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

                                    FORM 10-K

                /X/ Annual Report pursuant to Section 13 or 15(d)
                     of the Securities Exchange Act of 1934

                   For the fiscal year ended December 31, 2003
                   -------------------------------------------

              / / Transition report pursuant to Section 13 or 15(d)
                     of the Securities Exchange Act of 1934

                        For the transition period from to

                         Commission file number 0-26422
                         ------------------------------


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


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

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

                                 (215) 340-4699

              (Registrant's telephone number, including area code)

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

                                                       Name of each exchange
         Title of each class                            on which registered
         -------------------                            -------------------
             None                                               None

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

                       Common Stock, $.001 par value and,
                         Preferred Stock Purchase Rights
                                (Title of class)

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

Indicate by check mark if disclosure of delinquent  filers  pursuant to Item 405
of Regulation S-K (ss.229.405 of this chapter) is not contained herein, and will
not be contained, to the best of the registrant's knowledge, in definitive proxy
or  information  statements  incorporated  by reference in Part III of this Form
10-K or any amendment to this Form 10-K. / /

Indicate  by check mark  whether  the  registrant  is an  accelerated  filer (as
defined in Rule 12b-2 of the Act). YES /X/ NO / /




The aggregate market value of shares of voting and non-voting common equity held
by non-affiliates  of the registrant  computed using the closing price of common
equity as reported on NASDAQ  SmallCap  Market under the symbol DSCO on June 30,
2003, the last business day of the registrant's  most recently  completed second
fiscal quarter,  was approximately $285 million. For the purposes of determining
this amount only,  the  registrant  has defined  affiliates to include:  (a) the
executive officers named in Part III of this Annual Report on Form 10-K; (b) all
directors  of the  registrant;  and (c) each  shareholder  that has informed the
registrant by February 29, 2004 that it is the  beneficial  owner of 10% or more
of the outstanding shares of common stock of the registrant.

As of February 29, 2004, 43,697,370 shares of the registrant's common stock were
outstanding.

Portions of the information  required by Items 10 through 13 of Part III of this
Annual Report on Form 10-K are incorporated by reference to the extent described
herein from our definitive proxy statement,  which is expected to be filed by us
with the Commission within 120 days after the close of our 2003 fiscal year.


                                       ii




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

FORWARD LOOKING STATEMENTS

The statements set forth under Item 1:  "Business" and elsewhere in this report,
including  in  Item  7:  "Management's  Discussion  and  Analysis  of  Financial
Condition  and Results of  Operations - Risks Related to Our Business" and those
incorporated by reference  herein which are not historical,  including,  without
limitation,  statements  concerning  our research and  development  programs and
clinical  trials,  the  possibility  of  submitting  regulatory  filings for our
products  under  development,  the seeking of  collaboration  arrangements  with
pharmaceutical companies or others to develop,  manufacture and market products,
the research and development of particular  compounds and  technologies  and the
period of time for  which  our  existing  resources  will  enable us to fund our
operations,  constitute  "Forward  Looking  Statements"  within  the  meaning of
Section 27A of the  Securities  Act of 1933 and  Section  21E of the  Securities
Exchange Act of 1934. We intend that all  forward-looking  statements be subject
to the safe-harbor provisions of the Private Securities Litigation Reform Act of
1995.  These  forward-looking  statements are only  predictions  and reflect our
views as of the date they are made with respect to future  events and  financial
performance.   Forward-looking   statements   are  subject  to  many  risks  and
uncertainties which could cause our actual results to differ materially from any
future results expressed or implied by the forward-looking statements.

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

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



                                      iii




                          DISCOVERY LABORATORIES, INC.
                         Table of contents to Form 10-K
                   For the Fiscal Year Ended December 31, 2003



    PART I

                                                                                                           
    ITEM 1.     BUSINESS.......................................................................................1

    ITEM 2.     PROPERTIES....................................................................................17

    ITEM 3.     LEGAL PROCEEDINGS.............................................................................17

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


    PART II

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

    ITEM 6.     SELECTED FINANCIAL DATA.......................................................................19

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

    ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK....................................44

    ITEM 8.     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...................................................45

    ITEM 9.     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE..........45

    ITEM 9A.    CONTROLS AND PROCEDURES.......................................................................45


    PART III

    ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............................................45

    ITEM 11.    EXECUTIVE COMPENSATION........................................................................45

    ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
                MATTERS.......................................................................................45

    ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................................................45

    ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES........................................................45

    PART IV

    ITEM 15.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND
                REPORTS ON FORM 8-K...........................................................................46

    SIGNATURES................................................................................................47



                                       iv



                                     PART I

ITEM 1.  BUSINESS.

COMPANY SUMMARY

We are a  biopharmaceutical  company  developing our proprietary  humanized lung
surfactant  technology  as  Surfactant  Replacement  Therapies  for  respiratory
diseases.  Surfactants are compositions  produced naturally in the lungs and are
essential to the lungs' ability to absorb oxygen and to maintain  proper airflow
through the  respiratory  system.  The absence or  depletion of  surfactants  is
involved in a number of respiratory diseases.

Our technology  produces an engineered  version of natural human lung surfactant
that is  designed  to  closely  mimic the  essential  properties  of human  lung
surfactant.  We believe that our surfactant technology provides the opportunity,
for the first time,  for pulmonary  surfactants to be developed into a series of
respiratory  therapies for critical care and other  hospitalized  patients where
there are few or no approved therapies available.

We  recently  completed  two Phase 3 clinical  trials of  Surfaxin(R),  our lead
product, for the treatment of Respiratory Distress Syndrome in premature infants
and are preparing to file new drug  applications with the United States Food and
Drug Administration and other regulatory authorities in the rest of the world.

Our Surfactant  Replacement  Therapy is also in a Phase 2 clinical trial for the
treatment  of Acute  Respiratory  Distress  Syndrome in adults,  as well as in a
Phase 3 and Phase 2 clinical  trial for the  treatment  of  Meconium  Aspiration
Syndrome in full-term infants.  In addition,  we recently completed a successful
Phase 1b  clinical  trial in  healthy  volunteers  and mild  asthmatics  and are
currently  preparing to initiate a follow-on  Phase 2 clinical trial  evaluating
the  safety,  tolerability  and  efficacy  of  our  humanized  lung  surfactant,
delivered as an inhaled aerosol  (development  name DSC-104),  to treat patients
with asthma.

Presently,  we are evaluating the development of other aerosolized  formulations
of our humanized  surfactant to potentially  treat premature infants in Neonatal
Intensive  Care  Units  in  hospitals   that  are  suffering  from   Respiratory
Dysfunction.  We are also evaluating  aerosolized  formulations of our humanized
surfactant to potentially treat Acute Lung Injury, chronic obstructive pulmonary
disease  (often  referred to as COPD,  which is a chronic  condition of the lung
that  prevents  enough  oxygen from  reaching  the blood),  rhinitis,  sinusitis
(infection of the sinuses), sleep apnea and otitis media (inner ear infection).

We are presently  implementing  a long-term  commercial  strategy which includes
manufacturing  for the production of our humanized  surfactant  drug products to
meet  anticipated  clinical  and  commercial  needs,  and  sales  and  marketing
capabilities  to execute the launch of Surfaxin,  if  approved,  in the U.S. and
Europe.



                                       1


SURFACTANT TECHNOLOGY

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

Surfactants are protein and lipid (fat) compositions that are produced naturally
in the lungs and are  critical  to all  air-breathing  mammals.  They  cover the
entire alveolar surface,  or air sacs, of the lungs and the terminal  conducting
airways  which  lead to the air  sacs.  Surfactants  facilitate  respiration  by
continually  modifying the surface tension of the fluid normally  present within
the alveoli,  or air sacs,  that line the inside of the lungs. In the absence of
sufficient  surfactant or should the surfactant degrade,  these air sacs tend to
collapse,  and,  as a result,  the lungs do not  absorb  sufficient  oxygen.  In
addition to lowering aveolar  surface-tension,  surfactants play other important
roles in human respiration  including,  but not limited to, lowering the surface
tension of the  conducting  airways and  maintaining  airflow and airway patency
(keeping the airways open and expanded).  Human  surfactants  include four known
surfactant  proteins,  A, B, C and D. It has been established,  through numerous
studies, that surfactant protein B (SP-B) is essential for respiratory function.

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

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

Our humanized surfactant product candidates,  including Surfaxin, are engineered
versions of natural  human lung  surfactant  and  contain a  humanized  peptide,
sinapultide.  Sinapultide  is a 21 amino  acid  protein-like  substance  that is
designed to closely mimic the essential attributes of human surfactant protein B
(SP-B), the surfactant protein that is most important for the proper functioning
of the  respiratory  system.  Our  products  have the  ability  to be  precisely
formulated, either as a liquid instillate,  aerosolized liquid or dry powder, to
address various medical indications.


                                       2


We believe that our  engineered  humanized  surfactant  can be  manufactured  in
sufficient  quantities,  in  more  exact  and  consistent  pharmaceutical  grade
quality,  less  expensively  than  the  animal-derived  surfactants  and  has no
potential to cause  adverse  immunological  responses in young and older adults,
all important  attributes for our products to potentially meet significant unmet
medical needs. In addition, we believe that our engineered humanized surfactants
might possess other pharmaceutical  benefits not currently found with the animal
surfactants such as longer shelf-life,  reduced number of administrations to the
patient's lungs and elimination of the risk of animal-borne  diseases  including
the  brain-wasting  bovine spongiform  encephalopathy  (commonly called "mad-cow
disease").

Aerosolized Surfactant Formulations

Many respiratory  diseases are associated with an inflammatory event that causes
surfactant  dysfunction  and a  loss  of  patency  of  the  conducting  airways.
Scientific  data supports the premise that the therapeutic use of surfactants in
aerosol form has the ability to reestablish  airway patency,  improve  pulmonary
mechanics and act as an anti-inflammatory. Surfactant normally prevents moisture
from accumulating in the airways' most narrow sections and thereby maintains the
patency of the conducting airways.

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

The aerosolized  formulations of our humanized  surfactant that we are currently
developing are intended to be administered using various aerosol devices and, to
date, we have achieved the following important development objectives:

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

- --       full retention of the surfactant composition upon aerosolization;

- --       drug particle size suitable for deposition in the deep-lungs;

- --       delivery  rates to achieve  therapeutic  dosages in a  reasonable  time
         period; and

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




                                       3


SURFACTANT THERAPY FOR RESPIRATORY MEDICINE

Products for the Neonatal Intensive Care Unit

Surfaxin for Respiratory Distress Syndrome in Premature Infants

Respiratory Distress Syndrome is a condition in which premature infants are born
with an insufficient amount of their own natural  surfactant.  Premature infants
born prior to 32 weeks gestation have not fully developed their own natural lung
surfactant and therefore need  treatment to sustain life.  This condition  often
results in the need for the infant to undergo surfactant  replacement therapy or
mechanical   ventilation.   Respiratory  Distress  Syndrome  is  experienced  in
approximately  half of the babies born between 28 and 32 weeks  gestational age.
The incidence of Respiratory  Distress  Syndrome  approaches 100% in babies born
less than 26 weeks  gestational age.  Surfaxin is the first  humanized,  protein
B-based agent that mimics the surface-active  properties of human surfactant. To
treat  premature   infants   suffering  from  Respiratory   Distress   Syndrome,
surfactants,  including  Surfaxin,  are  delivered in a liquid form and injected
through an  endotracheal  tube (a tube inserted into the infant's mouth and down
the trachea).

During 2003, we completed and announced successful results from both a landmark,
pivotal  Phase 3  clinical  trial and a  supportive  Phase 3  clinical  trial of
Surfaxin  for the  treatment  of  Respiratory  Distress  Syndrome  in  premature
infants.  We intend to use the results from these trials to form the basis for a
new drug  application  (NDA) for  approval  in the United  States and to support
other  regulatory  applications  in the rest of the world.  Filing of the NDA is
anticipated in April 2004.

