CYGNUS INC /DE/, 10-K, 1997-03-21

CYGNUS INC /DE/
10-K, 1997-03-21
PHARMACEUTICAL PREPARATIONS

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-K

(X) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 OR

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

Commission File No. 0-18962

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CYGNUS, INC.

(Exact name of registrant as specified in its charter)

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DELAWARE 94-2978092
(State or other jurisdiction of (I.R.S. Employer
incorporation) Identification No.)
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400 PENOBSCOT DRIVE, REDWOOD CITY, CALIFORNIA 94063

(Address of principal executive offices and zip code)

(415) 369-4300

(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: NONE

Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $
0.001 PAR VALUE

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes_X_ No___

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

The aggregate market value of voting stock held by non-affiliates of the
registrant, based upon the closing price of Common Stock on March 10, 1997 as
reported on the Nasdaq National Market was approximately $ 286,288,509.
Determination of affiliate status for this purpose is not a determination of
affiliate status for any other purpose.

18,773,017

(Number of shares of common stock outstanding as of March 10, 1997)

Documents Incorporated by Reference

Items 5, 6, 7 and 8 of Part II incorporate information by reference from
certain portions of the Annual Report to Stockholders for the fiscal year ended
December 31, 1996.

Parts of the Registrant's definitive Proxy Statement filed pursuant to
Regulation 14A for its 1997 Annual Meeting of Stockholders are incorporated by
reference into Part III hereof.

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CYGNUS, INC.
1996 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

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PART I

ITEM 1. Business....................................................................................... 3
ITEM 2. Properties..................................................................................... 20
ITEM 3. Legal Proceedings.............................................................................. 20
ITEM 4. Submission of Matters to a Vote of Security Holders............................................ 21

PART II

ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters.......................... 24
ITEM 6. Selected Financial Data........................................................................ 24
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.......... 24
ITEM 8. Financial Statements and Supplementary Data.................................................... 24
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........... 24

PART III

ITEM 10. Directors and Executive Officers of the Registrant............................................. 25
ITEM 11. Executive Compensation......................................................................... 25
ITEM 12. Security Ownership of Certain Beneficial Owners and Management................................. 25
ITEM 13. Certain Relationships and Related Transactions................................................. 25

PART IV

ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K................................ 26

SIGNATURES................................................................................................. 30
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PART I

ITEM 1. BUSINESS

OVERVIEW

This Report on Form 10-K contains projections and forward looking statements
regarding future events and the future financial performance of the Company. We
wish to caution you that these statements are only our predictions and
objectives. Actual events or results may differ materially. Please note in
particular throughout this document where we have highlighted specific risks
associated with the Company and its activities. We also refer you to documents
the Company files from time to time, such as its Form 10-Q and Form 8-K reports.
This document, as well as the Company's Form 10-Q and Form 8-K reports, contain
important factors that could cause our actual results to differ from our current
expectations and the forward-looking statements contained in this Report on Form
10-K.

Cygnus, Inc. ("Cygnus" or the "Company") is engaged in the development of
diagnostic and drug delivery systems, with its current efforts primarily focused
on three core areas: a painless, automatic glucose monitoring device,
transdermal drug delivery systems and mucosal drug delivery systems. The three
core areas of the Company's business are as follows:

PAINLESS, AUTOMATIC GLUCOSE MONITORING. Worldwide sales of products for the
self-monitoring of blood glucose levels by people with diabetes exceeded $1.9
billion in 1995. Currently, people with diabetes test their blood glucose levels
on average less than half as often as recommended, largely due to the pain and
disruption of daily life associated with the prevailing "finger stab" method.
Clinical studies sponsored by the NIH indicate that more frequent testing should
enable people with diabetes to reduce or significantly delay many serious
diabetes-related complications. As a result, the Company believes that there is
a significant unmet demand for painless, automatic glucose monitoring.

The Company is addressing this unmet demand by developing a monitoring
device called the GlucoWatch-TM-, which is worn like a wristwatch. The
GlucoWatch is designed to extract and measure glucose automatically and
frequently through intact skin, and to display and store blood glucose levels
and trends. The extracted glucose is collected in a transdermal patch that is
changed daily. The GlucoWatch is expected to eliminate significant drawbacks of
the finger stab technique, such as the pain of repetitive stabbing and the
disruption of normal activities caused by cumbersome, time-consuming testing
procedures. It is designed to offer a combination of features not available in
currently marketed devices such as automatic data collection, an electronic
memory, personal computer downloading, and alarms indicating hypo- and
hyper-glycemic conditions. The Company believes these features can lead to
improved disease management enabling people with diabetes to prevent or delay
the severe complications associated with diabetes.

The Company has conducted early stage clinical studies using an initial
GlucoWatch prototype. The Company believes the results of these studies support
the technical feasibility of the product by indicating a level of accuracy and
reproducibility comparable to those associated with finger stab blood glucose
measurement devices now commercially available. The Company is currently
optimizing, miniaturizing and integrating certain components of the GlucoWatch.
In November 1996, the Company identified a short circuit in the application
specific integrated circuit (ASIC) which resulted in a delay in the receipt of
the latest prototype of these devices. The ASIC problem has been rectified and
the prototypes have been received. The Company believes that the submission will
be in the form of a 510(k) notification, although the final determination of the
type of submission cannot be made until discussions are held with the FDA.

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agreement with Tokyo-based Yamanouchi Pharmaceutical Co., Ltd. for the marketing
and distribution of the GlucoWatch in Japan and Korea. Cygnus will have primary
responsibility for completing product development and for manufacturing. Cygnus
will be eligible to receive up-front and milestone payments as well as a
percentage of the product's future commercial success from both Becton Dickinson
and Yamanouchi.

TRANSDERMAL DRUG DELIVERY SYSTEMS. Transdermal drug delivery systems
provide for the controlled release of drugs directly into the bloodstream
through intact skin. The Company's transdermal drug delivery products are thin
multilayer systems, in the form of small adhesive patches. Transdermal delivery
can provide a number of advantages over conventional methods of drug
administration, including enhanced efficacy, increased safety, greater
convenience and improved patient compliance. By delivering a steady flow of
drugs into the bloodstream over an extended period of time, transdermal systems
can avoid the "peak and valley" effect of oral or injectable therapy and can
enable more controlled, effective treatment. By avoiding first pass metabolism
through the gastrointestinal tract and the liver, the therapeutically equivalent
dosage for the transdermal delivery of certain compounds can be significantly
less than the corresponding oral dosage, potentially reducing dosage-related
side-effects.

The Company's transdermal product line is currently focused on smoking
cessation, hormone replacement therapy and contraception. The Company's two most
commercially advanced products are the currently marketed
Nicotrol-Registered Trademark- nicotine patch and the
FemPatch-Registered Trademark- estrogen replacement patch. FemPatch was approved
by the FDA in December 1996. The Company has strategic collaborations for its
transdermal products with American Home Products Corporation (hormone
replacement therapy), Ortho Pharmaceutical Corporation, a subsidiary of Johnson
& Johnson (contraception), Sanofi/Warner-Lambert (hormone replacement) and
Pharmacia & Upjohn, Inc. ("Pharmacia") (smoking cessation).

MUCOSAL DRUG DELIVERY. Mucosal drug delivery is the controlled release of
compounds through mucous membranes, typically using a disc, spray, lozenge or
other system. Drugs delivered through mucous membranes have the potential to
provide a faster onset and longer duration of action than certain products
currently on the market. Cygnus is pursuing potential collaborative partners for
mucosal delivery products in both the prescription and non-prescription
pharmaceutical markets.

STRATEGY

The Company's objective is to become a leader in the development and
commercialization of advanced drug delivery and diagnostic products for a wide
variety of applications utilizing a broad array of technologies. The Company
develops differentiated products based on proprietary technologies which have
the potential to provide significant value to patients. The Company's strategy
adheres to the following general principles:

- APPLY AND EXPAND ITS PROPRIETARY TECHNOLOGIES. Cygnus develops a broad
array of products by applying its expertise in skin biology, polymer chemistry,
drug diffusion, microparticles and adhesive technology. Cygnus devotes
significant resources to continued development of new drug delivery and
diagnostic technologies as well as additional products based on its existing
technologies. The Company also maintains an active technology in-licensing and
acquisition program. The Company's strategy is to maintain ownership of its drug
delivery technology, to out-license only specific product applications and to
aggressively protect its proprietary technology.

- DEVELOP A BROAD PORTFOLIO OF DIFFERENTIATED PRODUCTS. The Company's
broad range of proprietary technology has enabled it to develop a wide variety
of differentiated products. A diversity of products targeted to multiple markets
increases potential business opportunities, can provide a stream of new product
introductions over time and reduces the risks of reliance on a single product or
technology. The Company intends to expand its product line by continuing to
apply its technologies to new drug delivery and diagnostic systems.

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- ADDRESS LARGE MARKET OPPORTUNITIES. The Company's product development
efforts focus on large existing markets with unmet needs. The Company's target
markets (and industry estimates of their 1995 sales) include: glucose monitoring
(over $1.9 billion worldwide), hormone replacement (over $2.6 billion worldwide)
smoking cessation ($300 million in the U.S.) and contraception ($2.5 billion
worldwide).

- CONTROL PRODUCT MANUFACTURING. The Company's products are manufactured
using several proprietary materials and complex production technologies. The
Company's strategy is, where appropriate, to retain manufacturing rights to its
products. By retaining manufacturing rights, the Company can exercise control
over the quality of its products and capture a larger portion of the product
revenue stream. Cygnus has manufactured its transdermal patches for both
clinical trials and commercial sale for several years in its existing production
facility, and believes that this facility will have sufficient capacity to
support the planned market introduction of its current products.

- COLLABORATE WITH MARKET LEADERS. Cygnus seeks to establish strategic
relationships with leading companies in each of its target markets. These
companies typically have significant resources and strong franchises that, when
coupled with the Company's technology, increase the likelihood of commercial
success. The Company currently has strategic collaborations with American Home
Products, a leader in hormone replacement, Johnson & Johnson, a leader in
contraception, Warner-Lambert, a company with a leading female health care
franchise, and Pharmacia, a leader in smoking cessation. The Company is
increasingly taking a more active role with its collaborative partners in the
clinical trials, regulatory processes and marketing of its products.

PORTFOLIO OF PRODUCTS

The data in the following table summarize Cygnus' current product portfolio,
the potential indications, development status and licensees of marketing and
distribution rights. The data in the table are qualified by reference to the
more detailed descriptions set forth herein. Development of the various products
listed is being funded by the designated licensee, the Company, or both. The
Company has additional products in early development, which are not listed
below, and is conducting a number of new product feasibility studies.

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PRODUCT PORTFOLIO

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PRODUCT INDICATIONS STATUS(1) MARKETING RIGHTS
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DIAGNOSTIC SYSTEMS:
PAINLESS, AUTOMATIC GLUCOSE MONITORING:

GlucoWatch Diabetes Early stage clinicals(2) Becton Dickinson
Yamanouchi

DRUG DELIVERY SYSTEMS:
TRANSDERMAL DRUG DELIVERY:

SMOKING CESSATION:

Nicotrol Smoking cessation Commercialized in North Pharmacia & Upjohn,
America and certain Inc.: Johnson &
European countries Johnson(3)
Nicotine Patch Smoking cessation Phase 2 clinicals Cygnus

HORMONE REPLACEMENT:
ESTROGEN 7-DAY:
FemPatch Menopausal symptoms FDA approved Sanofi: Warner-
Lambert(4)
E2III Menopausal symptoms Phase 3 clinicals American Home Products

ESTROGEN/PROGESTIN:
Combination 3.5-Day Menopausal symptoms Phase 3 clinicals American Home Products
CONTRACEPTION:
Estrogen/Progestin:
Combination 7-Day Contraception Phase 2 clinicals Johnson & Johnson(5)

MUCOSAL DRUG DELIVERY:
Consumer Product Undisclosed Preclinical Cygnus
Consumer Product Undisclosed Development Cygnus
Consumer Product Undisclosed Development Cygnus
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(1) The Company's products are generally developed in the following stages:
development, prototype, pre-clinical studies (preparing to file an
Investigational New Drug Application ("IND")), clinical trials, and
regulatory submission.

(2) The Company has conducted early stage clinical studies using a research
prototype. Future trials will be conducted using a commercial version of the
product.

(3) Pharmacia has worldwide rights, and has sublicensed rights in North America
to Johnson & Johnson.

(4) Worldwide rights granted to Sanofi under its agreement with Cygnus are the
subject of an arbitration proceeding. Sanofi has granted a sublicense of
such rights with respect to North America to Warner-Lambert.

(5) The Company's agreement with Johnson & Johnson grants Johnson & Johnson
exclusive rights to the estrogen/progestin combination 7-day contraception
product.

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PAINLESS, AUTOMATIC GLUCOSE MONITORING

MARKET OPPORTUNITY

According to the American Diabetes Association (the "ADA"), approximately
seven million Americans have been diagnosed as having diabetes. Diabetes can
lead to severe complications over time, including blindness, loss of kidney
function and peripheral neuropathy, causing pain to the arms and legs and
potentially requiring amputation. The ADA estimated that the complications
arising from diabetes cost the U.S. healthcare system in excess of $45 billion
in 1992. These complications are largely a consequence of years of poor
management of glucose levels by people with diabetes. Results of the Diabetes
Control and Complication Trial, a major clinical trial sponsored by the NIH and
published in 1993, showed that more frequently monitored blood glucose levels
and rigid adherence to a program of diet, exercise and insulin injections could
prevent or significantly delay the onset of many of the long-term complications
of diabetes.

People with diabetes measure blood glucose levels to enable them to adjust
their diet and use of insulin to prevent these complications. Currently, people
with diabetes are required to stab their fingers with a lancet, draw blood,
place a drop of blood on a glucose reagent strip, then place the strip in an
instrument which provides a blood glucose reading. Each day of testing can
involve numerous stabs and the complete procedure is not only painful but
disruptive of daily life. As a result of this pain and disruption, people with
diabetes monitor their blood glucose levels on average less than twice per day,
instead of the recommended four to seven times per day. Even at this level of
testing, the market for products for self-monitoring of glucose levels by
diabetic patients is quite substantial. The worldwide market for these products
exceeded $1.9 billion in 1995. The Company believes that approximately 90% of
the sales were related to disposable glucose reagent strips for finger stab
monitoring, and believes that the successful development of a painless,
bloodless glucose monitoring device can significantly expand this market by
meeting needs not served by the finger stab technology.

THE GLUCOWATCH

The Company is addressing this unmet demand by developing a monitoring
device called the GlucoWatch, which is worn like a wristwatch. The GlucoWatch is
designed to extract and measure glucose automatically and frequently through
intact skin, and to display and store blood glucose levels and trends. The
extracted glucose is collected in a transdermal patch that is changed daily. The
GlucoWatch is expected to eliminate significant drawbacks of the finger stab
technique, such as the pain of repetitive stabbing and the disruption of normal
activities caused by cumbersome, time-consuming testing procedures. It is
designed to offer a combination of features not available in currently marketed
devices such as automatic data collection, an electronic memory, personal
computer downloading, and alarms to indicate hypo- and hyper-glycemic
conditions. The Company believes these features can lead to improved disease
management enabling people with diabetes to prevent or delay the severe
complications associated with diabetes.

The Company has conducted early stage clinical studies using an initial
GlucoWatch prototype. The Company believes the results of these studies support
the technical feasibility of the product by indicating a level of accuracy and
reproducibility comparable to those associated with finger stab blood glucose
measurement devices now commercially available. The Company is currently
optimizing, miniaturizing and integrating certain components of the GlucoWatch.
The Company believes that the submission will be in the form of a 510(k)
notification, although the final determination of the type of submission cannot
be made until discussions are held with the FDA.

The GlucoWatch extracts glucose molecules through intact skin utilizing a
proprietary process called electroosmosis, which uses low levels of electric
current. Glucose molecules are collected in a small, daily disposable pad, which
adheres to the skin and is connected to a biosensor and covered by the
GlucoWatch. The collected glucose triggers an electro-chemical reaction with a
reagent in the pad, causing an emission

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of electrons. The biosensor measures the electrons and a custom application
specific integrated circuit ("ASIC") in the GlucoWatch equates the level of
electron emission to a concentration of glucose in the patient's blood. The
GlucoWatch measures glucose levels at frequent intervals, providing readings
throughout the day and night. The GlucoWatch displays the most recent readings
and trends at the push of a button. Its electronic memory capabilities permit
the retrieval and downloading of data, allowing longer-term trend analysis for
better disease management.

The Company developed the basic GlucoWatch technology from 1988 to 1994,
resulting in the creation of an initial prototype. Using this prototype, the
Company has conducted two separate early stage clinical studies on diabetic and
non-diabetic subjects. The objective of these clinical studies was to
demonstrate the capability of the device to (i) painlessly extract glucose, (ii)
track high and low levels of blood glucose, and (iii) achieve levels of clinical
accuracy and reproducibility which are substantially equivalent to FDA-approved
finger stab devices. The studies included 21 clinical evaluations which
generated 315 data points. Subjects measured their glucose levels three times
each hour for at least five hours using both the finger stab method and the
Company's painless extraction method, and were administered glucose to elevate
their blood glucose levels. Diabetic subjects were also administered intravenous
insulin. The Company believes the results of these trials support the technical
feasibility of the product by achieving a level of clinical accuracy and
reproducibility comparable to those achieved with FDA-approved finger stab
glucose monitoring devices.

The Company has developed a second stage prototype and is currently working
to optimize the pad and the biosensor, to miniaturize certain electronic
components, and to integrate each component into a compact device. In November
1996, the Company identified a short circuit in the application specific
integrated circuit (ASIC) which resulted in a delay in the receipt of the latest
prototype of these devices. The ASIC problem has been rectified and the
prototypes have been received. Additional clinical studies will be conducted
with these new prototypes, and after confirming that the miniaturized device can
achieve a level of clinical accuracy and reproducibility comparable to those
achieved with commercially available products, Cygnus intends to conduct larger
scale clinical trials to support a medical device submission to the FDA. These
clinical trials would be conducted using early production lots of the GlucoWatch
designed for commercial sale. Certain components of this device will vary in a
number of respects from the initial prototype with which the Company has
conducted its early stage clinical studies and no assurance can be given that
the clinical trials will produce results that are consistent with the early
stage clinical studies or that the data generated will support the necessary
regulatory filings and approvals. The Company believes that the submission to
the FDA for the GlucoWatch will be in the form of a 510(k) notification,
although the final determination of the type of submission cannot be made until
discussions are held with the FDA. See "Need to Develop New Products:
Development Stage of Current Products."

In February 1996, the Company entered into an agreement with Becton
Dickinson for the marketing and distribution of the GlucoWatch. Under the terms
of the agreement, Becton Dickinson has exclusive worldwide marketing and
distribution rights, with the exception of Japan and Korea. Cygnus has primary
responsibility for completing product development, obtaining regulatory
approvals, manufacturing, and customer service and support for the product. In
July 1996, the Company entered into an agreement with Tokyo-based Yamanouchi
Pharmaceutical Co., Ltd. for the marketing and distribution of the GlucoWatch in
Japan and Korea. Cygnus will have primary responsibility for completing product
development and for manufacturing. Cygnus will be eligible to receive up-front
and milestone payments as well as a percentage of the product's future
commercial success from both Becton Dickinson and Yamanouchi.

TRANSDERMAL SYSTEMS

Transdermal drug delivery systems provide for the controlled release of
drugs directly into the bloodstream through intact skin. The Company's
transdermal drug delivery products are thin, multilayer systems, in the form of
small adhesive patches. Transdermal delivery can provide a number of advantages
over conventional methods of drug administration, such as oral administration,
bolus injection and

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continuous infusion. These advantages include enhanced efficacy, increased
safety, greater convenience and improved patient compliance. By delivering a
steady flow of drugs into the bloodstream over an extended period of time,
transdermal systems can avoid the "peak and valley" effect of oral or injectable
therapy and can provide a more controlled, effective treatment. By avoiding
first pass metabolism through the gastrointestinal tract and the liver, the
therapeutically equivalent dosage for the transdermal delivery of certain
compounds can be significantly less than the corresponding oral dosage,
potentially reducing dosage-related side-effects. By improving patient
compliance, transdermal delivery can also reduce the need for more costly
therapies in the future. As a result, transdermal systems can improve products
already on the market, and can enable the development of new therapies.

Transdermal delivery systems can also offer certain advantages to
pharmaceutical companies, such as brand extension, further product
differentiation and additional patent protection. Patented methods of
transdermal drug delivery may extend the product life of a drug for which the
patent is expiring and provide the pharmaceutical company with a competitive
advantage over generic products delivered by conventional means. The controlled
delivery of certain drugs can also result in the approval of new therapeutic
indications, thereby expanding the market for those drugs.

Cygnus has established a comprehensive, integrated approach to the
development of transdermal delivery systems. Cygnus develops a unique product
profile for each transdermal product based on an evaluation of several key
variables that change with each drug and therapeutic indication. Based on its
assessment of the product profile and the interrelationship between the drug and
the physical and biological characteristics of the skin, Cygnus formulates the
appropriate materials and designs the structure of the transdermal system to
achieve desired product characteristics such as comfort, extended wear, delayed
or enhanced onset and controlled release.

SMOKING CESSATION

MARKET OPPORTUNITY. According to the Center for Disease Control, cigarette
smoking kills nearly 420,000 Americans per year, most from heart and lung
disease, and cancer. Despite increased legislative and social pressures to stop
smoking, approximately 50 million U.S. adults continue to smoke. Smokers are
physiologically addicted to the drug nicotine, which is present in tobacco.
However, the primary health risk of smoking is caused by cigarette tars and
other components of tobacco smoke rather than nicotine. Smokers who attempt to
quit typically experience cravings, headaches, irritability and nausea when the
body stops receiving nicotine.

Nicotine replacement systems using transdermal patches or chewing gum have
been approved as safe and effective aids to relieve nicotine withdrawal
symptoms. Over the course of several months of therapy, nicotine addiction can
generally be attenuated or eliminated by gradually reducing the level of
nicotine delivered in the therapy. Transdermal nicotine patches were first
commercially available in the U.S. in 1991. The market for nicotine transdermal
systems experienced strong initial sales in 1992 as a result of initial stock
requirements of distributors and pharmacies, strong initial patient demand and
market promotion; since 1992 demand has contracted. However, according to
industry sources, smoking cessation is estimated to be a $450 million market
worldwide in 1996.

