future results expressed or implied by the forward-looking statements.

Examples of the risks and uncertainties include, but are not limited to: the
inherent risks and uncertainties in developing products of the type we are
developing; possible changes in our financial condition; the progress of our
research and development (including the results of clinical trials being
conducted by us and the risk that our lead product candidate, Surfaxin(R), will
not prove to be safe or useful for the treatment of certain indications);
clinical trials require adequate supplies of drug substance and drug product,
which may be difficult or uneconomical to procure or manufacture; timely
obtaining sufficient patient enrollment in our clinical trials; the impact of
development of competing therapies and/or technologies by other companies; our
ability to obtain additional required financing to fund our research programs;
our ability to enter into agreements with collaborators and the failure of
collaborators to perform under their agreements with us; the progress of the FDA
approvals in connection with the conduct of our clinical trials and the
marketing of our products; the additional costs and delays which may result from
requirements imposed by the FDA in connection with obtaining the required
approvals; and the other risks and certainties detailed in Item 7: "Management's
Discussion and Analysis of Financial Condition and Results of Operations - Risks
Related to Our Business," and in the documents incorporated by reference in this
report.

Except to the extent required by applicable laws or rules, we do not undertake
any obligation or duty to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.

iii

DISCOVERY LABORATORIES, INC.
TABLE OF CONTENTS TO FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

PART I

ITEM 1. DESCRIPTION OF BUSINESS 1

ITEM 2. DESCRIPTION OF PROPERTY 17

ITEM 3. LEGAL PROCEEDINGS 17

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 17

PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS 18

ITEM 6. SELECTED FINANCIAL DATA 19

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 20

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 41

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 42

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 42

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 43

ITEM 11. EXECUTIVE COMPENSATION. 43

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS 43

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 43

ITEM 14. CONTROLS AND PROCEDURES 43

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K 44

SIGNATURES 45

iv

PART I

ITEM 1. DESCRIPTION OF BUSINESS.

COMPANY SUMMARY

We are a late-stage specialty pharmaceutical company applying our humanized lung
surfactant technology to develop potential novel respiratory therapies and
products. Surfactants are substances that are produced naturally in the lungs
and are essential to the lungs' ability to absorb oxygen and to maintain proper
airflow through the respiratory system. The absence or depletion of surfactants
is involved in a number of respiratory diseases.

Our humanized surfactant technology produces an engineered version of natural
human lung surfactant and contains a peptide, sinapultide, that is designed to
precisely mimic the essential human lung surfactant protein B (SP-B). We believe
that our proprietary surfactant technology is the only surfactant technology
presently available to potentially treat a broad range of respiratory diseases
including Respiratory Distress Syndrome in adults and infants, asthma, chronic
obstructive pulmonary disease (often referred to as COPD, which is a chronic
condition of the lung that prevents enough oxygen from reaching the blood),
Acute Lung Injury (often referred to as ALI), and upper airway disorders such as
sinusitis (infection of the sinuses) and sleep apnea.

Surfaxin(R), our lead product, is being developed initially for critical care
patients with life-threatening respiratory disorders where there are few, if
any, approved therapies. Surfaxin is currently in two Phase 3 clinical trials
for Respiratory Distress Syndrome in premature infants, a Phase 3 clinical trial
for Meconium Aspiration Syndrome in full-term infants, and a Phase 2 clinical
trial for Acute Respiratory Distress Syndrome in adults. Aerosolized
formulations of our humanized surfactant are presently being developed to
potentially treat hospitalized patients suffering from severe acute asthma and
Acute Lung Injury (ALI), typically requiring mechanical ventilation. In
addition, we believe that scientific rationale supports the development of
aerosolized formulations of our humanized surfactant to potentially treat
chronic obstructive pulmonary disorder (COPD), sinusitis sleep apnea and otitis
media (inner ear infection).

We are presently developing a dedicated sales and marketing capability through a
collaboration with Quintiles Transnational Corp. to commercialize Surfaxin in
neonatal indications in the United States. We also have entered into a strategic
alliance with Laboratorios del Dr. Esteve to commercialize Surfaxin in Europe
and Latin America. We intend to establish additional strategic alliances, where
appropriate, for the development and commercialization of our products in other
indications and markets.

SURFACTANT TECHNOLOGY

Surfactants are protein and lipid (fat) compositions that are produced naturally
in the lungs and are critical to all air-breathing mammals. They cover the
entire alveolar surface, or air sacs, of the lungs and the terminal conducting
airways which lead to the alveoli. Surfactants facilitate respiration by
continually modifying the surface tension of the fluid normally present within
the

1

alveoli that line the inside of the lungs. In the absence of sufficient
surfactant or should the surfactant degrade, these air sacs tend to collapse,
and, as a result, the lungs do not absorb sufficient oxygen. In addition to
lowering aveolar surface-tension, surfactants play other important roles which
include lowering the surface tension of the conducting airways and maintaining
airflow and airway patency (keeping the airways open and expanded). Human
surfactants include four known surfactant proteins, A, B, C and D. It has been
established, through numerous studies, that surfactant protein B (SP-B) is
essential for respiratory function.

Presently, the FDA has approved surfactants as replacement therapy only for
Respiratory Distress Syndrome in premature infants, a condition in which infants
are born with an insufficient amount of their own natural surfactant. The most
commonly used of these approved replacement surfactants are derived from pig and
cow lungs. Though they are clinically effective, they have drawbacks and cannot
readily be scaled or developed to treat broader populations for Respiratory
Distress Syndrome in premature infants and other respiratory diseases. There is
presently only one approved synthetic surfactant available, however, this
product does not contain surfactant proteins, is not widely used, and it is not
currently being actively marketed by its manufacturer.

Animal-derived surfactant products are prepared using a chemical extraction
process from minced cow and pig lung. Because of the animal-sourced materials
and the chemical extraction processes, there is significant variation in
production lots and, consequently, product quality specifications must be broad.
In addition, the protein levels of these animal-derived surfactants are
inherently lower than the protein levels of native human surfactant. The
production costs of these animal-derived surfactants are high, relative to other
analogous pharmaceutical products, generation of large quantities is severely
limited, and these products cannot readily be reformulated for aerosol delivery
to the lungs.

Our humanized surfactant product candidates, including Surfaxin, are engineered
versions of natural human lung surfactant and contain a humanized peptide,
sinapultide. Sinapultide is a 21 amino acid protein-like substance that is
designed to precisely mimic the essential human surfactant protein B (SP-B). We
believe that our engineered humanized surfactant can be manufactured less
expensively than the animal-derived surfactants, in sufficient quantities, in
more exact and consistent pharmaceutical grade quality, and that it has no
potential to cause adverse immunological responses in young and older adults,
all important attributes for our products to potentially meet significant unmet
medical needs. Our products also have the ability to be more precisely
formulated, such as in the form of aerosolized liquids or dry powders, to
address various medical indications. In addition, we believe that our engineered
humanized surfactants might possess other pharmaceutical benefits not currently
found with the animal surfactants such as longer shelf-life, reduced number of
administrations to the patient's lungs, and elimination of the risk of
animal-borne diseases including the brain-wasting bovine spongiform
encephalopathy (commonly called "mad-cow disease").

Our humanized surfactant technology was invented at The Scripps Research
Institute and was exclusively licensed to Johnson & Johnson which, together with
its wholly-owned subsidiary, Ortho Pharmaceutical Corporation, developed it
further. We acquired the exclusive worldwide sublicense to the technology in
October 1996.

2

PRODUCTS - SURFACTANT BASED THERAPY FOR RESPIRATORY MEDICINE

SURFAXIN(R)

Surfaxin, our lead product, is the first humanized, protein B-based agent that
mimics the surface-active properties of human surfactant. Surfaxin has been
shown to remove inflammatory and infectious infiltrates from patients' lungs
when used by our proprietary lavage (or "lung wash") and replenish the vital
surfactant levels in the lungs. Currently, we are developing Surfaxin for the
treatment of Respiratory Distress Syndrome in premature infants, Meconium
Aspiration Syndrome in full-term infants, and Acute Respiratory Distress
Syndrome in adults. Surfaxin is delivered in a liquid form and is injected
through an endotracheal tube (a tube inserted into the infant's mouth and down
the trachea) in premature infants, and as a proprietary lavage through a tube,
called a bronchoscope, in full-term infants and adults.

Respiratory Distress Syndrome in Premature Infants

Respiratory Distress Syndrome is a condition in which premature infants are born
with an insufficient amount of their own natural surfactant. Premature infants
born prior to 32 weeks gestation have not fully developed a natural lung
surfactant and therefore need treatment to sustain life. This condition often
results in the need for mechanical ventilation.

We are conducting a pivotal, multinational landmark Phase 3 trial treating up to
1,500 patients for the treatment of Respiratory Distress Syndrome in premature
infants. This trial is designed to demonstrate the superiority of Surfaxin over
the only commercially available synthetic surfactant and has a reference arm
comparing Surfaxin to a bovine (cow) -derived surfactant. This pivotal trial is
intended, if successful, to provide the basis for New Drug Applications with the
FDA and other worldwide regulatory authorities. This pivotal trial is expected
to be completed and data announced early in the fourth quarter of 2003.

We are also conducting another multinational Phase 3 trial treating up to 500
patients for the treatment of Respiratory Distress Syndrome in premature
infants. The primary purpose of this trial is to demonstrate the non-inferiority
of Surfaxin over a certain porcine (pig) -derived surfactant. This trial is
expected to be completed within the same timeframe as the pivotal Phase 3 trial.
We are currently evaluating whether to conclude this trial early to conserve
financial resources and reallocate clinical resources to our pivotal Phase 3
trial.

Respiratory Distress Syndrome in premature infants affects approximately two
million babies worldwide with approximately 270,000 cases occurring in the
developed world. Due to limitations associated with the currently approved
animal-derived products, only approximately 100,000 infants are estimated to be
receiving surfactant therapy worldwide.

The FDA has granted us Orphan Drug Designation for Surfaxin for this indication.
Orphan drugs are pharmaceutical products that are intended to treat diseases
affecting fewer than 200,000 patients in the United States. The Office of Orphan
Product Development of the FDA grants certain advantages to the sponsors of
orphan drugs including, but not limited to, seven

3

years of market exclusivity upon approval of the drug, certain tax incentives
for clinical research and grants to fund testing of the drug. We are also
seeking Orphan Product designation from the European Medicines Evaluation Agency
(The European Union's regulatory approval agency that is similar to the FDA) for
Surfaxin for the treatment of Respiratory Distress Syndrome in premature
infants.

Acute Respiratory Distress Syndrome in Adults

Acute Respiratory Distress Syndrome (often referred to as ARDS) in adults is a
life-threatening disorder for which no approved therapies exist anywhere in the
world. It is characterized by an excess of fluid in the lungs and decreased
oxygen levels in the patient. One prominent characteristic of this disorder is
the destruction of surfactants naturally present in lung tissue. The conditions
are caused by illnesses including pneumonia and septic shock (a toxic condition
caused by infection) and events such as smoke inhalation, near drowning,
industrial accidents and other traumas.

We are presently conducting a Phase 2 open-label, controlled, multi-center
clinical trial of Surfaxin for adults with Acute Respiratory Distress Syndrome.
Up to 110 patients will receive high concentrations of Surfaxin via a
proprietary lavage technique that administers the drug sequentially through a
tube, called a bronchoscope. The procedure is intended to cleanse and remove
inflammatory substances and debris from the lungs, while leaving amounts of
Surfaxin behind to help re-establish the lungs' capacity to absorb oxygen. The
objective is to restore functional surfactant levels and to allow critically ill
patients to be removed from mechanical ventilation.

In July 2002, we completed the first part of this trial, a dose escalation
safety and tolerability study in 22 patients in four groups (of up to six
patients per group). In consultation with the Independent Safety Review
Committee, comprised of three prominent pulmonologists, that was assembled for
this trial, we determined that the Part A portion of the trial procedure is
generally safe and tolerable and that it was appropriate to proceed onto the
larger safety and efficacy portion of the study.

The last part of this Phase 2 trial, Part B, will evaluate safety and efficacy
of Surfaxin in direct comparison to standard of care at approximately 40 centers
in the United States. The primary endpoint of this part of the trial is to
determine the incidence rate of patients being alive and off mechanical
ventilation at the end of day 28 with one of the key secondary endpoints being
mortality. Our contract manufacturer for drug product for this trial has
experienced certain operational difficulties which have delayed the completion
of this part of the trial. However, we expect that clinical drug supply will be
available to allow us to complete this trial in the fourth quarter of 2003. See
Item 1: "Manufacturing and Distribution - Third Party Suppliers."

The current standard of care for Acute Respiratory Distress Syndrome includes
placing patients on mechanical ventilators in intensive care units at a cost of
approximately $8,500 per day, typically for an average of 21 to 28 days. There
are estimated to be between 150,000 and 250,000 adults per year in the United
States suffering from Acute Respiratory Distress Syndrome

4

with similar numbers afflicted in Europe. Because there are no approved
treatments for these diseases, the mortality rate can range from 35% to 50%.

The FDA has granted us Fast-Track Approval Status and Orphan Drug Designation
for Surfaxin for the treatment of Acute Respiratory Distress Syndrome for
adults. The European Medicines Evaluation Agency has granted us Orphan Product
designation for Surfaxin for the treatment of Acute Lung Injury in adults (which
in this circumstance encompasses Acute Respiratory Distress Syndrome). We were
awarded a $1 million Fast-Track Small Business Innovative Research Grant by the
National Institutes of Health to develop Surfaxin for the treatment of Acute
Respiratory Distress Syndrome and Acute Lung Injury in adults, of which $307,000
is still to be received, subject to certain performance criteria.

Meconium Aspiration Syndrome in Full-Term Infants

Meconium Aspiration Syndrome is a condition in which full-term infants are born
with meconium in their lungs that depletes the natural surfactant in their
lungs. Meconium is a baby's first bowel movement in its mother's womb and when
inhaled, Meconium Aspiration Syndrome can occur. Meconium Aspiration Syndrome
can be life-threatening as a result of the failure of the lungs to absorb
sufficient oxygen. This condition results in the need for mechanical
ventilation.

Surfaxin is being evaluated in a Phase 3 clinical trial for the treatment of
Meconium Aspiration Syndrome in full-term infants. To our knowledge, Surfaxin is
the only product being developed worldwide to treat this syndrome. The trial is
designed for the enrollment of up to 200 infants at medical centers throughout
the United States to compare Surfaxin lavage to the current standard of care.
Enrollment is ongoing but has been slower than expected and completion is now
anticipated for 2004. Given our belief in the importance of the pivotal Phase 3
trial for Respiratory Distress Syndrome in premature infants to our present
development plan, resources have been reallocated from the Meconium Aspiration
Syndrome program to the Respiratory Distress Syndrome program.

We also have initiated a Phase 2 clinical trial for Surfaxin lavage in up to 60
full-term infants for use as a prophylactic or early treatment for patients who
are at risk for Meconium Aspiration Syndrome but have not shown symptoms of
compromised respiratory function. There are approximately 600,000 babies born
each year that are at risk for Meconium Aspiration Syndrome, of which about 10%
develop the condition. We believe an effective and affordable surfactant
prophylactic therapy could significantly lower the risk to meconium-stained
infants of chronic respiratory conditions and reduce the need for costly
mechanical ventilation.

There are presently no drug therapies approved for the treatment of Meconium
Aspiration Syndrome in full-term infants. The FDA has granted us Fast-Track
Approval Status and Orphan Drug Designation for Surfaxin for the treatment of
Meconium Aspiration Syndrome in full-term infants. We have also received Orphan
Product designation of Surfaxin as for the treatment of Meconium Aspiration
Syndrome from the European Medicines Evaluation Agency.

5

OUR AEROSOLIZED HUMANIZED SURFACTANTS FOR RESPIRATORY THERAPY

Many respiratory diseases are associated with an inflammatory event that causes
surfactant dysfunction and a loss of patency of the conducting airways.
Scientific data supports that the therapeutic use of surfactants in aerosol form
has the ability to reestablish airway patency, improve pulmonary mechanics, and
act as an anti-inflammatory. Surfactant normally prevents moisture from
accumulating in the airways' most narrow sections and in this way maintains
patency of the conducting airways. However, use of currently available
animal-derived surfactants is not considered feasible for aerosolization and
because of their potential to cause an adverse immunological response such
products may exacerbate the inflammatory event associated with such diseases.

We are currently developing aerosolized formulations of our humanized surfactant
to potentially treat patients who could benefit from surfactant-based therapy to
improve lung function and maintain proper airflow through the respiratory
system. Our aerosol development program is initially focused on surfactant-based
therapy for hospitalized patients suffering from severe acute asthma or Acute
Lung Injury (ALI), hopefully avoiding or reducing the need for mechanical
ventilation. In addition, we believe that scientific rationale supports the
development of aerosolized formulations of our humanized surfactant to
potentially treat COPD, sinusitis, sleep apnea and otitis media (inner ear
infection).

We are presently working with various aerosol devices towards achieving the
following important development objectives:

- -- Full retention of the surface-tension lowering properties of a functioning
surfactant necessary to restore lung function and maintain patency of the
conducting airways.

- -- Full retention of the surfactant composition upon aerosolization.

- -- Drug particle size suitable for deposition in the deep-lungs.

- -- Delivery rates to achieve therapeutic dosages in a reasonable time period.

- -- Reproducible aerosol output and minimal waste of surfactant dose.

Our lead programs for surfactant-based therapy as an aerosol are:

Asthma

Asthma is a common disease characterized by sudden constriction and inflammation
of the lungs. Constriction of the upper airway system is caused by a tightening
of airway muscles, while inflammation is a swelling of the airways usually due
to an allergic reaction due to an airborne irritant. Both of these events cause
airways to narrow and may result in wheezing, shortness of breath and chest
tightness. Several studies have shown that surfactant damage and dysfunction is
a significant component of asthma -- airway obstruction occurs when there is a
surfactant dysfunction in the airways of the deep lung of the type that develops
during an asthma

6

attack. Surfactant replacement therapy has the potential to relieve the
obstruction in the airways associated with asthma.

According to information provided by the American Lung Association, asthma
afflicts approximately 20.3 million people in the United States and its
incidence rate is rising. Asthma is a chronic disease; prevalent in people of
all ages and an estimated 12 million people have experienced an asthma attack
within the past year. In the United States alone, there are roughly 1 million
hospital outpatient visits, approximately 1.8 million emergency room visits, and
9.3 million physician visits each year due to asthma. Asthma ranks within the
top 10 prevalent activity-limiting health conditions costing $14 billion in
United States healthcare costs annually.

Asthma may require life-long therapy to prevent or treat episodes. Ten percent
of patients are considered severe asthmatics and require moderate to high doses
of drugs. Currently available medications to treat and control asthma include
inhaled and oral steroids and bronchodilators. Bronchodilators cannot be used to
control severe episodes or chronic, severe asthma. Steroidal medications are
used to address these conditions, however, steroids can cause serious side
effects when used for prolonged periods. As a result, steroid use is typically
limited to severe asthmatic episodes and chronic, severe asthma.

Several small scientific studies report that patients suffering from a severe,
acute asthma attack were relieved when they inhaled aerosolized surfactant. We
believe that supplying surfactant as an aerosol spray would be a simple and
gentle way of relieving airway obstruction and thereby augmenting currently
available conventional asthma therapies to lead to a more rapid improvement in
symptoms.

Acute Lung Injury

Acute Lung Injury is associated with conditions that either directly or
indirectly injure the air sacs of the lung, the alveoli. Acute Lung Injury is a
syndrome of inflammation and increased permeability of the lungs with an
associated breakdown of the lungs' surfactant layer. The most serious
manifestation of Acute Lung Injury is Acute Respiratory Distress Syndrome.

Among the causes of Acute Lung Injury are complications typically associated
with certain major surgeries, mechanical ventilator induced lung injury (often
referred to as VILI), smoke inhalation, pneumonia, and sepsis. There is an
estimated 1 million patients at risk in the United States for Acute Lung Injury
annually and there are no currently-approved therapies.

We believe that our proprietary humanized aerosol surfactant may be effective as
a preventive measure for patients at risk for Acute Lung Injury. This
prophylactic approach may result in fewer patients requiring costly intensive
care therapy and shorter periods of therapy - thus offering cost savings in the
hospital setting.

Collaborative Research Arrangements

We have a collaborative relationship with Aerogen, Inc., to evaluate its aerosol
generator technology for the delivery of our proprietary aerosolized surfactants
to prevent and treat

7

respiratory diseases in the hospital. Aerogen's technology is designed to be
used with a hospital ventilator system or in an ambulatory manner to treat
patients anywhere in the hospital, including the emergency room, the hospital
floor and during patient transport.

We also have a collaborative research arrangement for our aerosolized surfactant
programs with CollaGenex Pharmaceuticals, Inc. to evaluate the combination of
their protease inhibitor technologies with our proprietary aerosolized
surfactant technology for the development of novel respiratory disease
therapeutics. Through the collaboration we anticipate developing and assessing
aerosol formulations of humanized lung surfactant and protease inhibitors as
potential treatments for diseases such as Acute Lung Injury and chronic
obstructive lung disease (COPD).

AEROSOLIZED HUMANIZED SURFACTANTS FOR PULMONARY DRUG DELIVERY

We are evaluating formulations of our engineered humanized surfactants as novel
pulmonary drug delivery vehicles with the potential to deliver other
pharmaceutical products to the lungs so that such products can exert their
pharmacological effects locally or systemically. Existing drug delivery
technology has effectively addressed the development of delivery devices, drug
storage systems and compatible drug formulations. However, a significant unmet
need in pulmonary drug delivery is to provide better performance once a drug is
deposited in the lungs.

An aerosol version of our humanized lung surfactant, with its ability to
penetrate and spread in an even manner throughout the lungs, has the potential
to more efficiently deliver drugs via or within the respiratory tract. These
drugs include antibiotics, pulmonary vasodilators that lower blood pressure in
the lung arteries, elastase inhibitors (drugs that are anti-inflammatory by
inhibiting a potentially destructive enzyme that comes from certain types of
white blood cells), bronchodilators (drugs that mitigate constriction of small
airways), steroids and proteins.

STRATEGIC ALLIANCES

LABORATORIOS DEL DR. ESTEVE, S.A.

In March 2002, we significantly expanded our existing relationship with
Laboratorios del Dr. Esteve by entering into a new collaboration arrangement
with Esteve. This new collaboration expands the territory covered by the
original agreements to include all of Europe and Latin America.