The  pivotal  Phase 3 trial  enrolled  1,294  patients  and  was  designed  as a
multinational,   multicenter,   randomized,  masked,  controlled,   prophylaxis,
event-driven,  superiority  trial to  demonstrate  the  safety and  efficacy  of
Surfaxin  over  Exosurf(R),   an  approved,   non-protein  containing  synthetic
surfactant.  Survanta(R),  a cow-derived  surfactant and the leading  surfactant
used in the United  States,  served as a reference  arm in the trial.  Key trial
results were  assessed by an  independent  adjudication  committee  comprised of
leading  neonatologists  and pediatric  radiologists.  This committee provided a
consistent and standardized  method for assessing  critical efficacy data in the
trial. An independent  Data Safety  Monitoring  Board (DSMB) was responsible for
monitoring  the  overall  safety of the trial and no major  safety  issues  were
identified.  In accordance with the study's trial design, we continue to conduct
six and twelve month clinical follow-up on all enrolled patients.

The supportive,  multinational  Phase 3 clinical trial enrolled 252 patients and
was designed as a  non-inferiority  trial comparing  Surfaxin to Curosurf(R),  a
porcine (pig) derived surfactant and the leading surfactant used in Europe. This
trial  demonstrated  the  overall  safety and  non-inferiority  of  Surfaxin  to
Curosurf.  In accordance  with the study's trial design,  we continue to conduct
six and twelve month clinical follow-up on all enrolled patients.

There are over 3,000,000  premature infants born annually  worldwide.  More than
850,000  of these  premature  infants  are  considered  "very low birth  weight"
infants (less than 1,250 grams), of which,  approximately 700,000 are considered
at  significant  risk for  Respiratory  Distress  Syndrome.  Due to  limitations
associated  with the  animal-derived  surfactant  products  that  are  currently
approved to treat Respiratory Distress Syndrome in premature infants,  access to
such  therapy is mainly  limited  to the  approximately  150,000  very low birth
weight  infants born in the United  States and Western  Europe.  This results in
hundreds of thousands of premature infants born in the world each year who need,
but do not receive, effective surfactant replacement therapy.



                                       4


The FDA has granted us Orphan Drug  Designation  for  Surfaxin  for  Respiratory
Distress Syndrome. Orphan drugs are pharmaceutical products that are intended to
treat diseases  affecting fewer than 200,000 patients in the United States.  The
Office of Orphan Product Development of the FDA grants certain advantages to the
sponsors of orphan  drugs  including,  but not limited to, seven years of market
exclusivity  upon  approval of the drug,  certain tax  incentives  for  clinical
research  and grants to fund  testing of the drug.  We are also  seeking  Orphan
Product designation from the European Medicines  Evaluation Agency (the European
Union's regulatory  approval agency that is similar to the FDA) for Surfaxin for
indications of Respiratory Distress Syndrome in premature infants.

Aerosolized  Surfactant  Replacement  Therapy  for  Respiratory  Dysfunction  in
Premature Infants

Serious  respiratory  problems  are some of the most  prevalent  medical  issues
facing  premature  infants  in  Neonatal  Intensive  Care  Units.  On top of the
approximately  700,000  premature  infants born  annually  worldwide at risk for
Respiratory  Distress  Syndrome,  there  are  another  approximately  1  million
premature infants,  300,000 of which are in the US and Europe,  born annually at
risk  for a range of  other  respiratory  problems  associated  with  surfactant
dysfunction.  These  infants are usually at a birth  weight  greater  than 1,250
grams and neonatologists  generally try to avoid mechanically  ventilating these
patients  because doing so requires  intubation (the highly invasive  process of
inserting a breathing tube down the patient's  trachea).  This reluctance is due
to the perceived risks by many neonatologists  regarding the intubation of these
larger babies,  such as the risk of trauma and the need of paralytic  agents and
sedation. As a result, many neonatologists will only intubate in cases of severe
respiratory  disease,  where the benefits clearly outweigh the risks. We believe
that there is growing  recognition  by the neonatal  medical  community  for the
potential utility of a non-invasive method of delivering surfactant  replacement
therapy to treat  premature  infants  suffering  from  Respiratory  Dysfunctions
beyond Respiratory Distress Syndrome.

We are presently  evaluating the development of aerosolized  formulations of our
humanized  surfactant  administered  via  a  nasal  continuous  positive  airway
pressure  or  similar  device  as a  non-invasive  means  to  potentially  treat
premature  infants in Neonatal  Intensive Care Units suffering from  Respiratory
Dysfunction.  We are  preparing to initiate a Phase 2 dose  escalation  clinical
trial that we anticipate  conducting at several leading  neonatal clinics in the
U.S. in the second half of 2004.

Surfaxin for Meconium Aspiration Syndrome in Full-Term Infants

Meconium  Aspiration  Syndrome  (often  referred  to as MAS) is an  inflammatory
condition in which full-term  infants are born with meconium in their lungs that
depletes the natural surfactant in their lungs. Meconium is a baby's first bowel
movement in its mother's womb and, when inhaled,  Meconium  Aspiration  Syndrome
can occur.  Meconium  Aspiration Syndrome can be life-threatening as a result of
the  failure of the lungs to absorb  sufficient  oxygen.  There are no  approved
therapies for this  condition and the standard of care  principally  consists of
mechanical ventilation.  Surfaxin has been shown to not only remove inflammatory
and infectious  infiltrates from the lungs when using our proprietary lavage (or
"lung wash") but to also  replenish the vital  surfactant  levels in the babies'
lungs.



                                       5


Surfaxin is being  evaluated  in a Phase 3 clinical  trial for the  treatment of
Meconium Aspiration Syndrome in full-term infants. To our knowledge, Surfaxin is
the only product being developed worldwide to treat this syndrome.  The trial is
designed for the enrollment of up to 200 infants at medical  centers  throughout
the United  States to compare  our  proprietary  Surfaxin  lavage to the current
standard of care.

We also have  initiated  a Phase 2 clinical  trial of our  proprietary  Surfaxin
lavage  in up to 60  full-term  infants  for  use  as a  prophylactic  or  early
treatment  for  patients  who  are at  risk of  developing  Meconium  Aspiration
Syndrome  but have not  shown  symptoms  of  compromised  respiratory  function.
Surfaxin is administered as a liquid bolus through an endotracheal  tube as well
as by our proprietary lavage  ("lung-wash")  technique.  We believe an effective
and affordable  surfactant  prophylactic  therapy could  significantly lower the
risk to meconium-stained  infants of chronic  respiratory  conditions and reduce
the need for costly and invasive mechanical ventilation.

We  presently  anticipate  both of the  trials  for the  treatment  of  Meconium
Aspiration  Syndrome  to  be  completed  in  2005.  See  Item  7:  "Management's
Discussion and Analysis of Financial Condition and Results of Operations - Risks
Related to our Business - The clinical trial and regulatory approval process for
our products is expensive and time consuming, and the outcome is uncertain."

There are  presently no drug  therapies  approved for the  treatment of Meconium
Aspiration  Syndrome in full-term infants.  An estimated 60,000 infants are born
in the United  States and Europe that  require  treatment  for MAS,  however,  a
significantly  greater  number of infants are born  worldwide each year at risk.
The FDA has  granted  us  Fast-Track  Status  and Orphan  Drug  Designation  for
Surfaxin in this indication. We have also received Orphan Product designation of
Surfaxin for this indication from the European Medicines Evaluation Agency.

Products for the Critical Care Unit and other Hospital Settings

Surfaxin for Acute Respiratory Distress Syndrome in Adults

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



                                       6


We are  presently  conducting  a Phase 2  open-label,  controlled,  multi-center
clinical  trial of Surfaxin for the  treatment of adults with Acute  Respiratory
Distress Syndrome.  Approximately 110 patients will receive high  concentrations
of Surfaxin  which will be  administered  via a  proprietary  sequential  lavage
technique,  or lung wash, where Surfaxin is delivered  through a bronchoscope to
each of the 19 segments of the lung.  The  procedure  is intended to cleanse and
remove  inflammatory  substances  and  debris  from  the  lungs,  while  leaving
sufficient  amounts of Surfaxin behind to help  re-establish the lungs' capacity
to absorb oxygen. The objective is to restore  functional  surfactant levels and
to allow  critically  ill  patients to be removed  from  mechanical  ventilation
sooner.

We have  completed Part A of this Phase 2 trial,  a dose  escalation  safety and
tolerability  study in 22  patients in four  groups (of up to six  patients  per
group).  In consultation with the trial's  Independent  Safety Review Committee,
comprised  of three  prominent  pulmonologists,  we  determined  that the Part A
portion of the trial  procedure is generally  safe and tolerable and that it was
appropriate for us to proceed onto the larger safety and efficacy portion of the
trial.

The last part of this Phase 2 trial,  Part B, is designed to evaluate safety and
efficacy of Surfaxin in direct  comparison  to the current  standard of care and
will be conducted at  approximately  40 centers  throughout  North America.  The
primary  endpoint  of Part B is to  determine  the  incidence  rate of  patients
surviving and off  mechanical  ventilation  at the end of day 28 with one of the
key secondary endpoints being all-cause mortality. The Phase 2 clinical trial is
anticipated to be completed in the second half of 2004.

The current standard of care for Acute  Respiratory  Distress  Syndrome includes
placing patients on mechanical ventilators in intensive care units at a cost per
patient of  approximately  $8,500 per day,  typically for an average of 21 to 28
days.  There are estimated to be between  150,000 and 200,000 adults per year in
the United  States  suffering  from Acute  Respiratory  Distress  Syndrome  with
similar numbers  afflicted in Europe.  Because there are no approved  treatments
for these diseases, the mortality rate can range from 35% to 50%.

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

Aerosolized Surfactant (development name DSC 104) for Severe, Acute Asthma

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



                                       7


According to  information  provided by the  American  Lung  Association,  asthma
afflicts more than 20,000,000 people in the United States and its incidence rate
continues to rise. Asthma is a chronic disease; it is prevalent in people of all
ages and an estimated 12,000,000 people have experienced an asthma attack within
the past year. In the United States alone,  there are roughly 1,000,000 hospital
outpatient visits,  approximately  1,800,000 emergency room visits and 9,300,000
physician  visits  each  year due to  asthma.  Asthma  ranks  within  the top 10
prevalent  activity-limiting  health  conditions  costing  $14 billion in United
States healthcare costs annually.

Asthma may require life-long  therapy to prevent or treat episodes.  Ten percent
of patients are considered  severe asthmatics and require moderate to high doses
of drugs.  Currently  available  asthma  medications  include  inhaled  and oral
steroids, bronchodilators and leukotriene antagonists. Bronchodilators cannot be
used to control severe  episodes or chronic,  severe  asthma.  Oral steroids can
cause  serious side  effects when used for  prolonged  periods  and,  thus,  are
typically  limited to severe asthmatic  episodes and chronic,  severe asthma. We
believe  that  supplying  surfactant  as an inhaled  aerosol may relieve  airway
obstruction  in the deep lung and lead to a more rapid  improvement in asthmatic
symptoms.

We recently  completed a Phase 1b clinical trial to evaluate the safety and lung
tolerability  and deposition  characteristics  of our humanized lung surfactant,
delivered  as an inhaled  aerosol to treat  individuals  who suffer from asthma.
This masked, placebo-controlled, randomized, Phase 1b study included six healthy
subjects and eight mild-persistent asthmatic patients. Results demonstrated that
DSC-104  was  safe and  well  tolerated,  did not  induce  bronchospasm  and was
deposited  to both  the  central  and  peripheral  regions  of the  lungs in the
mild-persistent  asthmatic  group and the healthy  volunteers.  We are presently
preparing a follow-on  Phase 2 dose  escalation  clinical  trial  evaluating the
safety,  tolerability and efficacy of DSC-104 to be conducted at several leading
asthma clinics in the United States that we anticipate  initiating in the second
half of 2004.

Aerosolized Surfactant for Acute Lung Injury

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

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



                                       8


We are  evaluating  aerosolized  formulations  of our  humanized  surfactant  to
potentially treat Acute Lung Injury.  We believe that our proprietary  humanized
aerosol surfactant may be effective as a preventive measure for patients at risk
for Acute Lung Injury.  This prophylactic  approach may result in fewer patients
requiring  costly  intensive care therapy,  thereby  eliminating long periods of
therapy and offering cost savings in the hospital setting.

STRATEGIC ALLIANCES

Quintiles Transnational Corp., and PharmaBio Development Inc.

