CYPRESS BIOSCIENCE INC, 10-K405, 1997-03-11

CYPRESS BIOSCIENCE INC
10-K405, 1997-03-11
BIOLOGICAL PRODUCTS, (NO DIAGNOSTIC SUBSTANCES)

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<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 1996

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _______ TO _______

Commission File No. 0-12943

CYPRESS BIOSCIENCE, INC.
(Exact Name of registrant as specified in its charter)
---------------

DELAWARE 22-2389839
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

4350 EXECUTIVE DRIVE, SUITE 325
SAN DIEGO, CALIFORNIA 92121
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (619) 452-2323

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK $.02 PAR VALUE
COMMON STOCK PURCHASE WARRANTS
UNITS CONSISTING OF THREE (3) SHARES OF
COMMON STOCK AND ONE (1) COMMON STOCK PURCHASE WARRANT
(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 (Section 229.405 of this chapter) 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]

The aggregate market value of the voting stock held by nonaffiliates of the
Registrant as of January 31, 1997 was $45,496,043.*

The number of shares outstanding of the Registrant's Common Stock as of January
31, 1997 was 34,573,111.

DOCUMENTS INCORPORATED BY REFERENCE None

- ----------
* Calculated based on 24,264,556 shares of common stock held by non-affiliates
as of January 31, 1997 and a per share market price of $1.875. Excludes for the
purposes of calculating aggregate market value of the voting stock held by
nonaffiliates of the Registrant shares of common stock of the Registrant held by
executive officers, directors and stockholders whose ownership exceeds 5% of the
common stock outstanding at January 31, 1997. Exclusion of such shares should
not be construed to indicate that any such person possesses the power, direct or
indirect, to direct or cause the direction of the management or policies of the
Registrant or that such person is controlled by or under common control with the
Registrant.

<PAGE> 2
CYPRESS BIOSCIENCE, INC.

FORM 10-K

INDEX

PART I

<TABLE>
<CAPTION>
Page
----
<S> <C> <C>
ITEM 1 Business . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
ITEM 2 Properties . . . . . . . . . . . . . . . . . . . . . . . . . . 17
ITEM 3 Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . 18
ITEM 4 Submission Of Matters To A Vote Of Security Holders . . . . . 18

PART II

ITEM 5 Market For The Company's Common Stock And Related
Security Holder Matters . . . . . . . . . . . . . . . . . . . . 19
ITEM 6 Selected Consolidated Financial Data . . . . . . . . . . . . . 20
ITEM 7 Management's Discussion And Analysis Of Financial Condition
And Results Of Operations . . . . . . . . . . . . . . . . . . . 21
ITEM 8 Financial Statements And Supplementary Data . . . . . . . . . . 25
ITEM 9 Changes In And Disagreements With Accountants On Accounting
And Financial Disclosure . . . . . . . . . . . . . . . . . . . 25

PART III

ITEM 10 Directors And Executive Officers Of The Company . . . . . . . . 26
ITEM 11 Executive Compensation . . . . . . . . . . . . . . . . . . . . 28
ITEM 12 Security Ownership Of Certain Beneficial Owners And Management. 33
ITEM 13 Certain Relationships And Related Transactions . . . . . . . . 35

PART IV

ITEM 14 Exhibits, Financial Statement Schedules And Reports On Form 8-K . 36

Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
</TABLE>

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PART I

ITEM 1. BUSINESS

Except for the historical information contained herein, the matters
discussed in this Annual Report on Form 10-K contain forward-looking statements
within the meaning of Section 21E of the Securities Exchange Act of 1934, as
amended (the "Exchange Act") that involve risks and uncertainties. The Company's
actual results may differ materially from those discussed below and elsewhere in
this report. Factors that could cause or contribute to such differences include,
without limitation, those discussed in the description of the Company's business
below as well as those discussed in the sections entitled "Risk Factors"
beginning on page 12 and "Management's Discussion and Analysis of Financial
Condition and Results of Operations" beginning on page 21.

COMPANY OVERVIEW

Cypress Bioscience, Inc. ("Cypress" or the "Company") researches,
develops, manufactures and markets medical devices and therapeutics for the
treatment of certain types of immune disorders and is engaged in the development
of novel therapeutic agents for the treatment of blood platelet disorders. The
Company's first product, the PROSORBA(R) column, a medical device, treats a
patient's defective immune system so that it can more effectively respond to
certain diseases. Through its acquisition of PRP, Inc. ("PRP"), a Boston-based
biopharmaceutical company engaged in the commercialization of novel agents to
treat blood platelet disorders, in November 1996, the Company acquired rights to
IPM(TM) (Infusible Platelet Membranes), which is being developed as a potential
substitute for traditional platelet transfusions.

THE PROSORBA(R) COLUMN

The Company's PROSORBA(R) column is a therapeutic, extracorporeal
immunoadsorption device which removes circulating immune complexes (CICs) and
immunoglobulin G (IgG) from a patient's plasma in a procedure that takes place
in an extracorporeal loop (i.e., outside the body) and returns all the other
necessary plasma components back to the patient. During the PROSORBA(R) column
therapy, blood is drawn from one arm of the patient, plasma and red blood cells
are separated, the plasma is filtered through the PROSORBA(R) column to remove
unwanted CICs and IgG, then combined with the red blood cells and returned to
the patient's other arm. The PROSORBA(R) column therapy is noninvasive and
administered on an outpatient basis. The Company received marketing approval
from the U.S. Food and Drug Administration ("FDA") in December 1987 to
distribute the PROSORBA(R) column for the treatment of idiopathic
thrombocytopenic purpura ("ITP"), an immune-mediated bleeding disorder. Since
1987, the Company has had approximately $24 million in sales of the PROSORBA(R)
column for use in ITP therapy.

The PROSORBA(R) column treats a defective immune system by modulating
the immune system to respond more effectively. The modulation can result in the
clearance of antigens or control of an autoimmune disease. The Company believes
that the PROSORBA(R) column treats a dysfunctional immune system response rather
than treating the disease itself. The Company is providing financial support for
an extramural program with leading academic laboratories to study the mechanisms
of action of the PROSORBA(R) column.

The PROSORBA(R) column is a plastic cylinder measuring three inches in
diameter and three and one half inches in height. The cylinder contains a solid
binding matrix composed of protein A bound to dry silica (sand) granules.
Protein A, a molecule produced by the fermentation of a bacterium, specifically
binds to both CICs and IgG, with preference for CICs. The FDA considers the
PROSORBA(R) column to be a medical device. The Company has historically produced
the PROSORBA(R) column at its own manufacturing facility which meets FDA good
manufacturing practice ("GMP") regulations for the manufacture of the product in
commercial quantities. The facility is currently subject to a GMP re-approval as
a result of substantial renovations made in conjunction with a consolidation of
facilities.

The Company believes that key factors in the Company's commercial
performance will be its ability to improve PROSORBA(R) column sales for its
currently approved indication, obtain FDA marketing approval for additional
disease indications for the PROSORBA(R) column, and obtain and develop
complementary therapeutic and diagnostic technologies. The Company's current
clinical efforts to expand the approved indications for the PROSORBA(R) column
are focused primarily on rheumatoid arthritis. Rheumatoid Arthritis

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Rheumatoid Arthritis

Rheumatoid arthritis is a potentially crippling autoimmune disease that
is estimated to affect over 5,000,000 people in North America and Europe. In
rheumatoid arthritis, the body's immune system inappropriately makes antibodies,
called rheumatoid factors, that collect in the joints and surrounding soft
tissue causing inflammation and tissue damage. Joints, typically those in the
hand, become painful and swollen, lose movement, and become deformed. These
individuals not only suffer a significantly reduced quality of life, but also a
shortened life expectancy.

In September 1995, the Company announced the results of its 15 patient
pilot clinical trial that used the PROSORBA(R) column for therapy in rheumatoid
arthritis. The results showed a statistically significant 76% reduction in
painful joints and a 70% reduction in swollen joints in 11 patients three months
after completing treatment with the PROSORBA(R) column. The Company believes
that these findings confirm the potential utility of the PROSORBA(R) column in
treating rheumatoid arthritis reported by an earlier independent study published
in the JOURNAL OF RHEUMATOLOGY in May 1994.

In June 1996, the Company commenced a Phase III pivotal trial designed
to confirm the findings of the pilot study in a larger group of patients. Up to
approximately 250 patients will be enrolled in the prospective, randomized,
multi-center, double-blind, controlled trial. The patients are to be randomly
entered into two treatment groups. Approximately half of the patients will be
treated with the PROSORBA(R) column and the other half of the patients with a
placebo treatment. Eight weeks after the conclusion of the twelve-week regimen,
the post-treatment composite "score" will be compared against the pre-treatment
score using the criteria recently recommended by the American College of
Rheumatology.

While this Phase III pivotal trial is not expected to be completed
until 1998, an interim analysis is planned by mid-1997 after approximately 60
patients have completed the protocol. If a positive outcome is achieved in this
pivotal trial, the Company would expect to submit an application to the FDA for
approval of the PROSORBA(R) column for the treatment of rheumatoid arthritis.
Such approval, if granted at all, would be granted no sooner than the year 1999.

In 1996, the Company began providing financial support to several leading
research facilities to further their efforts in studying the mechanism of action
of the PROSORBA(R) column in the treatment of rheumatoid arthritis.

Other Indications

While there are multiple additional indications in which the
PROSORBA(R) column has demonstrated some clinical effects, the Company has most
recently dedicated most of its internal resources, apart from rheumatoid
arthritis, toward the indications of pediatric ITP, paraneoplastic syndrome and
kidney transplantation.

In August 1995, the Company began a pilot clinical trial to evaluate
the PROSORBA(R) column as a means to increase the number of patients eligible
for kidney transplantation. The study was designed to determine if the
PROSORBA(R) column treatment would reduce the level of sensitizing antibodies
which cause acute organ rejection and which prevent a significant portion of the
patient population from receiving donor kidneys. The Company suspended
enrollment of patients in this study and is in the process of evaluating the
merits of continuing the study in light of the other opportunities available to
it.

The Company intends to pursue applications for the use of the
PROSORBA(R) column in the treatment of certain other autoimmune diseases. The
Company's Investigational Device Exemptions ("IDEs") which allow the Company to
perform human clinical trials include the following diseases: rheumatoid
arthritis, myasthenia gravis, systemic lupus erythematosus, multiple sclerosis,
thrombotic thrombocytopenic purpura, and kidney transplantation. Such trials
would be initiated if sufficient financing were obtained and the business
potential of each therapeutic opportunity were consistent with the Company's
goals. The Company is presently unable to predict when, or if, FDA-approval for
any such indications will be obtained.

IPM(TM)

The Company's strategy is to produce therapeutic agents that enhance,
inhibit, modify or replace the natural activity of platelets that have been
depleted or damaged by disease or therapy. In November 1996, the Company
acquired PRP. PRP's primary product, Infusible Platelet Membranes (IPM(TM)),
which is still in the clinical research phase, is being developed as a potential
substitute for traditional platelet transfusions. In connection with the
acquisition, the Company

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recorded a one time expense of approximately $5.1 million to record
acquired in-process research and development in the fourth quarter of 1996.
Currently, the Company is focusing most of its efforts on the development of
IPM(TM), a freeze-dried (lyophilized) powder prepared from either fresh or
outdated human platelets. A proprietary production process removes interior
platelet components, resulting in a product consisting primarily of platelet
membrane fragments. IPM(TM) is heat-treated during processing to inactivate,
below detection levels, any viruses (HIV, hepatitis, etc.) that may be present.
Preclinical and clinical trials conducted to date have shown that IPM(TM) is not
thrombogenic or immunogenic, and no dose limiting toxicity has been determined
in humans or animals. The lead indication for IPM(TM) is as an alternative to
platelet transfusions to restore control of bleeding due to platelet deficiency
in refractory patients.

IPM(TM) for the Treatment of Thrombocytopenia

If blood platelet levels become too low (severe thrombocytopenia), the
hemostasis system begins to deteriorate. Left untreated, thrombocytopenia can
lead to spontaneous bruising and bleeding and may progress to shock, circulatory
collapse, and death. Thrombocytopenia is a common side effect of the chemo- and
radiation therapies used to treat cancer and can also be caused by liver disease
or by major blood loss from traumatic injuries. Platelet dysfunction that is
similar in consequences to thrombocytopenia is caused by prolonged exposure to
some medical devices, such as heart-lung bypass machines used in open-heart
surgery.

Thrombocytopenia is currently treated with transfusion of human
platelets. Current sales of platelets to hospitals for this purpose are about
$1.5 billion worldwide, including approximately $600 million in the U.S.
Associated costs with platelet transfusions, including filters, HLA
cross-matching and donor recruitment add another approximately $200 million in
the U.S. Platelet usage in the U.S. grew at an average annual rate of about 5%
over the period 1980 to 1992, and the Company expects this growth to continue
for at least the next several years. IPM(TM) has the potential to replace a
major fraction of platelet transfusions for thrombocytopenia.

Platelet transfusion is generally an effective therapy, but it has a
number of significant drawbacks. IPM(TM) characteristics allow it to overcome a
majority of the disadvantages of platelet transfusion, as summarized in the
table below:

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------
Human Platelets IPM(TM) Benefits IPM(TM) Economic Impact
----------------------------------------------------------------------------------------------------------------

<S> <C> <C>
Can transmit viruses Viral Inactivation Increased safety, reduced liability
and testing costs

Patients frequently become Does not induce alloimmunization Reduced hospitalization, no platelet
alloimmunized* typing, improved outcomes

Platelets do not control bleeding IPM(TM) controls bleeding in many of Reduced morbidity and mortality
in some patients these patients

Shelf life of 3 to 5 days Shelf life of at least 3 years Reduced loss from out-dating,
emergency availability, improved
logistics and reduced infrastructure

Must be agitated constantly Small vial in refrigerator Reduced storage costs
----------------------------------------------------------------------------------------------------------------
</TABLE>

*Alloimmunization is the process whereby the body develops antibodies to
platelets that cause later transfusions to be ineffective

In addition to safety and toxicity testing in animals and humans, the
Company recently concluded a trial designed to study efficacy in patients with
low platelet counts during active bleeding episodes. The Phase II trial, which
began in early 1996, showed that IPM(TM) controlled or halted bleeding in 17 of
26 patients, a 65% response rate. Of the 26 patients, 12 had previously not
responded to platelet transfusions, the traditional therapy for uncontrolled
bleeding. In this subgroup of refractory non-responders, IPM(TM) was effective
in controlling or halting bleeding in 7 out of 12 patients, or 58% of the time.
The Company had originally planned to study 36 patients but due to the positive
results, the trial was halted at 31 patients so that the Company could begin a
pivotal trial in refractory patients.

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The Company anticipates that if continued clinical success is achieved,
IPM(TM) may be marketed and sold in the U.S. and Europe in 1999 for control of
bleeding in patients who do not respond to platelets, and one or two years later
for prevention of bleeding more generally in thrombocytopenia.

Potential Follow-on Indications

The Company believes that IPM(TM) may also be useful in treating
arterial restenosis. Of the nearly 500,000 patients who currently undergo
coronary angioplasty to open blocked arteries in the U.S. each year, about 25%
will suffer reocclusion (restenosis) of the treated artery within a few months,
and nearly half with a couple of years. A key factor in the development of
restenosis is exposure of smooth muscle cells in the artery walls to platelet
derived growth factory (PDGF). This happens when the patient's platelets adhere
to injuries in the artery walls that are always produced as a side effect of the
angioplasty procedure. After adhesion, the platelets activate, releasing their
interior components, including PDGF and various coagulation-inducing factors. If
platelets can be prevented from adhering to these injured areas, they will not
activate and release PDGF, and, therefore, will not contribute to restenosis.
Both animal and invitro work at the Company have shown that IPM(TM) binds to
arterial lesions and reduces platelet adhesion. Work at the Company and
elsewhere has shown that the IPM(TM) can carry anti-platelet agents to the
lesions and, in principle, concentrate activity of those agents to further
reduce platelet adhesion.

Other areas of potential interest include the use of IPM(TM) during
open heart surgery to prevent peri-operative bleeding and other complications,
the use of IPM(TM) to prevent or control bleeding that can result from the use
of anti-platelet agents, (in particular anti-GP IIb/IIIa agents), and the use of
IPM(TM) in disseminated intravascular coagulation.

IPM(TM) may also be studied in general surgical and emergency room
indications such as trauma. Efficacy in preventing or improving bleeding in
these indications could have great benefits in situations where the storage of
human platelets presents logistical difficulties, such as in military use and in
rural areas, and in situations in which there are potential imbalances between
supply and demand (e.g., in liver transplants which require hundreds of units of
platelets).

AP(4)A

Platelets play a key role in hemostasis and maintenance of normal
vascular impermeability. Although the process of hemostasis is critical, it
sometimes creates unnecessary blood clots that can lead to a wide variety of
ailments including heart attacks, strokes, phlebitis and pulmonary embolisms.
The Company is testing chemical analogs of a compound know as AP(4)A
(diadenosine tetraphosphate) that inhibit platelet aggregation, the first step
in clot formation, and therefore have potential to prevent the formations of
excessive clots an anti-thrombotic effect.

Working together, the Company and Worcester Foundation for Experimental
Biology have shown that AP(4)A inhibits platelet aggregation response and
thrombus formation, and that several analogs of AP(4)A have shown even more
potential anti-thrombotic effects than AP(4)A itself.

Funded by an NIH Small Business Innovation Research (SBIR) Phase I
grant, the Company discovered that one particular AP(4)A analog has promising
characteristics. The Company intends to focus on this compound for further
preclinical development under support of a $750,000 Phase II grant the NIH
awarded to the Company in the fall of 1996.

OTHER TECHNOLOGY

In November 1994, the Company's diagnostic division entered into a
licensing agreement under which it has licensed the right to use proprietary
nucleic acid probe technology (a genetic screening test) to predict which
rheumatoid arthritis patients will develop severe disease and hence may benefit
from early aggressive therapy. The test is currently a manually performed
reference laboratory test. In January 1995, the Company obtained the rights to
hybridization and chemical signal generation technology as well as to automated
clinical instrumentation which combined could provide the Company with the
opportunity to create an automated laboratory test using the nucleic acid probe
technology.

The Company's diagnostics division was originally created to employ
proprietary immunoassay technology to develop specific assays that provide
greater sensitivity and specificity than presently available in the market. The
diagnostics program is currently under evaluation within the Company and an
active effort to find appropriate partners for the program is underway.

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MARKETING AND SALES

Prior to 1994, the PROSORBA(R) column was sold by the Company's
internal sales force to physicians in the fields of immunology, hematology and
oncology. In April 1994, Baxter assumed sales and marketing responsibilities
under a 10-year exclusive distribution agreement, granting distribution rights
of the PROSORBA(R) column in the United States and Canada for the treatment of
thrombocytopenia. Baxter, at its own expense, was to provide sales and marketing
support for the sale of the product during the term of the agreement. The
Company was to provide significant marketing and promotional support to Baxter
for the first three years of the agreement.

Effective May 1, 1996, the Company and Baxter terminated the exclusive
distribution agreement, whereby the Company regained the right to sell its
PROSORBA(R) column directly to customers who had previously purchased the
PROSORBA(R) column through Baxter as well as to any other potential customers
who wish to purchase the PROSORBA(R) column.

In August 1996, the Company established an internal sales and marketing
program. The program included hiring a domestic sales force of approximately six
representatives as well as initiating marketing efforts including medical
education, direct mail, trade show participation and journal advertising.

