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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

(Mark One)

For the fiscal year ended December 31, 2003

OR

For the transition period from              to             .

Commission File No. 000-31135

INSPIRE PHARMACEUTICALS, INC.

(Exact Name of Registrant as Specified in Its Charter)

(919) 941-9777

(Registrant’s telephone number, including area code)

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

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 is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

Yes  x    No  ¨

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $291,533,919.

Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of January 31, 2004.

Documents incorporated by reference

None.

Item 1. Business.

Overview

We are a biopharmaceutical company dedicated to discovering, developing and commercializing prescription products in disease areas with significant commercial markets and unmet medical needs. Our primary focus is in the ophthalmic and respiratory therapeutic areas where we have significant expertise. Our ophthalmic products and product candidates are concentrated in the allergic conjunctivitis, dry eye disease and retinal disease indications. We are working on respiratory product candidates for the treatment of cystic fibrosis and upper respiratory disorders. Our portfolio of products and product candidates include:

We have acquired the rights to market Elestat^™ and Restasis® in the United States under co-promotion agreements with Allergan, Inc., or Allergan, and we receive royalty payments based upon net sales of these products. We have five product candidates in various stages of clinical development and one product candidate identified in preclinical development for which we expect to file an Investigational New Drug Application, or IND. Our product candidates in clinical trials are based on proprietary technology relating to specific receptors known as P2 receptors. Our lead product candidates are P2Y₂ receptor agonists that target ophthalmology, allergy and respiratory conditions and diseases where current treatments are not adequate. We have begun to apply our expertise to other applications of P2 receptor subtypes as well as advancing several non-P2Y programs.

We were incorporated in October 1993 and commenced operations in March 1995 following our first substantial financing and licensing of the initial technology from The University of North Carolina at Chapel Hill, or UNC. Since that time, we have been engaged in the discovery and development of novel pharmaceutical products, and more recently, in the co-promotion of products. We are located in Durham, North Carolina, adjacent to the Research Triangle Park.

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Our Strategy

Our business objective is to become a leading biopharmaceutical company focused on discovering, developing and commercializing new treatments for diseases primarily in the ophthalmic and respiratory areas. We intend to advance multiple product candidates in areas where we have expertise through drug discovery, clinical trials, strategic alliances and in-licensing, and to be involved in the marketing and sale of our products. A key element of our strategy is to build a sustainable pipeline of innovative new treatments based upon our expertise in certain therapeutic areas. All of our current clinical programs represent P2Y₂ receptor-based technology targeting ophthalmic and respiratory indications. We are also expanding into other clinical areas, such as P2Y₁₂ receptor blockers for a platelet aggregation inhibitor indication. Our strategy is to:

COMMERCIAL PRODUCTS

Elestat^™

Overview. In December 2003, we entered into an agreement with Allergan to co-promote Elestat^™ (epinastine HCl ophthalmic solution 0.05%) to ophthalmologists, optometrists and allergists in the United States. Elestat^™ was approved by the U.S. Food and Drug Administration, or FDA, in October 2003 for the prevention of itching associated with allergic conjunctivitis. We launched and began promoting Elestat^™ in the United States in February 2004 within the eye care and allergy area.

Elestat^™, a topical antihistamine with mast cell stabilizing and anti-inflammatory activity, was developed by Allergan for the relief of ocular itching associated with ocular allergies. Its multi-action effects inhibit binding to both H₁ and H₂ receptors, while preventing recruitment and activation of pro-inflammatory mediators that can trigger and exacerbate the allergic response. Elestat^™ has a rapid onset of action, and in pivotal clinical trials was well tolerated by patients and demonstrated a favorable safety profile.

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Market Opportunity. Allergies affect more than 40 million people in the United States annually, including 20% to 30% of adults and up to 40% of children. Allergic conjunctivitis may occur in up to 90% of those patients suffering from allergies. The annual United States market for ocular allergy prescriptions is approximately $425 million, with a strong growth rate of 17% over 2002. In terms of dollars, this market has shown double-digit growth over the past six years. Elestat^™ is indicated for adults and children at least 3 years old.

Co-Promotion Agreement. We have the primary responsibility for selling, promotional and marketing activities of Elestat^™ in the United States and will be responsible for the associated costs. We work with Allergan collaboratively on overall product strategy and management in the United States. Allergan records Elestat^™ sales and remains responsible for all other product costs. Allergan also retains the licensing rights relating to promotion of Elestat^™ to prescribers other than ophthalmologists, optometrists and allergists; but we have a right of first refusal to obtain such rights in the event Allergan decides to engage a third party to undertake such activities. Under the terms of the agreement, we paid Allergan an up-front payment and Allergan will pay a royalty to us on United States Elestat^™ net sales; except in the event that a third party is engaged by Allergan to promote Elestat^™ to prescribers outside of our field, in which case we will be paid a proportionate share of United States Elestat^™ net sales based upon filled prescriptions written by ophthalmologists, optometrists and allergists. Allergan also retains rights to all international sales and marketing activities relating to the drug. See “—Corporate Collaborations.”

Restasis®

Overview. In June 2001, we entered into a joint license, development and marketing agreement with Allergan to develop and commercialize diquafosol tetrasodium (INS365) which included the right to co-promote Allergan’s Restasis® (cyclosporine ophthalmic emulsion) 0.05%, each for the treatment of dry eye disease, in the United States. In December 2002, Restasis® was approved for sale by the FDA and Allergan launched Restasis® in the United States in April 2003. In January 2004, we began co-promotion of Restasis® in the United States and will receive a royalty on Restasis® net sales beginning April 2004.

Restasis® is the first approved pharmacologically active therapy for patients in the United States with keratoconjunctivitis sicca, or dry eye disease, whose tear production is presumed to be suppressed due to ocular inflammation. Dry eye disease is a painful, burning and irritating condition involving abnormalities and deficiencies in the tear film due to a variety of causes. Restasis® has been shown to improve tear production which leads to significant improvement in ocular surface integrity which, in turn, resolves dry eye symptoms and returns the surface of the eye to a more normal state while providing relief of the symptoms associated with dry eye disease.

Market Opportunity. Other than Restasis®, the current treatments for dry eye disease in the major markets consist of artificial tear solutions and lubricant eye drops. In some cases, small plugs are inserted by physicians in the tear duct to slow tear drainage. Artificial tears, which are available as over-the-counter and, in some countries, as prescription products, provide temporary relief of symptoms, but can also wash out the natural proteins and other components that keep an eye healthy. We estimate, based on an extrapolation from United States data, that moderate to severe dry eye disease affects approximately thirty million people in the eight major international prescription pharmaceutical markets and ten million are in North America. Dry eye disease can be caused by eye stress, aging, environmental factors, autoimmune disorders and various medications. Because dry eye disease is more prevalent among the elderly and post-menopausal women, this market is expected to grow as populations age. We estimate that, in the eight major international prescription pharmaceutical markets, sales of prescription and over-the-counter pharmaceutical products for dry eye disease treatments exceed $500 million annually. Allergan recorded $38.3 million of Restasis® revenue in the United States for the April to December 2003 time period, its first nine months as a commercial product. Allergan has projected 2004 Restasis® revenue of $75-95 million.

Collaborative Agreement. In the third quarter of 2003, we exercised our right to co-promote Restasis® under the joint license, development and marketing agreement with Allergan. In December 2003, at the time we entered into the co-promotion agreement relating to Elestat^™, we amended the joint license, development and marketing agreement to reduce the royalty rates that we would receive upon the sale of Restasis®. We began promoting Restasis® in January 2004 and we will receive royalty payments from Allergan on net sales of Restasis® beginning April 2004. See “—Corporate Collaborations.”

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HIGHER PRIORITY PRODUCTS IN CLINICAL DEVELOPMENT

Diquafosol tetrasodium (INS365) for the treatment of dry eye disease.

Overview. Diquafosol is an ophthalmic product candidate designed to treat dry eye disease and is expected to complement Restasis®, if and when it receives regulatory approval. The abnormalities responsible for dry eye disease are typically characterized by a decrease in tear production, an increase in tear evaporation or the improper mixture of the eye’s tear film components. If left untreated, dry eye disease can result in permanent corneal damage and visual impairment.

Diquafosol is a P2Y₂ receptor agonist that activates the P2Y₂ receptors on the surface of the eye and inner lining of the eyelid to stimulate the release of water, salt, mucin and lipids—the key components of natural tears. Mucin is made in specialized cells and acts to lubricate surfaces. Lipids in the eye are oily substances that form the outer-most layer of the tear film and are responsible for the prevention of excessive tear fluid evaporation. We are developing diquafosol as an eye drop for dry eye disease. We believe that diquafosol can be the second FDA approved pharmacologically active agents to treat dry eye disease, and the first one with this mechanism of action. In preclinical testing, our product increased the secretions of natural tear components, which we believe can help restore a natural tear film, reduce dry eye disease symptoms, help prevent long-term corneal damage, and improve ocular surface health in dry eye disease sufferers. Because diquafosol and Restasis® have different mechanisms of action, we consider them complementary products and believe the commercial opportunity of these products to be significant.

Development Status. On June 27, 2003, we submitted a New Drug Application, or NDA, to the FDA, and we were notified that our NDA was granted a “priority review” on July 31, 2003. On December 19, 2003, we received an approvable letter from the FDA. In January 2004, we met with the FDA to discuss the additional clinical study which they requested. Based upon this discussion, we now have a clear understanding of the FDA’s additional requirement for the regulatory approval of diquafosol and are working closely with them to develop a protocol for a new Phase III clinical study. We intend to initiate and begin enrollment in a confirmatory Phase III trial in early 2004. In addition, we are assisting Allergan in a European regulatory submission that will seek approval of the right to commercialize diquafosol for dry eye disease in the European Union. Submission of this application is expected in the second half of 2004.

Collaborative Agreement. Under the joint license, development and marketing agreement with Allergan, we have continued our efforts to develop and commercialize diquafosol. Under this agreement, we have received up-front and milestone payments of $11 million and may receive up to an additional $28 million in milestone payments assuming the successful completion of all remaining diquafosol milestones. We will also receive royalty payments from Allergan on net sales, if any, of diquafosol worldwide, excluding most larger Asian markets. In the third quarter of 2003, we exercised our right under the Allergan agreement to co-promote diquafosol with Allergan in the United States and expect to begin promoting this product if and when we receive FDA approval and the product is launched. Our partner, Santen Pharmaceutical Co., Ltd., or Santen, is developing diquafosol in Japan and nine other Asian countries. Diquafosol is currently in Phase II clinical trials in Japan. See “—Corporate Collaborations.”

INS37217 Respiratory (denufosol tetrasodium) for the treatment of cystic fibrosis.

Overview. We are developing INS37217 Respiratory (denufosol tetrasodium) as an inhaled product for the treatment of cystic fibrosis. We believe our product may become the first FDA approved product that mitigates the underlying ion-transport defect in the airways of patients with cystic fibrosis. This product has been granted orphan drug status by the FDA and is also on fast-track review status for its approval.

INS37217 Respiratory is designed to enhance the lung’s innate mucosal hydration and mucociliary clearance mechanisms, which in cystic fibrosis patients are impaired by a genetic defect. By hydrating airways and stimulating mucociliary clearance through stimulation of the P2Y₂ receptor, we expect that INS37217 Respiratory will help keep the lungs of cystic fibrosis patients clear of thickened mucus, reducing infections and the damage that occurs as a consequence of the retention of thick and tacky infected secretions. We further believe that these effects may result in reduced frequency and length of hospitalizations, reduced need for antibiotics and other medications, reduced deterioration of lung function, and improved respiratory symptoms and health status. In addition, this product is expected to be complementary with the two approved products, Pulmozyme® and TOBI®, neither of which affects the underlying ion-transport defects in cystic fibrosis airways.

Cystic fibrosis is a life-threatening disease involving a genetic mutation that disrupts the cystic fibrosis transmembrane regulator protein, an ion channel. In cystic fibrosis patients, a defect in this ion channel leads to poorly hydrated lungs and severely impaired mucociliary clearance. Chronic secondary infections invariably occur, resulting in progressive lung dysfunction and deterioration. Respiratory infections and complications account for more than 95% of the morbidity and mortality associated with this disease. According to the United States Cystic Fibrosis Foundation, the median life expectancy for patients is 33 years.

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Development Status. We completed all necessary preclinical studies for initial clinical testing and in the fall of 2000 filed an IND in the United States. We initiated and completed a Phase I clinical trial in late 2000 and a Phase I/II clinical trial for INS37217 Respiratory for cystic fibrosis in 2002. A multi-center Phase II study was initiated in collaboration with the Cystic Fibrosis Foundation Therapeutics, Inc., or the CFFT, in 2003. Enrollment of 90 patients has been completed and top-line results from the Phase II study are expected in the second quarter of 2004. This study is funded largely through a study funding arrangement established with the CFFT in October 2002. See “—Corporate Collaborations.”

Market Opportunity. The current therapeutic approaches to address cystic fibrosis mainly treat the symptoms, but do not cure the disease, and are aimed at reducing respiratory infections and breaking up thickened mucous secretions that cause airflow obstruction and harbor bacteria. For example, TOBI® is an inhaled antibiotic that treats the infection, and Pulmozyme® is an inhaled protein that breaks up excessive DNA in cystic fibrosis mucus that reduces the thickness and tackiness of the respiratory secretions. While both products are approved for the treatment of cystic fibrosis, neither product is designed to address the underlying ion-transport defect, which results in dehydrated mucus and severely impaired mucociliary clearance.

There are approximately 30,000 diagnosed cystic fibrosis patients in the United States and approximately 75,000 in the eight major international prescription pharmaceutical markets. The average annual cost of medicine to treat a cystic fibrosis patient in the United States exceeds $35,000, and the annual healthcare cost for patients in the United States is over $1 billion. We estimate that in the United States sales of prescription pharmaceutical products to treat cystic fibrosis currently are in excess of $200 million annually.

Collaborative Agreement. In October 2002, we entered into a study funding agreement with the CFFT in which they agreed to fund the majority of the external costs of a Phase II trial for the treatment of cystic fibrosis in exchange for milestone payments upon FDA approval, and the possibility of a sales milestone upon the commercialization and the achievement of a certain aggregate sales volume in the first five years following product approval. In the event of FDA approval, we are obligated to pay to the CFFT, over a period of five years, an amount equal to a multiple of the trial costs incurred by the CFFT as a development milestone payment, which could exceed $10 million. Additionally, in the event aggregate sales of the product exceed a certain level, we are obligated to pay the CFFT an additional $4 million sales milestone, payable over two years. See “—Corporate Collaborations.”

INS37217 Ophthalmic (denufosol tetrasodium) for the treatment of retinal disease.

Overview. INS37217 Ophthalmic (denufosol tetrasodium) is an investigative new drug under evaluation for the treatment of retinal diseases associated with pathological sub-retinal or intra-retinal accumulation of fluid. These sight-threatening retinal diseases are associated with retinal detachment (where fluid accumulates in the sub-retinal space between the retina and the underlying retinal pigment epithelium) and macular edema (where fluid accumulates in the central retina). Restoration of vision is contingent in part on the removal of the pathological fluid accumulation. INS37217 Ophthalmic has been shown in experimental models of retinal detachment to stimulate retinal re-attachment by reabsorbing (i.e., draining) extraneous sub-retinal fluid across the retinal pigment epithelium, or RPE, a layer of cells involved in controlling proper hydration of the retina and sub-retinal space. The retina is a thin layer of sensory tissue that captures and processes visual information, and normally remains attached to the underlying RPE. In the most common cause of retinal detachment, breaks or holes in the retina result in the influx of fluid from the vitreous into the sub-retinal space between the retina and RPE, thereby creating rhegmatogenous retinal detachment, or RRD. RRD results in acute loss of vision that may progress over a period of hours to days or weeks. Delayed treatment of this condition can lead to permanent loss of vision and ultimately detachment of the entire retina. RRD progresses when the rate of fluid influx into the sub-retinal space primarily through the retinal break(s) exceeds that of fluid reabsorption across the RPE, thereby enlarging the retinal detachment.

We are developing INS37217 Ophthalmic as an intravitreal injection initially for RRD. In RRD, fluid accumulates in the sub-retinal space between the retina and the underlying RPE and successful retinal re-attachment is contingent upon the reabsorption of this fluid across the RPE. We believe that INS37217 Ophthalmic may become the first FDA approved product to be administered as first-line therapy to enable retinal reattachment in some RRD patients without the need for surgery. Because of its ability to stimulate fluid reabsorption across the RPE, INS37217 Ophthalmic may be useful to treat other retinal diseases also associated with pathological accumulation of sub-retinal or intra-retinal fluid, including diabetic and non-diabetic macular edema.