We have a collaboration  arrangement with Quintiles Transnational Corp., and its
affiliate,  PharmaBio  Development  Inc., to provide  certain  commercialization
services in the United  States for  Surfaxin for the  treatment  of  Respiratory
Distress  Syndrome in  premature  infants and  Meconium  Aspiration  Syndrome in
full-term  infants.  Quintiles is obligated to hire and train a dedicated United
States  sales  force that will be branded in the market as ours.  PharmaBio  has
agreed to fund up to $70 million of the sales force costs as well as other sales
and marketing costs for  commercialization  of Surfaxin in the United States for
seven years.  Additionally,  the  collaboration  allows for this specialty sales
force to  become  ours at the end of the  seven  year  term,  with an  option to
acquire it sooner.

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

PharmaBio  also  extended  to us a secured  revolving  credit  facility of up to
$8,500,000 to $10,000,000 to fund pre-marketing  activities  associated with the
launch of Surfaxin in the United States as we achieve certain milestones. We are
obligated to use a significant  portion of the funds  borrowed  under the credit
facility  for  pre-launch  marketing  services  to  be  provided  by  Quintiles.
Principal  amounts owed by us under the credit facility may be repaid out of the
proceeds  of  milestone  payments  to  be  paid  to  us by  PharmaBio  upon  the
achievement  of  certain  corporate   milestones.   See  Item  7:  "Management's
Discussion  and  Analysis of  Financial  Condition  and Results of  Operations -
Liquidity and Capital Resources - Secured, Revolving Credit Facility and Capital
Lease Arrangement."

Laboratorios del Dr. Esteve, S.A.

We have a strategic alliance with Laboratorios del Dr. Esteve to develop, market
and sell  Surfaxin  throughout  Europe and Latin  America.  Esteve will  provide
certain commercialization services for Surfaxin for the treatment of Respiratory
Distress  Syndrome  in  premature  infants,   Meconium  Aspiration  Syndrome  in
full-term infants and Acute Lung Injury/Acute  Respiratory  Distress Syndrome in
adult patients.  Our exclusive supply agreement with Esteve provides that Esteve
will  purchase  from us all of its  Surfaxin  drug  product  requirements  at an
established  transfer  price  based on sales of  Surfaxin  by Esteve  and/or its
sublicensee(s).  Esteve has also agreed to sponsor certain  clinical trial costs
related  to  obtaining   regulatory  approval  in  Europe  for  the  Acute  Lung
Injury/Acute Respiratory Distress Syndrome indications. Esteve will make certain
milestone  payments to us upon the attainment of European  marketing  regulatory
approval for  Surfaxin.  See Item 7:  "Management's  Discussion  and Analysis of
Financial  Condition and Results of Operations - Liquidity and Capital Resources
- - Secured, Revolving Credit Facility and Capital Lease Arrangement."



                                       9


LICENSING ARRANGEMENTS; PATENTS AND PROPRIETARY RIGHTS

Patents and Proprietary Rights

Johnson & Johnson and The Scripps Research Institute

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

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

In June 2003, we were issued United States Patent No. 6,613,734,  which covers a
wide variety of combinations of peptides,  proteins and other molecules  related
to our proprietary  humanized pulmonary surfactant  technology.  The patent also
includes methods of making and using these molecules.

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



                                       10


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

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

The Scripps Research Institute Research Agreement

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

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

MANUFACTURING AND DISTRIBUTION - THIRD PARTY SUPPLIERS

Manufacturing

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

Our  humanized  surfactant  product  candidates  are  manufactured  through  the
combination of sinapultide,  which is provided by BACHEM  California,  Inc., and
PolyPeptides Laboratories, Inc., and certain other active ingredients, including
certain   lipids,   that  are  provided  by  other  suppliers  such  as  Genzyme
Pharmaceuticals, a division of the Genzyme Corporation, and Avanti Polar Lipids.



                                       11


Our humanized surfactant drug product, including Surfaxin, is manufactured using
the ingredients  discussed  above with our own  specialized  equipment under the
direction and supervision of our  manufacturing  and quality control  personnel.
Until recently,  our drug product was manufactured at the sterile  facilities of
our primary contract manufacturer, Akorn, Inc., which was the only manufacturing
facility  that we had  validated to produce  clinical  material of our humanized
surfactant drug product, including Surfaxin. In October 2003, we transferred our
manufacturing  capabilities from Akorn to a new contract manufacturer,  Laureate
Pharma,  L.P., to install and validate a manufacturing and filling line at their
facility  for  the  production  of  clinical  and  commercial   drug  supply  in
conformance  with cGMPs. All steps required for production of cGMP material have
been completed and we are presently producing Surfaxin for our Phase 2 trial for
the treatment of Acute Respiratory Distress Syndrome.

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

To support a long-term manufacturing strategy for the production of clinical and
commercial  supply of our humanized  surfactant drug product,  we are evaluating
further   development  and  scale-up  of  our  current  contract   manufacturer,
alternative contract manufacturers and building our own manufacturing operations
in order to secure additional manufacturing  capabilities to meet our production
needs as they expand.  We will rely on outside  manufacturers  for production of
our products after marketing approval.

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

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



                                       12


Distribution

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

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

COMPETITION

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

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



                                       13


There is presently only one approved synthetic surfactant available, Exosurf(R),
marketed by  GlaxoSmithKline,  plc.  However,  this product does not contain any
surfactant  proteins,  is not widely used and its active marketing  recently has
been discontinued by its manufacturer.

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

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

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

GOVERNMENT REGULATION

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

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



                                       14


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

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

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



                                       15


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

EMPLOYEES

We have approximately 75 full-time  employees,  primarily employed in the United
States, Europe and Latin America. Our future success depends in significant part
upon  the  continued  service  of our key  scientific  personnel  and  executive
officers  and our  continuing  ability to attract  and retain  highly  qualified
scientific  and  managerial  personnel.  There is a competitive  market for such
personnel  and we may not be able  to  retain  our  key  employees  or  attract,
assimilate or retain other highly qualified  technical and managerial  personnel
in the future.  See Item 7:  "Management's  Discussion and Analysis of Financial
Condition  and Results of Operations - Risks Related to Our Business - We depend
upon  key  employees  and  consultants  in  a  competitive  market  for  skilled
personnel.  If we are unable to  attract  and  retain  key  personnel,  it could
adversely affect our ability to develop and market our products."

AVAILABLE INFORMATION

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

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



                                       16


ITEM 2.  PROPERTIES.

Our principal offices and quality control laboratory  facility is located at 350
South Main Street,  Suite 307,  Doylestown,  Pennsylvania  18901.  The telephone
number of our executive  office is (215)  340-4699 and the  facsimile  number is
(215) 340-3940.  In January 2002, we established a research  facility in Redwood
City,  California,  to  develop  aerosolized  formulations  of  our  proprietary
humanized  surfactant.  We lease all of these  properties.  In December 2003, we
closed our satellite office in the United Kingdom.

ITEM 3.  LEGAL PROCEEDINGS.

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

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

No  matters  were  submitted  to a vote of  security  holders  during the fourth
quarter of 2003.



                                       17


                                     PART II

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

Our  common  stock is traded on the  Nasdaq  SmallCap  Market  under the  symbol
"DSCO." As of February 29, 2004, the number of  stockholders of record of shares
of our common stock was  approximately  186, and the number of beneficial owners
of shares of our common stock was approximately 12,000. As of February 29, 2004,
there  were  approximately  43,697,370  shares of our  common  stock  issued and
outstanding.

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

                                                                Low     High
                                                               -----    -----
         First Quarter 2002....................................$2.70    $4.19
         Second Quarter 2002...................................$1.28    $3.26
         Third Quarter 2002....................................$0.90    $1.97
         Fourth Quarter 2002...................................$1.60    $3.20
         First Quarter 2003....................................$1.32    $2.94
         Second Quarter 2003...................................$1.56    $7.40
         Third Quarter 2003....................................$6.12    $8.50
         Fourth Quarter 2003 ..................................$5.40    $10.75
         First Quarter 2004 (through February 29, 2004)........$10.00   $13.32

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

                        Sales of Unregistered Securities

During the year ended  December 31,  2003,  we granted an aggregate of 1,112,000
options  to our  officers,  directors,  employees  and  consultants  at  various
exercise  prices  ranging  from  $1.70  per  share to  $9.17  per  share.  These
securities were offered and sold in reliance upon  exemptions from  registration
pursuant  to Section  4(2) of the  Securities  Act of 1933 as  transactions  not
involving any public offering.  No broker/dealers  were involved in the sale and
no  commissions  were paid.  The  recipients  of these options  either  received
adequate  information  about  us or had  access,  through  employment  or  other
relationships, to such information.



                                       18


ITEM 6.  SELECTED FINANCIAL DATA

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



                                                                  For the year ended December 31,
                                                  ----------------------------------------------------------------
                                                    2003          2002          2001          2000          1999
                                                  --------      --------      --------      --------      --------
                                                                                           
Revenues from collaborative agreements            $  1,037      $  1,782      $  1,112      $    741      $    178
                                                  --------      --------      --------      --------      --------

Operating Expenses:

   Research and development                         19,750        14,347         8,007         7,494         2,869
   General and administrative                        5,722         5,458         5,067         5,145         2,421
                                                  --------      --------      --------      --------      --------

            Total expenses                          25,472        19,805        13,074        12,639         5,290
                                                  --------      --------      --------      --------      --------

Operating loss                                     (24,435)      (18,023)      (11,962)      (11,898)       (5,112)
Other income and expense                               155           580           816         1,037           154
                                                  --------      --------      --------      --------      --------


Net loss                                          $(24,280)     $(17,443)     $(11,146)     $(10,861)     $ (4,958)
                                                  ========      ========      ========      ========      ========

Net loss per common share - basic and diluted     $  (0.65)     $  (0.64)     $  (0.51)     $  (0.58)     $  (0.66)

Weighted average number of common
     shares outstanding                             37,426        27,351        22,038        18,806         7,545




Consolidated Balance Sheet Data:
(in thousands)



                                                                   For the year ended December 31,
                                                        -------------------------------------------------------
                                                         2003        2002        2001        2000        1999
                                                        -------     -------     -------     -------     -------
                              ASSETS
                                                                                         
Current Assets:
Cash/cash equivalents and
     marketable securities                              $29,422     $19,152     $16,696     $18,868     $ 3,547
Prepaid expenses and other current assets                   668         327       1,582         149         641
                                                        -------     -------     -------     -------     -------
Total current assets                                     30,090      19,479      18,278      19,017       4,188
                                                        -------     -------     -------     -------     -------
Property and equipment, net of depreciation               2,414       1,231         822         697         426
Other assets                                                211         352         965           3          18
                                                        -------     -------     -------     -------     -------

Total assets                                            $32,715     $21,062     $20,065     $19,717     $ 4,632
                                                        =======     =======     =======     =======     =======

               LIABILITIES AND STOCKHOLDERS' EQUITY


Credit facility with corporate partner - current        $ 2,436     $    --     $    --     $    --     $    --
Other current liabilities                                 4,593       3,202       1,794       2,399         440
                                                        -------     -------     -------     -------     -------
Total current liabilities                                 7,029       3,202       1,794       2,399         440
                                                        -------     -------     -------     -------     -------
Deferred revenue                                            672       1,393         615         851       1,036
Credit facility with corporate partner                       --       1,450          --          --          --
Capitalized lease                                           711         256          33          31          48
                                                        -------     -------     -------     -------     -------
Total liabilities                                         8,412       6,301       2,442       3,281       1,524
                                                        -------     -------     -------     -------     -------
Stockholders' equity                                     24,303      14,761      17,623      16,436       3,108
                                                        -------     -------     -------     -------     -------
Total liabilities and stockholders' equity              $32,715     $21,062     $20,065     $19,717     $ 4,632
                                                        =======     =======     =======     =======     =======
Common Stock, $0.001 par value, issued                   42,491      32,818      25,546      20,871       9,689
                                                        =======     =======     =======     =======     =======




                                       19


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

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

Overview

We are a  biopharmaceutical  company  developing our proprietary  humanized lung
surfactant  technology  as  Surfactant  Replacement  Therapies  for  respiratory
diseases.  Surfactants are compositions  produced naturally in the lungs and are
essential to the lungs' ability to absorb oxygen and to maintain  proper airflow
through the  respiratory  system.  The absence or  depletion of  surfactants  is
involved in a number of respiratory diseases.