In the latter part of the year, the Company launched a controlled
clinical study evaluating the efficacy of the PROSORBA(R) column in ITP. This is
the first prospective and controlled study of the device in its approved
indication and has been designed to confirm observations from 10 years of
historical use. Although the trial is not expected to be completed until 1998,
the Company expects to release interim data after approximately one-third of the
subjects have completed the protocol.

Internationally, the Company has entered into exclusive agreements for
distribution of the PROSORBA(R) column in Spain, Korea, Mexico, Brazil,
Argentina, and Hong Kong. However, sales to international customers represent
less than 10% of the Company's product sales.

Generally, in the United States the cost of treatment for ITP using the
PROSORBA(R) column has been reimbursed by third-party payors.

No customer represented more than 10% of the Company's annual sales
during the year ended December 31, 1996. For the years ended December 31, 1994
and 1995, sales to Baxter represented approximately 70% and 91%, respectively,
of the Company's sales.

Sale of the PROSORBA(R) column is not subject to seasonal fluctuation.

PATENTS AND PROPRIETARY TECHNOLOGY

The Company believes that its success depends primarily on the
experience, capabilities, and skills of its personnel. Notwithstanding this
fact, however, the Company seeks to protect its intellectual property rights by
a variety of means, including patents, maintaining trade secrets and proprietary
know-how, and technological innovation to develop and maintain its competitive
position. There can be no assurance that the Company will be able to obtain
additional patents either in the United States or in foreign jurisdictions or
that, if issued, such patents will provide sufficient protection or be of
commercial benefit to the Company. Insofar as the Company relies on trade
secrets and unpatented proprietary know-how, there can be no assurance that
others will not independently develop similar technology or that secrecy will
not be breached. Finally, there can be no assurance that the Company will be
able to develop further technological innovations.

THE PROSORBA(R) COLUMN

The Company presently owns nine issued U.S. patents and six
international patents (excluding patents relating to the area of platelet
therapeutics) which expire during 2004 to 2009. The process used in
manufacturing the PROSORBA(R) column is covered by one of these patents. Certain
U.S. and international applications are pending. The Company has an exclusive
license for a U.S. patent for a genetic screening test to predict which
rheumatoid arthritis patients will develop severe disease. In addition, the
Company has an exclusive license for a U.S. patent for treating cellular Fc
receptor-mediated hypersensitivity immune disorders.

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Negotiations regarding the licensing of certain patent rights relating
to the use of the PROSORBA(R) column have been ongoing for several years with an
individual who owns certain patents. Management does not believe the Company's
technology infringes upon such individual's patents.

IPM(TM)

The Company presently owns four issued U.S. patents and three pending
U.S. patent applications relating to the area of platelet therapeutics. Certain
international patent applications corresponding to the issued U.S. patents have
been filed. To date, four foreign patents have been issued while others are
still pending in countries or jurisdictions outside the U.S. These patents and
those that might issue on the pending patent applications are scheduled to
expire during 2010 to 2014.

GENERAL

There can be no assurance that the Company's patents will afford
commercially significant protection of its proprietary technology or have
commercial application. There has been no judicial determination of the validity
or scope of its proprietary rights. Moreover, the patent laws in foreign
countries may differ from those of the United States, and the degree of
protection afforded by foreign patents may be different.

Others have filed applications for, or have been issued, patents and
may obtain additional patents and other proprietary rights relating to products
or processes competitive with those of the Company. The scope and validity of
such patents is presently unknown. If existing or future patents are upheld as
valid by courts, the Company may be required to obtain licenses to use
technology covered by such patents.

In November 1995, a complaint was filed with the United States District
Court, Northern District of California, claiming that the Company's PROSORBA(R)
column allegedly infringes a patent issued to David S. Terman, M.D., which was
assigned in July 1993 to DTER-ENT, Inc., a California corporation ("DTER-ENT").
The Company first received notice of a claim of infringement from DTER-ENT in
July 1993. The Company has disclosed this claim in its public filings for the
past two years. The patent infringement claim was settled in April 1996 whereby
the Company was granted a non-exclusive license to use the Terman invention. The
settlement of the claim did not and will not have a material impact on the
Company's financial position or results of operations.

GOVERNMENT REGULATION

The Company's research and development activities and the future
manufacturing and marketing of products by the Company are subject to regulation
for safety and efficacy by numerous governmental authorities in the United
States and other countries. In the United States, both biologics and medical
devices are subject to rigorous FDA regulation. The Federal Food, Drug and
Cosmetic Act and the Public Health Service Act govern the testing, manufacture,
safety, efficacy, labeling, storage, record keeping, approval, advertising and
promotion of the Company's products. In addition to the FDA regulations, the
Company is also subject to other federal and state regulations such as the
Occupational Safety and Health Act and the Environmental Protection Act. Product
development and approval within this regulatory framework takes a number of
years and involves the expenditure of substantial resources. In addition, there
can be no assurance that this regulatory framework will not change or that
additional regulation will not arise at any stage of the Company's product
development which may affect approval or delay of an application or require
additional expenditures by the Company.

The Company's regulatory strategy is to pursue clinical development and
marketing approval of its products worldwide. The Company intends to seek input
from the FDA at each stage of the clinical process to facilitate appropriate and
timely clinical development, focusing on issues such as trial design and
clinical endpoints. Where appropriate, the Company intends to pursue available
opportunities, to the extent available, for accelerated approval of products. A
corporate partner may be helpful to accelerate international development.

The time required for completing such testing and obtaining such
approvals is uncertain and approval itself may not be obtained. In addition,
delays or rejections may be encountered based upon changes in FDA policy during
the period of product development and FDA regulatory review of each submitted
new drug application or product license application. Similar delays may also be
encountered in foreign countries. There can be no assurance that even after such
time and expenditures, regulatory approval will be obtained for any products
developed by the Company. Moreover, if regulatory

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approval of a product is granted, such approval may entail limitations on the
indicated uses for which the product may be marketed. Further, even if such
regulatory approval is obtained, a marketed product, its manufacturer and the
facilities in which the product is manufactured are subject to continual review
and periodic inspections. Late discovery of previously unknown problems with the
product, manufacturer or facility may result in restrictions on such product or
manufacturer, including withdrawal of the product from the market.

THE PROSORBA(R) COLUMN

The PROSORBA(R) column is regulated by the FDA as a Class III medical
device. The regulatory approval of a Class III medical device in the United
States intended for therapeutic use in humans involves many steps including
pre-clinical and clinical testing. Pre-clinical evaluation of a Class III device
includes testing to demonstrate that in clinical studies with human subjects the
product would not present an unreasonable hazard. Pre-clinical and clinical
evaluation of the PROSORBA(R) column was conducted as part of the approval
process for treatment of patients with ITP.

For each additional disease that the Company wants to treat with the
PROSORBA(R) column, clinical testing must be conducted. Before such clinical
testing can begin, an investigational device exemption ("IDE") application must
be prepared and filed with the FDA. This application consists of (i) information
on the composition of the product, (ii) manufacturing data, (iii) results of all
pre-clinical safety and effectiveness studies, and (iv) a design of the study
and protocol.

The clinical testing of a device may consist of a preliminary
feasibility study leading to a larger study of safety and effectiveness, or it
may consist of only the larger safety and effectiveness study. Upon completion
of the study and compilation of the data, a pre-market approval ("PMA")
application can be filed. The FDA is required to respond to the PMA submission
within 180 days, although the FDA may not and often does not adhere to this
schedule and further review may take additional time. After the FDA completes
its review of the PMA application, the clinical study data may be reviewed by an
advisory panel of medical experts who are not part of the FDA. The applicant is
required to answer questions posed by this panel. Based upon its review of the
data, the advisory panel may make a recommendation of approval or nonapproval to
the FDA. The FDA usually follows the recommendation of the panel but is not
required to. Assuming the advisory panel recommends approval of the PMA, the FDA
may approve the application and the product may then be commercially
distributed.

The manufacture and distribution of medical devices are subject to
continuing FDA regulation. In addition to the requirement that the device be
marketed only for its approved uses, applicable law requires compliance with the
FDA's good manufacturing practices ("GMP") regulations. Failure to comply with
the GMP regulations or with other applicable legal requirements can lead to
federal seizure of violating products, injunctive actions brought by the federal
government, and potential criminal liability on the part of the Company and of
the officers and employees of the Company who are responsible for the activities
that lead to the violations.

Although the Company has received marketing approval from the FDA for
the treatment of ITP with the PROSORBA(R) column, there can be no assurance that
any marketing clearances for other diseases or products will be granted on a
timely basis, or at all, or that it will be economically feasible to
commercialize the PROSORBA(R) column for these other diseases. The FDA may also
require post-marketing testing and surveillance programs to monitor the
effectiveness and safety of the Company's products. Product marketing approvals
may be withdrawn for noncompliance with regulatory standards or the occurrence
of unforeseen problems following initial marketing.

The PROSORBA(R) column is commercially distributed under a PMA that was
approved by the FDA in 1987. Changes to the product and its manufacturing
process, and certain types of labeling changes must be approved by the FDA prior
to implementation. The Company currently has one supplement to the PMA pending
with the FDA for the consolidation of the Company's manufacturing facilities
into one site. There can be no assurance that the current supplement or any
future supplements will be approved by the FDA.

IPM(TM)

IPM(TM) is regulated by the FDA as a biologic. The steps required
before a biologic may be marketed in the United States include (i) preclinical
laboratory and animal tests, (ii) the submission to the FDA of an application
for an Investigational New Drug ("IND"), which must become effective before
human clinical trials may commence in the United States, (iii) adequate and
well-controlled human clinical trials to establish the safety and efficacy of
the biologic, (iv) the submission of a

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Product License Application ("PLA") to the FDA and (v) the FDA approval of the
PLA prior to any commercial sale or shipment of the biologic. In addition to
obtaining FDA approval for each product, each domestic biologic manufacturing
establishment must be registered with, and approved by, the FDA.

Preclinical tests include laboratory evaluation of product chemistry
and animal studies to assess the safety and efficacy of the product and its
formulation. The results of the preclinical tests are submitted to the FDA as
part of an IND, and unless the FDA objects, the IND will become effective 30
days following its receipt by the FDA.

Clinical trials involve the administration of the biologic to healthy
volunteers, or to patients identified as ones with the condition for which the
biologic is being tested, under the supervision of a qualified principal
investigator. Clinical trials are conducted in accordance with protocols that
detail the objectives of the study, the parameters to be used to monitor safety,
and the efficacy criteria to be evaluated. Each protocol is submitted to the FDA
as part of the IND. Each clinical study is conducted under the auspices of an
independent Institutional Review Board ("IRB") at the institution at which the
study will be conducted. The IRB will consider, among other things, ethical
factors, the safety of human subjects and the possible liability of the
institution.

Clinical trials are typically conducted in three sequential phases, but
the phases may overlap. In Phase I, the initial introduction of the biologic
into healthy human subjects, the product is tested for safety (adverse effects),
dosage tolerance, metabolism, distribution, excretion and clinical pharmacology.
Phase II involves studies in a limited patient population to (i) determine the
efficacy of the drug for specific targeted indications, (ii) determine dosage
tolerance and optimal dosage and (iii) identify possible adverse side effects
and safety risks. When a compound is found to be effective and to have an
acceptable safety profile in Phase II evaluations, Phase III trials are
undertaken to further evaluate clinical efficacy and to test further for safety
within an expanded patient population at multiple clinical study sites. The FDA
reviews both the clinical plans and the results of the trials and may
discontinue the trials at any time if there are significant safety issues.

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

Among the conditions for NDA or PLA approval is the requirement that
the prospective manufacturer's quality control and manufacturing facilities are
subject to biennial FDA inspections and foreign manufacturing facilities are
subject to periodic FDA inspections or inspections by the foreign regulatory
authorities with reciprocal inspection agreements with the FDA.

The Prescription Drug Act of 1992 requires companies engaged in
pharmaceutical development, such as the Company, to pay user fees in the amount
of at least $100,000 upon submission of a PLA. The Company does not believe that
this requirement will have a material adverse effect on the Company's business.

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

In early 1992, the Company completed necessary pre-clinical studies and
filed in August of that year an IND to begin clinical studies of IPM(TM). The
FDA requested additional animal data which was provided in an amended IND
filing. The FDA approved the IND in September of 1993, and clinical trials
started in early 1994. In order to include an international site in the Phase II
trial, a CTX was filed and approved by the UK Medicines Control Agency.

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COMPETITION

THE PROSORBA(R) COLUMN

The PROSORBA(R) column, as well as other products which may be
developed by the Company in the future, are intended to compete with
conventional methods of treatment which generally consist of surgery, drug, or
radiation therapy and which have been accepted by the medical community as
classical treatment methods. In addition, the Company intends to compete with
methods of treatment focusing on the artificial stimulation and/or modification
of the human immune system by material or synthetic drugs or genetically
engineered compounds which are being pursued by numerous biotechnology and
medical companies and research institutions. Many of the Company's potential
competitors have significantly greater resources than the Company. The
PROSORBA(R) column, represents a different approach to the treatment of
immune-related diseases inasmuch as they focus on the removal of CIC's that are
suppressive to the body's immune system. The Company is aware of a select number
of other companies which are known to be pursuing approaches to disease
treatment similar to the Company's methodology. In addition, it is always
possible that established companies and research institutions with greater
resources may develop other treatment methods for various diseases.

The Company believes that its success will depend primarily on, among
other things, the market acceptance of its therapeutic approach, its scientific
expertise, the PROSORBA(R) column's performance measured against competing
products, adequate funding, and on its ability to develop, protect, and market
products in the future. The Company's competitive success will also depend on
its continued ability to attract and retain skilled and experienced personnel,
to develop and secure the rights to advanced proprietary technology and to
commercially exploit its technology prior to the development of competitive
products by others.

IPM(TM)

When and if the Company receives FDA approval for IPM(TM), it will
initially be launched for the control of bleeding in patients who are
non-responsive to platelet transfusions. There are currently no competing
therapies for such platelet-refractory patients. With respect to the remaining
platelet market, IPM(TM)'s advantages over traditional platelet therapy support
its usage. IPM(TM) also has several advantages over its closest competition,
CMV-free leukodepleted single-donor platelets. Products in development to filter
or virally deactivate platelets will only address one of the five advantages of
IPM(TM). The most important clinical advantage of IPM(TM) is its
nonimmunoginicity which no other competitive product in development currently
addresses. There can be no assurance, however, that other parties will not
develop competing therapies.

MANUFACTURING AND SUPPLY

The Company believes that raw materials and other components are
available in sufficient quantities to meet production requirements for the
PROSORBA(R) column. The Company's principal manufacturing operations for its
PROSORBA(R) column are based in Redmond, Washington.

The Company currently manufactures IPM(TM) in its Boston, Massachusetts
facility. The Company has single sources of supply for certain components but
believes it could obtain alternate sources of supplies if its current suppliers
were unable to provide the Company with adequate quantities of such components.

EMPLOYEES

As of December 31, 1996, the Company employed approximately 36
full-time employees, including eight who have doctorate degrees and three who
are registered nurses. None of the Company's employees is covered by collective
bargaining agreements, and management considers relations with its employees to
be good.

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RISK FACTORS

Except for the historical information contained herein, the following
discussion contains forward-looking statements within the meaning of Section 21E
of the Exchange Act that involve risks and uncertainties. The Company's actual
results could differ materially from those discussed below and elsewhere in this
Report. Factors that could cause or contribute to such differences include,
those discussed in the following Risk Factors as well as in the sections
entitled "Business" beginning on page 3 and "Management's Discussion and Anlysis
of Financial Condition and Results of Operations" beginning on page 21.

Need for Additional Capital

The Company is actively seeking opportunities to raise additional
capital to be used primarily to fund existing operations related to the
manufacture and sale of the PROSORBA(R) column, to develop new and complete
existing research and development activities, and to fund clinical trials
related to the proposed use of the PROSORBA(R) column for the treatment of
rheumatoid arthritis. In addition, the Company will require substantial
additional capital over a period of a number of years to further the development
and marketing of IPM(TM). Except in very limited circumstances, the Company is
obligated to expend no less than $4,000,000 on the development of IPM(TM), of
which the Company has expended $515,000 as of January 31, 1997. To the extent
the Company decides to continue the development of other products previously
being developed by PRP, it will be required to raise additional capital. The
amount of capital required by the Company is primarily dependent upon the
following factors: results of clinical trials, results of current research and
development efforts, the FDA regulatory process, potential competitive and
technological advances and levels of product sales. Because the Company is
unable to predict the outcome of the previously noted factors, some of which are
beyond the Company's control, the Company is unable to estimate, with certainty,
its mid- to long-term total capital needs. Although the Company may seek to
raise additional capital through a combination of additional equity offerings,
joint ventures, strategic alliances, borrowings and other available sources,
there can be no assurance that the Company will be able to raise additional
capital through such sources or that funds raised thereby will allow the Company
to maintain its current and planned operations as provided herein. If the
Company is unable to obtain additional financing, it may be required to delay,
scale back or eliminate some or all of its research and development activities,
to license to third parties technologies that the Company would otherwise seek
to develop itself, to seek financing through the debt market at potentially
higher costs to the Company and/or to seek additional methods of financing. The
Company believes that current capital amounts are sufficient to fund operations
until 1998.

History of Operating Losses

The Company has operated at a loss since its formation in October 1981.
As of December 31, 1996, the Company had an accumulated deficit of approximately
$57,000,000. The ability of the Company to achieve profitability is dependent
upon, among other things, successful completion of anticipated clinical trials
and obtaining FDA marketing approval of the PROSORBA(R) column in additional
disease indications in a timely manner. The Company would have to significantly
scale back its plans, curtail clinical trials, and limit its present operations
in order to become profitable or operate on a break-even basis if it does not
receive marketing approval from the FDA for the PROSORBA(R) column for the
treatment of diseases in addition to ITP or for IPM(TM) for the treatment of
platelet disorders. There can be no assurance that the Company will successfully
complete any present or future clinical trials, gain approval to begin any new
clinical trials, meet applicable regulatory standards or successfully market its
products to generate sufficient revenues to render the Company profitable. See
"--Prior Exclusive Agreement with Baxter; Necessity of Establishing a Sales
Force."

Management Changes; Dependence Upon Key Personnel

The Company has recently undergone changes in senior management. In
December 1995, Jay D. Kranzler, M.D., Ph.D. was appointed as Chief Executive
Officer and Vice Chairman of the Board of Directors and Debby Jo Blank, M.D. was
appointed as President, Chief Operating Officer and a member of the Board of
Directors of the Company. In April 1996, Susan E. Feiner was appointed as the
Company's Director of Finance, Controller, Secretary and Treasurer. In March
1996, Frank R. Jones resigned as Chief Scientific Officer and as Chairman of the
Board and in May 1996, Alex P. de Soto resigned as the Company's Vice President,
Chief Financial Officer, Secretary and Treasurer. Messrs. Jones' and de Soto's
resignations were a result of the restructuring of the Company and the Company's
relocation of its executive offices to San Diego, California.

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The Company's success is dependent upon certain key management and
technical personnel, including the new members of senior management. The loss of
the services of any of these key employees could have a material adverse effect
on the Company. The Company does not currently maintain any key employee
insurance coverage.