In July 1996, Cygnus' smoking cessation transdermal patch was the first
nicotine patch to be approved by the FDA for over-the-counter status in the U.S.
The Company's Nicotrol product had previously been approved for non-prescription
sale in the United Kingdom, Italy, and certain other European countries. The
Company believes the switch to over-the-counter status will positively affect
the smoking cessation category.

NICOTROL. Nicotrol, Cygnus' nicotine transdermal system, was introduced in
the U.S. as a prescription product in August 1992. In contrast to 24-hour
nicotine transdermal systems, Nicotrol's 16-hour delivery more closely parallels
the nicotine intake of a smoker. Nicotrol is designed to deliver nicotine only
while the patient is awake. This allows drug levels to be significantly reduced
in the bloodstream during sleep.

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Although controlled scientific studies comparing Nicotrol to competing products
have not yet been performed, the Company believes that nicotine delivery during
waking hours reduces the potential side effects of insomnia, nightmares and
headaches associated with competing 24-hour delivery systems. Another advantage
of Nicotrol is the solid state technology used in the drug matrix construction,
which slows the rate of delivery of the drug and minimizes skin irritation.

Pharmacia funded a portion of the development of Nicotrol, and has exclusive
worldwide rights to market the product. Pharmacia has sublicensed to Johnson &
Johnson the marketing rights to Nicotrol in North America. Cygnus was required,
per the amended November 1993 agreement, to manufacture and supply Pharmacia
with Nicotrol in North America until December 31, 1995. In February of 1996, the
Company and Pharmacia further amended the 1993 agreement, whereby Cygnus would
continue to manufacture and supply Nicotrol for the United States market through
1999. In addition to product revenues, the Company will also earn royalties on
sales within the United States. Pharmacia has the option to terminate this
agreement and purchase the U.S. manufacturing rights for Nicotrol upon the
payment of certain amounts to the Company. Pharmacia has exercised this option
to purchase the U.S. manufacturing rights for Nicotrol and the Company is
presently in negotiations with Pharmacia as to various transition matters
including Pharmacia's obligations for certain purchase order commitments and
existing inventory costs.

The Company currently relies on sales of Nicotrol for all of its product
sales revenues. A reduction in demand for Nicotrol would have an adverse effect
on the Company's results of operations. Although Nicotrol has been approved by
the regulatory authorities in the U.S., Canada, the United Kingdom, Italy and
several other European countries, no assurance can be given that further
regulatory approvals will be obtained. Currently, in addition to Nicotrol, there
is one other nicotine transdermal systems approved for over-the-counter sale in
the U.S The market for prescription nicotine transdermal systems experienced
strong initial sales in 1992 as a result of filling initial stocking
requirements of distributors and pharmacies, strong initial patient demand and
market promotion. However, demand for these systems has contracted since 1992.
The short- and long-term demand for Nicotrol is uncertain in both existing and
in potential markets. Furthermore, there can be no assurance that the market
demand for nicotine replacement products will be sustained or grow in the future
or that Nicotrol will maintain or increase its market share. In addition, there
can be no assurance that the Company can maintain or increase its Nicotrol sales
levels or that it will be able to sell its products profitably.

SECOND GENERATION NICOTINE TRANSDERMAL SYSTEM. The Company is developing a
portfolio of smoking cessation products designed to address currently
unsatisfied patient needs. These products are being developed to match the
nicotine dosing level with the patient's level of addiction. The first product
has completed Phase 2 clinical trials.

HORMONE REPLACEMENT

MARKET OPPORTUNITY. Recent demographic shifts towards an aging population
have resulted in an increase in the number of women entering and living many
years past menopause. The U.S. Census Bureau projects that the number of women
aged 45 to 54, the key menopausal group, is expected to grow 73% between 1990
and 2010. Menopause involves a decrease in the naturally occurring hormone
estrogen. In addition to the common menopausal symptoms, this decrease causes
osteoporosis, a progressive deterioration of the skeletal system through loss of
bone mass, which leads to increased susceptibility to bone fractures. The
decline in estrogen levels may also lead to increased risk of cardiovascular
disease. In response to these conditions, physicians often prescribe hormone
replacement therapy using either estrogen or a combination of estrogen and
progestin. However, industry estimates indicate that only 15% of the women in
the U.S. experiencing menopause now seek medical attention. According to
industry sources, 1995 worldwide sales of hormone replacement products exceeded
$2.6 billion. The Company expects this market to expand as an increasing number
of women are exposed to menopause-related health risks for a longer period of
time. In addition, the Company believes that heightened awareness of hormone

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replacement therapy can potentially expand this market by increasing the
percentage of affected women who seek treatment.

Estrogens and progestins are primarily administered orally. The Company
believes that transdermal delivery offers a number of advantages over oral
delivery. Clinical studies suggest that the high doses of orally administered
estrogen are associated with an increase in adverse side effects, including the
risk of endometrial cancer. Transdermal delivery avoids first pass metabolism
through the gastrointestinal tract and the liver, and as a result requires a
substantially lower dosage than oral delivery and may accordingly significantly
reduce dosage-related side-effects. In addition, it has been estimated that over
50% of women on replacement oral estrogen do not comply with their prescribed
dosing regimen. The convenience of transdermal patches lasting up to a week can
significantly improve patient compliance.

The Company believes that its transdermal hormone replacement products have
a competitive advantage over certain transdermal hormone replacement products as
a result of their seven-day extended delivery systems and superior patient
comfort profile. Many hormone replacement products under development by
competitors last for only 3.5 days. The Company believes, based in part on its
market research, that patients and physicians prefer 7-day systems to 3.5-day
systems because of increased convenience and the potential for improved
compliance. In addition, the Company believes its products will result in less
irritation and greater patient comfort than certain currently marketed
transdermal products, which could also lead to improved compliance.

ESTROGEN AND ESTROGEN/PROGESTIN TRANSDERMAL SYSTEMS. In designing its
hormone replacement patches, Cygnus identified certain product features that it
believes will give its product significant competitive advantages as compared to
the leading product, a 3.5-day estrogen patch: extended wear time, improved
adhesion, good skin tolerance, and greater comfort. The Company believes that
the solid drug matrix design of its 7-day patch enhances drug permeation while
providing improved skin tolerance, adhesion and appearance.

The first Cygnus estrogen transdermal system, FemPatch, was developed under
an agreement with Sanofi, a French pharmaceutical company. Warner-Lambert, which
is Sanofi's North American sublicensee, will market the product upon receipt of
regulatory approval. In May 1995, after Warner-Lambert had completed the
originally designed Phase 3 clinical studies for this product, the FDA requested
limited additional clinical data due to an improvement by Cygnus in the
quality-control specifications for one of the raw materials used in the patch.
Because the Company made this change after the Phase 3 studies, the FDA
requested the additional data to show that the patches currently produced are
equivalent to those used in the clinical trials. Warner-Lambert conducted a
bioequivalency study to meet the FDA request. The FDA approved FemPatch in
December 1996.

In December 1993, Cygnus and American Home Products entered into a multiple
product agreement for the development, manufacturing and marketing of
transdermal patches for hormone replacement and possibly other markets. Under
the terms of the agreement, American Home Products has worldwide marketing
rights with respect to the products resulting from the collaboration. Cygnus
received up-front fees and is entitled to receive milestone payments as well as
a percentage of net sales on all products to be manufactured by Cygnus for the
worldwide market. In addition, American Home Products will pay for all clinical
trial expenses. Cygnus is otherwise responsible for financing the development
and manufacture of the products.

Cygnus is developing two products that are covered by the American Home
Products agreement. The first is a new 7-day estrogen system for which Phase 3
clinical trials have begun. Cygnus is also developing a 3.5-day transdermal
product that is designed to deliver estrogen and progestin simultaneously from a
single drug matrix at different rates. This product is in Phase 3 clinical
trials.

The Company and Sanofi are currently engaged in an arbitration proceeding
relating to the agreements under which Sanofi was granted the marketing rights
to the FemPatch product. As part of this

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arbitration proceeding, Sanofi has asserted that the Company breached its
contractual obligations to Sanofi by pursuing the commercialization of
transdermal hormone replacement products with Warner-Lambert and American Home
Products. See Item 3--"Legal Proceedings."

CONTRACEPTION

Industry sources estimate the 1995 worldwide market for contraception to be
approximately $2.5 billion. The predominant method of birth control is the oral
contraceptive pill. The pill contains an estrogen and a progestin, and suffers
similar limitations as oral estrogen-based hormone therapy for menopausal
symptoms. In addition, the daily requirement of oral contraceptives occasionally
results in missed days of therapy and potentially unwanted pregnancy.

Cygnus is developing a 7-day contraceptive patch which could lead to
improved dosing compliance. In June 1994, Cygnus signed an agreement with
Johnson & Johnson for the development of a 7-day contraceptive transdermal
product. Johnson & Johnson has exclusive worldwide marketing rights to the
product; Cygnus received up-front payments and will receive milestone payments
as well as a percentage of net sales, and is responsible for the development and
manufacture of the products. This product is in Phase 2 clinical trials.

MUCOSAL PRODUCTS

Cygnus' expertise in transdermal drug delivery has led to a natural
extension of the Company's business into the development of mucosal drug
delivery products. Mucosal products are designed to provide the controlled
release of compounds through mucous membranes using a disc, spray, lozenge or
other system. Drugs delivered through mucous membranes have the potential to
provide a faster onset and longer duration of action than certain products
currently on the market. Mucosal delivery systems can act either locally (such
as in the throat) or systemically (through the bloodstream). A number of
consumer tests have demonstrated the capability of this delivery technology to
achieve a longer duration of action than currently marketed products in certain
markets. Cygnus is pursuing potential collaborative partners for mucosal
delivery products in both prescription and non-prescription markets.

NEED TO DEVELOP NEW PRODUCTS; DEVELOPMENT STAGE OF CURRENT PRODUCTS.

For the Company to be successful, it will need to develop and commercialize
new drug delivery and diagnostic products. Several products based on the
Company's technologies are currently under development by Cygnus and its
licensees. These products will require significant additional development and
investment, including preclinical and clinical testing, prior to their
commercialization and are not expected to be commercially available for several
years, if at all. There can be no assurance that such products or future
products can or will be successfully developed, prove to be safe and effective
in clinical trials, meet applicable regulatory standards, be capable of being
manufactured in commercial quantities at reasonable cost or be marketed
successfully. During 1994 and early 1995, the Company ceased certain of its
previous development efforts. For example, the Company has suspended the
development of transdermal systems for the delivery of alprazolam and prazosin,
primarily due to the systems' failure to meet financial/market goals. As
illustrated by the product development efforts recently terminated by the
Company, there can be no assurance that initial product development efforts or
third party collaborations will be successful.

Before the Company can market its GlucoWatch device, it must first complete
the development of a version of the product designed for commercial sale, then
conduct large scale clinical trials, prepare a submission to the FDA and obtain
clearance or approval from the FDA. Each of these stages will involve certain
risks and challenges. To date, the Company has only developed and tested a
research prototype of the GlucoWatch. Large scale clinical trials must be
conducted using a version of this device designed for commercial production and
sale. In order to develop a commercial version of the GlucoWatch, the

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Company must successfully complete certain additional development milestones,
including the optimization and miniaturization of certain components and
integration of each component into a compact and operative device. There can be
no assurances that the Company will succeed in these further developments. The
components of the commercial version of the GlucoWatch will vary in a number of
respects from those used in the earlier prototype with which the Company has
conducted its early stage clinical studies, and no assurance can be given that
clinical trials using the commercial prototype will produce results that are
consistent with the early stage clinical studies or that will support the
necessary regulatory filings and approvals. See Item 7--"Management's Discussion
and Analysis of Financial Condition and Results of Operations."

GOVERNMENT REGULATION

The development, manufacture and marketing of drug delivery systems and
diagnostic devices are subject to regulation by the FDA and other federal, state
and local entities. These entities regulate, among other things, research and
development activities and the testing, manufacture, safety, effectiveness,
labeling, storage, record keeping, approval, advertising and promotion of the
Company's products. Sales of the Company's products outside the U.S. are subject
to comparable regulatory requirements. These requirements vary widely from
country to country.

FDA permission to market and distribute a new device can be obtained in one
of two ways. If a new or significantly modified device is "substantially
equivalent" to an existing legally marketed device, the new device can be
commercially introduced after submission of a 510(k) notification to the FDA,
and after the subsequent clearance or approval by the FDA. Changes to existing
devices that do not significantly affect safety or effectiveness can be made by
the Company without a 510(k) notification.

The second, more comprehensive approval process applies to a new device that
is not substantially equivalent to an existing product. First, the Company must
conduct clinical trials in compliance with testing protocols approved by an
Institutional Review Board ("IRB") for the participating research institution.
Second, the Company must submit a Pre-Market Approval ("PMA") application that
contains, among other things, the results of the clinical trials. The PMA
application also contains other information required under the Federal Food,
Drug, and Cosmetic Act, such as a full description of the device and its
components, a full description of the methods, facilities and controls used for
manufacturing and proposed labeling. Finally, the manufacturing site for the
product subject to the PMA must operate using current good manufacturing
practices ("cGMP") and pass an FDA Pre-Approval Inspection ("PAI") before
product commercialization.

The Company believes that the submission to the FDA for the GlucoWatch will
be in the form of a 510(k) notification, although the final determination of the
type of submission cannot be made until discussions are held with the FDA. For
the glucose monitoring device being developed by Cygnus, both the 510(k) and PMA
processes would include: (i) pre-clinical tests, (ii) receipt of Non-Significant
Risk ("NSR") device investigation status by an IRB or filing of an
Investigational Device Exemption ("IDE") application, (iii) adequate and
controlled human clinical trials to establish the safety and efficacy of the
diagnostic device in its intended application, and (iv) FDA clearance or
approval. Delays or failures to receive clearance following a 510(k)
notification or approval of a PMA application could have a significant adverse
effect on the Company's business, financial condition and results of operations.

The process required by the FDA before a drug delivery system may be
marketed in the U.S. depends on whether the compound has existing approval for
use in other dosage forms. If the drug is a new chemical entity that has not
been approved, then the process includes (i) pre-clinical laboratory and animal
tests, (ii) the filing of an IND application, (iii) adequate and controlled
human clinical trials to establish the safety and efficacy of the drug in its
intended indication and (iv) FDA approval of an NDA. If the drug has been
previously approved, then the approval process is similar, except that certain
toxicity tests

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normally required for the IND and NDA applications may not be necessary. In
addition to the foregoing, the FDA requires proof that the drug delivery system
delivers sufficient quantities of the drug to the bloodstream to produce the
desired therapeutic result.

The results of preclinical studies and clinical studies are submitted to the
FDA in a submission for approval or clearance of the marketing and commercial
shipment of a drug delivery or diagnostic system. The FDA may deny a clearance
or approval if applicable regulatory criteria are not satisfied, or may require
additional clinical testing. Even if such data are submitted, the FDA may
ultimately decide that the submission does not satisfy the criteria for
clearance or approval. Product approvals may be withdrawn if compliance with
regulatory standards is not maintained or if problems occur after the product
reaches the market. The FDA may require testing in addition to surveillance
programs to monitor the effect of products that have been commercialized, and it
has the power to prevent or limit further marketing of the product based on the
results of these post-marketing programs.

Cygnus' licensees historically have been responsible for the clinical and
regulatory approval procedures. Cygnus has participated in this process by
submitting to the licensee portions of the Drug or Master File maintained by
Cygnus and data concerning the manufacturing process for the drug delivery
system. Cygnus' ability to manufacture and sell products developed under
contract depends upon the licensee's completing satisfactory clinical trials and
obtaining the foregoing approvals or clearances. Cygnus may prepare and submit
an IND or IDE application, or obtain NSR device investigation status from an
IRB, and perform initial clinical studies before licensing the product for
marketing. The Company is increasingly taking a more active role with its
collaborative partners in the clinical trials and regulatory processes of its
products.

There can be no assurance that problems will not arise that could delay or
prevent the commercialization of the Company's products, or that the FDA, state
and foreign regulatory agencies will be satisfied with the results of the
clinical trials and approve the marketing of any products.

REGULATORY APPROVALS UNCERTAIN.

The Company's products require the approval of the FDA before they can be
marketed in the U.S. In addition, approvals are required from regulatory
agencies in most foreign countries before the Company's product can be marketed
in such countries. To date, the Company has two products which have received FDA
approval, Nicotrol and FemPatch. Before a regulatory submission can be filed
with the FDA, a product must undergo extensive clinical trials. The Company's
drug delivery systems require the filing of a New Drug Application ("NDA") with
the FDA, and the FDA's approval of the NDA. Devices such as the glucose
monitoring system under development by the Company will require the filing and
FDA clearance or approval of a medical device submission. The time required for
regulatory approval of the Company's products after a filing is uncertain. There
can be no assurance that problems will not arise that could delay or prevent the
commercialization of the Company's products or that the FDA and foreign
regulatory agencies will be satisfied with the results of clinical trials or
approve the marketing of any products. Moreover, even if regulatory approval is
granted, such approval may include significant limitations on indicated uses for
which any such products could be marketed.

The Company believes that the submission to the FDA for the GlucoWatch will
be in the form of a premarket notification (a "510(k) notification"), although
the final determination of the type of submission cannot be made until
discussions are held with the FDA. In the event that a 510(k) notification is
not accepted by the FDA, the Company will be required to submit a pre-market
approval application ("PMA") for this product, rather than a 510(k)
notification. The FDA approval process for a PMA is typically more involved and
requires more time than a 510(k) submission.

A drug or medical device and its manufacturer are subject to continual
review after approval, and later discovery of previously unknown problems with a
product or the manufacturing process may result in restrictions on such product
or the manufacturer, including withdrawal of the product or products from the

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market. Failure to comply with applicable regulatory requirements may, among
other things, result in fines, suspensions of regulatory approvals, product
recalls, operating restrictions and criminal prosecution. In addition, new
government regulations may be established that could delay or prevent regulatory
approval of the Company's potential products. Cygnus is also subject to
regulation under federal, state and local regulations regarding work place
safety, environmental protection and hazardous and controlled substance
controls, among others.

DEPENDENCE ON LICENSEES AND COLLABORATIVE ARRANGEMENTS.

Cygnus depends on its licensees to fund a significant portion of product
development costs, to conduct clinical testing, to obtain regulatory approvals
and to market products. The Company is dependent on Pharmacia & Upjohn (formerly
Kabi Pharmacia Therapeutics AB), a subsidiary of Procordia AB ("Pharmacia") and
its sublicensee Johnson & Johnson for the marketing of Nicotrol. In February
1996, the Company entered into an agreement with Becton Dickinson for the
marketing and distribution of the GlucoWatch. Under the terms of the agreement,
Becton Dickinson has exclusive worldwide marketing and distribution rights, with
the exception of Japan and Korea. Cygnus will have primary responsibility for
completing product development, obtaining regulatory approvals, manufacturing,
and customer service and support for the product. In July 1996, the Company
entered into an agreement with Tokyo-based Yamanouchi Pharmaceutical Co., Ltd.
for the marketing and distribution of the GlucoWatch in Japan and Korea. Cygnus
will have primary responsibility for completing product development and for
manufacturing. Cygnus will be eligible to receive up-front and milestone
payments as well as a percentage of the product's future commercial success from
both Becton Dickinson and Yamanouchi. The Company's licensees generally have the
right to terminate the development funding for a product at any time for any
reason without significant penalty. Licensees have exercised this right in the
past, and there can be no assurance that current and future licensees will not
also exercise this right in the future.

Additionally, the resources and attention a licensee devotes to a product
are not within the Company's control. As a result, there may be delays in
clinical testing, the preparation and processing of regulatory filings and
commercialization efforts conducted by the Company's licensees. Certain of the
Company's licensees may also be permitted to offer products that are competitive
with those of the Company, which could interfere with their efforts on behalf of
the Company. The Company's ability to develop and commercialize products in the
future will also depend on its ability to enter into collaborative arrangements.
There can be no assurance that the Company will be able to enter into new
collaborative arrangements or renew existing collaborative arrangements.
Additionally, there can be no assurance that existing or future collaborative
arrangements will be successful. See Item 7--"Management's Discussion and
Analysis of Financial Condition and Results of Operations."

COMPETING PRODUCTS AND CHANGES IN TECHNOLOGY.

A large number of pharmaceutical companies are involved or are becoming
involved in the development and commercialization of products incorporating
advanced or novel drug delivery and diagnostic systems. This field is highly
competitive, and Cygnus believes that competition will substantially increase in
the future. A number of pharmaceutical companies have invested, and are
continuing to invest, significant resources in the development of their own drug
delivery and diagnostic systems. In addition, a number of companies have been
formed to develop specific advanced drug delivery and diagnostic systems. Many
of these pharmaceutical and other companies have greater financial, research and
development and other resources than Cygnus, as well as more experience than
Cygnus in commercializing pharmaceutical, drug delivery and diagnostic products.
Such companies may improve existing drug formulations and products more
efficiently than Cygnus and thus may represent significant potential
competitors. Other companies, which have substantially greater financial and
research and development resources than Cygnus, may acquire the skills required
to design and develop transdermal drug delivery and diagnostic systems and thus
may represent significant potential for future competition.

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The blood glucose monitoring industry is characterized by frequent new
product introductions and changes in technology. The Company's primary
competitors in the glucose monitoring industry are expected to include companies
that currently market finger stab method products. These companies have
significantly greater resources than Cygnus and could use these resources to
hinder the market penetration of the Company's product. In addition, a number of
companies are engaged in the development of products using technology which is
different than that under development by Cygnus, but also intended to permit
painless glucose monitoring. For example, a number of competitors are developing
non-invasive glucose monitoring devices based on infrared spectroscopy. These
devices would illuminate body tissue with radiation and measure the rate at
which the radiation is absorbed. There can be no assurance that these products
will not render the Company's glucose monitor uncompetitive or obsolete. In
addition, a number of companies are seeking to develop new drugs to treat
diabetes, and if any such development is successful it could reduce demand for
glucose monitoring systems.

The drug delivery industry is a rapidly evolving field. A number of other
companies, including major pharmaceutical companies, are also developing and
marketing transdermal, mucosal and similar systems for the controlled delivery
of drugs. Products currently on the market or under development by competitors
deliver the same drugs, or other drugs to treat the same indications as many of
the products under development by the Company. The first pharmaceutical product
to reach the market in a therapeutic area often obtains and maintains
significant market share relative to later entrants to the market. The Company's
transdermal and mucosal drug delivery products will also compete with drugs
marketed not only in similar drug delivery systems but also in traditional
dosage forms such as oral administration, bolus injection and continuous
infusion. New drugs, new therapeutic approaches or future developments in
alternative drug delivery technologies, such as time-release capsules, liposomes
and implants, may provide therapeutic or cost advantages over the drug delivery
systems being developed by the Company.