Our technology  produces an engineered  version of natural human lung surfactant
that is  designed  to  closely  mimic the  essential  properties  of human  lung
surfactant.  We believe that our surfactant technology provides the opportunity,
for the first time,  for pulmonary  surfactants to be developed into a series of
respiratory  therapies for critical care and other  hospitalized  patients where
there are few or no approved therapies available.

We recently completed two Phase 3 clinical trials of Surfaxin, our lead product,
for the treatment of Respiratory  Distress Syndrome in premature infants and are
preparing  to file  new drug  applications  with  the FDA and  other  regulatory
authorities in the rest of the world.

Our Surfactant  Replacement  Therapy is also in a Phase 2 clinical trial for the
treatment of Acute Respiratory Distress Syndrome in adults, as well as a Phase 3
and Phase 2 clinical trial for the treatment of Meconium  Aspiration Syndrome in
full-term  infants.  In addition,  we recently  completed a successful  Phase 1b
clinical  trial in healthy  volunteers  and mild  asthmatics  and are  currently
preparing to initiate a follow-on Phase 2 clinical trial  evaluating the safety,
tolerability  and efficacy of our  humanized  lung  surfactant,  delivered as an
inhaled aerosol (development name DSC-104), to treat patients with asthma.

Presently,  we are evaluating the development of other aerosolized  formulations
of our humanized  surfactant to potentially  treat premature infants in Neonatal
Intensive  Care  Units  suffering  from  Respiratory  Dysfunction.  We are  also
evaluating  aerosolized  formulations of our humanized surfactant to potentially
treat Acute Lung Injury,  chronic obstructive  pulmonary disease (often referred
to as COPD, which is a chronic condition of the lung that prevents enough oxygen
from reaching the blood), rhinitis,  sinusitis (infection of the sinuses), sleep
apnea and otitis media (inner ear infection).

We are presently  implementing  a long-term  commercial  strategy which includes
manufacturing  for the production of our humanized  surfactant  drug products to
meet  anticipated   clinical  and  commercial  needs  and  sales  and  marketing
capabilities  to execute  the launch of  Surfaxin  in the U.S.  and  Europe,  if
approved.



                                       20


Since our inception, we have incurred significant losses and, as of December 31,
2003, we had an  accumulated  deficit of  approximately  $97,000,000  (including
historical results of predecessor  companies).  The majority of our expenditures
to date  have  been  for  research  and  development  activities.  Research  and
development  expenses  represent  costs  incurred  for  scientific  and clinical
personnel,   clinical  trials,  regulatory  filings  and  manufacturing  efforts
(including raw material costs). We expense our research and development costs as
they are incurred.  General and  administrative  expenses  consist  primarily of
executive  management,   financial,  business  development,  legal  and  general
corporate activities and related expenses. See Item 7: "Management's  Discussion
and  Analysis  of  Financial  Condition  and  Results  of  Operations  - Plan of
Operations."

Historically,  we have  funded our  operations  with  working  capital  provided
principally   through  public  and  private  equity   financings  and  strategic
collaborations.  As of  December  31,  2003,  we had  cash  and  investments  of
approximately  $29,400,000, a secured revolving credit facility of $8,500,000 to
$10,000,000 with PharmaBio,  of which $5,700,000 was available for borrowing and
$2,400,000 was outstanding,  and a $4,000,000  capital equipment lease financing
arrangement  of  which  approximately  $962,000  was  outstanding.  See  Item 7:
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations - Liquidity and Capital Resources."

Critical Accounting Policies

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

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

Revenue Recognition- research and development collaborative agreements

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

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



                                       21


Research and Development Costs

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

Plan of Operations

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

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

(i)      increase our  research,  development  and  regulatory  activities in an
         effort to develop a broad pipeline of potential Surfactant  Replacement
         Therapies for respiratory diseases.

         We recently  completed two Phase 3 clinical  trials of Surfaxin for the
         treatment of Respiratory  Distress Syndrome in premature infants and we
         are now preparing to file new drug  applications with the FDA and other
         regulatory  authorities in the rest of the world.  Filing of the NDA is
         anticipated in April 2004. In accordance with the trial design for both
         Phase 3 studies,  we continue to conduct six and twelve month  clinical
         follow-up  on all enrolled  patients.  For Acute  Respiratory  Distress
         Syndrome in adults,  we currently are conducting a Phase 2 dose-ranging
         safety and efficacy  study of up to 110 patients in the United  States.
         We expect to have the  results  from this trial in the  second  half of
         2004.  For  Meconium  Aspiration  Syndrome  in  full-term  infants,  we
         currently are conducting a Phase 3 clinical trial in up to 200 patients
         and a Phase 2  clinical  trial in up to 60  patients.  Both  trials are
         expected to be  completed in 2005.  We recently  completed a successful
         Phase 1b clinical trial intended to evaluate the  tolerability and lung
         deposition of our humanized  lung  surfactant,  delivered as an inhaled
         aerosol  (development name DSC-104),  to treat patients with asthma and
         are currently preparing to initiate a follow-on Phase 2 clinical trial.
         We are evaluating the  development of aerosolized  formulations  of our
         humanized surfactant to potentially treat premature infants in Neonatal
         Intensive Care Units  suffering from  Respiratory  Dysfunction  and are
         preparing to initiate a clinical  trial in the second half of 2004.  In
         addition, we are evaluating the development of aerosolized formulations
         of our  humanized  surfactant to  potentially  treat Acute Lung Injury,
         COPD,  rhinitis,  sinusitis,  sleep apnea and otitis  media  (inner ear
         infection).

         The drug development, clinical trial and regulatory process is lengthy,
         expensive  and  uncertain  and  subject to  numerous  risks  including,
         without limitation, the following risks discussed in the "Risks Related
         to Our  Business" - "Our  technology  platform  is based  solely on our
         proprietary humanized,  engineered surfactant  technology.  Our ongoing
         clinical  trials for our lead surfactant  replacement  therapies may be
         delayed, or fail, which will harm our business";  - "The clinical trial
         and regulatory  approval process for our products is expensive and time
         consuming, and the outcome is uncertain."



                                       22


         (ii)     invest in and support a long-term  manufacturing  strategy for
                  the  production  of  our  humanized  surfactant  drug  product
                  including  further  development  and  scale-up  of our current
                  contract manufacturer,  alternative contract manufacturers and
                  building our own  manufacturing  operations in order to secure
                  additional manufacturing capabilities to meet production needs
                  as they expand.

         (iii)    invest   in   marketing   and   commercialization   (including
                  distribution)  resources to execute the launch of Surfaxin for
                  the treatment of  Respiratory  Distress  Syndrome in premature
                  infants,    if   approved,    and   the   execution   of   our
                  "Discovery/Surfaxin" worldwide sales and marketing strategy.

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

We are currently  implementing the initial phase of our long-term  manufacturing
strategy through the recent selection of Laureate to become our current contract
manufacturer.  In  October  2003,  we entered  into a  Technology  Transfer  and
Manufacturing  Agreement with Laureate which provides for the establishment of a
Surfaxin  manufacturing  line  together  with the  production  of  clinical  and
commercial drug supply in conformance with current Good Manufacturing  Practices
(cGMP).  This agreement also encompasses  plans for  manufacturing  scale-up and
enhancements,   including   additional  equipment  to  support  our  anticipated
commercial-scale  requirements  of Surfaxin  for the  treatment  of  Respiratory
Distress  Syndrome  in  premature  infants  and our  anticipated  clinical-scale
production  requirements  of Surfaxin  for the  treatment  of Acute  Respiratory
Distress  Syndrome in adults.  See "Risks  Related to Our Business - In order to
conduct our clinical trials we need adequate  supplies of our drug substance and
drug product and competitor's drug product, which may not be readily available";
and "If the parties we depend on for manufacturing our  pharmaceutical  products
do not timely  supply  these  products,  it may delay or impair  our  ability to
develop and market our products."

We  have  a  collaboration   arrangement  with  Quintiles,  and  its  affiliate,
PharmaBio,  to provide certain  commercialization  services in the United States
for Surfaxin for the  treatment of  Respiratory  Distress  Syndrome in premature
infants and  Meconium  Aspiration  Syndrome in full-term  infants.  Quintiles is
obligated to hire and train a dedicated  United  States sales force that will be
branded in the market as ours.  Quintiles has committed to make  available up to
$70,000,000  in  post-launch  funding to cover the first  seven  years of United
States sales and marketing costs. In return,  Quintiles is entitled to receive a
commission  on net  sales of  Surfaxin  over a  10-year  period.  The  Quintiles
arrangement  allows us to retain product  ownership and have sales and marketing
expertise in place for the  commercialization  of Surfaxin in the United States,
if approved.

                                       23


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

We will need to generate  significant revenues from product sales and or related
royalties  and transfer  prices to achieve and maintain  profitability.  Through
December  31,  2003,  we had no revenues  from any product  sales,  and have not
achieved  profitability  on a quarterly or annual basis.  Our ability to achieve
profitability depends upon, among other things, our ability to develop products,
obtain  regulatory  approval  for  products  under  development  and enter  into
agreements for product  development,  manufacturing  and  commercialization.  In
addition,  our results  are  dependent  upon the  performance  of our  strategic
partners and third party contract manufacturers and suppliers.  Moreover, we may
never achieve significant revenues or profitable operations from the sale of any
of our products or technologies.

Through December 31, 2003, we had not generated  taxable income. On December 31,
2003, net operating losses available to offset future taxable income for Federal
tax purposes were approximately $91,585,000. The future utilization of such loss
carryforwards  may be limited pursuant to regulations  promulgated under Section
382 of  the  Internal  Revenue  Code.  In  addition,  we  have  a  research  and
development  tax credit  carryforward  of $1,868,000.  The Federal net operating
loss and research and development tax credit  carryforwards  expire beginning in
2008 and continuing through 2021.

Results of Operations

The net loss for the three  years ended  December  31,  2003,  2002 and 2001 was
$24,280,000 (or $0.65 per common share), $17,443,000 (or $0.64 per common share)
and  $11,146,000  (or $0.51 per common  share),  respectively.  These  increased
losses  were  primarily  the  result  of  increasing  research  and  development
expenditures as discussed below.

Revenue

Total revenues  recognized for the three years ended December 31, 2003, 2002 and
2001 were $1,037,000,  $1,782,000 and $1,112,000,  respectively.  These revenues
are associated  with our research and  development  collaborative  arrangements,
primarily  our  alliance  with  Esteve  to  develop,  market  and sell  Surfaxin
throughout Europe and Latin America. Additional collaborative revenues relate to
our Small  Business  Innovative  Research  (SBIR) grant to develop  Surfaxin for
Acute Lung Injury/Acute  Respiratory  Distress Syndrome in adults and our Orphan
Products  Development grant to develop Surfaxin for Meconium Aspiration Syndrome
in full-term infants.  The decrease in 2003 reflects:  (i) the conclusion of our
Small Business  Innovative  Research (SBIR) grant for research for treatments of
Acute Lung Injury/Acute  Respiratory  Distress Syndrome in adults and our Orphan
Products  Development grant to develop Surfaxin for Meconium Aspiration Syndrome
in full-term  infants;  and (ii) the  extension of the  amortization  period and
related  revenue  recognition  of  the  funding  previously  provided  to  us in
connection with our strategic alliance with Esteve.



                                       24


Expenses

Research and  development  expenses for the three years ended December 31, 2003,
2002 and 2001 were $19,750,000,  $14,347,000 and $8,007,000,  respectively.  The
increases  primarily  reflect  costs  incurred  for  the:  (i)  development  and
regulatory  efforts to complete the two Phase 3 clinical trials for Surfaxin for
the treatment of Respiratory Distress Syndrome in premature infants;  (ii) Phase
2 clinical  trial for Surfaxin for the treatment of Acute  Respiratory  Distress
Syndrome in adults; (iii) investment in our clinical, statistical and regulatory
infrastructure to manage the various development  activities associated with our
surfactant   replacement   therapy  pipeline;   (iv)  research  and  development
activities  related  to  the  development  of  aerosolized  formulations  of our
humanized lung surfactant;  and (v) activities  associated with the installation
and  validation  of our Surfaxin  manufacturing  and filling line at  Laureate's
facility  for  the  production  of  clinical  and  commercial   drug  supply  in
conformance with current Good Manufacturing Practices (cGMPs).