Development Status. In 2001 we initiated a dose-escalating, randomized, double-masked, placebo-controlled Phase I/II clinical study of INS37217 Ophthalmic, given as a single intravitreal injection, in patients with RRD. The study was designed to evaluate the safety, tolerability, and pharmacological activity of INS37217 Ophthalmic in facilitating retinal re-attachment. Phase I/II results demonstrated that when compared with placebo the drug was well-tolerated and showed pharmacological activity in terms of reducing the extent of retinal detachment. In January 2004, we met with the FDA and were given guidance on the planning of a well-controlled Phase II study designed to advance this program. This Phase II study is expected to begin in the first half of 2004.

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Market Opportunity. There are currently no pharmaceutical products approved for RRD. While surgical techniques used to reattach the retina have relatively high single-operation success rates of 60-95%, patients frequently suffer from post-surgical problems, including diminished visual acuity, loss of eye motility, misaligned eyes, protracted periods of convalescence, and post-operative pain and discomfort. By stimulating fluid reabsorption across the RPE, INS37217 Ophthalmic may reverse the progression of RRD and stimulate retinal re-attachment in some RRD patients without the need for surgery. Approximately 50,000 retinal detachments occur each year in the United States.

INS50589 Cardiovascular

P2Y₁₂ receptor antagonists as inhibitors of platelet aggregation.

Overview. We are developing potent, selective and reversible inhibitors of platelet aggregation for the use in the treatment of acute cardiovascular diseases. Platelets, small disk-shaped blood cells, are responsible for initiating and maintaining blood clots. These cells have P2 receptors, including the P2Y₁₂ receptor, on their surface which respond to a soluble clotting factor called adenosine 5’-diphosphate (ADP). It has been demonstrated that pharmacological intervention to inhibit platelet aggregation has potential benefit on a number of debilitating acute and chronic diseases such as myocardial infarction, unstable angina, stroke and peripheral arterial disease. Inhibition of platelet P2Y₁₂ receptors in particular reduces the relative risk of atherosclerotic events such as myocardial infarction, stroke and cardiovascular death.

Development status. We have taken advantage of our expertise in nucleotide receptor chemistry and pharmacology and developed a new proprietary class of potent and selective P2Y₁₂ antagonists for use in the treatment of acute cardiovascular or cerebrovascular indications. Our molecules are novel platelet aggregation inhibitors that have a rapid onset and offset mechanism of action and are intended for intravenous administration. In preclinical studies it has been shown that our compounds produce dose-dependent and sustained inhibition of platelet aggregation during the administration of the drug, and protect against mortality resulting from systemic intravascular thromboembolism. We believe that the fast offset pharmacokinetic properties of our compounds, coupled with their ability to inhibit both platelet aggregation and degranulation/secretion, are key differentiating characteristics from other approved anti-platelet agents, such as aspirin, clopidogrel, ticlopidine, abciximab, tirofiban, and eptifibatide. Based on extensive structure-activity, pharmacological and safety information, we have identified a product candidate, INS50589 Cardiovascular for advancement into clinical studies in this program. We intend to file an IND application for INS50589 Cardiovascular pending completion of successful preclinical evaluation in the second half of 2004.

LOWER PRIORITY PRODUCTS IN CLINICAL DEVELOPMENT

INS37217 Intranasal (denufosol tetrasodium) for upper respiratory disorders.

Overview. We are developing INS37217 Intranasal (denufosol tetrasodium) as a nasal spray treatment for upper respiratory disorders in which mucociliary clearance is impaired, such as allergic rhinitis, rhinosinusitis, and common cold. These disorders affect millions of people and result in significant morbidity and several million office visits to doctors. To date we have completed four studies of INS37217 Intranasal in healthy volunteers, patients with allergic rhinitis, and individuals with common cold. Although the drug has been well-tolerated, in a recent 630 patient study of allergic rhinitis, INS37217 Intranasal was not superior to placebo. We have discussed the results from the program with several medical experts in the field and are currently considering our future development plans.

INS316 Diagnostic (uridine 5’-triphosphate) to aid in the diagnosis of lung cancer and lung infection.

Overview. INS316 Diagnostic (uridine 5’-triphosphate), a P2Y₂ agonist with a short duration of action, is being developed as an acute-use inhaled solution to stimulate enhanced clearance of mucus from the lungs to produce a sputum specimen to aid in the diagnosis of lung cancer. INS316 Diagnostic has been studied in a number of clinical trials and has been shown to increase the amount of sputum produced. In May 2001, we initiated a Phase III clinical trial. Enrollment has been slow and it appears likely that an additional trial will be required for regulatory approval. Therefore enrollment was stopped at approximately 700 of the original enrollment target of 800 patients and the results will be analyzed in the first half of 2004. It is unlikely we will progress further development of this program; however our partner Kirin Brewery Co, Ltd. or Kirin, may continue development. See “—Corporate Collaborations.”

Additional discussion of the costs and expenses associated with all of our research and development programs is discussed below in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Years Ended December 31, 2003, 2002 and 2001—Costs and Expenses.”

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Corporate Collaborations

Allergan, Inc.—Elestat^™

In December 2003, we entered into an agreement with Allergan to co-promote Elestat^™ to ophthalmologists, optometrists and allergists in the United States. Elestat^™ was approved by the FDA in October 2003 for the prevention of itching associated with allergic conjunctivitis. We will have the primary responsibility for selling, promotional and marketing activities of Elestat^™ in the United States and will be responsible for the associated costs. We work with Allergan collaboratively on overall product strategy and management in the United States. Allergan records Elestat^™ sales and remains responsible for all other product costs, as well as retaining responsibility for all international marketing and selling activities. Allergan also retains the licensing rights relating to promotion of Elestat^™ to prescribers other than ophthalmologists, optometrists and allergists; but we have a right of first refusal to obtain such rights in the event Allergan decides to engage a third party to undertake such activities. We have established a joint commercialization committee with Allergan to coordinate and oversee the broad strategies and promotion and manage the relationship. Allergan is responsible for supply chain management, managed healthcare, customer order processing and regulatory compliance. Under the terms of the agreement, we paid Allergan an up-front payment and Allergan will pay a royalty to us on United States Elestat^™ net sales; except in the event that a third party is engaged by Allergan to promote Elestat^™ to prescribers outside of our field, in which case we will be paid a proportionate share of United States Elestat^™ net sales based upon filled prescriptions written by ophthalmologists, optometrists and allergists. Under the terms of the agreement, we are required to achieve certain performance minimums to receive some or all of the royalty initially contemplated.

The agreement will be in effect until the earlier of: (i) the approval and launch of the first generic epinastine product; or (ii) the approval and launch of the first over-the-counter epinastine product; in each case after expiration of Elestat’s^™ listing in the FDA’s publication “Approved Drug Products with Therapeutic Equivalence Evaluations” (generally known as the “Orange Book”). Either Allergan or we may terminate the agreement in the event of a material breach of the agreement by the other or in the event of the other’s insolvency. Allergan can terminate the agreement if we fail to meet a defined minimum of net sales in any given year, or upon a change of control where we become an affiliate of a direct competitor of Allergan’s as that term is defined in the agreement. We can terminate the agreement in the event that Elestat^™ is withdrawn from the market for more than ninety days.

Allergan, Inc. – Restasis® and diquafosol

In June 2001, we entered into a joint license, development and marketing agreement with Allergan to develop and commercialize diquafosol which included the right to co-promote Restasis® in the United States. In December 2003, at the time we entered into the co-promotion agreement relating to Elestat^™, we amended the joint license, development and marketing agreement to reduce the royalty rates that we would receive upon the sale of Restasis®.

Under the terms of the amended agreement, Allergan obtained an exclusive license to develop and commercialize diquafosol worldwide, with the exception of Japan and nine other Asian countries covered by our agreement with Santen. In return, we will receive royalty payments from Allergan on diquafosol and Restasis® net sales, if any, worldwide, excluding most larger Asian markets. In December 2002, Restasis® was approved for sale by the FDA and Allergan launched Restasis® in the United States in April 2003. We will be entitled to receive royalties on net sales of Restasis® beginning April 2004, and have already received milestone payments under this agreement. In the third quarter of 2003, we exercised our right under the Allergan agreement to co-promote diquafosol and Restasis® with Allergan and began promoting Restasis® in January 2004 and will promote diquafosol if and when we receive FDA approval.

We have established a joint development committee with Allergan to oversee the joint development program and a joint commercial committee to establish the brand strategies and manage the relationship. Under the terms of the agreement, we provide bulk active drug substance while diquafosol is in development and Allergan is responsible for obtaining or manufacturing all of its bulk active drug substance requirements and for commercial supply of product.

We are responsible for conducting, in collaboration with Allergan, the Phase III clinical trials for diquafosol for dry eye disease and for United States NDA filing and approval. Allergan is responsible for all other development activities under the agreement, including all development outside the United States and in its territories, and for ex-United States regulatory submissions, filings, and approvals relating to products. Allergan is responsible for all commercial costs except for the cost of our sales force in the United States. Allergan is required to use commercially reasonable efforts to conduct development, seek regulatory approvals and market and sell the products.

The agreement will be in effect until all patents licensed under the agreement have expired. Either Allergan or we may terminate the agreement in the event of a material breach of the agreement. In addition, we have the right to terminate the agreement if we determine, subject to the joint commercialization or committee’s review and arbitration, that Allergan has not made reasonably sufficient progress in the commercialization of our product by giving 180 days prior notice. If Allergan

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breaches the agreement, becomes insolvent or we terminate for failure to make progress with the commercialization of our product, Allergan’s license will terminate and Allergan must provide us with all data and information relating to our product and must assign or permit us to cross-reference all regulatory filings and approvals.

Santen Pharmaceutical Co., Ltd.

In December 1998, we entered into a Development, License and Supply Agreement with Santen for the development of diquafosol for the therapeutic treatment of ocular surface diseases, such as dry eye disease, in Asia. Under the agreement, we granted Santen an exclusive license to market diquafosol for ocular surface diseases in Japan, China, South Korea, the Philippines, Thailand, Vietnam, Taiwan, Singapore, Malaysia and Indonesia.

We established a coordinating committee to review and evaluate Santen’s progress in the development and commercialization of products. Santen is responsible for all development, regulatory submissions, filings and approvals, and all marketing of products. We are obligated to supply Santen with its requirements of diquafosol in bulk drug substance form for all preclinical studies, clinical trials and commercial requirements at agreed-upon prices.

Under the terms of the agreement, we received an up-front equity investment of $1.5 million for shares of our preferred stock in December 1998, that were subsequently converted into shares of our common stock. During 2000, we received a milestone payment under the Santen Agreement of $500,000 based on achievement of a regulatory milestone by Santen. In addition, depending on whether all milestones are met, we could receive additional payments of up to $4.25 million, as well as royalties on net sales of licensed products.

The agreement will terminate when all patents licensed under the agreement have expired. Either Santen or we may terminate the agreement if the other materially breaches the agreement. In addition, we have the right to terminate the agreement at any time if we determine, subject to the coordinating committee’s review and arbitration, that Santen has not made reasonably sufficient progress in the development or commercialization of products. If Santen breaches the agreement, or if we terminate the agreement because Santen has not made sufficient progress, Santen’s license will terminate. Santen will provide us with all data and information relating to our products, and will assign or permit us to cross-reference all regulatory filings and approvals.

Cystic Fibrosis Foundation Therapeutics, Inc.

In October 2002, we entered into a study funding agreement with the CFFT, a non-profit drug development affiliate of the Cystic Fibrosis Foundation, for the funding of a Phase II study in INS37217 Respiratory for the treatment of cystic fibrosis. Under the agreement, the CFFT will provide the majority of funding of external costs for a Phase II trial of INS37217 Respiratory in exchange for post-commercialization development and sales milestone payments. The trial is a Phase II proof-of-concept study whereby predetermined success criteria have been defined. If the success criteria are achieved clinical development will continue, either directly by us or through a mutually acceptable licensee. If the product candidate ultimately receives FDA approval, we would be obligated to pay a development milestone to the CFFT, calculated as a multiple of the trial costs incurred by the CFFT. In addition, we would be obligated to pay a sales milestone if the product candidate achieves a certain aggregate sales volume in the first five years following product approval. The development milestone could exceed $10 million, payable over five years and the sales milestone would be an additional $4 million, payable over two years.

The trial was designed in collaboration with the CFFT and the Therapeutics Development Network. We are working with the Therapeutics Development Network and its coordinating center in conducting the study. The agreement will terminate no later than the expiration of all payment obligations under the agreement. Either the CFFT or we may terminate the agreement if the other materially breaches the agreement.

Kirin Brewery Co., Ltd. Pharmaceutical Division

In September 2000, we entered into a License Agreement with Kirin for the development and commercialization of INS316 Diagnostic. Under the agreement we granted Kirin an exclusive license to commercialize INS316 Diagnostic in 21 Asian countries and regions, including Japan.

We established a coordinating committee to review and evaluate Kirin’s progress in the development and commercialization of the product and to provide input and recommendations regarding development of the product. Kirin is responsible for all development, regulatory submissions, filings and approvals, and all marketing of the product. We are responsible for providing Kirin copies of preclinical and clinical data relating to the development and commercialization of the product within 30 days after any such information becomes available. Under the terms of the agreement, we received an up-front payment in cash and will receive milestone payments based on clinical success and approval.

The agreement will terminate on the later of the 10th anniversary of the first commercial sale of the product or the date on which the sale of the product ceases to be covered by a valid claim of any licensed patent under the agreement. Either Kirin or we may terminate the agreement if the other materially breaches the agreement. In addition, Kirin has the right, by giving us 180 days prior notice, to terminate the agreement at any time.

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Research and Development

Discovery

Our scientists have specific expertise and proprietary knowledge relating to the design and synthesis of P2 receptor agonists and antagonists, including P2Y₂ agonists, P2Y₁₂ antagonists and P2X antagonists. We have invested in state-of-the-art equipment and laboratory space for performing synthetic chemistry, determination of compound structure and receptor location and function identification. Our discovery effort is focused on conducting studies using cell-based scientific tests that measure biological activities caused by stimulation or blocking of P2 receptors, to identify new compounds that specifically and selectively bind to members of the P2 receptor family. These tests enable us to identify agonists and antagonists that act at specific receptor subtypes and demonstrate a level of specificity and activity that merits further investigation. We use data from these tests to design and synthesize compounds specific to each P2 receptor subtype that can be advanced to clinical trials.

By screening against several P2 receptor subtypes, we have been able to identify agonists and/or antagonists that interact preferentially with a specific receptor subtype. Several proprietary discovery compounds, including new chemical entities, with promising stability and metabolic profiles are being actively explored. We intend to conduct further preclinical development studies to advance such proprietary compounds to project status, if appropriate. These compounds will then be targeted to the treatment of new disease areas, as identified through our strategic planning process.

Additionally, we signed a fee-for-service agreement with Discovery Partners International in August 2002 in our P2 receptor antagonist program. This collaboration allows for efficient and cost-effective synthesis of compounds that may be important in the treatment of various diseases.

We obtain access to chemical libraries through our own proprietary chemistry, commercial sources and corporate agreements. The chemicals are screened for both agonist and antagonist activity. Our chemistry department also assists in the development of analytical protocols used by contract service organizations for analysis of a drug substance, clinical trial material and drug stability studies which will be incorporated into IND and NDA filings.

We use sponsored research agreements to investigate specific biological processes to augment our technology platform. We have sponsored research agreements at major universities. We use contract research organizations for all toxicology and most in vivo studies (studies involving live mammals) required for regulatory submissions, such as IND applications.

Development

After a molecule is determined to be an appropriate product candidate based upon our business strategy, it moves into the development phase of our organization, where extensive testing of both the characteristics of the actual product and the effects it has on humans are conducted. The progression of products through the various stages of development is overseen by the Portfolio Review Committee, a group comprised of the company officers and selected senior staff from the Development and Discovery departments. Our Development function is divided into four functional areas, Pharmaceutical Development, Regulatory Affairs, Clinical Research, and Biostatistics and Data Management

Generally, when a product is judged as ready for human testing, an IND is filed with the FDA allowing us to embark on human testing in the United States. Since 1997, we have filed six INDs for products that were subsequently evaluated in humans. Some of these products have progressed to later phases of development, most notably diquafosol eye drops for dry eye disease, for which an NDA was filed in June 2003. In addition to internal resources, we have many collaborations that allow us to perform development activities with a limited number of staff.

See “Management’s Discussion and Analysis of Financial Conditions and Results of Operations – Research and Development Expenses.”

Sales and Marketing

To fulfill our role in selling and promoting Elestat^™ and Restasis® and launching future products, we hired 64 highly experienced territory managers and 6 regional sales directors to provide us with national sales coverage for our ophthalmic products. Our small, specialty commercial organization will focus its promotional efforts on ophthalmologists, optometrists and allergists. We believe our focused marketing organization and a specialty sales force can effectively address these audiences and effectively co-promote these products. Eye care professionals account for the majority of the dry eye disease prescriptions, and combined with the allergists these specialties prescribe approximately half of the ocular allergies prescriptions. Targeting these

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medical specialties is an excellent strategic fit for Elestat^™ and our dry eye disease products, diquafosol (currently under FDA review) and Restasis®. In addition to our direct field efforts, we intend to heighten the awareness of our products through advertisements in professional journals, targeted direct mail and seminars designed to educate eye care professionals and allergists on the therapeutic areas in which we promote. We expect to experience seasonality in the sale of Elestat^™, with a large increase in sales in the spring and a lesser increase during the summer and fall.