In connection with this new Esteve collaboration, Esteve purchased 821,862
shares of our common stock at $4.867 per share for $4.0 million in cash and paid
us a non-refundable licensing fee of $500,000. Esteve agreed to provide certain
commercialization services in the expanded territory for Surfaxin for the
treatment of Respiratory Distress Syndrome in premature infants, Meconium
Aspiration Syndrome in full-term infants and Acute Lung Injury/Acute Respiratory
Distress Syndrome in adult patients.

We have agreed to an exclusive supply agreement which provides that Esteve will
purchase from us all of its Surfaxin drug product requirements at an established
transfer price based on sales of Surfaxin by Esteve and/or its sublicensee(s).
Esteve has also agreed to sponsor certain clinical

8

trial costs related to obtaining European Medicines Evaluation Agency approval
for commercialization of Surfaxin in Europe for the Acute Lung Injury/Acute
Respiratory Distress Syndrome indications. Esteve also agreed to make certain
milestone payments upon the attainment of European Medicines Evaluation Agency
marketing regulatory approval of Surfaxin for sale in Europe for the foregoing
indications.

QUINTILES TRANSNATIONAL CORP., AND PHARMABIO DEVELOPMENT, INC.

In December 2001, we entered into a collaboration arrangement with Quintiles,
and its affiliate, PharmaBio Development, Inc., to provide certain
commercialization services in the United States for Surfaxin for the treatment
of Respiratory Distress Syndrome in premature infants and Meconium Aspiration
Syndrome in full-term infants. We issued to PharmaBio 791,905 shares of our
common stock and warrants to purchase approximately 677,143 shares of our common
stock for aggregate net proceeds of approximately $2.7 million. Quintiles will
hire and train a dedicated United States sales force that will be branded in the
market as ours. PharmaBio has agreed to fund up to $70 million of the sales
force costs and other sales and marketing costs for Surfaxin for seven years of
commercialization of Surfaxin in the United States. Additionally, the
collaboration allows for the specialty sales force to become ours at the end of
the seven year term, with an option to acquire it sooner.

Under the collaboration, we will receive 100% of the revenues from sales of
Surfaxin and have agreed to pay PharmaBio a commission on net sales in the
United States of Surfaxin for the treatment of Respiratory Distress Syndrome in
premature infants and Meconium Aspiration Syndrome in full-term infants and all
"off-label" uses for 10 years following first launch of the product in the
United States. The collaboration allows us to retain product ownership and to
have sales and marketing expertise in place for the commercialization of
Surfaxin, if approved.

PharmaBio also extended to us a secured revolving credit facility of up to $8.5
million to $10 million to fund pre-marketing activities associated with the
launch of Surfaxin in the United States as we achieve certain milestones. We are
obligated to use a significant portion of the funds borrowed under the credit
facility for pre-launch marketing services to be provided by Quintiles.
Principal amounts owed by us under the credit facility may be repaid out of the
proceeds of milestone payments to be paid to us by PharmaBio upon the
achievement of certain corporate milestones. To the extent availability under
the credit facility is increased to greater than $8.5 million, for each such $1
million dollar increase, the amount of shares of common stock issuable pursuant
to the warrants will be increased by approximately 38,000 shares. See "Item 7:
Management's Discussion and Analysis - Liquidity and Capital Resources -
Secured, Revolving Credit Facility and Capital Lease Arrangement."

9

LICENSING ARRANGEMENTS; PATENTS AND PROPRIETARY RIGHTS

PATENTS AND PROPRIETARY RIGHTS

Johnson & Johnson and The Scripps Research Institute

Our humanized surfactant platform technology, including Surfaxin, is based on
the proprietary peptide, sinapultide, (a 21 amino acid protein-like substance
that precisely mimics the essential human lung protein SP-B). This technology
was invented at The Scripps Research Institute and was exclusively licensed to,
and further developed by, Johnson & Johnson, and its wholly owned subsidiary,
Ortho Pharmaceutical. We have received an exclusive, worldwide sublicense from
Johnson & Johnson and Scripps for, and have rights to, a series of over 30
patents and patent filings (worldwide) which are important, either individually
or collectively, to our strategy of commercializing our humanized surfactant
technology for the diagnosis, prevention and treatment of disease. The
sublicense gives us the rights to such patents for the life of the patents.

Patents covering our proprietary humanized surfactant technology that have been
issued or are pending worldwide include composition of matter, formulation,
manufacturing and uses, including the pulmonary lavage, or "lung wash"
techniques. Our most significant patent rights principally consist of five
issued United States patents: U.S. Patent No. 5,407,914; U.S. Patent No.
5,260,273; U.S. Patent No. 5,164,369; U.S. Patent No.5,789,381; and U.S. Patent
No. 6,013,619 (along with corresponding issued and pending foreign patents).
These patents relate to engineered humanized pulmonary surfactants (including
Surfaxin), certain related peptides (amino acid protein-like substances) and
compositions, methods of treating respiratory distress syndromes with these
surfactants and compositions, and our proprietary pulmonary lavage method of
treating respiratory distress syndrome with these surfactants. We also have
certain pending United States and foreign patent applications that relate to
methods of manufacturing certain peptides which may be used in the manufacture
of Surfaxin and other aspects of our humanized surfactant technology.

In October 2002, we were issued European Patent No. 59006 which covers claims
directed to compositions that contain our proprietary peptide, sinapultide, and
related peptides for use as a therapeutic surfactant for treating respiratory
distress syndrome and related conditions. We also have an issued European
Patent, No. 0350506, covering certain other surfactant peptides.

U.S. Patent No. 6,013,619 was issued to Scripps and licensed to us and covers
all known engineered (including Surfaxin), animal- or human-derived surfactants
for use in any form of pulmonary lavage for respiratory distress syndromes. Our
proprietary pulmonary lavage techniques (using surfactant) include lavage via a
bronchoscope in adults as well as direct pulmonary lung lavage via an
endotracheal tube in newborn babies with Meconium Aspiration Syndrome.
Scientific rationale supports that our proprietary lavage technique may provide
a clinical benefit to the treatment of Acute Lung Injury/Acute Respiratory
Distress Syndrome in adults and Meconium Aspiration Syndrome in full-term
infants by decreasing the amount of infectious and inflammatory debris in the
lungs, restoring the air sacs to a more normal state and possibly resulting in
patients getting off mechanical ventilation sooner.

10

Such patents, which include relevant European patents, expire on various dates
beginning in 2009 and ending 2017 or, in some cases, possibly later.

THE SCRIPPS RESEARCH INSTITUTE RESEARCH AGREEMENT

We are parties with Scripps to a research funding and option agreement which
expires in February 2005, subject to termination by us at any time with 90 days
prior notice. Pursuant to this agreement, we fund a portion of Scripps' research
efforts and are entitled to an option to acquire an exclusive worldwide license
to the technology developed from the research program during the term of the
agreement. Scripps owns all of the technology that it developed pursuant to work
performed under the agreement. To the extent we do not exercise our option, we
have the right to receive 50% of the net royalty income received by Scripps for
inventions that we jointly develop under the agreement.

See Item 7: "Management's Discussion and Analysis - Risks Related to Our
Business": " - If we cannot protect our intellectual property, other companies
could use our technology in competitive products. If we infringe the
intellectual property rights of others, other companies could prevent us from
developing or marketing our products"; " - Even if we obtain patents to protect
our products, those patents may not be sufficiently broad and others could
compete with us"; " - Intellectual property rights of third parties could limit
our ability to market our products"; and " - If we cannot meet requirements
under our license agreements, we could lose the rights to our products."

MANUFACTURING AND DISTRIBUTION - THIRD PARTY SUPPLIERS

Manufacturing

Our humanized surfactant product candidates must be manufactured in a sterile
environment and in compliance with good manufacturing practice requirements
(GMPs) set by the FDA and other relevant worldwide regulatory authorities.

Our humanized surfactant product candidates are manufactured through the
combination of a synthetically made peptide, sinapultide, (designed to precisely
mimic the essential human lung surfactant protein SP-B) which is provided by
BACHEM California, Inc., and PolyPeptides Laboratories, Inc., and certain other
active ingredients, including certain lipids, that are provided by other
suppliers such as Genzyme Pharmaceuticals, a division of the Genzyme
Corporation, and Avanti Polar Lipids.

Our humanized surfactant drug product, including Surfaxin, is manufactured using
our own specialized equipment, using the ingredients discussed above, under the
direction and supervision of our manufacturing and quality control personnel.
Currently, our drug product is manufactured at the sterile facilities of a
contract manufacturer, Akorn, Inc., which is presently the only manufacturing
facility that we have validated to produce appropriate clinical grade material
of our humanized surfactant drug substance, including Surfaxin.

11

Our present manufacturing capabilities should allow sufficient commercial
production of Surfaxin, if approved, to supply the present worldwide demand for
Respiratory Distress Syndrome for premature infants and Meconium Aspiration
Syndrome for full-term infants. We expect these capabilities to allow us to
provide adequate supply of Surfaxin for our planned clinical trials for Acute
Respiratory Distress Syndrome in adults.

We are presently investing in and evaluating alternative contract manufacturers
in order to provide backup for the production of our humanized surfactant drug
product and to scale up to meet clinical and commercial needs as they expand. We
will rely on outside manufacturers for production of our products after
marketing approval.

Should the proper financial and other resources be available, our manufacturing
process for our humanized surfactant drug product allows us, unlike that for the
currently-approved, animal-derived products, to scale-up production of our
humanized surfactant drug product, including Surfaxin. By scaling up our
production, we should be able to produce sufficient drug products to potentially
treat diseases with larger patient populations, such as Acute Respiratory
Disease Syndrome in adults, asthma, Acute Lung Injury, COPD, and other broader
respiratory diseases and upper airway disorders.

In December 2002, we reported that Akorn was experiencing certain operating
difficulties in a sterile production room primarily used for the filling of
sterile pharmaceutical products such as our drug product. Although Akorn's
difficulties with this sterile filling room were not directly related to the
actual production of our drug product, a delay in the supply of Surfaxin for
Part B of our ongoing Phase 2 clinical trial for Acute Respiratory Distress
Syndrome in adults occurred. On February 18, 2003, Akorn notified us that their
sterile filling room had returned to operational status. We have initiated
activities at Akorn and expect to recommence manufacture of Surfaxin in a
timeframe that allows us to complete our Phase 2 clinical trial for Acute
Respiratory Disease Syndrome in adults in the fourth quarter of 2003. The
difficulties experienced by Akorn are not expected to have an effect on our
ongoing Phase 3 trials for Surfaxin for Respiratory Distress Syndrome in
premature infants or our longer range clinical development plans for our
humanized surfactant drug candidates.

Manufacturing or quality control problems could occur at Akorn or our other
contract manufacturers, if any, and cause product production and shipment delays
or a situation where the contractor may not be able to maintain compliance with
the FDA's current GMP requirements necessary to continue manufacturing our drug
substance. If any such suppliers or manufacturers of our products fail to comply
with GMP requirements or other FDA and comparable foreign regulatory
requirements, it could adversely affect our clinical research activities and our
ability to market and develop our products. See Item 7: "Management's Discussion
and Analysis - Risks Related to Our Business": " - If the parties we depend on
for manufacturing our pharmaceutical products do not timely supply these
products, it may delay or impair our ability to develop and market our
products"; and " - In order to conduct our clinical trials we need adequate
supplies of our drug substance and drug product and competitors drug product,
which may not be readily available."

12

Distribution

Our collaboration agreement with Quintiles to provide certain commercialization
services in the United States for Surfaxin does not encompass distribution
services. We are currently evaluating third party distribution capability in
order to commercialize Surfaxin in the United States.

Our collaboration with Esteve provides that Esteve has the responsibility for
distribution throughout Europe and Latin America. See Item 7: "Management's
Discussion and Analysis - Risks Related to Our Business-Our lack of marketing
and sales experience could limit our ability to generate revenues from future
product sales."

COMPETITION

We are engaged in highly competitive fields of pharmaceutical research.
Competition from numerous existing companies and others entering the fields in
which we operate is intense and expected to increase. We expect to compete with,
among others, conventional pharmaceutical companies. Most of these companies
have substantially greater research and development, manufacturing, marketing,
financial, technological personnel and managerial resources than we do.
Acquisitions of competing companies by large pharmaceutical or health care
companies could further enhance such competitors' financial, marketing and other
resources. Moreover, competitors that are able to complete clinical trials,
obtain required regulatory approvals and commence commercial sales of their
products before we do may enjoy a significant competitive advantage over us.
There are also existing therapies that may compete with the products we are
developing. See Item 7: "Management's Discussion and Analysis - Risks Related to
Our Business - Our industry is highly competitive and we have less capital and
resources than many of our competitors, which may give them an advantage in
developing and marketing products similar to ours or make our products
obsolete."

Presently, the FDA has approved surfactants as replacement therapy only for
Respiratory Distress Syndrome in premature infants, a condition in which infants
are born with an insufficient amount of their own natural surfactant. The most
commonly used of these approved replacement surfactants are derived from a
chemical extraction process of pig and cow lungs. Curosurf(R) is a porcine lung
extract that is marketed in Europe by Chiesi Farmaceutici S.p.A., and in the
United States by Dey Laboratories, Inc. Survanta(R), marketed by the Ross
division of Abbott Laboratories, Inc., is derived from minced cow lung that
contains the cow version of surfactant protein B. Forest Laboratories, Inc.,
markets its calf lung surfactant extract, Infasurf(R), in the United States.

There is presently only one approved synthetic surfactant available, Exosurf(R),
marketed by GlaxoSmithKline, plc. However, this product does not contain any
surfactant proteins, is not widely used, and its active marketing recently has
been discontinued by its manufacturer. Our ongoing pivotal, landmark Phase 3
clinical trial for the treatment of Respiratory Distress Syndrome in premature
infants is designed as a prophylaxis, superiority trial comparing our Surfaxin
to Exosurf(TM).

13

With respect to the development of lung surfactants for the treatment of other
respiratory diseases and upper airway disorders, with the exception of one
porcine-derived surfactant drug candidate under development by Leo Pharma A/S in
Denmark, we are not aware of any other lung surfactant currently under
development.

There are no drugs currently approved that are specifically indicated for the
treatment of Acute Respiratory Distress Syndrome in adults or Meconium
Aspiration Syndrome in full-term infants. Current therapy consists of general
supportive care and mechanical ventilation. There are a significant number of
other potential therapies in development for the treatment of Acute Respiratory
Distress Syndrome in adults that are not surfactant related. Any of these
various drugs or devices could significantly impact the commercial opportunity
for Surfaxin.

Our humanized surfactant product candidates, including Surfaxin, are engineered
versions of natural human lung surfactant and contain a humanized peptide,
sinapultide (a 21 amino acid protein-like substance), that is designed to
precisely mimic the essential human surfactant protein B (SP-B). We believe that
our engineered humanized surfactant can be manufactured less expensively than
the animal-derived surfactants, in sufficient quantities, in exact and
consistent pharmaceutical grade quality, and has no potential to cause adverse
immunological responses in young and older adults, all important attributes to
potentially meet significant unmet medical needs. Our products also have the
ability to be more precisely formulated, such as in the form of aerosolized
liquids or dry powders to address various medical indications. In addition, we
believe that our engineered humanized surfactants might possess other
pharmaceutical benefits not currently found with the animal surfactants such as
longer shelf-life, reduced number of administrations to the patient's lungs, and
elimination of the risk of animal-borne diseases including the brain-wasting
bovine spongiform encephalopathy (commonly called "mad-cow disease").

GOVERNMENT REGULATION

The testing, manufacture, distribution, advertising and marketing of drug
products are subject to extensive regulation by federal, state and local
governmental authorities in the United States, including the FDA, and by similar
agencies in other countries. Any product that we develop must receive all
relevant regulatory approvals or clearances before it may be marketed in a
particular country.

The regulatory process, which includes preclinical studies and clinical trials
of each pharmaceutical compound to establish its safety and efficacy and
confirmation by the FDA that good laboratory, clinical and manufacturing
practices were maintained during testing and manufacturing, can take many years,
requires the expenditure of substantial resources and gives larger companies
with greater financial resources a competitive advantage over us. Delays or
terminations of clinical trials we undertake would likely impair our development
of product candidates. Delays or terminations could result from a number of
factors, including stringent enrollment criteria, slow rate of enrollment, size
of patient population, having to compete with other clinical trials for eligible
patients, geographical considerations and others.

14

The FDA review process can be lengthy and unpredictable, and we may encounter
delays or rejections of our applications when submitted. If questions arise
during the FDA review process, approval may take a significantly longer period
of time. Generally, in order to gain FDA approval, we first must conduct
preclinical studies in a laboratory and in animal models to obtain preliminary
information on a compound's efficacy and to identify any safety problems. The
results of these studies are submitted as part of an IND (Investigational New
Drug) application that the FDA must review before human clinical trials of an
investigational drug can start.

Clinical trials are normally done in three sequential phases and generally take
two to five years or longer to complete. Phase 1 consists of testing the drug
product in a small number of humans, normally healthy volunteers, to determine
preliminary safety and tolerable dose range. Phase 2 usually involves studies in
a limited patient population to evaluate the effectiveness of the drug product
in humans having the disease or medical condition for which the product is
indicated, determine dosage tolerance and optimal dosage and identify possible
common adverse effects and safety risks. Phase 3 consists of additional
controlled testing at multiple clinical sites to establish clinical safety and
effectiveness in an expanded patient population of geographically dispersed test
sites to evaluate the overall benefit-risk relationship for administering the
product and to provide an adequate basis for product labeling. Phase 4 clinical
trials are conducted after approval to gain additional experience from the
treatment of patients in the intended therapeutic indication.

After completion of clinical trials of a new drug product, FDA and foreign
regulatory authority marketing approval must be obtained. A New Drug Application
submitted to the FDA generally takes one to three years to obtain approval. If
questions arise during the FDA review process, approval may take a significantly
longer period of time. The testing and approval processes require substantial
time and effort and we may not receive approval on a timely basis, if at all.
Even if regulatory clearances are obtained, a marketed product is subject to
continual review, and later discovery of previously unknown problems or failure
to comply with the applicable regulatory requirements may result in restrictions
on the marketing of a product or withdrawal of the product from the market as
well as possible civil or criminal sanctions. For marketing outside the United
States, we also will be subject to foreign regulatory requirements governing
human clinical trials and marketing approval for pharmaceutical products. The
requirements governing the conduct of clinical trials, product licensing,
pricing and reimbursement vary widely from country to country. None of our
products under development have been approved for marketing in the United States
or elsewhere. We may not be able to obtain regulatory approval for any such
products under development. Failure to obtain requisite governmental approvals
or failure to obtain approvals of the scope requested will delay or preclude us,
or our licensees or marketing partners, from marketing our products, or limit
the commercial use of our products, and thereby would have a material adverse
effect on our business, financial condition and results of operations. See Item
7: "Management's Discussion and Analysis - Risks Related to Our Business": " -
Our technology platform is based solely on our proprietary humanized, engineered
surfactant technology and only our lead product candidate, Surfaxin, has been
subject to clinical studies. Our ongoing Phase 3 clinical trials for Surfaxin
for the treatment of Respiratory Distress Syndrome in premature infants may be
delayed, or fail, which will harm our business"; and " - The clinical trial and
regulatory approval process for our products is expensive and time consuming,
and the outcome is uncertain."

15

The FDA has granted us Fast-Track Approval Status for the Acute Respiratory
Distress Syndrome and Meconium Aspiration Syndrome indications. Fast-Track
Approval Status facilitates the development and expedites the review of new
drugs intended for treatment of life-threatening conditions for which there is
presently no medical option or an unmet medical need by providing for the FDA's
review of the New Drug Application for a drug granted such Fast Track Status
within six months following filing. We have also received Orphan Drug
Designation from the FDA's Office of Orphan Products Development of Surfaxin as
a treatment for Respiratory Distress Syndrome in premature infants, Meconium
Aspiration Syndrome in full-term infants, and Acute Respiratory Distress
Syndrome in adults. We have also received designation of Surfaxin as an Orphan
Product for Meconium Aspiration Syndrome and Acute Lung Injury (which, in this
circumstance, encompasses Acute Respiratory Distress Syndrome) from the European
Medicines Evaluation Agency (EMEA).

EMPLOYEES

We have approximately 65 full-time employees, primarily employed in the United
States, Europe and Latin America. Our future success depends in significant part
upon the continued service of our key scientific personnel and executive
officers and our continuing ability to attract and retain highly qualified
scientific and managerial personnel. It is a competitive market for such
personnel and we may not be able to retain our key employees or attract,
assimilate or retain other highly qualified technical and managerial personnel
in the future. See Item 7: "Management's Discussion and Analysis - Risks Related
to Our Business - We depend upon key employees and consultants in a competitive
market for skilled personnel. If we are unable to attract and retain key
personnel, it could adversely affect our ability to develop and market our
products."

1998 MERGER WITH ACUTE THERAPEUTICS, INC.

In June 1998, we completed the acquisition of the outstanding minority interest
of our then majority-owned subsidiary, Acute Therapeutics, Inc., a Delaware
corporation. Upon consummation of the merger, Robert J. Capetola, Ph.D., the
then President and Chief Executive Officer of Acute Therapeutics, became our
President and Chief Executive Officer.

AVAILABLE INFORMATION

We file annual, quarterly and current reports, proxy statements and other
information with the Securities and Exchange Commission. You may read and copy
any document we file with the Commission at the Commission's public reference
rooms at 450 Fifth Street, N.W., Washington, D.C. 20549, 233 Broadway, New York,
New York 10279, and Citicorp Center, 500 West Madison Street, Suite 1400,
Chicago, Illinois 60661- 2511. Please call the Commission at 1-800-SEC-0330 for
further information on the public reference rooms. Our SEC filings are also
available to the public from the SEC's Website at "http://www.sec.gov." We make
available free of charge our annual, quarterly and current reports, proxy
statements and other information upon request. To request such materials, please
send an e-mail to ir@DiscoveryLabs.com or

16

contact John G. Cooper, our Senior Vice President, Chief Financial Officer at
our address as set forth above.

We maintain a Website at "http://www.DiscoveryLabs.com" (this is not a
hyperlink, you must visit this website through an Internet browser). Our Website
and the information contained therein or connected thereto are not incorporated
into this Annual Report on Form 10-K.

ITEM 2. DESCRIPTION OF PROPERTY.