General and administrative expenses for the three years ended December 31, 2003,
2002 and 2001 were $5,722,000, $5,458,000 and $5,067,000,  respectively. General
and  administrative  expenses  consist  primarily  of  the  costs  of  executive
management,  financial  and  accounting,  business and  commercial  development,
legal,  facility  and  other  administrative  costs.  Included  in  general  and
administrative  costs are  approximately  $986,000 and  $1,450,000 for the years
ended  December  31,  2003  and  2002,   respectively,   related  to  pre-launch
commercialization  activities  for  Surfaxin  conducted  in  connection  with  a
collaboration  agreement  with  Quintiles  (for which funding is provided by the
secured, revolving credit facility with PharmaBio, discussed below in "Liquidity
and Capital  Resources").  Additionally,  included in general and administrative
costs for the years  ended  December  31,  2003,  2002 and  2001,  are  non-cash
compensation charges of $192,000, $403,000 and $517,000,  respectively. The 2003
non-cash  compensation charge is primarily related to the grant of stock options
to non-employee members of our Board of Directors under our Amended and Restated
1998 Stock  Option  Plan and the  vesting of certain  stock  options  granted to
consultants. The 2002 and 2001 non-cash compensation charges primarily relate to
the grant of stock  options to  non-employee  members of our Board of  Directors
under our stock option plan and certain modifications to certain options held by
three departing members of our Board of Directors.

Other Income and Expense

Other income and expense (net) for the years ended  December 31, 2003,  2002 and
2001 were $155,000, $580,000 and $816,000, respectively. Interest income for the
years  ended  December  31,  2003,  2002  and 2001 was  $452,000,  $724,000  and
$842,000,  respectively,  the  decreases  are  primarily  due to a reduction  in
interest  earned  on  our  cash,  cash  equivalents  and  marketable  securities
primarily due to a general  reduction in earned market interest rates.  Interest
expense for the years  ended  December  31,  2003,  2002 and 2001 was  $297,000,
$144,000 and $26,000,  respectively,  the increases are due to interest  expense
associated  with our  secured,  revolving  credit  facility  and  capital  lease
financing arrangements. See "Liquidity and Capital Resources."



                                       25


Liquidity and Capital Resources

Cash, Cash Equivalents and Marketable Securities

As of December 31, 2003, we had cash, cash equivalents and marketable securities
of  approximately  $29,400,000  as compared to  approximately  $19,200,000 as of
December  31,  2002.  As of  December  31,  2003,  we  had  working  capital  of
approximately  $23,100,000 as compared to the working  capital of  approximately
$16,300,000 as of December 31, 2002.  The increase in working  capital is due to
the net proceeds of $34,700,000  received  primarily from the sale of securities
and the  exercise  of certain  options  and  warrants,  offset by funds used for
operating  activities  and the  classification  to  current  liabilities  of the
$2,400,000  outstanding  as of December 31, 2003,  under the secured,  revolving
credit facility with PharmaBio, discussed below.

Secured, Revolving Credit Facility and Capital Lease Arrangement

We have a secured  revolving  credit facility of up to $8,500,000 to $10,000,000
with PharmaBio to fund  pre-marketing  activities  for a Surfaxin  launch in the
United States. The credit facility is available for use until December 10, 2004,
and  monies  become   available  in  three  tranches  upon  satisfying   certain
conditions.  We have satisfied the conditions for  availability of the first two
tranches  and at  December  31,  2003,  the  amount  available  under the credit
facility was  approximately  $5,700,000,  of which  $2,400,000 was  outstanding.
Interest on amounts advanced under the credit facility are payable  quarterly in
arrears.  Outstanding  principal and interest due under the credit  facility are
due and payable on December 10, 2004.  Although we may repay  principal  amounts
owed by us under the credit  facility from proceeds of milestone  payments to be
paid to us by PharmaBio upon the  achievement of certain  corporate  milestones,
there can be no assurance that we will achieve any of these  milestones prior to
the  repayment  date,  and doing so is not likely  unless the FDA  expedites the
review  of the NDA  for  Surfaxin  for the  treatment  of  Respiratory  Distress
Syndrome in premature infants that we expect to file with the FDA in April 2004,
and  approves  such NDA prior to December 10,  2004.  See Item 7:  "Management's
Discussion and Analysis of Financial Condition and Results of Operations - Risks
Related to our Business - The clinical trial and regulatory approval process for
our products is expensive and time consuming,  and the outcome is uncertain." We
are  obligated  to use a  significant  portion of the funds  borrowed  under the
credit facility for pre-launch marketing services to be provided by Quintiles.

We have a  capital  lease  financing  arrangement  with  the  Life  Science  and
Technology  Finance  Division  of  General  Electric  Capital  Corporation.   In
September  2003, the  arrangement  was increased to provide,  subject to certain
conditions, up to an aggregate $4,000,000 in financing for capital purchases. As
of  December  31,  2003,  approximately  $962,000  was  outstanding  under  this
financing arrangement.



                                       26


We believe  our  current  working  capital  is  sufficient  to meet our  planned
research and  development  and  operational  activities  into 2005. We will need
additional  financing from investors or collaborators  to complete  research and
development  and  commercialization  of our  current  product  candidates  under
development.

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

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

In June and July of 2003,  our common stock attained  certain price  performance
thresholds on the Nasdaq SmallCap Market that permitted us to provide notice for
redemption (and thereby  effectively compel the exercise thereof) to the holders
of three of our outstanding classes of warrants which represented, in aggregate,
the right to purchase  approximately  3.6 million  shares of common stock.  Such
warrants  (i.e.,  the Class I,  Class F and Class C  warrants)  were  previously
issued by us in  connection  with  certain  private  placement  financings  that
occurred in November 2002, October 2001, and April 1999,  respectively.  Between
the  dates  of June 1,  2003,  and  September  12,  2003,  holders  of  warrants
exercisable for  approximately 3.6 million shares of common stock exercised such
warrants,  in accordance with their respective  terms,  either cashlessly or for
cash,  resulting  in the  issuance to the holders of  approximately  3.3 million
shares of common  stock and our  receipt of  aggregate  cash  proceeds  equal to
approximately $6,100,000.

In June 2003,  we completed  the sale of  securities  in a private  placement to
selected   institutional   and   accredited   investors   for  net  proceeds  of
approximately  $25,900,000.  We issued  4,997,882  shares  of  common  stock and
999,577  Class A Investor  warrants  to  purchase  shares of common  stock at an
exercise price equal to $6.875 per share.  The Class A Investor  warrants have a
seven-year term.

In November 2002, we completed the sale of securities in a private  placement to
selected   institutional   and   accredited   investors   for  net  proceeds  of
approximately  $11,900,000.  We issued  6,397,517  shares  of  common  stock and
2,878,883  Class I Warrants  to purchase  shares of Common  Stock at an exercise
price of $2.425 per share. The Class I warrants had a five-year term and we were
entitled to redeem the Class I warrants, with 60 days' prior written notice, for
$.001,  upon  the  attainment  of  certain  exchange-related  price  performance
thresholds of the common stock. In June 2003, the price performance criteria was
met and we provided  notice to the Class I warrant  holders of our  intention to
redeem the Class I warrants. All Class I warrants have been exercised.



                                       27


Pursuant  to our  collaboration  arrangement  with  Esteve on March 6, 2002,  we
issued  821,862  shares of common  stock to Esteve at a purchase  price equal to
$4.867 per share and received a licensing fee of $500,000,  for  approximate net
aggregate proceeds of $4,450,000. See Item 1: "Business - Strategic Alliances."

Pursuant to the  collaboration  arrangement  we entered into with  Quintiles and
PharmaBio  in  December  2001,  we  issued to  PharmaBio,  for  approximate  net
aggregate proceeds of $2,000,000:  (i) 791,905 shares of common stock at a price
equal to $3.79 per share;  and (ii) Class G warrants to purchase  357,143 shares
of common  stock at an  exercise  price  equal to $3.485 per share  (subject  to
adjustment).  In  connection  with the credit  facility,  we issued to PharmaBio
Class H  warrants  to  purchase  320,000  shares  of common  stock.  The Class H
warrants are  exercisable  at $3.03 per share  (subject to  adjustment)  and are
exercisable  proportionately  only upon availability of the credit facility.  To
the  extent  the credit  facility  availability  is  increased  to greater  than
$8,500,000,  for each $1,000,000 increase,  the amount of shares of common stock
issuable  pursuant to the Class H warrants  shall be increased by  approximately
38,000 shares. See Item 1: "Business - Strategic Alliances."

In October  2001,  we received  approximately  $7,300,000 in net proceeds from a
private financing.  In the financing, we issued 3,562,759 shares of common stock
and 712,553  Class F warrants to purchase  shares of common stock at an exercise
price of $2.365 per share. The Class F warrants had a five-year term and we were
entitled to redeem the Class F warrants, with 20 days' prior written notice, for
$.001,  upon  the  attainment  of  certain  exchange-related  price  performance
thresholds of the common stock. In July 2003, the price performance criteria was
met and we provided  notice to the Class F warrant  holders of our  intention to
redeem the Class F warrants. All Class F warrants have been exercised.

In April 2001,  we received  approximately  $1,000,000  in proceeds in a private
offering of 296,560 shares of common stock at a per share price equal to $3.37.

Contractual Obligations

Our long-term contractual obligations include commitments and estimated purchase
obligations entered into in the normal course of business.



                                       28


Payments due under contractual obligations at December 31, 2003, are as follows:



                                               2004             2005            2006            2007           Total
                                          ---------------  --------------- ---------------- -------------- --------------
                                                                                            
Credit facility with corporate
partner(1)                                     2,436,000                -                -              -      2,436,000
Capital lease obligations(1)                     473,000          425,000          238,000        131,000      1,267,000
Operating lease obligations(2)                   530,000          291,000           28,000              -        849,000
Purchase obligations(3)                          554,000                -                -              -        554,000
Employment agreements(4)                       1,820,000        1,567,000                -              -      3,387,000
                                          ---------------  --------------- ---------------- -------------- --------------
Total                                          5,813,000        2,283,000          266,000        131,000      8,493,000


(1)      See  Item  7:  "Management's   Discussion  and  Analysis  of  Financial
         Condition and  Operations - Liquidity  and Capital  Resources - Secured
         Revolving Credit Facility and Capital Lease Arrangement".

(2)      Operating  lease   obligations   include  property  rental   agreements
         discussed below.

(3)      Purchase  obligations include commitments of equipment and services for
         the enhancement of our manufacturing capabilities for Surfaxin.

(4)      See discussion below.

In addition to the  contractual  obligations  above,  we have certain  milestone
payment obligations,  aggregating $2,750,000, and royalty payment obligations to
Ortho Pharmaceuticals related to our product licenses.

Operating Lease Obligations

At December 31,  2003,  we leased  office and  laboratory  space in  Doylestown,
Pennsylvania  under  leases  which expire in  September  2004,  March 2005,  and
September 2005. Additionally,  the Company leased office and laboratory space in
Redwood City,  California  under a lease that expires  February 2006, and office
space in Windsor, United Kingdom, under a lease which expired December 2003.

Employment Agreements

At December 31, 2003, we had employment  agreements with six officers  providing
for an aggregate annual salary of $1,440,000.  The agreements  expire on various
dates through December 2005, however, commencing on January 1, 2006, and on each
January 1st thereafter,  the term of these  agreements  shall  automatically  be
extended for one additional year,  unless at least 90 days prior to such January
1st date,  we or the  officer  shall have given  notice that it does not wish to
extend the agreement.  We also had employment agreements with two other officers
that provide for an aggregate annual salary of $467,000. These agreements expire
in December  2005. All of the foregoing  agreements  provide for the issuance of
annual  bonuses and the granting of options  subject to approval by our Board of
Directors.