FDA Approval and Regulations

The Company is currently conducting a controlled clinical trial of the
PROSORBA(R) column for treatment of rheumatoid arthritis. Although the FDA has
approved the commercial sale of the PROSORBA(R) column for the treatment of ITP,
there can be no assurance that current or future clinical trials will produce
data satisfactory to the FDA to establish the effectiveness of the PROSORBA(R)
column for treatment of diseases other than ITP, such as rheumatoid arthritis,
or that the FDA will approve the PROSORBA(R) column for treatment of such
diseases in a timely manner, if at all.

The Company plans to continue the Phase II clinical trials of IPM(TM)
currently underway. Clinical trials are vigorously regulated by the FDA and must
meet requirements for institutional review board oversight and informed consent
as well as FDA review and oversight and good clinical practice regulations.
There can be no assurance that the clinical trials being conducted for IPM(TM)
will be completed successfully within any specified period of time, if at all,
or that if successful the Company will be able to further develop IPM(TM).
Furthermore, the Company or the FDA may delay or suspend clinical trials at any
time if it is determined that the subjects participating in such trials are
being exposed to unacceptable health risks. Any such delay or suspension could
have a material adverse effect on the Company's business.

The PROSORBA(R) column is commercially distributed under a premarket
approval ("PMA") application that was approved by the FDA in 1987. Changes to
the product and its manufacturing process, and certain types of labeling changes
must be approved by the FDA prior to implementation. The Company currently has
one supplement to the PMA pending with the FDA for the consolidation of its two
manufacturing facilities into one site. There can be no assurance that the
Company will receive approval of its pending PMA supplement or that any future
PMA supplements will be approved by the FDA.

Even if FDA approval is granted to market a product for the treatment
of a particular disease, subsequent discovery of previously unknown problems may
result in restrictions on the product's future use or withdrawal of the product
from the market. In addition, any other products developed in the future will
require clinical testing and FDA marketing approval before they can be
commercially exploited in the United States. Such approval process is typically
very lengthy and there is no assurance that FDA approvals will be obtained.

The manufacture and distribution of medical devices are subject to
continuing FDA regulation. In addition to the requirement that the device be
marketed only for its approved use, applicable law requires compliance with the
FDA's GMP regulations. Failure to comply with the FDA's GMP regulations or with
other applicable legal requirements can lead to federal seizure of non-complying
products, injunctive actions brought by the federal government, and potential
criminal liability on the part of the Company and of the officers and employees
of the Company who are responsible for the activities that lead to the
violations.

Through December 31, 1996, production of commercial quantities of the
raw materials utilized in production of the PROSORBA(R) column has been
performed at the Redmond facility. Final assembly of the PROSORBA(R) column has
been performed at the Seattle facility. In conjunction with the Company's
restructuring plan and corresponding reduction in facilities, the Seattle and
Redmond, Washington facilities have been consolidated into a single
manufacturing facility in Redmond. The Redmond facility has been renovated in
order to enable both the production of raw materials, as well as the final
assembly of the PROSORBA(R) column, to be performed in the Redmond facility. The
renovated Redmond facility must comply with the FDA's GMP regulations and must
complete the GMP re-approval process. Although the renovations are complete, the
GMP re-approval process has not yet been completed. There can be no assurance
that the renovated facility will receive GMP approval in time to sustain
uninterrupted production of the PROSORBA(R) column, if at all.

Furthermore, PRP occupies a facility that includes a GMP-approved pilot
production plant where all phases of production of clinical-grade IPM(TM)
occurs, except for filling and lyophilization. There can be no assurance that
the Company will be able to maintain the facility's GMP-approved status or that,
if approval is not maintained, it will be able to find an alternate GMP-approved
production facility.

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Acquisition of PRP, Inc.; Integration of Operations

In November of 1996, the Company completed the acquisition of PRP. In
connection with such acquisition, the Company recorded a non-recurring expense
of approximately $5.1 million as acquired in-process research and development in
the fourth quarter of 1996.

The Company is currently in the process of integrating the operations
of PRP with those of the Company. If the Company is to realize the anticipated
benefits of the acquisition, the operations of PRP and the Company must be
integrated and combined efficiently. The process of rationing management and
administrative resources, facilities, management information systems and other
aspects of operations, while managing a larger and geographically expanded
entity, will present a significant challenge to the management of the combined
company. There can be no assurance that the integration process will be
successful or that the anticipated benefits of the business combination will be
fully realized. The dedication of management resources to such integration may
detract attention from the day-to-day business of the combined company. The
difficulties of integration may be increased by the necessity of coordinating
geographically separated organizations, integrating personnel with disparate
business backgrounds and combining different corporate cultures. There can be no
assurance that there will not be substantial costs associated with the
integration process, that such activities will not result in a decrease in
revenues or that there will not be other material adverse effects of these
integration efforts.

Competitive Environment; Technological Change; Effectiveness of Products

The field of medical devices in general and the particular areas in
which the Company will market its products are extremely competitive. In
developing and marketing medical devices to treat immune-mediated diseases, the
Company competes with other products, therapeutic techniques and treatments
which are offered by national and international healthcare and pharmaceutical
companies, many of which have greater marketing, human and financial resources
than the Company.

The immunological therapy market is characterized by rapid
technological change and potential introductions of new products or therapies.
To respond to these changes, the Company may be required to develop or purchase
new products to protect its technology from obsolescence. There can be no
assurance that the Company will be able to develop or obtain such products, or,
if developed or obtained, that such products will be commercially viable. In
addition, there can be no assurance that the Company's PROSORBA(R) column will
prove effective in the treatment of diseases other than ITP or that IPM(TM), if
approved for sale by the FDA, will be effective in treating thrombocytopenia or
other blood platelet disorders.

Dependence on Third Party Arrangements

The Company's commercial sale of its proposed products and its future
product development may be dependent upon entering into arrangements with
corporate partners and other third parties for the development, marketing,
distribution and/or manufacturing of products utilizing the Company's
proprietary technology. While the Company is currently seeking collaborative
research and development arrangements and joint venture opportunities with
corporate sponsors and other partners, there can be no assurance that the
Company will be successful in entering into such arrangements or joint ventures
or that any such arrangements will prove to be successful.

Prior Exclusive Agreement with Baxter; Necessity of Establishing a Sales Force

In March 1996, the Company and Baxter terminated their exclusive
distribution agreement, whereby, effective May 1, 1996, the Company regained the
right, among other things, to sell its PROSORBA(R) column directly to customers
who had previously purchased PROSORBA(R) columns through Baxter as well as to
any other potential customers who wish to purchase PROSORBA(R) columns. As a
result of the termination of the distribution agreement with Baxter, the Company
has established a domestic sales force to sell the PROSORBA(R) column directly
to customers who previously purchased PROSORBA(R) columns from Baxter and to
other potential customers who wish to purchase PROSORBA(R) columns directly from
the Company.

In May 1996, the Company increased the sales price of the PROSORBA(R)
column to be sold directly to customers by approximately 9%. This is the first
such price increase implemented by the Company since January 1994. The Company
believes that such price increase reflects a nominal price increase for a
medical device for the period covered by such increase. However, there can be no
assurance that the Company will be successful in selling the PROSORBA(R) column
at the increased price, if at all.

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Limited International Sales and Marketing

The Company conducts limited marketing of the PROSORBA(R) column
outside the United States through foreign distributors. Sales to foreign
distributors have not been material to the Company's results from operations.
There can be no assurance that foreign sales arrangements will become material
to the Company's results of operations.

Uncertainty of Patent Protection and Claims to Technology

The Company believes that its success depends primarily on the
experience, capabilities, and skills of its personnel. Notwithstanding this
fact, however, the Company seeks to protect its intellectual property rights by
a variety of means, including patents, the maintenance of trade secrets and
proprietary know-how, and technological innovation to develop and maintain its
competitive position. There can be no assurance that the Company will be able to
obtain additional patents either in the United States or in foreign
jurisdictions or that, if issued, such patents will provide sufficient
protection or be of commercial benefit to the Company. Insofar as the Company
relies on trade secrets and unpatented proprietary know-how, there can be no
assurance that others will not independently develop similar technology or that
secrecy will not be breached. Finally, there can be no assurance that the
Company will be able to develop further technological innovations.

The Company presently owns four issued U.S. patents and three pending
U.S. patent applications relating to the area of platelet therapeutics.
International patent applications corresponding to the issued U.S. patents have
been filed. To date, four foreign patents have been issued while others are
still pending in countries or jurisdictions outside the U.S. These patents and
those that might issue on the pending patent applications are scheduled to
expire during 2010 to 2014.

In connection with the acquisition of PRP, the Company acquired certain
exclusive rights with respect to the use, manufacture and sale of products
and/or processes related to analogs of the compound diadenosine tetraphosphate
("AP(4)A"), which rights were granted to PRP in July 1992 pursuant to a license
agreement between PRP and a collaborator of PRP (the "Licensor"). Under the
terms of the license agreement, PRP was obligated to file an IND with respect to
the commercial application of such rights within four years of acquiring such
rights. Neither PRP nor the Company has filed such IND. Due to such failure,
Licensor has the right to cancel upon 30 days written notice the exclusive
license or to convert the exclusive license to a nonexclusive license. If
Licensor elects to cancel such license, there can be no assurance that the
Company will be able to acquire or license the similar rights on terms
acceptable to the Company, if at all.

Various scientific personnel of the Company were previously associated
with non-profit research or education institutions that typically require
researchers to execute agreements giving such institutions broad rights to
inventions created or developed during the period that the scientist is
associated with such institution. While no such institution has to date

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asserted rights to the Company's technology, such assertions may be made in the
future, and if made, there can be no assurances that the Company will be
successful in any such litigation.

Concentration of Ownership

As of January 31, 1997, Allen & Company Incorporated and Mr. Richard M.
Crooks, a director of the Company, beneficially owned approximately 18.1% and
3.2% respectively, of the outstanding common stock of the Company. Mr. Crooks
is also a director and consultant to Allen & Company Incorporated. Together, Mr.
Crooks and Allen & Company Incorporated own a significant amount of the total
outstanding common stock of the Company and may be able to exert substantial
influence over the outcome of matters requiring stockholder approval.

Insurance Reimbursement

Successful commercialization of a new medical product, such as the
PROSORBA(R) column or IPM(TM) depends, in part, on reimbursement by public and
private health insurers to health care providers for use of such products. The
availability of such reimbursement is subject to a variety of factors, many of
which could affect the Company as it commercializes use of the PROSORBA(R)
column and continues development and commercialization of IPM(TM). Although the
Company has been generally successful in assisting health care providers in
arranging reimbursement for the use of the PROSORBA(R) column in the treatment
of ITP, there can no assurance that public and private insurers will continue to
reimburse for the use of the PROSORBA(R) column. In addition, there can be no
assurance that health care providers will reimburse for the use of IPM(TM), when
and if commercialized.

Uncertainty of Health Care Reform

There are widespread efforts to control health care costs in the U.S.
and worldwide. Various federal and state legislative initiatives regarding
health care reform and similar issues continue to be at the forefront of social
and political discussion. These trends may lead third-party payors to decline or
limit reimbursement for the Company's product, which could negatively impact the
pricing and profitability of, or demand for, the Company's product. The Company
believes that government and private efforts to contain or reduce health care
costs are likely to continue. There can be no assurance concerning the
likelihood that any such legislative or regulatory initiative will be enacted,
or market reform initiated, or that, if enacted such reform or initiative will
not result in a material adverse impact on the business, financial condition or
results of operations of the Company.

Product Liability

The use of the PROSORBA(R) column and, when and if approved for use by
the FDA, IPM(TM), involve the possibility of adverse effects occurring to
end-users that could expose the Company to product liability claims. The Company
believes that its product liability insurance coverage is adequate in light of
the Company's business. However, although the Company currently maintains
product liability insurance coverage, there can be no assurance that such
coverage or any increased amount of coverage will be adequate to protect the
Company and there can be no assurance that the Company will have sufficient
resources to pay any liability resulting from such a claim.

Possible Volatility of Stock Price; Absence of Dividends

There has been significant volatility in the market prices of
securities of biomedical companies in general, including the Company's
securities. Factors such as announcements by the Company or by others of
technological innovations, results of clinical trials, new commercial products,
regulatory approvals or proprietary rights developments, coverage decisions by
third-party payors for therapies and public concerns regarding the safety and
other implications of biotechnology and biomedical products may have a
significant impact on the Company's business and market price of the Company's
securities. In addition, in connection with the acquisition of PRP, the Company
is obligated to make a $5,000,000 milestone payment to the former holders of
equity securities (including holders of warrants and options) of PRP upon the
public announcement of an FDA approvable letter relating to the use of IPM(TM)
for the treatment of thrombocytopenia. The Company has the option to make such
milestone payment in the form of common stock of the Company. The issuance of
common stock with a value of $5,000,000 could have a significant impact on the
market price of the Company's securities.

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No dividends have been paid on the Company's common stock to date, and
the Company does not anticipate paying dividends on its common stock in the
foreseeable future.

Hazardous Material

The Company's research and development programs involve the controlled
use of biohazardous materials such as viruses, and may include the use of the
HIV virus that causes AIDS. Although the Company believes that its safety
procedures for handling such materials comply with the standards prescribed by
state and federal regulations, the risk of accidental contamination or injury
from these materials cannot be completely eliminated. In the event of such an
accident, the Company could be held liable for any damages that result, and any
such liability could exceed the resources of the Company.

Limitation of Net Operating Loss Carryforwards

The Company's sale of common stock in November 1990 and September 1991
when taken together with prior issuances, caused the limitation of Section 382
of the Internal Revenue Code of 1986, as amended, to be applicable. This
limitation will allow the Company to use only a portion of the net operating
loss carryforwards to offset future taxable income, if any, for federal income
tax purposes. Based upon the limitations of Section 382 and before consideration
of the effect of issuances of common stock after 1991, the Company may be
allowed to use no more than a prescribed amount of such losses each year to
reduce taxable income, if any. To the extent not utilized by the Company, unused
losses will carry forward subject to the limitations to offset future taxable
income, if any, until such unused losses expire. All unused net operating losses
will expire 15 years after any year in which they were generated. The years in
which such expiration will take place range from 1998 to 2010.

ITEM 2. PROPERTIES

The Company currently occupies approximately 17,800 square feet of
leased office and manufacturing facilities in San Diego, California, Redmond,
Washington and Boston, Massachusetts. The 2,800 square foot San Diego facility
houses the Company's executive offices, as well as its administration, research
and medical personnel. The five year lease for this facility expires in 2001.
The Boston facility is approximately 7,000 square feet, and its lease expires in
2001. It is used primarily for the manufacture of IPM(TM) and qualifies as a GMP
pilot production plant.

The Company leases 8,000 square feet for its manufacturing facility in
Redmond under a lease expiring in 2004. The facility has historically been used
to produce commercial quantities of both protein A and the chemically coated
silica matrix used in the manufacture of the PROSORBA(R) column. Assembly of the
PROSORBA(R) column has historically been performed in the Company's Seattle
facility. The Redmond facility, however, has been recently renovated so that
both raw material production and assembly of the PROSORBA(R) column can be
performed in a single facility. Although the Redmond facility has historically
complied with the FDA GMP regulations, the renovated facility must still
complete the FDA GMP re-approval process. There can be no assurance that the
renovated facility will receive GMP approval in a timely manner, if at all.

The Company leases a 14,400 square foot facility in Seattle, Washington
under a lease expiring in 2004. In conjunction with the Company's 1996
restructuring plan and corresponding reduction in facilities, this space was
subleased to another party in April 1996 for the remainder of the lease term.
The Company retained rights to use a small portion of the space through February
1997 until renovations at the Company's Redmond facility were completed, at
which time the Company vacated the Seattle facility.

17
<PAGE> 18
ITEM 3. LEGAL PROCEEDINGS

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

No matters were submitted to a vote of security holders during the
fourth quarter of 1996.

18
<PAGE> 19
PART II

ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER
MATTERS

The Company's common stock is traded on the over-the-counter market on
the NASDAQ Smallcap Market under the symbol "CYPB". Prior to May 21, 1996 the
Company's common stock was traded on the NASDAQ Smallcap Market under the symbol
"IMRE". Set forth below are the high and low closing bid prices for the
Company's common stock for each quarter of 1996 and 1995 as reported by the
NASDAQ Stock Market, Inc.

<TABLE>
<CAPTION>
1996 High Bid Low Bid
---- -------- -------
<S> <C> <C>
First Quarter . . . . . . . . . . . . . . . . 2 5/8 1 7/8

Second Quarter . . . . . . . . . . . . . . . . 2 9/16 2 1/4

Third Quarter . . . . . . . . . . . . . . . . 2 1/4 1 3/4

Fourth Quarter . . . . . . . . . . . . . . . . 2 3/8 1 5/8

1995 High Bid Low Bid
---- -------- -------
First Quarter . . . . . . . . . . . . . . . . . 2 1/8 1 1/4

Second Quarter . . . . . . . . . . . . . . . . . 2 1/8 1 7/16

Third Quarter . . . . . . . . . . . . . . . . . 4 1/2 1 7/8

Fourth Quarter . . . . . . . . . . . . . . . . . 3 5/8 1 3/4
</TABLE>

The above quotations are interdealer prices, without retail mark-up
mark-down, or commission and may not necessarily represent actual transactions.
At January 31, 1997, there were approximately 1,273 holders of record of the
Company's common stock. The Company has never paid cash dividends on its common
stock and does not anticipate any being paid in the foreseeable future.

19
<PAGE> 20
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following table presents selected consolidated financial data of
the Company. The information set forth below is not necessarily indicative of
the results of future operations and should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" in Item 7 of this report and the consolidated financial statements
and the related notes thereto included elsewhere herein.

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------------------------------------------------------------
1996 1995 1994 1993 1992
------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF
OPERATIONS DATA:
Results of Operations:
Product sales $ 1,967,976 $ 1,104,224 $ 4,918,126 $ 5,410,530 $ 4,076,021
Revenue under distribution
agreement - 3,000,000 - - -
------------ ------------ ------------ ------------ ------------
1,967,976 4,104,224 4,918,126 5,410,530 4,076,021
Costs and expenses:
Production costs 1,482,563 2,041,422 2,571,168 1,582,986 1,166,025
Sales and marketing 794,356 819,907 3,550,037 4,758,427 3,952,481
Research and development 4,002,968 3,219,324 2,107,694 2,059,129 1,506,742
General and administrative 3,529,378 2,626,817 2,694,489 2,105,743 1,279,077
Acquired in-process research
and development (1) 5,146,943 625,000 - - -
Restructuring expense 493,712 644,656 - - -
Debt conversion expense 183,688 810,386 - - -
------------ ------------ ------------ ------------ ------------
15,633,608 10,787,512 10,923,388 10,506,285 7,904,325

Other income (expense):
Interest income 458,070 118,994 71,986 134,483 363,539
Interest expense (56,726) (261,958) (218,036) (7,659) (16,721)
------------ ------------ ------------ ------------ ------------
401,344 (142,964) (146,050) 126,824 346,818
------------ ------------ ------------ ------------ ------------

Loss from operations (13,264,288) (6,826,252) (6,151,312) (4,968,931) (3,481,486)
Minority interest in loss - - - 47,711 38,260
------------ ------------ ------------ ------------ ------------
Net loss $(13,264,288) $ (6,826,252) $ (6,151,312) $ (4,921,220) $ (3,443,226)
============ ============ ============ ============ ============

Net loss per share $ (0.45) $ (0.39) $ (0.40) $ (0.33) $ (0.25)
============ ============ ============ ============ ============

Weighted average number of
shares outstanding 29,206,470 17,598,735 15,243,860 14,716,472 14,030,224
============ ============ ============ ============ ============
</TABLE>

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------------------------------------------------------------
1996 1995 1994 1993 1992
----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and short-
term investments $10,935,668 $ 1,009,878 $ 3,670,616 $ 2,283,583 $ 1,286,679
Total assets $14,961,076 $ 4,563,709 $ 7,721,013 $ 7,761,598 $ 8,441,703
Long term debt (net of current portion) $ 412,020 $ 1,539,722 $ 4,247,759 $ - $ -
Total stockholder's equity $12,134,565 $ (524,762) $ 1,980,719 $ 4,839,725 $ 7,492,047
Working capital (deficit) $10,161,170 $ (688,771) $ 4,360,749 $ 3,787,412 $ 6,902,330
</TABLE>

(1) Reflects the acquisition of in-process research and development associated
with the acquisition by the Company of PRP in 1996 and the merger of the Company
in 1995 with one of its subsidiaries.