In the United States, we are co-promoting Elestat^™ and Restasis® and intend to co-promote diquafosol if and when that product candidate receives FDA approval. We co-promote Restasis® in the United States with Allergan, but have primary United States sales and marketing responsibilities for Elestat^™. Outside of the United States, we expect diquafosol and any other product candidates that we successfully develop to be commercialized through arrangements or collaborations with third parties, as we do not intend to develop international operations outside of North America. We have not developed commercial plans for our product candidates beyond Elestat^™, Restasis® and diquafosol as these plans will be dependent in large part on their market potential and our financial resources. We intend to establish corporate partnering, licensing or other arrangements for the marketing and sale of these products, especially outside of the United States. Accordingly, third parties may have significant control or influence over important aspects of the commercialization of our product candidates, including market identification, marketing methods, pricing, composition and magnitude of sales force and promotional activities. We may have limited control over the amount and timing of resources that a third party devotes to our products.

We feel the establishment of commercial operations provides us with the opportunity and flexibility to market and sell other products we are developing, or products that we may in-license or otherwise acquire and to maximize their commercial value in the United States.

Compliance

We are committed to conducting our business fairly, honestly, ethically and lawfully. We act responsibly and with integrity in our relationships with patients, health care professionals, providers, governments, regulatory entities, customers, suppliers, and vendors.

We have designated a Corporate Compliance Officer who reports to the Chief Executive Officer and Chairman of the Audit Committee of the Board of Directors. The Corporate Compliance Officer is responsible for evaluating potential compliance risks within the company and designing control procedures. This is achieved by conducting audits consistent with implementation of codes, policies and other controls. Areas of control include, but are not limited to, compliance with current Federal and State law, such as Sarbanes-Oxley Act of 2002, U.S. Foreign Corrupt Practices Act of 1977, NASDAQ and National Association of Securities Dealers listing requirements and Securities and Exchange Commission, FDA, and Office of Inspector General regulations. Codes and policies that have been implemented include, but are not limited to, “Code Of Ethics and Conduct Relating to Financial Affairs,” “Code of Business Ethics,” “Whistleblower Policy” and “Code of Conduct: Promotional Interactions with Health Care Professionals.” The Corporate Compliance Officer provides frequent updates to senior management, the Audit Committee of the Board of Directors and to the full Board of Directors.

Manufacturing and Supply

We do not currently engage in, nor do we expect to engage in, the manufacture of bulk active pharmaceutical ingredients, or APIs, for preclinical, clinical or commercial purposes. We rely on a contract manufacturing supply arrangement with a single manufacturer, Yamasa Corporation located in Choshi, Japan, for the development stage production of INS316 Diagnostic, diquafosol and INS37217. We expect that Yamasa will ultimately supply commercial quantities of INS316 Diagnostic, diquafosol and INS37217 for both respiratory and ophthalmic applications. We have already obtained clinical trial grade batches of these compounds from Yamasa and, in addition, they have completed the validation of the manufacturing process for diquafosol. Although we have identified alternative sources for product candidates, we presently depend on Yamasa as the sole manufacturer of our supply of APIs for our product candidates. See “Risk Factors— Reliance on a single party to manufacture and supply either finished product or the bulk APIs for a product or product candidates could adversely affect us.”

In addition to the bulk APIs, our products incorporate pharmacopeial grade excipients such as sodium chloride, sodium hydroxide and hydrochloric acid, all of which are readily available from numerous sources. Many of our clinical trial materials are packaged in unit-dose form-fill-seal vials, which are manufactured by Cardinal Health Pharmaceutical Technologies & Services—Automatic Liquid Packaging of Woodstock, Illinois, but similar vials are also available from other commercial filling and packing companies. In addition to unit-dose vial packaging, we also administer our products as metered-dose nasal sprays and intravitreal injections. The metered-dose nasal pump delivery system is comprised of a plastic bottle manufactured by Createchnic AG of Nuerensdorf, Switzerland and a nasal spray pump manufactured by Pfeiffer GmbH of Radolfzell, Germany. The intravitreal injections have been manufactured by Cardinal Health Pharmaceutical Technologies & Services — SP Pharmaceuticals of Albuquerque, NM and Formatech of Andover, MA using standard glass vials and rubber stoppers. In the case of both the nasal spray and intravitreal injection products, alternate sources of both components and manufacturing sites are available.

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We have established a Corporate Quality Assurance and Regulatory Compliance Division to conduct qualification and routine audits of our contract manufacturers. These contract manufacturers are identified in our regulatory agency filings, such as with the FDA, and are subject to Regulatory Agency Inspections. We also attempt to stay informed on the financial condition of contract manufacturers and their status with regulatory agencies. We also maintain an inventory of drug product in order to minimize the risk of material shortage. A prolonged interruption in supply could adversely disrupt our manufacturing plans.

The manufacture of our products and product candidates is based in part on technology that we believe to be proprietary to our contract manufacturers or our collaborative partners. Such manufacturers may not abide by the limitations or confidentiality restrictions in agreements with us. In addition, any such manufacturer may develop process technology related to the manufacture of our compounds that such supplier owns either independently or jointly with us. This would increase our reliance on such manufacturer or require us to obtain a license from such manufacturer in order to have our products manufactured.

Patents and Proprietary Rights

We believe that the proprietary protection of our product candidates, processes and know-how is important to the success of our business. We aggressively file and prosecute patents covering our proprietary technology, and, if warranted, will defend our patents and proprietary technology. As of January 31, 2004, we owned or licensed patent rights consisting of 39 issued United States patents, none of which expire before 2011, and numerous pending applications in the United States and corresponding patents and patent applications in foreign jurisdictions. We seek patent protection for our proprietary technology and products in the United States and Canada and in key commercial European and Asia/Pacific countries and other major commercial sectors of the world, as appropriate. We intend to seek trademark protection in the United States and foreign countries, as appropriate. We also rely upon trade secrets, know-how, continuing technological innovation and licensing opportunities to develop and maintain our competitive position.

In March 1995, September 1998, and January 2002, we entered into three separate agreements with UNC granting us exclusive worldwide licenses to develop, make, use and sell products based on UNC patented technology relating to the use of P2Y receptor agonists and antagonists for respiratory therapeutics, such as INS365 Respiratory; respiratory diagnostics, such as INS316 Diagnostic; and prevention of platelet aggregation. The term of each of the UNC exclusive licenses is based upon the duration of the patents covered by each of these agreements. The United States government may have limited rights in some of this UNC patented technology. We also entered into a fourth agreement that granted us a non-exclusive worldwide license to use other UNC patented technology as a research tool to identify agonists and antagonists for P2Y receptors. The agreements require us to pay licensing fees upon the attainment of development milestones and royalties on net sales or a share of sublicensing income on products covered by the patents. We are also required to meet due diligence milestones and UNC may terminate the licenses if we fail to do so. In connection with the licenses, we issued to UNC an aggregate of 326,286 shares of our common stock, of which 128,610 shares have been transferred to the inventors of the licensed UNC patented technology. We also entered into consulting agreements with some of the inventors of these technologies, all of whom are from UNC, including Dr. Richard C. Boucher, one of our founders and an Emeritus Board Observer, Dr. M. Jackson Stutts, Dr. Kendall Harden and Dr. Michael Knowles, in which they agreed to consult with us regarding their respective fields of knowledge.

Additional patent applications have since been filed on discoveries made in support of such technologies, from research conducted at UNC or in our own laboratories. Our sponsored research agreements, material transfer agreements, and other collaborations have the potential to result in license agreements with universities, institutes and businesses. We believe that our patents and licensed patents provide a substantial proprietary base that will allow us, and our collaborative partners, to exclude others from conducting our business as described in this report and as encompassed by our issued patents and issued patents licensed to us. We cannot be sure, however, that pending or future applications will issue, that the claims of any patents which do issue will provide any significant protection of our technology or that our directed discovery research will yield compounds and products of therapeutic and commercial value.

Our competitors or potential competitors may have filed for, or have received, United States and foreign patents and may obtain additional patents and proprietary rights relating to compounds, uses and/or processes which may compete with our product candidates. Accordingly, there can be no assurance that our patent applications will result in patents being issued or that, if issued, the claims of the patents will afford protection against competitors with similar technology, nor can we be sure that others will not obtain patents that we would need to license or circumvent in order to practice our inventions.

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Competition

Many pharmaceutical companies engage in research and development to commercialize products to treat allergic conjunctivitis, dry eye disease, cystic fibrosis, allergic rhinitis and other diseases that we are researching. We compete with these companies for funding, access to licenses, personnel, third party collaborators and product development. Almost all of these companies have substantially greater financial, marketing, sales, distribution and technical resources and more experience in research and development, clinical trials and regulatory matters, than we do. We are aware of existing palliative treatments that will compete with our products.

We believe that several major pharmaceutical companies have initiated research programs to design P2Y receptor agonists or antagonists. However, we are not aware of any competing P2Y₂ receptor agonists that have entered clinical testing. If successfully developed and commercialized, our products will compete with existing therapeutics and any new treatments developed by competitors.

Although we believe that none of the therapeutic approaches described above address the underlying problem of excessive retained mucus and impaired mucociliary clearance, drugs based on other therapeutic mechanisms may be efficacious in treating respiratory diseases. The development by others of treatments that are not related to our mucociliary clearance approach could render our product candidates non-competitive or obsolete.

There are multiple therapies available to treat or prevent allergic conjunctivitis. The primary brands that Elestat^™ will compete with are the antihistamine and mast cell stabilizers and include: Patanol®, Zaditor® and Optivar®. Patanol® currently has the majority of the prescriptions in the allergic conjunctivitis market.

The current prescription and non-prescription treatments for dry eye disease include artificial tear replacement therapy or lubricant eye drops. The FDA approved Restasis® in December of 2002 for patients with dry eye disease whose tear production is presumed to be suppressed due to ocular inflammation. We are aware of the following dye eye disease products in clinical development: 15HETE, by Alcon, Inc.; OPC-12759 (rebamipide), by Otsuka Pharmaceuticals; ProGraf/FK-506, by Fujisawa Healthcare, Inc.; and Androgen Tears, by Allergan.

There are two products approved in the United States specifically for the treatment of cystic fibrosis: Pulmozyme^®, an agent designed to break up thickened airway secretions, and TOBI^®, an inhaled antibiotic. At least one study has been completed that demonstrated clinical benefit with Zithromax^®, an oral antibiotic. Although Zithromax^® has not been officially approved for use in cystic fibrosis, it has been added to the treatment regimen in patients with evidence of airway infection.

We are not aware of any other pharmaceuticals treatments available for retinal detachment.

Plavix® is an approved platelet aggregation inhibitor that irreversibly inhibits the P2Y₁₂ receptor on platelets. There are two P2Y₁₂ receptor antagonists in clinical development as platelet aggregation inhibitors. Cangrelor (The Medicines Company) has finished Phase II clinical testing using intravenous administration. AZD6140 (AstraZeneca) is in Phase II clinical testing and is an oral formulation.

The introduction of new products or the development of new processes by competitors or new information about existing products may result in price reductions or product replacements, even for products protected by patents. However, we believe our competitive position is enhanced by our commitment to research leading to the discovery and development of new products. Other factors that may help us meet competition include the quality and breadth of our technology platform, the skill of our employees and our ability to recruit and retain skilled employees, our aggressive program of seeking patent protection and our capabilities for early stage research and drug discovery. However, many large pharmaceutical and biotechnology companies have significantly larger intellectual property estates than we do, more substantial capital resources than we have and greater capabilities and experience than we do in preclinical and clinical development, sales, marketing, manufacturing and regulatory affairs.

Governmental Regulation

The research, development, testing, manufacture, promotion, marketing and distribution of human therapeutic and diagnostic products are extensively regulated by governmental authorities in the United States and other countries. In the United States, the FDA regulates drugs and diagnostic products and similar regulatory bodies exist in other countries. The steps ordinarily required before a new drug may be marketed in the United States, which are similar to steps required in most other countries, include:

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Preclinical tests include laboratory evaluation of product toxicity and formulation, as well as animal studies. The results of preclinical testing are submitted to the FDA as part of an IND. A 30-day waiting period after the filing of each IND is required before the commencement of clinical testing in humans. At any time during this 30-day period or later, the FDA may halt proposed or ongoing clinical trials until the FDA authorizes trials under specified terms. The IND process may be extremely costly and substantially delay development of our products. Moreover, positive results of preclinical tests will not necessarily indicate positive results in clinical trials.

Clinical trials to support NDAs are typically conducted in three sequential phases, but the phases may overlap. During Phase I, the initial introduction of the drug into healthy human subjects or patients, the drug is tested to assess metabolism, pharmacokinetics and pharmacological actions and safety, including side effects associated with increasing doses. Phase II usually involves studies in a limited patient population to:

If a compound is found to be potentially effective and to have an acceptable safety profile in Phase II evaluations, Phase III trials, also called pivotal studies, major studies or advanced clinical trials, are undertaken to further demonstrate clinical efficacy and to further test for safety within an expanded patient population at geographically dispersed clinical study sites.

After successful completion of the required clinical testing, generally a NDA is submitted. The FDA may request additional information before accepting a NDA for filing, in which case the application must be resubmitted with the additional information. Once the submission has been accepted for filing, the FDA has 180 days to review the application and respond to the applicant. The review process is often significantly extended by FDA requests for additional information or clarification. The FDA may refer the NDA to an appropriate advisory committee for review, evaluation and recommendation as to whether the application should be approved, but the FDA is not bound by the recommendation of an advisory committee.

If FDA evaluations of the NDA and the manufacturing facilities are favorable, the FDA may give us either an approval letter or an approvable letter. An approvable letter will usually contain a number of conditions that must be met, which may include additional testing, in order to secure final approval of the NDA and authorization of commercial marketing of the drug for particular indications. The FDA may refuse to approve the NDA or give us a non-approvable letter, outlining the deficiencies in the submission. If regulatory approval of a product is granted, it will be limited to particular disease states or conditions.

We and any of our contract manufacturers are also required to comply with the applicable FDA current good manufacturing practice regulations. Good manufacturing practice regulations include requirements relating to quality control and quality assurance as well as the corresponding maintenance of records and documentation. Manufacturing facilities are subject to inspection by the FDA. These facilities must be approved before we can use them in commercial manufacturing of our products. Our contract manufacturers or we may not be able to comply with the applicable good manufacturing practice requirements and other FDA regulatory requirements.

Outside the United States, our ability to market our products will also depend on our receipt of marketing authorizations from the appropriate regulatory authorities. The requirements governing the conduct of clinical trials and marketing authorization vary widely from country to country. At present, foreign marketing authorizations are applied for at a national level, although within the European Union procedures are available to companies wishing to market a product in more than one member state. If the regulatory authority is satisfied that adequate evidence of safety, quality and efficacy has been presented, a marketing authorization will be granted. This foreign regulatory approval process, including those in Europe and Japan, involves all of the risks associated with FDA clearance discussed above.

Health Care Reform Measures and Third Party Reimbursement

The efforts of governments and third party payors to contain or reduce the cost of health care will continue to affect the business and financial condition of drug companies. A number of legislative and regulatory proposals to change the health care system have been considered in recent years. In addition, an increasing emphasis on managed care in the United States has and will continue to increase pressure on drug pricing. Legislative or regulatory proposals or changes in managed care systems may be adopted that may have a negative effect on our business. The announcement and/or adoption of proposals could have an adverse effect on our ability to earn profits and financial condition. Sales of prescription drugs depend significantly on the availability of reimbursement to the consumer from third party payors, such as government and private insurance plans. These

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third party payors frequently require that drug companies give them predetermined discounts from list prices, and they are increasingly challenging the prices for medical products and services. Third party payors may not consider products we may bring to the market cost effective and may not reimburse the consumer sufficiently to allow us, and/or our collaborators, to sell our products on a profitable basis.

Employees

As of January 31, 2004, we had 150 full-time and part-time employees. In addition, we utilize interns, outside contractors and consultants as needed. Our future success will depend in large part upon our ability to attract and retain highly qualified personnel. Our employees are not represented by any collective bargaining agreements, and we have never experienced a work stoppage. Employees are required to execute confidentiality and assignment of intellectual property agreements.

Internet Information

Our internet site is located at www.inspirepharm.com. Copies of our reports filed pursuant to Section 13(a) or 15(d) of the Exchange Act, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports may be accessed from our website, free of charge, as soon as reasonably practicable after we electronically file such reports with, or furnish such reports to, the Securities and Exchange Commission.

We file our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 electronically with the Securities and Exchange Commission, or the SEC. The public may read or copy any materials we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of that site is www.sec.gov.