We  will  require  substantial  additional  funding  to  conduct  our  business,
including our expanded research and product development activities. Based on our
current  operating  plan,  we believe that our  currently  available  resources,
including amounts currently  available under our credit facility with PharmaBio,
and our capital  lease  financing  arrangement  with  General  Electric  Capital
Corporation, will be adequate to satisfy our capital needs into 2005. Our future
capital  requirements will depend on the results of our research and development


                                       29


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

Risks Related to Our Business

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

Because we are a biopharmaceutical  company, we may not successfully develop and
market our products,  and even if we do, we may not generate  enough  revenue or
become profitable.

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

To date, we have only generated  revenues from investments,  research grants and
collaborative  research and  development  agreements.  We will need to engage in
significant,  time-consuming  and  costly  research,  development,  pre-clinical
studies,  clinical  testing  and  regulatory  approval  for our  products  under
development  prior to their  commercialization.  In  addition,  pre-clinical  or
clinical studies may show that our products are not effective or safe for one or
more  of   their   intended   uses.   We  may  fail  in  the   development   and
commercialization  of  our  products.  As of  December  31,  2003,  we  have  an
accumulated deficit of approximately  $96,800,000,  and we expect to continue to
incur significant increasing operating losses over the next several years. If we
succeed in the development of our products, we still may not generate sufficient
or sustainable revenues or we may not be profitable.



                                       30


Our technology platform is based solely on our proprietary humanized, engineered
surfactant  technology.  Our  ongoing  clinical  trials for our lead  surfactant
replacement technologies may be delayed, or fail, which will harm our business.

Our  humanized,  engineered  surfactant  platform  technology  is  based  on the
scientific   rationale  for  surfactant   replacement   therapy  to  treat  life
threatening  respiratory  disorders and as the foundation for the development of
novel  respiratory  therapies and products.  Our business is dependent  upon the
successful  development  and  approval of our product  candidates  based on this
platform technology. Recently we completed and announced top-line results from a
pivotal Phase 3 clinical  trial and  supportive  Phase 3 clinical trial with our
lead product,  Surfaxin,  for the treatment of Respiratory  Distress Syndrome in
premature infants.  In addition,  we are conducting a Phase 2 clinical trial for
the treatment of Acute Respiratory Distress syndrome in adults and a Phase 3 and
a Phase 2 clinical  trial for the treatment of Meconium  Aspiration  Syndrome in
full-term  infants.  We recently completed a Phase 1b clinical trial to evaluate
the safety and  tolerability of our humanized lung  surfactant,  delivered as an
inhaled aerosol to treat individuals who suffer from asthma.

Companies in the  pharmaceutical  and  biotechnology  industries  have  suffered
significant setbacks in advanced clinical trials, even after obtaining promising
results in earlier  trials.  Data obtained from tests are susceptible to varying
interpretations  which may  delay,  limit or  prevent  regulatory  approval.  In
addition,  we may be  unable  to  enroll  patients  quickly  enough  to meet our
expectations  for  completing  any  or all  of  these  trials.  The  timing  and
completion  of current and  planned  clinical  trials of our product  candidates
depend on, among other factors,  the rate at which patients are enrolled,  which
is a function of many factors, including:

- --the number of clinical sites;
- --the size of the patient population;
- --the proximity of patients to the clinical sites;
- --the  eligibility  criteria for the study;
- --the existence of competing clinical trials; and
- --the existence of alternative available products.

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

We will need additional  capital and our ability to continue all of our existing
planned  research  and  development  activities  is  uncertain.  Any  additional
financing could result in equity dilution.



                                       31


We will need  substantial  additional  funding to conduct our presently  planned
research  and product  development  activities.  Based on our current  operating
plan,  we believe  that our  currently  available  financial  resources  will be
adequate to satisfy our capital needs into 2005. Our future capital requirements
will depend on a number of factors that are uncertain,  including the results of
our  research  and  development   activities,   clinical   studies  and  trials,
competitive and technological advances and the regulatory process, among others.
We will likely need to raise substantial  additional funds through collaborative
ventures with potential corporate partners and through additional debt or equity
financings.  We may also continue to seek  additional  funding  through  capital
lease  transactions.  We may in some cases elect to develop  products on our own
instead of entering into  collaboration  arrangements.  This would  increase our
cash requirements for research and development.

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

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

The clinical trial and regulatory approval process for our products is expensive
and time consuming, and the outcome is uncertain.

In order to sell  our  products  that are  under  development,  we must  receive
regulatory  approvals  for each  product.  The FDA and  comparable  agencies  in
foreign countries extensively and rigorously regulate the testing,  manufacture,
distribution,  advertising,  pricing and  marketing  of drug  products  like our
products. This approval process includes preclinical studies and clinical trials
of each  pharmaceutical  compound to establish the safety and  effectiveness  of
each product and the confirmation by the FDA and comparable  agencies in foreign
countries that the  manufacturer  of the product  maintains good  laboratory and
manufacturing  practices  during  testing  and  manufacturing.  Although  we are
involved in certain late-stage clinical trials, pharmaceutical and biotechnology
companies have suffered  significant  setbacks in advanced clinical trials, even
after promising  results in earlier  clinical trials or in preliminary  findings
for such clinical trials.  Further,  even if favorable testing data is generated
by clinical  trials of drug  products,  the FDA may not approve a NDA filed by a
pharmaceutical or biotechnology company for such drug product.

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



                                       32


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

Clinical  trials  generally  take two to five  years or more to  complete,  and,
accordingly,  our first product is not expected to be commercially  available in
the United  States until at least 2005,  and our other product  candidates  will
take longer.  The FDA has notified us that two of our intended  indications  for
our  humanized   surfactant-based   therapy,  Meconium  Aspiration  Syndrome  in
full-term infants and Acute Respiratory  Distress Syndrome in adults,  have been
granted  designation as "fast-track"  products under  provisions of the Food and
Drug  Administration  Modernization  Act of 1997.  The FDA has also  granted  us
Orphan Drug  Designation  for three of our intended  indications  for  Surfaxin:
Acute Respiratory Distress Syndrome in adults;  Respiratory Distress Syndrome in
infants;  and Meconium  Aspiration Syndrome in full-term infants. To support our
development of Surfaxin for the treatment of Meconium Aspiration  Syndrome,  the
FDA has awarded us an Orphan Products Development Grant.  Fast-Track Status does
not  accelerate  the  clinical  trials  nor  does it mean  that  the  regulatory
requirements are less stringent.  The Fast-Track  Status provisions are designed
to  expedite  the  FDA's  review  of new  drugs  intended  to treat  serious  or
life-threatening  conditions.  The  FDA  generally  will  review  the  New  Drug
Application  for a drug granted  Fast-Track  Status within six months instead of
the typical one to three  years.  Our  products  may not,  however,  continue to
qualify for expedited  review and our other drug  candidates may fail to qualify
for fast track  development  or expedited  review.  Even though some of our drug
candidates have qualified for expedited review,  the FDA may not approve them at
all or any sooner than other drug  candidates  that do not qualify for expedited
review.

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



                                       33


In order to conduct our clinical  trials we need  adequate  supplies of our drug
substance  and drug  product and  competitor's  drug  product,  which may not be
readily available.

To succeed, clinical trials require adequate supplies of drug substance and drug
product,  which may be difficult or uneconomical  to procure or manufacture.  We
rely on third party  contract  manufacturers  for our drug  substance  and other
active  ingredients for Surfaxin and to produce material that meets  appropriate
standards for use in clinical  trials of our products.  We recently  transferred
our manufacturing  capabilities from our single validated clinical manufacturing
facility, owned and operated by Akorn to a new contract manufacturer,  Laureate,
with the objective of producing  appropriate clinical grade material of our drug
substance  that meet the  standards  for use in our  ongoing  clinical  studies.
Laureate may not be able to produce Surfaxin to appropriate standards for use in
clinical studies. A failure by Laureate to do so may delay or impair our ability
to obtain  regulatory  approval  for  Surfaxin.  See also "Risks  Related to Our
Business - If the  parties  we depend on for  manufacturing  our  pharmaceutical
products do not timely supply these products, it may delay or impair our ability
to develop and market our products."

If the parties we depend on for manufacturing our pharmaceutical products do not
timely supply these products,  it may delay or impair our ability to develop and
market our products.

We rely on  outside  manufacturers  for our  drug  substance  and  other  active
ingredients  for  Surfaxin  and  to  produce  material  that  meets  appropriate
standards for use in clinical  studies of our products.  Presently,  Laureate is
our sole  clinical  manufacturing  facility  that has been  qualified to produce
appropriate clinical grade material of our drug substance for use in our ongoing
clinical studies.

Laureate or other outside  manufacturers may not be able to (i) produce our drug
substance to  appropriate  standards for use in clinical  studies,  (ii) perform
under any  definitive  manufacturing  agreements  with us or (iii) remain in the
contract  manufacturing  business for a sufficient time to successfully  produce
and market our product candidates. If we do not maintain important manufacturing
relationships, we may fail to find a replacement manufacturer or develop our own
manufacturing  capabilities  which  could  delay or impair our ability to obtain
regulatory  approval for our products  and  substantially  increase our costs or
deplete profit margins, if any. If we do find replacement manufacturers,  we may
not be able to enter into agreements with them on terms and conditions favorable
to us and,  there could be a  substantial  delay before a new facility  could be
qualified and registered with the FDA and foreign regulatory authorities.

We may in the  future  elect to  manufacture  some of our  products  on our own.
Although we own certain specialized  manufacturing equipment, are considering an
investment   in   additional   manufacturing   equipment   and  employ   certain
manufacturing  managerial  personnel,  we do not  presently  maintain a complete
manufacturing  facility or  manufacturing  department  and we do not  anticipate
manufacturing  on our own any of our products  during the next 12 months.  If we
decide  to  manufacture  products  on our  own and do not  successfully  develop
manufacturing capabilities, it will adversely affect sales of our products.



                                       34


The FDA and foreign  regulatory  authorities  require  manufacturers to register
manufacturing  facilities.  The FDA and  corresponding  foreign  regulators also
inspect these facilities to confirm  compliance with current Good  Manufacturing
Practices (cGMPs) or similar requirements that the FDA or corresponding  foreign
regulators  establish.  Manufacturing or quality control problems could occur at
the contract  manufacturers  causing product production and shipment delays or a
situation  where the contractor may not be able to maintain  compliance with the
FDA's current cGMP  requirements  necessary to continue  manufacturing  our drug
substance.  Any  failure  to  comply  with  cGMP  requirements  or other FDA and
comparable foreign  regulatory  requirements could adversely affect our clinical
research activities and our ability to market and develop our products.

Our strategy,  in many cases,  is to enter into  collaboration  agreements  with
third  parties  with  respect  to our  products  and we may  require  additional
collaboration  agreements. If we fail to enter into these agreements or if we or
the third  parties do not perform  under such  agreements,  it could  impair our
ability to commercialize our products.

Our strategy for the completion of the required development and clinical testing
of our products and for the manufacturing,  marketing and  commercialization  of
our  products,   in  many  cases,   depends  upon  entering  into  collaboration
arrangements  with  pharmaceutical   companies  to  market,   commercialize  and
distribute our products.  We have a  collaboration  arrangement  with Esteve for
Surfaxin  covering all of Europe and Latin  America.  Esteve will be responsible
for the marketing of Surfaxin for the treatment of Respiratory Distress Syndrome
in premature  infants,  Meconium  Aspiration  Syndrome in full-term  infants and
Acute Lung Injury/Acute  Respiratory  Distress  Syndrome in adults.  Esteve will
also be responsible for the sponsorship of certain  clinical trial costs related
to obtaining European Medicines Evaluation Agency approval for commercialization
of Surfaxin in Europe for the indications of Acute Lung Injury/Acute Respiratory
Distress  Syndrome.  We will be responsible  for the remainder of the regulatory
activities  relating to Surfaxin,  including with respect to European  Medicines
Evaluation Agency filings.