20
<PAGE> 21
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Except for the historical information contained herein, the following
discussion contains forward-looking statements within the meaning of Section 21E
of the Exchange Act that involve risks and uncertainties. The Company's actual
results could differ materially from those discussed below and elsewhere in this
Report. Factors that could cause or contribute to such differences include,
without limitation, those discussed in the section below as well as those
discussed in the sections entitled "Business" beginning on page 21 and "Risk
Factors" beginning on page 12.

LIQUIDITY AND CAPITAL RESOURCES

Cash, cash equivalents and short-term investments totaled $10.9
million, $1.0 million, and $3.7 million at December 31, 1996, 1995, and 1994,
respectively. Net working capital was $10.2 million, a deficit of $689,000, and
$4.4 million, respectively, at those same dates. The significant increase in
cash from 1995 to 1996 was due primarily to approximately $18.3 million in net
proceeds raised in the equity private placements completed in January 1996 and
October 1996, respectively. In connection with the private placement completed
in January 1996, the Company also converted $1.5 million of outstanding Senior
Convertible Debentures into common stock of the Company. The $5.1 million
decrease in working capital in 1995 is principally attributable to the $6.8
million net loss from operations for the year ended December 31, 1995 and
$685,000 of capital expenditures which were partially offset by $2.7 million of
expenses which did not impact working capital.

The Company expects to incur operating losses until it can obtain
marketing approval from the FDA for additional disease indications for the
PROSORBA(R) column, or obtain FDA approval for IPM(TM), or until sales for the
PROSORBA(R) column for its existing indication of idiopathic thrombocytopenic
purpura ("ITP") increase significantly. A clinical trial is currently being
conducted using the PROSORBA(R) column for rheumatoid arthritis therapy to
obtain the necessary clinical data to apply to the FDA to obtain marketing
approval. The Company anticipates that interim results of this trial will be
available in mid-1997. There can be no assurance that the Company will be able
to obtain FDA approval to market the PROSORBA(R) column for disease indications
other than ITP. In addition, there can be no assurance that the interim data
regarding the use of the PROSORBA(R) column for the therapy of rheumatoid
arthritis will be favorable.

Financing and Investing Activities

In December 1995 and January 1996, the Company completed an offering of
$1,500,000 of Senior Convertible Debentures to certain accredited investors. In
January 1996, the Company completed a private placement of approximately 8.5
million shares of its common stock resulting in net proceeds to the Company of
approximately $12.0 million (the "January Private Placement"). Upon the closing
of the January Private Placement, $1.5 million of outstanding Senior Convertible
Debentures were converted into an additional 1,000,000 shares of common stock of
the Company.

In October 1996, the Company completed a private placement of Units
(with each Unit consisting of two shares of common stock and one warrant)
collectively priced at $4.00 per Unit (the "October Private Placement"). Holders
of each five-year warrant (the "1996 Warrants") are entitled to purchase one
share of the Company's common stock at an exercise price of $2.00 per share. A
total of 1,734,000 units were sold resulting in net proceeds of approximately
$6.3 million.

During 1996, the Company implemented a restructuring plan which
included consolidating its manufacturing facilities to one location in the state
of Washington and moving all other operations of the Company to San Diego,
California. The Company has incurred approximately $1.3 million of capital
expenditures through December 31, 1996 to consolidate its two Washington
manufacturing facilities. The Company believes that the funds resulting from the
January and October Private Placements, coupled with the Company's reduction in
expenses as a result of the restructuring, will provide the resources necessary
to fund operations, including clinical trials, until 1998.

In September 1995, the Company completed an exchange offering to
holders of its 7% Convertible Debentures. The Company offered to exchange the 7%
Convertible Debentures for common stock at a price of $2.25 per share. Of the
original $4,245,000 outstanding principal amount of the 7% Convertible
Debentures, $2,200,000 was converted pursuant to the exchange offering. In the
fourth quarter of 1995 and the first quarter of 1996, an additional $700,000 and
$100,000, respectively, of outstanding principal amount of the 7% Convertible
Debentures was converted into common stock under their original $2.875 per share
conversion price. In March

21
<PAGE> 22

1996, the Company completed a second exchange offering made to holders of its
outstanding 7% Convertible Debentures. The Company offered to exchange the 7%
Convertible Debentures for common stock of the Company at a price of $2.25 per
share. Of the $1,245,000 outstanding principal amount, $845,000 was converted
into 399,252 shares of common stock of the Company (which amount includes 23,700
shares issued as interest on the 7% Convertible Debentures), pursuant to the
exchange offering. At December 31, 1996, there was outstanding principal of
$400,000 of the 7% Convertible Debentures.

The Company will require additional financing in order to fund the
completion of a pivotal clinical trial in rheumatoid arthritis, initiate pivotal
clinical trials using the PROSORBA(R) column in other diseases and to apply the
Company's technology to applications beyond the PROSORBA(R) column. The Company
is seeking corporate partners to fund additional clinical trials.

The principal changes in the components of working capital from 1994 to
1995 were a $2.7 million decrease in cash resulting from the excess of cash
expenditures for 1995 over the $1.0 million of proceeds received from debt
financing, a $390,000 decrease in trade accounts receivable resulting from the
lower amount of sales during the end of 1995 compared to 1994, a decrease of
$350,000 in inventory to reflect the lower sales demands of Baxter, and a
combined increase of $540,000 in accounts payable, accrued compensation and
accrued liabilities due primarily to increasing payment cycles to suppliers to
preserve the Company's cash position as of December 31, 1995.

RESULTS OF OPERATIONS

Revenues

Revenues associated with product shipments were $2.0 million, $1.1
million and $4.9 million in 1996, 1995, and 1994, respectively. The decrease of
$3.8 million in revenue in 1995 from 1994 was due primarily to Baxter selling
approximately 50% less product to customers than when the Company sold directly
to health care providers. In addition, a lower sales price was charged to Baxter
than the Company previously charged to its customers. A substantial amount of
the PROSORBA(R) columns shipped by the Company to Baxter remained in Baxter's
ending inventory as of December 31, 1995. Revenues associated with product
shipments began to increase in 1996 in conjunction with the Company regaining
distribution rights effective in May 1996 and initiating direct sales and
marketing efforts thereafter.

In April 1994, Baxter assumed sales and marketing responsibilities
under a 10-year exclusive distribution agreement, granting distribution rights
of the PROSORBA(R) column in the United States and Canada for the treatment of
thrombocytopenia. Baxter, at its own expense, was to provide sales and marketing
support for the sale of the product during the term of the agreement. The
Company was to provide significant marketing and promotional support to Baxter
for the first three years of the agreement.

In March 1995, the two companies amended the agreement whereby Baxter:
(a) made a take-or-pay payment on March 31, 1995 for the first sales year of
$3.0 million, (b) agreed to purchase $1.0 million of product during the second
quarter of 1995, (c) released the Company from its obligation to provide
marketing and promotional support for the second and third years of the
agreement, (d) gave the Company the right to co-market with Baxter, (e)
relinquished its first right to negotiate for new PROSORBA(R) column
indications, and (f) agreed under certain circumstances to provide advance
payments to the Company for Baxter's 1996 purchases. The Company agreed to
eliminate purchase minimums and the take-or-pay concept included in the original
agreement and freed Baxter to pursue competing thrombocytopenia therapies.

The impact of the revised Baxter agreement referred to above had a
variety of effects on the operations of the Company during the year ended
December 31, 1995. The Company's revenue included the $3.0 million take-or-pay
payment made by Baxter in March 1995 and sales and marketing costs relative to
sales decreased based upon Baxter agreeing to assume all marketing and
promotional costs.

22
<PAGE> 23

Operating Expenses

Consolidated operating expenses for the years ended December 31, 1996,
1995, and 1994 were $15.6 million, $10.8 million, and $10.9 million,
respectively. The increase of $4.8 million in 1996 from 1995 relates primarily
to the $5.1 million non-recurring, and primarily non-cash, charge incurred in
connection with the acquisition of PRP recorded in the fourth quarter, as well
as to costs associated with the Company's restructuring. These increases were
offset, in part, by a reduction in operating costs resulting from the Company's
restructuring. For the year ended December 31, 1996, consolidated operating
expenses include only the two months of PRP's operations subsequent to its
acquisition by the Company.

Production costs were $1.5 million, $2.0 million, and $2.6 million for
the years ended December 31, 1996, 1995, and 1994, respectively. During the
first half of 1996, production was impacted by both the termination of the
Baxter agreement and the consolidation of facilities undertaken in connection
with the restructuring. There were very few PROSORBA(R) columns shipped during
the first four months of 1996 as the Company did not resume direct shipments to
domestic customers until May 1996. In anticipation of a temporary cessation of
manufacturing during the remodeling and subsequent FDA re-approval process of
the Redmond, Washington facility, the Company increased production during the
second and third quarters to build its inventories. As a result, production
costs for the year reflect this unusual activity. The decrease in production
costs in 1996 from 1995 is also attributable to a reduction in manufacturing
labor and overhead costs associated with the restructuring. The total number of
PROSORBA(R) columns produced in 1996 was in excess of that amount produced in
1995. Since manufacturing overhead was fairly consistent in 1995 and 1994, the
fluctuation in production costs is directly attributable to the decrease in the
number of units produced in 1995.

Sales and marketing expenses decreased to $794,000 in 1996, from
$820,000 in 1995 and from $3.6 million in 1994. This significant decrease over
the last two years is a result of the Company's March 1995 renegotiation of its
distribution agreement with Baxter. During the first quarter of 1995, the
Company was still obligated to provide marketing and promotional support to
Baxter. In March 1995, the Company was released from that obligation and, thus,
incurred significantly less expense through the May 1996 re-initiation of
product sales directly to customers. As a result of that termination, however,
and the related establishment of an internal sales force to directly sell the
PROSORBA(R) column, the Company anticipates an increase of sales and marketing
expenses in future periods.

Research and development expenses increased to $4.0 million in 1996,
from $3.2 million and $2.1 million in 1995 and 1994, respectively. The 24%
increase in 1996 from 1995 is indicative of the Company's increased focus on the
clinical development of new products and relates primarily to the June 1996
launch of the Company's Phase III pivotal trial of the PROSORBA(R) column for
use in rheumatoid arthritis. In 1996, research and development expenses
increased by $784,000 over 1995. The increase of $1.1 million in 1995 from 1994
was primarily a result of the Company completing its rheumatoid arthritis
clinical trial for 15 patients and the commencement of a pilot clinical trial in
kidney transplantation during the last six months of 1995. During the last six
months of 1994, the Company began its rheumatoid arthritis clinical trial. In
January 1996, the Company suspended enrollment of patients in its kidney
transplantation study in light of other clinical opportunities.

General and administrative expenses were $3.5 million, $2.6 million,
and $2.7 million for the years ended December 31, 1996, 1995 and 1994,
respectively. The increase of $900,000 in 1996 from 1995 was principally a
result of costs associated with the hirings of the Company's new Chief Executive
Officer and President, Chief Operating Officer in December 1995. Such expenses
were partially offset by the resignation of the Company's Chief Scientific
Officer in March 1996. The new Chief Executive Officer has assumed the Chief
Scientific Officer's duties. In addition, approximately $444,000 was recorded as
compensation expense in 1996 for stock options granted at less than the closing
sales price on the date of grant. The decrease of $100,000 in 1995 from 1994 was
principally a result of a reduction in investor relations and legal expenses
which was partially offset by an increase in salary expenses. This increase
resulted from $400,000 of salary expenses associated with the severance
agreement for the Company's former Chief Executive Officer who resigned in
December 1995 and $100,000 of signing bonuses paid to the Company's new Chief
Executive Officer and its new President, Chief Operating Officer.

In 1995, the Company acquired CELx Corporation, a majority owned
subsidiary of the Company. In connection with the acquisition, the Company
recorded $625,000 as acquired in-process research and development. The charge
was based upon the fair market value of the Company's common stock.

The Company recorded a non-cash expense of approximately $184,000 for
debt conversion expense in the year ended December 31, 1996. Such expense
represents the fair market value of the increased number of shares issued by the
Company

23
<PAGE> 24

under the terms of an exchange offering to holders of the Company's 7%
Convertible Debentures. The Company recorded a non-cash expense of $810,000 in
1995 as a debt conversion expense for the conversion of the same 7% Convertible
Debentures discussed above. The expense represents the fair market value of the
increased number of shares issued under the terms of the exchange offering
compared to the original terms of the 7% Convertible Debentures.

In December 1995, the Company recorded a restructuring charge
aggregating $645,000 relating to the Company's plan to consolidate its
manufacturing facilities to one location in the state of Washington and to move
all other operations to San Diego, California. This charge included
approximately $350,000 related to write-downs of equipment and leasehold
improvements for the manufacturing facility vacated in 1996, $200,000 related to
abandonment of leases in Seattle and Princeton with the remainder related to a
severance commitment with its former Executive Vice President who resigned in
December 1995. In January 1996, the Company notified approximately twenty
employees, which was slightly greater than half of its work force, that their
positions were being terminated immediately as part of the restructuring. Such
positions were from all departments of the Company. In March 1996, the Company
entered into a termination agreement with its former Chief Scientific Officer.
Costs related to these terminations were approximately $494,000 and were
recorded as a restructuring expense in 1996. In addition, the Company incurred
approximately $300,000 in costs associated with moving the administration,
research and medical departments to San Diego, with most costs being
attributable to relocation costs of the few members of management moving to San
Diego. Such costs were recorded as general and administrative expenses in 1996.

Acquisition of PRP, Inc.

On November 1, 1996, the Company acquired PRP. As a result of the
acquisition, the Company assumed all of the assets and liabilities of PRP. The
transaction has been accounted for as a purchase and the Company recorded a
non-recurring expense of approximately $5.1 million as acquired in-process
research and development in the fourth quarter of 1996.

In connection with the acquisition, the Company issued to certain
holders of outstanding debt of PRP, in full satisfaction and settlement of such
indebtedness, Units with an approximated total value of $4.5 million (based upon
a price of $4.00 per Unit with each Unit being comprised of two shares of the
Company's common stock and one common stock purchase warrant).

The holders of PRP equity securities (including holders of options and
warrants of PRP) (the "Equity Holders") will also be entitled to receive
earn-out payments, if any, on a pro rata basis, on net sales of products
developed using PRP's technology acquired by the Company in the acquisition. In
addition, in conjunction with obtaining approval from the FDA of the use of
Infusible Platelet Membranes ("IPM(TM)") for the treatment of thrombocytopenia,
the Company shall make a payment of $5 million (the "Milestone Payment") to the
Equity Holders, with such payment being in the form of, at the Company's
discretion, cash, Company common stock, or a combination of the two.

In consideration of certain investment banking advisory services
provided by EGS Securities Corp. ("EGS") to PRP in connection with the
acquisition, the Company issued to EGS Units with a total value of approximately
$120,000. In addition, the Company is obligated to pay EGS an amount in cash
equal to two and one-half percent (2 1/2%) of a certain milestone payment and
each earn-out payment made to the Equity Holders, at the time any such payments
are made.

Subject to limited exceptions, the Company is obligated to spend $4.0
million to commercialize and advance IPM(TM) as a principal product of the
Company. The only circumstances under which the Company may decrease or cease
commercialization of IPM(TM) prior to expending $4.0 million would be if the
Company encounters critical problems with the commercialization of IPM(TM),
including problems related to IPM(TM) safety, efficacy or economic viability,
such as would render IPM(TM), on a stand-alone basis, unsafe, ineffective or
incapable of generating a reasonable, positive cash flow.

Net Loss

For the year ended December 31, 1996, the acquisition of PRP and the
decrease in total revenues was only partially offset by the decrease in
recurring operating expenses thereby resulting in an increased net loss of $13.3
million or $0.45 per share. For the years ended December 31, 1995 and 1994, the
Company reported net losses of $6.8 million and $6.2 million, respectively. The
increase in net loss from 1994 to 1995 was primarily a result of the decrease in
revenues.

24
<PAGE> 25

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Refer to the Index on Page F-1 of the Financial Report included herein.

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

None

25
<PAGE> 26
PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY

The directors and executive officers of the Company are as follows:

<TABLE>
<CAPTION>
Name Age Position
---- --- --------
<S> <C> <C>
Jay D. Kranzler, M.D., Ph.D. (1)(2) 39 Chief Executive Officer, Chief Scientific Officer and
Vice Chairman of the Board of Directors

Debby Jo Blank, M.D. (1)(2) 45 President, Chief Operating Officer and Director

Susan E. Feiner 28 Director of Finance, Controller, Treasurer and
Corporate Secretary

R. Michael Gendreau, M.D. 41 Vice President, Research & Development and
Chief Medical Officer

Richard M. Crooks, Jr. (3)(4)(5) 57 Chairman of the Board of Directors

Philip J. O'Reilly (3)(4)(5) 58 Director

Jack H. Vaughn (3)(5) 76 Director
</TABLE>

- ----------
(1)Member of the 401(k) Plan Committee
(2)Member of the Non-Executive Officer Stock Option Committee
(3)Member of Audit Committee
(4)Member of Stock Option Committee
(5)Member of Compensation Committee

JAY D. KRANZLER, M.D., Ph.D., 39, was appointed Chief Executive Officer
and Vice Chairman of the Company in December 1995. In April 1996, Dr. Kranzler
also assumed the position of Chief Scientific Officer of the Company. From
January 1989 until August 1995, Dr. Kranzler served as President, Chief
Executive Officer and a director of Cytel Corporation, a publicly-held
biotechnology company. Dr. Kranzler has been an adjunct member of the Research
Institute of Scripps Clinic since January 1989. Before joining Cytel, Dr.
Kranzler was employed by McKinsey & Company, a management consulting firm, from
1985 to January 1989 as a consultant specializing in the pharmaceutical
industry.

DEBBY JO BLANK, M.D., 45, was appointed President, Chief Operating
Officer and Director of the Company in December 1995. Prior to joining the
Company, from 1994 through the end of 1995, Dr. Blank was Senior Vice President,
Marketing, for Advanced Technology Laboratories, a publicly-held manufacturer
and distributor of ultrasound equipment. From 1993 to 1994, she was Vice
President, U.S. Marketing for Syntex. From 1989 to 1993, Dr. Blank held various
positions at the DuPont Company and the DuPont Merck Pharmaceutical Company
("DuPont"), including Vice President Worldwide Marketing, Vice President, New
Product Planning & Licensing, and Vice President, Strategy and Business
Development. Before joining DuPont, she was employed by the management
consulting firm, Arthur D. Little, from 1986 to 1989 as a consultant in its
pharmaceutical practice.