RISK FACTORS

An investment in the shares of our common stock involves a substantial risk of loss. You should carefully read this entire report and should give particular attention to the following risk factors. You should recognize that other significant risks may arise in the future, which we cannot foresee at this time. Also, the risks that we now foresee might affect us to a greater or different degree than expected. There are a number of important factors that could cause our actual results to differ materially from those indicated by any forward-looking statements in this document. These factors include, without limitation, the risk factors listed below and other factors presented throughout this document and any other documents filed by us with the Securities and Exchange Commission.

If our products are not safe or we are not able to demonstrate efficacy, we will be unable to obtain FDA or foreign regulatory approval and will not be able to sell those products.

To achieve profitable operations, we must, alone or with others, successfully identify, develop, introduce and market proprietary products. We have not received marketing approval for any of our products, although we are co-promoting two products with Allergan, and have one product candidate, diquafosol for dry eye disease, under review by the FDA for commercial approval. Although our NDA has been accepted and we have received an approvable letter for diquafosol, the FDA has informed us that an additional clinical study must be conducted to replicate the efficacy that was demonstrated by an earlier clinical trial. There is no guarantee that an additional clinical trial will be successful or that the FDA will approve diquafosol and allow us to begin selling it in the United States. Even if we do receive FDA approval for diquafosol, we and Allergan may not be able to successfully commercialize diquafosol in the United States. We have not applied for marketing approval of diquafosol in any other jurisdiction.

With the exception of our five product candidates in clinical trials, diquafosol, INS37217 Respiratory, INS37217 Ophthalmic, INS37217 Intranasal and INS316 Diagnostic, all of our remaining product candidates are in research or preclinical development. A substantial amount of work will be required to advance these candidates to clinical testing. We will have to conduct significant additional development activities and non-clinical and clinical tests, and obtain regulatory approval before our product candidates can be commercialized. Product candidates that may appear to be promising at early stages of development may not successfully reach the market for a number of reasons. The results of preclinical and initial clinical testing of our products under development may not necessarily indicate the results that will be obtained from later or more extensive testing. Companies in the pharmaceutical and biotechnology industries have suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier trials, as was the case with our INS37217 Intranasal program. Our ongoing clinical studies might be delayed or halted for various reasons, including:

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The introduction of our products in foreign markets will subject us to foreign regulatory clearances, the receipt of which may be unpredictable and uncertain, and which may impose substantial additional costs and burdens which we or our partners in such foreign markets may be unwilling or unable to pay. As with the FDA, foreign regulatory authorities must be satisfied that adequate evidence of safety, quality, and efficacy of the product has been presented before marketing authorization is granted. The foreign regulatory approval process includes all of the risks associated with obtaining FDA marketing approval. Approval by the FDA does not ensure approval by other regulatory authorities.

Failure to successfully market and commercialize Restasis® and Elestat^™ will limit our revenues.

Allergan launched Restasis® in the United States in April 2003. Although we are entitled to receive royalty payments from Allergan on the sales of Restasis® beginning in April 2004, Allergan is primarily responsible for marketing and commercializing Restasis®. Our agreement with Allergan provides, and we have exercised, the right to co-promote Restasis® in the United States. In February 2004, we launched Elestat^™ in the United States. Our agreement with Allergan provides that we will have the primary responsibility for selling, promotional and marketing activities related to Elestat^™ in the United States. We are required to pay the costs in relation to such activities.

Until our launch of Elestat^™ and co-promotion of Restasis®, we had never been involved in the promotion or co-promotion of a product. The commercial success of both Restasis® and Elestat^™ will largely depend on the acceptance by eye care professionals, allergists and patients, the launch into other major pharmaceutical markets, ongoing promotional activities, a knowledgeable sales force and adequate market penetration.

Failure to adequately control compliance with all applicable regulations may adversely affect our business.

There are extensive state, federal and foreign regulations applicable to public pharmaceutical companies engaged in the discovery, development and commercialization of medicinal products. There are laws that govern areas including financial controls, testing, manufacturing, labeling, safety, packaging, shipping, distribution and promotion of pharmaceuticals. We have implemented corporate quality, ethics and compliance programs, however we cannot guarantee against all possible transgressions. The potential ramifications are far-reaching if there are areas identified as out of compliance by regulatory agencies including, but not limited to, significant financial penalties, manufacturing and clinical trial consent decrees, commercialization restrictions or other restrictions and litigation.

Failure to adequately market and commercialize diquafosol, if approved by the FDA, will limit our revenues.

Although we plan to co-promote our diquafosol product candidate in the event we receive approval from the FDA, Allergan is primarily responsible for marketing diquafosol in the United States and other major, ex-Asia, pharmaceutical markets in the event the FDA, or foreign regulatory authorities, approves such product candidate. If approved by the FDA and other applicable regulatory authorities, the commercial success of diquafosol will largely depend on the scope of the launch into the United States and other major pharmaceutical markets, acceptance by patients and eye care professionals and allergists, ongoing promotional activities, a knowledgeable sales force and adequate market penetration. If diquafosol is not successfully commercialized, our revenues will be adversely affected.

We cannot sell Restasis®, Elestat^™ or any of our product candidates if we do not obtain and maintain governmental approvals.

Pharmaceutical companies are subject to heavy regulation by a number of national, state and local agencies, including the FDA. Failure to comply with applicable regulatory requirements could, among other things, result in fines, suspensions of regulatory approvals of products, product recalls, delays in product distribution, marketing and sale, and civil or criminal sanctions.

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The manufacturing and marketing of drugs, including our products, are subject to continuing FDA and foreign regulatory review, and later discovery of previously unknown problems with a product, manufacturing process or facility may result in restrictions, including withdrawal of the product from the market. The FDA is permitted to revisit and change its prior determinations and it may change its position with regard to the safety or effectiveness of our products. The FDA is authorized to impose post-marketing requirements such as:

Even before any formal regulatory action, we, or our collaborative partners, could voluntarily decide to cease distribution and sale or recall any of our products if concerns about safety or effectiveness develop.

In its regulation of advertising, the FDA from time to time issues correspondence to pharmaceutical companies alleging that some advertising or promotional practices are false, misleading or deceptive. The FDA has the power to impose a wide array of sanctions on companies for such advertising practices, and if we were to receive correspondence from the FDA alleging these practices we might be required to:

In recent years, various legislative proposals have been offered in Congress and in some state legislatures that include major changes in the health care system. These proposals have included price or patient reimbursement constraints on medicines and restrictions on access to certain products. We cannot predict the outcome of such initiatives, and it is difficult to predict the future impact of the broad and expanding legislative and regulatory requirements affecting us.

If Elestat^™ and, to a lesser extent, Restasis® do not gain and sustain market acceptance, our revenues may not be predictable and may not cover our operating expenses.

Our future revenues will depend, in part, upon eye care professionals, allergists and patient acceptance of Elestat^™ and, to a lesser extent, Restasis^®. Factors that could affect the acceptance of Elestat^™ and Restasis^® include:

We cannot predict the potential long-term patient acceptance of, or the effects of competition and managed health care on, sales of either product.

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Because our clinical candidates utilize a new mechanism of action and in some cases there are no regulatory precedents, designing clinical trials and obtaining regulatory approval may be difficult, expensive and prolonged, which would delay any marketing of our products.

To complete successful clinical trials, our candidates must meet the criteria for clinical approval, or endpoints, which we establish in the clinical study. Generally, we will establish these endpoints in consultation with the FDA, following its clinical trial design guidelines on the efficacy, safety and tolerability measures required for approval of products. However, since our product candidates are based on our novel receptor technology, and some of the diseases we are researching do not have products that have been approved by the FDA, the FDA may not have established guidelines for the design of our clinical trials and may take longer than average to consider our products for approval. The FDA could change its view on clinical trial design and establishment of appropriate standards for efficacy, safety and tolerability and require a change in study design, additional data or even further clinical trials before granting approval of our product candidates. We could encounter delays and increased expenses in our clinical trials if the FDA determines that the endpoints established for a clinical trial do not predict a clinical benefit. To the best of our knowledge, no P2Y₂ products have received marketing approval from the FDA.

After initial regulatory approval, the FDA continues to review a marketed product and its manufacturer. They may require us or our partners to conduct long-term safety studies after approval. Discovery of previously unknown problems through adverse event reporting may result in restrictions on the product, including withdrawal from the market. Additionally, we and our officers and directors could be subject to civil and criminal penalties.

Projected development costs are difficult to estimate and may change frequently prior to regulatory approval.

While all new compounds require standard regulated phases of testing, the actual type and scope of testing can vary significantly among different product candidates which may result in significant disparities in total costs required to complete the respective development programs.

The number and type of studies that may be required by the FDA for a particular compound are based on the compound’s clinical profile compared to existing therapies for the targeted patient population. Factors that affect the costs of a clinical trial include:

Other activities required before submitting a NDA include regulatory preparation for submission, biostatistical analyses, scale-up synthesis, and validation of commercial product. In addition prior to product launch, production of a certain amount of commercial grade drug product inventory meeting FDA current good manufacturing practice standards is required.

Also, ongoing development programs and associated costs are subject to frequent, significant and unpredictable changes due to a number of factors, including:

If we are not able to obtain sufficient additional funding to meet our expanding capital requirements, we may be forced to reduce or eliminate research programs and product development.

We have used substantial amounts of cash to fund our research and development activities. Our operating expenses exceeded $37.4 million in the fiscal year ended December 31, 2003, $30.3 million in the fiscal year ended December 31, 2002, and $34.0 million in the fiscal year ended December 31, 2001. We anticipate that our operating expenses in 2004 will increase from our 2003 operating expenses to provide for a new clinical trial for diquafosol and greater commercial activities. Our cash, cash equivalents and investments totaled approximately $75.2 million on December 31, 2003. We expect that our capital and operating expenditures will continue to exceed our revenue over the next several years as we conduct our research and

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development activities, address possible difficulties with clinical studies and undertake commercial sales. Many factors will influence our future capital needs. These factors include:

We are relying on the CFFT to fund the majority of the external costs of our Phase II trial for the treatment of cystic fibrosis. In addition, our capital requirements will depend upon:

In the event that we do not receive timely regulatory approvals, we may need substantial additional funds to fully develop, manufacture, market and sell all of our other potential products and support our co-promotion efforts. We may seek such additional funding through public or private equity offerings and debt financings. Additional financing may not be available when needed. If available, such financing may not be on terms favorable to us or our stockholders. Stockholders’ ownership will be diluted if we raise additional capital by issuing equity securities. If we raise funds through collaborations and licensing arrangements, we may have to give up rights to our technologies or product candidates which are involved in these future collaborations and arrangements or grant licenses on unfavorable terms. If adequate funds are not available, we would have to scale back or terminate research programs and product development and we may not be able to successfully commercialize any product candidate.

Clinical trials may take longer to complete and cost more than we expect, which would adversely affect our ability to commercialize product candidates and achieve profitability.

Clinical trials are lengthy and expensive. They require adequate supplies of drug product and sufficient patient enrollment. Patient enrollment is a function of many factors, including:

Delays in patient enrollment can result in increased costs and longer development times. Although we started our Phase III clinical trial for INS316 Diagnostic in May 2001, as a result of very slow enrollment, we curtailed enrollment to approximately 700 patients, instead of a previously expected enrollment of at least 800 patients. Following completion of the trial we will analyze the data, but it is unlikely that we will progress the INS316 Diagnostic program beyond the trial. Even if we successfully complete clinical trials, we may not be able to submit any required regulatory submissions in a timely manner and we may not receive regulatory approval for the product candidate. In addition, if the FDA or foreign regulatory authorities require additional clinical trials we could face increased costs and significant development delays.

We intend to initiate a new study for diquafosol; however, we must first complete the design of the study protocol in consultation with the FDA to ensure the study design is acceptable.

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We conduct clinical trials in different countries around the world and are subject to the risks and uncertainties of doing business internationally. Disruptions in communication and transportation, changes in governmental policies, civil unrest and currency exchange rates may affect the time and costs required to complete clinical trials in other countries.

Changes in regulatory policy or new regulations could also result in delays or rejection of our applications for approval of our product candidates. Product candidates designed as “fast track” products by the FDA may not continue to qualify for expedited review. Even if some of our product candidates receive “fast track” designation, the FDA may not approve them at all or any sooner than other product candidates that do not qualify for expedited review.

Our common stock price has been highly volatile and your investment in our stock may decline in value.

The market price of our common stock has been highly volatile. These fluctuations create a greater risk of capital losses for our stockholders as compared to less volatile stocks. Factors that have caused volatility and could cause additional volatility in the market price of our common stock include among others:

Extreme price and volume fluctuations occur in the stock market from time to time that can particularly affect the prices of biotechnology companies. These extreme fluctuations are sometimes unrelated to the actual performance of the affected companies.

If we continue to incur operating losses for a period longer than anticipated, or in an amount greater than anticipated, we may be unable to continue our operations.

We have experienced significant losses since inception. We incurred net losses of $31.4 million for the year ended December 31, 2003, $24.7 million for the year ended December 31, 2002, and $23.1 million for the year ended December 31, 2001. As of December 31, 2003, our accumulated deficit was approximately $127.1 million. We expect to incur additional significant operating losses over the next several years and expect that cumulative losses may increase in the near-term due to expanded research and development efforts, preclinical studies, clinical trials and commercialization efforts. We expect that losses will fluctuate from quarter to quarter and that such fluctuations may be substantial. Such fluctuations will be affected by the following:

To achieve and sustain profitable operations, we must, alone or with others, develop successfully, obtain regulatory approval for, manufacture, introduce, market and sell our products. The time frame necessary to achieve market success is long and uncertain. We do not expect to generate revenues from sales of our products or any licensed products until the first quarter of 2004. We may not generate sufficient product revenues to become profitable or to sustain profitability. If the time required to achieve profitability is longer than we anticipate, we may not be able to continue our business.

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If we fail to reach milestones or to make annual minimum payments or otherwise breach our obligations, UNC may terminate our agreements with them.

Our INS316 Diagnostic clinical development program depends on two exclusive licenses and one non-exclusive license from UNC. We also hold licenses for INS365 for respiratory diseases and a P2Y₁₂ receptor program for a cardiovascular indication. If we fail to meet performance milestones relating to the timing of regulatory filings or pay the minimum annual payments under our respective UNC licenses, UNC may terminate the applicable license. The termination of one or more of these license agreements will prohibit us from completing the development of INS316 Diagnostic and adversely effect any programs in our pipeline based on the technology licensed from UNC. In addition, if UNC were to re-license some or all of the technologies currently covered by our licenses, competitors could develop products that compete with ours.

In addition, it may be necessary in the future for us to obtain additional licenses from UNC or other third parties to develop future commercial opportunities or to avoid infringement of third party patents. We do not know the terms on which such licenses may be available, if at all.

Reliance on a single party to manufacture and supply either finished product or the bulk APIs for a product or product candidates could adversely affect us.

Under our agreements with Allergan, Allergan is responsible for the manufacture and supply of Elestat^™ and Restasis®. We understand that in each case Allergan relies upon an arrangement with a single third party for the manufacture and supply of APIs and then Allergan completes the manufacturing process to yield finished product. In the event such third party was unable to supply Allergan, or Allergan was unable to complete the manufacturing cycle, sales of the product could be adversely impacted, which would result in a reduction in any royalties received under our agreements with Allergan.

In addition, we have relied upon supply agreements with third parties for the manufacture and supply of the bulk APIs of our product candidates for purposes of preclinical testing and clinical trials. While we have used several different suppliers for INS316 Diagnostic, we currently rely on Yamasa Corporation for its production. We presently also depend upon Yamasa as the sole manufacturer of our supply of APIs for our other product candidates and intend to contract with Yamasa, as necessary, for commercial scale manufacturing of our products where we are responsible for such activities. In the case of diquafosol, Allergan will purchase commercial quantities of bulk APIs from Yamasa. Although we have identified alternate sources for these supplies, it would be time consuming and costly to qualify these sources. Under our current agreements, either Yamasa or we may terminate our supply arrangement, without cause, by giving 180 days prior notice. If Yamasa were to terminate our arrangement or fail to meet our supply needs we might be forced to delay our development programs and/or be unable to supply products to the market which could delay or reduce revenues and result in loss of market share.

If we are unable to contract with third parties for the synthesis of APIs required for preclinical testing, for the manufacture of drug products for clinical trials, or for the large-scale manufacture of any approved products, we may be unable to develop or commercialize our drug products.

We have no experience or capabilities to conduct the large-scale manufacture of any of our drug substance candidates and no capabilities to manufacture any pharmaceutical drug products. We do not currently expect to engage directly in the manufacturing of drug substance or drug products, but instead intend to contract with third parties to accomplish these tasks. With the exception of Santen, for which we are required to supply bulk active pharmaceutical ingredient, all of our partners are responsible for making their own arrangements for the manufacture of drug products, including arranging for the manufacture of bulk active pharmaceutical ingredient. Our dependence upon third parties for the manufacture of both drug substance and finished drug products that remain unpartnered may adversely affect our ability to develop and deliver such products on a timely and competitive basis. Similarly, our dependence on our partners to arrange for their own supplies of finished drug products may adversely affect our revenues. If we, or our partners, are unable to engage or retain third party manufacturers on commercially acceptable terms, our products may not be commercialized as planned. Our strategy of relying on third parties for manufacturing capabilities presents the following risks:

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Our dependence on collaborative relationships may lead to delays in product development, lost revenues and disputes over rights to technology.