Changes in drug delivery and diagnostic technology will require substantial
investments by companies to maintain their competitive position and may provide
opportunities for new competitors to enter the industry. There can be no
assurance that developments by others will not render the Company's drug
delivery or diagnostic products or other technologies uncompetitive or obsolete.

Cygnus generally seeks to retain rights to manufacture the transdermal
products developed for its licensees. To date, Cygnus has manufactured only
Nicotrol in commercial quantities on a continuous basis. No assurance can be
given that manufacturing or control problems will not arise as the Company
increases production of its products or as additional facilities are required in
the future. Cygnus must continue to develop, adapt or acquire the production
technology, facilities and technical and managerial personnel to manufacture
each of its planned products in commercial quantities or find alternative means,
if available, to manufacture such products. No assurance can be given that
Cygnus will be able to successfully increase its manufacturing capabilities at a
reasonable cost. The production of the GlucoWatch will involve the manufacture
and assembly of electronic and other components that require manufacturing and
sourcing capabilities with which the Company has little experience. No assurance
can be given that the Company will be able to develop these manufacturing
capabilities or arrange for qualified sources of those components that it is not
able to manufacture.

Furthermore, the manufacture of the Company's products is subject to current
good manufacturing practices requirements prescribed by the FDA or other
standards prescribed by the appropriate regulatory agency in the country of use.
Additionally, the Company's agreements with licensees either specify pricing
formulas for products manufactured and sold by Cygnus to its licensees or
specify that prices will be negotiated in the future. There can be no assurance
that prices for the Company's products will cover the manufacturing costs for
these products in light of the Company's limited manufacturing experience and
general supply and demand conditions in the marketplace.

The Company expects to market and sell certain of its products directly or
through co-promotion with third parties. The Company has limited experience in
sales, marketing or distribution. If the Company

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wishes to market a product directly, the Company must develop a substantial
marketing staff and sales force with technical expertise. There can be no
assurance that the Company will be able to build such a marketing staff or sales
force, that the cost of establishing such a marketing staff or sales force will
not exceed any product revenues, or that the Company's direct sales and
marketing efforts will be successful. In addition, the Company may have to
compete with other companies that currently have extensive and well-funded
marketing and sales operations.

THIRD-PARTY REIMBURSEMENT.

Successful commercialization of certain of the Company's products may depend
in part on the availability of reimbursement from third-party health care
payors, such as private insurance plans and the government. There can be no
assurance that such reimbursement will be available. Third-party payors are
increasingly attempting to contain health care costs by limiting both coverage
and the level of reimbursement for new therapeutic and diagnostic products. This
could potentially have an adverse effect on the Company.

PATENTS AND PROPRIETARY RIGHTS

The Company's policy is to file patent applications in appropriate
situations to protect and preserve, for its own use, technology, inventions and
improvements that it considers important to the development of its business. The
Company seeks patent protection for its proprietary technologies and products in
the U.S., Canada, Australia and key European and Asian countries. The Company
also relies on trade secrets, know-how, continuing technological innovations and
licensing opportunities to develop and maintain its competitive position.

The GlucoWatch incorporates technology developed by Cygnus as well as
technology licensed exclusively to the Company by the University of California
at San Francisco ("UCSF"). UCSF holds two U.S. patents covering technology for
extraction of glucose and other analytes through the intact skin, and has a
pending U.S. patent application containing further claims. Corresponding foreign
applications are also pending. The Company has an exclusive license worldwide
under these patents and patent applications. Certain of the Company's glucose
monitoring technology had been developed under research and development
agreements between Cygnus and PaineWebber R&D Partners II, L.P. In December
1994, Cygnus acquired all of this entity's rights to this technology in exchange
for 1,529,941 shares of Cygnus' common stock. The Company has filed ten
applications for U.S. patents covering aspects of glucose monitoring technology.

Cygnus has filed patent applications in the U.S. and elsewhere covering
aspects of the composition and manufacture of its transdermal drug delivery
systems which it considers patentable. As of December 31, 1996, the Company had
a total of 31 U.S. patents issued or allowed, covering compounds that alter the
skin's permeation properties, the composition of elastomeric transdermal
products, a process for fabricating volatile and heat sensitive drugs into a
solid matrix transdermal patch, and ultrasound enhanced drug delivery. The
Company has issued United States and foreign patents relating to its transdermal
hormone delivery systems and additional applications directed to alternative
delivery systems useful for hormone replacement therapy. The Company has
numerous additional patent applications worldwide, covering transdermal patch
composition, usage, application and chemical enhancers.

The Company's success depends in large part on its ability to obtain patent
protection for its products, preserve its trade secrets and operate without
infringing the proprietary rights of others, both in the U.S. and in other
countries. Patent applications in the U.S. are maintained in secrecy until
patents issue, and since publication of discoveries in the scientific or patent
literature tends to lag behind actual discovery by several months, Cygnus cannot
be certain that it was the first to file patent applications on such inventions.
No assurance can be made that patents will issue with respect to any of the
Company's patent applications or that any patents will provide competitive
advantages for its products or will not be challenged or

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circumvented by competitors. Cygnus also relies on trade secrets and proprietary
know-how that it seeks to protect, in part, by confidentiality agreements with
its licensees, employees and consultants. There can be no assurance that these
agreements will not be breached, that the Company would have adequate remedies
for any breach or that the Company's trade secrets will not otherwise become
known or be independently developed by its competitors.

The design, development, manufacture and use of the Company's products
involve an inherent risk of product liability claims and associated adverse
publicity. The Company currently maintains liability insurance; however, there
can be no assurance that its insurance will be adequate to cover claims made
against the Company. Such insurance is expensive, difficult to obtain and may
not be available in the future on acceptable terms or at all. A successful claim
brought against the Company in excess of the Company's insurance coverage could
have a material adverse effect upon the Company and its financial condition.

Any litigation, in the U.S. or abroad, as well as any interference
proceedings that may be declared by the United States Patent and Trademark
Office (the "Patent Office") to determine the priority of inventions, could
result in substantial expense to the Company and significant diversion of effort
by the Company's technical and management personnel. Litigation may be necessary
to enforce patents issued to the Company or to protect trade secrets or know-how
owned by the Company. A negative determination in litigation or interference
proceedings in which the Company is a party could subject the Company to
significant liabilities to third parties or require the Company to seek licenses
from third parties. Although patent and intellectual property disputes in the
pharmaceutical product area have often been settled through licensing or similar
arrangements, costs associated with such arrangements may be substantial and
could include ongoing royalties. Furthermore, there can be no assurance that
necessary licenses would be available to the Company on satisfactory terms if at
all. Accordingly, an adverse determination in a judicial or administrative
proceeding or failure to obtain necessary licenses could prevent the Company
from manufacturing and selling certain of its products which would have a
material adverse effect on the Company.

Alza Corporation ("Alza") owns a patent that was issued on May 13, 1986 and
contains claims for the transdermal delivery of fentanyl. The Alza fentanyl
patent claims were reviewed by the Patent Office during two re-examination
procedures, one of which was instituted by Cygnus, but were nevertheless
confirmed in January 1989. In January 1994, Cygnus filed a complaint in the U.S.
District Court in San Francisco, California against Alza for violation of the
antitrust laws and for declaration of unenforceability and invalidity of the
Alza patent on fentanyl transdermal systems. In April 1995, motions by Alza to
dismiss the suit were granted primarily on the basis that Alza had made
insufficient threat of enforcement. The Company appealed this ruling in May
1995. The United States Court of Appeals for the Federal Circuit upheld a 1995
decision of the United States District Court for the Northern District of
California which dismissed Cygnus' action seeking a declatory judgment of
invalidity and/or unenforceability of Alza Corporation's United States patent
relating to the transdermal administration of fentanyl. In dismissing the
action, the court did not consider the merits of Cygnus' arguments relating to
invalidity/unenforceability of the Alza Corporation patent nor associated
antitrust claims, but rather dismissed the action on jurisdictional grounds as
failing to establish the presence of an actual controversy between the parties.
The Company has effectively suspended its development efforts for the
transdermal administration of fentanyl.

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and that such claims are otherwise without merit. Cygnus plans to continue
aggressively defending against this arbitration and has asserted certain
counterclaims exceeding the amount being sought by Sanofi. A hearing was held in
May 1996 with respect to the liability aspects of Sanofi's claims against
Cygnus, and the Tribunal of International Chambers of Commerce (the "Tribunal")
announced an interim award in the arbitration proceedings in October 1996. The
Tribunal found that two transdermal products for hormone replacement therapy
licensed by Cygnus to another company fall within the scope of exclusive license
previously granted to Sanofi. Remaining to be heard are Cygnus' liability claims
against Sanofi and a determination as to the amount of damages to be awarded to
either party. The first of these further hearings is scheduled to take place in
March 1997. Should all or part of the claims as sought for by Sanofi, and in the
amounts asserted be successful, and should Cygnus' counter claims and defenses
not be allowed, the Company could be materially and adversely affected.

MANUFACTURING

Cygnus generally retains manufacturing rights for its products. The
Company's transdermal patches are manufactured using several proprietary
materials and production technologies developed by Cygnus in conjunction with
equipment and material suppliers. Production of advanced transdermal drug
delivery and diagnostic systems requires specialized skills in several areas,
such a polymer chemistry and adhesive technology. Since the Company designs a
unique transdermal system for each drug, Cygnus' process development engineers
become involved early in the product design process. The Company believes that
close interaction at the design stage permits development of efficient
manufacturing techniques. In addition, Cygnus performs analytical testing
in-house for each aspect of the manufacturing process, from raw material studies
to final product characterization. The Company has developed proprietary assays
to measure patch characteristics such as drug release rate, drug and solvent
residues, and product stability. The Company has patented certain aspects of its
manufacturing processes.

Several materials used in the Company's products are currently obtained from
single sources. Although the Company has not experienced difficulty acquiring
these materials for the manufacture of its products for sale or clinical trials,
there can be no assurance that supply interruptions will not occur or that the
Company will not have to obtain substitute vendors, if such vendors are
available, which would require additional regulatory submissions and approvals.
Any such interruption of supplies could have a material adverse effect on the
Company's ability to develop, manufacture and sell its products.

The Company has a 21,000 square foot manufacturing facility and a 22,000
square foot warehouse used in the commercial production of Nicotrol and
FemPatch, and the clinical supply of other products. The Company believes the
facility will have sufficient capacity to support the planned market
introduction of its current products. The facility complies with applicable
regulatory requirements. In December 1996, the FDA approved the FemPatch NDA.
See "Government Regulation."

EMPLOYEES

As of February 10, 1997, the Company had 180 employees. Of this total number
of employees, 74 were engaged in research and development, including process
development, 31 in scientific/regulatory affairs and quality assurance, 21 in
general administration, finance, information technology and business
development, and 54 in operations and human resources. None of the Company's
employees is represented by a labor union. Cygnus has experienced no work
stoppages and it believes its employee relations are good.

19
<PAGE>
The Company's success will depend in large part on the continued services of
its scientific, managerial and manufacturing personnel. The loss of a
significant group of key personnel could have a material adverse effect on the
Company. The Company's success also depends upon its ability to continue to
attract and retain other highly qualified scientific, managerial and
manufacturing personnel. Competition for such personnel is intense. In this
respect, the Company competes with numerous pharmaceutical and health care
companies, as well as universities and nonprofit research organizations. There
can be no assurance that the Company will continue to be able to attract and
retain sufficient qualified personnel.

ITEM 2. PROPERTIES

Cygnus leases approximately 92,000 square feet in four buildings. Three are
located in Redwood City, California and the fourth is located in Menlo Park,
California. The headquarters building, approximately 38,000 square feet, is used
for laboratories and administrative offices. The manufacturing building,
approximately 21,000 square feet, is wholly dedicated to manufacturing and
support. The third facility, also in Redwood City, California, has approximately
11,000 square feet of which approximately 8,000 square feet are utilized for
additional administrative offices and the remainder is reserved for expansion
purposes. The fourth facility, which is located in Menlo Park, has approximately
22,000 square feet, and is used for storage of manufacturing materials and final
products.

The three facilities in Redwood City are leased through 1998 with an option
to renew at the then fair market value through 2003. The facility in Menlo Park
is leased over a three period ending in 1999.

The manufacturing facility was designed and constructed to comply with cGMP
standards. Cygnus has received licenses from the California Department of Health
Services and the DEA for the manufacture of drug products in this facility, and
has filed a Drug Master File for the facility with the FDA. The Company believes
that this manufacturing facility has sufficient capacity to meet current
operating requirements and satisfy foreseeable future demands for its commercial
products Nicotrol and FemPatch. To the extent that the manufacturing facility is
not used for commercial production, the Company intends to maintain a minimum
level of staffing and utilize the excess capacity for producing clinical
supplies and process improvement.

As the Company completes the development of its hormone replacement
products, it will begin the evaluating its existing manufacturing plans under
which a new manufacturing site may become necessary.

ITEM 3. LEGAL PROCEEDINGS

The United States Court of Appeals for the Federal Circuit upheld a 1995
decision of the United States District Court for the Northern District of
California which dismissed Cygnus' action seeking a declatory judgment of
invalidity and/or unenforceability of Alza Corporation's United States patent
relating to the transdermal administration of fentanyl. In dismissing the
action, the court did not consider the merits of Cygnus' arguments relating to
invalidity/unenforceability of the Alza Corporation patent nor associated
antitrust claims, but rather dismissed the action on jurisdictional grounds as
failing to establish the presence of an actual controversy between the parties.
The Company has effectively suspended its development efforts for the
transdermal administration of fentanyl.

20
<PAGE>
and that such claims are otherwise without merit. Cygnus plans to continue
aggressively defending against this arbitration and has asserted certain
counterclaims exceeding the amount being sought by Sanofi. A hearing was held in
May 1996 with respect to the liability aspects of Sanofi's claims against
Cygnus, and the Tribunal of International Chambers of Commerce (the "Tribunal")
announced an interim award in the arbitration proceedings in October 1996. The
Tribunal found that two transdermal products for hormone replacement therapy
licensed by Cygnus to another company fall within the scope of exclusive license
previously granted to Sanofi. Remaining to be heard are Cygnus' liability claims
against Sanofi and a determination as to the amount of damages to be awarded to
either party. The first of these hearings is scheduled to take place in March
1997. Should all or part of the claims as sought for by Sanofi, and in the
amounts asserted be successful, and should Cygnus' counter claims and defenses
not be allowed, the Company could be materially and adversely affected.

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

No matters were brought to a vote of the Company's Stockholders in the
quarter ended December 31, 1996.

21
<PAGE>
EXECUTIVE OFFICERS

As of February 1, 1997, the executive officers of the Company, who serve at
the discretion of the Board of Directors, are as follows:

<TABLE>
<CAPTION>
NAME AGE TITLE
- ----------------------------------------------------- --- -----------------------------------------------------

<S> <C> <C>
Gary W. Cleary, Ph.D................................. 54 Chairman of the Board of Directors and Chief
Technical Officer

Gregory B. Lawless, Ph.D............................. 57 President, Chief Executive Officer and Director

Neil R. Ackerman, Ph.D............................... 53 Senior Vice President, Research & Development

Craig W. Carlson..................................... 48 Vice President, Corporate Marketing and Strategic
Planning

James F. Grady, Jr., Ph.D............................ 48 Vice President, Operations and Human Resources

John C. Hodgman...................................... 42 Vice President, Finance and Chief Financial Officer;
President, Cygnus Diagnostics

Stephen N. Kirnon.................................... 34 Vice President, Business Development

Alan F. Russell, Ph.D................................ 55 Senior Vice President, Scientific Affairs
</TABLE>

Dr. Cleary, the Company's founder and Chairman of the Board of Directors,
also served as the Company's President and Chief Executive Officer from its
inception until July 1986. Since 1986, Dr. Cleary has served as Chief Technical
Officer of the Company. During his professional career, Dr. Cleary served as an
investigator with the U.S. Food and Drug Administration and held research and
management positions at Cutter Labs, Alza Corporation, Key Pharmaceuticals, Inc.
and Genentech Inc. Dr. Cleary holds an M.B.A. in Health Sciences from the
University of Miami, a Ph.D. in Pharmaceutical Sciences from Rutgers University
and a Pharm.D. in Pharmacy from the University of California, San Francisco.

Dr. Lawless joined Cygnus in January 1992 as President, Chief Executive
Officer and Director. From March 1989 to January 1992, Dr. Lawless was President
and Chief Operating Officer of Chiron Corporation, a biopharmaceutical company.
Prior to joining Chiron he held various positions with the DuPont Co. from May
1969 to March 1989, including serving as Chief Operating Officer of its
pharmaceutical subsidiary and as Director of DuPont Specialty Diagnostic
Division. He holds a Ph.D. in Pharmaceutical Chemistry from Temple University.

Dr. Ackerman joined Cygnus in May of 1994 as Vice President of Research and
Development. In January 1997 Dr. Ackerman was promoted to Senior Vice President
of Research and Development. Since 1990, Dr. Ackerman served as Vice President
of Research and Development for Glycomed, leading their discovery efforts
focused on cardiovascular and inflammatory diseases. From 1982 to 1990, he was
Research Director, Cancer and Inflammatory Diseases, with DuPont
Pharmaceuticals, responsible for leading a 100-person staff that had the
objective of discovering therapeutics for cancer, inflammatory and immune-based
diseases. Prior to that he was employed by Syntex and Pfizer in research and
management capacities. Dr. Ackerman received a B.S. and Ph.D. from the
University of Maryland and completed a post-doctoral fellowship at Stanford
University.

Mr. Carlson joined the Company in July 1993 as Vice President, Corporate
Communications, after 15 years in the advertising and marketing industry. In
January 1997, Mr. Carlson was given additional responsibilities for strategic
planning. His current title is Vice President, Corporate Marketing and Strategic
Planning. From 1988 to July 1993, he was Vice President and Group Director at
Young &

22
<PAGE>
Rubicam Advertising in San Francisco. Prior to that, Mr. Carlson was Vice
President of Campbell-Mithun Advertising. He holds a B.A. from Union College and
an M.B.A. from Stanford University.

Dr. Grady joined the Company in May 1993 as Vice President, Human Resources.
In June 1995, Dr. Grady was additionally appointed Vice President, Operations
and Human Resources. From January 1989 to May 1993, Dr. Grady led the human
resources function for a division of Beckman Instruments. From 1986 to January
1989, Dr. Grady held various positions with SmithKline Beckman (now SmithKline
Beechman) including Director of Compensation & Organizational Development for
their worldwide research and development business unit. He holds a B.S. in
Psychology and a Ph.D. in Education from the University of Pittsburgh.

Mr. Hodgman joined Cygnus in August 1994 as Vice President, Finance and
Chief Financial Officer. In June 1995, Mr. Hodgman was additionally appointed
President of Cygnus Diagnostics. Prior to joining Cygnus, Mr. Hodgman served as
Vice President of Operations and Finance and Chief Financial Officer for Central
Point Software, a PC and networking software company. Prior to that, he was the
Vice President of Finance and Administration and Chief Financial Officer of Ateq
Corporation. Mr. Hodgman holds a B.S. degree from Brigham Young University and
an M.B.A. from the University of Utah.

Mr. Kirnon joined Cygnus in April 1993 as Director, Business Development. In
January 1997, Mr. Kirnon was promoted to Vice President, Business Development.
Prior to joining Cygnus, Mr. Kirnon served as the National Sales & Marketing
Manager for BioGenex, Inc. Prior to that, he worked at SmithKline Beecham
Corporation. Mr. Kirnon holds a B.A. in Biochemical Sciences from Harvard
University and an MBA from Pepperdine University in General Management.

Dr. Russell joined the Company in May 1992 as Vice President, Scientific
Affairs, and was promoted to Senior Vice President in November, 1994. Dr.
Russell was Vice President for Scientific Affairs at Chiron Corporation from
1987 to April 1992. He held the same position at Beecham Laboratories from 1983
to 1987, prior to which he held various positions at Syntex Corporation from
1971 to 1983, including Director of Regulatory Affairs for Investigational
Drugs. He holds a Ph.D. in Organic Chemistry from the University of New South
Wales and an M.B.A. and J.D. from the University of Santa Clara.

23
<PAGE>
PART II

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

The market price for shares of the Company's Common Stock has been highly
volatile. Factors such as the results of preclinical studies and clinical trials
for Cygnus' products or products of its competitors, announcements of
technological innovations, strategic relationships, new product introductions by
the Company or its competitors, governmental regulation, regulatory approvals or
delays or developments relating to patent or proprietary rights, as well as
period-to-period fluctuations in financial results, may have a significant
impact on the market price of the Common Stock. Additionally, in recent years,
the stock market has experienced extreme price and volume fluctuations.

The section entitled "Market Price of and Dividends on Common Stock and
Related Shareholder Matters" on page 25 of the Company's Consolidated Financial
Statements section of the Annual Report to Stockholders for the year ended
December 31, 1996 is incorporated herein by reference.

ITEM 6. SELECTED FINANCIAL DATA

The section entitled "Selected Financial Data" on page 1 of the Company's
Consolidated Financial Statements section of the 1996 Annual Report is
incorporated herein by reference.

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

The section entitled "Management's Discussion and Analysis of Financial
Condition and Results of Operations" on pages 2 through 8 of the Company's
Consolidated Financial Statements section of the 1996 Annual Report is
incorporated herein by reference.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The consolidated financial statements and footnotes thereto, together with
the report thereon of Ernst & Young LLP dated January 20, 1997 on pages 9
through 24 of the Company's Consolidated Financial Statements section of the
1996 Annual Report is incorporated herein by reference.

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

Not Applicable.

24
<PAGE>
PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Cygnus incorporates by reference the information concerning its directors
set forth under the heading "Proposal One--Re-Election of Directors" in Cygnus'
definitive Proxy Statement filed for its 1997 Annual Meeting of Stockholders.

Information concerning Cygnus' executive officers appears at the end of Part
I of this report.