SUSAN E. FEINER, 28, was appointed Director of Finance, Controller,
Corporate Secretary and Corporate Treasurer of the Company in April 1996. Prior
to joining the Company, from March 1994 until March 1996, Ms. Feiner held
various positions, including Finance Manager and Financial Accounting Manager at
Pyxis Corporation, a publicly-held manufacturer and distributor of automated
medication distribution systems. From July 1990 until March 1994 she was
employed by Ernst & Young LLP, as a senior auditor.

R. MICHAEL GENDREAU, M.D., 41, was appointed Vice President of Research
and Development and Chief Medical Officer of the Company in December 1996. Dr.
Gendreau joined the Company in 1994 and held various positions from 1994 through
1996, including Executive Director of Scientific Affairs. From 1991 to 1994, Dr.
Gendreau was Vice President of

26
<PAGE> 27

Research and Development and Chief Medical Officer for MicroProbe Corporation, a
developer and manufacturer of DNA probe-based diagnostic equipment.

MR. RICHARD M. CROOKS, JR., 57, has been a director of the Company
since 1994. He has been President of RMC Consultants, a financial advisory
services firm, since June 1990. Mr. Crooks is a director of and consultant to
Allen & Company Incorporated, a privately held investment banking firm, which is
the Company's principal stockholder. He served as a Managing Director of Allen &
Company Incorporated for more than five years prior to June 1990. Mr. Crooks is
also a director of Excaliber Technologies Corporation.

MR. PHILIP J. O'REILLY, 58, has been a director of the Company since
1994. He is a partner in the law firm of O'Reilly, Marsh, Kearney & Corteselli
P.C., in Mineola, New York. He has been in private practice for more than twenty
years. Mr. O'Reilly also serves as a director of Excalibur Technologies
Corporation.

MR. JACK H. VAUGHN, 76, has served as a director of the Company since
1991. Currently, Mr. Vaughn is Chairman of ECOTRUST, a Portland, Oregon-based
foundation promoting environmentally friendly development in the Pacific
Northwest. From 1988 to 1992, he was the U.S. Government's Senior Environmental
Advisor for Central America. Prior to that, Mr. Vaughn had been the founding
Chairman of Conservation International, a private foundation encouraging
biological diversity. Mr. Vaughn was a director of Allegheny & Western Energy
Corporation from 1981 through 1995 and was a member of its Compensation
Committee.

SCIENTIFIC ADVISORY BOARDS

The Company has established four scientific advisory boards to provide
scientific and clinical support and guidance related to the Company's products.
The areas of focus of the scientific advisory boards are immunology,
rheumatology, hematology, and platelet therapy.

The Immunology Advisory Board (the "IAB") is currently composed of
Gerald T. Nepom, M.D., Ph.D., Scientific Director of the Virginia Mason Research
Center in Seattle, Washington; Eng Tan, M.D., Director, W.M. Keck Autoimmune
Disease Center, The Scripps Clinic and Research Institute, San Diego,
California; Eric Sasso, M.D., Ph.D., Assistant Professor, Department of
Medicine, Division of Hematology, University of Washington, Harborview Medical
Center; and Gregg Silverman, M.D., Associate Professor in Residence, Department
of Medicine, Division of Rheumatology, University of California, San Diego. The
focus of the IAB will be to provide guidance to the extramural research
investigating the PROSORBA(R) column's immunologic mechanism of action.

The Rheumatology Advisory Board (the "RAB") is composed of David
Felson, M.D., M.P.H. Professor of Medicine and Public Health, Director, Boston
University Arthritis Health Services Center; Richard Panush, M.D., Professor and
Chairman, Department of Medicine, St. Barnabas Medical Center, Livingston, New
Jersey; George Ehrlich, M.D., University of Pennsylvania Medical School, Member,
Expert Advisory Panel on Chronic Degenerative Disease, World Health
Organization. The RAB will oversee and guide the Company's programs in
rheumatoid arthritis. The RAB members are all serving as advisors to the FDA in
the Drug Division which reviews New Drug Applications for rheumatology
pharmaceutical product.

The Hematology Advisory Board (the "HAB") is composed of James B.
Bussel, M.D., Associate Professor of Pediatrics, Director of ITP Program,
Division of Pediatrics Hematology/Oncology, Cornell Medical Center; John Harlan,
M.D., Professor of Medicine, Division Head, Hematology, Massachusetts General
Hospital; and David J. Kuter, M.D., D.Phil., Chairman, Department of Hematology,
Massachusetts General Hospital. The HAB will oversee and guide the Company's
programs in ITP.

The Platelet Advisory Board (the "PAB") is composed of Richard H.
Aster, M.D., former President, Blood Center of Southeast Wisconsin; Ernest
Beutler, M.D., Chairman, Department of Molecular and Experimental Medicine, The
Scripps Clinic and Research Foundation, San Diego, California; Leon W. Hoyer,
M.D., Director, Holland Laboratories, Vice President, Research and Development,
American Red Cross; John Lawler, Ph.D., Associate Professor, Department of
Pathology, Harvard Medical School, Brigham and Women's Hospital; Ernest R.
Simon, M.D., Retired Executive Vice President, Medical Affairs, Blood Systems,
Inc.; Scott N. Swisher, M.D., Chairman, FDA Blood Products Advisory Committee;
Professor of Medicine (emeritus), University of Michigan; and Paul C. Zamecnik,
M.D., Professor of Medicine (emeritus) Harvard Medical School,

27
<PAGE> 28
Principal Scientist, Worcester Foundation for Biomedical Research. The PAB will
oversee the Company's programs as they relate to platelet therapy.

ITEM 11. EXECUTIVE COMPENSATION

COMPENSATION OF DIRECTORS

Each nonemployee director of the Company is entitled to receive $12,000
per year for such person's service as a director. Messrs. O'Reilly and Vaughn
each received $12,000 in cash compensation for service as a director during
fiscal year 1996. In addition, each nonemployee director is entitled to receive
an option to purchase 10,000 shares of common stock of the Company upon such
nonemployee director's initial election to the Board and an option to purchase
an additional 10,000 shares of common stock of the Company upon each annual
re-election of such nonemployee director to the Board. Each of Messrs. Crooks,
O'Reilly and Vaughn received an option to purchase 10,000 shares of common stock
for service as a director during fiscal year 1996. Directors who are employees
of the Company do not receive any fee for their service as directors. None of
the Company's directors receive any fees for their service on any committee of
the Board. All of the Company's directors are reimbursed for their out-of-pocket
travel and accommodation expenses incurred in connection with their service as
directors of the Company.

COMPENSATION OF EXECUTIVE OFFICERS

The following table sets forth information concerning compensation
awarded or paid to, or earned for the fiscal years ended December 31, 1996, 1995
and 1994 by the Chief Executive Officer of the Company during fiscal year 1996,
and those executive officers whose salary and bonus for fiscal year 1996
exceeded $100,000 (collectively, the "Named Executive Officers"):

SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
Long-Term
Annual Compensation Compensation (1)
------------------- ----------------
Shares All Other
Name and Principal Fiscal Base Underlying Compensation
Position Year Salary($) Bonus($) Options(#) ($)
- --------------------------- ------ ---------- ------------ --------------- --------------
<S> <C> <C> <C> <C> <C>
Jay D. Kranzler, M.D., Ph.D., 1996 $240,000 $135,000 3,025,327 $ 10,700(3)
Chief Executive Officer, 1995 - $ 50,000 - -
Chief Scientific Officer
and Vice Chairman(2)

Debby Jo Blank, M.D., 1996 $210,000 $135,000 1,134,497 $164,236(5)
President, Chief Operating 1995 - $ 50,000 - -
Officer and Director(4)

R. Michael Gendreau, M.D. 1996 $145,000 $ 25,000 125,000 $ 57,804(6)
Vice President, Research 1995 $145,000 - 141,000 7,537(7)
and Development and 1994 $ 37,750 - - -
Chief Medical Officer
</TABLE>

(1) The Company's 1996 Equity Incentive Plan (the "1996 Plan"), Incentive
Stock Option and Appreciation Plan and the 1988 Non-Qualified Stock
Option Plan (collectively, the "Plans") are intended to further the
interests of the Company by providing for the grant of stock awards to
directors, officers and employees of and consultants to the Company.

(2) Dr. Kranzler was appointed Chief Executive Officer of the Company on
December 28, 1995 and received approximately $20,000 as a consultant to
the Company during 1995.

(3) Includes $1,200 paid by the Company on behalf of Dr. Kranzler for life
insurance premiums during 1996, and $9,500 of contributions made by the
Company under its 401(k) Plan.

(4) Dr. Blank was appointed President and Chief Operating Officer on
December 28, 1995, and received approximately $20,000 as a consultant
to the Company during 1995.

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<PAGE> 29
(5) Includes $154,736 paid to Dr. Blank for relocation costs and related
tax gross-ups associated with Dr. Blank's relocation to San Diego,
California upon joining the Company. Also includes $9,500 of
contributions made by the Company under its 401(k) plan.

(6) Includes $52,583 paid to Dr. Gendreau for relocation costs associated
with Dr. Gendreau's relocation to San Diego, California. Also includes
$5,221 of contributions made by the Company under its 401(k) plan.

(7) Represents contributions made by the Company under its 401(k) plan.

STOCK OPTION GRANTS AND EXERCISES

The following table sets forth certain information regarding options
granted during the fiscal year ended December 31, 1996 to the Named Executive
Officers:

<TABLE>
<CAPTION>
Individual Grants
--------------------------------------------------
Potential Realizable Value
at Assumed Annual Rates of
Stock Appreciation for
Shares % of Total Option
Underlying Options Granted Term($)(2)
Options Granted to Employees in Exercise Price Expiration ------------------------
Name (#) Fiscal Year(%)(1) Per Share($) Date 5% 10%
- --------------------------- --------------- ----------------- -------------- ---------- -------- ---------
<S> <C> <C> <C> <C> <C> <C>
Jay D. Kranzler, M.D., Ph.D. 3,025,327(3) 46.07 $ 1.500 01/19/06 $4,702,568 $10,175,990

Debby Jo Blank, M.D. 1,134,497(3) 17.28 1.500 01/19/06 1,763,462 3,815,994

R. Michael Gendreau, M.D. 125,000(4) 1.90 2.019 04/29/06 231,263 517,713
</TABLE>

(1) Based upon options to purchase a total of 6,566,157 shares of common
stock of the Company granted during the fiscal year 1996.

(2) The potential realizable value is based upon the assumption that the
fair market value of the common stock appreciates at the annual rate
shown (compounded annually) from the date of grant until the end of the
option term. Actual realizable value, if any, on stock option exercises
is dependent on the future performance of the common stock and overall
market conditions, as well as the option holder's continued employment
through the vesting period.

(3) Such options vest 25% on the date of grant with the remainder vesting
ratably and daily over the four-year period following the date of
grant.

(4) Such options vest as follows: 20,000 on the date of grant, 25,000 on
August 31, 1996 and 80,000 vest ratably and daily over a four-year
period following the date of grant.

AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
AND FISCAL YEAR-END OPTION VALUES

The following table sets forth certain information as of December 31,
1996, regarding options held by the Named Executive Officers. None of such
individuals exercised any options during the fiscal year ended December 31,
1996. There were no stock appreciation rights outstanding at December 31, 1996.

<TABLE>
<CAPTION>
Number of Shares Value of Unexercised
Underlying Unexercised Options at In-The-Money Options
FY-End (#) as of FY-End ($) (1)
--------------------------------- ------------------------------
Name Exercisable Unexercisable Exercisable Unexercisable
- ---------------------------- ------------- --------------- ----------- -------------
<S> <C> <C> <C> <C>
Jay D. Kranzler, M.D., Ph.D. 1,295,238 1,730,089 $566,667 $756,914

Debby Jo Blank, M.D. 485,714 648,783 212,500 283,843

R. Michael Gendreau, M.D. 93,720 172,280 6,047 18,141
</TABLE>

(1) Calculation based upon $1.9375, the closing sales price of the
underlying shares of common stock as reported on the Nasdaq SmallCap
Market on December 31, 1996, less the exercise price.

29
<PAGE> 30
EMPLOYMENT AND CHANGE OF CONTROL AGREEMENTS

The Company entered into five year employment agreements commencing on
December 28, 1995 with Dr. Jay D. Kranzler, the Company's Chief Executive
Officer and Chief Scientific Officer and Dr. Debby Jo Blank, the Company's
President and Chief Operating Officer (collectively, the "Employment
Agreements"). Drs. Kranzler and Blank receive an annual base salary of $240,000,
and $210,000, respectively, and performance based bonuses of up to an additional
twenty-five percent (25%) of their respective annual base salaries. In addition,
the Employment Agreements provided for bonuses of $185,000, payable in
installments upon the occurrence of certain milestone events achieved by the
Company and Drs. Kranzler and Blank. As of the date hereof, the total amount of
these bonuses have been paid to Drs. Kranzler and Blank.

In addition to their base salary and bonus, Drs. Kranzler and Blank
were granted options to purchase approximately eight percent (8%) and three
percent (3%), respectively, of the Company's common stock on a fully diluted
basis at an exercise price equal to $1.50 per share. The options vest
twenty-five percent (25%) immediately upon grant and thereafter ratably and
daily over a four (4) year period. The options shall fully vest immediately upon
the consummation of any (i) merger or consolidation of the Company with or into
any other corporation or other entity or person, or any other corporate
reorganization, in which the stockholders of the Company immediately prior to
such consolidation, merger or reorganization, own less than 50% of the Company's
voting power immediately after such consolidation, merger or reorganization; (2)
transaction or series of related transactions in which in excess of 50% of the
Company's voting power is transferred; or (3) sale of all or substantially all
of the assets of the Company and (ii) with respect to each of Drs. Kranzler and
Blank, the termination without cause of their employment with the Company and
the death or disability of each of them.

In April 1996, the Company entered into an employment agreement with R.
Michael Gendreau, M.D., whereby Dr. Gendreau will receive an annual base salary
of $145,000. In addition, during 1996 Dr. Gendreau received $52,583 to offset
the costs of relocating from Seattle, Washington to San Diego, California. The
Company also granted Dr. Gendreau options to purchase up to 125,000 shares of
the Company's common stock at an exercise price of $2.019 per share. As of
January 31, 1997, options to purchase 61,657 shares of common stock have vested
with the remainder vesting ratably and daily such that all of such options shall
be fully vested on April 29, 2001. In the event that Dr. Gendreau's employment
with the Company is terminated by the Company without cause due to a corporate
merger or acquisition, Dr. Gendreau will receive severance pay equal to $72,500.

REPORT OF COMPENSATION COMMITTEE ON EXECUTIVE COMPENSATION

The Compensation Committee (the "Committee") is comprised of directors
who are not employees of the Company. The Committee is responsible for
establishing and administering the Company's executive compensation
arrangements.

The Company believes that a competitive, goal-oriented compensation
policy is critically important to the creation of value for stockholders. To
that end, the Company has created an incentive compensation program intended to
reward outstanding individual performance.

COMPENSATION PHILOSOPHY

The Company's compensation program is intended to implement the
following principles:

o Compensation should be related to the value created for
stockholders.

o Compensation programs should support the short-term and
long-term strategic goals and objectives of the Company.

o Compensation programs should reflect and promote the Company's
values and reward individuals for outstanding contributions to
the Company's success.

o Short-term and long-term compensation programs play a critical
role in attracting and retaining well-qualified executives.

o While compensation opportunities should be based in part upon
individual contribution, the actual amounts earned by
executives in variable compensation programs should also be
based upon how the Company performs.

30
<PAGE> 31

COMPENSATION MIX AND MEASUREMENT

The Company's executive compensation for the Chief Executive Officer and all
other executives is based upon three components, each of which is intended to
serve the Company's compensation principles:

Base Salary

Base salary is targeted at the competitive median for similar companies
in the biotechnology industry. For the purpose of establishing these levels, the
Committee compares the Company's compensation structure from time to time with
the companies covered in a compensation survey of the biotechnology industry
entitled, Biotechnology Compensation and Benefits Survey which is prepared by
Radford Associates and sponsored by the Biotechnology Industry Organization.
Many of the Companies covered in that survey are also included in the published
industry line-of-business index included in the Company's Stock Price
Performance Graph, included elsewhere in this document.

Based upon its reviews of industry data, the Compensation Committee
determined that the base salaries of the Chief Executive Officer and all other
executive officers were appropriate and necessary to attract individuals of such
high caliber within the biotechnology industry.

The Committee reviews the salaries of the Chief Executive Officer and
other executive officers each year and such salaries may be increased based upon
(i) the individual's performance and contribution to the Company and (ii)
increases in median competitive pay levels.

Annual Incentives

The Company has a cash bonus program whereby bonus amounts are
determined based upon the achievement of corporate goals and individual
performance. Any bonus is based, in part, upon Company performance and in part
on individual performance. The Committee believes bonus amounts are similar to
those paid by other companies in the biotechnology industry.

Based upon the Committee's review of the financial performance of the
Company, no annual incentive bonuses were awarded to any members of senior
management for 1996.

Long-Term Incentives

Long-term incentive compensation is provided through grants of options
to purchase shares of the Company's common stock to the Chief Executive Officer
and other executive officers. The stock options are intended to retain and
motivate all employees to improve long-term performance of the Company. It is
common in the biotechnology industry to grant stock options to all employees. As
of the beginning of 1997, stock options had been granted to all full-time
employees of the Company. The Committee believes the amount and value of such
grants are based upon levels similar to other companies in the biotechnology
industry.

Generally, stock options are granted with an exercise price equal to
prevailing market value. The stock options generally vest in increments over a
period of years and an employee must be employed by the Company at the time of
vesting in order to exercise his or her options.

Compensation of the Chief Executive Officer

The Company appointed Jay D. Kranzler, M.D., Ph.D. as its new Chief
Executive Officer on December 28, 1995. Accordingly, his compensation was
determined based upon prevailing compensation packages in the biotechnology
industry, since a compensation package consistent with the biotechnology
industry was believed necessary to attract an individual of Dr. Kranzler's
caliber. His annual compensation consists of base salary of $240,000 and cash
bonuses of up to twenty-five percent (25%) of his annual base salary. In
addition, under his employment agreement, Dr. Kranzler was granted options to
purchase 3,025,327 shares of the Company's common stock at an exercise price of
$1.50 per share. In 1996, he earned bonuses totaling $135,000 pursuant to the
terms of his employment agreement.

31
<PAGE> 32

Under the Omnibus Budget Reconciliation Act of 1993, beginning in 1994,
the federal income tax deduction for certain types of compensation paid to the
Chief Executive Officer and four other most highly compensated officers of
publicly held companies is limited to $1,000,000 per officer per fiscal year
unless such compensation meets certain requirements. The Committee is aware of
this limitation and believes that the deductibility of compensation payable in
1996 will not be affected by this limitation.

STOCK OPTION COMMITTEE COMPENSATION COMMITTEE
Richard M. Crooks, Jr. Richard M. Crooks, Jr.
Philip J. O'Reilly Philip J. O'Reilly
Jack H. Vaughn

NON-EXECUTIVE OFFICER STOCK OPTION COMMITTEE
Jay D. Kranzler, M.D., Ph.D.
Debby Jo Blank, M.D.

STOCK PRICE PERFORMANCE GRAPH

COMPARISON OF 5-YEAR CUMULATIVE RETURN

The following Stock Price Performance Graph compares the Company's
cumulative total stockholder return on the Company's common stock for the
periods indicated with the cumulative total return of the NASDAQ OTC Index and
the NASDAQ Pharmaceuticals Stock Index. The Company has not declared any
dividends since its inception. The Board and the Committee recognize that the
market price of the Company's common stock is influenced by many factors, only
one of which is Company performance. The historical stock price performance
shown on the Stock Price Performance Graph is not necessarily indicative of
future stock price performance.