Our principal offices and quality control laboratory facility is located at 350
South Main Street, Suite 307, Doylestown, Pennsylvania 18901. The telephone
number of our executive office is (215) 340-4699 and the facsimile number is
(215) 340-3940. In January 2002, we established a research facility in Redwood
City, California, to develop aerosolized formulations of our proprietary
humanized surfactant. We maintain a satellite office in the United Kingdom to
manage and oversee our European clinical research programs. We lease all of
these properties.

ITEM 3. LEGAL PROCEEDINGS.

We are not aware of any pending or threatened legal actions other than disputes
arising in the ordinary course of our business that would not, if determined
adversely to us, have a material adverse effect on our business and operations.

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

No matters were submitted to a vote of security holders during the fourth
quarter of 2002.

17

PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

Our common stock is traded on the Nasdaq SmallCap Market under the symbol
"DSCO." As of February 26, 2003, the number of stockholders of record of shares
of our common stock was approximately 235, and the number of beneficial owners
of shares of our common stock was approximately 4,500. As of February 26, 2003,
there were approximately 32,857,000 shares of our common stock issued and
outstanding.

The following table sets forth the quarterly price ranges of our common stock
for the periods indicated, as reported by Nasdaq.

First Quarter 2001.................................... $2.72 $5.91
Second Quarter 2001 .................................. $2.94 $5.49
Third Quarter 2001.................................... $2.00 $4.65
Fourth Quarter 2001................................... $2.22 $4.38
First Quarter 2002.................................... $2.70 $4.19
Second Quarter 2002................................... $1.28 $3.26
Third Quarter 2002.................................... $0.90 $1.97
Fourth Quarter 2002................................... $1.60 $3.20
First Quarter 2003 (through February 26, 2003)........ $1.76 $2.94

We have not paid dividends on our common stock. It is anticipated that we will
not pay dividends on our common stock in the foreseeable future.

SALES OF UNREGISTERED SECURITIES

In the year ended December 31, 2002, we granted an aggregate of 1,131,000
options to our officers, directors, employees and consultants at various
exercise prices ranging from $1.26 per share to $3.65 per share. These
securities were offered and sold in reliance upon exemptions from registration
pursuant to Section 4(2) of the Securities Act of 1933 as transactions not
involving any public offering. No broker/dealers were involved in the sale and
no commissions were paid. The recipients of these options either received
adequate information about us or had access, through employment or other
relationships, to such information.

18

ITEM 6. SELECTED FINANCIAL DATA

Selected Financial Data

Consolidated Statement of Operations Data:
(in thousands, except per share data)

For the year ended December 31,
------------------------------------------------------------------------------
2002 2001 2000 1999 1998
---------------- -------------------------------- ----------------------------

Revenues from collaborative agreements $ 1,782 $ 1,112 $ 741 $ 178 $ 27
-------- -------- -------- ------- --------
Operating Expenses:
Research and development 14,347 8,007 7,494 2,869 5,082
General and administrative 5,458 5,067 5,145 2,421 2,788
Write-off of acquired in-process research
and development and supplies -- -- -- -- 8,220
-------- -------- -------- ------- --------
Total expenses 19,805 13,074 12,639 5,290 16,090
-------- -------- -------- ------- --------
Operating loss (18,023) (11,962) (11,898) (5,112) (16,063)
Other income and expense 580 816 1,037 154 394
Minority interest in net loss of subsidiary -- -- -- -- 24
-------- -------- -------- ------- --------
Net loss $(17,443) $(11,146) $(10,861) $(4,958) $(15,645)
======== ======== ======== ======= ========
Net loss per common share - basic and diluted $ (0.64) $ (0.51) $ (0.58) $ (0.66) $ (4.02)
Weighted average number of common
shares outstanding 27,351 22,038 18,806 7,545 3,896

Consolidated Balance Sheet Data:
(in thousands)

For the year ended December 31,
------------------------------------------------------------------------------
2002 2001 2000 1999 1998
---------------- -------------------------------- ----------------------------

ASSETS
Current Assets:
Cash/cash equivalents and
marketable securities $ 19,190 $ 16,696 $ 18,868 $ 3,547 $ 4,018
Prepaid expenses and other current assets 327 1,582 149 641 778
-------- -------- -------- ------- --------
Total current assets 19,517 18,278 19,017 4,188 4,796
-------- -------- -------- ------- --------
Property and equipment, net of depreciation 1,231 822 697 426 326
Other assets 314 965 3 18 18
-------- -------- -------- ------- --------
Total assets $ 21,062 $ 20,065 $ 19,717 $ 4,632 $ 5,140
======== ======== ======== ======= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Total current liabilities $ 3,202 $ 1,794 $ 2,399 $ 440 $ 1,088
Deferred revenue 1,393 615 851 1,036 --
Credit facility with corporate partner 1,450 -- -- -- --
Capitalized lease 256 33 31 48 --
-------- -------- -------- ------- --------
Total liabilities 6,301 2,442 3,281 1,524 1,088
-------- -------- -------- ------- --------
Stockholders' equity 14,761 17,623 16,436 3,108 4,052
-------- -------- -------- ------- --------
Total liabilities and stockholders' equity $ 21,062 $ 20,065 $ 19,717 $ 4,632 $ 5,140
======== ======== ======== ======= ========
Common Stock, $0.001 par value, issued 32,857 25,546 20,871 9,689 5,085

19

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

This Item 7: "Management's Discussion and Analysis of Financial Condition and
Results of Operations" should be read in connection with our Consolidated
Financial Statements. See Item 15: "Exhibits, Financial Statement Schedules, and
Reports on Form 8-K."

OVERVIEW

We are a late-stage specialty pharmaceutical company applying our humanized lung
surfactant technology to develop potential novel respiratory therapies and
products. Surfactants are substances that are produced naturally in the lungs
and are essential to the lungs' ability to absorb oxygen and to maintain proper
airflow through the respiratory system. The absence or depletion of surfactant
is involved in a number of respiratory diseases. Our humanized surfactant
technology produces an engineered version of natural human lung surfactant and
contains a peptide, sinapultide, that is designed to precisely mimic the
essential human lung surfactant protein B (SP-B).

Surfaxin(R), our lead product, is being developed initially for critical care
patients with life-threatening respiratory disorders for which there are few, if
any, approved therapies. Surfaxin is currently in two Phase 3 clinical trials
for Respiratory Distress Syndrome in premature infants, a Phase 3 clinical trial
for Meconium Aspiration Syndrome in full-term infants, and a Phase 2 clinical
trial for Acute Respiratory Distress Syndrome in adults. Aerosolized
formulations of our humanized surfactant are presently being developed to
potentially treat hospitalized patients suffering from severe acute asthma and
Acute Lung Injury, typically requiring mechanical ventilation. In addition, we
believe there is the scientific rationale for the development of aerosolized
formulations of our humanized surfactant to potentially treat COPD, sinusitis,
sleep apnea and otitis media (inner ear infection).

We are presently developing a dedicated sales and marketing capability through a
collaboration with Quintiles to commercialize Surfaxin for neonatal indications
in the United States. We also have entered into a strategic alliance with Esteve
to commercialize Surfaxin in Europe and Latin America. We intend to establish
additional strategic alliances, where appropriate, for the development and
commercialization of our products in other indications and markets.

Since our inception, we have incurred significant losses and, as of December 31,
2002, had a deficit accumulated during the development stage of approximately
$73 million (including historical results of predecessor companies). The
majority of our expenditures to date have been for research and development
activities. Research and development expenses represent costs incurred for
scientific and clinical personnel, clinical trials, regulatory filings and
manufacturing efforts (including raw material costs). We expense our research
and development costs as they are incurred. General and administrative expenses
consist primarily of executive management, financial, business development,
legal and general corporate activities and related expenses. See Item 7:
"Management's Discussion and Analysis - Plan of Operations."

20

Historically, we have funded our operations with working capital provided
principally through public and private equity financings and strategic
collaborations. In November 2002, we completed the sale of securities in a
private placement to selected institutional and accredited investors for gross
proceeds of approximately $12.8 million. As of December 31, 2002, we had cash
and investments of approximately $19.2 million, a secured revolving credit
facility of $8.5 million to $10 million with Quintiles, of which $5.7 million
was available for borrowing and $1.45 million was outstanding, and a $1 million
capital equipment lease financing arrangement of which approximately $285,000
has been used. See Item 7: "Management's Discussion and Analysis - Liquidity and
Capital Resources."

CRITICAL ACCOUNTING POLICIES

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

We have identified below some of our more critical accounting policies and
changes to accounting policies. For further discussion of our accounting
policies see Footnote 2 "Summary of Significant Accounting Policies" in the
Notes to Consolidated Financial Statements. See Item 15: "Exhibits, Financial
Statement Schedules, and Reports on Form 8-K."

Revenue Recognition - research and development collaborative agreements

For up-front payments and licensing fees related to our contract research or
technology, we defer and recognize revenue as earned over the life of the
related agreement. Milestone payments are recognized as revenue upon achievement
of contract-specified events and when there are no remaining performance
obligations.

Revenue earned under our research and development collaborative agreement
contracts is recognized over a number of years as we perform research and
development activities. For up-front payments and licensing fees related to our
contract research or technology, we defer and recognize revenue as earned over
the estimated period the services are expected to be performed.

Research and Development Costs

Research and development costs are expensed as incurred. We will continue to
incur research and development costs as we continue to expand our product
development activities. Our research and development costs have included, and
will continue to include, expenses for internal development personnel, supplies
and facilities, clinical trials, regulatory compliance and reviews, validation
of processes and start up costs to establish commercial manufacturing
capabilities. At the time our product candidates are approved by the FDA and we
begin commercial manufacturing, we will no longer expense certain manufacturing
costs as research and development costs.

21

PLAN OF OPERATIONS

We expect to continue to incur increasing operating losses for the foreseeable
future, primarily due to our continued research and development activities
attributable to new and existing products, manufacturing, initial
commercialization, and general and administrative activities.

We anticipate that during the next 12 to 24 months we will:

(i) significantly increase our research, development and regulatory
activities.

It is anticipated that our research and development activities will
be the several clinical trials for Surfaxin indications and related
regulatory filings. We are presently conducting a pivotal,
multinational landmark Phase 3 trial treating up to 1,500 patients
for the treatment of Respiratory Distress Syndrome in premature
infants. This pivotal trial is intended, if successful, to provide
the basis for New Drug Applications with the FDA and other worldwide
regulatory authorities. This pivotal trial is expected to be
completed and data announced early in the fourth quarter of 2003. We
are also conducting another multinational Phase 3 trial treating up
to 500 patients for the treatment of Respiratory Distress Syndrome
in premature infants. This trial is expected to be completed within
the same timeframe as the pivotal Phase 3 trial. We are currently
evaluating whether to conclude this trial early to conserve
financial resources and reallocate clinical resources to our pivotal
Phase 3 trial. For Acute Respiratory Distress Syndrome in adults, we
currently are conducting a Phase 2 dose-ranging safety and efficacy
study of up to 110 patients in the United States. We expect to
complete this trial in the third quarter of 2003. For Meconium
Aspiration Syndrome in full-term infants, we currently are
conducting a Phase 3 clinical trial of up to 200 patients in the
United States. Enrollment is ongoing but has been slower than
expected and completion is now anticipated in 2004. Given our belief
in the importance of the pivotal Phase 3 trial for Respiratory
Distress Syndrome in premature infants to our present development
plan, resources have been and may continue to be reallocated from
the Meconium Aspiration Syndrome program to the Respiratory Distress
Syndrome program, as needed. We are conducting a Phase 2 clinical
trial of Surfaxin lavage in up to 60 infant patients for use as a
prophylactic for patients who are at risk for Meconium Aspiration
Syndrome. The clinical trial and regulatory process is lengthy,
expensive and uncertain and subject to numerous risks including,
without limitation, the following risks discussed in the "Risks
Related to Our Business" section: "The clinical trial and regulatory
approval process for our products is expensive and time consuming,
and the outcome is uncertain"; and "Our technology platform is based
solely on our proprietary humanized, engineered surfactant
technology and only our lead product candidate, Surfaxin, has been
subject to clinical studies. Our ongoing Phase 3 clinical trials for
Surfaxin for the treatment of Respiratory Distress Syndrome in
premature infants may be delayed, or fail, which will harm our
business."

Aerosolized formulations of our humanized surfactant are presently being
developed to potentially treat hospitalized patients suffering from severe
acute asthma and Acute Lung Injury. In addition, we are evaluating the
development of aerosolized formulations of our

22

humanized surfactant to potentially treat COPD, sinusitis, sleep apnea and
otitis media (inner ear infection).

(ii) invest in additional manufacturing capability in order to provide
backup for the production of our humanized surfactant drug product
and to scale up to meet clinical and commercial needs as they
expand.

(iii) invest in additional general and administrative resources primarily
to support our business development initiatives, financial systems
and controls and management information technologies.

(iv) invest in marketing and commercialization management infrastructure
to manage the strategic relationships with our collaborative
partners for the launch of Surfaxin, if approved, and the execution
of our "Discovery/Surfaxin" worldwide marketing strategy.

In December 2001, we entered into a collaboration arrangement with Quintiles,
and its affiliate, PharmaBio, to provide certain commercialization services in
the United States for Surfaxin for the treatment of Respiratory Distress
Syndrome in premature infants and Meconium Aspiration Syndrome in full-term
infants. Quintiles will hire and train a dedicated United States sales force
that will be branded in the market as ours. Quintiles will make available up to
$70 million in post-launch funding to cover the first seven years of U.S. sales
and marketing costs. In return, Quintiles will receive a commission on net sales
of Surfaxin over a 10-year period. The Quintiles arrangement allows us to retain
product ownership and have sales and marketing expertise in place for the
commercialization of Surfaxin in the United States, if approved.

In March 2002, we expanded our existing alliance with Esteve to develop, market
and sell Surfaxin throughout Europe and Latin America. Esteve will provide
certain commercialization services for Surfaxin for the treatment of Respiratory
Distress Syndrome in premature infants, Meconium Aspiration Syndrome in
full-term infants and Acute Lung Injury/Acute Respiratory Distress Syndrome in
adult patients. Our exclusive supply agreement with Esteve provides that Esteve
will purchase from us all of its Surfaxin drug product requirements at an
established transfer price based on sales of Surfaxin by Esteve and/or its
sublicensee(s). Esteve has also agreed to sponsor certain clinical trial costs
related to obtaining regulatory approval in Europe for the Acute Lung
Injury/Acute Respiratory Distress Syndrome indications. Esteve also agreed to
make certain milestone payments to us upon the attainment of European marketing
regulatory approval for Surfaxin.

We will need to generate significant revenues from product sales and or related
royalties and transfer prices to achieve and maintain profitability. Through
December 31, 2002, we had no revenues from any product sales, and have not
achieved profitability on a quarterly or annual basis. Our ability to achieve
profitability depends upon, among other things, our ability to develop products,
obtain regulatory approval for products under development and enter into
agreements for product development, manufacturing and commercialization. In
addition, our results are dependent upon the performance of our strategic
partners and third party contract manufacturers and suppliers. Moreover, we may
never achieve significant revenues or profitable operations from the sale of any
of our products or technologies.

23

Through December 31, 2002, we had not generated taxable income. On December 31,
2002, net operating losses available to offset future taxable income for Federal
tax purposes were approximately $65.1 million. The future utilization of such
loss carryforwards may be limited pursuant to regulations promulgated under
Section 382 of the Internal Revenue Code. In addition, we have a research and
development tax credit carryforward of $1,225,000. The Federal net operating
loss and research and development tax credit carryforwards expire beginning in
2008 and continuing through 2021.

RESULTS OF OPERATIONS

The net loss for the three years ended December 31, 2002, 2001 and 2000 was
$17,443,000 (or $0.64 per common share), $11,146,000 (or $0.51 per common
share), and $10,861,000 (or $0.58 per common share), respectively. These
increased losses were primarily the result of increasing research and
development expenditures as discussed below.

Revenue

Total revenues recognized for the three years ended December 31, 2002, 2001 and
2000 were $1,782,000, $1,112,000, and $741,000, respectively. These revenues are
associated with our research and development collaborative arrangements,
primarily our alliance with Esteve to develop, market and sell Surfaxin
throughout Europe and Latin America. Additional collaborative revenues relate to
our Small Business Innovative Research (SBIR) grant to develop Surfaxin for
Acute Lung Injury/Acute Respiratory Distress Syndrome in adults and our Orphan
Products Development grant to develop Surfaxin for Meconium Aspiration Syndrome
in full-term infants.

Expenses

Research and development expenses for the three years ended December 31, 2002,
2001 and 2000 were $14,347,000, $8,007,000, and $7,494,000, respectively. The
increases primarily reflect clinical trial costs incurred for our lead product,
Surfaxin, currently in three Phase 3 trials and one Phase 2 trial for critical
care patients with life threatening respiratory disorders, and research and
development activities related to the development of aerosolized formulations of
our humanized lung surfactant to potentially treat a variety of respiratory and
upper airway conditions.

General and administrative expenses for the three years ended December 31, 2002,
2001 and 2000 were $5,458,000, $5,067,000, and $5,145,000, respectively. General
and administrative expenses consist primarily of costs of business and
commercial development, executive management, financial and accounting, legal,
facility and other administrative costs. Included in the year ended December 31,
2002, is a charge of $1,450,000 for pre-launch commercialization activities for
Surfaxin in connection with a collaboration agreement with Quintiles (for which
funding is provided by a secured, revolving credit facility with PharmaBio,
discussed below in "Liquidity and Capital Resources"). Additionally, included in
the years ended December 31, 2002, 2001, and 2000, are non-cash compensation
charges of $402,000, $517,000,

24

and $2,515,000, respectively. The 2002 and 2001 non-cash compensation charges
primarily relate to the grant of stock options to non-employee members of our
Board of Directors under our stock option plan and certain modifications to
certain options held by three departing members of our Board of Directors. The
2000 non-cash compensation charge is primarily related to the grant of stock
options to non-employee members of our Board of Directors under the Company's
Stock Option Plan and the vesting of certain milestone-based stock options.

Other Income and Expense

Interest income for the three years ended December 31, 2002, 2001, and 2000 was
$724,000, $842,000 and $1,042,000, respectively. Interest income decreased
primarily due to the decline in interest rates and the average balance of
marketable securities throughout the three year period.

Interest expense for the three years ended December 31, 2002, 2001, and 2000 was
$144,000, $26,000 and $5,000, respectively. The increase in interest expense is
primarily related to the secured, revolving credit facility with PharmaBio
(discussed below in "Liquidity and Capital Resources").

LIQUIDITY AND CAPITAL RESOURCES

Cash, Cash Equivalents and Marketable Securities

As of December 31, 2002, we had cash, cash equivalents and marketable securities
of approximately $19.2 million.

Secured, Revolving Credit Facility and Capital Lease Arrangement

In December 2001, we entered into a secured revolving credit facility of up to
$8.5 million to $10 million with PharmaBio to fund pre-marketing activities for
a Surfaxin launch in the United States. The credit facility is available for use
until December 10, 2004, and monies become available in three tranches upon
satisfying certain conditions. We have satisfied the conditions for availability
of the first two tranches and at December 31, 2002, the amount available under
the credit facility was approximately $5.7 million, of which $1.45 million was
outstanding. Interest on amounts advanced under the credit facility will be
payable quarterly in arrears. We may repay principal amounts owed by us under
the credit facility from proceeds of milestone payments to be paid to us by
PharmaBio upon the achievement of certain corporate milestones. We are obligated
to use a significant portion of the funds borrowed under the credit facility for
pre-launch marketing services to be provided by Quintiles.

In December 2002, we entered into a lease financing arrangement with the Life
Science and Technology Finance Division of General Electric Capital Corporation
that provides, subject to certain conditions, for up to $1 million in financing
for capital purchases. As of December 31, 2002, we had used approximately
$285,000 of this financing arrangement.

We believe our current working capital is sufficient to meet our planned
research and development and operational activities into the second quarter of
2004. We will need additional

25

financing from investors or collaborators to complete research and development
and commercialization of our current product candidates under development.

Our working capital requirements will depend upon numerous factors, including,
without limitation, the progress of our research and development programs,
clinical trials, timing and cost of obtaining regulatory approvals, timing and
cost of pre-launch marketing activities, levels of resources that we devote to
the development of manufacturing and marketing capabilities, levels of resources
that our collaboration partners devote to the development of sales and marketing
capabilities, technological advances, status of competitors and our ability to
establish collaborative arrangements with other organizations, the ability to
defend and enforce our intellectual property rights and the establishment of
additional strategic or licensing arrangements with other companies or
acquisitions.

Historically, the Company's working capital has been provided from the proceeds
of private financings and strategic alliances:

In November 2002, we completed the sale of securities in a private placement to
selected institutional and accredited investors for net proceeds of
approximately $11.9 million. We issued 6,397,517 shares of Common Stock and
2,878,883 Class I Warrants to purchase shares of Common Stock at an exercise
price of $2.425 per share. The Class I warrants have a five-year term.

Pursuant to our collaboration arrangement with Esteve on March 6, 2002, we
issued 821,862 shares of Common Stock to Esteve at a purchase price equal to
$4.867 per share and received a licensing fee of $500,000, for approximate net
aggregate proceeds of $4.45 million. See Item 1: "Description of Business."

Pursuant to the collaboration arrangement we entered into with Quintiles and
PharmaBio in December 2001, we issued to PharmaBio, for approximate net
aggregate proceeds of $2.7 million: (i) 791,905 shares of common stock at a
price equal to $3.79 per share; and (ii) Class G warrants to purchase 357,143
shares of common stock at an exercise price equal to $3.485 per share (subject
to adjustment). In connection with the credit facility, we issued to PharmaBio
Class H warrants to purchase 320,000 shares of common stock. The Class H
warrants are exercisable at $3.03 per share (subject to adjustment) and are
exercisable proportionately only upon availability of the credit facility. To
the extent the credit facility availability is increased to greater than $8.5
million, for each $1 million increase, the amount of shares of common stock
issuable pursuant to the Class H warrants shall be increased by approximately
38,000 shares. See Item 1: "Description of Business."

In October 2001, we received approximately $7.3 million in net proceeds from a
private financing. In the financing, we issued 3,562,759 shares of common stock
and 712,553 Class F warrants to purchase shares of common stock at an exercise
price of $2.365 per share. The Class F warrants have a five-year term.

In April 2001, we received approximately $1 million in proceeds in a private
offering of 296,560 shares of common stock at a per share price equal to $3.37.

26

In March 2000, we received approximately $17,500,000 in net proceeds in a
private placement offering from the sale of 2,902,846 shares of common stock and
580,567 Class E warrants to purchase common stock at $7.38 per share. The Class
E warrants issued in the offering are exercisable through March 2005.