Our business strategy depends to some extent upon the formation of research collaborations, licensing and/or marketing arrangements. We currently have development collaborations with Santen and Kirin and development and commercialization collaborations with Allergan. The termination of any collaboration may lead to delays in product development and disputes over technology rights and may reduce our ability to enter into collaborations with other potential partners. Kirin has the right to terminate our license agreement, without cause, by giving us 180 days prior notice or, if we breach the agreement, Kirin may terminate immediately, if we fail to: (i) cure the breach, within 60 days of notice of the breach; or (ii) if such breach cannot be cured within 60 days, commence diligent efforts to cure the breach. Allergan and Santen may immediately terminate their agreements with us if we breach the applicable agreement and fail to cure the breach within sixty (60) days of being notified of such breach. If we materially breach our co-promotion agreement with Allergan for Elestat^™, Allergan has the right to terminate the agreement upon ninety (90) days written notice if we fail to cure the breach within that ninety (90) day period. If we do not maintain the Allergan, Santen or Kirin collaborations, or establish additional research and development collaborations or licensing arrangements, it will be difficult to develop and commercialize products using our technology. Any future collaborations or licensing arrangements may not be on terms favorable to us.

Our current or any future collaborations or licensing arrangements ultimately may not be successful. Under our current strategy, and for the foreseeable future, we do not expect to develop or market products on our own in all global markets. As a result, we will continue to depend on collaborators and contractors for the preclinical study and clinical development of therapeutic products and for manufacturing and marketing of products which result from our technology. Our agreements with collaborators typically allow them some discretion in electing whether to pursue such activities. If any collaborator were to breach or terminate its agreement with us or otherwise fail to conduct collaborative activities in a timely and successful manner, the preclinical or clinical development or commercialization of product candidates or research programs would be delayed or terminated. Any delay or termination in clinical development or commercialization would delay or eliminate potential product revenues relating to our research programs.

Disputes may arise in the future over the ownership of rights to any technology developed with collaborators. These and other possible disagreements between us and our collaborators could lead to delays in the collaborative development or commercialization of therapeutic or diagnostic products. Such disagreement could also result in litigation or require arbitration to resolve.

We may not be able to successfully compete with other biotechnology companies and established pharmaceutical companies.

The biotechnology and pharmaceutical industries are intensely competitive and subject to rapid and significant technological change. Our competitors in the United States and elsewhere are numerous and include, among others, major multinational pharmaceutical and chemical companies, specialized biotechnology firms and universities and other research institutions. These competitors include Alcon, AstraZeneca, Aventis, Boehringer Ingelheim, Chiron, Genentech, GlaxoSmithKline, Millennium Pharmaceuticals, Novartis, Pfizer and Schering-Plough. Most of these competitors have greater financial and other resources than we or our collaborative partners, including larger research and development staffs and more experienced marketing and manufacturing organizations.

In addition, most of our competitors have greater experience than we do in conducting preclinical and clinical trials and obtaining FDA and other regulatory approvals. Accordingly, our competitors may succeed in obtaining FDA or other regulatory approvals for product candidates more rapidly than we do. Companies that complete clinical trials, obtain required regulatory approvals, and commence commercial sale of their drugs before we do may achieve a significant competitive advantage, including patent and FDA marketing exclusivity rights that would delay our ability to market products. Drugs resulting from our research and development efforts, or from our joint efforts with our collaborative partners, may not compete successfully with competitors’ existing products or products under development.

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Acquisitions of competing companies and potential competitors by large pharmaceutical companies or others could enhance financial, marketing and other resources available to such competitors. Academic and government institutions have become increasingly aware of the commercial value of their research findings and are more likely to enter into exclusive licensing agreements with commercial enterprises to market commercial products. Many of our competitors have far greater resources than we do and may be better able to afford larger license fees and milestones attractive to those institutions. Our competitors may also develop technologies and drugs that are safer, more effective, or less costly than any we are developing or which would render our technology and future drugs obsolete and non-competitive. Current products marketed to treat cystic fibrosis include Pulmozyme® and TOBI®. Primary treatments for dry eye disease currently involve over-the-counter artificial tear replacement drops, punctual plugs and Restasis®. Current treatments for allergic conjunctivitis include antihistamines such as Patanol®, Zaditor® and Optivar®, as well as mast cell stabilizers. Current treatments for colds, allergic rhinitis and rhinosinusitis include antihistamines, antibiotics, decongestants and anti-inflammatory steroids, such as Flonase® and Nasonex®. In addition, alternative approaches to treating diseases which we have targeted, such as gene therapy, may make our product candidates obsolete.

We will rely substantially on third parties to market, distribute and sell our products and those third parties may not perform.

We have developed a commercialization organization to co-promote Elestat^™ and Restasis®, but we are dependent on Allergan, or other experienced third parties, to perform or assist us in the marketing, distribution or sale of these products and our product candidates. In addition, we may not identify acceptable partners or enter into favorable agreements with them for our other product candidates. If third parties do not successfully carry out their contractual duties, meet expected sales goals, maximize the commercial potential of our products, we may be required to hire or expand our own staff and sales force. If Allergan, or other third parties do not perform, or assist us in performing, these functions, it could have an adverse effect on our operations.

We have had limited experience in sales, marketing or distribution of products.

We have recently established a sales force to market and distribute Elestat^™, Restasis® and other potential products. Although the members of our sales force have had experience in sales with other companies, we have never had a sales force and may undergo difficulties maintaining the sales force. We have incurred substantial expenses in establishing the sales force, including substantial additional expenses for the training and management of personnel, and the infrastructure to enable the sales force to be effective. We expect to continue to incur substantial expenses in the future. The costs of maintaining our sales force may exceed our product revenues. We compete with many companies that currently have extensive and well-funded marketing and sales operations. Many of these competing companies have had substantially more experience in, and financial resources for sales, marketing and distribution. Our selling and marketing efforts may be unsuccessful.

Failure to hire and retain key personnel may hinder our product development programs and our business efforts.

We depend on the principal members of management and scientific staff, including Christy L. Shaffer, Ph.D., our Chief Executive Officer and a director, and Gregory J. Mossinghoff, our President and a director. If either of these people leaves us, we may have difficulty conducting our operations. We have not entered into agreements with either of the above officers or any other members of our management and scientific staff that bind them to a specific period of employment. Our future success also will depend in part on our ability to attract, hire and retain additional personnel skilled or experienced in the pharmaceutical industry. There is intense competition for such qualified personnel. We may not be able to continue to attract and retain such personnel.

If our patent protection is inadequate, the development and any possible sales of our product candidates could suffer or competitors could force our products completely out of the market.

Our business and competitive position depends on our ability to continue to develop and protect our products and processes, proprietary methods and technology. Except for patent claims covering new chemical compounds, most of our patents are use patents containing claims covering methods of treating disorders and diseases by administering therapeutic chemical compounds. Use patents, while providing adequate protection for commercial efforts in the United States, may afford a lesser degree of protection in other countries due to their patent laws. Besides our use patents, we have patents covering pharmaceutical formulations and patent applications covering processes for large-scale manufacturing. Many of the chemical compounds included in the claims of our use patents, formulation patents and process applications were known in the scientific community prior to our formation. None of our composition of matter patents to the compounds themselves cover these previously known chemical compounds, which are in the public domain. As a result, competitors may be able to commercialize products that use the

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same chemical compounds used by us for the treatment of disorders and diseases not covered by our use patents. In such a case, physicians, pharmacies and wholesalers could possibly substitute these products for our products. Such substitution would reduce our revenues.

If we must defend a patent suit, or if we choose to initiate a suit to have a third party patent declared invalid, we may need to make considerable expenditures of money and management time in litigation. We believe that there is significant litigation in the pharmaceutical and biotechnology industry regarding patent and other intellectual property rights. A patent does not provide the patent holder with freedom to operate in a way that infringes the patent rights of others. While we are not aware of any patent that we are infringing, nor have we been accused of infringement by any other party, other companies currently have, or may acquire, patent rights which we might be accused of infringing. A judgment against us in a patent infringement action could cause us to pay monetary damages, require us to obtain licenses, or prevent us from manufacturing or marketing the affected products. In addition, we may need to initiate litigation to enforce our proprietary rights against others. Should we choose to do this, as with the above, we may need to make considerable expenditures of money and management time in litigation. Further, we may have to participate in interference proceedings in the United States Patent and Trademark Office, or USPTO, to determine the priority of invention of any of our technologies.

Our ability to develop sufficient patent rights in our pharmaceutical, biopharmaceutical and biotechnology products to support commercialization efforts is uncertain and involves complex legal and factual questions. For instance, while the USPTO has recently issued guidelines addressing the requirements for demonstrating utility for biotechnology inventions, USPTO examiners may not follow these guidelines in examining our patent applications. If we have to appeal a decision to the USPTO’s Appeals Board for a final determination of patentability we could incur substantial legal fees.

Because we rely upon trade secrets and agreements to protect some of our intellectual property, there is a risk that unauthorized parties may obtain and use information that we regard as proprietary.

We rely upon the laws of trade secrets and non-disclosure agreements and other contractual arrangements to protect our proprietary compounds, methods, processes, formulations and other information for which we are not seeking patent protection. We have taken security measures to protect our proprietary technologies, processes, information systems and data, and we continue to explore ways to further enhance security. However, despite these efforts to protect our proprietary rights, unauthorized parties may obtain and use information that we regard as proprietary. Employees, academic collaborators and consultants with whom we have entered confidentiality and/or non-disclosure agreements may improperly disclose our proprietary information. In addition, competitors may, through a variety of proper means, independently develop substantially the equivalent of our proprietary information and technologies, gain access to our trade secrets, or properly design around any of our patented technologies.

If physicians and patients do not accept our product candidates, they will not be commercially successful.

Even if regulatory authorities approve our product candidates, those products may not be commercially successful. Acceptance of and demand for our products will depend largely on the following:

In addition, to achieve broad market acceptance of our product candidates, in many cases we will need to develop, alone or with others, convenient methods for administering the products. INS37217 Intranasal is administered as a nasal spray. Some patients may find the spray difficult to administer. We intend that diquafosol for the treatment of dry eye disease will be applied from a vial containing a single day’s dosage of non-preserved medication. Patients may prefer to purchase preserved medication for multiple doses. We have not yet established a plan to develop a multi-dose formulation. Although our partner, Santen, is developing a multi-dose formulation for use in their licensed territories, a multi-dose formulation has not been developed by our other partner, Allergan, for use in the remainder of the world. INS37217 Ophthalmic is administered through an intravitreal injection. It may be beneficial to patients to a have a sustained delivery device. We have not yet established a plan for a sustained delivery device for certain indications such as for chronic use. Similar challenges exist in identifying and perfecting convenient methods of administration for our other product candidates.

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If third party payors will not provide coverage or reimburse patients for any products we develop, our ability to derive revenues will suffer.

If government and health administration authorities, private health insurers and other third party payors do not provide adequate coverage and reimbursement levels for our products, the market acceptance of these products may be reduced. Reimbursement for newly approved health care products is uncertain. Third party payors, such as Medicare, are increasingly challenging the prices charged for medical products and services. Government and other third party payors are increasingly attempting to contain health care costs by limiting both coverage and the level of reimbursement for new therapeutic products. In the United States, a number of legislative and regulatory proposals aimed at changing the health care system have been proposed in recent years. In addition, an increasing emphasis on managed care in the United States has and will continue to increase pressure on pharmaceutical pricing. While we cannot predict whether legislative or regulatory proposals will be adopted or what effect those proposals or managed care efforts, including those relating to Medicare payments, may have on our business, the announcement and/or adoption of such proposals or efforts to do so could increase our costs and reduce or eliminate profit margins. Third party insurance coverage may not be available to patients for any products we discover or develop. In various foreign markets, pricing or profitability of medical products is subject to government control.

Our operations involve a risk of injury from hazardous materials, which could be very expensive to us.

Our research and development activities involve the controlled use of hazardous materials and chemicals. We cannot completely eliminate the risk of accidental contamination or injury from these materials. If such an accident were to occur, we could be held liable for any damages that result and any such liability could exceed our resources. In addition, we are subject to laws and regulations governing the use, storage, handling and disposal of these materials and waste products. The costs of compliance with these laws and regulations are substantial.

Our commercial insurance and umbrella policies include limited coverage designated for pollutant clean-up and removal and limited general liability coverage per occurrence and in the aggregate. The cost of these policies is significant and there can be no assurance that we will be able to maintain these policies or that coverage amounts will be sufficient to insure potential losses.

Use of our products may result in product liability claims for which we may not have adequate insurance coverage.

Clinical trials or manufacturing, marketing and sale of our potential products may expose us to liability claims from the use of those products. Although we carry clinical trial liability insurance and product liability insurance, we, or our collaborators, may not maintain sufficient insurance. If our insurance is insufficient, we do not have the financial resources to self-insure and it is unlikely that we will have these financial resources in the foreseeable future. If we are unable to protect against potential product liability claims adequately, we may find it difficult or impossible to continue to co-promote our products, or to commercialize the products we develop. If claims or losses exceed our liability insurance coverage, we may go out of business.

Our existing directors, executive officers and principal stockholders hold a substantial amount of our common stock and may be able to prevent other stockholders from influencing significant corporate decisions.

As of January 31, 2004, our directors, executive officers and current 5% stockholders and their affiliates beneficially own over 24% of our outstanding common stock. These stockholders, if they act together, may be able to direct the outcome of matters requiring approval of the stockholders, including the election of our directors and other corporate actions such as:

The decisions of these stockholders may conflict with our interests or those of our other stockholders.

Future sales by stockholders into the public market may cause our stock price to decline.

Future sales of our common stock by current stockholders into the public market could cause the market price of our stock to fall. As of January 31, 2004, there were 31,872,922 shares of common stock outstanding. Of these outstanding shares of common stock, 12,075,000 shares were sold in public offerings and are freely tradable without restriction under the Securities Act of 1933 (the “Securities Act”), unless purchased by our “affiliates.” Up to 6,428,571 shares of our common stock are issued or issuable upon exercise of stock options that have been, or may be, issued pursuant to our stock option plan. These shares have been registered pursuant to a registration statement on Form S-8. The remaining shares of common stock outstanding are not registered under the Securities Act and may be resold in the public market only if registered or if there is an exemption from registration, such as Rule 144.

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If some or all of such shares are sold into the public market over a short period of time, the value of all publicly traded shares is likely to decline, as the market may not be able to absorb those shares at then-current market prices. Such sales may make it more difficult for us to sell equity securities or equity-related securities in the future at a time and price that our management deems acceptable, or at all.

Further, we may issue additional shares:

As of January 31, 2004, there were outstanding options, which were exercisable to purchase 1,965,931 shares of our common stock, and outstanding warrants, which were exercisable to purchase 285,092 shares of our common stock. This amount combined with the total common stock outstanding at January 31, 2004 is 34,123,945 shares of common stock.

As a result of these factors, a substantial number of shares of our common stock could be sold in the public market at any time.

Our rights agreement, the anti-takeover provisions in our amended and restated certificate of incorporation and bylaws, and our right to issue preferred stock, may discourage a third party from making a take-over offer that could be beneficial to us and our stockholders and may make it difficult for stockholders to replace the board of directors and effect a change in our management if they desire to do so.

In October 2002, we entered into a Rights Agreement with Computershare Trust Company. The Rights Agreement could discourage, delay or prevent a person or group from acquiring 15% or more of our common stock. The Rights Agreement provides that if a person acquires 15% or more of our common stock without the approval of our board of directors, all other stockholders will have the right to purchase securities from us at a price that is less than its fair market value, which would substantially reduce the value of our common stock owned by the acquiring person. As a result, our board of directors has significant discretion to approve or disapprove a person’s efforts to acquire 15% or more of our common stock.

Our amended and restated certificate of incorporation and bylaws contain provisions which could delay or prevent a third party from acquiring shares of our common stock or replacing members of our board of directors. Our amended and restated certificate of incorporation allows our board of directors to issue shares of preferred stock. The board can determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. As a result, our board of directors could make it difficult for a third party to acquire a majority of our outstanding voting stock. Since management is appointed by the board of directors, any inability to effect a change in the board may result in the entrenchment of management.

Our amended and restated certificate of incorporation also provides that the members of the board will be divided into three classes. Each year the terms of approximately one-third of the directors will expire. Our bylaws do not permit our stockholders to call a special meeting of stockholders. Under the bylaws, only our Chief Executive Officer, President, Chairman of the Board, a majority of the board of directors, or the Secretary or any other officer upon the written request of one or more stockholders holding of record at least a majority of the outstanding shares of stock entitled to vote at such a meeting are able to call special meetings. The staggering of directors’ terms of office and the inability of stockholders to call a special meeting may make it difficult for stockholders to remove or replace the board of directors should they desire to do so. The bylaws also require that stockholders give advance notice to our Secretary of any nominations for director or other business to be brought by stockholders at any stockholders’ meeting. These provisions may delay or prevent changes of control or management, either by third parties or by stockholders seeking to change control or management.