We have entered into an exclusive collaboration arrangement in the United States
with Quintiles and PharmaBio to  commercialize,  sell and market Surfaxin in the
United States for  indications  of  Respiratory  Distress  Syndrome and Meconium
Aspiration Syndrome.  As part of our collaboration with Quintiles,  Quintiles is
obligated to build a sales force solely  dedicated to the sale of Surfaxin  upon
the approval of a New Drug  Application  for either of the two  indications.  If
Quintiles and we fail to devote appropriate resources to commercialize, sell and
market  Surfaxin,   sales  of  Surfaxin  could  be  reduced.   As  part  of  the
collaboration,  PharmaBio  has  committed to provide us with  certain  financial
assistance in connection with the commercialization of Surfaxin,  including, but
not limited to, a secured,  revolving  credit  facility for at least  $8,500,000
which  may be  increased  to  $10,000,000.  A  failure  by us to  repay  amounts
outstanding  under the credit  facility would have a material  adverse effect on
us. To obtain the benefits of such  financing,  we are obligated to meet certain
development and performance milestones. The failure by us to meet the milestones
or  other  terms  and  conditions  of  the  financing   leading  to  PharmaBio's
termination  thereof or the failure by  PharmaBio to fulfill its  obligation  to
partially  fund the  commercialization  of  Surfaxin,  may affect our ability to
successfully market Surfaxin.



                                       35


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

If we cannot protect our  intellectual  property,  other companies could use our
technology in competitive  products.  If we infringe the  intellectual  property
rights of others,  other companies could prevent us from developing or marketing
our products.

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

- -defend  our  patents  and  otherwise  prevent  others  from  infringing  on our
 proprietary rights;
- -protect trade secrets; and
- -operate without infringing upon the proprietary rights of others, both in the
 United States and in other countries.

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



                                       36


Even if we obtain  patents to protect  our  products,  those  patents may not be
sufficiently broad and others could compete with us.

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

Furthermore,  the life of our patents is limited.  We have  licensed a series of
patents from  Johnson & Johnson and Ortho  Pharmaceutical  which are  important,
either  individually or  collectively,  to our strategy of  commercializing  our
surfactant  technology.  Such patents,  which include relevant European patents,
expire on various dates  beginning in 2009 and ending in 2017 or, in some cases,
possibly later.  We have filed,  and when possible and  appropriate,  will file,
other patent  applications  with  respect to our  products and  processes in the
United States and in foreign countries. We may not be able to develop additional
products or processes  that will be patentable or additional  patents may not be
issued to us.  See also  "Risks  Related  to Our  Business  - If we cannot  meet
requirements  under our  license  agreements,  we could  lose the  rights to our
products."

Intellectual  property rights of third parties could limit our ability to market
our products.

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



                                       37


If we cannot meet requirements under our license  agreements,  we could lose the
rights to our products.

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

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

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

We  rely  on  confidentiality  agreements  that  could  be  breached  and may be
difficult to enforce.

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

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




                                       38


Our lack of marketing and sales  experience  could limit our ability to generate
revenues from future product sales.

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

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

We depend upon key employees and consultants in a competitive market for skilled
personnel.  If we are unable to  attract  and  retain  key  personnel,  it could
adversely affect our ability to develop and market our products.

We are highly  dependent  upon the  principal  members of our  management  team,
especially our Chief Executive Officer, Dr. Capetola, and our directors, as well
as  our  scientific  advisory  board  members,   consultants  and  collaborating
scientists.  Many of these  people have been  involved in our  formation or have
otherwise  been involved with us for many years,  have played  integral roles in
our progress and we believe  that they will  continue to provide  value to us. A
loss of any of these personnel may have a material  adverse effect on aspects of
our  business and  clinical  development  and  regulatory  programs.  We have an
employment  agreement  with Dr.  Capetola  that expires on December 31, 2005. We
also have employment  agreements with other key personnel with termination dates
from 2004 through 2005. Although these employment  agreements  generally provide
for  severance  payments  that are  contingent  upon the  applicable  employee's
refraining from competition with us, the loss of any of these persons'  services
would adversely affect our ability to develop and market our products and obtain
necessary regulatory approvals,  and the applicable noncompete provisions can be
difficult and costly to monitor and enforce. Further, we do not maintain key-man
life insurance.



                                       39


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

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

Our industry is highly  competitive  and we have less capital and resources than
many of our  competitors,  which may give them an  advantage in  developing  and
marketing products similar to ours or make our products obsolete.

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

- --developing products;
- --undertaking preclinical testing and human clinical trials;
- --obtaining FDA and other  regulatory  approvals  or products;  and
- --manufacturing  and  marketing products.

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

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



                                       40


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

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

If product  liability  claims are  brought  against us, it may result in reduced
demand for our products or damages that exceed our insurance coverage.

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



                                       41


We expect to face uncertainty over reimbursement and healthcare reform.

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

Directors,  executive officers,  principal  stockholders and affiliated entities
own a significant  percentage of our capital stock,  and they may make decisions
that you do not consider to be in your best interest.

As  of  December  31,  2003,  our  directors,   executive  officers,   principal
stockholders  and  affiliated  entities  beneficially  owned,  in the aggregate,
approximately 15% of our outstanding voting securities.  As a result, if some or
all of them acted  together,  they would have the  ability to exert  substantial
influence  over the election of our Board of Directors and the outcome of issues
requiring approval by our stockholders. This concentration of ownership may have
the effect of delaying or preventing a change in control of our Company that may
be  favored by other  stockholders.  This could  prevent  transactions  in which
stockholders  might  otherwise  recover a premium for their  shares over current
market prices.

The market price of our stock may be adversely affected by market volatility.

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

- --announcements of the results of clinical trials by us or our competitors;
- --adverse reactions to products;
- --governmental  approvals,   delays  in  expected   governmental   approvals  or
  withdrawals  of any prior  governmental  approvals  or public or  regulatory
  agency concerns regarding the safety or effectiveness of our products;
- --changes in the United States or foreign regulatory policy during the period of
  product  development;
- --developments  in  patent or other  proprietary  rights, including any third
  party challenges of our intellectual property rights;
- --announcements of technological innovations by us or our competitors;
- --announcements of new products or new contracts by us or our competitors;



                                       42


- --actual or anticipated variations in our operating results due to the level of
  development expenses and other factors;
- --changes in financial estimates by securities analysts and whether our earnings
  meet or exceed the estimates;
- --conditions and trends in the pharmaceutical and other industries;
- --new accounting standards; and
- --the occurrence of any of the risks described in this "Management's Discussion
  and Analysis of Financial Condition and Results of Operations - Risks Related
  to Our Business."

Our common stock is listed for quotation on the NASDAQ SmallCap Market.  For the
12-month  period  ended  December  31,  2003,  the price of our common stock has
ranged from $1.32 to $10.75.  We expect the price of our common  stock to remain
volatile.   The  average  daily  trading  volume  in  our  common  stock  varies
significantly.  For the  12-month  period ended  December 31, 2003,  the average
daily trading  volume in our common stock was  approximately  401,301 shares and
the average number of transactions per day was approximately 735. Our relatively
low average volume and low average number of transactions per day may affect the
ability  of our  stockholders  to sell  their  shares  in the  public  market at
prevailing prices and a more active market may never develop.

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

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

A  substantial  number of our  securities  are eligible for future sale and this
could affect the market price for our stock and our ability to raise capital.

The market  price of our common  stock could drop due to sales of a large number
of shares of our common stock or the perception that these sales could occur. As
of December 31, 2003, we had 42,491,438 shares of common stock  outstanding.  In
addition,  as of December 31, 2003, up to approximately  8,753,000 shares of our
common stock were issuable upon exercise of outstanding options and warrants. On
December 19, 2003,  we filed a Form S-3 shelf  registration  statement  with the
Commission for the proposed offering from time to time of up to 6,500,000 shares
of common stock.  We have no immediate  plans to sell any  securities  under the
shelf  registration.  However,  as the registration  statement has been declared
effective  by the  Commission,  we may  issue  securities  from  time to time in
response to market  conditions or other  circumstances  on terms and  conditions
that will be determined at such time.



                                       43


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

Provisions of our Certificate of  Incorporation,  Shareholders  Rights Agreement
and Delaware law could defer a change of our management  which could  discourage
or delay offers to acquire us.

Provisions of our Certificate of  Incorporation,  Shareholders  Rights Agreement
and Delaware law may make it more difficult for someone to acquire control of us
or for our  stockholders to remove existing  management,  and might discourage a
third  party  from  offering  to acquire  us,  even if a change in control or in
management would be beneficial to our stockholders. For example, our Certificate
of  Incorporation  allows us to issue shares of preferred stock without any vote
or further action by our stockholders.  Our Board of Directors has the authority
to fix and determine the relative rights and preferences of preferred stock. Our
Board of Directors  also has the  authority  to issue  preferred  stock  without
further  stockholder  approval.  As a  result,  our  Board  of  Directors  could
authorize  the  issuance  of a series of  preferred  stock that  would  grant to
holders the preferred right to our assets upon liquidation, the right to receive
dividend  payments  before  dividends are  distributed  to the holders of common
stock and the right to the  redemption  of the shares,  together with a premium,
prior  to the  redemption  of our  common  stock.  In  addition,  our  Board  of
Directors,  without further  stockholder  approval,  could issue large blocks of
preferred  stock.  We have adopted a shareholders  rights  agreement which under
certain circumstances would significantly impair the ability of third parties to
acquire  control of us without prior approval of our Board of Directors  thereby
discouraging  unsolicited  takeover  proposals.  The  rights  issued  under  the
shareholders  rights agreement would cause  substantial  dilution to a person or
group that  attempts to acquire us on terms not approved in advance by our Board
of Directors.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our  exposure  to market  risk is confined  to our cash,  cash  equivalents  and
available  for sale  securities.  We place our  investments  with  high  quality
issuers and, by policy,  limit the amount of credit  exposure to any one issuer.
We  currently  do not hedge  interest  rate or currency  exchange  exposure.  We
classify highly liquid investments  purchased with a maturity of three months or
less as "cash equivalents" and commercial paper and fixed income mutual funds as
"available  for sale  securities."  Fixed income  securities may have their fair
market  value  adversely  affected  due to a rise in  interest  rates and we may
suffer  losses in principal if forced to sell  securities  that have declined in
market value due to a change in interest rates.



                                       44


ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

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

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

Not Applicable.

ITEM 9A. CONTROLS AND PROCEDURES

Our Chief Executive Officer,  Chief Operating  Officer,  Chief Financial Officer
and  Chief  Accounting  Officer,  after  evaluating  the  effectiveness  of  our
"disclosure  controls  and  procedures"  (as  defined  in  Rules  13a-14(c)  and
15d-14(c)  of the  Securities  Exchange Act of 1934) as of the end of the fiscal
year  ended  December  31,  2003,  have  concluded  that as of the  time of such
evaluation,  our disclosure  controls and procedures  were effective in ensuring
that  information  required  to be  disclosed  by us in this  annual  report  is
accumulated  and  communicated  by our  management,  to allow  timely  decisions
regarding required disclosure.

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

                                    PART III

The  information  required by Items 10 through 14 of Part III is incorporated by
reference to our definitive  proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the end of our fiscal year.

We have adopted a Code of Ethics that  applies to our  officers,  including  our
principal executive,  financial and accounting  officers,  and our directors and
employees.  We have  posted  the  Code of  Ethics  on our  Internet  Website  at
"http://www.DiscoveryLabs.com"  (this is not a  hyperlink,  you must  visit this
website through an Internet browser) under the Legal section.  We intend to make
all  required  disclosures  on a  Current  Report  on Form  8-K  concerning  any
amendments to, or waivers from, our Code of Ethics with respect to our executive
officers and directors.  Our Website and the  information  contained  therein or
connected thereto are not incorporated into this Annual Report on Form 10-K.



                                       45


                                     PART IV

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

(a) Exhibits

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

(b) Reports on Form 8-K

We filed  three  Current  Reports  on Form 8-K  during  the three  months  ended
December 31, 2003. We filed a Current Report on October 22, 2003,  reporting the
initiation of a Technology Transfer and Manufacturing Agreement with Laureate as
part of the manufacturing  facility transfer from Akorn to Laureate.  We filed a
Current Report on November 25, 2003, reporting positive primary endpoint results
from the pivotal, multinational,  landmark phase 3 superiority clinical trial of
Surfaxin  for the  treatment  of  Respiratory  Distress  Syndrome  in  premature
infants. We filed a Current Report on December 19, 2003, reporting the filing of
a Form S-3 shelf  registration  statement  with the  Commission for the proposed
offering from time to time of up to 6,500,000 shares of our common stock.