In October 1999, in connection with our strategic alliance with Esteve, we
issued to Esteve in a private placement 317,164 shares of common stock at a
purchase price of $2.68 per share.

In July 1999, we raised approximately $2,233,000 in net proceeds in a private
placement offering of an aggregate of 2,024,792 shares of common stock and
2,024,792 Class D warrants to purchase common stock. All of the Class D warrants
have been exercised.

During March and April 1999, we raised $1.0 million in a private placement
offering of 826,447 shares of common stock and 569,026 Class C warrants to
purchase common stock at an exercise price of $2.15 per share. The Class C
warrants are exercisable through April 2006.

We will require substantial additional funding to conduct our business,
including our expanded research and product development activities. Based on our
current operating plan, we believe that our currently available resources will
be adequate to satisfy our capital needs into the second quarter of 2004. Our
future capital requirements will depend on the results of our research and
development activities, clinical studies and trials, competitive and
technological advances and the regulatory process. Our operations will not
become profitable before we exhaust our current resources; therefore, we will
need to raise substantial additional funds through additional debt or equity
financings or through collaborative ventures with potential corporate partners.
We may in some cases elect to develop products on our own instead of entering
into collaboration arrangements and this would increase our cash requirements.
Other than our credit facility with Esteve and our capital lease financing
arrangement with General Electric Capital Corporation, we have not entered into
any additional arrangements to obtain any additional financing. The sale of
additional equity and debt securities may result in additional dilution to our
stockholders, and we cannot be certain that additional financing will be
available in amounts or on terms acceptable to us, if at all. If we fail to
enter into collaborative ventures or to receive additional funding, we may have
to reduce significantly the scope of or discontinue our planned research,
development and commercialization activities, which could significantly harm our
financial condition and operating results. Furthermore, we could cease to
qualify for listing of our common stock on the NASDAQ SmallCap Market if the
market price of our common stock declines as a result of the dilutive aspects of
such potential financings. See "Risks Related to Our Business": " - We will need
additional capital, and our ability to continue all of our existing planned
research and development activities is uncertain. Any additional financing could
result in equity dilution"; " - The market price of our stock may be adversely
affected by market volatility"; and " - A substantial number of our securities
are eligible for future sale and this could affect the market price for our
stock and our ability to raise capital."

27

RISKS RELATED TO OUR BUSINESS

The following risks, among others, could cause our actual results, performance,
achievements or industry results to differ materially from those expressed in
our forward-looking statements contained herein and presented elsewhere by
management from time to time.

BECAUSE WE ARE A DEVELOPMENT STAGE COMPANY, WE MAY NOT SUCCESSFULLY DEVELOP AND
MARKET OUR PRODUCTS, AND EVEN IF WE DO, WE MAY NOT GENERATE ENOUGH REVENUE OR
BECOME PROFITABLE.

We are a development stage company. Therefore, you must evaluate us in light of
the uncertainties and complexities present in a development stage biotechnology
company. We currently have no products approved for sale and are conducting
research and development on our product candidates. As a result, we have not
begun to market or generate revenues from the commercialization of any of these
products. Our long-term viability will be impaired if we are unable to obtain
regulatory approval for, or successfully market, our product candidates.

To date, we have only generated revenues from investments, research grants and
collaborative research and development agreements. We will need to engage in
significant, time-consuming and costly research, development, pre-clinical
studies, clinical testing and regulatory approval for our products under
development prior to their commercialization. In addition, pre-clinical or
clinical studies may show that our products are not effective or safe for one or
more of their intended uses. We may fail in the development and
commercialization of our products. As of December 31, 2002, we have incurred a
deficit accumulated during the development stage of approximately $72 million,
and we expect to continue to incur significant increasing operating losses over
the next several years. If we succeed in the development of our products, we
still may not generate sufficient or sustainable revenues or we may not be
profitable.

OUR TECHNOLOGY PLATFORM IS BASED SOLELY ON OUR PROPRIETARY HUMANIZED, ENGINEERED
SURFACTANT TECHNOLOGY AND ONLY OUR LEAD PRODUCT CANDIDATE, SURFAXIN, HAS BEEN
SUBJECT TO CLINICAL STUDIES. OUR ONGOING PHASE 3 CLINICAL TRIALS FOR SURFAXIN
FOR THE TREATMENT OF RESPIRATORY DISTRESS SYNDROME IN PREMATURE INFANTS MAY BE
DELAYED, OR FAIL, WHICH WILL HARM OUR BUSINESS.

Our humanized, engineered surfactant platform technology is based on the
scientific rationale for surfactant replacement therapy to treat life
threatening respiratory disorders and as the foundation for the development of
novel respiratory therapies and products. Our business is dependent upon the
successful development and approval of our product candidates based on this
platform technology. Our lead product, Surfaxin, is currently in two Phase 3
clinical trials for Respiratory Distress Syndrome in premature infants, a Phase
3 clinical trial for Meconium Aspiration Syndrome in full-term infants, and a
Phase 2 clinical trial for Acute Respiratory Distress syndrome in adults.

Companies in the pharmaceutical and biotechnology industries have suffered
significant setbacks in advanced clinical trials, even after obtaining promising
results in earlier trials. Data obtained from tests are susceptible to varying
interpretations which may delay, limit or prevent regulatory

28

approval. In addition, we may be unable to enroll patients quickly enough to
meet our expectations for completing any or all of these trials. The timing and
completion of current and planned clinical trials of our product candidates
depend on, among other factors, the rate at which patients are enrolled, which
is a function of many factors, including:

- -- the number of clinical sites;

- -- the size of the patient population;

- -- the proximity of patients to the clinical sites;

- -- the eligibility criteria for the study;

- -- the existence of competing clinical trials; and

- -- the existence of alternative available products.

Delays in patient enrollment in clinical trials may occur, which would likely
result in increased costs, program delays or both.

WE WILL NEED ADDITIONAL CAPITAL, AND OUR ABILITY TO CONTINUE ALL OF OUR EXISTING
PLANNED RESEARCH AND DEVELOPMENT ACTIVITIES IS UNCERTAIN. ANY ADDITIONAL
FINANCING COULD RESULT IN EQUITY DILUTION.

We will need substantial additional funding to conduct our presently planned
research and product development activities. Based on our current operating
plan, we believe that our currently available financial resources will be
adequate to satisfy our capital needs into the second quarter of 2004. Our
future capital requirements will depend on a number of factors that are
uncertain, including the results of our research and development activities,
clinical studies and trials, competitive and technological advances and the
regulatory process, among others. We will likely need to raise substantial
additional funds through collaborative ventures with potential corporate
partners and through additional debt or equity financings. We may also continue
to seek additional funding through capital lease transactions. We may in some
cases elect to develop products on our own instead of entering into
collaboration arrangements. This would increase our cash requirements for
research and development.

We have not entered into arrangements to obtain any additional financing, except
for the credit facility with PharmaBio and our capital equipment lease financing
arrangement with General Electric Capital Corporation. Any additional financing
could include unattractive terms or result in significant dilution of
stockholders' interests and share prices may decline. If we fail to enter into
collaborative ventures or to receive additional funding, we may have to delay,
scale back or discontinue certain of our research and development operations,
and consider licensing the development and commercialization of products that we
consider valuable and which we otherwise would have developed ourselves. If we
are unable to raise required capital, we may be forced to limit many, if not
all, of our research and development programs and related operations, curtail
commercialization of out product candidates and, ultimately, cease operations.

Furthermore, we could cease to qualify for listing of our securities on the
NASDAQ SmallCap Market if the market price of our common stock declines as a
result of the dilutive aspects of such potential financings. See "Risks Related
to Our Business-The market price of our stock may be adversely affected by
market volatility."

29

THE CLINICAL TRIAL AND REGULATORY APPROVAL PROCESS FOR OUR PRODUCTS IS EXPENSIVE
AND TIME CONSUMING, AND THE OUTCOME IS UNCERTAIN.

In order to sell our products that are under development, we must receive
regulatory approvals for each product. The FDA and comparable agencies in
foreign countries extensively and rigorously regulate the testing, manufacture,
distribution, advertising, pricing and marketing of drug products like our
products. This approval process includes preclinical studies and clinical trials
of each pharmaceutical compound to establish its safety and effectiveness and
confirmation by the FDA and comparable agencies in foreign countries that the
manufacturer maintains good laboratory and manufacturing practices during
testing and manufacturing. Although we are involved in certain late-stage
clinical trials, pharmaceutical and biotechnology companies have suffered
significant setbacks in advanced clinical trials, even after promising results
in earlier clinical trials.

The approval process is lengthy, expensive and uncertain. It is also possible
that the FDA or comparable foreign regulatory authorities could interrupt, delay
or halt any one or more of our clinical trials. If we, or any regulatory
authorities, believe that trial participants face unacceptable health risks, any
one or more of our trials could be suspended or terminated. We also may not
reach agreement with the FDA and/or comparable foreign agencies on the design of
any one or more of the clinical studies necessary for approval. Conditions
imposed by the FDA and comparable agencies in foreign countries on our clinical
trials could significantly increase the time required for completion of such
clinical trials and the costs of conducting the clinical trials. Data obtained
from clinical testing are susceptible to varying interpretations which may
delay, limit or prevent regulatory approval.

Delays and terminations of the clinical trials we conduct could result from
insufficient patient enrollment. Patient enrollment is a function of several
factors, including the size of the patient population, stringent enrollment
criteria, the proximity of the patients to the trial sites, having to compete
with other clinical trials for eligible patients, geographical and geopolitical
considerations and others. Delays in patient enrollment can result in greater
costs and longer trial timeframes. Patients may also suffer adverse medical
events or side effects that are common to this class of drug such as a decrease
in the oxygen level of the blood upon administration.

Clinical trials generally take two to five years or more to complete, and,
accordingly, our first product is not expected to be commercially available in
the United States until at least 2004, and our other product candidates will
take longer. The FDA has notified us that two of our intended indications for
Surfaxin, Meconium Aspiration Syndrome in full-term infants and Acute
Respiratory Distress Syndrome in adults, have been granted designation as "fast-
track" products under provisions of the Food and Drug Administration
Modernization Act of 1997, and the FDA has awarded us an Orphan Products
Development Grant to support our development of Surfaxin for the treatment of
Meconium Aspiration Syndrome. Fast-Track Status does not accelerate the clinical
trials nor does it mean that the regulatory requirements are less stringent. The
Fast-Track Status provisions are designed to expedite the FDA's review of new
drugs intended to treat serious or life-threatening conditions. The FDA
generally will review the New Drug Application

30

for a drug granted Fast-Track Status within six months instead of the typical
one to three years. Our products may not, however, continue to qualify for
expedited review and our other drug candidates may fail to qualify for fast
track development or expedited review. Even though some of our drug candidates
have qualified for expedited review, the FDA may not approve them at all or any
sooner than other drug candidates that do not qualify for expedited review.

The FDA and comparable foreign agencies could withdraw any approvals we obtain.
Further, if there is a later discovery of unknown problems or if we fail to
comply with other applicable regulatory requirements at any stage in the
regulatory process, the FDA may restrict or delay our marketing of a product or
force us to make product recalls. In addition, the FDA could impose other
sanctions such as fines, injunctions, civil penalties or criminal prosecutions.
To market our products outside the United States, we also need to comply with
foreign regulatory requirements governing human clinical trials and marketing
approval for pharmaceutical products. The FDA and foreign regulators have not
yet approved any of our products under development for marketing in the United
States or elsewhere. If the FDA and other regulators do not approve our
products, we will not be able to market our products.

IN ORDER TO CONDUCT OUR CLINICAL TRIALS WE NEED ADEQUATE SUPPLIES OF OUR DRUG
SUBSTANCE AND DRUG PRODUCT AND COMPETITORS DRUG PRODUCT, WHICH MAY NOT BE
READILY AVAILABLE.

To succeed, clinical trials require adequate supplies of drug substance and drug
product, which may be difficult or uneconomical to procure or manufacture. We
rely on outside manufacturers for our drug substance and other active
ingredients for Surfaxin and to produce material that meets appropriate
standards for use in clinical studies for our products. We have validated only a
single clinical manufacturing facility, owned and operated by Akorn to produce
appropriate clinical grade material of our drug substance that meets standards
for use in our ongoing clinical studies. Akorn has been experiencing significant
operational and financial difficulties and is currently attempting to
restructure its financial obligations and improve its day to day operations. In
February 2003, Akorn informed us that certain operating difficulties experienced
in one of its production rooms primarily used for the filling of sterile
pharmaceutical had been rectified and that the room had been returned to
operational status. Our ability to timely recommence Surfaxin manufacture for
our Phase 2 clinical trial for Acute Respiratory Distress Syndrome in adults is
dependent upon the success of Akorn's efforts to correct its difficulties and
its ability to maintain operational status of the sterile production room and
its other Surfaxin-related facilities.

OUR STRATEGY, IN MANY CASES, IS TO ENTER INTO COLLABORATION AGREEMENTS WITH
THIRD PARTIES WITH RESPECT TO OUR PRODUCTS AND WE MAY REQUIRE ADDITIONAL
COLLABORATION AGREEMENTS. IF WE FAIL TO ENTER INTO THESE AGREEMENTS OR IF WE OR
THE THIRD PARTIES DO NOT PERFORM UNDER SUCH AGREEMENTS, IT COULD IMPAIR OUR
ABILITY TO COMMERCIALIZE OUR PRODUCTS.

Our strategy for the completion of the required development and clinical testing
of our products and for the manufacturing, marketing and commercialization of
our products, in many cases, depends upon entering into collaboration
arrangements with pharmaceutical companies to market, commercialize and
distribute our products. In March 2002, we expanded our relationship with Esteve
by entering into a collaboration arrangement with Esteve for Surfaxin covering
all of Europe and Latin America. Esteve will be responsible for the marketing of

31

Surfaxin for the treatment of Respiratory Distress Syndrome in premature
infants, Meconium Aspiration Syndrome in full-term infants, and Acute Lung
Injury/Acute Respiratory Distress Syndrome in adults. Esteve will also be
responsible for the sponsorship of certain clinical trial costs related to
obtaining European Medicines Evaluation Agency approval for commercialization of
Surfaxin in Europe for the Acute Lung Injury/Acute Respiratory Distress Syndrome
indications. We will be responsible for the remainder of the regulatory
activities relating to Surfaxin, including with respect to European Medicines
Evaluation Agency filings.

In December 2001, we entered into an exclusive collaboration arrangement in the
United States with Quintiles, and its affiliate, PharmaBio, to commercialize,
sell and market Surfaxin in the United States for indications of Respiratory
Distress Syndrome and Meconium Aspiration Syndrome. As part of our collaboration
with Quintiles, Quintiles will build a sales force solely dedicated to the sale
of Surfaxin upon the approval of a New Drug Application for either of the two
indications. If Quintiles and we fail to devote appropriate resources to
commercialize, sell and market Surfaxin, sales of Surfaxin could be reduced. As
part of the collaboration, PharmaBio is obligated to provide us with certain
financial assistance in connection with the commercialization of Surfaxin,
including, but not limited to, a secured, revolving credit facility for at least
$8.5 million which may be increased to $10 million. A failure by us to repay
amounts outstanding under the credit facility would have a material adverse
effect on us. To obtain the benefits of such financing, we are obligated to meet
certain development and performance milestones. The failure by us to meet the
milestones or other terms and conditions of the financing leading to PharmaBio's
termination thereof or the failure by PharmaBio to fulfill its obligation to
partially fund the commercialization of Surfaxin, may affect our ability to
successfully market Surfaxin.

If Esteve, Quintiles or we breach or terminate the agreements that make up such
collaboration arrangements or Esteve or Quintiles otherwise fail to conduct
their Surfaxin-related activities in a timely manner or if there is a dispute
about their respective obligations, we may need to seek other partners or we may
have to develop our own internal sales and marketing capability for the
indications of Surfaxin which Esteve and/or Quintiles have agreed to assist in
commercializing. Accordingly, we may need to enter into additional collaboration
agreements and our success, particularly outside of the United States, may
depend upon obtaining additional collaboration partners. In addition, we may
depend on our partners' expertise and dedication of sufficient resources to
develop and commercialize our proposed products. We may, in the future, grant to
collaboration partners rights to license and commercialize pharmaceutical
products developed under collaboration agreements. Under these arrangements, our
collaboration partners may control key decisions relating to the development of
the products. The rights of our collaboration partners would limit our
flexibility in considering alternatives for the commercialization of our
products. If we fail to successfully develop these relationships or if our
collaboration partners fail to successfully develop or commercialize any of our
products, it may delay or prevent us from developing or commercializing our
products in a competitive and timely manner and would have a material adverse
effect on the commercialization of Surfaxin. See "Risks Related to Our
Business-Our lack of marketing and sales experience could limit our ability to
generate revenues from future product sales."

32

IF WE CANNOT PROTECT OUR INTELLECTUAL PROPERTY, OTHER COMPANIES COULD USE OUR
TECHNOLOGY IN COMPETITIVE PRODUCTS. IF WE INFRINGE THE INTELLECTUAL PROPERTY
RIGHTS OF OTHERS, OTHER COMPANIES COULD PREVENT US FROM DEVELOPING OR MARKETING
OUR PRODUCTS.

We seek patent protection for our drug candidates so as to prevent others from
commercializing equivalent products in substantially less time and at
substantially lower expense. The pharmaceutical industry places considerable
importance on obtaining patent and trade secret protection for new technologies,
products and processes. Our success will depend in part on our ability and that
of parties from whom we license technology to:

- -- defend our patents and otherwise prevent others from infringing on our
proprietary rights;

- -- protect trade secrets; and

- -- operate without infringing upon the proprietary rights of others, both in
the United States and in other countries.

The patent position of firms relying upon biotechnology is highly uncertain and
involves complex legal and factual questions for which important legal
principles are unresolved. To date, the United States Patent and Trademark
Office has not adopted a consistent policy regarding the breadth of claims that
the United States Patent and Trademark Office allows in biotechnology patents or
the degree of protection that these types of patents afford. As a result, there
are risks that we may not develop or obtain rights to products or processes that
are or may seem to be patentable.

EVEN IF WE OBTAIN PATENTS TO PROTECT OUR PRODUCTS, THOSE PATENTS MAY NOT BE
SUFFICIENTLY BROAD AND OTHERS COULD COMPETE WITH US.

We, or the parties licensing technologies to us, have filed various United
States and foreign patent applications with respect to the products and
technologies under our development, and the United States Patent and Trademark
Office and foreign patent offices have issued patents with respect to our
products and technologies. These patent applications include international
applications filed under the Patent Cooperation Treaty. Our pending patent
applications, those we may file in the future or those we may license from third
parties may not result in the United States Patent and Trademark Office or
foreign patent office issuing patents. Also, if patent rights covering our
products are not sufficiently broad, they may not provide us with sufficient
proprietary protection or competitive advantages against competitors with
similar products and technologies. Furthermore, if the United States Patent and
Trademark Office or foreign patent offices issue patents to us or our licensors,
others may challenge the patents or circumvent the patents, or the patent office
or the courts may invalidate the patents. Thus, any patents we own or license
from or to third parties may not provide any protection against competitors.

Furthermore, the life of our patents is limited. We have licensed a series of
patents from Johnson & Johnson and Ortho Pharmaceutical which are important,
either individually or collectively, to our strategy of commercializing our
surfactant technology. Such patents, which include relevant European patents,
expire on various dates beginning in 2009 and ending in 2017 or, in some cases,
possibly later. We have filed, and when possible and appropriate, will file,
other patent applications with respect to our products and processes in the
United States and in foreign

33

countries. We may not be able to develop additional products or processes that
will be patentable or additional patents may not be issued to us. See also
"Risks Related to Our Business-If we cannot meet requirements under our license
agreements, we could lose the rights to our products."

INTELLECTUAL PROPERTY RIGHTS OF THIRD PARTIES COULD LIMIT OUR ABILITY TO MARKET
OUR PRODUCTS.

Our commercial success also significantly depends on our ability to operate
without infringing the patents or violating the proprietary rights of others.
The United States Patent and Trademark Office keeps United States patent
applications confidential while the applications are pending. As a result, we
cannot determine which inventions third parties claim in pending patent
applications that they have filed. We may need to engage in litigation to defend
or enforce our patent and license rights or to determine the scope and validity
of the proprietary rights of others. It will be expensive and time consuming to
defend and enforce patent claims. Thus, even in those instances in which the
outcome is favorable to us, the proceedings can result in the diversion of
substantial resources from our other activities. An adverse determination may
subject us to significant liabilities or require us to seek licenses that third
parties may not grant to us or may only grant at rates that diminish or deplete
the profitability of the products to us. An adverse determination could also
require us to alter our products or processes or cease altogether any related
research and development activities or product sales.

IF WE CANNOT MEET REQUIREMENTS UNDER OUR LICENSE AGREEMENTS, WE COULD LOSE THE
RIGHTS TO OUR PRODUCTS.

We depend on licensing arrangements with third parties to maintain the
intellectual property rights to our products under development. Presently, we
have licensed rights from Johnson & Johnson and Ortho Pharmaceutical. These
agreements require us to make payments and satisfy performance obligations in
order to maintain our rights under these licensing arrangements. All of these
agreements last either throughout the life of the patents, or with respect to
other licensed technology, for a number of years after the first commercial sale
of the relevant product.

In addition, we are responsible for the cost of filing and prosecuting certain
patent applications and maintaining certain issued patents licensed to us. If we
do not meet our obligations under our license agreements in a timely manner, we
could lose the rights to our proprietary technology.

In addition, we may be required to obtain licenses to patents or other
proprietary rights of third parties in connection with the development and use
of our products and technologies. Licenses required under any such patents or
proprietary rights might not be made available on terms acceptable to us, if at
all.

WE RELY ON CONFIDENTIALITY AGREEMENTS THAT COULD BE BREACHED AND MAY BE
DIFFICULT TO ENFORCE.

Although we believe that we take reasonable steps to protect our intellectual
property, including the use of agreements relating to the non-disclosure of
confidential information to third parties,

34

as well as agreements that purport to require the disclosure and assignment to
us of the rights to the ideas, developments, discoveries and inventions of our
employees and consultants while we employ them, the agreements can be difficult
and costly to enforce. Although we seek to obtain these types of agreements from
our consultants, advisors and research collaborators, to the extent that they
apply or independently develop intellectual property in connection with any of
our projects, disputes may arise as to the proprietary rights to this type of
information. If a dispute arises, a court may determine that the right belongs
to a third party, and enforcement of our rights can be costly and unpredictable.
In addition, we will rely on trade secrets and proprietary know-how that we will
seek to protect in part by confidentiality agreements with our employees,
consultants, advisors or others. Despite the protective measures we employ, we
still face the risk that:

- -- they will breach these agreements;

- -- any agreements we obtain will not provide adequate remedies for this type
of breach or that our trade secrets or proprietary know-how will otherwise
become known or competitors will independently develop similar technology;
and

- -- our competitors will independently discover our proprietary information
and trade secrets.