ITEM 11. EXECUTIVE COMPENSATION

Cygnus incorporates by reference the information set forth under the heading
"Executive Compensation and Other Information" in the Cygnus' definitive Proxy
Statement filed pursuant to Regulation 14A for its 1997 Annual Meeting of
Stockholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Cygnus incorporates by reference the information set forth under the heading
"Security Ownership of Certain Beneficial Owners and Management" in the Cygnus'
definitive Proxy Statement filed pursuant to Regulation 14A for its 1997 Annual
Meeting of Stockholders.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Cygnus incorporates by reference the information set forth under the
headings "Proposal One--Re-Election of Directors" and "Executive Compensation
and Other Information" in the Cygnus' definitive Proxy Statement filed pursuant
to Regulation 14A for its 1997 Annual Meeting of Stockholders.

25
<PAGE>
PART IV

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

a.1) FINANCIAL STATEMENTS AND REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The following Consolidated Financial Statements included in the Annual
Report to Stockholders are incorporated by reference in Item 8.

<TABLE>
<CAPTION>
PAGE REFERENCE IN
ANNUAL REPORT TO
STOCKHOLDERS
-----------------
<S> <C>
Consolidated Statements of Operations for the years ended December 31, 1996, 1995 and
1994................................................................................... 8
Consolidated Balance Sheets as of December 31, 1996 and 1995............................. 9
Consolidated Statement of Stockholders' Equity for the years ended December 31, 1996,
1995 and 1994.......................................................................... 10
Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1995 and
1994................................................................................... 11
Notes to Consolidated Financial Statements............................................... 12
</TABLE>

a.2) FINANCIAL STATEMENT SCHEDULE

<TABLE>
<S> <C>
II. Valuation and Qualifying Accounts.................................. S-1
</TABLE>

All other financial statement schedules are omitted because they are not
required or the information is disclosed in the financial statements listed
in item 14a.1).

b) REPORTS ON FORM 8-K

No Reports on Form 8-K were filed during the fourth quarter of 1996.

c) EXHIBITS

The following exhibits are filed herewith or incorporated by reference:

<TABLE>
<C> <S>
3.1 Bylaws of the Registrant, as amended, incorporated by reference to Exhibit
3.3 of the Registrant's Registration Statement Form S-1 No. 33-38363.

3.2 Restated Articles of Incorporation of the Registrant, as amended to date,
incorporated by reference to Exhibit 3.4 of the Registrant's Registration
Statement Form S-1 No. 33-38363.

4.1 Specimen of Common Stock certificate of the Registrant, incorporated by
reference to Exhibit 4.1 of the Registrant's Registration Statement Form
S-1 No. 33-38363.

4.2 Rights Agreement dated September 21, 1993 between the Company and Chemical
Trust Bank of California (the "Transfer Agent"), which includes the
Certificate of Determination for the Series A Junior Participating
Preferred Stock as Exhibit A, the form of Right Certificate as Exhibit B
and the Summary of Rights to purchase Preferred Shares as Exhibit C,
incorporated by reference to Exhibit I of the Registrant's Form 8-A filed
on October 21, 1993, Registration No. 0-18962.

10.1 Warrant dated September 28, 1990 issued by the Registrant to Paine Webber
R&D Partners II, L.P., incorporated by reference to Exhibit 10.5 of the
Registrant's Registration Statement Form S-1 No. 33-38363.
</TABLE>

26
<PAGE>
<TABLE>
<C> <S>
10.2 Agreement dated October 1, 1992 between the Registrant and Kabi Pharmacia,
incorporated by reference to Exhibit 19.1 of the Registrant's Form 10-Q
for the quarter ended September 30, 1992, Registration No. 0-18962.

10.3 Amended August 29, 1986 Agreement dated as of May 30, 1988 between the
Registrant and Sanofi S.A. ("Sanofi"), incorporated by reference to
Exhibit 10.9A of the Registrant's Registration Statement Form S-1 No.
33-38363.

10.4 Amendment No. 1 made as of May 4, 1990 to the Amended August 29, 1986
Agreement between the Registrant and Sanofi, incorporated by reference to
Exhibit 10.9B of the Registrant's Form S-1 Registration Statement No.
33-38363.

10.5 Amendment No. 2 made as of August 31, 1990 to the Amended August 29, 1986
Agreement between the Registrant and Sanofi, incorporated by reference to
Exhibit 10.9C of the Registrant's Form S-1 Registration Statement No.
33-38363.

10.6 Supply Agreement dated September 28, 1990 between the Registrant and Warner-
Lambert Company, incorporated by reference to Exhibit 10.12 of the
Registrant's Form S-1 Registration Statement No. 33-38363.

10.7 Agreement dated November 29, 1990 between the Registrant and Warner-Lambert
Company, incorporated by reference to Exhibit 10.13 of the Registrant's
Form S-1 Registration Statement No. 33-38363.

10.8 Ten-year Industrial Net Lease Agreement (Building No. 2) dated September 27,
1988 between the Registrant and Seaport Centre Venture Phase I,
incorporated by reference to Exhibit 10.26 of the Registrant's Form S-1
Registration Statement No. 33-38363.

10.9 Ten-year Industrial Net Lease Agreement (Building No. 8) dated September 27,
1988 between the Registrant and Seaport Centre Venture Phase I,
incorporated by reference to Exhibit 10.27 of the Registrant's Form S-1
Registration Statement No. 33-38363.

10.10 Sublease Agreement dated June 12, 1990 between the Registrant and M&T
Publishing, Inc., incorporated by reference to Exhibit 10.28 of the
Registrant's Form S-1 Registration Statement No. 33-38363.

10.11 Letter Agreement dated December 18, 1991 between the Registrant and Menlo
Capital Corporation, incorporated by reference to Exhibit 10.33 of the
Registrant's Form S-1 Registration Statement No. 33-45180.

10.12 Lease Agreement dated as of October 15, 1991 between the Registrant and
Lincoln Menlo Associates Limited, a California Limited Partnership,
incorporated by reference to Exhibit 10.34 of the Registrant's Form S-1
Registration Statement No. 33-45180.

10.13 Services Agreement made as of April 6, 1990 between the Registrant and
DepoMed Systems, Inc., incorporated by reference to Exhibit 10.35 of the
Registrant's Form S-1 Registration Statement No. 33-45180.

10.14 Loan and Security Agreement dated June 26, 1992 between the Registrant and
AT&T Commercial Finance Corporation. Incorporated by reference to Exhibit
10.30 of the Registrant's Form 10-K for the fiscal year ended December 31,
1993.

*10.15 Distributorship Agreement dated as of February 9, 1996 between the
Registrant and Becton Dickinson. Incorporated by reference to exhibit 10.1
of the Company's Form 10-Q for the quarter ended March 31, 1996.
</TABLE>

27
<PAGE>
<TABLE>
<C> <S>
*10.16 Agreement dated November 11, 1993 between the Registrant and Kabi Pharmacia
(the "Kabi Agreement") Incorporated in reference to exhibit 10.33 of the
Company's Form 10-K for the fiscal year ended December 31, 1993.

*10.17 Development, Supply and License Agreement dated December 28, 1993 between
the Registrant and Wyeth-Ayerst, a division of American Home Products (the
"U.S. Agreement") Incorporated by reference to exhibit 10.34 of the
Company's Form 10-K for the fiscal year ended December 31, 1993.

*10.18 Development, Supply and License Agreement dated December 28, 1993 between
the Registrant and Wyeth-Ayerst, a division of American Home Products (the
"International Agreement") Incorporated by reference to exhibit 10.35 of
the Company's Form 10-K for the fiscal year ended December 31, 1993.

*10.19 Loan and Security Agreement between the Registrant and Silicon Valley Bank
entered into as of June 24, 1996. Incorporated by reference to exhibit
10.1 of the Company's Form 10-Q for the quarter ended June 30, 1996.

10.20 Product Development, Supply and License Agreement dated June 8, 1994 between
the Registrant and Ortho Pharmaceutical Corporation, a division of Johnson
& Johnson. Incorporated by reference to exhibit 10.35 of the Company's
Form 10-Q for the quarter ended June 30, 1994.

10.21 Agreement dated November 22, 1994, between the Registrant and Kabi Pharmacia
(the "Kabi" Agreement). Incorporated by reference to exhibit 10.39 of the
Company's Form 10-K for the fiscal year ended December 31, 1994.

10.22 Loan and Security Agreement between Silicon Valley Bank and Registrant
entered into as of December 21, 1994. Incorporated by reference to exhibit
10.40 of the Company's Form 10-K for the fiscal year ended December 31,
1994.

10.23 GMS Technology Purchase Agreement dated December 30, 1994, between the
Registrant and PaineWebber. Incorporated by reference to exhibit 10.41 of
the Company's Form 10-K for the fiscal year ended December 31, 1994.

10.24 Lease Agreement dated January 18, 1995, between the Registrant and Comdisco
for $4.5 million. Incorporated by reference to exhibit 10.42 of the
Company's Form 10-K for the fiscal year ended December 31, 1994.

*10.25 Product Supply and Distribution Agreement between the Registrant and
Yamanouchi Pharmaceutical Co., LTD. dated as of July 14, 1996.
Incorporated by reference to exhibit 10.1 of the Company's Form 10-Q for
the quarter ended June 30, 1996.

EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS

10.26 1994 Stock Option / Award Plan, incorporated by reference to Exhibit 99.1 of
the Registrant's Form S-8 Registration Statement No. 333-18357.

10.27 Amended 1991 Employee Stock Purchase Plan incorporated by reference to
Exhibit 99.2 of the Registrant's Form S-8 Registration Statement No.
333-18357.

10.28 Form of Indemnification Agreement for Directors and Officers, incorporated
by reference to Exhibit 10.29 of the Registrant's Form S-1 Registration
Statement No. 33-38363.

10.29 1991 Bonus Plan for Director-Level Employees and Officers, incorporated by
reference to Exhibit 10.36 of the Registrant's Form S-1 Registration
Statement No. 33-45180.
</TABLE>

28
<PAGE>
<TABLE>
<C> <S>
10.30 Amended and Restated Employment Agreement dated January 29, 1996 between the
Registrant and Gregory B. Lawless.

10.31 Form of Agreement with Executive Officers relating to change in control .
</TABLE>

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

<TABLE>
<C> <S>
11.1 Statement regarding Computation of Loss per Share

13.0 Company's Consolidated Financial Statements section of the 1996 Annual
Report

23.1 Consent of Ernst & Young LLP, Independent Auditors

25.1 Power of Attorney (see page 31)

27.0 Financial Data Schedule
</TABLE>

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

* A confidential treatment request has been applied for or granted with
respect to a portion of this document.

29
<PAGE>
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized, on the 21st day of March,
1997.

CYGNUS, INC.

By: /s/ JOHN C. HODGMAN
------------------------------------------
John C. Hodgman
VICE PRESIDENT, FINANCE AND CHIEF
FINANCIAL OFFICER
(AND PRINCIPAL ACCOUNTING OFFICER);
PRESIDENT, CYGNUS DIAGNOSTICS

30
<PAGE>
POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints, jointly and severally, Gregory B. Lawless and
John C. Hodgman, and each one of them, attorneys-in-fact for the undersigned,
each with the power of substitution, for the undersigned in any and all
capacities, to sign any and all amendments to this Report on Form 10-K, and to
file the same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby ratifying and
confirming all that each of said attorneys-in-fact, or his substitute or
substitutes, may do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, each of the undersigned has executed this Power of
Attorney as of the date indicated opposite his/her name.

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

<C> <S> <C>
/s/ GARY W. CLEARY, PH.D. Chairman of the Board of Directors and March 21, 1997
------------------------------------------- Chief Technical Officer
Gary W. Cleary, Ph.D.

/s/ GREGORY B. LAWLESS, PH.D. President, Chief Executive Officer March 21, 1997
------------------------------------------- (Principal Executive Officer) and
Gregory B. Lawless, Ph.D. Director

/s/ JOHN C. HODGMAN Vice President, Finance and Chief March 21, 1997
------------------------------------------- Financial Officer (and Principal
John C. Hodgman Accounting Officer); President, Cygnus
Diagnostics

/s/ JAMES GRADY, JR., PH.D. Vice President, Operations and Human March 21, 1997
------------------------------------------- Resources (and Secretary)
James Grady, Jr., Ph.D.

/s/ FRANK T. CARY Director March 21, 1997
-------------------------------------------
Frank T. Cary

/s/ ANDRE F. MARION Director March 21, 1997
-------------------------------------------
Andre F. Marion

/s/ RICHARD G. ROGERS Director March 21, 1997
-------------------------------------------
Richard G. Rogers

/s/ WALTER B. WRISTON Director March 21, 1997
-------------------------------------------
Walter B. Wriston
</TABLE>

31
<PAGE>
SCHEDULE II

CYGNUS, INC.
VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
(DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
BALANCE AT CHARGED TO CHARGED TO
BEGINNING OF COSTS AND OTHER BALANCE AT
YEAR EXPENSES ACCOUNTS DEDUCTIONS END OF YEAR
------------- ------------- ------------- ------------- -----------
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1996:
Deducted from asset accounts:
Allowance for doubtful accounts.............. $ 1,137 $ -- $ -- $ -- $ 1,137
Warranty reserve............................. 435 -- -- -- 435
------ ----- ----- ----- -----------
$ 1,572 $ -- $ -- $ -- $ 1,572
------ ----- ----- ----- -----------
------ ----- ----- ----- -----------
Year ended December 31, 1995:
Deducted from asset accounts:
Allowance for doubtful accounts.............. $ 1,028 $ 109 $ -- $ -- $ 1,137
Warranty reserve............................. 435 -- -- -- 435
------ ----- ----- ----- -----------
$ 1,463 $ 109 $ -- $ -- $ 1,572
------ ----- ----- ----- -----------
------ ----- ----- ----- -----------
Year ended December 31, 1994:
Deducted from asset accounts:
Allowance for doubtful accounts.............. $ 1,014 $ 14 $ -- $ -- $ 1,028
Warranty reserve............................. 435 -- -- -- 435
------ ----- ----- ----- -----------
$ 1,449 $ 14 $ -- $ -- $ 1,463
------ ----- ----- ----- -----------
------ ----- ----- ----- -----------
</TABLE>

S-1

<PAGE>

EXHIBIT 10.30

AMENDED AND RESTATED
EMPLOYMENT AGREEMENT

AMENDED AND RESTATED EMPLOYMENT AGREEMENT made as of the 29th day of
January, 1996 by and between Cygnus, Inc. a Delaware corporation (the
"COMPANY") and Gregory B. Lawless (the "Executive").

WHEREAS, on January 29, 1992, Cygnus Therapeutic Systems, a California
corporation and the predecessor by merger to the COMPANY (California Cygnus)
and the Executive entered into an Employment Agreement (the "Prior
Agreement") providing for the employment of the executive as the President
and Chief Executive Officer of the COMPANY for a period of four (4) years
ending on January 29, 1996.

WHEREAS, pursuant to the terms of the Prior Agreement, the COMPANY and
California Cygnus have (i) paid the Executive a base salary of $208,846 in
1992, $237,500 in 1993 and $252,740 in 1994, (ii) paid certain bonuses to the
Executive in each such year, and (iii) granted the Executive a non-qualified
option to purchase an aggregate of Three Hundred and Fifty Thousand (350,000)
shares of Common Stock with an exercise price equal to 85% of the fair market
value of such shares as of the date of grant, vesting over a period of four
(4) years. The Executive has subsequently received additional grants of
options to purchase a total of 51,429 shares of Common Stock in 1993 and a
total of 225,000 shares of Common Stock in 1994.

WHEREAS, the COMPANY and the Executive desire that the Executive
continue to serve as the President and Chief Executive Officer of the COMPANY
for an additional four (4) year period beginning on January 30, 1996 and
ending on January 29, 2000, and to receive therefor the compensation provided
for herein; provided, further, that the Prior Agreement is hereby amended and
restated as set forth herein with respect to Executive's employment by the
Company for the period subsequent to January 29, 1996.

NOW, THEREFORE, THE PARTIES HERETO AGREE AS FOLLOWS:

ARTICLE I. TERM OF EMPLOYMENT

Section 1.1. The COMPANY hereby employs the Executive and the Executive
hereby accepts employment with the COMPANY for a period of four (4) years
beginning on January 30, 1996 and extending through January 29, 2000.

<PAGE>

ARTICLE II. DUTIES OF EXECUTIVE

Section 2.1. GENERAL. The Executive shall serve as President and Chief
Executive Officer of the COMPANY. Consistent with his position as President
and Chief Executive Officer, Executive shall perform all services and do all
things necessary or advisable to manage and conduct the operations and
business of the COMPANY, subject always to the authority of the Board of
Directors of the COMPANY (the "Board"). The COMPANY will use its best
efforts to ensure that Executive will remain a member of the Board during the
term of his employment, and shall use its best efforts to communicate with
its shareholders as necessary to ensure such result.

Section 2.2. FULL TIME. The Executive shall devote his full business
time, ability and attention to the business of the COMPANY during the
employment term. Executive shall not directly or indirectly actively engage
in or perform any duties which may interfere with Executive's performance
under this Agreement, provided that Executive may serve as a director of
other corporations with the prior approval of the Board. Executive
represents he is not presently an officer, director or employee of, or a
consultant to, any other person or entity.

Section 2.3. DUTIES. Executive will perform such duties as are
consistent with his position as the President and Chief Executive Officer of
the COMPANY and shall have the powers and authorities as may be needed to
carry out those duties as set forth in the COMPANY's Bylaws. In addition,
Executive shall perform such other duties and undertake responsibilities as
are reasonably assigned to him by the Board.

Section 2.4. VACATIONS. The Executive shall be entitled to three (3)
weeks paid vacation per annum, with such additional paid vacation time as a.
the Board (or the chairman thereof) may reasonably determine, or b. is
consistent with the COMPANY's vacation policy as it exists from time to time.

ARTICLE III. COMPENSATION

Section 3.1. SALARY. As compensation for his services hereunder
(including his services as a member of the Board), the Executive shall
receive a base salary (the "Base Salary") of at least $305,000 per annum.
The Base Salary shall be payable in periodic installments on the dates of the
COMPANY's usual payroll, which shall be at least once per calendar month.
The Executive's Base Salary may be increased, but not decreased, at the end
of each twelve (12) month period (or other more frequent intervals) by the
Board consistent with the Executive's performance and the COMPANY's policy
regarding increases in officer compensation established from time to time by
the Board.

Section 3.2. BONUS. The Executive shall participate in the COMPANY's
annual Incentive Bonus Plan and, pursuant to such plan, Executive shall be
entitled (upon

<PAGE>

satisfaction of the bonus criteria approved by the Compensation Committee of
the Board (the "Compensation Committee")) to receive annual cash bonuses in
an amount as determined by the Compensation Committee up to one hundred
percent (100%) of his Base Salary for the year in which he satisfied the
bonus criteria.

Section 3.3. EXPENSES. The COMPANY shall reimburse Executive, on a
monthly basis, for reasonable costs incurred by him with respect to monthly
and actual usage fees payable for his cellular phone (excluding usage fees
solely attributable to personal matters), his automobile operating expenses,
and insurance premiums for life, accidental death and dismemberment, salary
protection, disability and auto insurance.

ARTICLE IV. EXECUTIVE BENEFITS

Section 4.1. STOCK OPTIONS. The COMPANY will grant to the Executive
non-qualified options to purchase such number of shares of Common Stock of
the COMPANY as shall be determined from time to time by the Compensation
Committee, at such times and on such terms as shall be determined by the
Compensation Committee. All options granted to Executive shall terminate six
(6) months after Executive's employment with the COMPANY terminates.
Notwithstanding any ambiguity or inconsistency in any other agreement or
document, any options granted to the Executive prior to the date hereof shall
terminate six (6) months after Executive's employment and the COMPANY
terminates, and to the extent any other document or agreement between
Executive and the COMPANY provides otherwise, such agreement or document
shall be deemed amended hereby.

Section 4.2. VESTING OF STOCK OPTIONS. Any stock options granted to
Executive during the term of his employment by the COMPANY (including options
granted prior to the date hereof) shall vest in full over a four (4) year
period, with the commencement date of such vesting being specified in the
particular option agreement. In the event (i) COMPANY or its shareholders in
one or more related transactions dispose of all or substantially all of the
assets or outstanding capital stock of COMPANY by means of sale, merger,
reorganization or liquidation; (ii) any Person as Beneficial Owner, as
defined under Section 13 of the Securities Exchange Act of 1934, as amended,
directly or indirectly acquires securities of the COMPANY representing a
majority of the voting power represented by the COMPANY's then outstanding
voting securities; or (iii) of any change in the Executive's title or
reporting responsibility or any material reduction in his responsibilities
specified hereunder or which are otherwise performed by him; then, in any
such event, each such granted option shall automatically become fully vested
and immediately exercisable by Executive. All such options shall be subject
to such terms and conditions as are set forth in the particular stock option
agreement with the Executive, which agreements shall otherwise be in the
COMPANY's standard form as of the date of grant.

<PAGE>

Section 4.3. OTHER BENEFITS. The Executive shall be eligible to
participate in such other employee benefit programs (including medical,
dental, life and disability insurance, which shall be effective as of and
from the date of the Executive's employment hereunder) as the COMPANY shall
maintain from time to time for the benefit of employees in positions
comparable to the Executive's position under this Agreement. The Executive
may receive such other and additional benefits as the Board may determine
from time to time in its sole discretion.

ARTICLE V. BUSINESS EXPENSES

The COMPANY will promptly reimburse the Executive for all reasonable and
customary business expenses incurred during the employment term by the
Executive, provided that the Executive furnishes to the COMPANY reasonably
adequate records and other documentary evidence of such expenses.

ARTICLE VI. TERMINATION OF AGREEMENT

Section 6.1. COMPANY TERMINATION FOR CAUSE. Notwithstanding anything
to the contrary herein, the Executive's employment hereunder may be
terminated by the Board at any time for cause immediately upon written notice
to the Executive, if any of the following events occur:

(a) The Executive is physically or mentally incapacitated so that
he is unable to discharge his duties for a period of sixty (60) consecutive
days or a total of ninety (90) days in any twelve (12) month period.

(b) The Executive is found guilty of serious, criminal misconduct
(I.E., other than traffic violations and other minor infractions) by a court
of competent jurisdiction, or acts or omits to act in reckless or willful
disregard of lawful instructions given under authority of the Board, or
engages in acts of gross misconduct, or misuses corporate funds.

(c) The Executive materially breaches any of his obligations
under this Agreement and fails to correct the same within thirty (30) days
from written notice thereof by COMPANY.

The Executive shall be entitled to a full hearing before a quorum
of the Board at a Board meeting prior to any termination of his employment
under this Section 6.1.