We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. Under these provisions, if anyone becomes an “interested stockholder,” we may not enter a “business combination” with that person for three years without special approval, which could discourage a third party from making a take-over offer and could delay or prevent a change of control. For purposes of Section 203, “interested stockholder” means, generally, someone owning 15% or more of our outstanding voting stock or an affiliate of ours that owned 15% or more of our outstanding voting stock during the past three years, subject to certain exceptions as described in Section 203.

FORWARD LOOKING INFORMATION

This annual report on Form 10-K, including the documents that we incorporate by reference, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and within the meaning of Section 21E

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of the Securities Exchange Act of 1934, as amended, that are subject to the “safe harbor” created by those sections. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These statements are often, but not always, made through the use of words or phrases such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “believe,” “expect,” “future” and “intend” and similar expressions to identify forward-looking statements. There are a number of important factors that could cause our actual results to differ materially from those indicated by any forward-looking statements, including, without limitation, the risk factors listed above and other factors presented throughout this annual report and any other documents filed by us with the Securities and Exchange Commission.

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Item 2. Properties.

We lease contiguous administrative and laboratory facilities that comprise approximately 32,000 square feet in Durham, North Carolina, which is adjacent to the Research Triangle Park. The various leases underlying our facilities expire in July 2005 through November 2006 and are renewable. We believe our facilities will be adequate to meet our operational needs through July 2005 when certain of our leases expire.

Item 3. Legal Proceedings.

We are not a party to any material legal proceedings.

Item 4. Submission of Matters to a Vote of Security Holders.

Not applicable.

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PART II

Item 5. Market for the Company’s Common Equity and Related Stockholder Matters.

Our common stock has been traded on the Nasdaq National Market under the symbol “ISPH” since August 3, 2000. The following table sets forth, for the calendar periods indicated, the range of high and low closing sale prices for our common stock on the Nasdaq National Market:

As of January 30, 2004, there were 78 record stockholders and over 2,000 beneficial stockholders of our common stock. On January 30, 2004, the last sale price reported on the Nasdaq National Market for our common stock was $13.00 per share.

We have not paid or declared dividends on our common stock since our inception and do not plan to pay dividends on our common stock in the foreseeable future. Any earnings that we may realize will be retained to finance our growth.

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Item 6. Selected Financial Data.

The selected statement of operations data and balance sheet data with respect to the years ended December 31, 2003, 2002, 2001, 2000 and 1999 set forth below are derived from our financial statements which have been audited by PricewaterhouseCoopers LLP, independent auditors. The selected financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in Item 7 below, and our financial statements and the notes thereto contained in Item 8 below. Historical results are not necessarily indicative of our future results.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Cautionary Statement

The discussion below contains forward-looking statements regarding our financial condition and the results of operations that are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted within the United States. The preparation of these financial statements requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an ongoing basis. These estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.

We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. We are subject to risks common to biopharmaceutical companies, including risks inherent in our research, development and commercialization efforts, preclinical testing, clinical trials, uncertainty of regulatory and marketing approvals, reliance on collaborative partners, enforcement of patent and proprietary rights, the need for future capital, potential competition associated with our product candidates, use of hazardous materials and retention of key employees. In order for one of our product candidates to be commercialized, it will be necessary for us to conduct preclinical tests and clinical trials, demonstrate efficacy and safety of our product candidate to the satisfaction of regulatory authorities, obtain marketing approval, enter into manufacturing, distribution and marketing arrangements, obtain market acceptance and, in many cases, obtain adequate reimbursement from government and private insurers. We cannot provide assurance that we will generate significant revenues or achieve and sustain profitability in the future. Statements contained in Management’s Discussion and Analysis of Financial Conditions and Results of Operations which are not historical facts are, or may constitute, forward looking statements. Forward looking statements involve known and unknown risks that could cause our actual results to differ materially from expected results. These risks are discussed in the section entitled “Risk Factors.” Although we believe the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.

Our operating expenses are difficult to predict and will depend on several factors. Development expenses, including expenses for drug synthesis and manufacturing, preclinical testing and clinical research activities, will depend on the ongoing requirements of our drug development programs, availability of capital and direction from regulatory agencies, which are difficult to predict. Management may in some cases be able to control the timing of development expenses in part by accelerating or decelerating preclinical testing, other discovery and basic research activities and clinical trial activities, but many of these expenditures will occur irrespective of whether our product candidates are approved when anticipated or at all. We have begun to incur significant selling and marketing expenses to successfully commercialize our products. Once again, management may in some cases be able to control the timing of these expenses, but many of these expenditures will occur irrespective of the commercial success of our products, at least initially. As a result of these factors, we believe that period to period comparisons are not necessarily meaningful and you should not rely on them as an indication of future performance. Due to all of the foregoing factors, it is possible that our consolidated operating results will be below the expectations of market analysts and investors. In such event, the prevailing market price of our common stock could be materially adversely affected.

Overview

We are a biopharmaceutical company dedicated to discovering, developing and commercializing prescription products in disease areas with significant commercial markets and unmet medical needs. Our primary focus is in the ophthalmic and respiratory therapeutic areas where we have significant expertise. Our ophthalmic products and product candidates are concentrated in the allergic conjunctivitis, dry eye disease and retinal detachment indications. We are working on respiratory product candidates for the treatment of cystic fibrosis and upper respiratory disorders.

We have acquired the rights to market Elestat^™ and Restasis® in the United States under co-promotion agreements with Allergan and we receive royalty payments based upon net sales of these products. We have five product candidates in various stages of clinical development and one product candidate identified in preclinical development for which we expect to file an IND. Our product candidates in clinical trials are based on proprietary technology relating to specific receptors known as P2 receptors. Our lead product candidates are P2Y₂ receptor agonists that target ophthalmology, allergy and respiratory conditions and diseases where current treatments are not adequate. We have begun to apply our expertise to other applications of P2 receptor subtypes as well as advancing several non-P2Y programs.

We were incorporated in October 1993 and commenced operations in March 1995 following our first substantial financing and licensing of the initial technology from UNC. Since that time, we have been engaged in the discovery and development of novel pharmaceutical products, and more recently, in the co-promotion of products. We are located in Durham, North Carolina, adjacent to the Research Triangle Park.

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To date, we have not derived any revenue from product sales; although, we expect to have royalty revenue from product sales in our first quarter 2004 financial results. As of December 31, 2003, our revenues have consisted of payments under various corporate partnerships. We have recently built a commercial organization, including a small, specialty sales force, and began marketing Elestat^™ for allergic conjunctivitis and Restasis® for dry eye disease in the first quarter of 2004. We will be receiving a royalty on net sales of both of these products under the terms of our collaboration agreements in which we co-promote these products in the United States with Allergan. We have historically devoted substantially all of our efforts to discovery and clinical development of our product candidates as well as establishing strategic partnerships for the development and commercialization of our products when approved.

On June 27, 2003, we submitted an NDA to the FDA and we were notified that our NDA was granted a “priority review” on July 31, 2003. On December 19, 2003, we received an approvable letter from the FDA. In January 2004, we met with the FDA to discuss the additional clinical study which they requested. Based upon this discussion, we now have a clear understanding of the FDA’s additional requirement for the regulatory approval of diquafosol and are working closely with them to develop a protocol for a new Phase III clinical study. We intend to initiate and begin enrollment in a confirmatory Phase III trial in early 2004. In addition, we are assisting Allergan in a European regulatory submission that will seek approval of the right to commercialize diquafosol for dry eye disease in the European Union. Submission of this application is expected in the second half of 2004.

We have incurred significant operating losses since our inception and, as of December 31, 2003, we had an accumulated deficit of $127.1 million. We expect to incur losses for the next several years. We have financed our operations through proceeds received from the sale of equity securities including private sales of preferred stock, the sale of common stock in our initial public offering, an additional public offering of common stock in March 2003, as well as revenues received under corporate collaborations. We operate in a single business segment and do not have any foreign operations.

In December 2003, we entered into an agreement with Allergan to co-promote Elestat^™ in the United States. Allergan records all product sales and retains all product costs and licensing rights, with the exception of primary selling, promotional and marketing activities in the United States which will be our responsibility. Under the terms of the agreement, we paid Allergan an up-front payment and Allergan will pay a royalty to us on United States Elestat^™ net sales.

In June 2001, we entered into a joint license, development and marketing agreement with Allergan to develop and commercialize diquafosol which included the right to co-promote Restasis® in the United States, and amended this agreement in December 2003. Under the terms of this agreement, we have received up-front and milestone payments of $11 million and may receive up to an additional $28 million in milestone payments assuming the successful completion of all remaining diquafosol milestones. In addition, we had the ability to co-promote Restasis® and diquafosol and exercised this right in the third quarter of 2003. Restasis® received FDA approval and we began co-promotion activities in January 2004. Allergan records all product sales and retains all product costs and licensing rights with the exception of costs for our domestic sales force which is our responsibility. We are to receive royalty revenue based upon Restasis® net sales and diquafosol royalty revenue for worldwide, except Asia, net sales if and when the product candidate is approved by regulatory agencies. We will begin to receive royalty revenue on Restasis® net sales in April 2004.

In October 2002, we entered into a study funding agreement with the CFFT in which they agreed to fund the majority of the external costs of a Phase II trial for the treatment of cystic fibrosis in exchange for a milestone payment upon FDA approval, and the possibility of a sales milestone upon the commercialization and the achievement of a certain aggregate sales volume in the first five years following product approval. In the event of FDA approval, we are obligated to pay, over a period of five years, a development milestone to the CFFT equal to a multiple of the trial costs incurred by the CFFT, which could exceed $10 million. Additionally, in the event aggregate sales of the product exceed a certain level, we are obligated to pay the CFFT an additional $4 million sales milestone, payable over two years.

In December 1998, we entered into a Development, License and Supply Agreement with Santen for the development of diquafosol for the therapeutic treatment of ocular surface diseases. We are obligated to supply Santen with its requirements of diquafosol in bulk drug substance form for all preclinical studies, clinical trials and commercial requirements at agreed-upon prices. Under the agreement, we received an up-front equity investment of $1.5 million for shares of our stock and a milestone payment of $500,000. In addition, if all milestones are met, we could receive additional payments of up to $4.25 million, as well as royalties on net sales of licensed products. Santen is developing diquafosol in Japan and nine other Asian countries, and is currently in Phase II clinical trials.

Critical Accounting Policies and Estimates

Our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principals, require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses

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and related disclosure of contingent assets and liabilities. We evaluate our estimates, judgments and the policies underlying these estimates on a periodic basis as the situation changes, and regularly discuss financial events, policies, and issues with members of our audit committee and our independent auditors. We routinely evaluate our estimates and policies regarding revenue recognition, taxes and clinical trial, preclinical/toxicology and manufacturing liabilities.

Revenue Recognition

We recognize revenue under our collaborative research and development agreements when we have performed services under such agreements or when we or our collaborative partner has met a contractual milestone triggering a payment to us. Non-refundable fees received at the initiation of collaborative agreements for which we have an ongoing research and development commitment are deferred and recognized ratably over the period of ongoing research and clinical development commitment. We are also entitled to receive milestone payments under our collaborative research and development agreements based upon achievement of development milestones by us or our collaborative partners. We recognize milestone payments as revenues ratably over the remaining period of our research and development commitment. The recognition period begins at the date the milestone is achieved and acknowledged by the collaborative partner, which is generally at the date payment is received from the collaborative partner, and ends on the date that we have fulfilled our research and development commitment. This period is based on estimates by management and the progress towards milestones in our collaborative agreements. The estimate is subject to revision as our development efforts progress and we gain knowledge regarding required additional development. Revisions in the commitment period are made in the period that the facts related to the change first become known. This may cause our revenue to fluctuate from period to period.

Taxes

Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. We have recorded a valuation allowance of $55.6 million as of December 31, 2003, due to uncertainties related to our ability to utilize deferred tax assets, primarily consisting of certain net operating losses carried forward, before they expire. The valuation allowance is based on estimates of taxable income in each of the jurisdictions in which we operate and the period over which our deferred tax assets will be recoverable.

Liabilities

We generally enter into contractual agreements with third party vendors to provide clinical, preclinical/toxicology, manufacturing and other services in the ordinary course of business. Many of these contracts are subject to milestone-based invoicing and the contract could be conducted over an extended period of time. We record liabilities under these contractual commitments when we determine an obligation has been incurred, regardless of the timing of the invoice. Because of the nature of contracts and related delay in the contract’s invoicing, the obligation to these vendors may be based upon management’s estimate of the underlying obligation. In all cases, actual results may differ from our estimates.

Impact of Inflation

Although it is difficult to predict the impact of inflation on our costs and revenues in connection with our products, we do not anticipate that inflation will materially impact our cost of operation or the profitability of our products when marketed.

Results of Operations

Years Ended December 31, 2003, 2002 and 2001

Revenues

Our revenues for the year ended December 31, 2003 were $5.2 million, compared to $4.9 million in 2002, and $7.3 million in 2001. Revenues in each year were derived primarily from collaborative research and development agreements with strategic partners. Milestone payments from our collaborative partners are recognized over the period of ongoing research and development commitment under the applicable collaborative agreement. Fluctuations in revenue between the periods relate to the timing and magnitude of milestone payments and amortization of deferred revenue recognized under our collaborative agreements.

The increase in 2003 revenues, as compared to 2002, relates to the achievement of a milestone payment with our strategic partner Allergan. The decrease in 2002 revenues, as compared to 2001, relates primarily to the termination of our collaborative agreements with Genentech, Inc. and Kissei Pharmaceutical Co., Ltd., which resulted in no revenue related to these agreements being recorded in 2002. We expect to generate royalty revenue on Elestat^™ in the first quarter of 2004 and Restasis®

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royalty revenue in the second quarter of 2004, but do not expect this revenue to exceed our 2004 operating expenses. Our future revenue will depend on whether we enter into additional collaboration agreements, achieve milestones under existing or future collaboration agreements, regulatory approvals, commercialization of our product candidates and net sales of Restasis® and Elestat^™.

Costs and Expenses

Research and Development Expenses

Research and development expenses for the year ended December 31, 2003 were $27.6 million, compared to $25.2 million in 2002 and $28.2 million in 2001. Research and development expenses vary according to the number of programs in preclinical and clinical development and the stage of development of our clinical programs. Later stage clinical programs tend to cost more than earlier stage programs, due to the length of the trial and the number of patients enrolled in later stage clinical trials.

The increase in 2003 expenses, as compared to 2002, relates to increased spending on our clinical programs, particularly our INS37217 Intranasal program, in which we completed a Phase III study in perennial allergic rhinitis in 2003, and our INS37217 Ophthalmic program. Also in October 2002, we entered into a research and development agreement with the CFFT, whereby the majority of the expenses for a Phase II INS37217 Respiratory proof-of-concept clinical trial are funded by the CFFT, but we also record the corresponding expenses and liabilities as the CFFT incurs these costs. The majority of the costs associated with this trial have been incurred in 2003. If we receive FDA approval for INS37217 Respiratory for the treatment of cystic fibrosis, we will be obligated to pay a development milestone, and possibly a sales milestone, to the CFFT. If we do not receive FDA approval, we will have no financial obligation to the CFFT, including the Phase II clinical trial costs the CFFT is currently funding on our behalf. As of December 31, 2003, we have recorded approximately $1.3 million of contingent liabilities associated with this agreement.

The decrease in research and development expenses in 2002, as compared to 2001, was due to our efforts to focus our resources on our higher priority clinical programs in the ophthalmology and respiratory areas, whereby we reduced the number of high priority clinical programs from six to four and reduced “Other discovery and development costs” by decreasing the magnitude of preclinical and early stage clinical research and development programs between the two years.

Research and development expenses include all direct costs, including salaries for our research and development personnel, consulting fees, clinical trial costs, sponsored research and clinical trial insurance, license fees and other fees and costs related to the development of product candidates.

Our research and development expenses for the years ended December 31, 2003, 2002, 2001 and from the project’s inception are shown below (in thousands).

Our future research and development expenses will depend on the results and magnitude of our clinical, preclinical and discovery activities and requirements imposed by regulatory agencies. Accordingly, our development expenses may fluctuate significantly from period to period. In addition, if we in-license or out-license rights to product candidates, our development expenses may fluctuate significantly from prior periods.

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Selling and Marketing Expenses

Selling and marketing costs for the year ended December 31, 2003 were $2.8 million, compared to $60,000 in 2002 and $124,000 in 2001. The increase in selling and marketing expenses in 2003, as compared to 2002, resulted from increases in personnel and other administrative costs from building our sales and marketing infrastructure for the co-promotion of Elestat^™ and Restasis®.