IF THE PARTIES WE DEPEND ON FOR MANUFACTURING OUR PHARMACEUTICAL PRODUCTS DO NOT
TIMELY SUPPLY THESE PRODUCTS, IT MAY DELAY OR IMPAIR OUR ABILITY TO DEVELOP AND
MARKET OUR PRODUCTS.

We rely on outside manufacturers for our drug substance and other active
ingredients for Surfaxin and to produce material that meets appropriate
standards for use in clinical studies for our products. We have validated only a
single clinical manufacturing facility owned and operated by Akorn to produce
appropriate clinical grade material of our drug substance that meets standards
for use in our ongoing clinical studies. Recently, Akorn has experienced a
number of operational and financial difficulties that, although not directly
involving the manufacturing process for our Surfaxin and other proprietary
surfactant drug substance or drug product, may have an adverse effect on our
clinical research and development activities. We will also rely on outside
manufacturers for production of our products after marketing approval. We may
also enter into arrangements with other manufacturers for the manufacture of
materials for use in clinical testing and after marketing approval.

Our outside manufacturers may not perform as they have agreed or may not remain
in the contract manufacturing business for a sufficient time to successfully
produce and market our product candidates. If we do not maintain important
manufacturing relationships, we may fail to find a replacement manufacturer or
to develop our own manufacturing capabilities. If we cannot do so, it could
delay or impair our ability to obtain regulatory approval for our products and
substantially increase our costs or deplete any profit margins. If we do find
replacement manufacturers, we may not be able to enter into agreements with them
on terms and conditions favorable to us and, there could be a substantial delay
before a new facility could be qualified and registered with the FDA and foreign
regulatory authorities.

We may in the future elect to manufacture some of our products on our own.
Although we own certain specialized manufacturing equipment, are considering an
investment in additional

35

manufacturing equipment and employ certain manufacturing managerial personnel,
we do not presently maintain a complete manufacturing facility or manufacturing
department and we do not anticipate manufacturing on our own any of our products
during the next 12 months. If we decide to manufacture products on our own and
do not successfully develop manufacturing capabilities, it will adversely affect
sales of our products.

The FDA and foreign regulatory authorities require manufacturers to register
manufacturing facilities. The FDA and corresponding foreign regulators also
inspect these facilities to confirm compliance with good manufacturing practices
(GMPs) or similar requirements that the FDA or corresponding foreign regulators
establish. Manufacturing or quality control problems could occur at the contract
manufacturers causing product production and shipment delays or a situation
where the contractor may not be able to maintain compliance with the FDA's
current GMP requirements necessary to continue manufacturing our drug substance.
If our third-party foreign or domestic suppliers or manufacturers of our
products or, if we decide to manufacture our products on our own, we, fail to
comply with GMP requirements or other FDA and comparable foreign regulatory
requirements, it could adversely affect our clinical research activities and our
ability to market and develop our products.

OUR LACK OF MARKETING AND SALES EXPERIENCE COULD LIMIT OUR ABILITY TO GENERATE
REVENUES FROM FUTURE PRODUCT SALES.

We do not have marketing, sales or distribution experience or marketing or sales
personnel. As a result, we will depend on our collaboration with Quintiles for
the marketing and sales of Surfaxin for indications of Respiratory Distress
Syndrome in premature infants and Meconium Aspiration Syndrome in full-term
infants in the United States and with Esteve for the marketing and sales of
Surfaxin for the treatment of Respiratory Distress Syndrome, Meconium Aspiration
Syndrome and Acute Lung Injury/Acute Respiratory Distress Syndrome in adult
patients in all of Europe and Latin America. See "Risks Related to Our
Business-Our strategy, in many cases, is to enter into collaboration agreements
with third parties with respect to our products and we may require additional
collaboration agreements. If we fail to enter into these agreements or if we or
the third parties do not perform under such agreements, it could impair our
ability to commercialize our products." If we do not develop a marketing and
sales force of our own, then we will depend on arrangements with corporate
partners or other entities for the marketing and sale of our remaining products.

The sales and marketing of Surfaxin for indications of Respiratory Distress
Syndrome in premature infants, Meconium Aspiration Syndrome in full-term
infants, and Acute Lung Injury/Acute Respiratory Distress Syndrome in adult
patients in the relevant territories depends, in part, on Quintiles' and
Esteve's performance of their contractual obligations. The failure of either
party to do so would have a material adverse effect on the sales and marketing
of Surfaxin. We may not succeed in entering into any satisfactory third party
arrangements for the marketing and sale of our remaining products. In addition,
we may not succeed in developing marketing and sales capabilities, our
commercial launch of certain products may be delayed until we establish
marketing and sales capabilities or we may not have sufficient resources to do
so. If we fail to establish marketing and sales capabilities or fail to enter
into arrangements with third parties, either in a timely manner, it will
adversely affect sales of our products.

36

WE DEPEND UPON KEY EMPLOYEES AND CONSULTANTS IN A COMPETITIVE MARKET FOR SKILLED
PERSONNEL. IF WE ARE UNABLE TO ATTRACT AND RETAIN KEY PERSONNEL, IT COULD
ADVERSELY AFFECT OUR ABILITY TO DEVELOP AND MARKET OUR PRODUCTS.

We are highly dependent upon the principal members of our management team,
especially our Chief Executive Officer, Dr. Capetola, and our directors, as well
as our scientific advisory board members, consultants and collaborating
scientists. Many of these people have been involved in our formation or have
otherwise been involved with us for many years, have played integral roles in
our progress and we believe that they will continue to provide value to us. A
loss of any of these personnel may have a material adverse effect on aspects of
our business and clinical development and regulatory programs. We have an
employment agreement with Dr. Capetola that expires on December 31, 2005. We
also have employment agreements with other key personnel with termination dates
from 2003 through 2005. Although these employment agreements generally provide
for severance payments that are contingent upon the applicable employee's
refraining from competition with us, the loss of any of these persons' services
would adversely affect our ability to develop and market our products and obtain
necessary regulatory approvals, and the applicable noncompete provisions can be
difficult and costly to monitor and enforce. Further, we do not maintain key-man
life insurance.

Our future success also will depend in part on the continued service of our key
scientific and management personnel and our ability to identify, hire and retain
additional personnel, including marketing and sales staff. We experience intense
competition for qualified personnel, and the existence of non-competition
agreements between prospective employees and their former employers may prevent
us from hiring those individuals or subject us to suit from their former
employers.

While we attempt to provide competitive compensation packages to attract and
retain key personnel, some of our competitors are likely to have greater
resources and more experience than we have, making it difficult for us to
compete successfully for key personnel.

OUR INDUSTRY IS HIGHLY COMPETITIVE AND WE HAVE LESS CAPITAL AND RESOURCES THAN
MANY OF OUR COMPETITORS, WHICH MAY GIVE THEM AN ADVANTAGE IN DEVELOPING AND
MARKETING PRODUCTS SIMILAR TO OURS OR MAKE OUR PRODUCTS OBSOLETE.

Our industry is highly competitive and subject to rapid technological innovation
and evolving industry standards. We compete with numerous existing companies
intensely in many ways. We intend to market our products under development for
the treatment of diseases for which other technologies and treatments are
rapidly developing and, consequently, we expect new companies to enter our
industry and that competition in the industry will increase. Many of these
companies have substantially greater research and development, manufacturing,
marketing, financial, technological, personnel and managerial resources than we
have. In addition, many of these competitors, either alone or with their
collaborative partners, have significantly greater experience than we do in:

- -- developing products;

37

- -- undertaking preclinical testing and human clinical trials;

- -- obtaining FDA and other regulatory approvals or products; and

- -- manufacturing and marketing products.

Accordingly, our competitors may succeed in obtaining patent protection,
receiving FDA or comparable foreign approval or commercializing products before
us. If we commence commercial product sales, we will compete against companies
with greater marketing and manufacturing capabilities who may successfully
develop and commercialize products that are more effective or less expensive
than ours. These are areas in which, as yet, we have limited or no experience.
In addition, developments by our competitors may render our product candidates
obsolete or noncompetitive.

Presently, there are no approved drugs that are specifically indicated for
Meconium Aspiration Syndrome in full-term infants or Acute Lung Injury/Acute
Respiratory Distress Syndrome in adults. Current therapy consists of general
supportive care and mechanical ventilation.

Four products, three that are animal-derived and one that is a synthetic, are
specifically approved for the treatment of Respiratory Distress Syndrome in
premature infants. Exosurf(R) is synthetic and is marketed by GlaxoSmithKline,
plc, outside the United States and contains only phospholipids (the fats
normally present in the lungs) and synthetic organic detergents and no
stabilizing protein or peptides. Curosurf(R) is a porcine lung extract that is
marketed in Europe by Chiesi Farmaceutici S.p.A., and in the United States by
Dey Laboratories, Inc. Survanta(R), marketed by the Ross division of Abbott
Laboratories, Inc., is an extract of bovine lung that contains the cow version
of surfactant protein B. Forrest Laboratories, Inc., markets its calf lung
surfactant, Infasurf(R) in the United States for the treatment of Respiratory
Distress Syndrome in premature infants. Although none of the four approved
surfactants for Respiratory Distress Syndrome in premature infants is approved
for Acute Lung Injury or Acute Respiratory Distress Syndrome in adults, which
are significantly larger markets, there are a significant number of other
potential therapies in development for the treatment of Acute Lung Injury/Acute
Respiratory Distress Syndrome that are not surfactant-related. Any of these
various drugs or devices could significantly impact the commercial opportunity
for Surfaxin. We believe that engineered humanized surfactants such as Surfaxin
will be far less expensive to produce than the animal-derived products approved
for the treatment of Respiratory Distress Syndrome in premature infants and will
have no capability of transmitting the brain-wasting bovine spongiform
encephalopathy (commonly called "mad-cow disease") or causing adverse
immunological responses in young and older adults.

We also face, and will continue to face, competition from colleges,
universities, governmental agencies and other public and private research
organizations. These competitors are becoming more active in seeking patent
protection and licensing arrangements to collect royalties for use of technology
that they have developed. Some of these technologies may compete directly with
the technologies that we are developing. These institutions will also compete
with us in recruiting highly qualified scientific personnel. We expect that
therapeutic developments in the areas in which we are active may occur at a
rapid rate and that competition will intensify as advances in this field are
made. As a result, we need to continue to devote substantial resources and
efforts to research and development activities.

38

IF PRODUCT LIABILITY CLAIMS ARE BROUGHT AGAINST US, IT MAY RESULT IN REDUCED
DEMAND FOR OUR PRODUCTS OR DAMAGES THAT EXCEED OUR INSURANCE COVERAGE.

The clinical testing of, marketing and use of our products exposes us to product
liability claims in the event that the use or misuse of those products causes
injury, disease or results in adverse effects. Use of our products in clinical
trials, as well as commercial sale, could result in product liability claims. In
addition, sales of our products through third party arrangements could also
subject us to product liability claims. We presently carry product liability
insurance with coverages of up to $10,000,000 per occurrence and $10,000,000 in
the aggregate, an amount we consider reasonable and customary relating to our
clinical trials of Surfaxin. However, this insurance coverage includes various
deductibles, limitations and exclusions from coverage, and in any event might
not fully cover any potential claims. We may need to obtain additional product
liability insurance coverage prior to initiating other clinical trials. We
expect to obtain product liability insurance coverage before commercialization
of our proposed products; however, the insurance is expensive and insurance
companies may not issue this type of insurance when we need it. We may not be
able to obtain adequate insurance in the future at an acceptable cost. Any
product liability claim, even one that was not in excess of our insurance
coverage or one that is meritless and/or unsuccessful, could adversely affect
our cash available for other purposes, such as research and development. In
addition, the existence of a product liability claim could affect the market
price of our common stock.

WE EXPECT TO FACE UNCERTAINTY OVER REIMBURSEMENT AND HEALTHCARE REFORM.

In both the United States and other countries, sales of our products will depend
in part upon the availability of reimbursement from third party payors, which
include government health administration authorities, managed care providers and
private health insurers. Third party payors are increasingly challenging the
price and examining the cost effectiveness of medical products and services.

DIRECTORS, EXECUTIVE OFFICERS, PRINCIPAL STOCKHOLDERS AND AFFILIATED ENTITIES
OWN A SIGNIFICANT PERCENTAGE OF OUR CAPITAL STOCK, AND THEY MAY MAKE DECISIONS
THAT YOU DO NOT CONSIDER TO BE IN YOUR BEST INTEREST.

As of February 26, 2003, our directors, executive officers, principal
stockholders and affiliated entities beneficially owned, in the aggregate,
approximately 14% of our outstanding voting securities. As a result, if some or
all of them acted together, they would have the ability to exert substantial
influence over the election of our Board of Directors and the outcome of issues
requiring approval by our stockholders. This concentration of ownership may have
the effect of delaying or preventing a change in control of our company that may
be favored by other stockholders. This could prevent transactions in which
stockholders might otherwise recover a premium for their shares over current
market prices.

39

THE MARKET PRICE OF OUR STOCK MAY BE ADVERSELY AFFECTED BY MARKET VOLATILITY.

The market price of our common stock, like that of many other development stage
pharmaceutical or biotechnology companies, has been and is likely to be
volatile. In addition to general economic, political and market conditions, the
price and trading volume of our stock could fluctuate widely in response to many
factors, including:

- -- announcements of the results of clinical trials by us or our competitors;

- -- adverse reactions to products;

- -- governmental approvals, delays in expected governmental approvals or
withdrawals of any prior governmental approvals or public or regulatory
agency concerns regarding the safety or effectiveness of our products;

- -- changes in the United States or foreign regulatory policy during the
period of product development;

- -- developments in patent or other proprietary rights, including any third
party challenges of our intellectual property rights;

- -- announcements of technological innovations by us or our competitors;

- -- announcements of new products or new contracts by us or our competitors;

- -- actual or anticipated variations in our operating results due to the level
of development expenses and other factors;

- -- changes in financial estimates by securities analysts and whether our
earnings meet or exceed the estimates;

- -- conditions and trends in the pharmaceutical and other industries;

- -- new accounting standards; and

- -- the occurrence of any of the risks described in these "Management's
Discussion and Analysis - Risks Related to Our Business."

Our common stock is listed for quotation on the NASDAQ SmallCap Market. For the
12-month period ended December 31, 2002, the price of our common stock has
ranged from $0.90 to $4.19. We expect the price of our common stock to remain
volatile. The average daily trading volume in our common stock varies
significantly. For the 12-month period ending December 31, 2002, the average
daily trading volume in our common stock was approximately 50,072 shares and the
average number of transactions per day was approximately 57. Our relatively low
average volume and low average number of transactions per day may affect the
ability of our stockholders to sell their shares in the public market at
prevailing prices and a more active market may never develop.

In addition, we may not be able to continue to adhere to the strict listing
criteria of the SmallCap Market. If the common stock were no longer listed on
the SmallCap Market, investors might only be able to trade in the
over-the-counter market in the Pink Sheets(R) (a quotation medium operated by
the National Quotation Bureau, LLC) or on the OTC Bulletin Board(R) of the
National Association of Securities Dealers, Inc. This would impair the liquidity
of our securities not only in the number of shares that could be bought and sold
at a given price, which might be depressed by the relative illiquidity, but also
through delays in the timing of transactions and reduction in media coverage.

40

In the past, following periods of volatility in the market price of the
securities of companies in our industry, securities class action litigation has
often been instituted against companies in our industry. If we face securities
litigation in the future, even if meritless or unsuccessful, it would result in
substantial costs and a diversion of management attention and resources, which
would negatively impact our business.

A SUBSTANTIAL NUMBER OF OUR SECURITIES ARE ELIGIBLE FOR FUTURE SALE AND THIS
COULD AFFECT THE MARKET PRICE FOR OUR STOCK AND OUR ABILITY TO RAISE CAPITAL.

The market price of our common stock could drop due to sales of a large number
of shares of our common stock or the perception that these sales could occur. As
of February 26, 2003, we had 32,856,526 shares of common stock outstanding. In
addition, as of February 26, 2003, up to approximately 11,504,000 shares of our
common stock were issuable on exercise of outstanding options and warrants.

Holders of our stock options and warrants are likely to exercise them, if ever,
at a time when we otherwise could obtain a price for the sale of our securities
that is higher than the exercise price per security of the options or warrants.
This exercise, or the possibility of this exercise, may impede our efforts to
obtain additional financing through the sale of additional securities or make
this financing more costly, and may reduce the price of our common stock.

PROVISIONS OF OUR CERTIFICATE OF INCORPORATION AND DELAWARE LAW COULD DEFER A
CHANGE OF OUR MANAGEMENT WHICH COULD DISCOURAGE OR DELAY OFFERS TO ACQUIRE US.

Provisions of our Certificate of Incorporation and Delaware law may make it more
difficult for someone to acquire control of us or for our stockholders to remove
existing management, and might discourage a third party from offering to acquire
us, even if a change in control or in management would be beneficial to our
stockholders. For example, our Certificate of Incorporation allows us to issue
shares of preferred stock without any vote or further action by our
stockholders. Our Board of Directors has the authority to fix and determine the
relative rights and preferences of preferred stock. Our Board of Directors also
has the authority to issue preferred stock without further stockholder approval.
As a result, our Board of Directors could authorize the issuance of a series of
preferred stock that would grant to holders the preferred right to our assets
upon liquidation, the right to receive dividend payments before dividends are
distributed to the holders of common stock and the right to the redemption of
the shares, together with a premium, prior to the redemption of our common
stock. In addition, our Board of Directors, without further stockholder
approval, could issue large blocks of preferred stock.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk is confined to our cash, cash equivalents and
available for sale securities. We place our investments with high quality
issuers and, by policy, limit the amount of credit exposure to any one issuer.
We currently do not hedge interest rate or currency exchange exposure. We
classify highly liquid investments purchased with a maturity of three months or
less as "cash equivalents" and commercial paper and fixed income mutual funds as

41

"available for sale securities." Fixed income securities may have their fair
market value adversely affected due to a rise in interest rates and we may
suffer losses in principal if forced to sell securities that have declined in
market value due to a change in interest rates.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

See Index to Consolidated Financial Statements on Page F-1.

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

Not Applicable.

42

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

Information called for by Item 10 with respect to directors, executive officers
and compliance with Section 16(a) of the Securities Act may be found in the
sections captioned "Nominees for Election to the Board of Directors," "Executive
Officers" " and "Section 16(a) Beneficial Ownership Reporting Compliance"
appearing in our definitive Proxy Statement and is hereby incorporated by
reference to such Proxy Statement, which is expected to be filed within 120 days
after the close of our fiscal year.

ITEM 11. EXECUTIVE COMPENSATION.

Information called for by Item 11 is hereby incorporated by reference to the
information in our definitive proxy statement under the heading "Executive
Compensation," which is expected to be filed by us within 120 days after the
close of our fiscal year.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.

Information called for by Item 12 is hereby incorporated by reference to the
information in our definitive proxy statement under the heading "Security
Ownership of Directors, Officers and Certain Beneficial Owners," which is
expected to be filed by us within 120 days after the close of our fiscal year.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

Information called for by Item 13 is hereby incorporated by reference to the
information in our definitive proxy statement under the heading "Certain
Relationships and Related Transactions," which is expected to be filed by us
within 120 days after the close of our fiscal year.

ITEM 14. CONTROLS AND PROCEDURES.

Our Chief Executive Officer, Chief Operating Officer, Chief Financial Officer
and Chief Accounting Officer, after evaluating the effectiveness of our
"disclosure controls and procedures" (as defined in Rules 13a-14(c) and
15d-14(c) of the Securities Exchange Act of 1934) as of a date within 90 days
before the filing date of this annual report, have concluded that as of the time
of such evaluation, our disclosure controls and procedures were effective in
ensuring that information required to be disclosed by us in this annual report
is accumulated and communicated by our management, to allow timely decisions
regarding required disclosure.

There were no significant changes in our internal controls or other factors that
could significantly affect our disclosure controls and procedures subsequent to
the date of their evaluation and there were no corrective actions with regard to
significant deficiencies and material weaknesses.

43

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.

(a) EXHIBITS

Exhibits are listed on the Index to Exhibits at the end of this Annual Report.
The exhibits required by Item 601 of Regulation S-K, listed on such Index in
response to this Item, are incorporated herein by reference.

(b) REPORTS ON FORM 8-K

We filed two Current Reports on Form 8-K during the three months ended December
31, 2002. A Current Report was filed on November 12, 2002, reporting our
completion of a private placement of approximately 6.4 million shares of our
common stock and approximately 2.8 million warrants to purchase our common
stock. On December 19, 2002, a Current Report was filed reporting a delay in our
ongoing Phase 2 clinical trial for Acute Respiratory Distress Syndrome in adults
due to an interruption in the supply of Surfaxin caused by operational
difficulties experienced by Akorn.

44

SIGNATURES

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

DISCOVERY LABORATORIES, INC.

Date: March 31, 2003 By: /s/ Robert J. Capetola
-------------- --------------------------
Robert J. Capetola, Ph.D.
President and
Chief Executive Officer

In accordance with the Exchange Act, this Report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.

SIGNATURE NAME & TITLE DATE
--------- ------------ ----

/s/ Robert J. Capetola
- ------------------------------- Robert J. Capetola, Ph.D. March 31, 2003
President and Chief Executive Officer

/s/ John G. Cooper
- ------------------------------- John G. Cooper March 31, 2003
Senior Vice President and Chief Financial Officer

/s/ Cynthia Davis
- ------------------------------- Cynthia Davis March 31, 2003
Vice President, Administrative Operations and
Controller
(Principal Accounting Officer)

/s/ Herbert H. McDade, Jr.
- ------------------------------- Herbert H. McDade, Jr. March 31, 2003
Chairman of the Board of Directors

/s/ Marvin E. Rosenthale
- ------------------------------- Marvin E. Rosenthale, Ph.D. March 31, 2003
Director

/s/ Max E. Link
- ------------------------------- Max E. Link, Ph.D. March 31, 2003
Director

/s/ Antonio Esteve
- ------------------------------- Antonio Esteve, Ph.D. March 31, 2003
Director

45

CERTIFICATIONS

CERTIFICATIONS PURSUANT TO
SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002

I, Robert J. Capetola, certify that:

1. I have reviewed this annual report on Form 10-K of Discovery Laboratories,
Inc.;

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report is
being prepared;

b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;

5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

46

b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officer and I have indicated in this annual
report whether there were significant changes in internal controls or in other
factors that could significantly affect internal controls subsequent to the date
of our most recent evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.