Upon termination for cause under this Section 6.1, all compensation
and benefits (except the ability to exercise options, to the extent vested,
during the Exercise

<PAGE>

Period) shall immediately cease. Termination for cause under this Section
6.1 shall be without prejudice to any other remedy to which the COMPANY may
be entitled either at law or in equity or under this Agreement.

Section 6.2. UNCONDITIONAL TERMINATION.

(a) BY COMPANY. The COMPANY may terminate the employment of the
Executive hereunder, for any reason, or for no reason, by giving sixty (60)
days prior written notice thereof to the Executive; PROVIDED, THAT, upon any
such termination hereunder (other than for cause under Section 6.1 above),
the parties agree that the COMPANY shall continue to pay, on the COMPANY's
normal payroll schedule, an aggregate amount equal to the Executive's then
current annual Base Salary plus an amount equal to all bonus compensation
paid to the Executive for the full calendar year preceding the date of
termination until the earlier of (1) the Executive obtaining comparable
employment or (2) twelve (12) months after the date of termination. In
addition to the foregoing, the COMPANY shall:

(i) immediately vest the Executive in all options to purchase
shares of Common Stock, provided that the option shall terminate to
the extent unexercised at the end of the Exercise Period;

(ii) continue, at its sole expense, all medical, dental and life
insurance coverage until the earlier of (x) twelve (12) months from
the date of such termination or (y) such time as the Executive
receives similar paid coverage from another employer;

(iii) if so requested by the Executive, pay for reasonable
outplacement services engaged by the Executive in seeking new
employment, which services may include the provision to Executive of
appropriate office, telephone and secretarial services until the
earlier of (x) twelve (12) months from the date of such termination or
(y) such time as Executive obtains other employment; and

(iv) agree with the Executive on any and all statements which
will be issued relative to the reasons for such termination.

Any change in the Executive's title or reporting responsibility,
any material reduction by the COMPANY (or its successor) in the Executive's
responsibilities specified hereunder (or those otherwise assumed by Executive
in the ordinary course of the COMPANY's business) or any requirement that
Executive's place of employment be in other than the San Francisco Bay Area,
shall be deemed to be a termination under this subsection Section 6.2(a)
unless cured within thirty (30) days of receipt by the COMPANY of written
notice from the Executive specifying the notice of such change in title or
reporting responsibility or reduction in responsibility.

<PAGE>

The COMPANY's obligations in this Section 6.2(a) shall constitute
Executive's exclusive remedy for termination by COMPANY under this Section
6.2(a) during the term of Executive's employment.

(b) BY THE EXECUTIVE. A termination of his employment by the
Executive, other than as a result of the breach of this Agreement by the
COMPANY, shall be a breach of this Agreement and shall entitle the Executive
to no further salary or benefits except the ability to exercise options, to
the extent vested, during the Exercise Period.

ARTICLE VII. GENERAL PROVISIONS

Section 7.1. CONFIDENTIALITY AGREEMENT. The Executive agrees to adhere
to the COMPANY's standard form Employee Confidentiality Agreement, which he
has previously executed.

Section 7.2. SUCCESSORS. The COMPANY will require any successor
(whether direct or indirect, by purchase, merger, consolidation or otherwise)
to all or substantially all of the business and/or assets of the COMPANY to
expressly assume and agree to perform this Agreement in the same manner and
to the same extent that the COMPANY would be required to perform it if no
such succession had taken place.

Section 7.3. GOVERNING LAW. This Agreement shall be construed and
enforced in accordance with and be governed by the laws of the state of
California.

Section 7.4. ENTIRE AGREEMENT. This Agreement sets forth the entire
agreement and understanding between the Executive and the COMPANY, and
supersedes any other negotiations, agreements, understandings, oral
agreements, representations and past or future practices whether written or
oral.

Section 7.5. MODIFICATION. This Agreement may not be amended,
modified, changed or discharged in any respect except as agreed in writing
and signed by the Executive and the COMPANY.

Section 7.6. SEVERABILITY AND INTERPRETATION. In the event that any
provision or any portion of this Agreement is held invalid or unenforceable
by a court of competent jurisdiction, such provision or portion thereof shall
be considered separate and apart from the remainder of this Agreement and the
other provisions shall remain fully valid and enforceable. In the event that
any provision is held to be overly broad as written, such provision shall be
deemed amended to narrow its application to the extent necessary to make the
provision enforceable according to applicable law and enforced as amended.

<PAGE>

Section 7.7. NOTICES. All notices required by this Agreement shall be
given in writing either by personal delivery or by first class mail, return
receipt requested, to the then most current address of the parties notified
to the other. Notice given by mail shall be deemed given five (5) days
following the date of mailing.

Section 7.8. WAIVER. A waiver by either party of any of the terms or
conditions of this Agreement in any instance shall not be deemed or construed
to be a waiver of such term or condition for the future, or of any subsequent
breach thereof.

Section 7.9. ATTORNEYS' FEES. In the event either party shall bring
any action or legal proceeding of an alleged breach of any provision of this
Agreement or to enforce, protect or establish any term or covenant of this
Agreement or right of either party under this Agreement, the prevailing party
shall be entitled to recover as part of such action or proceeding, or in a
separate action brought for that purpose, reasonable attorneys' fees and
court costs as may be fixed by the court.

IN WITNESS WHEREOF, the parties hereto have executed this Agreement
effective as of the day and year first above written.

CYGNUS, INC.

By /s/ Gary W. Cleary
---------------------------------
Gary W. Cleary, Chairman

EXECUTIVE

/s/ Gregory B. Lawless
---------------------------------
Gregory B. Lawless, an individual

<PAGE>

EXHIBIT 10.31
FORM OF AGREEMENT
WITH EXECUTIVE OFFICER
RELATING TO CHANGE OF CONTROL

________, 19__

First Name- Initial/Last Name-
Title-
Cygnus, Inc.
400 Penobscot Drive
Redwood City, CA 94063

Dear Salutation-:

Cygnus, Inc., a Delaware corporation (the "Company"), considers the
establishment and maintenance of a sound and vital management to be essential to
protecting and enhancing the best interests of the Company and its shareholders.
In this connection, the Company recognizes that, as is the case with many
publicly held corporations, the possibility of a change in control may arise and
that such possibility, and the uncertainty and questions which it may raise
among management, may result in the departure or distraction of management
personnel to the detriment of the Company and its shareholders.

In view of the above, the Board of Directors of the Company (the
"Board") has determined that appropriate steps should be taken to reinforce and
encourage the continued attention and dedication of members of the Company's
management to their assigned duties without distraction in circumstances arising
from the possibility of a change in control of the Company. In particular, the
Board believes it important, should the Company or its shareholders receive a
proposal for transfer of control of the Company, that you be able to assess and
advise the Board whether such proposal would be in the best interests of the
Company and its shareholders and to take such other action regarding such
proposal as the Board might determine to be appropriate, without being
influenced by the uncertainties of your own situation.

In order to induce you to remain in the employ of the Company, this
letter agreement, which has been approved by the Board, sets forth the severance
benefits which the Company agrees will be provided to you in the event your
employment with the Company is terminated subsequent to a "change in control" of
the Company under the circumstances described below. This letter agreement
includes, as if set forth in full

<PAGE>

Page 2

herein, those definitions and miscellaneous terms and provisions set forth in
Exhibit A hereto, which exhibit is specifically incorporated herein by this
reference.

1. AGREEMENT TO PROVIDE SERVICES; RIGHT TO TERMINATE.

(i) Except as otherwise provided in paragraph (ii) below, the Company
or you may terminate your employment at any time, subject to the Company's
providing the benefits hereinafter specified in accordance with the terms
hereof.

(ii) In the event a tender offer or exchange offer is made by a Person
(as defined herein) for more than 50% of the combined voting power of the
Company's outstanding securities ordinarily having the right to vote at
elections of directors ("Voting Securities"), or in the event of any
solicitation of proxies or written consents not approved by the Board, you agree
that such event will not lead you to leave the employ of the Company (other than
as a result of Disability or upon Retirement, as such terms are defined herein)
and will render the services contemplated in the recitals to this Agreement
until such tender offer or exchange offer has been abandoned or terminated or a
"change in control" of the Company, as defined herein, has occurred.

2. TERM OF AGREEMENT. This Agreement shall commence on the date hereof
and shall continue in effect until December 31, 19__; provided, however, that
commencing on January 1, 19__ and each January 1 thereafter, the term of this
Agreement shall automatically be extended for one additional year unless at
least 90 days prior to such January 1st date, the Company or you shall have
given notice that this Agreement shall not be extended; and provided, further,
that this Agreement shall continue in effect for a period of twenty-four (24)
months beyond the term provided herein if a change in control of the Company
shall have occurred during such term. Notwithstanding anything in this
Section 2 to the contrary, this Agreement shall terminate if you or the Company
terminate your employment prior to a change in control of the Company.

3. TERMINATION FOLLOWING CHANGE IN CONTROL. If any of the events
described in Exhibit A hereto constituting a change in control of the Company
shall have occurred, you shall be entitled to the benefits provided in
paragraphs (iii) and (iv) of Section 4 hereof upon the termination of your
employment within twenty-four (24) months after such event, unless such
termination is (a) because of your death or Retirement, (b) by the Company for
Cause or Disability or (c) by you other than for Good Reason (as all such
capitalized terms are defined herein).

<PAGE>

Page 3

Any purported termination by the Company or by you following a change
in control shall be communicated by written Notice of Termination to the other
party hereto. For purposes of this Agreement, a "Notice of Termination" shall
mean a notice which shall indicate the specific termination provision in this
Agreement relied upon.

4. COMPENSATION UPON TERMINATION OR DURING DISABILITY; OTHER AGREEMENTS.

(i) During any period following a change in control that you fail to
perform your duties as a result of incapacity due to physical or mental illness,
you shall continue to receive your salary at the rate then in effect and any
benefits or awards under any Plans shall continue to accrue during such period,
to the extent not inconsistent with such Plans, until your employment is
terminated pursuant to and in accordance with the provisions hereof.
Thereafter, your benefits shall be determined in accordance with the Plans then
in effect.

(ii) If your employment shall be terminated for Cause following a
change in control of the Company, the Company shall pay you your salary through
the Date of Termination at the rate in effect just prior to the time a Notice of
Termination is given plus any benefits or awards (including both the cash and
stock components) which pursuant to the terms of any Plans have been earned or
become payable, but which have not yet been paid to you. Thereupon the Company
shall have no further obligations to you under this Agreement.

(iii) Subject to Section 7 hereof, if, within twenty-four (24)
months after a change in control of the Company shall have occurred, as defined
herein, your employment by the Company shall be terminated (a) by the Company
other than for Cause, Disability or Retirement or (b) by you for Good Reason,
then, by no later than the fifth day following the Date of Termination (except
as otherwise provided), you shall be entitled, without regard to any contrary
provisions of any Plan, to the benefits as provided below:

(A) the Company shall pay your salary through the Date of
Termination at the rate in effect just prior to the time a Notice of
Termination is given plus any benefits or awards (including both the cash
and stock components) which pursuant to the terms of any Plans have been
earned or become payable, but which have not yet been paid to you
(including amounts which previously had been deferred at your request);

<PAGE>

Page 4

(B) as severance pay and in lieu of any further salary for
periods subsequent to the Date of Termination, the Company shall pay to you
an amount in cash equal to one times (1x) your annual base salary in effect
immediately prior to the change in control plus the amount of any cash
bonus awards made to you with respect to the Company's full fiscal year
immediately preceding the change of control; and

(C) with respect to any stock options, restricted stock, share
rights or other incentive compensation awards made to you by the Company
which (i) were originally denominated in Common Stock of the Company, (ii)
are subject to a vesting requirement (based solely upon your period of
continuous employment by the Company or a Successor (as defined in Section
5 hereof)) and (iii) have been assumed or replaced by a Successor, such
vesting requirement shall be automatically accelerated by 12 months from
the Date of Termination.

(iv) Following a change in control of the Company, unless you are
terminated for Cause, Disability or Retirement or you terminate your employment
other than for Good Reason, the Company shall maintain in full force and effect,
for the continued benefit of you and your dependents for a period terminating on
the earliest of (a) one year after the Date of Termination, (b) the commencement
date of equivalent benefits from a new employer or (c) your normal retirement
date under the terms of the Retirement Policy, all insured and self-insured
employee welfare benefit Plans in which you were entitled to participate
immediately prior to the Date of Termination, provided that your continued
participation is possible under the general terms and provisions of such Plans
(and any applicable funding media) and you continue to pay an amount equal to
your regular contribution under such plans for such participation. If, at the
end of two years after the Termination Date, you have not reached your normal
retirement date and you have not previously received or are not then receiving
equivalent benefits from a new employer, the Company shall arrange, at its sole
cost and expense, to enable you to convert your and your dependents' coverage
under such Plans to individual policies or programs upon the same terms as
employees of the Company may apply for such conversions. In the event that your
participation in any such Plan is barred, the Company, at its sole cost and
expense, shall arrange to have issued for the benefit of you and your dependents
individual policies of insurance providing benefits substantially similar (on an
after-tax basis) to those which you otherwise would have been entitled to
receive under such Plans pursuant to this paragraph (iv) or, if such insurance
is not available at a reasonable cost to the Company, the Company shall
otherwise provide you and your dependents equivalent benefits (on an after-tax
basis). You shall not be

<PAGE>

Page 5

required to pay any premiums or other charges in an amount greater than that
which you would have paid in order to participate in such Plans.

(v) Except as specifically provided in paragraph (iv) above, the
amount of any payment provided for in this Section 4 shall not be reduced,
offset or subject to recovery by the Company by reason of any compensation
earned by you as the result of employment by another employer after the Date of
Termination, or otherwise.

5. SUCCESSORS; BINDING AGREEMENT.

(i) Upon your written request, the Company will seek to have any
Successor (as hereinafter defined), by agreement in form and substance
satisfactory to you, assent to the fulfillment by the Company of its obligations
under this Agreement. Failure of the Company to obtain such assent at least
three business days prior to the time a Person becomes a Successor (or where the
Company does not have at least three business days' advance notice that a Person
may become a Successor, within one business day after having notice that such
Person may become or has become a Successor) shall constitute Good Reason for
termination by you of your employment and, if a change in control of the Company
has occurred, shall entitle you immediately to the benefits provided in
paragraphs (iii) and (iv) of Section 4 hereof upon delivery by you of a Notice
of Termination. For purposes of this Agreement, "Successor" shall mean any
Person that succeeds to, or has the practical ability to control (either
immediately or with the passage of time), the Company's business directly, by
merger or consolidation, or indirectly, by purchase of the Company's Voting
Securities, all or substantially all of its assets or otherwise.

(ii) This Agreement shall inure to the benefit of and be enforceable
by your personal or legal representatives, executors, administrators,
successors, heirs, distributees, devisees and legatees. If you should die while
any amount would still be payable to you hereunder if you had continued to live,
all such amounts, unless otherwise provided herein, shall be paid in accordance
with the terms of this Agreement to your devisee, legatee or other designee or,
if there be no such designee, to your estate.

(iii) For purposes of this Agreement, the "Company" shall include
any corporation or other entity which is the surviving or continuing entity in
respect of any merger, consolidation or form of business combination in which
the Company ceases to exist.

<PAGE>

Page 6

6. FEES AND EXPENSES; MITIGATION.

(i) The Company shall pay all reasonable legal fees and related
expenses incurred by you in connection with the Agreement following a change in
control of the Company, including, without limitation, (a) all such fees and
expenses, if any, incurred in contesting or disputing any such termination or
(b) your seeking to obtain or enforce any right or benefit provided by this
Agreement.

(ii) You shall not be required to mitigate the amount of any payment
the Company becomes obligated to make to you in connection with this Agreement,
by seeking other employment or otherwise.

7. TAXES. All payments to be made to you under this Agreement will be
subject to required withholding of federal, state and local income and
employment taxes.

8. SURVIVAL. The respective obligations of, and benefits afforded to,
the Company and you as provided in Sections 4, 5, 6, 7 and 8 of this Agreement
shall survive termination of this Agreement.

9. EMPLOYEE'S COMMITMENT. You agree that subsequent to your period of
employment with the Company, you will not at any time communicate or disclose to
any unauthorized person, without the written consent of the Company, any
proprietary or other confidential information concerning the Company or any
subsidiary which, if disclosed, would have a material adverse effect upon the
business or operations of the Company and its subsidiaries, taken as a whole; it
being understood, however, that the obligations of this Section 9 shall not
apply to the extent that the aforesaid matters (a) are disclosed in
circumstances where you are legally required to do so or (b) become generally
known to and available for use by the public otherwise than by your wrongful act
or omission.

<PAGE>

Page 7

If this letter correctly sets forth our agreement on the subject
matter hereof, kindly sign and return to the Company the enclosed copy of this
letter which will then constitute our agreement on this subject.

Very truly yours,

CYGNUS, INC.

By
---------------------------
Signee-
Signee Title-
Agreed to this day of
--------
, 19 .
- ------------------------ --

- -------------------------------------
First Name- Initial/Last Name-

<PAGE>

EXHIBIT A

TERMS, PROVISIONS AND DEFINITIONS
APPLICABLE TO CYGNUS, INC.
CHANGE OF CONTROL AGREEMENTS

I. DEFINITIONS.

For purposes of the letter agreement to which this Exhibit A is
attached, the terms set forth below shall be defined as follows:

CAUSE. Termination by the Company of your employment for "Cause" shall
mean termination upon (a) the willful and continued failure by you to
perform substantially your duties with the Company (other than any such
failure resulting from your incapacity due to physical or mental illness)
after a demand for substantial performance is delivered to you by the
Chairman of the Board or President of the Company which specifically
identifies the manner in which such executive believes that you have not
substantially performed your duties, or (b) the willful engaging by you in
illegal conduct which is materially and demonstrably injurious to the
Company. For purposes of this definition, no act, or failure to act, on
your part shall be considered "willful" unless done, or omitted to be done,
by you in bad faith and without reasonable belief that your action or
omission was in, or not opposed to, the best interests of the Company. Any
act, or failure to act, based upon authority given pursuant to a resolution
duly adopted by the Board or based upon the advice of counsel for the
Company shall be conclusively presumed to be done, or omitted to be done, by
you in good faith and in the best interests of the corporation. It is also
expressly understood that your attention to matters not directly related to
the business of the Company shall not provide a basis for termination for
Cause so long as the Board has approved your engagement in such activities.
Notwithstanding the foregoing, you shall not be deemed to have been
terminated for Cause unless and until there shall have been delivered to you
a copy of a resolution duly adopted by the affirmative vote of not less than
three quarters of the entire membership of the Board at a meeting of the
Board called and held for the purpose (after reasonable notice to you and an
opportunity for you, together with your counsel, to be heard before the
Board), finding that in the good faith opinion of the Board you were guilty
of the conduct set forth above in (a) or (b) of this definition and
specifying the particulars thereof in detail.

i
<PAGE>

CHANGE IN CONTROL. A "change in control" of the Company shall mean a
change in control of a nature that would be required to be reported
(assuming such event has not been "previously reported") in response to
Item 1(a) of the Current Report on Form 8-K, as in effect on the date
hereof, pursuant to Section 13 or 15(d) of the Exchange Act; provided that,
without limitation, such a change in control shall be deemed to have
occurred at such time as (a) any Person is or becomes the "beneficial owner"
(as defined in Rule 13d-3 under the Exchange Act), directly or indirectly,
of 50% or more of the combined voting power of the Company's Voting
Securities; or (b) individuals who constitute the Board on the date hereof
(the "Incumbent Board") cease for any reason to constitute at least a
majority thereof, provided that any person becoming a director subsequent to
the date hereof whose election, or nomination for election by the Company's
shareholders, was approved by a vote of at least three quarters of the
directors comprising the Incumbent Board (either by a specific vote or by
approval of the proxy statement of the Company in which such person is named
as a nominee for director, without objection to such nomination) shall be,
for purposes of this clause (b), considered as though such person were a
member of the Incumbent Board. Notwithstanding anything in the foregoing to
the contrary, no change in control shall be deemed to have occurred by
virtue of any transaction which results in you, or a group of Persons which
includes you, acquiring, directly or indirectly, 30% or more of the combined
voting power of the Company's Voting Securities.

DATE OF TERMINATION. "Date of Termination" following a change in control
shall mean (a) if your employment is to be terminated for Disability, thirty
(30) days after Notice of Termination is given (provided that you shall not
have returned to the performance of your duties on a full-time basis during
such thirty (30) day period), (b) if your employment is to be terminated by
the Company for Cause or by you for Good Reason, the date specified in the
Notice of Termination, or (c) if your employment is to be terminated by the
Company for any reason other than Cause, the date specified in the Notice of
Termination, which in no event shall be a date earlier than ninety (90) days
after the date on which a Notice of Termination is given, unless an earlier
date has been expressly agreed to by you in writing either in advance of, or
after, receiving such Notice of Termination. In the case of termination by
the Company of your employment for Cause, if you have not previously
expressly agreed in writing to the termination, then within thirty (30) days
after receipt by you of the Notice of Termination with respect thereto, you
may notify the Company that a dispute exists concerning the termination, in
which event the Date of Termination shall be the date set either by mutual
written agreement of the parties or through a judicial determination.
During the pendency

ii
<PAGE>

of any such dispute, the Company will continue to pay you your full
compensation in effect just prior to the time the Notice of Termination is
given and until the dispute is resolved in accordance with the terms hereof.

DISABILITY. Termination by the Company of your employment based on
"Disability" shall mean termination because of your absence from your duties
with the Company on a full time basis for one hundred eighty (180)
consecutive days as a result of your incapacity due to physical or mental
illness, unless within thirty (30) days after Notice of Termination (as
defined herein) is given to you following such absence you shall have
returned to the full time performance of your duties.