In December 2003, we began hiring 64 territory managers and 6 regional sales directors to provide us with national sales coverage for our ophthalmic products. Our commercial organization will focus its promotional efforts on ophthalmologists, optometrists and allergists. The decrease in 2002 expenses, as compared to 2001, resulted from lower personnel costs in 2002. Future selling and marketing expenses will depend on the level of our future commercialization activities. We expect our sales and marketing expenses to increase in 2004 when the building of our commercial infrastructure is complete and we begin to co-promote Restasis® and Elestat^™. We expect selling and marketing expenses will increase in periods that immediately precede and follow product launches. We also expect to experience seasonality in the sale of Elestat^™, with a large increase in sales in the spring and a lesser increase during the summer and fall.

General and Administrative Expenses

General and administrative costs for the year ended December 31, 2003 were $7.0 million, compared to $5.1 million in 2002 and $5.8 million in 2001. Our general and administrative expenses consist primarily of personnel and related costs for general corporate functions, including business development, finance, accounting, legal, human resources, quality assurance, facilities and information systems. The increase in 2003 general and administrative expenses is primarily due to our increased development activities, building a sales and marketing infrastructure, and overall corporate growth as we prepared for the co-promotion of Restasis® and Elestat^™. The decrease in general and administrative expenses in 2002, as compared to 2001, resulted from our efforts to focus our resources on our higher priority clinical programs in the ophthalmic and respiratory areas. By focusing our clinical efforts, we were able to reduce the corporate and administrative efforts needed to support the company. The decreases occurred primarily in personnel costs and additional professional services, including legal and public relation expense. Future general and administrative expenses will depend on the level of our future development and commercialization activities.

Other Income (Expense)

Other income, net totaled $876,000 for the year ended December 31, 2003, compared to $804,000 for 2002 and $3.7 million for 2001. Other income fluctuates from year to year based upon fluctuations in the interest income earned on variable cash and investment balances and realized gains and losses on investments offset by interest expense on debt obligations. The increase in 2003 other income, as compared to 2002, represents larger interest income earned on higher average cash and investment balances offset by interest expense and increased losses on our investments, including a write-down on our strategic investment in Parion Sciences, Inc. The decrease in 2002 other income, as compared to 2001, resulted from lower interest income earned on smaller cash balances than in 2001. Future other income will depend on our future cash and investment balances, the return on these investments, as well as levels of debt and the associated interest rates.

Liquidity and Capital Resources

We have financed our operations through the sale of equity securities, including private sales of preferred stock, the sale of common stock in our initial public offering and an additional public offering in March 2003.

At December 31, 2003, we had net working capital of $66.2 million, an increase of approximately $38.6 million from $27.6 million at December 31, 2002. The increase in working capital is principally due to our successful offering of common stock in March 2003, offset by the use of funds for our normal operating expenses. In March 2003, we completed the sale of 5.75 million shares of common stock (including the full exercise of the underwriters’ over-allotment option) in a public offering at $13.50 per share. The total net proceeds, after deducting offering costs, were $72.6 million. Our principal sources of liquidity at December 31, 2003 were $34.3 million in cash and cash equivalents, $40.1 million in investments which are considered “available-for-sale,” $0.5 million of restricted deposits and $0.2 million of strategic corporate investments, reflecting a $43.5 million increase of cash, cash equivalents and investment balances over those at December 31, 2002.

Our working capital requirements may fluctuate in future periods depending on many factors, including: the efficiency of manufacturing processes developed on our behalf by third parties; the magnitude, scope and timing of our drug development programs; the cost, timing and outcome of regulatory reviews and changes in regulatory requirements; the costs of obtaining patent protection for our product candidates; the timing and terms of business development activities; the rate of technological

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advances relevant to our operations; the timing, method and cost of the commercialization of our product candidates; the level of required administrative and legal support; the availability of capital to support product candidate development programs we pursue, the commercial potential of our products and product candidates; and the potential expansion of facility space. We believe that our existing cash, cash equivalents and investments will be adequate to satisfy our anticipated working capital requirements through the second quarter of 2005. We are targeting 2004 operating expenses of $54-58 million. However, we expect that we will be required to raise additional capital to fund our future operations through equity or debt financings or from other sources. Additional funding may not be available on favorable terms from any of these sources or at all. Our ability to achieve our operating expense target range is subject to several risks including unanticipated cost overruns, the need to expand the magnitude of scope of existing development programs, the need to change the number or timing of clinical trials, unanticipated regulatory requirements, costs to successfully commercialize our products and product candidates, commercial success of our products and product candidates and other factors described under the caption “Risk Factors” elsewhere in this Form 10-K.

We expect to generate royalty revenue on Elestat^™ in the first quarter of 2004 and Restasis® royalty revenue in the second quarter of 2004, but do not expect this revenue to exceed our 2004 operating expenses.

As part of our drug development strategy, we outsource significant amounts of our preclinical and clinical programs and the manufacture of drug substance used in those programs. Accordingly, we have entered into contractual commitments or purchase arrangements with various clinical research organizations, manufacturers of active pharmaceutical ingredients and drug product and others. The amount of our financial commitments under these arrangements totaled approximately $2.1 million at December 31, 2003. In addition, we have other contractual commitments outside of drug development under arrangements which totaled approximately $1.9 million at December 31, 2003. These amounts may vary dependent upon the results of underlying studies, the completion of studies and/or projects and certain other variable components that may yield a result that differs from management’s estimate. Also, at December 31, 2003, we have future contractual commitments to pay $3.6 million of lease obligations for our administrative offices, laboratory facilities and equipment, and $277,000 of corporate debt obligations. Our existing license, collaboration and sponsored research agreements may require future cash payments. In the aggregate, these agreements may require payments of up to $12.4 million assuming the achievement of all development milestones, up to $4.0 million assuming the achievement of all sales milestones and up to $200,000 assuming the achievement of all research milestones. Amounts payable by us under these agreements are uncertain and are contingent on a number of factors, including the progress of our discovery and drug development programs, our ability to obtain regulatory approvals, and the commercial success of our approved products. Additionally, we are obligated to pay royalties on net sales, if any, of certain product candidates currently in our portfolio. Some of our license agreements require minimum annual license preservation fees under our existing license agreements ranging from $5,000 to $10,000. In addition, if we obtain licenses on additional product candidates in the future, or if our collaborative arrangements identify additional product candidates, our license obligations would increase.

Subject to the information and qualifications included in the above paragraph, as of December 31, 2003, our contractual obligations are as follows (in thousands):

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Impact of Recently Issued Accounting Pronouncements

In December 2002, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123 to provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of SFAS No. 123 to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation and amends Accounting Principles Board Opinion, or APB, No. 28 to require disclosure about those effects in interim financial information. The provisions of SFAS No. 148 are required to be applied to fiscal years ending after December 15, 2002. The adoption of SFAS No. 148 did not have a significant impact on our financial position or results of operations.

In January 2003, the FASB issued Interpretation No. 46, or FIN No. 46, “Consolidation of Variable Interest Entities,” which requires the assets, liabilities and results of operations of variable interest entities, or VIE, be consolidated into the financial statements of the company that has controlling financial interest. FIN No. 46 also provides the framework for determining whether a VIE should be consolidated based on voting interest or significant financial support provided to the VIE. We adopted these provisions, as required, with respect to VIEs created after January 31, 2003. The effective date for applying the provisions of FIN No. 46 for interests held by public entities in VIEs or potential VIEs created before February 1, 2003 has been deferred and will be effective as of March 31, 2004 except for interests in special purpose entities. We do not have interests in special purpose entities.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities,” establish accounting and reporting standards for derivative instruments including derivatives embedded in other contracts (collectively referred to as derivatives) and for hedging activities. SFAS No. 149 contains amendments relating to FASB Concepts Statement No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements,” and SFAS No. 65, “Accounting for Certain Mortgage Banking Activities,” SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases,” SFAS No. 95, “Statement of Cash Flows,” and SFAS No. 126, “Exemption from Certain Required Disclosures about Financial Instruments for Certain Nonpublic Entities.” The provisions of SFAS No. 149 are effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS No. 149 did not have a significant impact on our financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of debt and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies the obligation of the issuer. The provisions of SFAS No. 150 are effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatory redeemable financial instruments of a nonpublic entity. The adoption of SFAS No. 150 did not have a significant impact on our financial position or results of operations.

In December 2003, the FASB revised SFAS No. 132-R “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” SFAS No. 132-R revises employer’s disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by SFAS No. 87 “Employers’ Accounting for Pensions,” SFAS No. 88 “Employer’s Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” and SFAS No. 106 “Employer’s Accounting for Postretirement Benefits Other Than Pensions.” This revision retains the disclosure requirements contained in the original SFAS No. 132 and provides additional disclosures about assets, obligations, cash flows, and net periodic benefit costs of defined benefit pension plans and other defined benefit postretirement plans. The required information should be provided separately for pension plans and for other postretirement benefit plans. The provisions of SFAS No. 132-R are effective for financial statements with fiscal years ending after December 15, 2003. The adoption of SFAS No. 132-R did not have a material impact on our financial position or results of operations.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

Interest Rate Sensitivity

We are subject to interest rate risk on our investment portfolio. We maintain an investment portfolio consisting primarily of high quality money market instruments and government obligations. Our portfolio has a current average maturity of less than 12 months.

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Our exposure to market risk for changes in interest rates relates to the increase or decrease in the amount of interest income we can earn on our investment portfolio, changes in the market value of investments due to changes in interest rates, the increase or decrease in realized gains and losses on investments and the amount of interest expense we must pay with respect to various outstanding debt instruments. Our risk associated with fluctuating interest expense is limited to capital leases and other short-term debt obligations. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure the safety and preservation of invested principal funds by limiting default risk, market risk and reinvestment risk. We reduce default risk by investing in investment grade securities. Our investment portfolio includes only marketable securities and instruments with active secondary or resale markets to help insure portfolio liquidity and we have implemented guidelines limiting the duration of investments. A hypothetical 100 basis point drop in interest rates along the entire interest rate yield curve would not significantly affect the fair value of our interest sensitive financial instruments. At December 31, 2003, our portfolio of available-for-sale investments consisted of approximately $37.1 million of investments maturing within one year and approximately $3.0 million of investments maturing after one year but within 21 months. In addition, we have $0.5 million of our long-term investments that are held in a restricted account that collateralizes a letter of credit with a financial institution. Additionally, we generally have the ability to hold our fixed income investments to maturity and therefore do not expect that our operating results, financial position or cash flows will be affected by a significant amount due to a sudden change in interest rates.

Strategic Investment Risk

In addition to our normal investment portfolio, we have a strategic investment in Parion Sciences, Inc. valued at $0.2 million. This investment represents unregistered preferred stock and is subject to higher investment risk than our normal investment portfolio due to the lack of an active resale market for the investment.

Item 8. Financial Statements and Supplementary Data.

The financial statements required to be filed pursuant to this Item 8 are appended to this Annual Report on Form 10-K. A list of the financial statements filed herewith is found at “Index to Financial Statements” on page F-1.

Item 9. Changes in and Disagreements with Auditors on Accounting and Financial Disclosure.

Not applicable.

Item 9A. Controls and Procedures.

Our Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our current disclosure controls and procedures are effective in timely providing them with material information relating to us which is required to be disclosed in the reports we file or submit under the Exchange Act.

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PART III

Item 10. Directors and Executive Officers of the Registrant.

Pursuant to our Amended and Restated Certificate of Incorporation, as amended, the Board of Directors is divided into three classes, each class consisting, as nearly as possible, of an equal number of directors. There are currently seven members of the Board of Directors. Class A consists of Dr. Shaffer and Mr. Mossinghoff, whose terms will expire at the Annual Meeting of Stockholders in 2004. Class B consists of Kip A. Frey and Kenneth B. Lee, Jr., whose terms will expire at the Annual Meeting of Stockholders in 2005. Class C consists of Gary D. Novack, Ph.D., William R. Ringo, Jr. and W. Leigh Thompson, M.D., Ph.D., D.Sc., whose terms will expire at the Annual Meeting of Stockholders in 2006. In addition, Richard Boucher, M.D. serves as an emeritus board observer.

The name, age and position of each person who is currently serving as a director and/or executive officer and who served as an executive officer in 2003, is listed below, followed by summaries of their background and principal occupations. Executive officers are elected annually, and serve at the discretion of the Board of Directors. Certain information contained in this report relating to the occupations and security holdings of our directors and officers is based upon information received from the individual directors and officers.

Christy L. Shaffer, Ph.D., has served as our Chief Executive Officer and as a director since January 1999 and previously served as our President, as well as CEO, from January 1999 through June 2002, at which time she proposed that Mr. Mossinghoff assume the role of President. Dr. Shaffer is also a member of our Corporate Governance Committee. Dr. Shaffer joined us in June 1995 as our first full-time employee, Director, Clinical Operations. She was promoted to Senior Director, Development in June 1996 and to Vice President, Development and Chief Operating Officer in January 1998. Dr. Shaffer has fifteen years of experience in drug development within the pharmaceutical industry. She previously served in a variety of positions in the clinical research division of Burroughs Wellcome Co. including International Project Leader for cardiopulmonary programs. She served as the Associate Director of pulmonary research in the department of pulmonary/critical care medicine at Burroughs Wellcome immediately prior to joining Inspire in June 1995. Dr. Shaffer coordinated several IND submissions and one NDA submission at Burroughs Wellcome. Dr. Shaffer received a Ph.D. in pharmacology from the University of Tennessee and completed two years of postdoctoral training in cardiovascular research in the Biochemistry Department at the Chicago Medical School before her one-year postdoctoral appointment at University of North Carolina.

Gregory J. Mossinghoff has served as our President since June 2002 and a director since June 2001. Mr. Mossinghoff joined us in June 1998 as our Senior Director of Strategic Planning and Operations and was promoted to Vice President, Corporate Development in January 1999; Chief Business Officer in December 1999; and Senior Vice President in November 2000. Mr. Mossinghoff has also served as our Secretary since October 1998, and as our Treasurer from March 2000 to May 2003. In his current role he helps us develop and realize strategic objectives, expand our corporate partnerships in the United States and abroad, and oversees all business-related activities including commercial operations and finance. Before joining us, from February 1996 to June 1998, Mr. Mossinghoff was worldwide Director of Business Analysis at Glaxo Wellcome plc. Before joining Glaxo Wellcome, Mr. Mossinghoff held various roles with increasing responsibility at Hoffmann LaRoche Inc., from June 1988 to February 1996, including Manager, Business Development and Strategic Planning from 1994 to 1996. Mr. Mossinghoff received a B.A. degree in Economics from the University of Virginia, Charlottesville, VA and an M.B.A. in Financial Management & Analysis from George Mason University, Fairfax, VA.

W. Leigh Thompson, M.D., Ph.D., D.Sc. has served as a director since April 1996, is a member of our Corporate Governance Committee, its Nominating sub-committee, and our Compensation Committee and has served as our Chairman of the

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Board since June 2002. In December 1994, Dr. Thompson retired from Eli Lilly and Co. where he served as Chief Scientific Officer and a member of the management committee. Dr. Thompson has enjoyed a distinguished career in both academic medicine and the pharmaceutical industry and has published extensively, particularly in the area of critical care medicine. He is a member of numerous corporate, academic, and civic boards, and consults in the areas of health informatics, enterprise strategic planning, and related areas and has been inducted into the Johns Hopkins Society of Scholars. Since 1995, Dr. Thompson has been the Chief Executive Officer of Profound Quality Resources, Ltd., a worldwide scientific consulting firm. He is currently a director of Bioanalytical Systems Inc., DepoMed, Inc., Guilford Pharmaceuticals, Inc., Medarex Inc., Diabetogen Biosciences, Inc., La Jolla Pharmaceutical Company and Sontra Medical Corporation.

Kip A. Frey has served as a director since June 2002, is a member of our Audit Committee and the Chairman of our Corporate Governance Committee, and its Nominating sub-committee. He is currently a Professor of the Practice in Entrepreneurial Management & Law at Duke University with joint appointments from the Fuqua School of Business and Duke Law School. He served as 2001-2002 Chairman of the Council for Entrepreneurial Development in Research Triangle Park, NC. He is the former President and Chief Executive Officer of OpenSite, a software company acquired by Siebel Systems in May 2000. Over the past five years, Mr. Frey has been the leader and architect of three of Research Triangle Park’s most notable entrepreneurial ventures, Ventana Communications Group, Accipiter, Inc. and OpenSite. He is a member of the Board of Directors of the Raleigh Chamber of Commerce, the Council for Entrepreneurial Development, Duke Law School’s Board of Visitors, and several local civic and charitable organizations. He is also a Partner at Intersouth Partners, a North Carolina venture capital firm. In 1999, Digital South Magazine named him the Southeast’s top CEO. Mr. Frey is a Phi Beta Kappa graduate of the University of Southern California Film School and of Duke Law School.