Date: March 31, 2003 /s/ Robert J. Capetola
-------------- -----------------------------------
Robert J. Capetola, Ph.D. President and
Chief Executive Officer

47

CERTIFICATIONS PURSUANT TO
SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002

I, John G. Cooper, certify that:

1. I have reviewed this annual report on Form 10-K of Discovery Laboratories,
Inc.;

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report is
being prepared;

b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;

5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and

48

6. The registrant's other certifying officer and I have indicated in this annual
report whether there were significant changes in internal controls or in other
factors that could significantly affect internal controls subsequent to the date
of our most recent evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.

Date: March 31, 2003 /s/ John G. Cooper
--------------- --------------------------------
John G. Cooper
Senior Vice President and
Chief Financial Officer

49

EXHIBIT INDEX

EXHIBIT NO. DESCRIPTION

2.1(1) Agreement and Plan of Merger dated as of March 5, 1998, among Discovery, ATI Acquisition Corp. and Old
ATI.

2.2(3) Agreement and Plan of Reorganization and Merger, dated as of July 16, 1997, by and between Discovery
and Old Discovery.

3.1 Restated Certificate of Incorporation of Discovery, dated September 18, 2002.

3.2(2) By-laws of Discovery.

3.3(10) Certificate of Ownership Merging ATI Acquisition Corp., into Discovery.

4.1(6) Form of Class C Warrant.

4.2(9) Class E Warrant issued to PharmaBio.

4.3(10) Unit Purchase Option issued to Paramount Capital, Inc., in connection with the March 1999 private
placement.

4.4(14) Form of Class F Warrant.

4.5(15) Form of Class G Warrant issued to PharmaBio.

4.6(15) Form of Class H Warrant issued to PharmaBio.

4.7(15) Form of Promissory Note issued to PharmaBio.

4.8(23) Form of Class I Warrant.

4.9 Promissory Note issued to General Electric Capital Corporation

10.1 Reference is made to Exhibits 2.1 and 2.2.

10.2(1) Investor Rights Agreement, dated as of March 20, 1996, between Old Discovery and RAQ, LLC.

10.3(1) Registration Rights Agreement, dated as of October 28, 1996, between ATI, Johnson & Johnson Development
Corporation ("JJDC"), and The Scripps Research Institute ("Scripps").

10.4(4)+ Sublicense Agreement, dated as of October 28, 1996, between ATI, Johnson & Johnson, Inc., and Ortho
Pharmaceutical Corporation.

10.5(2) Restated 1993 Stock Option Plan of Discovery.

10.6(2) 1995 Stock Option Plan of Discovery.

10.7(22) Amended and Restated 1998 Stock Incentive Plan of Discovery (amended as of September 13, 2002).

10.8(6) Indenture of Lease, dated as of July 1, 1998, between SLT1, LLC and Discovery Laboratories, Inc.

10.9(12) Amendment, dated as of September 15, 2000, to the Indenture of Lease dated as of July 1, 1998, between
SLT1, LLC and Discovery.

10.10(6) Registration Rights Agreement, dated as of June 16, 1998, among Discovery, JJDC and Scripps.

10.11(6) Stock Exchange Agreement, dated as of June 16, 1998, between Discovery and JJDC.

10.12(12) Employment Agreement, dated January 1, 2001, between Discovery and Robert J. Capetola, Ph.D.

10.13(18) Employment Agreement, dated as of June 16, 2001, between Discovery and Christopher J. Schaber.

10.14(18) Employment Agreement, dated as of June 16, 2001, between Discovery and Cynthia Davis.

10.15(6) Form of Intellectual Property and Confidential Information Agreement.

10.16(6) Form of Stock Purchase Agreement Under the 1998 Stock Incentive Plan of Discovery.

10.17(8) Notice of Grant of Stock Option.

10.18(10) Securities Purchase Agreement between Discovery and Laboratorios P.E.N., S.A., dated October 26, 1999.

10.19(10)+ Research Funding and Option Agreement, dated as of March 1, 2000, between Discovery and Scripps.

10.20(13) Amended and Restated 1998 Stock Incentive Plan of Discovery, amended on June 15, 2001.

10.21(18) Employment Agreement, dated as of December 1, 2001, between Discovery and Ralph Niven, Ph.D.

10.22(18) Employment Agreement, dated as of December 11, 2001, between Discovery and John G. Cooper.

10.23(18) Employment Agreement, dated as of August 15, 2000, between Discovery and Deni M. Zodda, Ph.D.

10.24(16)+ Commercialization Agreement, dated as of December 10, 2001, between Discovery and Quintiles.

10.25(16)+ Investment and Commission Agreement, dated as of December 10, 2001, between Discovery and PharmaBio.

10.26(16) Common Stock and Warrant Purchase Agreement, dated as of December 10, 2001, between Discovery and
PharmaBio.

10.27(16)+ Loan Agreement, dated as of December 10, 2001, between Discovery and PharmaBio.

10.28(17)+ Sublicense and Collaboration Agreement, dated as of March 6, 2002, between Discovery and Laboratorios
del Dr. Esteve ("Esteve").

10.29(17)+ Supply Agreement, dated as of March 6, 2002, between Discovery and Esteve.

10.30(17) Common Stock Purchase Agreement, dated as of March 6, 2002, between Discovery and Esteve.

10.31(19) Form of Common Stock and Warrant Purchase Agreement, dated November 5, 2002, between Discovery and certain
investors.

10.32 Master Security Agreement, dated December 23, 2002, between Discovery and General Electric Capital
Corporation.

10.33 Amendment, dated December 23, 2003, to the Master Security Agreement between Discovery and General
Electric Capital Corporation.

16.1(5) Letter dated as of January 28, 1998, from Ernst & Young LLP to the Securities and Exchange Commission.

16.2(11) Letter dated January 9, 2001, from Eisner LLP, to the Securities and Exchange Commission.

21.1(1) Subsidiaries of Discovery.

23.1 Consent of Eisner LLP.

23.2 Consent of Ernst & Young LLP

99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

99.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

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

(1) Incorporated by reference to Discovery's Annual Report on Form 10-KSB for
the year ending December 31, 1997.

(2) Incorporated by reference to Discovery's Registration Statement on Form
SB-2 (File No. 33-92-886).

(3) Incorporated by reference to Discovery's Registration Statement on Form
S-4 (File No. 333-34337).

(4) Incorporated by reference to Discovery's Registration Statement on Form
SB-2 (File No. 333-19375).

(5) Incorporated by reference to Discovery's Current Report on Form 8-K/A
dated January 16, 1998.

(6) Incorporated by reference to Discovery's Annual Report on Form 10-KSB for
the year ending December 31, 1998.

(7) Incorporated by reference to Discovery's Proxy Statement on Schedule 14A
filed June 1, 1999.

(8) Incorporated by reference to Discovery's Quarterly Report on Form 10-QSB
for the quarter ending September 30, 1999.

(9) Incorporated by reference to Discovery's Current Report on Form 8-K filed
March 29, 2000.

(10) Incorporated by reference to Discovery's Annual Report on Form 10-KSB for
the year ending December 31, 1999.

(11) Incorporated by reference to Discovery's Amended Current Report on Form
8-K/A filed January 9, 2001.

(12) Incorporated by reference to Discovery's Annual Report on Form 10-KSB for
the year ending December 31, 2000.

(13) Incorporated by Reference to Discovery's Quarterly Report on Form 10-QSB
for the quarter ending June 30, 2001.

(14) Incorporated by Reference to Discovery's Current Report on Form 8-K filed
October 5, 2001.

(15) Incorporated by Reference to Discovery's Current Report on Form 8-K filed
December 19, 2001.

(16) Incorporated by Reference to Discovery's Amended Current Report on Form
8-K/A filed January 14, 2002.

(17) Incorporated by Reference to Discovery's Current Report on Form 8-K filed
March 8, 2002.

(18) Incorporated by Reference to Discovery's Annual Report on Form 10-KSB for
the year ending December 31, 2001.

(19) Incorporated by Reference to Discovery's Current Report on Form 8-K filed
November 12, 2002.

+ Confidential treatment requested as to certain portions of these exhibits.
Such portions have been redacted and filed separately with the Commission.

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

CONTENTS

PAGE
----

CONSOLIDATED FINANCIAL STATEMENTS

Reports of independent auditors F-2

Balance sheets as of December 31, 2002 and December 31, 2001 F-4

Statements of operations for the years ended December 31, 2002, 2001 and 2000, and the
period from May 18, 1993 (inception), through December 31, 2002 F-5

Statements of changes in stockholders' equity for the period from May 18, 1993 (inception),
through December 31, 2002 F-6

Statements of cash flows for the years ended December 31, 2002, 2001 and 2000, and the
period from May 18, 1993 (inception), through December 31, 2002 F-8

Notes to consolidated financial statements:

Note 1 - The Company and Basis of Presentation F-9

Note 2 - Summary of Significant Accounting Policies F-10

Note 3 - Investments F-11

Note 4 - Note Receivable F-12

Note 5 - Property and Equipment F-12

Note 6 - Income Taxes F-12

Note 7 - License, Research Funding, and Commercialization Agreements F-13

Note 8 - Stockholders' Equity F-15

Note 9 - Stock Options F-17

Note 10 - Commitments F-19

Note 11 - Related Party Transactions F-19

Note 12 - Selected Quarterly Financial Data (unaudited) F-20

F-1

REPORT OF INDEPENDENT AUDITORS

Board of Directors and Stockholders
Discovery Laboratories, Inc.
Doylestown, Pennsylvania

We have audited the accompanying consolidated balance sheets of Discovery
Laboratories, Inc. (a development stage enterprise) as of December 31, 2002 and
2001, and the related consolidated statements of operations, changes in
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 2002, and for the period May 18, 1993 (inception) through
December 31, 2002. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits. The consolidated financial statements
for the period May 18, 1993 (inception) through December 31, 1999 include total
revenues and net loss of $1,673,000 and $32,446,000, respectively. Our opinion
on the consolidated statements of operations, stockholders' equity, and cash
flows for the period May 18, 1993 (inception) through December 31, 2002, insofar
as it relates to amounts for prior periods through December 31, 1999, is based
solely on the report of other auditors.

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

In our opinion, based on our audits and the report of other auditors, the
financial statements referred to above present fairly, in all material respects,
the consolidated financial position of Discovery Laboratories, Inc. (a
development stage enterprise) at December 31, 2002 and 2001, and the
consolidated results of its operations and its cash flows for each of the three
years in the period ended December 31, 2002, and for the period May 18, 1993
(inception) through December 31, 2002, in conformity with accounting principles
generally accepted in the United States.

/s/ Ernst & Young LLP

Philadelphia, Pennsylvania
February 26, 2003

F-2

INDEPENDENT AUDITOR'S REPORT

Board of Directors and Stockholders
Discovery Laboratories, Inc.
Doylestown, Pennsylvania

We have audited the consolidated statements of operations, changes in
stockholders' equity and cash flows of Discovery Laboratories, Inc. and
subsidiary's (a development stage company) for the period from May 18, 1993
(inception) through December 31, 1999. The consolidated statements of operations
and cash flows are not presented separately herein. 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 audit 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 audit provides a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements enumerated above present
fairly, in all material respects, the consolidated results of operations and
consolidated cash flows of Discovery Laboratories, Inc. and subsidiary for the
period from May 18, 1993 (inception) through December 31, 1999, in conformity
with accounting principles generally accepted in the United States of America.

/s/ Eisner LLP

New York, New York
February 25, 2000

F-3

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

CONSOLIDATED BALANCE SHEETS

December 31,
-----------------------------
2002 2001
------------ -------------

ASSETS

Current assets:
Cash and cash equivalents $ 8,538,000 $ 3,758,000
Available-for-sale marketable securities 10,652,000 12,938,000
Note receivable - current 2,000 2,000
Prepaid expenses and other current assets 325,000 1,580,000
------------ ------------
Total current assets 19,517,000 18,278,000

Property and equipment, net of accumulated depreciation 1,231,000 822,000
Note receivable, net of current portion 195,000 197,000
Other assets 119,000 768,000
------------ ------------
Total assets $ 21,062,000 $ 20,065,000
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable and accrued expenses $ 3,013,000 $ 1,750,000
Capitalized lease - current 189,000 44,000
------------ ------------
Total current liabilities 3,202,000 1,794,000

Deferred revenue 1,393,000 615,000
Credit facility with corporate partner 1,450,000 --
Capitalized lease, net of current portion 256,000 33,000
------------ ------------
Total liabilities 6,301,000 2,442,000

Stockholders' Equity:
Common stock, $.001 par value; 60,000,000 authorized;
32,856,526 and 25,546,293 shares issued and outstanding
at December 31, 2002 and 2001, respectively 33,000 26,000
Additional paid-in capital 87,463,000 73,163,000
Unearned portion of compensatory stock options (95,000) (264,000)
Deficit accumulated during the development stage (72,578,000) (55,135,000)
Treasury stock (at cost; 38,243 shares of
common stock at December 31, 2002 and 2001) (239,000) (239,000)
Accumulated other comprehensive income 177,000 72,000
------------ ------------
Total stockholders' equity 14,761,000 17,623,000
------------ ------------
$ 21,062,000 $ 20,065,000
============ ============

See notes to consolidated financial statements

F-4

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

CONSOLIDATED STATEMENTS OF OPERATIONS

May 18, 1993
(inception)
Year Ended through
December 31, December 31,
------------ -------------
2002 2001 2000 2002
------------ ------------ ------------ ------------

Revenues:
Research and development
collaborative agreements $ 1,782,000 $ 1,112,000 $ 741,000 $ 3,840,000
------------ ------------ ------------ ------------
Expenses:
Research and development 14,347,000 8,007,000 7,494,000 42,717,000
General and administrative 5,458,000 5,067,000 5,145,000 23,425,000
Write-off of acquired in-process
research and development
and supplies -- -- -- 13,508,000
------------ ------------ ------------ ------------
Total expenses 19,805,000 13,074,000 12,639,000 79,650,000
------------ ------------ ------------ ------------
Operating loss (18,023,000) (11,962,000) (11,898,000) (75,810,000)

Other income and expense:
Interest income, dividends, realized
gains, and other income 724,000 842,000 1,042,000 4,076,000
Minority interest in net loss of subsidiary -- -- -- 26,000
Interest expense (144,000) (26,000) (5,000) (188,000)
------------ ------------ ------------ ------------
Net loss $(17,443,000) $(11,146,000) $(10,861,000) $(71,896,000)
============ ============ ============ ============
Net loss per common share -
basic and diluted $ (0.64) $ (0.51) $ (0.58)

Weighted average number of common
shares outstanding -
basic and diluted 27,350,835 22,038,067 18,806,265

See notes to consolidated financial statements

F-5

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

Consolidated Statements of Changes in Stockholders' Equity
May 18, 1993 (Inception) Through December 31, 2002

Preferred Stock
------------------------------------------
Common Stock Series B Stock Series C Stock Additional
------------------ ------------------------------------------ Paid-in
Shares Amount Shares Amount Shares Amount Capital
----------------------------------------------------------------------------

Issuance of common stock, May 1993 440,720 $ 1,000 $ 1,000

Expenses paid on behalf of the Company, 1993

Payment on stock subscriptions, 1995

Issuance of common stock, February 1995 143,016 1,000

Expenses paid on behalf of the Company, 1995 18,000

Issuance of common stock, March 1996 1,070,175 1,000 5,000

Issuance of private placement units
August, October and November 1996 856,138 1,000 2,200,256 $ 2,000 18,933,000

Issuance of common stock for cash and
compensation, September 1996 82,502 42,000

Exercise of stock options,
1996, 1997, 1998, 1999, 2000 820,438 587,000

Private placement expenses, 1997 (11,000)

Issuance of common stock pursuant to
Ansan Merger, November 1997 546,433 2,459,000

Accumulated dividends preferred stock, 1997

Issuance of common stock pursuant to
ATI Merger, June 1998 1,033,500 1,000 5,037,000

Fair value of Common Stock issuabe on
Exercise of ATI options, 1998 2,966,000

Series C preferred stock issued pursuant to
ATI Merger, June 1998 2,039 $2,039,000

Accrued dividends payable on Series C
Preferred stock at time of ATI Merger,
1998 238,000

Common Stock issued in settlement of
Series C preferred stock dividends, 1998 49,846 (204,000) 204,000

Common Stock and warrants in a private
placement offering in March and April 1999 826,447 1,000 999,000

Issuance of private placement units in July
and August 1999 (net of offering costs) 2,024,792 2,000 2,231,000

Common Stock issued in connection with
sublicense agreement, 1999 317,164 1,000 563,000

Series B preferred stock converted, 1998,
1999, 2000 6,746,219 7,000 (2,200,256) (2,000) (5,000)

Noncash exercise of private placement
warrants, 1998 8,372

Common Stock issued in payment for services,
1998, 1999, 2000 30,664 94,000

Compensatory stock options granted 37,000

Dividends payable on Series C preferred
stock, 1998, 1999, 2000 444,000

Treasury stock acquired, 1998, 1999

Treasury stock issued in payment for
services, 1998, 1999, 2000 14,000

Unrealized gain (loss) on Available-for-sale
marketable securities, 1998, 1999

Fair value of options granted, 1998 142,000

Amortization of unearned portion of
Compensatory stock options, 1998, 1999

Common placement warrant conversions, 2000 18,232

Preferred placement warrant conversions,
2000 18,511

Exercise of class C & D warrant conversions,
2000 2,536,911 3,000 3,792,000

Compensation charge on vesting of options
and warrants, 2000 2,330,000

Compensatory stock options and warrants
granted, 2000 495,000

Series C preferred stock conversions, 2000 398,186 (2,039) (2,517,000) 2,517,000

Issuance of private placement units, 2000 2,902,846 3,000 17,440,000

Other comprehensive income - unrealized gain
on marketable securities available-for-
sale

Net loss, Inception through 12/31/00
------------ --------- ----------- --------- ------- ----------- -------------
Balance - December 31, 2000 20,871,112 $ 21,000 0 $60,891,000
------------ --------- ----------- --------- ------- ----------- -------------
(carried forward)

Unearned Deficit
Portion of Accumulated
Compensatory During Treasury Stock
Stock Development -------------------------
Options Stage Shares Amount
-------------------------------------------------------

Issuance of common stock, May 1993

Expenses paid on behalf of the Company, 1993

Payment on stock subscriptions, 1995

Issuance of common stock, February 1995

Expenses paid on behalf of the Company, 1995

Issuance of common stock, March 1996

Issuance of private placement units
August, October and November 1996

Issuance of common stock for cash and
compensation, September 1996

Exercise of stock options,
1996, 1997, 1998, 1999, 2000 (31,743) $ (245,000)

Private placement expenses, 1997

Issuance of common stock pursuant to
Ansan Merger, November 1997

Accumulated dividends preferred stock, 1997 $ (238,000)

Issuance of common stock pursuant to
ATI Merger, June 1998

Fair value of Common Stock issuabe on
Exercise of ATI options, 1998

Series C preferred stock issued pursuant to
ATI Merger, June 1998

Accrued dividends payable on Series C
Preferred stock at time of ATI Merger,
1998

Common Stock issued in settlement of
Series C preferred stock dividends, 1998

Common Stock and warrants in a private
placement offering in March and April 1999

Issuance of private placement units in July
and August 1999 (net of offering costs)

Common Stock issued in connection with
sublicense agreement, 1999

Series B preferred stock converted, 1998,
1999, 2000

Noncash exercise of private placement
warrants, 1998

Common Stock issued in payment for services,
1998, 1999, 2000

Compensatory stock options granted $ (37,000)

Dividends payable on Series C preferred
stock, 1998, 1999, 2000 (444,000)

Treasury stock acquired, 1998, 1999 (33,750) $ (95,000)

Treasury stock issued in payment for
services, 1998, 1999, 2000 38,750 127,000

Unrealized gain (loss) on Available-for-sale
marketable securities, 1998, 1999

Fair value of options granted, 1998 (142,000)

Amortization of unearned portion of
Compensatory stock options, 1998, 1999 142,000

Common placement warrant conversions, 2000

Preferred placement warrant conversions,
2000

Exercise of class C & D warrant conversions,
2000

Compensation charge on vesting of options
and warrants, 2000

Compensatory stock options and warrants
granted, 2000 (310,000)

Series C preferred stock conversions, 2000

Issuance of private placement units, 2000

Other comprehensive income - unrealized gain
on marketable securities available-for-
sale

Net loss, Inception through 12/31/00 (43,307,000)
------------ ------------- ------------ -------------
Balance - December 31, 2000 $ (347,000) $(43,989,000) (26,743) $ (213,000)
------------ ------------- ------------ -------------
(carried forward)

Accumulated
Stock Other
Subscriptions Comprehensive
Receivable Loss Total
-----------------------------------------

Issuance of common stock, May 1993 $ (2,000) $ --

Expenses paid on behalf of the Company, 1993 1,000 1,000

Payment on stock subscriptions, 1995 2,000 2,000

Issuance of common stock, February 1995 (1,000) --

Expenses paid on behalf of the Company, 1995 18,000

Issuance of common stock, March 1996 6,000

Issuance of private placement units
August, October and November 1996 18,936,000

Issuance of common stock for cash and
compensation, September 1996 42,000

Exercise of stock options,
1996, 1997, 1998, 1999, 2000 342,000

Private placement expenses, 1997 (11,000)

Issuance of common stock pursuant to
Ansan Merger, November 1997 2,459,000

Accumulated dividends preferred stock, 1997 (238,000)

Issuance of common stock pursuant to
ATI Merger, June 1998 5,038,000

Fair value of Common Stock issuabe on
Exercise of ATI options, 1998 2,966,000

Series C preferred stock issued pursuant to
ATI Merger, June 1998 2,039,000

Accrued dividends payable on Series C
Preferred stock at time of ATI Merger,
1998 238,000

Common Stock issued in settlement of
Series C preferred stock dividends, 1998 --

Common Stock and warrants in a private
placement offering in March and April 1999 1,000,000

Issuance of private placement units in July
and August 1999 (net of offering costs) 2,233,000