GOOD REASON. Termination by you of your employment for "Good Reason" shall
mean termination based on:

(A) an adverse change in your status or position(s) as an officer
of the Company as in effect immediately prior to the change in control,
including, without limitation, any adverse change in your status or position
as a result of a material diminution in your duties or responsibilities
(other than, if applicable, any such change directly attributable to the
fact that the Company is no longer publicly owned) or the assignment to you
of any duties or responsibilities which, in your reasonable judgment, are
inconsistent with such status or position(s), or any removal of you from or
any failure to reappoint or reelect you to such position(s) (except in
connection with the termination of your employment for Cause, Disability or
Retirement or as a result of your death or by you other than for Good
Reason);

(B) a reduction by the Company in your base salary as in effect
immediately prior to the change in control;

(C) the failure by the Company to continue in effect any Plan (as
defined herein) in which you are participating at the time of the change in
control of the Company (or Plans providing you with at least substantially
similar benefits) other than as a result of the normal expiration of any
such Plan in accordance with its terms as in effect at the time of the
change in control, or the taking of any action, or the failure to act, by
the Company which would adversely affect your continued participation in any
of such Plans on at least as favorable a basis to you as is the case on the
date of the change in control or which would materially reduce your benefits
in the future under any of such Plans or deprive you of any material benefit
enjoyed by you at the time of the change in control;

iii
<PAGE>

(D) the failure by the Company to provide and credit you with the
number of paid vacation days to which you are then entitled in accordance
with the Company's normal vacation policy as in effect immediately prior to
the change in control;

(E) the Company's requiring you to be based more than 50 miles from
where your office is located immediately prior to the change in control
except for required travel on the Company's business to an extent
substantially consistent with the business travel obligations which you
undertook on behalf of the Company prior to the change in control;

(F) the failure by the Company to obtain from any Successor (as
defined herein) the assent to this Agreement as contemplated by the terms
hereof;

(G) any purported termination by the Company of your employment
which is not effected pursuant to a Notice of Termination satisfying the
requirements of paragraph (v) below (and, if applicable, paragraph (iii)
above); and for purposes of this Agreement, no such purported termination
shall be effective; or

(H) any refusal by the Company to continue to allow you to attend to
matters or engage in activities not directly related to the business of the
Company which, prior to the change in control, you were permitted by the
Board to attend to or engage in.

PERSON. "Person" shall mean and include any individual, corporation,
partnership, group, association or other "person," as such term is used in
Section 14(d) of the Securities Exchange Act of 1934 (the "Exchange Act"),
other than the Company, a wholly-owned subsidiary of the Company or any
employee benefit plan(s) sponsored by the Company.

PLAN. The term "Plan" shall mean any compensation plan such as an
incentive, stock option or restricted stock plan or any pension or profit
sharing plan.

RETIREMENT. Termination by you or by the Company of your employment based
on "Retirement" shall mean termination on or after your normal retirement
date under the terms of the Company's retirement policy (or any successor or
substitute

iv
<PAGE>

policy or policies of the Company put into effect prior to a change in
control) (the "Retirement Policy").

II. MISCELLANEOUS PROVISIONS.

The following terms and provisions shall be included in, and
incorporated into, the letter agreement to which this Exhibit A is attached:

1. NOTICE. Notices and all other communications provided for in the
Agreement shall be in writing and shall be deemed to have been duly
given when delivered or mailed by United States registered mail, return
receipt requested, postage prepaid and addressed, in the case of the
Company, to Cygnus, Inc., 400 Penobscot Drive, Redwood City, California
94063, Attention: Chief Executive Officer or, in the case of the
undersigned employee, to the address set forth below his signature,
provided that all notices to the Company shall be directed to the
attention of the Chairman of the Board or President of the Company, with
a copy to the Secretary of the Company, or to such other address as
either party may have furnished to the other in writing in accordance
herewith, except that notice of change of address shall be effective
only upon receipt.

2. MISCELLANEOUS. No provision of this Agreement may be modified, waived
or discharged unless such modification, waiver or discharge is agreed to
in a writing signed by you and the Chairman of the Board or President of
the Company. No waiver by either party hereto at any time of any breach
by the other party hereto of, or of compliance with, any condition or
provision of this Agreement to be performed by such other party shall be
deemed a waiver of similar or dissimilar provisions or conditions at the
same or at any prior or subsequent time. No agreements or
representations, oral or otherwise, express or implied, with respect to
the subject matter hereof have been made by either party which are not
expressly set forth in this Agreement. The validity, interpretation,
construction and performance of this Agreement shall be governed by the
laws of the State of California.

3. VALIDITY. The invalidity or unenforceability of any provision of this
Agreement shall not affect the validity or enforceability of any other
provision of this Agreement, which shall remain in full force and
effect.

v
<PAGE>

4. RELATED AGREEMENTS. To the extent that any provision of any other
agreement between the Company or any of its subsidiaries and you shall
limit, qualify or be inconsistent with any provision of this Agreement,
then for purposes of this Agreement, while the same shall remain in
force, the provision of this Agreement shall control and such provision
of such other agreement shall be deemed to have been superseded, and to
be of no force or effect, as if such other agreement had been formally
amended to the extent necessary to accomplish such purpose.

5. COUNTERPARTS. This Agreement may be executed in several counterparts,
each of which shall be deemed to be an original but all of which
together will constitute one and the same instrument.

<PAGE>
EXHIBIT 11.1

CYGNUS, INC.
STATEMENT REGARDING COMPUTATION OF LOSS PER SHARE

(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------
1996 1995 1994
---------- ---------- ----------
<S> <C> <C> <C>
Primary and fully diluted:
Weighted average of common shares outstanding during the period............. 18,544 16,265 13,947
---------- ---------- ----------
Shares used in computation of net loss per share.............................. 18,544 16,265 13,947
---------- ---------- ----------
---------- ---------- ----------
Net loss...................................................................... $ (11,052) $ (12,842) $ (17,360)
---------- ---------- ----------
---------- ---------- ----------
Net loss per share............................................................ $ (0.60) $ (0.79) $ (1.24)
---------- ---------- ----------
---------- ---------- ----------
</TABLE>

<PAGE>
SELECTED FINANCIAL DATA

The selected consolidated financial data presented below are derived from
the consolidated financial statements of Cygnus, Inc. The financial consolidated
statements as of December 31, 1996 and 1995 and for each of the years in the
three-year period ended December 31, 1996 are included elsewhere herein. The
selected financial data as of December 31, 1994, 1993, and 1992 and for each of
the years in the two-year period ended December 31, 1993, are derived from
audited consolidated financial statements not included herein. The data should
be read in conjunction with the consolidated financial statements and related
notes, the information set forth under "Management's Discussion and Analysis of
Financial Conditions and Results of Operations" and other financial information
included herein.

No dividends have been paid for any of the periods presented.

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------------------------
1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Product revenues.................................... $ 17,211 $ 3,704 $ 1,917 $ 8,587 $ 20,292
Contract revenues................................... 13,085 12,579 14,533 7,156 5,287
Royalty and other revenues.......................... 5,907 2,723 4,820 1,734 64
---------- ---------- ---------- ---------- ----------
TOTAL REVENUES.................................. 36,203 19,006 21,270 17,477 25,643

Costs and expenses:
Costs of products sold............................ 16,659 4,746 3,293 9,534 18,549
Research and development.......................... 23,165 20,029 21,605 13,675 14,718
Purchase of in process research and development... -- -- 9,000 -- --
Marketing, general and administrative............. 9,296 7,369 5,491 5,846 11,017
---------- ---------- ---------- ---------- ----------
Total costs and expenses........................ 49,120 32,144 39,389 29,055 44,284
---------- ---------- ---------- ---------- ----------
Loss from operations.................................. (12,917) (13,138) (18,119) (11,578) (18,641)

Net loss.............................................. $ (11,052) $ (12,842) $ (17,360) $ (10,609) $ (17,501)
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
Net loss per share.................................... $ (0.60) $ (0.79) $ (1.24) $ (0.77) $ (1.36)
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
Shares used in computation of net loss per share...... 18,544 16,265 13,947 13,752 12,846
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
</TABLE>

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------------------------
1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Working capital....................................... $ 36,386 $ 38,555 $ 18,041 $ 24,044 $ 31,487
Total assets.......................................... 68,798 57,854 38,116 46,861 52,667
Long-term obligations................................. 13,437 8,331 7,398 6,509 4,597
Accumulated deficit................................... (86,071) (75,014) (62,588) (44,814) (34,205)
Stockholders' equity.................................. 31,213 38,252 18,117 26,243 36,153
</TABLE>

1
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

THE DISCUSSION SET FORTH BELOW CONTAINS PROJECTIONS AND FORWARD LOOKING
STATEMENTS REGARDING FUTURE EVENTS AND THE FUTURE FINANCIAL PERFORMANCE OF THE
COMPANY. WE WISH TO CAUTION YOU THAT THESE STATEMENTS ARE ONLY OUR PREDICTIONS
AND OBJECTIVES. ACTUAL EVENTS OR RESULTS MAY DIFFER MATERIALLY. PLEASE NOTE IN
PARTICULAR THROUGHOUT THIS DOCUMENT WHERE WE HAVE HIGHLIGHTED SPECIFIC RISKS
ASSOCIATED WITH THE COMPANY AND ITS ACTIVITIES. WE ALSO REFER YOU TO DOCUMENTS
THE COMPANY FILES FROM TIME TO TIME WITH THE SECURITIES AND EXCHANGE COMMISSION,
SUCH AS ITS FORM 10-K, ITS 10-Q AND FORM 8-K REPORTS. THESE DOCUMENTS AND THE
DISCUSSION BELOW CONTAIN IMPORTANT FACTORS, INCLUDING WITHOUT LIMITATION THOSE
INVOLVING CERTAIN ONGOING ARBITRATION PROCEEDINGS INVOLVING THE COMPANY, THAT
COULD CAUSE OUR ACTUAL RESULTS TO DIFFER FROM OUR CURRENT EXPECTATIONS AND THE
FORWARD-LOOKING STATEMENTS CONTAINED HEREIN.

GENERAL

Cygnus, Inc. (the "Company" or "Cygnus") is engaged in the development of
diagnostic and drug delivery systems, with its current efforts primarily focused
on three core technologies: a painless, automatic glucose monitoring device,
transdermal drug delivery systems and mucosal drug delivery systems.

The Company's product development efforts have been and are expected to
continue to be either self-funded, funded by licensees, or both. In general, the
Company's licensing agreements provide that Cygnus will manufacture drug
delivery systems and receive manufacturing revenues from sales of these products
to its licensees. Cygnus may also receive royalties based on certain of its
licensees' product sales. In certain circumstances, the Company may elect to
license manufacturing rights for the product to its licensees in exchange for a
technology transfer fee and/or a higher royalty rate.

Cygnus' licensees generally have the right to abandon a product development
effort at any time for any reason without significant penalty, and this can
result in delays in clinical testing, in the preparation and processing of
regulatory filings and in commercialization efforts. Licensees have exercised
this right in the past, and there can be no assurance that current and future
licensees will not exercise this right in the future. Such cancellations may
cause delays in product development. If a licensee were to terminate funding one
of the Company's products, Cygnus would either self-fund development efforts,
identify and enter into an agreement with an alternative licensee or suspend
further development work on the product. There can be no assurance that, if
necessary, the Company would be able to negotiate an agreement with an
alternative licensee on acceptable terms. Since all payments to the Company
under its licensing agreements following their execution are contingent on the
occurrence of future events or sales levels, and the agreements are terminable
by the licensee, no assurance can be given as to whether the Company will
receive any particular payment thereunder or as to the amount or timing of any
such payment. The Company may choose to self-fund certain research and
development projects in order to exploit its technologies. Any increase in
Company-sponsored research and development activities will have an immediate
adverse effect on the Company's results of operations. However, should such
Company-sponsored research and development activities result in a commercial
product, the long-term effect on the Company's results of operations could be
favorable.

For the Company to be successful, it will need to develop new drug delivery
and diagnostic products. Furthermore, the Company's ability to develop and
commercialize products in the future will depend on its ability to enter into
collaborative arrangements with additional licensees on favorable terms. There
can be no assurance that the Company will be able to enter into new
collaborative arrangements on such terms, if at all.

The Company's results of operations vary significantly from year to year and
depend on, among other factors, the signing of new product development
agreements and the timing of recognizing payment amounts specified thereunder,
the timing of recognizing license fees and cost reimbursement payments made by
licensees, the demand for and shipments of its Nicotrol-Registered Trademark-
product, and the costs associated with

2
<PAGE>
the manufacture of Nicotrol. The Company's contract revenues are generally
earned and recognized based on the percentage of actual efforts expended
compared to total expected efforts during the development period for each
contract. However, contract revenues are not always aligned with the timing of
related expenses. To date, research and development expenses generally have
exceeded contract revenue in any particular period and the Company expects the
same situation to continue for the next several years. In addition, the level of
revenues in any given period is not necessarily indicative of expected revenues
in future periods. The Company has incurred net losses each year since its
inception and does not believe it will achieve profitability in 1997. At
December 31, 1996, the Company's accumulated deficit was approximately $86.1
million.

RESULTS OF OPERATIONS

COMPARISON FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995

PRODUCT REVENUES for the year ended December 31, 1996 were $17.2 million
compared to $3.7 million for the year ended December 31, 1995. This reflects
increased demand for additional shipments of Nicotrol during 1996 due to the
change of Nicotrol's status from a prescription to an over-the-counter ("OTC")
product. On July 3, 1996 the United States ("U.S.") Food and Drug Administration
(the "FDA") approved Nicotrol as the first OTC smoking cessation transdermal
patch.

In November 1993, the Company entered into an agreement pursuant to which
the Company granted Pharmacia & Upjohn, Inc. ("Pharmacia") the exclusive
worldwide right to manufacture Nicotrol in return for a royalty based on
Pharmacia's sales of such products. Prior to that, Pharmacia had the exclusive
right to manufacture Nicotrol outside of North America and was obligated to pay
to Cygnus a royalty based on Pharmacia's sales of such products outside of North
America. The November 1993 agreement, as amended in November 1994, obligated
Cygnus to continue to manufacture and supply Nicotrol until December 31, 1995.
In February of 1996, the Company and Pharmacia further amended the 1993
agreement to provide that Cygnus will continue to manufacture and supply
Nicotrol for the U.S. market through 1999. In addition to product revenues under
this agreement, the Company also earns royalties on sales within the U.S.
Pharmacia has the option to terminate this agreement and purchase the U.S.
manufacturing rights upon the payment of certain amounts to the Company.
Pharmacia has exercised this option to purchase the U.S. manufacturing rights
for Nicotrol and the Company is presently in negotiations with Pharmacia as to
various transition matters including Pharmacia's obligations for certain
purchase order commitments and existing inventory costs.

The Company anticipates that the demand for Nicotrol within the U.S. during
1997 will be well below 1996 levels as a result of the ability of the Company's
marketing partner to meet product demand by utilizing existing inventories. In
addition, the long-term demand for Nicotrol is uncertain in both existing and
potential markets. Currently, in addition to Nicotrol, there are other smoking
cessation transdermal patches and other smoking cessation products that have
been approved for OTC sale by the FDA which are not made by or licensed from
Cygnus. A reduction in demand for Nicotrol will have the effect of reducing the
Company's revenues and therefore negatively impact its overall results of
operations.

Due to the above factors, the uncertainty of the success of the Company's
recently approved FemPatch-TM- product, and the uncertainty regarding when and
if additional products obtain FDA clearance and when and if licensees sell and
market such products, the Company believes that the level of product revenues
experienced to date are not indicative of future results.

CONTRACT REVENUES for the year ended December 31, 1996 were $13.1 million
compared to the $12.6 million for the year ended December 31, 1995. Contract
revenues primarily reflect labor and material cost reimbursements associated
with certain transdermal delivery systems and the amortization of milestone
payments relating to certain transdermal delivery systems and the glucose
monitoring device.

3
<PAGE>
In February 1996 the Company entered into an agreement with Becton Dickinson
for the marketing and distribution of the GlucoWatch-TM-, Cygnus' painless,
automatic glucose monitoring device. Under the terms of the agreement, Becton
Dickinson has exclusive worldwide marketing and distribution rights, with the
exception of Japan and Korea. Cygnus will have primary responsibility for
completing product development, obtaining regulatory approvals and
manufacturing. In addition, Cygnus will participate in sales, marketing and
customer service and support for the product. In the first half of 1996, Cygnus
received an up-front non-refundable payment from Becton Dickinson and is
eligible to receive milestone payments as well as a percentage of the product's
future commercial success.

In July 1996 the Company entered into an agreement with Tokyo-based
Yamanouchi Pharmaceutical Co., Ltd. ("Yamanouchi") for the marketing and
distribution of the GlucoWatch. Under the terms of this agreement, Yamanouchi
has exclusive marketing and distribution rights in Japan and Korea. Cygnus will
have primary responsibility for completing product development and for
manufacturing. In the third quarter of 1996, Cygnus received an up-front
non-refundable payment from Yamanouchi and is eligible to receive milestone
payments as well as a percentage of the product's future commercial success. In
July 1996 the Company also entered into a development and marketing agreement
with Yamanouchi for a 7-day transdermal product to deliver a proprietary
Yamanouchi compound. Under the terms of the agreement, Cygnus will receive
funding for the development of the transdermal product and will have exclusive
rights to manufacture and supply Yamanouchi with the product and Yamanouchi will
have exclusive worldwide marketing rights to the product.

Contract revenues are expected to fluctuate from quarter to quarter and from
year to year, and future contract revenues cannot be reasonably predicted. The
contributing factors to achieving contract revenues include, but are not limited
to, future successes in finalizing new collaborative agreements, timely
achievement of milestones under current contracts, and strategic decisions on
self-funding certain projects. Cygnus' licensees generally have the right to
abandon the rights to a product and the obligation to make related payments.
Since all payments to the Company under these agreements following their
execution are contingent on the occurrence of future events or sales levels, and
the agreements are terminable by the licensee, no assurance can be given as to
whether the Company will receive any particular payment thereunder or as to the
amount or timing of any such payment. The Company is unable to predict to what
extent the termination of existing contracts by current partners, or new
collaborative agreements, if any, will impact overall contract revenues in 1997
and subsequent future periods.

ROYALTY AND OTHER REVENUES for the year ended December 31, 1996 were $5.9
million, compared to $2.7 million for the year ended December 31, 1995. The
amounts include royalties from sales by Pharmacia of the Company's nicotine
transdermal product in Europe and Canada, and by Pharmacia's marketing partner
in the U.S. Additionally, in the first half of 1995, amounts included the
amortization of the unearned balance of prepayments from Pharmacia. As of June
30, 1995, all of the prepayments were fully amortized. The net increase in
royalty and other revenues is primarily due to the significant increase in
volume of units shipped as a result of the change of Nicotrol's status to OTC in
the U.S.

Royalty income will fluctuate from period to period since it is primarily
based upon sales by the Company's licensees. The level of royalty income for a
product also depends on various external factors, including the size of the
market for the product, product pricing levels and the ability of the Company's
licensee to market the product. Therefore, the level of royalty income for any
given period is not indicative of the expected royalty income for future
periods. It is anticipated that royalty revenue in 1997 will reflect the
recognition of previously deferred royalty payments associated with the U.S. OTC
sales of Nicotrol during the second half of 1996.

4
<PAGE>
COSTS OF PRODUCTS SOLD for the year ended December 31, 1996, were $16.7
million compared to $4.7 million for the year ended December 31, 1995. Costs of
products sold include direct and indirect manufacturing costs of Nicotrol
production and facility and personnel costs required to meet production levels.
In addition, due to uncertainties related to the level of the future sales of
Nicotrol, the Company recorded in 1996 as part of cost of products sold, certain
expenses relating to estimated committed future production costs. Costs of
products sold increased primarily due to increased Nicotrol shipments as a
result of the change of Nicotrol's status to OTC in the U.S. and the expenses
related to the estimated committed future productions costs. While the Company
experienced a positive product margin during 1996 due to increased demand for
additional shipments of Nicotrol, the Company experienced negative product
margins during 1995, primarily due to low production volumes which prevented the
Company from absorbing all of the fixed costs associated with its production of
Nicotrol.

While the Company anticipates that due to decreasing short-term demand for
its Nicotrol product, the direct and indirect manufacturing cost associated with
Nicotrol production will be reduced, there can be no assurance that product
margins associated with Nicotrol production will improve or remain consistent
with current levels.

RESEARCH AND DEVELOPMENT EXPENSES for the year ended December 31, 1996 were
$23.2 million compared to $20.0 million for the year ended December 31, 1995.
This increase reflects the Company's accelerated level of research and
development costs primarily associated with the glucose monitoring system.
Research and development and clinical activities primarily include the glucose
monitoring development program, the support of the Company's hormone replacement
therapy products (one of which, FemPatch, was approved by FDA on December 5,
1996 and two of which are in clinical trials), and a contraception product.
Cygnus expects that its anticipated development of new products, continued
research of new technologies and preparation for regulatory filings and
clinicals could result in an increase in its overall research and development
expenses.

MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES for the year ended December
31, 1996 were $9.3 million, compared to $7.4 million for the year ended December
31, 1995. The increase resulted from increased legal expenses primarily related
to the Sanofi arbitration (See Note 7 to the Financial Statements). The Company
believes that marketing, general and administrative expenses could increase in
the future as the Company expands its operations.

INTEREST INCOME, NET OF INTEREST AND OTHER EXPENSE for the year ended
December 31, 1996 was $1.9 million as compared to $0.3 million for the year
ended December 31, 1995. The increase is due primarily to interest earned on the
proceeds from the Company's 1995 public offering.

INCOME TAXES. At December 31, 1996, the Company had federal net operating
loss and research and development tax credit carryforwards of approximately
$57.0 million and $1.3 million, respectively. The Company had state net
operating loss and tax credit carryforwards of approximately $4.3 million and
$0.9 million, respectively. These carryforwards will expire at various dates
beginning in 2000. Because of the "change in ownership" provisions of the Tax
Reform Act of 1986, a substantial portion of the Company's net operating loss
and tax credit carryforwards may be subject to annual limitations. The annual
limitation may result in the expiration of net operating losses and tax credits
before utilization.

FOURTH QUARTER LOSS for the three months ended December 31, 1996 was $1.0
million compared to $2.7 for the three months ended December 31, 1995. The
decrease in fourth quarter losses for 1996 was primarily attributable to
increased product and royalty revenues relating to Nicotrol sales as mentioned
above.

5
<PAGE>
COMPARISON FOR THE YEARS ENDED DECEMBER 31, 1995 AND 1994

PRODUCT REVENUES for the year ended December 31, 1995 were $3.7 million
compared to $1.9 million for the year ended December 31, 1994. This reflects
increased demand for additional shipments of Nicotrol in 1995. In 1994 the
Company's marketing partner was able to meet product demand by utilizing
inventories existing as of the beginning of the period.

CONTRACT REVENUES for the year ended December 31, 1995 were $12.6 million
compared to the $14.5 million for the year ended December 31, 1994. The decrease
in contract revenues primarily reflects a decrease in billings related to the
Company's first hormone replacement product due to agreed upon maximum cost
reimbursements, the mutually agreed upon termination of funding obligations
Paine Webber R&D Partners II L.P. ("PWLP") had under a research and development
agreement and the mutually agreed upon termination of the certain collaborations
to develop and market consumer and smoking cessation products. The technology
resulting from the Paine Webber partnership agreement was purchased by the
Company from PWLP in December 1994 in exchange for 1,529,941 shares of the
Company's Common Stock.