Kenneth B. Lee, Jr. joined the board as a director in September 2003, is a member of our Compensation Committee, the Chairman of our Audit Committee and serves as our Audit Committee Financial Expert. Mr. Lee has over 30 years of experience with technology-based companies. He is a former Ernst & Young partner, where he was employed for 29 years, and was instrumental in the founding and successful development of the Ernst & Young life science practice in the San Francisco Bay Area. Mr. Lee is currently a General Partner with BioVista Capital, LLC, which he joined in 2003. Prior to that, he served as President of A.M. Pappas & Associates, LLC, a venture capital concern. He serves on the boards of three other public companies: Abgenix, Inc., CV Therapeutics, Inc. and POZEN Inc. During his tenure with Ernst & Young, he co-founded the National Conference on Biotechnology Ventures, the International Strategic Partnering Conference and the Palo Alto Center for Strategic Transactions. Mr. Lee received a Bachelor of Arts degree from Lenoir-Rhyne College and an M.B.A. from the University of North Carolina at Chapel Hill.

Gary D. Novack, Ph.D. joined the board as a director in January 2003 and is a member of our Audit Committee. Dr. Novack is the founder and President of Pharma·Logic Development, Inc., a pharmaceutical and medical device development consulting firm that he started in 1989. He has worked with Inspire as a consultant, providing important strategic input to our preclinical and clinical ophthalmology programs. Dr. Novack is a board-certified clinical pharmacologist and has 25 years experience in pharmaceutical research and development. He has consulted with over 150 pharmaceutical and medical device firms, and has authored over 240 abstracts and publications in pharmacology, ophthalmology, neurology, dermatology and medical communications. He serves on the editorial board of The Ocular Surface, and is a member of the scientific advisory board of the Foundation Fighting Blindness. He received his bachelor’s degree in Biology from the University of California, Davis, his Ph.D. in Pharmacology and Toxicology from the University of California at Davis, and was an NIH postdoctoral trainee in neurophysiology at the University of California, Los Angeles. Dr. Novack is also an alumni member of the University of California Board of Regents. He has held managerial positions at Allergan and Merrell Dow Pharmaceuticals and has served on several boards of not-for-profit organizations.

William R. Ringo, Jr. joined the board in June 2003 and is the Chairman of our Compensation Committee. William R. Ringo has over 30 years of leadership experience in the pharmaceutical industry. From 1973 until his retirement in 2001, Mr. Ringo served in a variety of senior roles at Eli Lilly and Company, most recently as President of Oncology and Critical Care Products. During his tenure at Eli Lilly, Mr. Ringo also served as President of Internal Medicine Products and President of the Infectious Disease Business Unit, and held senior positions in sales, marketing and business planning. He serves as a Director of a number of other biopharmaceutical companies including La Jolla Pharmaceutical Company, Praecis Pharmaceuticals Inc., Encysive Pharmaceuticals Inc., Xcel Pharmaceuticals, Inc. and Intermune Inc. Mr. Ringo received a B.S. in Business Administration and Management and an M.B.A. from the University of Dayton.

Richard Boucher, M.D. has served as a director from March 1995 to June 2003 and as an Emeritus Board Observer since June 2003. One of our four founders, Dr. Boucher is the William Rand Kenan Professor of Medicine, Chief of Pulmonary Medicine and Director of the Cystic Fibrosis/Pulmonary Research and Treatment Center at The University of North Carolina at Chapel Hill School of Medicine. Dr. Boucher obtained his M.D. degree from Columbia University College of Physicians and Surgeons. Following residency training, he joined the Faculty of Medicine at The University of North Carolina at Chapel Hill in 1977. Dr. Boucher has authored or co-authored more than 200 original research articles and more than 100 additional publications

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including book chapters. He received the Doris Tulcin and Paul Di Sant’Agnese CF Research Awards and the Julius Comroe Award from The American Physiology Society. He is an established principal investigator with the National Institutes of Health, and is a member of the American College of Physicians and the Association of American Physicians. In recent years, Dr. Boucher has pioneered new approaches for the treatment of cystic fibrosis.

Mary B. Bennett has served as our Senior Vice President, Operations and Communications since March 2003. Prior to that, Ms. Bennett served as Vice President, Operations and Communications from March 2001 until March 2003. As Senior Vice President, Operations and Communications, she manages a variety of areas for Inspire, including Human Resources, Communications, Investor Relations and Operations. Ms. Bennett came to Inspire from Glaxo Wellcome, where she served as Worldwide Director for R&D Human Resources Effectiveness, Planning and Communication. Prior to her role in Human Resources, Ms. Bennett held various roles during her 13 years at Glaxo Wellcome, including Worldwide Director for R&D Communications, Director of R&D Operations and Department Head of Comparative Medicine. She also led R&D communications for major company redesign initiatives, and for the Glaxo Wellcome merger. Ms. Bennett holds a B.A. in Behavioral Science from National Louis University and an M.B.A. from Duke University.

Richard M. Evans, Ph.D. has served as our Vice President, Pharmaceutical Development since June 2000. Dr. Evans joined us in October 1996 and has previously held several positions including Director and Senior Director of Pharmaceutical Development. He is responsible for all activities related to the manufacture, formulation development and testing of our products in development and for the identification and development of relevant drug delivery technologies. He also serves as Vice-Chair of the Inhalation Technology Focus Group for the American Association of Pharmaceutical Scientists. Prior to joining Inspire, Dr. Evans was Section Manager of Inhalation Dosage Forms at Rhône-Poulenc Rorer. He has over 13 years experience in the pharmaceutical industry, including positions at Delphi Pharmaceuticals and Rhône-Poulenc Rorer. Dr. Evans holds both a Bachelor of Pharmacy degree and a Doctorate in Pharmaceutical Chemistry, in the field of inhalation drug delivery, from the Welsh School of Pharmacy, University of Wales College of Cardiff.

Donald J. Kellerman, Pharm.D. has served as our Senior Vice President, Development since May 2000. He is responsible for the clinical and regulatory affairs aspects of our programs. Dr. Kellerman joined us in July 1999 as Vice President, Development. Before joining us, Dr. Kellerman spent 11 years with Glaxo Wellcome, from August 1997 to July 1999 and from April 1988 to August 1996, where he was director of various groups, including International OTC, United States Infectious Diseases, and the Inhaled Corticosteroid Group. He was clinical project leader for Flovent^® from the first United States clinical studies in 1989 to approval in 1996. From September 1996 to August 1997, he was Vice President of Clinical Research at Sepracor, Inc., where he was project leader for the Xopenex^® NDA team. Before Glaxo Wellcome, Dr. Kellerman worked at E.R. Squibb and Sons, Inc. and Ciba-Geigy Corporation on several cardiovascular products. Dr. Kellerman holds a Doctor of Pharmacy and Bachelor of Science degree from the University of Minnesota.

Joseph K. Schachle has served as our Senior Vice President, Marketing and Sales since January 2004 and as Vice President, Marketing and Sales since January 2003. Mr. Schachle is responsible for establishing a high-value marketing and sales infrastructure in North America to commercialize potential products from the Company’s pipeline, as well as partnered products. Mr. Schachle has extensive experience in pharmaceutical marketing and sales, and has had responsibility for the successful launch of major new products including the marketing of Glaxo SmithKline’s Advair^®. His experience includes marketing and sales positions of significant responsibility at The Upjohn Company, Glaxo SmithKline, Inspire and MedImmune. He most recently served as Director of Marketing for infectious disease products at MedImmune from April 2002 until January 2003, where he was responsible for strategic brand management and promotion of Synagis^® and Cytogam^®. In his previous role at Inspire from April 2001 to April 2002, Mr. Schachle was responsible for the new product planning and market research that laid the groundwork for the commercialization of diquafosol, the first potential product from Inspire’s pipeline. Mr. Schachle will now be responsible for implementing these plans, and for developing and implementing a co-promotion strategy for diquafosol and Allergan’s Restasis^® both for dry eye disease as well as launch and promotion of Elestat^™ for allergic conjunctivitis. Mr. Schachle holds a B.B.A. in Marketing from James Madison University and an M.B.A. from Old Dominion University.

Thomas R. Staab, II joined Inspire in May 2003 as Chief Financial Officer and Treasurer. Previously, he held senior financial positions with Triangle Pharmaceuticals, Inc., a biotechnology company listed on the NASDAQ national exchange prior to its being acquired by Gilead Sciences, Inc. in 2003. Mr. Staab served five years with Triangle, most recently as Vice President/Treasurer and Acting Chief Financial Officer. His experience includes equity financing, strategic alliances, mergers and acquisitions, drug commercialization, SEC reporting, treasury management and investor relations. Before joining Triangle, Mr. Staab was a manager with PricewaterhouseCoopers LLP providing audit and business advisory services to national and multi-national corporations in the biotechnology, pharmaceutical, pulp and paper, and communications industries. Mr. Staab is a Certified Public Accountant and received a B.S. in Business Administration and a Masters of Accounting from the University of North Carolina.

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Benjamin R. Yerxa, Ph.D. has served as our Senior Vice President, Discovery since May 2003. Dr. Yerxa joined us in August 1995 and previously held several positions, including Vice President, Discovery and Senior Director of Preclinical Programs. He supervises the chemistry, pharmacology, preclinical and intellectual property teams and all drug discovery and early preclinical development activities. He created a new strategic opportunity for us by developing the concept of ophthalmic uses for our core P2Y₂ technology. Before being promoted to the position of Senior Director of Preclinical Programs in December 1999, Dr. Yerxa was Director of Preclinical Programs and, before that, Senior Research Chemist. While in chemistry, he served as the preclinical project leader for INS365. As a Senior Research Chemist his work focused on designing and synthesizing new P2Y receptor agonists. Before joining us, from October 1993 to August 1995, Dr. Yerxa was a Research Scientist at Burroughs Wellcome Co. Dr. Yerxa worked at Biophysica, Inc. for over two years, synthesizing radiocontrast agents. He developed scale-up procedures for the industrial production of Oxilan^®, a marketed imaging product. Dr. Yerxa received his Ph.D. in Organic Chemistry from the University of California, Irvine in 1993.

Audit Committee Financial Expert

Our Board of Directors has determined that Kenneth B. Lee, Jr., the Chairman of our Audit Committee, is an audit committee financial expert, as that term is defined under Regulation S-K, Item 401(h), and that he is independent, as that term is used in Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act.

Compliance with Section 16(a) of the Exchange Act

Under the securities laws of the United States, directors, executive officers and any person holding more than ten percent (10%) of our common stock are required to report their ownership of common stock and any changes in that ownership to the Securities and Exchange Commission on Forms 3, 4 and 5. Based on our review of the copies of such forms we have received, all required reports have been timely filed.

Code of Ethics

We have adopted a code of ethics, entitled the “Inspire Pharmaceuticals, Inc. Code of Ethics and Conduct Relating to Financial Affairs,” or the Code. The Code applies to our principal executive officer, principal financial and accounting officer, as well as all of the rest of our employees and members of our Board of Directors. A copy of the Code can be found on our Internet website, www.inspirepharm.com.

Item 11. Executive Compensation.

DIRECTOR COMPENSATION

Prior to 2003, directors received no cash compensation for their services as directors or as members of committees. On September 9, 2003, the Board of Directors adopted an amended and restated compensation policy, effective June 9, 2003. Under the policy, all non-employee directors shall receive the following compensation: (i) $15,000 annually to cover general availability and participation in meetings and conference calls of the Board and committees of the Board (ii) $2,500 per in-person Board meeting for attendance in any matter (whether in-person, via video conference or telephone conference) and (iii) stock option grants in the amount of 30,000 shares will be granted to each director elected to a 3-year term, to vest 1/36^th per month until fully vested at the end of such 3-year term. In addition, all non-employee directors who serve on the Audit Committee will also receive the following compensation: (i) $10,000 annually to cover general availability and participation in Audit Committee conference calls and meetings and (ii) stock option grants in the amount of 10,000 shares will be granted to each director elected to the Audit Committee, to vest 1/36^th per month until fully vested at the end of 3 years. In addition, the director who serves as the Chairman of the Board will also receive the following compensation: (i) $10,000 annually to cover general availability and participation in Board conference calls and meetings and (ii) stock option grants in the amount of 10,000 shares will be granted to the director elected as Chairman of the Board, to vest 1/36^th per month until fully vested at the end of 3 years.

In March 2003, we granted 6,667 options to Dr. Novack who was elected by the Board of Directors to fill the remainder of a term. The options have an exercise price of $14.72 per share. In June 2003, we granted all newly elected directors 30,000 options and an additional 10,000 options if the director was also a member of the audit committee. The June options have an exercise price of $13.21 per share. We also granted an option to Dr. Boucher in June 2003 to purchase 30,000 shares, exercisable immediately, at an exercise price of $12.25 per share in consideration for past service to us. In September of 2003, we granted 23,333 options to Mr. Lee who was elected to fill the remainder of a term with an exercise price of $15.82 per share. All options are subject to conditions relating to vesting and retention for each recipient’s participation on the Board of Directors and its committees. All directors are reimbursed for expenses incurred in connection with attendance at Board of Directors and committee meetings.

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EXECUTIVE COMPENSATION

The following table shows, for the fiscal years ended December 31, 2003, 2002 and 2001, the annual and long-term compensation we paid to our chief executive officer and our four most highly compensated executive officers who were serving at December 31, 2003 (collectively, the “named executive officers”). Following the rules of the Securities and Exchange Commission, the compensation described in the table does not include medical, group life insurance and other benefits which are available generally to all of our salaried employees.

SUMMARY COMPENSATION TABLE

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OPTION GRANTS IN 2003

The following grants of stock options were made to the named executive officers during the fiscal year ended December 31, 2003.

AGGREGATED STOCK OPTION EXERCISES IN 2003

AND 2003 YEAR-END STOCK OPTION VALUES

The following table provides certain information as to certain stock options exercisable by the named executive officers for the fiscal year ended December 31, 2003, and the value of such options held by them at December 31, 2003, measured in terms of the closing price of our common stock on The NASDAQ Stock Market on December 31, 2003 which was $14.15 per share.

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401(k) Profit Sharing Plan

We have adopted a tax-qualified 401(k) Profit Sharing Plan (the “401(k) Plan”) covering all qualified employees. The effective date of the 401(k) Plan is August 1, 1995. Participants may elect a salary reduction of at least 1% as a contribution to the 401(k) Plan, up to the statutorily prescribed annual limit for tax-deferred contributions ($12,000 in 2003). Modification of salary reductions can be made quarterly. The 401(k) Plan permits employer matching of up to 8% of a participant’s salary. If employer matching is implemented, participants will begin vesting 100% immediately in employer contributions. In 2003, we elected a safe harbor contribution at 3.0% of annual compensation. All of our safe harbor contributions vest 100% immediately.

COMPENSATION COMMITTEE REPORT

The Compensation Committee, which consists of Mr. Ringo, as chairperson, Dr. Thompson and Mr. Lee, reviews and approves executive officer salaries and bonuses, administers the Amended and Restated 1995 Stock Plan, as amended, and approves all other compensation benefits of Inspire’s executive officers. In addition, the Compensation Committee consults with management regarding its benefit plans, performance evaluation and career development initiatives and is responsible for reviewing overall compensation policies and practices of Inspire.

Compensation Philosophies

Inspire intends that each employee will have continuous growth in skills and performance aided by appropriate mentoring and challenging career opportunities and rewarded by appropriate performance-based compensation. Compensation is a means of aligning the objectives of employees and shareholders.

Inspire provides competitive salaries based on contribution and performance. All employees are eligible to be granted cash bonuses based on short-term corporate and personal performance and organizational level. In addition, all employees are eligible for stock options based on personal performance and organizational level, and as incentives to continued contributions. Stock options are generally granted at the time of employment and periodically thereafter, with vesting over four years. Executive officers tend to have greater fractions of their total compensation from performance-based bonuses and stock options.

In 2003, executive compensation consisted of base salary, cash bonuses and stock options. A full compensation analysis was conducted in late 2003 by an independent third party to ensure that base salaries, cash bonuses and stock option grants were competitive as compared to peer companies. Changes to the compensation plan will be implemented in 2004 based on findings from the independent compensation analysis. The following describes in more detail the elements of compensation that are part of the Compensation Committee’s policies.

Base Salaries

Compensation of all Inspire executive officers is based on their: (i) demonstrated skills, experience, education and continued career development; (ii) impact within and outside of Inspire; (iii) the alignment of the employee’s performance with Inspire’s success; (iv) Inspire’s achievement of annual and long-term corporate goals; and (v) compensation of comparable employees within peer companies.

Bonuses

Cash bonuses are used to retain and motivate executives. These bonuses are paid taking into account the executive officer’s achievement of individual objectives and the contribution of the executive to the overall success and achievements of the company and its management team. In determining the level of the cash bonus during 2003, the Compensation Committee considered each executive’s achievement of specific, measurable corporate and individual goals, and also considered qualitative factors including overall leadership performance.

Stock Options

The Compensation Committee believes that stock options are an excellent long-term incentive for executives that aligns executive and stockholder interests and assists in retention of key officers and employees. At the recommendation of the Compensation Committee to the Board, stock options are issued to new employees, including executive officers, following the commencement of employment.