<TABLE>
<CAPTION>
91 92 93 94 95 96
------ ------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C>
NASDAQ OTC 100 116.4 133.6 130.6 184.7 227.2
CYPRESS BIOSCIENCE, INC. 100 104.5 138.5 78.5 98.3 68.2
NASDAQ PHARMACEUTICAL INDEX 100 83.2 74.2 55.8 102.1 102.4
</TABLE>

The above comparison assumes $100 was invested in the Company's common
stock and each index on December 31, 1991.

32
<PAGE> 33
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth information as of January 31, 1997 with
respect to (i) each stockholder known to the Company to be the beneficial owner
of more than five percent (5%) of the outstanding common stock of the Company,
(ii) each director, (iii) each executive officer listed in the table entitled
"Summary Compensation Table" under the heading "Compensation Executive Officers"
above employed by the Company in that capacity on January 31, 1997 and (iv) all
directors and Named Executive Officers of the Company as a group. Except as set
forth below, each of the named persons and members of the group has sole voting
and investment power with respect to the shares shown.

<TABLE>
<CAPTION>
Amount and Nature of
Beneficial Owner (1) Beneficial Ownership (2) Percent of Class (2)
- -------------------- ------------------------ --------------------
<S> <C> <C>
Allen & Company Incorporated............................ 6,457,391(3) 18.1%
711 Fifth Avenue
New York, New York 10022
Paramount Capital Asset Management, Inc................. 2,769,134(4) 8.0%
787 Seventh Avenue, 44th Floor
New York, NY 10019
Jay D. Kranzler......................................... 1,578,038(5) 4.4%
Debby Jo Blank.......................................... 680,185(6) 1.9%
R. Michael Gendreau..................................... 133,953(7) *
Richard M. Crooks, Jr................................... 1,111,897(8) 3.2%
Jack H. Vaughn.......................................... 66,000(9) *
Philip J. O'Reilly...................................... 74,625(10) *
All Directors and Named Executive Officers as a
Group (6 persons)..................................... 3,503,224(11) 9.5%
</TABLE>

- ----------
*Less than one percent

(1) This table is based upon information supplied by officers, directors
and principal stockholders and Schedule 13Ds filed with the Securities
and Exchange Commission (the "Commission"). Except as shown otherwise
in the table, the address of each stockholder listed is in care of the
Company at 4350 Executive Drive, Suite 325, San Diego, California
92121.

(2) Except as otherwise indicated in the footnotes of this table and
pursuant to applicable community property laws, the persons named in
the table have sole voting and investment power with respect to all
shares of common stock. Beneficial ownership is determined in
accordance with the rules of the Commission and generally includes
voting or investment power with respect to securities. Shares of common
stock subject to options or warrants exercisable within 60 days of
January 31, 1997 are deemed outstanding for computing the percentage of
the person or entity holding such options or warrants but are not
deemed outstanding for computing the percentage of any other person.
Percentage of beneficial ownership is based upon 34,573,111 shares of
the Company's common stock outstanding as of January 31, 1997.

(3) This information was derived from information provided to the Company
by Allen & Company Incorporated. Includes warrants to purchase
1,021,700 shares of common stock. Excludes 2,620,621 shares of common
stock, and warrants and options to purchase 192,267 shares of common
stock, owned by Allen & Company Incorporated. Allen & Company
Incorporated disclaims beneficial ownership of these shares of common
stock.

(4) Dr. Lindsay A. Rosenwald is the sole shareholder of Paramount Capital
Asset Management, Inc. ("Paramount Capital"). Paramount Capital is the
general partner of Aries Domestic Fund, L.P., a limited partnership
incorporated in Delaware ("Aries Domestic") and the investment manager
of The Aries Trust, a Cayman Islands trust ("Aries Trust"). Of the
2,769,134 shares of common stock indicated as beneficially held,
Paramount Capital shares voting and dispositive power with the
following persons or entities: Dr. Rosenwald with respect to 2,769,134
of the shares; Aries Domestic with respect to 819,967 of the shares;
and Aries Trust with respect to 1,949,167 of the shares. This
information was derived from a Schedule 13D filed by Paramount Capital
with the Commission on December 10, 1996.

(5) Includes 1,436,564 shares of common stock issuable pursuant to options
exercisable within 60 days of January 31, 1997. Also includes 141,474
shares of common stock held by the Company's 401(k) plan for which Dr.
Kranzler, as co-trustee of the 401(k) plan, has voting rights to such
shares.

(6) Includes 538,711 shares of common stock issuable pursuant to options
exercisable within 60 days of January 31, 1997. Also includes 141,474
shares of common stock held by the Company's 401(k) plan for which Dr.
Blank, as co-trustee of the 401(k) plan, has voting rights to such
shares.

(7) Includes 133,953 shares of common stock issuable pursuant to options
exercisable within 60 days of January 31, 1997.

33
<PAGE> 34

(8) Includes 40,000 shares of common stock issuable pursuant to options
exercisable within 60 days of January 31, 1997. Also includes 692,829
shares of common stock and presently exercisable warrants to purchase
6,667 shares of common stock held by Allen & Company Incorporated, in
which Mr. Crooks has a pecuniary interest pursuant to an arrangement
with Allen & Company Incorporated. This information was derived from
information provided to the Company by Allen & Company Incorporated.

(9) Includes 65,000 shares of common stock issuable pursuant to options
exercisable within 60 days of January 31, 1997.

(10) Includes 58,825 shares of common stock issuable pursuant to options or
other rights exercisable within 60 days of January 31, 1997.

(11) Includes 2,279,720 shares of common stock issuable pursuant to options
and warrants exercisable within 60 days of January 31, 1997. Also
includes 141,474 shares of common stock held by the Company's 401(K)
plan for which certain individuals in the group exercise voting power.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

In October 1996, the Company completed a private placement (the
"October Private Placement") of 1,734,000 Units (with each Unit being comprised
of two shares of common stock of the Company and a warrant to purchase one share
of common stock of the Company at an exercise price of $2.00) at a sales price
of $4.00 per Unit. Net proceeds to the Company from the October Private
Placement were approximately $6,429,000. Allen & Company Incorporated served as
a non-exclusive placement agent in connection with the October Private Placement
and received $116,000 as a placement agent fee.

In May 1996, the Company entered into a resignation agreement (the
"Resignation Agreement") with Alex P. de Soto, the Company's former Vice
President, Chief Financial Officer, Secretary and Treasurer, whereby Mr. de Soto
resigned as an officer of the Company effective May 6, 1996, but remained an
employee of the Company through June 30, 1996. Pursuant to the terms of the
Resignation Agreement, the Company paid to Mr. de Soto an aggregate of $77,364
during 1996 and issued to Mr. de Soto 11,765 registered shares of common stock
of the Company. In addition, the Company retained Mr. de Soto as a consultant
for a period of ten months commencing on July 1, 1996 at a total cost of
$70,000.

The Company entered into letter agreements with Mr. de Soto, whereby
the Company has agreed to pay for certain expenses (including attorney's fees)
incurred by him related to inquiries being conducted by the State of
Washington's Board of Accountancy and the SEC in advance of any final
disposition of such inquiries. In the event it is ultimately determined that Mr.
de Soto is not entitled to indemnification under the terms of the Company's
Bylaws or other applicable laws or regulations, Mr. de Soto is obligated to
repay all amounts advanced by the Company on his behalf.

In March 1996, the Company entered into a letter of resignation (the
"Letter of Resignation") with Dr. Frank Jones relating to the terms and
conditions of Dr. Jones' resignation as Chief Scientific Officer and a director
of the Company. Pursuant to the Letter of Resignation, the Company paid Dr.
Jones a severance payment in the aggregate amount of $251,500 (which amount is
net of amounts paid by Dr. Jones to purchase certain personal property from the
Company). Under the terms of the Letter of Resignation, certain options and
warrants to purchase common stock of the Company held by Dr. Jones were canceled
and options to purchase 705,000 shares of the Company's common stock at an
exercise price of $2.25 per share were issued to Dr. Jones in their place.

Allen & Company Incorporated acted as a non-exclusive placement agent
in connection with the January Private Placement and received 20,000 shares of
common stock of the Company as a placement agent fee. As of January 31, 1997,
Allen & Company Incorporated beneficially held approximately 18.1% of the
Company's common stock.

Mr. Richard Crooks, Jr., a director of the Company, is a director of
and consultant to, Allen & Company Incorporated, as a principal stockholder of
the Company. As of January 31 ,1997, Mr. Crooks beneficially held approximately
3.2% of the Company's common stock.

Allen & Company Incorporated is compensated for investment banking
services rendered to the Company under a one year consulting agreement
specifying monthly payments of $5,000. In 1996, the Company paid Allen & Company
Incorporated a total of $20,000 under this agreement.

Under Section 145 of the Delaware General Corporation Law (the "DGCL"),
the Company has broad powers to indemnify its directors and officers against
liabilities they may incur in such capacities, including liabilities under the
Securities Act of 1933, as amended (the "Securities Act").

In addition, the Company's Certificate of Incorporation and By-laws
include provisions to (i) eliminate the personal liability of its directors for
monetary damages resulting from breaches of their fiduciary duty to the extent
permitted by Section

34
<PAGE> 35

102(b)(7) of the DGCL and (ii) require the Company to indemnify its directors
and officers to the fullest extent permitted by applicable law, including
circumstances in which indemnification is otherwise discretionary. Pursuant to
Section 145 of the DGCL, a corporation generally has the power to indemnify its
present and former directors, officers, employees and agents against expenses
incurred by them in connection with any suit to which they are or are threatened
to be made, a party by reason of their serving in such positions so long as they
acted in good faith and in a manner they reasonably believed to be in or not
opposed to, the best interests of the corporation and with respect to any
criminal action, they had no reasonable cause to believe their conduct was
unlawful. The Company believes that these provisions are necessary to attract
and retain qualified persons as directors and officers. These provisions do not
eliminate the directors' or officers' duty of care, and, in appropriate
circumstances, equitable remedies such as injunctive or other forms of
non-monetary relief will remain available under the DGCL. In addition, each
director will continue to be subject to liability pursuant to Section 174 of the
DGCL, for breach of the director's duty of loyalty to the Company, for acts or
omissions not in good faith or involving intentional misconduct, for knowing
violations of law, for acts or omissions that the director believes to be
contrary to the best interests of the Company or its stockholders, for any
transaction from which the director derived an improper personal benefit, for
acts or omissions involving a reckless disregard for the director's duty to the
Company or its stockholders when the director was aware or should have been
aware of a risk of serious injury to the Company or its stockholders, for acts
or omission that constitute an unexcused pattern of inattention that amounts to
an abdication of the director's duty to the Company or its stockholders, for
improper transactions between the director and the Company and for improper
loans to directors and officers. The provision also does not affect a director's
responsibilities under any other law, such as the federal securities law or
state or federal environmental laws.

35
<PAGE> 36
PART IV

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

(A) (1) FINANCIAL STATEMENTS

The financial statements of the Company are included herein as
required under Item 8 of this Annual Report on Form 10-K. See Index
on page F-1.

(2) FINANCIAL STATEMENT SCHEDULES

Financial statement schedules have been omitted since they are
either not required, not applicable, or the information is
otherwise included.

(3) EXHIBITS

<TABLE>
<CAPTION>
Exhibit No. Description Incorporated by Reference to
----------- ------------------------------------------------- ----------------------------------------------
<S> <C> <C>
3.1 Amended and Restated Certificate of Incorporation Exhibit 3.1 to Form 10-Q for the quarter ended
March 30, 1996

3.2 By-Laws, as amended Exhibit 3.2 to 1995 Form 10-K

4.1 Form of Stock Certificate Exhibit 4.1 to Form S-1 Registration Statement
No. 33-41225

4.2 Warrant Certificate Exhibit 4.2 to Form 8-K filed November 1, 1996

10.1 Form of Common Stock Purchase Warrant Exhibit 3.1 to Form S-1 Registration Statement
No. 33-41225

10.2 Form of Employee Stock Warrant Exhibit 10.13 to Form S-1 Registration Statement
No. 33-41225

10.3 Agreement and Plan of Merger and Reorganization Exhibit 2.1 to Form 10-Q for quarter ended
dated October 10, 1996, by and among Registrant, September 30, 1996
Cypress Acquisition Sub, Inc. and PRP, Inc.

10.4 Warrant Agreement dated September 18, 1996, Exhibit 4.1 to Form 10-Q for the quarter ended
between Registrant and American Stock Transfer & September 30, 1996
Trust Company

10.5 Exchange of Bridge Debt and Warrant Termination Exhibit 4.2 to Form 10-Q for quarter ended
Agreement between Registrant and certain holders September 30, 1996
of indebtedness of PRP, Inc.

10.6 Incentive Stock Option Exhibit 28.2 to Form S-8 Registration Statement
No. 33-20188

10.7 Form of Nonqualified Stock Option Exhibit 4.5 to Form 10-K for the year ended
December 31, 1993
</TABLE>

36
<PAGE> 37
<TABLE>
<S> <C> <C>
10.8 Form of 7% Convertible Debentures Exhibit 10.1 to Form 10-Q for the quarter ended
March 31, 1994

10.9 Warrant Agreement dated as of April 22, 1994 Exhibit 10.3 to Form 10-Q for March 31, 1994
between IMRE Corporation and Allen & Company
Incorporated

10.10 Form 7% Convertible Debenture Purchase Agreement Exhibit 10.4 to Form 10-Q for the quarter ended
March 31, 1994

10.11 Form of Senior Convertible Debenture Exhibit 4.10 to 1995 Form 10-K

10.12 Form of Senior Convertible Debenture Purchase Exhibit 4.11 to 1995 Form 10-K
Agreement

10.13 Form of Stock Purchase Agreement for January 1996 Exhibit 4.12 to 1995 Form 10-K
Private Placement

10.14 Form of Warrant to Purchase Common Stock Exhibit 99.1 to Form S-8 Registration Statement
No. 333-19465

10.15 1996 Equity Incentive Plan (the "1996 Plan") Exhibit 99.1 to Form S-8 Registration Statement
No. 333-06771

10.16 Sub-Lease Agreement dated April 15, 1996, between Exhibit 3.1 to Form 10-Q for the quarter ended
the Company and Bristol-Myers Squibb Company March 30, 1996

10.17 Common Stock Purchase Warrant dated June 10, 1991 Exhibit 99.1 to Form S-8 Registration Statement
No. 333-06765

10.18 Warrant Agreement dated as of August 29, 1991 Exhibit 99.1 to Form S-3 Post Effective Amendment
between IMRE Corporation and Manufacturers to Registration Statement No. 33-71278
Hanover Trust Company of California (now known
as Chemical Trust Company of California)

10.19 Successor Warrant Agent Agreement date July 23, Exhibit 99.2 to Form S-3 Post Effective Amendment
1996 between the Registrant and American Stock to Registration Statement No. 33-71278
Transfer & Trust Company

10.20 Form of Incentive Stock Option Agreement under Exhibit 3.1 to Form 10-Q for the quarter ended
the 1996 Plan March 30, 1996

10.21 1996 Equity Incentive Plan Form of Non-Statutory Exhibit 3.1 to Form 10-Q for the quarter ended
Stock Option Agreement March 30, 1996

10.22 Incentive Stock Option and Appreciation Plan, as Exhibit 99.4 to Form S-8 Registration Statement
amended June 29, 1992 No. 333-06771

10.23 Form of Incentive Stock Option Agreement under Exhibit 99.5 to Form S-8 Registration Statement
the ISO Plan No. 333-06771

10.24 Amended and Restated 1988 Nonqualified Stock Exhibit 99.6 to Form S-8 Registration Statement
Option Plan No. 333-06771
</TABLE>

37
<PAGE> 38
<TABLE>
<S> <C> <C>
10.25 Form of Nonqualified Stock Option Agreement under Exhibit 99.7 to Form S-8 Registration Statement
the 1988 Plan No. 333-06771

10.26 Form of Stock Option Agreement for issuances of Exhibit 99.8 to Form S-8 Registration Statement
all non-plan options No. 333-06771

10.27 Form of Nonstatutory Stock Option Exhibit 99.3 to Form S-8 Registration Statement
Agreement under the 1996 Plan No. 333-06771

10.28 Stock Option and Stock Appreciation Plan Exhibit 28.1 to Form S-8 Registration Statement
No. 333-06771

10.29 Warrant Agreement dated September 19, 1996 Exhibit 10.1 to Form S-3 Registration Statement
between the Registrant and American Stock No. 333-15483
Transfer & Trust company

10.30 1988 Nonqualified Stock Option Plan Exhibit 28.3 to Form S-8 Registration Statement
No. 333-06771

10.31 Sub-lease Agreement dated October 11, 1991 Exhibit 10.3 to 1993 Form 10-K

10.32 Lease Agreement dated April 26, 1994 Exhibit 10.4 to 1994 Form 10-K

10.33 Warrant Agreement dated as of August 29, 1991 Exhibit 99.1 to Form S-3 Registration Statement
between IMRE Corporation and Manufacturers No. 33-71278
Hanover Trust Company of California (now known as
Chemical Trust Company of California)

10.34 Form of Exchange of Bridge Debt and Warrant Exhibit 10.1 to Form S-3 Registration Statement
Termination Agreement No. 333-15483

10.35 Severance Agreement with Martin D. Cleary Exhibit 10.6 to 1995 Form 10-K

10.36 Modified Fee Agreement dated October 10, 1996 by Exhibit 10.1 to Form S-3 Registration Statement
and among Registrant, PRP, Inc. and EGS No. 333-15483
Securities Corp.

10.37 Employment Agreement with Jay D. Kranzler Exhibit 10.8 to 1995 Form 10-K

10.38 Employment Agreement with Debby Jo Blank Exhibit 10.9 to 1995 Form 10-K

10.39 Employment Arrangement with Frank R. Jones Exhibit 10.10 to 1995 Form 10-K

10.40 Employment Agreement with Alex P. de Soto Exhibit 10.11 to 1995 Form 10-K

11.1 Statement regarding computation of per share loss Item 8 of 1995 Form 10-K

23.1 Consent of Ernst & Young, LLP, Independent
Auditors

24.1 Powers of Attorney See page 40

27.1 Financial Data Schedule
</TABLE>

38
<PAGE> 39

(B) REPORTS ON FORM 8-K

On November 18, 1996, the Company filed a Current Report on Form 8-K which
disclosed certain information under Item 2.

On January 17, 1997, the Company filed a Current Report on Form 8-K/A
which disclosed certain information under Item 7.

The Company hereby files as part of this Form 10-K the exhibits listed
in Item 14(a)(3) set forth above.

39
<PAGE> 40
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on March 10, 1997.

Cypress Bioscience, Inc.

By: /s/ Jay D. Kranzler
------------------------------
Jay D. Kranzler, M.D., Ph. D.
Chief Executive Officer, and
Chief Scientific Officer

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Jay D. Kranzler, M.D., Ph.D. and Susan E.
Feiner, and each of them, as his true and lawful attorneys-in-fact and agents,
with full power of substitution and resubstitution, for him and in his name,
place and stead, in any and all capacities, to sign any and all amendments to
this Annual Report on Form 10-K, and to file the same, with all exhibits
thereto, and other documents in connection therewith, with the Securities and
Exchange Commission, granting unto said attorneys-in-fact and agents, and each
of them, full power and authority to do and perform each and every act and thing
requisite and necessary to be done in connection therewith, as fully to all
intents and purposes as he might or could do in person, hereby ratifying and
confirming that all said attorney-in-fact and agents, or any of them or their or
his substitute or resubstitute, may lawfully do or cause to be done by virtue
hereof.