ROYALTY AND OTHER REVENUES for the year ended December 31, 1995, were $2.7
million compared to $4.8 million for the year ended December 31, 1994. The
amounts included royalties from sales by Pharmacia of the Company's nicotine
transdermal product in Europe and beginning in 1994, Canada. Additionally, the
amounts include the amortization of the unearned balance of prepayments from
Pharmacia included in "Customer Advances". As of June 30, 1995, all of the
prepayments were fully amortized. The decrease in 1995 was primarily
attributable to 1995 including a half year amortization of "Customer Advances"
compared to 1994 which included a full year of amortization as well as the sale
of $1.3 million of previously reserved excess inventory to Pharmacia.

COSTS OF PRODUCTS sold for the year ended December 31, 1995, were $4.7
million compared to $3.3 million for the year ended December 31, 1994. Costs of
products sold included direct and indirect manufacturing costs of Nicotrol
production. Costs of products sold increased primarily due to increased Nicotrol
shipments, offset in part by a $1.0 million charge to reduce the net realizable
value of Nicotrol production equipment incurred in the second quarter of 1994.

The Company experienced negative product margins during 1995 and 1994
primarily due to low production volumes which prevented the Company from
absorbing all the fixed costs associated with Nicotrol production.

RESEARCH AND DEVELOPMENT EXPENSES for the year ended December 31, 1995 were
$20.0 million compared to $21.6 million for the year ended December 31, 1994.
This decrease reflects a reduced level of materials required in ongoing
development programs and the Company's ongoing cost control measures. Research
and development and clinical activities primarily include the support of the
Company's hormone replacement therapy products, contraception products and the
glucose monitoring development program.

PURCHASE OF IN-PROCESS RESEARCH AND DEVELOPMENT expense for the year ended
December 31, 1994 represents a $9.0 million charge for the acquisition by the
Company of all rights previously held by PWLP to certain non-invasive glucose
monitoring technology developed under research and development agreements
between Cygnus and PWLP. Based on the early stage of development and the
uncertainty as to the feasibility of the technology, the acquisition cost was
expensed to in-process research and development. No such purchases were made in
1995.

6
<PAGE>
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES for the year ended December
31, 1995 were $7.4 million, compared to $5.5 million for the year ended December
31, 1994. The increase primarily reflects an increase in business development
activities related to the glucose monitoring development program and increased
legal expenses due to the Company's legal proceedings against Alza and Sanofi
(see Note 7 to the Financial Statements).

INTEREST INCOME, NET OF INTEREST AND OTHER EXPENSE for the year ended
December 31, 1995 was $0.3 million as compared to $0.8 million for the year
ended December 31, 1994. The decrease is primarily due to lower prevailing
interest rates and lower levels of cash and short term investments through the
first three quarters of 1995.

INCOME TAXES. At December 31, 1995, the Company has federal net operating
loss carryforwards of approximately $50.2 million and federal and state research
and development credits of approximately $1.8 million. These carryforwards will
expire beginning in 2000. Because of the "change in ownership" provision of the
Tax Reform Act of 1986, a substantial portion of the Company's net operating
loss and tax credit carryforwards are subject to annual limitations.

LIQUIDITY AND CAPITAL RESOURCES

Through October 1995, the Company received net proceeds of approximately
$82.1 million from public offerings. Through 1996, the Company financed
approximately $8.4 million of manufacturing and research equipment under capital
loan and lease arrangements. In December of 1994, the Company borrowed $1.7
million under a bank line of credit to finance the purchase of manufacturing and
research equipment. This line will be repaid in monthly installments by June 30,
1998. In June 1996, the Company received $8.0 million under a bank loan
agreement for short-term working capital. This line will be repaid monthly
beginning in January 1997 through December 1999. Both lines are subject to a
number of financial and other covenants. In addition to the cash from the public
offerings, equipment lease and short-term working capital financing, the Company
has been financing its operations primarily through revenues and interest
income.

Net cash used in operating activities for the twelve month period ended
December 31, 1996 was $6.3 million, compared with net cash used of $12.5 million
for the year ended December 31, 1995. Cash used in operations during the year
ended December 31, 1996 was primarily due to the Company's net loss of $11.1
million, increases in accounts receivable, inventories, and prepaid expenses and
other assets offset by increases in accounts payable and other accrued
liabilities, accrued compensation, deferred revenue, and accrued rent and other
liabilities. Cash used in operations during the year ended December 31, 1995 was
primarily due to the Company's net loss of $12.8 million, increases in accounts
receivable and prepaid and other assets, and the decreases in accounts payable
and other accrued liabilities, offset by increases in deferred revenue and
accrued rent and other liabilities.

The current level of cash used in operating activities is not necessarily
indicative of the level of future cash usage. As a result of increased
expenditures for the development of new products, preparation for regulatory
filings and clinical trials and the expected reduction in product revenues, the
Company anticipates an increase in cash usage for 1997 operating activities.

Net cash used in investing activities of $1.5 million for the twelve month
period ended December 31, 1996 resulted primarily from purchases of short-term
investments and capital expenditures. Net cash provided by investing activities
of $0.9 million for the twelve month period ended December 31, 1995 resulted
from sales of short-term investments to finance operating activities offset by
capital expenditures.

7
<PAGE>
Net cash provided by financing activities of $10.5 million for the twelve
months ended December 31, 1996 includes $8.0 million received from the Company's
working capital loan and security agreement, $4.0 million of common stock
issuance proceeds and $0.5 million received under the equipment lease agreement
offset by scheduled long-term debt and capital lease repayments. Net cash
provided by financing activities of $32.9 million for the twelve months ended
December 31, 1995 includes net proceeds of approximately $29.8 million from the
October 1995 public offering and $2.1 million received under the equipment lease
agreement offset by long-term debt and capital lease repayments. The Company
continues to evaluate the benefits of using equipment leases to finance
equipment purchases.

Overall, the cash, cash equivalents and short-term investment balances as of
December 31, 1996 totaled $49.4 million, representing an increase of $2.9
million from the total as of December 31, 1995.

The Company's long term capital expenditure requirements will depend upon
numerous factors, including the progress of the Company's research and
development programs; the time required to obtain regulatory approvals; the
resources that the Company devotes to the development of self-funded products,
proprietary manufacturing methods and advanced technologies; the ability of the
Company to obtain additional licensing arrangements and to manufacture products
under those arrangements; the additional expenditures to support the manufacture
of new products if and when approved; and possible acquisitions of products,
technologies and companies. As the Company evaluates the progress of its
development projects, in particular the glucose monitoring device and hormone
replacement products, its commercialization plans and the lead time to set up
manufacturing capabilities, Cygnus may commence long-term planning for another
manufacturing site. Nevertheless, the Company believes that such long-term
planning will not result in any material impact on cash flows and liquidity for
1997.

Based upon current expectations for operating losses and capital
expenditures for 1997, the Company believes that its existing cash, cash
equivalents and short-term investments of $49.4 million, when coupled with
expected future product sales and royalty, contract revenues from development
agreements, interest income and possible additional equipment financing, will be
sufficient to meet its operating expenses and capital expenditure requirements
through at least 1997. However, there can be no assurance that the Company will
not require additional financing depending upon future business strategies,
results of clinical trials and management decisions to accelerate certain
research and development programs and other factors.

8
<PAGE>
CYGNUS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------
1996 1995 1994
---------- ---------- ----------
<S> <C> <C> <C>
REVENUES:
Product revenues............................................................ $ 17,211 $ 3,704 $ 1,917
Contract revenues........................................................... 13,085 12,579 14,533
Royalty and other revenues.................................................. 5,907 2,723 4,820
---------- ---------- ----------
TOTAL REVENUES............................................................ 36,203 19,006 21,270

COSTS AND EXPENSES:
Costs of products sold...................................................... 16,659 4,746 3,293
Research and development.................................................... 23,165 20,029 21,605
Purchase of in-process research and development............................. -- -- 9,000
Marketing, general and administrative....................................... 9,296 7,369 5,491
---------- ---------- ----------
TOTAL COSTS AND EXPENSES.................................................. 49,120 32,144 39,389

Loss from operations.......................................................... (12,917) (13,138) (18,119)

Interest and other income..................................................... 2,851 1,139 1,049

Interest and other expense.................................................... (986) (843) (290)
---------- ---------- ----------
NET LOSS...................................................................... $ (11,052) $ (12,842) $ (17,360)
---------- ---------- ----------
---------- ---------- ----------
NET LOSS PER SHARE............................................................ $ (0.60) $ (0.79) $ (1.24)
---------- ---------- ----------
---------- ---------- ----------
Shares used in computation of net loss per share.............................. 18,544 16,265 13,947
---------- ---------- ----------
---------- ---------- ----------
</TABLE>

See accompanying notes.

9
<PAGE>
CYGNUS, INC.

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS)

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1996 1995
--------- ---------
<S> <C> <C>
ASSETS:

CURRENT ASSETS:
Cash and cash equivalents.................................................................. $ 33,148 $ 30,445
Short-term investments..................................................................... 16,286 16,053
Trade accounts receivable, net of allowance (1996--$1,137; 1995--$1,137)................... 7,759 2,310
Inventories................................................................................ 2,331 378
Prepaid expenses and other current assets.................................................. 1,010 640
--------- ---------
Total current assets................................................................... 60,534 49,826

EQUIPMENT AND IMPROVEMENTS:
Office and laboratory equipment............................................................ 12,781 11,492
Leasehold improvements..................................................................... 6,681 6,640
--------- ---------
19,462 18,132
Less accumulated depreciation and amortization............................................. (13,872) (11,260)
--------- ---------
Net equipment and improvements......................................................... 5,590 6,872
Lease deposits and other assets.............................................................. 2,674 1,156
--------- ---------
Total Assets........................................................................... $ 68,798 $ 57,854
--------- ---------
--------- ---------

LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
Accounts payable........................................................................... $ 2,153 $ 1,006
Accrued compensation....................................................................... 3,177 2,191
Accrued professional services.............................................................. 691 726
Other accrued liabilities.................................................................. 2,465 1,287
Customer advances.......................................................................... 1,146 846
Current portion of deferred revenue........................................................ 10,912 3,301
Current portion of long-term debt.......................................................... 2,289 489
Current portion of capital lease obligations............................................... 1,315 1,425
--------- ---------
Total current liabilities.............................................................. 24,148 11,271
Long-term portion of deferred revenue........................................................ 2,567 3,532
Long-term portion of debt.................................................................... 6,444 734
Long-term portion of capital lease obligations............................................... 1,076 1,976
Accrued rent and other long-term liabilities................................................. 3,350 2,089

STOCKHOLDERS' EQUITY:
Preferred stock, $0.001 par value: 5,000 shares authorized; no shares issued and
outstanding.............................................................................. -- --
Common stock, $0.001 par value: 30,000 shares authorized; issued and outstanding: 18,691
and 18,223 shares at December 31, 1996 and 1995, respectively............................ 117,284 113,266
Accumulated deficit........................................................................ (86,071) (75,014)
--------- ---------
Total stockholders' equity............................................................. 31,213 38,252
--------- ---------
Total liabilities and stockholders' equity........................................... $ 68,798 $ 57,854
--------- ---------
--------- ---------
</TABLE>

See accompanying notes.

10
<PAGE>
CYGNUS, INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY

FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994

(IN THOUSANDS)

<TABLE>
<CAPTION>
TOTAL
COMMON ACCUMULATED STOCKHOLDERS'
STOCK DEFICIT EQUITY
---------- ------------ ------------
<S> <C> <C> <C>
BALANCE, DECEMBER 31, 1993............................................... $ 71,057 $ (44,814) $ 26,243
Issuance of 97 shares of common stock.................................... 103 -- 103
Issuance of 1,530 shares of common stock in exchange for the acquisition
of glucose monitoring technology....................................... 9,000 -- 9,000
Issuance of 95 shares of common stock under the Employee Stock Purchase
Plan................................................................... 545 -- 545
Unrealized loss on investments........................................... -- (414) (414)
Net loss................................................................. -- (17,360) (17,360)
---------- ------------ ------------
BALANCE, DECEMBER 31, 1994............................................... 80,705 (62,588) 18,117
Issuance of 245 shares of common stock................................... 2,129 -- 2,129
Issuance of 2,300 shares of common stock in third public offering, net of
issuance costs of $2,379............................................... 29,821 -- 29,821
Issuance of 105 shares of common stock under the Employee Stock Purchase
Plan................................................................... 611 -- 611
Unrealized gain on investments........................................... -- 416 416
Net loss................................................................. -- (12,842) (12,842)
---------- ------------ ------------
BALANCE, DECEMBER 31, 1995............................................... 113,266 (75,014) 38,252
Issuance of 333 shares of common stock................................... 2,749 -- 2,749
Issuance of 90 shares of common stock under the Employee Stock Purchase
Plan................................................................... 823 -- 823
Issuance of 45 shares of common stock through exercise of warrant........ 446 446
Unrealized loss on investments........................................... -- (5) (5)
Net loss................................................................. -- (11,052) (11,052)
---------- ------------ ------------
BALANCE, DECEMBER 31, 1996 $ 117,284 $ (86,071) $ 31,213
---------- ------------ ------------
---------- ------------ ------------
</TABLE>

See accompanying notes

11
<PAGE>
CYGNUS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

INCREASE/(DECREASE) IN CASH AND CASH EQUIVALENTS

(IN THOUSANDS)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------
1996 1995 1994
---------- ---------- ----------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss...................................................................... $ (11,052) $ (12,842) $ (17,360)
Adjustments to reconcile net loss to net cash (used in)/provided by operating
activities:
Non-cash purchase of in-process research and development.................... -- -- 9,000
Depreciation and amortization............................................... 2,802 2,683 2,436
Loss on write-down and disposals of equipment............................... -- -- 1,017
Other....................................................................... (280) 88 14
(Increase)/decrease in assets:
Receivables................................................................. (5,449) (588) 7,222
Inventories................................................................. (1,953) (232) (146)
Prepaid expenses and other assets........................................... (1,888) (427) 792
Increase/(decrease) in liabilities:
Accounts payable and other accrued liabilities.............................. 2,325 (1,166) 809
Accrued compensation........................................................ 986 (670) 998
Accrued professional services............................................... (35) 121 (656)
Customer advances........................................................... 300 (449) (2,905)
Deferred revenue............................................................ 6,646 670 1,163
Accrued rent and other liabilities.......................................... 1,261 267 (623)
---------- ---------- ----------
Net cash provided by/(used in) operating activities........................... (6,337) (12,545) 1,761
---------- ---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures.......................................................... (1,515) (2,405) (2,668)
Purchases of short-term investments........................................... (31,565) (21,697) (23,232)
Maturity and sale of short-term investments................................... 31,602 24,959 29,002
---------- ---------- ----------
Net cash provided by/(used in) investing activities..................... (1,478) 857 3,102
---------- ---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from sale and leaseback of assets.................................... 464 2,122 --
Issuance of common stock...................................................... 4,018 32,561 648
Proceeds from long-term debt.................................................. 8,000 -- 1,692
Principal payments of long-term debt.......................................... (490) (469) --
Payment of capital lease obligations.......................................... (1,474) (1,301) (1,097)
---------- ---------- ----------
Net cash provided by financing activities............................... 10,518 32,913 1,243
---------- ---------- ----------
Net increase in cash and cash equivalents..................................... 2,703 21,225 6,106
Cash and cash equivalents at beginning of year................................ 30,445 9,220 3,114
---------- ---------- ----------
Cash and cash equivalents at end of year...................................... $ 33,148 $ 30,445 $ 9,220
---------- ---------- ----------
---------- ---------- ----------
</TABLE>

See accompanying notes.

12
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BRIEF DESCRIPTION OF BUSINESS

Cygnus, Inc. was incorporated in California in April 1985. In September 1995
the Company changed its name from Cygnus Therapeutic Systems to Cygnus, Inc. and
its place of incorporation to Delaware. Cygnus is engaged in the development of
diagnostic and drug delivery systems, with its current efforts primarily focused
on three core areas: a painless, automatic glucose monitoring device,
transdermal delivery systems and mucosal drug delivery systems. The Company's
products in the most advanced stages of development include one in the market
(Nicotrol; marketed as Nicorette-Registered Trademark- in Europe; collectively
"Nicotrol Products"), one approved by the FDA (FemPatch) and several in
different stages of clinical trials.

CONSOLIDATION

The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries after elimination of all material
inter-company balances and transactions. Cygnus' subsidiaries were inactive in
1996, 1995 and 1994.

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 amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates. Certain
reserves and accrued liabilities that the Company recorded relating to Nicotrol
inventory and purchases were based on information available at the time such
estimates were necessary, and it is possible that changes in this information
could occur which could have a material impact on such estimates in the future.

REVENUE RECOGNITION

Product sales are recorded when Nicotrol Products are shipped. Upfront and
interim milestone payments from feasibility and development contracts are
generally earned and recognized based on percentage of actual efforts expended
compared to total expected efforts during the development period for each
contract. The total expected efforts under each contract are estimated by
management and updated periodically in light of the current conditions and
expected development timeline. Milestone payments received at the end of the
development period of an agreement are generally recognized upon receipt.
Deferred revenue includes the portion of upfront and interim milestone payments
received on research and development agreements which have been deferred and
will be recognized over the related development period in relation to efforts
expended under the agreement and portions of deferred royalty from U.S.
over-the-counter ("OTC") sales of Nicotrol. Royalty income from Nicotrol
Products is recognized in the quarter following the quarter in which the sales
occurred. Customer advances at December 31, 1996 consists primarily of a
pre-payment for a portion of launch quantities of the Company's FemPatch
product.

13
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
One customer provided for 100% of product sales and royalty and other income
in 1996, 1995 and 1994. Four customers provided for 28%, 25%, 14% and 13% of
contract revenues in 1996. Two of these customers provided for 34% and 27% of
contract revenues in 1995. These same two customers provided for 21% and 5% of
contract revenues in 1994.

COSTS OF PRODUCTS SOLD

Direct and indirect costs associated with manufacturing Nicotrol products
are included in costs of products sold.

RESEARCH AND DEVELOPMENT

The Company has entered into license and collaboration agreements with
certain companies. In general, these agreements provide that Cygnus will create
and/or manufacture the drug delivery or diagnostic system and receive
reimbursements for cost incurred and royalties based on product sales by its
licensees. Additionally, under such agreements, Cygnus may receive one or more
of upfront payments and milestone payments (which are made upon the occurrence
of certain events, such as the filing of the New Drug Application for a
product), as well as reimbursements of certain research and development
expenses. Research and development expenses consist of process development
costs, costs associated with work performed under development agreements and
self-funded research, and costs incurred in clinical studies and
regulatory/scientific affairs. Research and development expenses covered under
contracts partially funded by the Company's licensees for the years ended
December 31, 1996, 1995 and 1994 were approximately $18,422, $16,951 and
$17,838, respectively. Cygnus' pharmaceutical company licensees generally have
the right to abandon the rights to a product and the obligation to make related
payments. Since all payments to the Company under these agreements are
contingent on the occurrence of future events or sales levels, and the
agreements are terminable by the licensee, no assurance can be given as to
whether the Company will receive any particular payment thereunder or as to the
amount or timing of any such payment.

INVENTORIES

Inventories are stated at the lower of cost (first-in, first-out method) or
market, after appropriate consideration was given to obsolescence and
inventories in excess of anticipated future demand. Net inventories consist of
the following:

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1996 1995
--------- ---------
<S> <C> <C>
Raw materials................................................................ $ 1,111 $ 378
Work in process.............................................................. 842 --
Finished goods............................................................... 378 --
--------- ---------
$ 2,331 $ 378
--------- ---------
--------- ---------
</TABLE>

14
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
Inventories at December 31, 1996 relate to the Company's nicotine (Nicotrol)
and estradiol (FemPatch) transdermal products. Inventories at December 31, 1995
related to the Company's nicotine transdermal product.

RECEIVABLES

Approximately 83% of the receivables are due from two customers. The
remaining balance of the receivables are due from three customers, all of which
are large pharmaceutical companies. Generally, the Company does not require any
collateral on receivable balances.

OTHER ACCRUED LIABILITIES

Due to the uncertainties of the future sales of Nicotrol and other
commitments, the Company has recorded $1,400 as part of the other accrued
liabilities relating to estimated committed future production costs and
non-cancelable purchase commitments.

EQUIPMENT AND IMPROVEMENTS

Equipment and improvements are recorded at the lower of cost or net
realizable value. Depreciation of equipment is computed on a straight-line basis
over the estimated useful lives of three to six years. Leasehold improvements
and assets recorded under capital leases are amortized using the straight-line
method over the shorter of the estimated useful life of the assets or the term
of the leases.

DEFERRED COMPENSATION

In 1995, the Company adopted a non-qualified deferred compensation plan. The
Plan is intended to be unfunded and is maintained by an employer primarily for
the purpose of providing deferred compensation for a select group of management.
As of December 31, 1996 and 1995, the Company maintained $2,463 and $946,
respectively under other long-term assets and under other long-term liabilities
related to the plan which included both contributions and net investment
earnings. These investments are directed by the participants.

NET LOSS PER SHARE

Net loss per share is computed using the weighted average number of shares
of common stock outstanding. Common equivalent shares from stock options and
warrants are excluded from the computation as their effect is anti-dilutive.

15
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
ACCOUNTING FOR STOCK BASED COMPENSATION

In October 1995, the Financial Accounting Standards Board issued Statement
No. 123, "Accounting for Stock-Based Compensation" (FAS 123). The Statement is
effective for fiscal years beginning after December 15, 1995. Under the
Statement, stock-based compensation expense to employees is measured using
either the intrinsic value method as prescribed by Accounting Principle Board
Opinion No. 25 , "Accounting for Stock Issued to Employees" (APB 25) or the
fair-value method described in FAS 123. Companies choosing the intrinsic value
method will be required to disclose the pro-forma impact of the fair-value
method on net income and earnings per share. Cygnus has elected to follow APB 25
and related Interpretations in accounting for its employee stock options (See
Note 4). There was no effect of adopting the standard on Cygnus' financial
position or results of operations.

CONCENTRATION OF CREDIT RISK

The Company maintains its cash, cash equivalents and short-term investments
primarily with a bank and two brokerage houses. This practice is consistent with
the Company's policy to maintain high liquidity and ensure safety of principal.