Common Stock issued in connection with
sublicense agreement, 1999 564,000

Series B preferred stock converted, 1998,
1999, 2000 --

Noncash exercise of private placement
warrants, 1998 --

Common Stock issued in payment for services,
1998, 1999, 2000 94,000

Compensatory stock options granted --

Dividends payable on Series C preferred
stock, 1998, 1999, 2000 --

Treasury stock acquired, 1998, 1999 (95,000)

Treasury Stock issued in payment for
services, 1998, 1999, 2000 141,000

Unrealized gain (loss) on Available-for-sale
marketable securities, 1998, 1999 --

Fair value of options granted, 1998 --

Amortization of unearned portion of
Compensatory stock options, 1998, 1999 142,000

Common placement warrant conversions, 2000 --

Preferred placement warrant conversions, --
2000

Exercise of class C & D warrant conversions,
2000 3,795,000

Compensation charge on vesting of options
and warrants, 2000 2,330,000

Compensatory stock options and warrants
granted, 2000 185,000

Series C preferred stock conversions, 2000 --

Issuance of private placement units, 2000 17,443,000

Other comprehensive income - unrealized gain
on marketable securities available-for-
sale 73,000 73,000

Net loss, Inception through 12/31/00 (43,307,000)
------------ ------------- ------------
Balance - December 31, 2000 $ -- $ 73,000 $16,436,000
------------ ------------- ------------
(carried forward)

F-6

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

Consolidated Statements of Changes in Stockholders' Equity
May 18, 1993 (Inception) Through December 31, 2002

Preferred Stock
------------------------------------------
Common Stock Series B Stock Series C Stock Additional
------------------ ------------------------------------------ Paid-in
Shares Amount Shares Amount Shares Amount Capital
----------------------------------------------------------------------------

(brought forward)
------------ --------- ----------- --------- ------- ----------- -------------
Balance - December 31, 2000 20,871,112 21,000 -- -- -- -- (60,891,000)
------------ --------- ----------- --------- ------- ----------- -------------
Comprehensive loss:

Net loss

Other comprehensive loss - unrealized loss
on marketable securities available-for-
sale

Total comprehensive loss

Exercise of stock options 6,224 2,000

Common Stock issued in payment for services 10,902 42,000

Compensation charge on modifications of
options 109,000

Compensatory stock options and warrants
granted/earned 325,000

Common Stock issued in April 2001
private financing 296,560 998,000

Common Stock and warrants issued in
October 2001 private financing 3,562,759 4,000 7,256,000

Common Stock and warrants issued in
December 2001 791,905 1,000 3,540,000

Placement agent warrant exercise 6,831

Purchase of Treasury Stock
------------ --------- ----------- --------- ------- ----------- -------------
Balance - December 31, 2001 25,546,293 $ 26,000 -- $ -- -- $ -- $ 73,163,000
------------ --------- ----------- --------- ------- ----------- -------------
Comprehensive loss:

Net loss

Other comprehensive loss - unrealized loss
on marketable securities available-for-
sale

Total comprehensive loss

Exercise of stock options 77,925 60,000

Common Stock issued in lieu of payment for
services 6,086 26,000

Compensation charge on modification of
options 171,000

Compensation charge on vesting of options
and warrants 63,000

Common Stock issued in March 2002 private
financing 821,862 2,666,000

Private financing expenses (5,000)

Common Stock issued in November 2002 private
financing 6,397,517 7,000 11,937,000

Change in value of Class H warrants (618,000)

Conversion of warrants 6,843
------------ --------- ----------- --------- ------- ----------- -------------
Balance - December 31, 2002 32,856,526 $ 33,000 -- $ -- -- $ -- $ 87,463,000
============ ========= =========== ========= ======= =========== =============

Unearned Deficit
Portion of Accumulated
Compensatory During Treasury Stock
Stock Development -------------------------
Options Stage Shares Amount
-------------------------------------------------------

(brought forward)
------------ ------------- ------------ -------------
Balance - December 31, 2000 (347,000) (43,989,000) (26,743) (213,000)
------------ ------------- ------------ -------------
Comprehensive loss:

Net loss (11,146,000)

Other comprehensive loss - unrealized loss
on marketable securities available-for-
sale

Total comprehensive loss

Exercise of stock options

Common Stock issued in payment for services

Compensation charge on modifications of
options

Compensatory stock options and warrants
granted/earned 83,000

Common Stock issued in April 2001
private financing

Common Stock and warrants issued in
October 2001 private financing

Common Stock and warrants issued in
December 2001

Placement agent warrant exercise

Purchase of Treasury Stock (11,500) (26,000)
------------ ------------- ------------ -------------
Balance - December 31, 2001 $ (264,000) $(55,135,000) (38,243) $ (239,000)
------------ ------------- ------------ -------------
Comprehensive loss:

Net loss (17,443,000)

Other comprehensive loss - unrealized loss
on marketable securities available-for-
sale

Total comprehensive loss

Exercise of stock options

Common Stock issued in lieu of payment for
services

Compensation charge on modification of
options

Compensation charge on vesting of options
and warrants 169,000

Common Stock issued in March 2002 private
financing

Private financing expenses

Common Stock issued in November 2002 private
financing

Change in value of Class H warrants

Conversion of warrants
------------ ------------- ------------ -------------
Balance - December 31, 2002 $ (95,000) $(72,578,000) (38,243) $ (239,000)
============ ============= ============ =============

Accumulated
Stock Other
Subscriptions Comprehensive
Receivable Loss Total
-----------------------------------------

(brought forward)
------------ ------------ ------------
Balance - December 31, 2000 -- 73,000 16,436,000
------------ ------------ ------------
Comprehensive loss:

Net loss (11,146,000)

Other comprehensive loss - unrealized loss
on marketable securities available-for-
sale (1,000) (1,000)
-------------
Total comprehensive loss (11,147,000)

Exercise of stock options 2,000

Common Stock issued in payment for services 42,000

Compensation charge on modifications of
options 109,000

Compensatory stock options and warrants
granted/earned 408,000

Common Stock issued in April 2001
private financing 998,000

Common Stock and warrants issued in
October 2001 private financing 7,260,000

Common Stock and warrants issued in
December 2001 3,541,000

Placement agent warrant exercise --

Purchase of Treasury Stock (26,000)
------------ ------------ ------------
Balance - December 31, 2001 $ -- $ 72,000 17,623,000
------------ ------------ ------------
Comprehensive loss:

Net loss (17,443,000)

Other comprehensive loss - unrealized loss
on marketable securities available-for-
sale 105,000 105,000
-------------
Total comprehensive loss (17,338,000)

Exercise of stock options 60,000

Common Stock issued in lieu of payment for
services 26,000

Compensation charge on modification of
options 171,000

Compensation charge on vesting of options
and warrants 232,000

Common Stock issued in March 2002 private
financing 2,666,000

Private financing expenses (5,000)

Common Stock issued in November 2002 private
financing 11,944,000

Change in value of Class H warrants (618,000)

Conversion of warrants --
------------ ------------ ------------
Balance - December 31, 2002 $ -- $ 177,000 14,761,000
============ ============= ============

See notes to consolidated financial statements

F-7

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

CONSOLIDATED STATEMENTS OF CASH FLOWS

May 18, 1993
(inception)
Year Ended through
December 31, December 31,
2002 2001 2000 2002
------------ ------------ ------------ ------------

CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(17,443,000) $(11,146,000) $(10,861,000) $(71,896,000)
Adjustments to reconcile net loss to net cash used
in operating activities:
Write-off of acquired in-process research
and development and supplies -- -- -- 13,508,000
Write-off of licenses -- -- -- 683,000
Depreciation and amortization 285,000 205,000 123,000 829,000
Compensatory stock options 403,000 517,000 2,515,000 3,577,000
Expenses paid using treasury stock and common stock 26,000 42,000 84,000 230,000
Loss on sale of property -- -- 4,000 4,000
Changes in: --
Prepaid expenses, inventory and other current assets 1,255,000 (876,000) 492,000 836,000
Accounts payable and accrued expenses 1,263,000 (632,000) 1,957,000 2,880,000
Other assets (2,000) (18,000) 15,000 (23,000)
Proceeds from research and development
collaborative agreements 1,833,000 -- 605,000 3,474,000
Amortization of deferred revenue (1,055,000) (791,000) (790,000) (2,636,000)
Expenses paid on behalf of company -- -- -- 18,000
Employee stock compensation -- -- -- 42,000
Reduction of research and development supplies -- -- -- (161,000)
------------ ------------ ------------ ------------
Net cash used in operating activities (13,435,000) (12,699,000) (5,856,000) (48,635,000)
------------ ------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (227,000) (257,000) (948,000) (1,978,000)
Proceeds from sale of property and equipment -- -- 550,000 575,000
Loan to related party -- (200,000) -- (200,000)
Related party loan payments received 2,000 1,000 -- 3,000
Acquisition of licenses -- -- -- (711,000)
Purchase of marketable securities (8,569,000) (10,676,000) (11,514,000) (52,504,000)
Proceeds from sale or maturity of marketable securities 10,960,000 9,324,000 -- 42,434,000
Net cash payments on merger -- -- -- (1,670,000)
------------ ------------ ------------ ------------
Net cash provided by (used in) investing activities 2,166,000 (1,808,000) (11,912,000) (14,051,000)
------------ ------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of securities, net of expenses 14,665,000 11,033,000 21,517,000 70,009,000
Proceeds from credit facility 1,450,000 -- -- 1,450,000
Purchase of treasury stock -- (26,000) -- (121,000)
Principal payments under capital lease obligation (66,000) (23,000) (15,000) (114,000)
------------ ------------ ------------ ------------
Net cash provided by financing activities 16,049,000 10,984,000 21,502,000 71,224,000
------------ ------------ ------------ ------------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS 4,780,000 (3,523,000) 3,734,000 8,538,000
Cash and cash equivalents - beginning of period 3,758,000 7,281,000 3,547,000 --
------------ ------------ ------------ ------------
CASH AND CASH EQUIVALENTS - END OF PERIOD $ 8,538,000 $ 3,758,000 $ 7,281,000 $ 8,538,000
============ ============ ============ ============
SUPPLEMENTARY DISCLOSURE OF CASH FLOWS INFORMATION:
Interest Paid: $ 88,000 $ 26,000 $ 5,000 $ 132,000
NONCASH TRANSACTIONS:
Class H warrants issued/revalued $ (618,000) $ 768,000 $ -- $ 150,000
Accrued dividends on Series C preferred stock -- -- 36,000 682,000
Series C preferred stock dividends paid using common stock -- -- -- 204,000
Preferred Stock issued for inventory -- -- -- 575,000
Equipment acquired through capitalized lease 434,000 52,000 -- 559,000
Unrealized gain (loss) on marketable securities 105,000 (1,000) 73,000 177,000

F-8
See notes to consolidated financial statements

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

NOTE 1 - THE COMPANY AND BASIS OF PRESENTATION

Discovery Laboratories, Inc. (the "Company") is a late-stage specialty
pharmaceutical company applying its humanized lung surfactant technology to
develop potential novel respiratory therapies and products. Surfactants are
substances that are produced naturally in the lungs and are essential to the
lungs' ability to absorb oxygen and to maintain proper airflow through the
respiratory system. The absence or depletion of surfactant is involved in a
number of respiratory diseases.

The Company's humanized surfactant technology produces an engineered version of
natural human lung surfactant and contains a peptide, sinapultide, that is
designed to precisely mimic the essential human lung surfactant protein B
(SP-B). The Company believes that this proprietary surfactant technology is the
only surfactant technology presently available to potentially treat a broad
range of respiratory diseases.

The Company's lead product, Surfaxin(R), is being developed initially for
critical care patients with life-threatening respiratory disorders where there
are few, if any, approved therapies. Surfaxin is currently in two Phase 3
clinical trials for Respiratory Distress Syndrome in premature infants, a Phase
3 clinical trial for Meconium Aspiration Syndrome in full-term infants, and a
Phase 2 clinical trial for Acute Respiratory Distress Syndrome in adults.
Aerosolized formulations of the Company's humanized surfactant are presently
being developed to potentially treat patients suffering from severe acute asthma
and Acute Lung Injury, the Company's lead preclinical programs, as well as COPD,
sinusitis, and upper airway disorders such as sleep apnea and otitis media
(inner ear infection).

The Company is presently developing a dedicated sales and marketing capability
through a collaboration with Quintiles Transnational Corp. ("Quintiles") to
commercialize Surfaxin in neonatal indications in the United States. The Company
has also entered into a strategic alliance with Laboratorios del Dr. Esteve
("Esteve") to commercialize Surfaxin in Europe and Latin America. The Company
intends to establish strategic alliances, where appropriate, for the development
and commercialization of the Company's products in other indications and
markets.

HISTORICAL FOUNDING TRANSACTIONS

The Company, formerly known as Ansan Pharmaceuticals, Inc. ("Ansan"), was
incorporated in Delaware on November 6, 1992. In November 1997, Ansan merged
(the "Ansan Merger") with Discovery Laboratories, Inc. ("Predecessor Discovery")
in a transaction accounted for as a reverse acquisition with Predecessor
Discovery as the acquirer for financial reporting purposes since its
stockholders owned approximately 92% of the merged entity. The consolidated
financial statements include the accounts of Ansan from November 25, 1997 (the
date of acquisition).

In October 1996, the Company invested $7,500,000 in exchange for 600,000 shares
of Series A preferred stock, of Acute Therapeutics, Inc., a Delaware Corporation
("ATI"). The stock represented 75% of the voting securities of ATI.

In June 1998, ATI was merged with and into the Company (the "ATI Merger").
Pursuant to the ATI Merger, each outstanding share of ATI's Common Stock was
exchanged for 3.90 shares (the "ATI Exchange Ratio") of the common stock
("Common Stock"), par value $0.001 per share, of the Company; each share of
ATI's Series B preferred stock was converted into one share of the Company's
Series C preferred stock and all outstanding options to purchase ATI Common
Stock were assumed by the Company and became exercisable for shares of the
Common Stock on the basis of the ATI Exchange Ratio. Transaction costs of
$216,000 were incurred associated with the ATI Merger. The value of the Common
Stock issued to ATI's Common Stockholders plus the assumption of the outstanding
ATI options and merger related costs has been attributed to in-process research
and development upon management's evaluation and was recorded as an expense in
connection with the ATI Merger. The accompanying consolidated financial
statements include the accounts of the Company and ATI (through the date of its
merger into the Company).

The Company currently maintains one subsidiary, which is inactive.

F-9

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

MANAGEMENT'S PLANS AND FINANCINGS

The Company is a development stage company and has incurred substantial losses
since inception. To date, the Company has funded its operations primarily
through the issuance of equity and strategic alliances. The Company expects to
continue to expend substantial amounts for continued product research,
development, and commercialization activities for the foreseeable future.
Management's plans with respect to funding this development are to secure
additional equity, if possible, and to secure additional strategic alliances
that will provide available cash funding for operations. Continuation of the
Company is dependent on its ability to obtain additional financing and,
ultimately, on its ability to achieve profitable operations. There is no
assurance, however, that such financing will be available or that the Company's
efforts ultimately will be successful.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

CASH AND CASH EQUIVALENTS

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

AVAILABLE-FOR-SALE MARKETABLE SECURITIES

The investments are classified as available for sale and are comprised of
shares of high quality fixed income commercial paper and mutual funds.
Investments are carried at fair market value. Realized gains and losses
are computed using the average cost of securities sold. Any
appreciation/depreciation on these investments is recorded as other
comprehensive income (loss) in the statements of changes in stockholders'
equity until realized.

PROPERTY AND EQUIPMENT

Property and equipment is recorded at cost. Depreciation of furniture and
equipment is computed using the straight-line method over the estimated
useful lives of the assets (five to seven years). Leasehold improvements
are amortized over the lower of the (a) term of the lease or (b) useful
life of the improvements.

USE OF ESTIMATES

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

LONG-LIVED ASSETS

Statement of Financial Accounting Standards (SFAS) No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets", was issued in August
2001 and was adopted by the Company in 2002. Under SFAS No. 144, the
Company is required to recognize an impairment loss only if the carrying
amount of a long-lived asset is not recoverable from its undiscounted cash
flows and measure any impairment loss as the difference between the
carrying amount and the fair value of the asset. No impairment was
recorded during the year ended December 31, 2002, as management of the
Company believes the sum of its future undiscounted cash flows will exceed
the carrying amount of the assets.

RESEARCH AND DEVELOPMENT

Research and development costs are charged to operations as incurred.

F-10

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

REVENUE RECOGNITION - RESEARCH AND DEVELOPMENT COLLABORATIVE AGREEMENTS

The Company received nonrefundable fees from companies under license,
sublicense, collaboration and research funding agreements. The Company
initially records such funds as deferred revenue and recognizes research
and development collaborative contract revenue when the amounts are
earned, which occurs over a number of years as the Company performs
research and development activities. See Note 7 - License, Research
Funding, and Commercialization Agreements for a detailed description of
the Company's revenue recognition methodology under these agreements.

Additionally, the Company has been awarded grants from certain third party
organizations to help fund research for the drugs that the Company is
attempting to bring to full commercial use. Once research and development
expenditures qualifying under the grant are incurred, grant reports are
periodically completed and submitted to the granting agency for review. If
approved, the granting agency will then remit payment to the Company. Such
amounts are recorded as revenue upon receipt.

STOCK-BASED COMPENSATION

The Company has adopted SFAS No. 123, "Accounting for Stock-Based
Compensation". The provisions of SFAS No. 123 allow companies to either
expense the estimated fair value of employee stock options or to continue
to follow the intrinsic value method set forth in Accounting Principles
Board Opinion 25, "Accounting for Stock Issued to Employees" ("APB 25")
but disclose the pro forma effects on net income (loss) had the fair value
of the options been expensed. The Company has elected to continue to apply
APB 25 in accounting for its employee stock option incentive plans and to
provide the required SFAS No. 123 disclosures. See Note 9 - Stock Options.

NET LOSS PER COMMON SHARE

Net loss per common share is computed pursuant to the provisions of
Statement of Financial Accounting Standards No. 128, "Earnings per Share",
and is based on the weighted average number of common shares outstanding
for the periods. For the years ended December 31, 2002, 2001 and 2000,
4,032,000, 5,211,000 and 2,891,000 common shares, respectively, are
potentially issuable upon the exercise of certain of the Company's stock
options and warrants and are not included in the calculation of net loss
per share as the effect would be anti-dilutive.

RECLASSIFICATION

Certain prior year balances have been reclassified to conform with the
current presentation. The reclassification had no effect on net income.

NOTE 3 - INVESTMENTS

The available-for-sale marketable securities are as follows:

December 31,
--------------------------------
2002 2001
------------- -------------
Cost $ 10,475,000 $ 12,866,000
Gross unrealized gain 178,000 131,000
Gross unrealized loss (1,000) (59,000)
------------- ------------
Estimated fair value $ 10,652,000 $ 12,938,000
============= ============

F-11

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

NOTE 4 - NOTE RECEIVABLE

Note receivable pertains to a $200,000, 7% per annum mortgagor's note due from a
vice president of the Company. This note is secured by a mortgage agreement
dated July 24, 2001. The note calls for monthly payments of principal and
interest over a 360-month period. The principal balance outstanding at December
31, 2002 and 2001 was approximately $197,000 and $199,000, respectively.

NOTE 5 - PROPERTY AND EQUIPMENT

Property and equipment as of December 31, 2002 and 2001 was comprised of the
following:

December 31,
--------------------------
2002 2001
---------- ----------
Leashold Improvements $ 144,000 $ 144,000
Furniture 239,000 189,000
Equipment 1,600,000 989,000
---------- ----------
1,983,000 1,322,000
Less accumulated depreciation 752,000 500,000
---------- ----------
$1,231,000 $ 822,000
========== ==========

The equipment balance at December 31, 2002 and 2001 includes $559,000 and
$125,000, respectively, of property subject to a capital lease. The related
accumulated depreciation was $57,000 and $26,000 at December 31, 2002 and 2001,
respectively.

As of December 31, 2002, the Company had construction commitments outstanding
totaling approximately $188,000 related to the enhancement of manufacturing
capabilities for Surfaxin.

NOTE 6 - INCOME TAXES

Since its inception, the Company has never recorded a provision or benefit for
Federal and state income taxes.

The reconciliation of the income tax benefit computed at the Federal statutory
rates to the Company's recorded tax benefit for the years ended December 31,
2002, 2001, and 2000 are as follows:

December 31,
-----------------------------------------
2002 2001 2000
----------- ----------- -----------

Income tax benefit, statutory rates $ 5,938,000 $ 3,783,000 $ 3,652,000
State taxes on income, net of federal benefit 1,088,000 698,000 836,000
Research and development tax credit 274,000 90,000 85,000
Other (755,000) 3,000 (95,000)
----------- ----------- -----------
Income tax benefit 6,545,000 4,574,000 4,478,000
Valuation allowance (6,545,000) (4,574,000) (4,478,000)
----------- ----------- -----------
Income tax benefit $ -- $ -- $ --
=========== =========== ===========

F-12

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

The tax effects of temporary differences that give rise to deferred tax assets
and deferred tax liabilities, at December 31, 2002 and 2001, are as follows:

December 31,
-----------------------------
2002 2001
------------ -------------
Long-term deferred tax assets:
Net operating loss carryforwards
(federal and state) $ 25,526,000 $ 19,275,000
Research and development tax credits 1,225,000 846,000
Capitalized research and development 222,000 268,000
------------ ------------
Total long-term deferred tax assets 26,973,000 20,389,000
------------ ------------
Long-term deferred tax liabilities:
Property and equipment (108,000) (69,000)
------------ ------------
Net deferred tax assets 26,865,000 20,320,000
Less: valuation allowance (26,865,000) (20,320,000)
------------ ------------
$ -- $ --
============ ============

The Company was in a net deferred tax asset position at December 31, 2002 and
2001 before the consideration of a valuation allowance. Due to the fact that the
Company is in the development stage and has never realized a profit, management
has fully reserved the net deferred tax asset since realization is not assured.

At December 31, 2002 and 2001, the Company had available carryforward net
operating losses for Federal tax purposes of approximately $65,112,000 and
$47,496,000, respectively, and a research and development tax credit
carryforward of $1,225,000 and $846,000, respectively. The Federal net operating
loss and research and development tax credit carryforwards expire beginning in
2008 and continuing through 2021. Additionally, at December 31, 2002 and 2001,
the Company had available carryforward losses of approximately $51,385,000 and
$43,244,000, respectively, for state tax purposes. The utilization of the
Federal net operating loss carryforwards is subject to annual limitations in
accordance with Section 382 of the Internal Revenue Code. Certain state
carryforward net operating losses are also subject to annual limitations.