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

<TABLE>
<CAPTION>
Signature Title Date
- --------- ----- ----
<S> <C> <C>
/s/ Jay D. Kranzler Chief Executive Officer, Chief Scientific March 10, 1997
- ---------------------------- Officer, and Vice Chairman of the Board
Jay D. Kranzler, M.D., Ph.D. (Principal Executive Officer)

/s/ Debby Jo Blank President, Chief Operating Officer and March 10, 1997
- ---------------------------- Director
Debby Jo Blank, M.D.

Director of Finance, Controller, Corporate March 10, 1997
/s/ Susan E. Feiner Secretary, and Treasurer (Principal
- ----------------------------- Financial and Accounting Officer)
Susan E. Feiner

/s/ Richard M. Crooks, Jr. Chairman of the Board of Directors March 10, 1997
- -----------------------------
Richard M. Crooks, Jr.

/s/ Philip J. O'Reilly Director March 10, 1997
- -----------------------------
Philip J. O'Reilly

/s/ Jack H. Vaughn Director March 10, 1997
- -----------------------------
Jack H. Vaughn
</TABLE>

40
<PAGE> 41
CYPRESS BIOSCIENCE, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<S> <C>
Report of Ernst & Young LLP, Independent Auditors . . . . . . . . . . . F-2

Consolidated Balance Sheets . . . . . . . . . . . . . . . . . . . . . . F-3

Consolidated Statements of Operations . . . . . . . . . . . . . . . . . F-4

Consolidated Statements of Stockholders' Equity . . . . . . . . . . . . F-5

Consolidated Statements of Cash Flows . . . . . . . . . . . . . . . . . F-6

Notes to Consolidated Financial Statements . . . . . . . . . . . . . . F-7
</TABLE>

F-1
<PAGE> 42

Report of Ernst & Young LLP, Independent Auditors

The Board of Directors and Stockholders
CYPRESS BIOSCIENCE, INC.

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

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

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

/s/ Ernst & Young LLP

San Diego, California
January 17, 1997

F-2
<PAGE> 43

CYPRESS BIOSCIENCE, INC.
CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
DECEMBER 31,
1996 1995
----------- ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 8,045,508 $ 1,009,878
Short-term investments 2,890,160 -
Accounts receivable:
Trade, net of allowance for doubtful
accounts of $181,377 in
1996 and $200,312 in 1995 344,041 23,850
Other 150,954 533,989
Inventories 973,767 1,148,506
Prepaid expenses 171,231 143,755
----------- ------------
Total current assets 12,575,661 2,859,978

Property and equipment, net 2,351,928 1,425,020
Convertible debenture issuance costs, net 33,487 278,711
=========== ============
Total assets $14,961,076 $ 4,563,709
=========== ============

LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities:
Accounts payable $ 999,442 $ 892,501
Accrued compensation 485,751 456,939
Accrued liabilities 902,090 672,488
Senior convertible debentures - 1,500,000
Current portion of notes payable 27,208 26,821
----------- ------------
Total current liabilities 2,414,491 3,548,749

Convertible debentures 400,000 1,345,000
Notes payable, net of current portion 12,020 25,972
Accrued compensation - 168,750

Commitments and contingencies

Stockholders' equity:
Common stock, $.02 par value; authorized 60,000,000
shares; issued and outstanding, 34,573,111 and
18,693,595 shares at December 31, 1996
and 1995, respectively 691,462 373,872
Additional paid-in capital 70,062,301 43,143,000
Deferred compensation (1,313,276) -
Accumulated deficit (57,305,922) (44,041,634)
----------- ------------
Total stockholders' equity 12,134,565 (524,762)
=========== ============
Total liabilities and stockholders' equity $14,961,076 $ 4,563,709
=========== ============
</TABLE>

See accompanying notes.

F-3
<PAGE> 44

CYPRESS BIOSCIENCE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1996 1995 1994
------------ ----------- -----------
<S> <C> <C> <C>
Product sales $ 1,967,976 $ 1,104,224 $ 4,918,126
Revenue under distribution agreement - 3,000,000 -
------------ ----------- -----------
1,967,976 4,104,224 4,918,126

Costs and expenses:
Production costs 1,482,563 2,041,422 2,571,168
Sales and marketing 794,356 819,907 3,550,037
Research and development 4,002,968 3,219,324 2,107,694
General and administrative 3,529,378 2,626,817 2,694,489
Acquired in-process research and
development 5,146,943 625,000 -
Restructuring expense 493,712 644,656 -
Debt conversion expense 183,688 810,386 -
------------ ----------- -----------
15,633,608 10,787,512 10,923,388

Other income (expense):
Interest income 458,070 118,994 71,986
Interest expense (56,726) (261,958) (218,036)
------------ ----------- -----------
401,344 (142,964) (146,050)
------------ ----------- -----------

Net loss $(13,264,288) $(6,826,252) $(6,151,312)
============ =========== ===========

Net loss per share $ (0.45) $ (0.39) $ (0.40)
============ =========== ===========
Shares used in computing net loss
per share 29,206,470 17,598,735 15,243,860
============ =========== ===========
</TABLE>

See accompanying notes.

F-4
<PAGE> 45

CYPRESS BIOSCIENCE, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994

<TABLE>
<CAPTION>
Common Stock Additional
--------------------------- Paid-in Deferred Accumulated
Shares Par Value Capital Compensation Deficit Total
------------ ------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Balance December 31, 1993 15,072,472 $ 301,449 $ 35,602,346 $ -- $(31,064,070) $ 4,839,725

Stock options exercised 1,000 20 2,605 -- -- 2,625
Stock warrants exercised 6,500 130 12,058 -- -- 12,188
Stock warrants issued for services -- -- 483,000 483,000
Stock issued to match 401(k)
contributions 70,040 1,401 159,677 -- -- 161,078
Stock issued in private
placement 1,850,000 37,000 2,596,415 -- -- 2,633,415
Net loss -- -- -- -- (6,151,312) (6,151,312)
------------ ------------ ------------ ------------ ------------ ------------

Balance December 31, 1994 17,000,012 340,000 38,856,101 -- (37,215,382) 1,980,719

Stock issued for services 61,141 1,223 86,322 -- -- 87,545
Stock issued to match 401(k)
contributions 65,125 1,303 160,036 -- -- 161,339
Stock issued for minority
interest in CELx 312,500 6,250 618,750 -- -- 625,000
Stock issued for debt
conversion 1,254,817 25,096 3,421,791 -- -- 3,446,887
Net loss -- -- -- -- (6,826,252) (6,826,252)
------------ ------------ ------------ ------------ ------------ ------------

Balance December 31, 1995 18,693,595 373,872 43,143,000 -- (44,041,634) (524,762)

Stock options exercised 47,500 950 84,050 -- -- 85,000
Stock issued for services 31,765 635 54,365 -- -- 55,000
Stock issued for debenture
interest 12,005 240 28,963 -- -- 29,203
Stock issued for debt
conversion 1,435,955 28,719 2,402,713 -- -- 2,431,432
Stock issued to match 401(k)
contributions 50,791 1,016 100,910 -- -- 101,926
Stock issued in January 1996
private placement 8,540,702 170,814 11,736,057 -- -- 11,906,871
Stock issued in October 1996
private placement 3,468,000 69,360 6,215,554 -- -- 6,284,914
Stock issued in conjunction with the
acquisition of PRP, Inc. 2,292,798 45,856 4,539,740 -- -- 4,585,596
Deferred compensation -- -- 1,756,949 (1,756,949) -- --
Amortization of deferred
compensation -- -- -- 443,673 -- 443,673
Net loss -- -- -- -- (13,264,288) (13,264,288)
------------ ------------ ------------ ------------ ------------ ------------
Balance December 31, 1996 34,573,111 $ 691,462 $ 70,062,301 $ (1,313,276) $(57,305,922) $ 12,134,565
============ ============ ============ ============ ============ ============
</TABLE>

See accompanying notes.

F-5

<PAGE> 46

CYPRESS BIOSCIENCE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1996 1995 1994
-------------- -------------- --------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net loss $ (13,264,288) $ (6,826,252) $ (6,151,312)
Adjustments to reconcile net loss to net cash used
by operating activities:
Depreciation and amortization 182,845 373,306 325,549
Acquired in-process research and development 5,146,943 625,000 --
Amortization of deferred compensation 443,673 -- --
Common stock issued for services and expenses 186,129 248,884 161,078
Debt conversion expense 183,688 810,386 --
Restructuring expense -- 644,656 --
(Gain) loss on disposal of property and equipment (11,110) 23,437 --
Minority interest -- -- (3,436)
Changes in operating assets and
liabilities, net of effects
from acquisition of PRP, Inc.
Accounts receivable, net (320,191) 394,549 2,228,102
Other receivables (111,020) 30,034 (14,634)
Inventories 174,739 345,806 (159,292)
Prepaid expenses 39,655 64,805 174,232
Accounts payable and accrued expenses (94,678) 345,259 (1,410,290)
-------------- -------------- --------------
Net cash used by operating activities (7,443,615) (2,920,130) (4,850,003)

INVESTING ACTIVITIES
Purchase of equipment (997,602) (714,947) (549,486)
Proceeds from sale of property and equipment 36,735 30,393 --
Purchase of short-term investments (2,890,160) -- --
Acquisition of PRP, Inc., net of $83,399 cash acquired (361,029) -- --
-------------- -------------- --------------
Net cash used by investing activities (4,212,056) (684,554) (549,486)

FINANCING ACTIVITIES
Net proceeds from issuance of common stock 18,276,785 -- 2,648,228
Proceeds from issuance of convertible debentures 500,000 1,000,000 4,245,000
Payment of capital lease obligation and notes payable (13,565) (22,140) --
Notes payable, net -- (11,812) (12,853)
Debt issuance costs (71,919) (22,102) (93,853)
-------------- -------------- --------------
Net cash provided by financing activities 18,691,301 943,946 6,786,522

INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 7,035,630 (2,660,738) 1,387,033
Cash and cash equivalents at beginning of the year 1,009,878 3,670,616 2,283,583
============== ============== ==============
Cash and cash equivalents at end of the year $ 8,045,508 $ 1,009,878 $ 3,670,616
============== ============== ==============

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid $ 14,681 $ 322,968 $ 11,824
============== ============== ==============
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES
Stock issued for debt conversion $ 2,351,607 $ 2,586,000 $ -
============== ============== ==============
</TABLE>

See accompanying notes.

F-6
<PAGE> 47

CYPRESS BIOSCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. FORMATION AND BUSINESS OF THE COMPANY

Cypress Bioscience, Inc. ("Cypress" or the "Company") researches,
develops, manufactures and markets medical devices and therapeutics for the
treatment of certain types of immune disorders and is engaged in the development
of novel therapeutic agents for the treatment of blood platelet disorders. The
Company's first product, the PROSORBA(R) column, a medical device, treats a
patient's defective immune system so that it can more effectively respond to
certain diseases. Through its acquisition of PRP, Inc. in November 1996, the
Company acquired rights to Infusible Platelet Membranes (IPM(TM)), which is
positioned to become a substitute for traditional platelet transfusions.

The Company commenced business activities in January 1982. The U.S.
Food and Drug Administration ("FDA") approved the PROSORBA(R) column for
commercial sale in December 1987 for the treatment of patients with idiopathic
thrombocytopenic purpura ("ITP"), an immune-related bleeding disorder. The
Company continues to devote most of its efforts to obtaining FDA marketing
approval for the use of the PROSORBA(R) column for the treatment of additional
autoimmune diseases as well as to the continued development of IPM(TM). The
Company is currently conducting a Phase III pivotal clinical trial using the
PROSORBA(R) column for therapy for rheumatoid arthritis as a follow-on to a
pilot clinical trial completed in September 1995. Clinical trials for certain
platelet disorders are being planned for 1997.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The consolidated financial statements include the accounts of the
Company and its wholly owned subsidiaries. All material intercompany accounts
and transactions have been eliminated.

Use of Estimates

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

Cash and Cash Equivalents

The Company considers all investments with an original maturity of
three months or less when purchased to be cash equivalents. Cash equivalents
primarily represent funds invested in a money market fund whose cost
approximates market value.

Inventories

Inventories are stated at weighted average cost, determined on the
first-in, first-out method, but not in excess of net realizable value.

Property and Equipment

Property and equipment are recorded at cost. Depreciation is provided
using the straight-line method over useful lives of three to five years, and
leasehold improvements are amortized over the term of the related lease.

F-7
<PAGE> 48

Convertible Debenture Issuance Costs

Convertible debenture issuance costs are comprised primarily of the
value assigned to stock warrants issued for placement agent services (see Note
8), other placement agent fees and legal expenses. Such costs are being
amortized over the life of the related debentures.

Stock and Stock Warrants Issued for Services

Common stock and common stock warrants issued for services rendered to
the Company are generally recorded at the fair market value of the stock or
stock warrant issued or the value of the services rendered, whichever is more
clearly determinable.

Revenue Recognition

The Company records sales of its product as earned revenue when the
product is shipped.

Revenue resulting from the settlement of the annual take-or-pay
provisions of the Company's distribution agreement (see Note 6) was recognized
at the end of the sales year period ended March 31, 1995.

Net Loss Per Share

The computation of net loss per share is based upon the weighted
average number of shares of common stock outstanding for each period. Options,
warrants and Convertible Debentures have not been considered in the calculation
inasmuch as they would be antidilutive.

3. FINANCIAL STATEMENT DETAILS

Short-term Investments

Short-term investments at December 31, 1996, which were classified as
"available-for-sale," consisted of U.S. Treasury Notes with various maturity
dates, all of which are due within one year of the date of purchase. The cost of
these investments at December 31, 1996 approximates fair market value.

Inventories

Inventories are comprised of the following as of December 31:

<TABLE>
<CAPTION>
1996 1995
------------ ------------
<S> <C> <C>
Raw materials and components $ 214,632 $ 513,883
Work in progress 700,815 557,222
Finished goods 58,320 77,401
============ ============
$ 973,767 $ 1,148,506
============ ============
</TABLE>

F-8
<PAGE> 49

Property and Equipment

Property and equipment are comprised of the following as of
December 31:

<TABLE>
<CAPTION>
1996 1995
----------- -----------
<S> <C> <C>
Laboratory and production equipment $ 629,269 $ 602,152
Office equipment 537,244 281,914
Vehicles 20,924 52,097
Leasehold improvements 51,753 48,585
Construction in progress 1,787,686 976,671
----------- -----------
3,026,876 1,961,419
Accumulated depreciation and amortization (674,948) (536,399)
----------- -----------
$ 2,351,928 $ 1,425,020
=========== ===========
</TABLE>

Depreciation expense for the years ended December 31, 1996, 1995 and 1994 was
$171,015, $305,912, and $268,894, respectively.

Accrued Liabilities

Accrued liabilities are comprised of the following as of December 31:

<TABLE>
<CAPTION>
1996 1995
------------ ------------
<S> <C> <C>
Accrued clinical trial costs $ 590,473 $ 250,858
Accrued convertible debenture interest 18,718 64,200
Other 292,899 357,430
============ ============
$ 902,090 $ 672,488
============ ============

Advertising Costs
</TABLE>

The Company incurred advertising expenses of approximately $18,000,
$77,000 and $658,000 for the years ended December 31, 1996, 1995 and 1994,
respectively, all of which were substantially for advertising agency costs.

4. ACQUISITIONS

PRP, Inc.

On November 1, 1996, the Company acquired all assets and assumed all
liabilities of PRP, Inc. ("PRP"), a biopharmaceutical company located in Boston,
Massachusetts engaged in the development of novel agents to treat blood and
platelet disorders. The transaction has been accounted for as a purchase.

In connection with the merger, the Company issued to certain
debtholders of PRP, in full satisfaction and settlement of such indebtedness,
units (with each unit consisting of two shares of common stock of the Company
and one common stock purchase warrant) with a total value equal to approximately
$4.5 million (based upon a price of $4.00 per unit). The Company recorded a
charge to acquired in-process research and development for approximately $5.1
million, representing the excess of the purchase price over the net liabilities
assumed.

In addition, the Company is obligated to make earn-out payments on net
sales, if any, of products developed using PRP's technology acquired by the
Company in the acquisition. In conjunction with obtaining approval from the FDA
of the use of IPM(TM) for the treatment of thrombocytopenia, the Company shall
make an additional payment of $5 million (the "Milestone Payment"), with such
payment being in the form of, at the Company's sole discretion, cash, Company
common stock or a combination of the two.

F-9
<PAGE> 50

In consideration of certain investment banking advisory services
provided by EGS Securities Corp. ("EGS") to PRP in connection with the Merger,
the Company issued to EGS Units with a total value of approximately $120,000. In
addition, the Company is obligated to pay EGS an amount in cash equal to two and
one-half percent (2 1/2%) of each earn-out payment and the Milestone Payment
made to the former PRP Stockholders, when and if such payments become due.

Pursuant to the terms of the merger agreement, subject to limited
exceptions, the Company is obligated to spend $4.0 million to commercialize and
advance IPM(TM) as a principal product of the Company. After the Company has
expended $4.0 million on the commercialization of IPM(TM), the Company has
agreed to use commercially reasonable efforts to optimize commercialization of
IPM(TM) and other existing products of PRP.

The following unaudited pro forma data reflects the combined results of
operations of the Company and PRP as though the acquisition had occurred on
January 1, 1995, and assumes the charge of $5,147,000 for acquired in-process
research and development was recorded on that date.

PRO FORMA RESULTS OF OPERATIONS
(unaudited)

<TABLE>
<CAPTION>
December 31,
----------------------------------
1996 1995
-------------- --------------
<S> <C> <C>
Revenues $ 2,029,773 $ 4,104,224
Net loss $ (9,853,328) $ (14,448,974)
Net loss per share $ (0.32) $ (0.73)
</TABLE>

CELx Corporation

In 1995, the Company and CELx Corporation ("CELx"), the Company's
former majority owned subsidiary, agreed to the merger of CELx into the Company
and the exchange of shares of CELx by persons other than the Company into an
aggregate of 312,500 shares of the Company's common stock. The dissolution of
CELx resulted in a charge of $625,000 recorded as acquired in-process research
and development. The charge was based upon the fair market value of the
Company's common stock.

5. RESTRUCTURING EXPENSE

In January 1996, the Company notified approximately twenty employees,
which was slightly greater than half of its work force, that their positions
were being terminated immediately as part of the restructuring. Such positions
were from all departments of the Company. In March 1996, the Company entered
into a termination agreement with its former Chief Scientific Officer. Costs
related to these terminations were approximately $494,000 and were recorded as a
restructuring expense in 1996. In addition, the Company incurred approximately
$300,000 in costs associated with moving the administration, research and
medical departments to San Diego, with most costs being attributable to
relocation costs of the few members of management moving to San Diego. Such
costs were recorded as general and administrative expenses in 1996.

The Company has also incurred approximately $1.3 million of capital
expenditures through December 31, 1996 in connection with the consolidation of
its two Washington manufacturing facilities.