SECURITIES AVAILABLE-FOR-SALE

Securities available-for-sale are carried at fair value, based on quoted
market prices, and the unrealized gains and losses have been combined with the
accumulated deficit due to immateriality. Realized gains and losses and declines
in value judged to be other-than-temporary on available-for-sale securities are
included in investment income. The cost of securities sold is based on the
specific identification method. Interest and dividends on securities classified
as available-for-sale are included in investment income.

The Company considers all highly liquid investments with a maturity from the
date of purchase of three months or less to be cash equivalents. The Company
invests its excess (to current demands) cash in short term, highly liquid
instruments. These investments have included, but are not limited to, Treasury
Notes, Federal Agency Securities, Auction Rate Certificates, Auction Rate
Preferred Stock, and Commercial Paper.

DEPENDENCE ON NICOTROL; UNCERTAINTY OF MARKET

The Company currently relies on sales of Nicotrol for all of its product
sales revenues. On July 3, 1996, the FDA approved Nicotrol as the first OTC
smoking cessation transdermal patch. To meet the OTC launch demand, additional
patches of Nicotrol were produced and shipped during 1996. The Company
anticipates that the short-term demand for Nicotrol within the U.S. will be
reduced as a result of the ability of the Company's marketing partner to meet
product demand by utilizing existing inventories. In addition, the long-term
demand for Nicotrol is uncertain in both existing and potential markets.
Currently, in addition to Nicotrol, there are other smoking cessation
transdermal patches and other smoking cessation products that have been approved
for OTC sale by the FDA which are not made by or licensed from Cygnus. A
reduction in demand for Nicotrol will have the effect of reducing the Company's
revenues and therefore negatively impact its overall results of operations.

16
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
DEPENDENCE ON SUPPLIERS

DEPENDENCE ON LICENSEES AND COLLABORATIVE ARRANGEMENTS

Cygnus depends on its licensees to fund a significant portion of product
development costs, to conduct clinical testing, to obtain regulatory approvals
and to market products. The Company is dependent on Pharmacia & Upjohn,
(Formerly Kabi Pharmacia Therapeutics AB), a subsidiary of Procordia AB
("Pharmacia") and its sublicensee Johnson & Johnson for the marketing of
Nicotrol. In February 1996, the Company entered into an agreement with Becton
Dickinson for the marketing and distribution of the GlucoWatch. Under the terms
of the agreement, Becton Dickinson has exclusive worldwide marketing and
distribution rights, with the exception of Japan and Korea. Cygnus has primary
responsibility for completing product development, obtaining regulatory
approvals, manufacturing, and customer service and support for the product. In
July 1996, the Company entered into an agreement with Tokyo-based Yamanouchi
Pharmaceutical Co., Ltd. for the marketing and distribution of the GlucoWatch in
Japan and Korea. Cygnus will have primary responsibility for completing product
development and for manufacturing. Cygnus will be eligible to receive up-front
and milestone payments as well as a percentage of the product's future
commercial success from both Becton Dickinson and Yamanouchi. The Company's
licensees generally have the right to terminate the development funding for a
product at any time for any reason without significant penalty. Licensees have
exercised this right in the past, and there can be no assurance that current and
future licensees will not also exercise this right in the future.

17
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 2: FAIR VALUE OF FINANCIAL INSTRUMENTS

For the year ended December 31, 1996, the net unrealized gains and losses on
available-for-sale securities was immaterial.

As of December 31, 1996, all debt securities are classified as
available-for-sale. The following is a summary of available-for-sale securities
as of December 31, 1996 and 1995:

<TABLE>
<CAPTION>
AVAILABLE-FOR-SALE SECURITIES
----------------------------------------------------
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
--------- ------------- ------------- -----------
<S> <C> <C> <C> <C>
AS OF DECEMBER 31, 1996:

Cash Equivalents:
Money Market Fund................................................ $ 5,952 $ -- $ -- $ 5,952
Short-term Corporate note / Commercial Paper, due in less than
ninety days.................................................... 7,881 7,881
Federal Agency Securities, due in less than ninety days.......... 13,981 -- -- 13,981
--------- ----- ----- -----------
Total Cash Equivalents....................................... $ 27,814 $ -- $ -- $ 27,814
--------- ----- ----- -----------
--------- ----- ----- -----------
Short-Term Investments:
Federal Agency Securities........................................ $ 2,006 $ -- $ (5) $ 2,001
Auction Rate Certificates........................................ 2,206 2,206
Auction Rate Preferred........................................... 9,042 9,042
Corporate Notes.................................................. 3,037 -- -- 3,037
--------- ----- ----- -----------
Total Short-Term Investments................................. $ 16,291 $ -- $ (5) $ 16,286
--------- ----- ----- -----------
--------- ----- ----- -----------
AS OF DECEMBER 31, 1995:

Cash Equivalents:
Money Market Fund................................................ $ 14,709 $ -- $ -- $ 14,709
Federal Agency Securities, due in less than ninety days.......... 7,989 -- -- 7,989
--------- ----- ----- -----------
Total Cash Equivalents....................................... $ 22,698 $ -- $ -- $ 22,698
--------- ----- ----- -----------
--------- ----- ----- -----------
Short-Term Investments:
Auction Rate Certificates........................................ 12,045 -- -- 12,045
Auction Rate Preferred........................................... 4,008 -- -- 4,008
--------- ----- ----- -----------
Total Short-Term Investments................................. $ 16,053 $ -- $ -- $ 16,053
--------- ----- ----- -----------
--------- ----- ----- -----------
</TABLE>

All cash equivalents and short-term investments as of December 31, 1996 have
maturity dates of less than one year.

18
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 3: CREDIT LINE AND LEASES

In December 1994, the Company borrowed $1,712 under a bank line of credit to
finance the purchase of manufacturing and research equipment. The line bears
interest at two percentage points above the prime rate (10.25% in total as of
December 31, 1996). Borrowings under this line are secured by the equipment
purchased and will be paid off in monthly installments through June 30, 1998. As
of December 31, 1996, $733 was outstanding. In June of 1996, the Company
received $8,000 under a bank loan agreement for short-term working capital. The
line bears interest at a fixed rate of 9.57% per year. Borrowings under this
line are secured by the Company's assets excluding those securing lease lines of
credit. This line will be repaid monthly starting January 1997 and is scheduled
to be fully paid by December 1999. As of December 31, 1996, $8,000 was
outstanding. Both lines are subject to certain financial covenants including
minimum cash balances, tangible net worth, and debt to net worth ratio.

Assets leased under capital leases are included in equipment with a cost of
$5,717 and $5,182 at December 31, 1996 and 1995, respectively, with related
accumulated amortization of approximately $3,914 and $3,061 at December 31, 1996
and 1995, respectively. Upon the expiration of the leases, Cygnus has purchase
options for the leased equipment at market values.

The future aggregate principal payments of long-term debt and minimum lease
payments under capital leases, together with the present value of the net
minimum lease payments as of December 31, 1996 are as follows:

<TABLE>
<CAPTION>
LONG-TERM DEBT CAPITAL LEASES
--------------- ---------------
<S> <C> <C>
Years ending December 31,
1997....................................................... $ 2,288 $ 1,445
1998....................................................... 3,345 737
1999....................................................... 3,100 332
2000....................................................... -- 72
2001....................................................... -- --
------ ------
Total principal and minimum lease payments, respectively..... $ 8,733 2,586
------
------
Less amount representing interest............................ 195
------
Present value of net minimum lease payments.................. 2,391
Current portion.............................................. 1,315
------
Amounts due after one year................................... $ 1,076
------
------
</TABLE>

The fair market value of the equipment line of credit and short-term working
capital bank loan approximates their carrying value of $8,733.

The Company leases its facilities under a non-cancelable operating lease
expiring in 1998, with a five-year renewal option at the end of the lease. The
terms of the lease provide for rental payments on a graduated scale. The Company
is recognizing rent expense on a straight-line method over the lease period and
therefore has accrued for the rent expense incurred but not paid. Additionally,
the Company leases an off-site warehouse with a three-year lease term ending in
1999.

19
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 3: CREDIT LINE AND LEASES (CONTINUED)
Minimum future rental commitments under the operating leases at December 31,
1996 amount to $1,172 in 1997, $1,172 in 1998, and $96 in 1999. Rent expense
amounted to $1,013, $1,011, and $1,075 for the years ended December 31, 1996,
1995 and 1994, respectively.

NOTE 4: STOCKHOLDERS' EQUITY

PREFERRED SHARE PURCHASE RIGHTS PLAN

Pursuant to the Company's Stockholder Rights Plan, the Board declared a
dividend distribution of one Preferred Share Purchase Right ("Right") for each
outstanding share of Common Stock, issuable on October 18, 1993 to stockholders
of record on that date. These rights will remain outstanding until September 21,
2003.

WARRANTS

In September 1990, in connection with the Paine Webber product development
program, a warrant to purchase 300 shares of common stock at $9.90 per share was
issued to the development partner. Warrants to purchase 45 shares have been
exercised as of December 31, 1996. The remaining warrants expire September 1997
(or at an accelerated date under certain circumstances).

STOCK ISSUED IN EXCHANGE FOR IN PROCESS RESEARCH AND DEVELOPMENT

In December 1994, Cygnus acquired all rights previously held by Paine Webber
R&D Partners II L.P. ("PWLP") to certain non-invasive glucose monitoring
technology, valued at $9,000, developed under research and development
agreements between Cygnus and PWLP. Based on the early stage of development and
the uncertainty as to the feasibility of the technology, the acquisition cost
was expensed to in-process research and development. In return, Cygnus issued
1,530 shares of common stock to PWLP.

EMPLOYEE STOCK PURCHASE PLAN

As part of an employee retention program, the Company established the 1991
Employee Stock Purchase Plan (the "Stock Purchase Plan") to provide employees
with an opportunity to purchase common stock of the Company through payroll
deductions. A total of 575 shares of common stock were reserved for issuance to
eligible employees under the amended Stock Purchase Plan. The amended Stock
Purchase Plan will terminate in 2023 unless sooner terminated by the Board of
Directors. Under this Stock Purchase Plan, the Company's employees, subject to
certain restrictions, may purchase shares of common stock at 85 percent of the
lesser of the fair market value at either the date of enrollment or the date of
purchase. During 1996 and 1995, 90 and 105 shares, respectively, were issued
under the Stock Purchase Plan, and at December 31, 1996, 191 shares were
available for issuance.

At December 31, 1996, the total number of shares of common stock reserved
for issuance under all stock plans and for warrant exercises was 4,547.

20
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 4: STOCKHOLDERS' EQUITY (CONTINUED)
STOCK OPTION PLAN

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, because 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 Company has an Incentive Stock Plan (the "Stock Plan") which authorizes
the Board of Directors to grant incentive stock options, nonstatutory stock
options, stock purchase rights and stock bonuses to employees and consultants.
The Stock Plan, as amended, authorizes the issuance of up to 5,916 common shares
of which 1,668 are available for grant at December 31, 1996.

Under the Stock Plan, incentive stock options must be granted at fair market
value at the date of grant as determined by the Board of Directors or committee
thereof. Options vest over a four-year period and are exercisable for a term of
ten years after issuance unless otherwise determined by the Board of Directors
or committee thereof.

Pro forma information regarding net income and earnings per share is
required by Statement 123, which also requires that the information be
determined as if the Company has accounted for its employee stock options
granted subsequent to December 31, 1994 under the fair value method of that
Statement. The fair value for these options and the fair value for the stocks
issued under the 1991 Employee Stock Purchase Plan (the "Stock Purchase Plan")
were estimated at the date of grant using a Black-Scholes option pricing model
with the following weighted-average assumptions for 1996 and 1995: risk-free
interest rate of 6.125%; a dividend yield of 0.0%; volatility factors of the
expected market price of the Company's common stock of .68 and .69,
respectively; and a weighted-average expected life of the option of 5 years.

The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.

21
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 4: STOCKHOLDERS' EQUITY (CONTINUED)
For purposes of pro forma disclosures, the estimated fair value of the
options issued under the Stock Plan is amortized to expense over the options'
vesting period. The estimated fair value of the compensation benefit received
under the Stock Purchase Plan is expensed in the year of purchase. The Company's
pro forma information follows:

<TABLE>
<CAPTION>
1996 1995
---------- ----------
<S> <C> <C>
Pro forma net loss.................................................... $ (13,653) $ (14,145)
Pro forma loss per share.............................................. $ (0.74) $ (0.87)
</TABLE>

BECAUSE STATEMENT 123 IS APPLICABLE ONLY TO OPTIONS GRANTED SUBSEQUENT TO
DECEMBER 31, 1994 ITS PRO FORMA EFFECT WILL NOT BE FULLY REFLECTED UNTIL 1999.

A summary of the Company's stock option activity, including the number,
weighted-average exercise price, and weighted-average remaining contractual life
for options outstanding and the number and weighted-average exercise price of
options exercisable for the year ended December 31, 1996 is as follows:

<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS
------------------------------------------------- EXERCISABLE
WEIGHTED --------------------------------
NUMBER WEIGHTED AVERAGE AVERAGE NUMBER
OUTSTANDING REMAINING EXERCISE EXERCISABLE WEIGHTED AVERAGE
RANGE OF EXERCISE PRICES AT YEAR-END CONTRACTUAL LIFE PRICE AT YEAR-END EXERCISE PRICE
- ------------------------- ------------- ------------------- ------------- ------------- -----------------
<S> <C> <C> <C> <C> <C>
$5.75 - $7.75 915 7.63 $ 7.05 460 $ 7.07
$7.875 - $15.625 995 6.54 $ 12.05 785 $ 12.42
$15.75 - $24.375 522 8.47 $ 19.67 105 $ 16.35
----- --- ------ ----- ------
$5.75 - $24.375 2,432 7.36 $ 11.81 1,350 $ 10.90
</TABLE>

<TABLE>
<CAPTION>
OPTION ACTIVITY SUMMARY FOR THE YEAR ENDED DECEMBER 31:
- ----------------------------------------------------------------------------------------------------------------
1996 1995
------------------------------ ------------------------------
OPTIONS WEIGHTED AVERAGE OPTIONS WEIGHTED AVERAGE
(000) EXERCISE PRICE (000) EXERCISE PRICE
----------- ----------------- ----------- -----------------
<S> <C> <C> <C> <C>
Outstanding-beginning of year................... 2,372 $ 9.66 2,174 $ 10.20
Granted......................................... 486 $ 19.78 758 $ 7.51
Exercised....................................... (333) $ 8.41 (245) $ 8.59
Forfeited....................................... (93) $ 10.75 (315) $ 9.06
----- -----
Outstanding-end of year......................... 2,432 $ 11.81 2,372 $ 9.66
Exercisable at end of year...................... 1,350 $ 10.90 1,008 $ 11.54
Weighted-average fair value of options granted
during the year............................... $ 9.54 $ 3.65
</TABLE>

22
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 4: STOCKHOLDERS' EQUITY (CONTINUED)

Under the Stock Plan, stock may be sold and stock bonuses or rights to
purchase common stock may be granted by the Board of Directors or a committee
thereof (the "Board") for past services at the fair market value at the date of
grant. The Board may impose certain repurchase rights, in favor of the Company,
in the event that an employee is terminated prior to certain predetermined
vesting dates. As of December 31, 1996 and 1995, no shares were subject to
repurchase.

NOTE 5: INCOME TAXES

An income tax benefit has not been accrued on net losses due to the
uncertainty regarding the Company's future profitability.

Significant components of the Company's deferred tax assets for federal and
state income taxes as of December 31, 1996 and 1995 are as follows:

<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
----------------------
1996 1995
---------- ----------
<S> <C> <C>
Net operating loss carryforwards...................................... $ 19,700 $ 17,090
Research and development credits...................................... 1,980 1,600
Reserves and accruals................................................. 3,300 3,450
Customer advances..................................................... 5,490 3,080
Capitalized R&D....................................................... 5,940 5,950
Other--net............................................................ 1,140 1,050
---------- ----------
Total deferred tax assets........................................... $ 37,550 $ 32,220
Valuation allowance for deferred tax assets........................... (37,550) (32,220)
---------- ----------
Net deferred tax assets............................................... $ 0 $ 0
---------- ----------
---------- ----------
</TABLE>

Approximately $2,720 of the valuation allowance results from tax deductions
under the stock option plans and will be credited to common stock when
recognized.

At December 31, 1996, the Company had federal net operating loss and
research and development tax credits carryforwards of approximately $57,000 and
$1,300, respectively. The Company had state net operating loss and tax credit
carryforwards of approximately $4,300 and $900, respectively. These
carryforwards will expire at various dates beginning in 2000.

Because of the "change in ownership" provisions of the Tax Reform Act of
1986, a substantial portion of the Company's net operating loss and tax credit
carryforwards may be subject to annual limitations. The annual limitation may
result in the expiration of net operating losses and tax credits before
utilization.

23
<PAGE>
CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

FOR THE YEAR ENDED DECEMBER 31, 1996

(IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 6: STATEMENTS OF CASH FLOWS DATA

<TABLE>
<CAPTION>
1996 1995 1994
--------- --------- ---------
<S> <C> <C> <C>
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS INFORMATION
Interest paid...................................................... $ 844 $ 548 $ 290

SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING
ACTIVITIES
Non-cash purchase of in process research and development........... $ -- $ -- $ 9,000
Equipment purchased under capital leases........................... $ 464 $ 2,122 $ --
Unrealized gain/(loss) on investments.............................. $ (5) $ 416 $ (414)
</TABLE>

NOTE 7: LEGAL PROCEEDINGS

On June 30, 1994, Sanofi, S.A. ("Sanofi") filed a request for arbitration
against Cygnus with the International Court of Arbitration. In its request for
arbitration, Sanofi has alleged that Cygnus breached its existing contract with
Sanofi by, among other things, entering into a product development agreement
with another company for the development of transdermal systems in the field of
hormone replacement therapy (which agreements pertain to each of the Company's
hormone replacement products other than FemPatch). Sanofi claims it has a
proprietary interest in certain Cygnus technologies and that it has incurred
substantial damages as a result of the alleged breach. Sanofi is seeking to
recover from Cygnus approximately $60.0 million for damages attributable to the
alleged breach. Cygnus has answered Sanofi's request for arbitration by
maintaining that Sanofi's claims are inconsistent with its contractual
relationship and that such claims are otherwise without merit. Cygnus plans to
continue aggressively defending against this arbitration and has asserted
certain counterclaims exceeding the amount being sought by Sanofi. A hearing was
held in May 1996 with respect to the liability aspects of Sanofi's claims
against Cygnus, and the Tribunal of International Chambers of Commerce (the
"Tribunal") announced an interim award in the arbitration proceedings in October
1996. The Tribunal found that two transdermal products for hormone replacement
therapy licensed by Cygnus to another company fall within the scope of exclusive
license previously granted to Sanofi. Remaining to be heard are Cygnus'
liability claims against Sanofi and a determination as to the amount of damages
to be awarded to either party. The first of these further hearings is scheduled
to take place in March 1997. Should all or part of the claims as sought for by
Sanofi, and in the amounts asserted be successful, and should Cygnus' counter
claims and defenses not be allowed, the Company could be materially and
adversely affected.

24
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Cygnus, Inc.

We have audited the accompanying consolidated balance sheets of Cygnus, 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 on 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 financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Cygnus, Inc. at
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.

[SIG]

Palo Alto, California
January 20, 1997

MARKET PRICE OF AND DIVIDENDS ON COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The Company's Common Stock trades on the Nasdaq National Market tier of the
Nasdaq Stock Market-SM- under the symbol "CYGN." The following table sets forth,
for the periods indicated, the high and low closing sale prices per share of the
Common Stock as reported by the national market.

<TABLE>
<CAPTION>
HIGH LOW
------- -------
<S> <C> <C>
1996:
First Quarter................. $24 1/2 $19 3/8
Second Quarter................ 23 15
Third Quarter................. 17 1/4 11
Fourth Quarter................ 16 7/8 12

1995:
First Quarter................. $ 9 $ 5 5/8
Second Quarter................ 10 1/4 7 1/2
Third Quarter................. 19 7/8 9 7/8
Fourth Quarter................ 23 14 1/8
</TABLE>

As of December 31, 1996, there were approximately 596 record holders of the
Company's Common Stock. Cygnus has not paid any cash dividends since its
inception and does not intend to pay any cash dividends on its Common Stock in
the foreseeable future.

<PAGE>
EXHIBIT 23.1

CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

We consent to the incorporation by reference in this Annual Report (Form
10-K) of Cygnus, Inc. of our report dated January 20, 1997, included in the 1996
Annual Report to Stockholders of Cygnus, Inc.

Our audits also included the financial statement schedule of Cygnus, Inc.
listed in Item 14(a). This schedule is the responsibility of the Company's
management. Our responsibility is to express an opinion based on our audits. In
our opinion, the financial statement schedule referred to above, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.

We consent to the incorporation by reference in the Registration Statements
(Form S-8 Nos. 33-41502, 33-43710, 33-59774, 33-86038 and 333-18357) pertaining
to the Amended 1986 Stock Option Plan, the 1991 Amended Employee Stock Purchase
Plan, the Amended 1986 Incentive Stock Plan and the 1994 Stock Option/Award Plan
of Cygnus, Inc. of our report dated January 20, 1997, with respect to the
consolidated financial statements and schedule of Cygnus, Inc. included or
incorporated by reference in the Annual Report (Form 10-K) for the year ended
December 31, 1996.

/s/ ERNST & YOUNG LLP

Palo Alto, California
March 20, 1997

<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<CASH> 33,148
<SECURITIES> 16,286<F1>
<RECEIVABLES> 9,049
<ALLOWANCES> 1,014
<INVENTORY> 2,331
<CURRENT-ASSETS> 60,534
<PP&E> 19,462
<DEPRECIATION> 13,872
<TOTAL-ASSETS> 68,798
<CURRENT-LIABILITIES> 24,148
<BONDS> 0
0
0
<COMMON> 117,284
<OTHER-SE> (86,071)
<TOTAL-LIABILITY-AND-EQUITY> 68,798
<SALES> 36,203
<TOTAL-REVENUES> 36,203
<CGS> 16,659
<TOTAL-COSTS> 16,659
<OTHER-EXPENSES> 32,461
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 844
<INCOME-PRETAX> (10,931)
<INCOME-TAX> 121
<INCOME-CONTINUING> (11,052)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (11,052)
<EPS-PRIMARY> (.60)
<EPS-DILUTED> (.60)
<FN>
<F1>This amount represents short-term investments
held by the Company at 12/31/96
</FN>

</TABLE>