The difference between the deficit accumulated during the development stage for
financial reporting purposes and the net operating loss carryforwards for tax
purposes is primarily due to the write-off of the acquired in-process research
and development and supplies, which were not deducted for tax purposes.

NOTE 7 - LICENSE, RESEARCH FUNDING, AND COMMERCIALIZATION AGREEMENTS

In March 2002, the Company expanded its existing alliance with Esteve to
develop, market and sell Surfaxin throughout Europe and Latin America. In
connection with this new Esteve collaboration, Esteve purchased 821,862 shares
of Common Stock for an aggregate consideration of $4 million (at a 50% premium
over the average closing price for the 30 days prior to the closing date) and
paid the Company a non-refundable licensing fee of $500,000. Esteve agreed to
provide certain commercialization services for Surfaxin for the treatment of
Respiratory Distress Syndrome in premature infants, Meconium Aspiration Syndrome
in full-term infants and Acute Lung Injury/Acute Respiratory Distress Syndrome
in adult patients. The Company has agreed to an exclusive supply agreement which
provides that Esteve will purchase from the Company all of its Surfaxin drug
product requirements at an established transfer price based on sales of Surfaxin
by Esteve and/or its sublicensee(s). Esteve has also agreed to sponsor certain
clinical trial costs related to obtaining regulatory approval in Europe for
Acute Lung Injury/Acute Respiratory Distress Syndrome indications. Further,
Esteve also agreed to make certain milestone payments to the Company upon the
attainment of European marketing regulatory approval of Surfaxin.

F-13

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

In October 1999, the Company granted an exclusive license to Esteve to
commercialize and sell Surfaxin within Central and South America, Mexico and
certain Southern European countries (with an option to include Italy). This
license was terminated and superseded by the collaboration entered into with
Esteve in March 2002, discussed above. In connection with this exclusive
license, the Company received a nonrefundable license fee of $375,000, an
additional $375,000 in advance for Surfaxin supplied for certain clinical trials
to be conducted in the licensed territory; and Esteve agreed to reimburse
certain research and development expenditures borne by the Company in conducting
such clinical trials. In addition, an affiliate of Esteve invested $850,000 in
the Company in exchange for Common Stock issued at a 50% premium over the
ten-day average closing price preceding the closing of the investment; the
Company has accounted for the premium as additional license fees amounting to
$286,000.

The Company has accounted for the license fees (including the $286,000 premium
paid for Common Stock), the reimbursement of research and development
expenditures, and the advance payment for Surfaxin received from Esteve to be
used in clinical trials as deferred revenue. The balance in deferred revenue at
December 31, 2002 relates entirely to the license agreement with Esteve for
which the Company will recognize revenue using a straight line method through
the anticipated date of FDA approval for the first Surfaxin neonatal indication.

On December 10, 2001, the Company entered into a collaboration arrangement with
Quintiles and its affiliate, PharmaBio Development, Inc. ("PharmaBio"), whereby
Quintiles will provide pre- and post-launch marketing services for the
commercialization of Surfaxin for Respiratory Distress Syndrome in premature
infants and/or for Meconium Aspiration Syndrome in full-term infants in the
United States. In connection therewith, the Company issued to PharmaBio for
aggregate consideration of $3 million: (i) 791,905 shares of Common Stock; (ii)
Class G warrants to purchase 357,143 shares of Common Stock at an exercise price
equal to $3.485 per share; and (iii) Class H warrants to purchase 320,000 shares
of Common Stock at an exercise price equal to $3.03 per share.

PharmaBio also committed to provide the Company with a secured revolving credit
facility (the "Credit Facility"), primarily for use to pay pre-launch marketing
services to be provided by Quintiles, subject to the Company satisfying certain
conditions, for up to $8.5 million, which may be increased to $10 million in
specified circumstances. To the extent the Credit Facility availability is
increased to greater than $8.5 million, for each $1 million dollar increase, the
amount of shares of Common Stock issuable pursuant to the Class H warrants will
be increased by approximately 38,000 shares. Principal amounts owed under the
Credit Facility may be paid out of the proceeds of milestone payments to be paid
by PharmaBio to the Company at certain intervals upon the achievement of certain
corporate milestones by the Company. At December 31, 2002, $1,450,000 was
outstanding under the Credit Facility. At December 31, 2001, no amounts were
outstanding.

The Company and Ortho Pharmaceuticals, Inc., a wholly-owned subsidiary of
Johnson & Johnson, Inc., are parties to an agreement granting an exclusive
license of the Surfaxin technology to the Company in exchange for certain
license fees ($200,000 of which was paid in November 1996), milestone payments
aggregating $2,750,000 and royalties.

The Company and The Scripps Research Institute ("Scripps") are parties to a
research funding and option agreement which expires in February 2005, subject to
termination by the Company at any time with 90 days prior notice. Pursuant to
this agreement, the Company is obligated to fund a portion of Scripps' research
efforts and thereby has the option to acquire an exclusive worldwide license to
the technology developed from the research program during the term of the
agreement. Scripps owns all of the technology that it developed pursuant to work
performed under the agreement. To the extent the Company does not exercise its
option to technology developed under the agreement, the Company has the right to
receive 50% of the net royalty income received by Scripps for inventions that
are jointly developed under the agreement. Payments to Scripps under this
agreement were $572,000, $508,000 and $468,000 in 2002, 2001 and 2000,
respectively.

F-14

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

NOTE 8 - STOCKHOLDERS' EQUITY

2002 PRIVATE PLACEMENT

In November 2002, the Company received approximately $11.9 million in net
proceeds from the sale of 6,397,517 shares of Common Stock and 2,878,883 Class I
warrants to purchase Common Stock at an exercise price of $2.425 per share. The
Class I warrants are exercisable through November 5, 2007. In connection with
this private placement, the placement agent received fees of approximately
$766,000. As of December 31, 2002, all of the Class I warrants remain
unexercised.

2001 PRIVATE PLACEMENTS

In October 2001, the Company received approximately $7.3 million in net proceeds
from the sale of 3,562,759 shares of Common Stock and 712,553 Class F warrants
to purchase Common Stock at an exercise price of $2.365 per share. The Class F
warrants are exercisable through September 30, 2006. In connection with this
private placement, the placement agent received fees of approximately $360,000
and warrants to purchase 164,911 shares of Common Stock at $2.394 per share. All
of the warrants remain unexercised as of December 31, 2002.

In April 2001, the Company received approximately $1 million in proceeds in a
private placement sale of 296,560 shares of Common Stock to a limited
partnership.

2000 PRIVATE PLACEMENT

In March 2000, the Company received approximately $17,500,000 in net proceeds
from the sale of 2,902,846 shares of Common Stock and 580,567 Class E warrants
to purchase shares of Common Stock at an exercise price of $7.38 per share in a
private placement offering. The Class E warrants of the Company are exercisable
through March 2005. In connection with this private placement, the placement
agent received fees of approximately $1,321,000 and warrants to purchase 348,341
shares of Common Stock at $8.113 per share. All of the warrants remain
unexercised as of December 31, 2002.

1999 PRIVATE PLACEMENTS

During March and April 1999, the Company raised $1.0 million in a private
placement offering of 826,447 shares of Common Stock and 569,026 Class C
warrants to purchase Common Stock at an exercise price of $2.15 per share. The
Class C warrants are exercisable through April 2006. As of December 31, 2002,
approximately 57,000 Class C warrants remain unexercised.

In July 1999, the Company raised approximately $2,233,000 in net proceeds (net
of offering costs of approximately $217,000) from the sale of 2,024,792 shares
of Common Stock and 2,024,792 Class D warrants to purchase shares of Common
Stock at an exercise price of $1.33 per share in a private placement offering.
All Class D warrants have been exercised. The placement agent received fees of
7% of the gross proceeds, reimbursement of certain expenses and an option to
purchase approximately 405,000 shares of Common Stock at $1.33 per share. As of
December 31, 2002, approximately 395,000 options issued to the placement agent
remain unexercised.

1996 PRIVATE PLACEMENT

In 1996, in a private placement offering, the Company sold securities which
converted in the Ansan Merger into 2,200,256 shares of Series B convertible
preferred stock of the Company and 856,138 shares of Common Stock. Net proceeds
from the private placement approximated $19,000,000. Pursuant to the terms of
the offering, on December 1, 1998, the conversion rate was adjusted whereby each
share of preferred stock was convertible at the option of the holders into 3.11
shares of Common Stock. Conversions took place at various dates and on March 14,
2000, all of the remaining Series B shares were converted into 4,766,000 shares
of Common Stock of the Company.

F-15

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

The placement agent for the offering received approximately $2,860,000 in cash
plus warrants which, pursuant to the Ansan Merger gave the holders thereof the
right to acquire 220,025 shares of Series B preferred stock (which as a result
of the conversion of the Series B preferred stock were convertible into 685,000
shares of Common Stock) at a price of $11 per share, through November 8, 2006,
and to acquire 85,625 shares of Common Stock at a price of $0.64 per share
through November 8, 2006. As of December 31, 2002, approximately 47,000 warrants
were outstanding.

COMMON SHARES RESERVED FOR ISSUANCE

As of December 31, 2002 and 2001, the Company has reserved shares of Common
Stock for issuance upon exercise of options and warrants as follows:

December 31,
----------------------
2002 2001
--------- ---------
Stock option plans 4,908,000 4,275,000
Placement agent and underwriter warrants 1,610,000 1,619,000
Class C warrants (1999 private placement) 57,000 57,000
Class E warrants (2000 private placement) 581,000 581,000
Class F warrants (2001 private placement) 713,000 713,000
Class G warrants (2001 Quintiles Alliance) 357,000 357,000
Class H warrants (2001 Quintiles Credit Facility) 565,000 565,000
Class I warrants (2002 private placement) 2,879,000 --
Other warrants 75,000 115,000
---------- ----------
11,745,000 8,282,000
========== ==========

TREASURY STOCK/COMMON STOCK ISSUED FOR SERVICES

In 1998, the Company's Board of Directors ("Board of Directors") approved a
stock repurchase program wherein the Company could buy its own shares from the
open market and use such shares to settle indebtedness. Such shares are
accounted for as treasury stock.

During 2002, the Company did not acquire, nor did it issue, any Common Stock
accounted for as treasury stock.

During 2001, the Company acquired 11,500 shares of Common Stock for
approximately $26,000. Such shares are accounted for as treasury stock. In
addition, during 2001, the Company issued 10,902 shares of Common Stock in lieu
of cash payments for services and rent.

During 2000, the Company acquired 31,743 shares of Common Stock in exchange for
option conversions, having a value of $245,000, and issued 7,000 shares of
treasury stock in satisfaction of services rendered. In addition, during 2000,
the Company issued 9,496 shares of Common Stock in lieu of cash payments for
services and rent.

During 1999, the Company acquired 2,000 shares of Common Stock for approximately
$5,000 and issued 15,600 shares of treasury stock, having a value of
approximately $53,000, in settlement of $39,000 of indebtedness. The difference
between fair market value and amount of indebtedness was charged to expense and
credited to paid-in-capital.

SERIES C PREFERRED STOCK

The Company's Series C redeemable convertible preferred stock was convertible at
the option of the holder into Common Stock at a conversion price equal to the
market price of the Common Stock, as defined. On March 3, 2000, the sole Series
C shareholder, Johnson & Johnson, Inc., elected to convert its Series C
preferred stock shares into 398,186 shares of Common Stock.

F-16

NOTE 9 - STOCK OPTIONS

In March 1998, the Company adopted its 1998 Stock Incentive Plan which includes
three equity programs (the "1998 Plan"). Under the Discretionary Option Grant
Program, options to acquire shares of the Common Stock may be granted to
eligible persons who are employees, non-employee directors, consultants and
other independent advisors. Pursuant to the Stock Issuance Program, such
eligible persons may be issued shares of the Common Stock. Under the Automatic
Option Grant Program, eligible non-employee directors will automatically receive
option grants at periodic intervals at an exercise price equal to the fair
market value per share on the date of the grant. Options granted under the 1998
Plan expire no later than ten years from the date of the grant.

The 1998 Plan was successively amended at each of the Annual Meeting of
Stockholders for the years 2002, 2001 and 2000, to increase the maximum number
of shares of Common Stock reserved for issuance over the term of the plan by
1,000,000 shares, 1,150,000 shares and 799,041 shares, respectively. After
giving effect to these amendments, there are currently 5,150,000 shares of
Common Stock reserved for issuance over the term of the plan. In addition, in
2002 the Board of Directors approved amendments to the 1998 Plan that (i)
increased the exercise price of options granted to non-employee directors
pursuant to the Automatic Option Grant Program from 60% of the fair market value
per share on the date of the grant to 100% of such fair market value and (ii)
removed the Plan Administrator's authority to effect the cancellation and
regrant of any outstanding options under the Discretionary Option Grant Program.

The Company applies APB 25 in accounting for stock options and, accordingly,
recognizes compensation expense for the difference between the fair value of the
underlying Common Stock and the exercise price of the option at the date of
grant. The effect of applying SFAS No. 123 on pro forma net loss is not
necessarily representative of the effects on reported net income or loss for
future years due to, among other things, (i) the vesting period of the stock
options and (ii) the fair value of additional stock options in future years. Had
compensation cost for the Company's stock option plans been determined based
upon the fair value of the options at the grant date of awards under the plans
consistent with the methodology prescribed under SFAS No. 123, the Company's net
loss for each of the years ended December 31, 2002, 2001 and 2000 would have
been approximately $18,586,000 or $0.68, $13,455,000 or $0.61 per share and
$14,092,000 or $0.75 per share per share, respectively. The weighted average
fair value of the options granted are estimated at $1.15, $1.93 and $3.40 per
share, respectively, for the years ended December 31, 2002, 2001 and 2000, on
the date of grant using the Black-Scholes option-pricing model with the
following weighted average assumptions: dividend yield 0%, volatility of 95%,
118% and 130%, respectively, risk-free interest rate of 2.5%, 4% and 6%,
respectively and expected life of three and a half years.

F-17

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

Additional information with respect to the stock option activity is summarized
as follows:

Weighted Average
Weighted Average Remaining
Price Per Share Shares Exercise Price Contractual Life
--------------- ------ ---------------- ----------------

Balance at January 1, 2000 $0.0026 - $7.00 2,479,653 $2.27 7.930 years
Options granted 1.66 - 7.00 1,187,000 4.36
Options exercised 0.08 - 4.44 (532,059) 0.98
Options forfeited 0.32 (39,000) 0.32
---------
Balance at December 31, 2000 0.0026 - 7.00 3,095,594 3.39 8.330 years
Options granted 2.10 - 5.25 1,279,000 2.58
Options exercised 0.3205 - 0.87 (6,224) 0.47
Options forfeited 2.10 - 5.19 (92,983) 4.01
---------
Balance at December 31, 2001 0.0026 - 7.00 4,275,387 3.16 8.018 years
Options granted 1.26 - 3.65 1,131,000 1.79
Options exercised 0.0821 - 2.10 (77,925) 0.77
Options forfeited 0.3205 - 7.00 (420,778) 3.3379
---------
Balance at December 31, 2002 0.0026 - 5.375 4,907,684 2.86 7.550 years
=========

The following table provides further detail with regard to the options
outstanding and exercisable at December 31, 2002:

Weightd Weighted Average
Average Price Remaining
Price per share Shares per Share Contractual Life
- --------------- ------ -------------- ----------------
$0.0026 - $2.00 1,579,689 $1.44 8.20 years
$2.01 - $4.00 1,780,845 $2.63 8.27 years
$4.00 - $6.00 1,547,150 $4.62 6.74 years

The following table pertains to options granted and exercisable at less than
fair value:

Year Ended Year Ended Year Ended
December 31, 2002 December 31, 2001 December 31, 2000
----------------- ----------------- -----------------

Weighted average exercise price $2.00 $2.11 $1.94
Weighted average fair value $3.33 $3.53 $3.24

Currently, all options granted under the 1998 Plan are exercisable immediately
upon grant, however, the shares issuable upon exercise of the options are
subject to repurchase by the Company at the exercise price paid per share. Such
repurchase rights lapse as the options vest according to their stated terms.

In September 1999, management was granted, in the aggregate, options to purchase
500,000 shares of the Common Stock subject to the achievement of certain
corporate milestones. In January 2000, certain milestones related to the options
had been achieved and 50% of the 250,000 related options vested. In September
2000, the Board of Directors accelerated the remaining 50% of the 250,000
milestone options and the Company incurred non-cash compensation charges
amounting to $2,515,000, representing the excess of the fair value over the
exercise price of the options granted.

Included in the options outstanding at December 31, 2001, are options to
purchase 123,200 shares of Common Stock (at an exercise price of $4.44) granted
during 1998, which vest upon the Company achieving specified milestones and
expire in June 2008. In December 2002, the related milestones were achieved.

F-18

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

In December 2002, the Board of Directors approved the issuance of options to
management to purchase up to 800,000 shares of Common Stock at an exercise price
of $2.75 per share. Such options are expressly subject to the requisite approval
of the Company's shareholders, obtained no later than the Company's Annual
Meeting of Shareholders for 2003, for an amendment to the 1998 Plan authorizing
an increase in the number of shares issuable under the plan in an amount equal
to or greater than the aggregate amount of such options. Accordingly, such
options are not included in the options outstanding at December 31, 2002.
Provided the shareholders of the Company approve such amendment, such options
shall vest in their entirety upon the fourth anniversary of the date of grant or
at such earlier time, if ever, upon the receipt by the Company of a New Drug
Application (NDA) approval by the United States Food and Drug Administration for
Surfaxin for either Respiratory Distress Syndrome in premature infants, Meconium
Aspiration Syndrome in full-term infants, or Acute Respiratory Distress Syndrome
in adults.

NOTE 10 - COMMITMENTS

At December 31, 2002, the Company had employment agreements with six officers
providing for an aggregate annual salary of $1,249,000. The agreements expire on
various dates through December 2005. The Company also had employment agreements
with two other executives that provide for an aggregate annual salary of
$393,000. The agreements expire on various dates through July 2003. All of the
foregoing agreements provide for the issuance of annual bonuses and the granting
of options subject to approval by the Board of Directors.

The Company leases office and laboratory space in Doylestown, Pennsylvania under
leases which expire in September 2004 and September 2005. Additionally, the
Company leases office and laboratory space in Redwood City, California and
office space in Windsor, United Kingdom. Payments made under these leases for
the years ended December 31, 2002, 2001 and 2000 were $481,000, $273,000 and
$170,000, respectively. Aggregate future minimum annual rents for these leases
are as follows:

2003 $ 528,000
2004 462,000
2005 274,000
2006 28,000
----------
$1,292,000
==========

The Company entered into agreements to lease laboratory and office equipment,
which are being accounted for as capital leases. Future minimum lease payments
for these leases are as follows:

2003 $230,000
2004 168,000
2005 115,000
--------
513,000
Less amounts repressenting interest (68,000)
--------
$445,000
========

NOTE 11 - RELATED PARTY TRANSACTIONS

In November 2001, the Company entered into an agreement with Clinical Data
Management, Inc. (CDM), replacing an earlier similar agreement, to perform
duties associated with processing data for the Company's ongoing clinical
trials. Such agreement expired on November 14, 2002 pursuant its terms and the
Company has not entered into any further

F-19

DISCOVERY LABORATORIES, INC. AND SUBSIDIARY
(a development stage company)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002

arrangements with CDM. CDM is wholly-owned by the spouse of the Company's
President and Chief Executive Officer. Payments made to CDM and its owner for
the years ended December 31, 2002, 2001 and 2000 were approximately $289,000,
$221,000 and $111,000, respectively.

In March 2002, the Company expanded its existing relationship with Esteve by
entering into an agreement to expand the territory covered by the collaboration
arrangement entered into with Esteve in October 1999. Pursuant to this
agreement, Esteve purchased 821,862 shares of the Company's Common Stock at
$4.867 per share for $4 million in cash and paid a non-refundable licensing fee
of $500,000. A member of the Company's board of directors is an executive
officer of Esteve.

NOTE 12 - SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

The following table contains unaudited statement of operations information for
each quarter of 2002 and 2001. The operating results for any quarter are not
necessarily indicative of results for any future period.

2002 Quarters Ended:

(in thousands, except per share data)
Mar. 31 June 30 Sept. 30 Dec. 31 Total Year
-------- -------- -------- -------- ----------

Revenues from collaborative agreements $ 237 $ 783 $ 368 $ 394 $ 1,782
-------- -------- -------- -------- --------
Operating Expenses: --
Research and development 2,605 3,721 3,475 4,546 14,347
General and administrative 1,132 1,538 1,633 1,155 5,458
-------- -------- -------- -------- --------
Total expenses 3,737 5,259 5,108 5,701 19,805
-------- -------- -------- -------- --------
Operating loss (3,500) (4,476) (4,740) (5,307) (18,023)
Other income and expense 130 189 211 50 580
-------- -------- -------- -------- --------
Net loss $ (3,370) $ (4,287) $ (4,529) $ (5,257) $(17,443)
======== ======== ======== ======== ========
Net loss per common share -
basic and diluted $ (0.13) $ (0.16) $ (0.17) $ (0.17) $ (0.64)
Weighted average number of common
shares outstanding 25,834 26,394 26,441 30,717 27,351

2001 Quarters Ended:

(in thousands, except per share data)
Mar. 31 June 30 Sept. 30 Dec. 31 Total Year
-------- -------- -------- -------- ----------

Revenues from collaborative agreements $ 456 $ 262 $ 197 $ 197 $ 1,112
-------- -------- -------- -------- --------
Operating Expenses:
Research and development 1,762 2,049 1,921 2,275 8,007
General and administrative 1,055 984 733 2,295 5,067
-------- -------- -------- -------- --------
Total expenses 2,817 3,033 2,654 4,570 13,074
-------- -------- -------- -------- --------
Operating loss (2,361) (2,771) (2,457) (4,373) (11,962)
Other income and expense 301 416 (62) 161 816
-------- -------- -------- -------- --------
Net loss $ (2,060) $ (2,355) $ (2,519) $ (4,212) $(11,146)
======== ======== ======== ======== ========
Net loss per common share -
basic and diluted $ (0.10) $ (0.11) $ (0.12) $ (0.17) $ (0.51)
Weighted average number of common
shares outstanding 20,872 21,075 21,188 25,017 22,038

F-20