F-10
<PAGE> 51

6. DISTRIBUTION AGREEMENT

Prior to April 1994, the PROSORBA(R) column was sold by the Company's
internal sales force to physicians in the fields of immunology, hematology and
oncology. In April 1994, Baxter Healthcare Corporation ("Baxter") assumed sales
and marketing responsibilities under a 10-year exclusive agreement, granting
distribution rights of the PROSORBA(R) column in the United States and Canada
for the treatment of thrombocytopenia. Baxter, at its own expense, was to
provide sales and marketing support for the sale of the product during the term
of the agreement. The Company was to provide significant marketing and
promotional support to Baxter for the first three years of the agreement.

7. COMMITMENTS AND CONTINGENCIES

Operating Leases

The Company leases approximately 14,400 square feet of production,
laboratory and administrative facilities in Seattle, Washington under a lease
expiring in 1999. In connection with the restructuring (see Note 5), this space
was sub-leased to another party in April 1996 for the remainder of the lease
term.

The Company leases approximately 8,000 square feet of manufacturing
facilities in Redmond, Washington under a lease expiring in 2004. The Company
leases approximately 2,800 square feet of office space in San Diego, California
under a lease expiring in 2001. This facility houses the Company's
administrative offices. The lease for approximately 7,000 square feet of
manufacturing facilities in Boston, which expires in 2001, was assumed in
conjunction with the PRP acquisition.

The table below indicates future minimum lease payments due, and
sublease income to be received, over the remaining life of the leases, under the
agreements in place as of December 31, 1996:

<TABLE>
<CAPTION>
Payments Sublease Income
------------------ -------------------
<S> <C> <C>
1997 $ 534,388 $251,289
1998 533,738 301,546
1999 470,916 238,724
2000 232,192 -
2001 122,098 -
Thereafter through 2005 288,000 -
================== ===================
$2,181,332 $791,559
================== ===================
</TABLE>

F-11
<PAGE> 52

Total rent expense was approximately $494,000, $521,000 and $417,000
for the years ended December 31, 1996, 1995 and 1994, respectively. Sublease
income was approximately $149,000 for the year ended December 31, 1996.

Patent Contingency

Severance Agreements

The Company entered into a severance agreement as of December 28, 1995
with its former Chief Executive Officer. The terms of the severance agreement
were based primarily on the termination clause of the employment agreement
entered into between the former officer and the Company in September 1994. Such
terms include the payment of $225,000 in 1996 and $168,750 in 1997. The total
cost of this severance agreement of $393,750 was included in general and
administrative expense in 1995.

The Company entered into a severance agreement as of March 29, 1996
with its former Chief Scientific Officer, the terms of which correlate to the
employment agreement renegotiated with the former officer as of December 28,
1995. Such terms include the payment of $244,000 in 1996 and the issuance of
non-qualified stock options to purchase 705,000 shares of common stock at $2.25
per share. These options replaced an equal number of options outstanding at the
date of termination.

Employment Agreements

The Company entered into employment agreements in December 1995 with a
new Chief Executive Officer and a new President, Chief Operating Officer. The
agreements provide for specified compensation which include salary, signing
bonuses, annual performance bonuses and a lump sum payments in the event of a
termination of employment, without cause, as defined. Signing bonuses of
approximately $100,000 were included in general and administrative expense in
1995. An additional $270,000 of bonuses were earned and included in general and
administrative expenses in 1996.

The agreements provided for the granting of an aggregate of 4,179,824
options to purchase the Company's Common Stock. The options were granted upon
the closing of the private placement in January 1996 (see Note 10). Options to
purchase 25% of the total amount granted vested immediately with the remainder
to vest over a four year period. Such options will vest immediately upon a
merger of the Company or in the event of a termination of employment without
cause, as defined. The Company recorded a charge to deferred compensation
expense of $1,756,949 to reflect the difference between the grant price and the
deemed value for accounting purposes of the common stock issuable upon exercise
of such options. The deferred compensation balance will be amortized over the
service period of the options. Accordingly, the Company recorded amortization
expense of $443,673 for the year ended December 31, 1996.

Defined Contribution Plan

The Company sponsors a defined contribution plan pursuant to Section
401(k) of the Internal Revenue Code of 1986. This plan covers substantially all
employees who provide more than 1,000 hours of service during the year.

The Plan provides for matching contributions whereby the Company
contributes common stock to the Plan on behalf of participants in an amount
equal to 100% of the participants' contributions during the six-month periods
ending on the last day of June and December. The Company's contributions will
vest six months after the amount of the contribution is determined if the
employee is still employed by the Company at the end of the vesting period,
except for employees who have

F-12
<PAGE> 53

been with the Company more than five years for whom contributions will vest
immediately. The expense recognized for shares contributed on behalf of
employees was approximately $102,000, $161,000 and $161,000 for the years ended
December 31, 1996, 1995 and 1994, respectively, based upon the market value of
the Company's common stock on the date of the contribution.

8. 7% CONVERTIBLE DEBENTURES

In April 1994, the Company completed a private placement of $4,245,000
principal amount of 7% convertible debentures due March 2001 ("7% Convertible
Debentures"). Interest is payable in cash or shares of common stock at the
option of the Company. The conversion price for the principal amount is $2.875
per share of registered common stock, the fair market value on the date of
closing. The conversion price for the interest is the lower of $4.00 per share
of Common Stock or the average closing price for the 10 days prior to the annual
April 30 interest payment date. The debentures are redeemable by the Company
after April 1998 at a redemption price of 106% of the principal amount reduced
to 104% and 102% the following two years. Allen & Company Incorporated ("Allen &
Company"), a shareholder of the Company, acted as placement agent with respect
to a majority of this private placement and received a five-year warrant valued
at $483,000 to purchase 300,000 shares of common stock at $2.875 for its
services as placement agent. The cost of issuing the 7% Convertible Debentures,
including the cost of the warrants, has been deferred and is reported on the
accompanying balance sheet net of amortization expense which is being recorded
over the term of the 7% Convertible Debentures. Allen & Company purchased $1.0
million of the 7% Convertible Debentures.

In September 1995, the Company completed an exchange offering to
holders of the 7% Convertible Debentures. The Company offered to exchange the 7%
Convertible Debentures for restricted common stock at $2.25 per share. Of the
original $4,245,000 outstanding principal amount, $2,200,000 of the 7%
Convertible Debentures was converted. The Company recorded a non-cash expense of
$810,386 which represents the fair market value of the increased number of
shares issued under the terms of the offering compared to the original
conversion terms. In the fourth quarter of 1995 and the first quarter of 1996,
an additional $700,000 and $100,000, respectively, of 7% Convertible Debentures
was converted into common stock at the original conversion price. For
substantially all 7% Convertible Debentures that were converted, the interest
accrued up to the date of conversion was paid through the issuance of common
stock at either $2.25 per share or $2.875 per share. The Company also charged
$314,000 to additional paid-in capital in 1995 for the unamortized deferred debt
issuance costs related to the converted debentures.

In March 1996, the Company completed a second exchange offering made
to holders of its outstanding 7% Convertible Debentures. The Company offered to
exchange the 7% Convertible Debentures for common stock of the Company at a
price of $2.25 per share. Of the $1,245,000 outstanding principal amount,
$845,000 was converted into 399,252 shares of common stock of the Company (which
amount includes 23,700 shares issued as interest on the 7% Convertible
Debentures), pursuant to the exchange offering. At December 31, 1996, there was
outstanding principal of $400,000 of the 7% Convertible Debentures. In 1996, the
Company charged an additional $93,000 to additional paid-in capital for the
unamortized deferred debt issuance costs related to the debentures converted in
1996.

9. SENIOR CONVERTIBLE DEBENTURES

In December 1995, the Company completed a private placement of
$1,500,000 principal amount of senior convertible debentures due in July 1996
("Senior Convertible Debentures") to a group of investors, including $500,000
issued to Allen & Company. The Company received $1,000,000 in cash on 1995 and
the remaining $500,000 during the first week of January 1996.

In January 1996, the Senior Convertible Debentures, under their
original terms, were automatically converted at $1.50 per share into 1,000,000
shares of the Company's common stock. The conversion was made simultaneously
with the closing of a private placement of common stock (see Note 10).

10. STOCKHOLDERS' EQUITY

Authorized Shares

The Company is authorized to issue up to 15,000,000 shares of "blank
check" preferred stock. Terms and rights of such preferred stock shall be
determined by the Board of Directors when such preferred stock, if any, is
issued.

F-13
<PAGE> 54

Private Placements

In January 1996, the Company sold approximately 8,500,000 shares of
common stock for $1.50 per share in a private placement, resulting in net
proceeds to the Company of approximately $12,000,000. As a result of this
private placement, the Senior Convertible Debentures automatically converted
into 1,000,000 shares of common stock (see Note 9). In addition, upon closing of
the private placement, the Company issued stock options to the new Chief
Executive Officer and President aggregating 4,159,824 shares at an exercise
price of $1.50 per share.

In October 1996, the Company completed a private placement of units
with each unit consisting of two shares of common stock and one common stock
purchase warrant (the "1996 Warrants") collectively priced at $4.00 per unit.
Holders of each warrant are entitled to purchase one share of the Company's
common stock at an exercise price of $2.00 per share over a five-year period. A
total of 1,734,000 units were sold resulting in net proceeds to the Company of
approximately $6.3 million.

Warrants

In 1991, the Company granted warrants to purchase 749,900 shares of
common stock to certain officers, directors and employees, which are exercisable
through June 2001 at $1.875 per share. In September 1991, the Company granted
warrants to purchase 1,850,000 shares of common stock at an exercise price of
$2.50 per share in connection with its public offering of units. The warrants
will expire on April 30, 1997, and are now redeemable by the Company at $0.75
each. In April 1994, the Company issued Allen & Company a five-year warrant to
purchase 300,000 shares of Common stock at $2.875 for its services as a
placement agent for the 7% Convertible Debentures (see Note 8). In conjunction
with the private placement completed in October 1996, as well as in conjunction
with the PRP acquisition, the Company granted warrants to purchase 2,880,399
shares of common stock. The warrants entitle the holder to purchase a share of
common stock for $2.00 per share. The warrants expire in October 2001 and are
redeemable, in certain circumstances, for $0.10 per warrant, beginning in
September 1997.

Stock Options

1996 Equity Incentive Plan. In April 1996, the Company adopted the 1996
Equity Incentive Plan authorizing the issuance of both incentive and
non-qualified options to purchase the Company's common stock, as well as the
granting of stock appreciation rights, stock bonuses and rights to purchase
restricted stock. Under the plan, 7,000,000 shares of the Company's common stock
are reserved for issuance to directors, officers and key employees of, and
consultants and certain advisors to, the Company.

Incentive Stock Options. In June 1985, the Company adopted an Incentive
Stock Option and Appreciation Plan. The plan authorizes options to purchase, and
appreciation rights with respect to, the Company's common stock, which may be
granted to such officers and key employees as may be selected by the Board of
Directors or a committee appointed by the Board to administer the plan. The plan
was amended in June 1992 to increase the number of shares reserved for issuance
to 750,000. The plan expired in 1995; however, options previously granted under
the plan remain effective according to their respective terms and conditions.

Non-Qualified Stock Options. The Company has reserved 572,000 shares of
common stock for issuance under its 1988 Non-qualified Stock Option Plan, as
amended in 1992 and 1995 (the "1988 Plan"). Under the 1988 Plan, directors,
officers, employees and consultants may be granted non-qualified stock options
at exercise prices and terms determined by the Board of Directors.

Stock Options-Other. The Company has, at various times, granted to
employees and others options to purchase common stock, other than from under a
formal option plan.

Options granted pursuant to each of the plans above have a term of up
to ten years and generally vest over four years.

The Company has elected to follow Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FASB
Statement No. 123, "Accounting for Stock-Based Compensation," requires use of
option valuation models that were not developed for use in valuing employee
stock options. Under APB 25,

F-14
<PAGE> 55

when the exercise price of the Company's employee stock options equals the
market price of the underlying stock on the date of grant, no compensation
expense is recognized.

The following table summarizes the activity of the Company's stock
options and warrants:

<TABLE>
<CAPTION>
Number of Warrants / Options
------------------------------------------------------------------------
1996
Equity Incentive Non-Qualified
Incentive Stock Stock Other
Warrants Plan Options Options Options Options
-------------- -------------- ------------ ------------- -------------
<S> <C> <C> <C> <C> <C>
Balance December 31, 1993 2,569,700 - 216,200 75,000 762,835
Granted 300,000 - 100,500 810,000 110,000
Exercised (6,500) - (1,000) - -
Canceled (20,300) - (5,000) - -
Expired - - - (65,000) (40,000)
-------------- -------------- ------------ ------------- -------------
Balance December 31, 1994 2,842,900 - 310,700 820,000 832,835
Granted - - - 1,179,000 20,000
Canceled - - - (476,500) -
Expired (23,100) - (42,100) - (177,000)
-------------- -------------- ------------ ------------- -------------
Balance December 31, 1995 2,819,800 - 268,600 1,522,500 675,835
Granted 2,880,399 5,607,157 - 30,000 929,000
Exercised - - - (47,500) -
Canceled (335,000) (20,000) (207,600) (533,000) (454,000)
Expired - - - (500,000) -
-------------- -------------- ------------ ------------- -------------
Balance December 31, 1996 5,365,199 5,587,157 61,000 472,000 1,150,835
============== ============== ============ ============= =============
</TABLE>

With respect to the Company's outstanding warrants at December 31,
1996, 5,365,199 warrants were exercisable at exercise prices ranging from $1.85
to $2.88 and 5,365,199 shares of common stock were reserved for future issuance.

With respect to stock options, at December 31, 1996 there were
1,512,843 options available for future grant and 8,783,835 shares of common
stock were reserved for future issuance.

Following is a further breakdown of the options outstanding as of
December 31, 1996:

<TABLE>
<CAPTION>
Weighted Weighted
Average Average
Remaining Weighted Exercise
Range of Contractual Average Price of
Exercise Options Life in Exercise Options Options
Prices Outstanding Years Price Exercisable Exercisable
- -------------- ------------- ------------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C>
$1.00 - $1.50 4,417,074 8.95 $1.50 1,842,202 $1.50
$1.51 - $2.25 2,589,583 6.89 2.02 885,093 2.07
$2.26 - $3.25 168,105 4.81 2.69 168,105 2.69
$3.26 - $3.88 96,230 3.11 3.79 96,230 3.79
------------- -------------
7,270,992 2,991,630
</TABLE>

F-15
<PAGE> 56

The weighted average exercise prices and fair values for 1996 are as follows:

<TABLE>
<CAPTION>
Weighted Average
-------------------------------
Exercise Price on Fair Exercise
Date of Grant Value Price
--------------------------------- --------------- ------------
<S> <C> <C>
Equal to market price of stock $ 1.41 $ 2.04
Less than market price of stock $ 1.38 $ 1.51
Exceeds market price of stock $ 1.19 $ 3.43
</TABLE>

Pro forma information regarding net loss and net loss per share is
required by Statement 123, and has been determined as if the Company had
accounted for its employee stock options under the fair value method of that
Statement. The fair value for these options was estimated at the date of grant
using a Black-Scholes option pricing model with the following weighted-average
assumptions for 1995 and 1996: a risk-free interest rate of 6.49%; a dividend
yield of 0%; a volatility factor of the expected market price of the Company's
common stock of 65%; and a life of the option of 7 years.

The weighted average exercise prices for stock option activity are as
follows:

<TABLE>
<CAPTION>
Number of Stock Weighted
Options Under Average
All Plans Exercise Prices
----------------- -----------------
<S> <C> <C>
Balance December 31, 1993 1,054,035 $2.49
Granted 1,020,500 2.50
Exercised (1,000) 2.63
Canceled (5,000) 3.00
Expired (105,000) 2.51
----------------- -----------------
Balance December 31, 1994 1,963,535 2.49
Granted 1,199,000 2.01
Canceled (476,500) 2.05
Expired (219,100) 2.53
----------------- -----------------
Balance December 31, 1995 2,466,935 2.34
Granted 6,566,157 1.69
Exercised (47,500) 1.79
Canceled (1,214,600) 2.46
Expired (500,000) 2.19
----------------- -----------------
Balance December 31, 1996 7,270,992 $1.74
================= =================
</TABLE>

For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The Company's
pro forma information follows:

<TABLE>
<CAPTION>
1996 1995
------------ -----------
<S> <C> <C>
Pro forma net loss (in thousands) $ (15,980) $ (7,348)
Pro forma net loss per share (0.55) (0.42)
</TABLE>

The proforma results above for 1996 and 1995 are not likely to be
representative of the effects of applying FAS 123 on reported net income or loss
for future years as these amounts reflect the expense for only two years or one
year of vesting, respectively.

F-16
<PAGE> 57

11. INCOME TAXES

Significant components of the Company's deferred income tax assets as
of December 31, are as follows:

<TABLE>
<CAPTION>
1996 1995
---- ----
<S> <C> <C>
Net operating loss carryforward $ 14,639,000 $ 9,139,000
Capitalized research & development 3,212,000 --
Other 1,174,000 741,000
------------ -----------
19,025,000 9,880,000
Valuation allowed (19,025,000) (9,880,000)
------------ -----------
$ -- $ --
------------ -----------
</TABLE>

As of December 31, 1996, the Company has accumulated Federal and
California net operating loss carryforwards of approximately $42,944,000 and
$2,257,000, respectively, which expire beginning in 1998. Additionally, the
Company has Federal and California research and development tax credit
carryforwards of approximately $600,000 and $10,000, respectively, which will
begin expiring in 2004 unless previously utilized.

In accordance with certain provision of the Internal Revenue Code, a
change in ownership of greater than 50% within a three-year period will place an
annual limitation on the Company's ability to utilize its existing net operating
loss and tax credit carryforwards.

As a result of the Company's sales of common stock in November 1990 and
September 1991, the utilization of net operating loss carryforwards which had
accumulated as of November 1991 will be limited to a prescribed amount in each
successive year. However, the Company believes that this limitation will not
have a material effect on the financial statements.

Within the prior three year period, the Company underwent several
private placements and debt to common stock conversions. However, the additional
stock issuances during the prior three year period have not triggered an
ownership change of greater than 50%.

F-17

<PAGE> 1
EXHIBIT 23.1

CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

We consent to the incorporation by reference in the Registration Statements
(Forms S-3 and S-8) of our report dated January 17, 1997, with respect to the
consolidated financial statements of Cypress Bioscience, Inc. included in its
Annual Report (Form 10-K) for the year ended December 31, 1996.

/s/ ERNST & YOUNG LLP

San Diego, California
March 6, 1997

<ARTICLE> 5
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<CASH> 8,046
<SECURITIES> 2,890
<RECEIVABLES> 525
<ALLOWANCES> 181
<INVENTORY> 974
<CURRENT-ASSETS> 12,576
<PP&E> 3,027
<DEPRECIATION> 675
<TOTAL-ASSETS> 14,961
<CURRENT-LIABILITIES> 2,415
<BONDS> 400
0
0
<COMMON> 68,997
<OTHER-SE> 444
<TOTAL-LIABILITY-AND-EQUITY> 14,961
<SALES> 1,968
<TOTAL-REVENUES> 2,426
<CGS> 1,483
<TOTAL-COSTS> 8,327
<OTHER-EXPENSES> 5,824,343
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 57
<INCOME-PRETAX> (13,264)
<INCOME-TAX> 0
<INCOME-CONTINUING> (13,264)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (13,264)
<EPS-PRIMARY> (0.45)
<EPS-DILUTED> 0

</TABLE>