                                       46


                                   SIGNATURES

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

                          DISCOVERY LABORATORIES, INC.

Date:  March 15, 2004                   By: /s/ Robert J. Capetola
                                            ----------------------------------
                                            Robert J. Capetola, Ph.D.
                                            President and
                                            Chief Executive Officer

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



         Signature                                   Name & Title                                     Date
         ---------                                   ------------                                     ----
                                                                                          
/s/ Robert J. Capetola                  Robert J. Capetola, Ph.D.                               March 15, 2004
- -----------------------------           President and Chief Executive Officer

/s/ John G. Cooper                      John G. Cooper                                          March 15, 2004
- -----------------------------           Senior Vice President and Chief Financial Officer

/s/ Cynthia Davis                       Cynthia Davis                                           March 15, 2004
- -----------------------------           Vice President, Administrative Operations and
                                        Controller
                                        (Principal Accounting Officer)

/s/ Herbert H. McDade, Jr.              Herbert H. McDade, Jr.                                  March 15, 2004
- -----------------------------           Chairman of the Board of Directors

/s/ Marvin E. Rosenthale                Marvin E. Rosenthale, Ph.D.                             March 15, 2004
                                        Director

/s/ Max E. Link                         Max E. Link, Ph.D.                                      March 15, 2004
- ----------------------------            Director


/s/ Antonio Esteve                      Antonio Esteve, Ph.D.                                   March 15, 2004
- ----------------------------            Director




                                       47


                                  EXHIBIT INDEX

EXHIBIT NO.     DESCRIPTION
- -----------     -----------

3.1(16)         Restated  Certificate  of  Incorporation  of  Discovery,   dated
                September 18, 2002.

3.2*            Amended and Restated  By-laws of  Discovery,  as of December 12,
                2003.

4.1(7)          Class E Warrant issued to PharmaBio.

4.2(8)          Unit  Purchase  Option  issued to Paramount  Capital,  Inc.,  in
                connection with the March 1999 private placement.

4.3(11)         Form of Class G Warrant issued to PharmaBio.

4.4(1)          Form of Class H Warrant issued to PharmaBio.

4.5(11)         Form of Promissory Note issued to PharmaBio.

4.6(16)         Promissory Note issued to General Electric Capital Corporation.

4.7(17)         Form of Class A Investor Warrant.

10.1(1)         Registration  Rights  Agreement,  dated as of October 28,  1996,
                between ATI, Johnson & Johnson  Development  Corporation and The
                Scripps Research Institute.

10.2(3)+        Sublicense Agreement, dated as of October 28, 1996, between ATI,
                Johnson & Johnson, Inc., and Ortho Pharmaceutical Corporation.

10.3(2)         Restated 1993 Stock Option Plan of Discovery.

10.4(2)         1995 Stock Option Plan of Discovery.

10.5(18)        Amended and  Restated  1998 Stock  Incentive  Plan of  Discovery
                (amended as of July 15, 2003).

10.6(5)         Indenture of Lease,  dated as of July 1, 1998, between SLT1, LLC
                and Discovery.

10.7(10)        Amendment,  dated as of September  15, 2000, to the Indenture of
                Lease dated as of July 1, 1998, between SLT1, LLC and Discovery.

10.8(5)         Registration Rights Agreement,  dated as of June 16, 1998, among
                Discovery, JJDC and Scripps.



                                       48


10.9(5)         Stock  Exchange  Agreement,  dated as of June 16, 1998,  between
                Discovery and JJDC.

10.10(10)       Employment  Agreement,  dated January 1, 2001, between Discovery
                and Robert J. Capetola, Ph.D.

10.11(14)       Employment  Agreement,  dated  as  of  June  16,  2001,  between
                Discovery and Christopher J. Schaber.

10.12(14)       Employment  Agreement,  dated  as  of  June  16,  2001,  between
                Discovery and Cynthia Davis.

10.13(5)        Form  of  Intellectual  Property  and  Confidential  Information
                Agreement.

10.14(5)        Form of Stock Purchase  Agreement Under the 1998 Stock Incentive
                Plan of Discovery.

10.15(6)        Form of Notice of Grant of Stock Option.

10.16(8)        Securities Purchase Agreement between Discovery and Laboratorios
                P.E.N., S.A., dated October 26, 1999.

10.17(8)+       Research  Funding  and  Option  Agreement,  dated as of March 1,
                2000, between Discovery and Scripps.

10.18(14)       Employment  Agreement,  dated as of  December  1, 2001,  between
                Discovery and Ralph Niven, Ph.D.

10.19(14)       Employment  Agreement,  dated as of December 11,  2001,  between
                Discovery and John G. Cooper.

10.20(14)       Employment  Agreement,  dated as of  August  15,  2000,  between
                Discovery and Deni M. Zodda, Ph.D.

10.21(12)+      Commercialization  Agreement,  dated as of  December  10,  2001,
                between Discovery and Quintiles.

10.22(12)+      Investment  and Commission  Agreement,  dated as of December 10,
                2001, between Discovery and PharmaBio.

10.23(12)       Common  Stock  and  Warrant  Purchase  Agreement,  dated  as  of
                December 10, 2001, between Discovery and PharmaBio.



                                       49


10.24(12)+      Loan Agreement, dated as of December 10, 2001, between Discovery
                and PharmaBio.

10.25(13)+      Sublicense  and  Collaboration  Agreement,  dated as of March 6,
                2002, between Discovery and Laboratorios del Dr. Esteve.

10.26(13)+      Supply Agreement,  dated as of March 6, 2002,  between Discovery
                and Esteve.

10.27(13)       Common  Stock  Purchase  Agreement,  dated as of March 6,  2002,
                between Discovery and Esteve.

10.28(15)       Form of  Common  Stock and  Warrant  Purchase  Agreement,  dated
                November 5, 2002, between Discovery and certain investors.

10.29(16)       Master  Security  Agreement,  dated  December 23, 2002,  between
                Discovery and General Electric Capital Corporation.

10.30(16)       Amendment,  dated  December  23,  2003,  to the Master  Security
                Agreement   between   Discovery  and  General  Electric  Capital
                Corporation.

10.31(19)+      Technology  Transfer  and  Manufacturing  Agreement  dated as of
                October 13, 2003, between Discovery and Laureate Pharma, L.P.

16.1(4)         Letter dated as of January 28,  1998,  from Ernst & Young LLP to
                the Securities and Exchange Commission.

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

21.1(1)         Subsidiaries of Discovery.

23.1*           Consent of Ernst & Young LLP.

31.1*           Certification  of  Chief  Executive  Officer  Pursuant  to  Rule
                13a-14(a) of the Exchange Act.

31.2*           Certification   of  Chief   Financial   Officer  and   Principal
                Accounting  Officer  Pursuant to Rule  13a-14(a) of the Exchange
                Act.

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

______________________________
* filed herewith



                                       50


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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



                                       51


(16)     Incorporated by Reference to Discovery's Annual Report on Form 10-K for
         the year ending December 31, 2002.

(17)     Incorporated  by Reference to  Discovery's  Current  Report on Form 8-K
         filed June 30, 2003.

(18)     Incorporated by reference to Discovery's Registration Statement on Form
         S-8 (File No. 333-109274).

(19)     Incorporated  by Reference to  Discovery's  Current  Report on Form 8-K
         filed October 22, 2003.

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



                                       52






DISCOVERY LABORATORIES, INC. AND SUBSIDIARY


CONTENTS
                                                                                                               PAGE
                                                                                                               ----
CONSOLIDATED FINANCIAL STATEMENTS
                                                                                                          
    Report of independent auditor                                                                               F-2

    Balance sheets as of December 31, 2003 and December 31, 2002                                                F-3

    Statements of operations for the years ended
         December 31, 2003, 2002, and 2001                                                                      F-4

    Statements of changes in stockholders' equity for the years ended
         December 31, 2003, 2002, and 2001                                                                      F-5

    Statements of cash flows for the years ended
         December 31, 2003, 2002, and 2001                                                                      F-6

    Notes to consolidated financial statements:

         Note 1 - The Company and Basis of Presentation                                                         F-7

         Note 2 - Summary of Significant Accounting Policies                                                    F-8

         Note 3 - Investments                                                                                  F-10

         Note 4 - Note Receivable                                                                              F-10

         Note 5 - Property and Equipment                                                                       F-10

         Note 6 - Income Taxes                                                                                 F-11

         Note 7 - License, Research Funding, and Commercialization Agreements                                  F-12

         Note 8 - Stockholders' Equity                                                                         F-13

         Note 9 - Stock Options                                                                                F-15

         Note 10 - 401(k) Match                                                                                F-16

         Note 11 - Commitments                                                                                 F-17

         Note 12 - Related Party Transactions                                                                  F-18

         Note 13 - Selected Quarterly Financial Data (unaudited)                                               F-19



                                                                             F-1


REPORT OF INDEPENDENT AUDITORS

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

We have audited the accompanying consolidated balance sheets of Discovery
Laboratories, Inc. as of December 31, 2003, and 2002, and the related
consolidated statements of operations, changes in stockholders' equity and cash
flows for each of the three years in the period ended December 31, 2003. 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 auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Discovery
Laboratories, Inc. at December 31, 2003, and 2002, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended December 31, 2003, in conformity with accounting principles generally
accepted in the United States.


                                                           /s/ Ernst & Young LLP




Philadelphia, Pennsylvania
February 13, 2004
CONSOLIDATED BALANCE SHEETS



                                                                                  DECEMBER 31,         DECEMBER 31,
                                                                                     2003                  2002
                                                                               ----------------      -----------------
ASSETS
Current assets:
                                                                                              
     Cash and cash equivalents                                                 $     29,422,000      $       8,500,000
     Available-for-sale marketable securities                                                --             10,652,000
     Note receivable - current                                                            3,000                  2,000
     Prepaid expenses and other current assets                                          665,000                325,000
                                                                               ----------------      -----------------

                       Total current assets                                          30,090,000             19,479,000


Property and equipment, net of accumulated depreciation                               2,414,000              1,231,000
Note receivable                                                                         192,000                195,000
Other assets                                                                             19,000                157,000
                                                                               ----------------      -----------------

                       Total Assets                                            $     32,715,000      $      21,062,000
                                                                               ================      =================


See notes to consolidated financial statements                               F-2







DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

LIABILITIES & STOCKHOLDERS' EQUITY

Current liabilities:
                                                                                              
     Accounts payable and accrued expenses                                     $      4,210,000      $       3,013,000
     Credit facility with corporate partner - current portion                         2,436,000                     --
     Capitalized lease - current portion                                                383,000                189,000
                                                                               ----------------      -----------------

                       Total current liabilities                                      7,029,000              3,202,000


Deferred revenue                                                                        672,000              1,393,000
Credit facility with corporate partner                                                       --              1,450,000
Capitalized lease, net of current portion                                               711,000                256,000
                                                                               ----------------      -----------------

                       Total Liabilities                                              8,412,000              6,301,000

Shareholders' equity:
     Common stock, $.001 par value; 60,000,000 authorized;
          42,491,438 and 32,818,283 issued and outstanding
          at December 31, 2003 and December 31, 2002, respectively                       43,000                 33,000
     Additional paid-in capital                                                     122,409,000             87,463,000
     Unearned portion of compensatory stock options                                     (2,000)               (95,000)
     Accumulated deficit                                                           (96,858,000)           (72,578,000)
      Treasury stock (at cost; 167,179 and 38,243 shares of common
           stock at December 31, 2003, and 2002)                                    (1,289,000)              (239,000)
     Accumulated other comprehensive income                                                 --                177,000
                                                                               ----------------      -----------------

                       Total shareholders' equity                                    24,303,000             14,761,000
                                                                               ----------------      -----------------

Total Liabilities & Equity                                                     $     32,715,000      $      21,062,000
                                                                               ================      =================



See notes to consolidated financial statements                               F-3





DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS


                                                                            YEAR ENDED DECEMBER 31,
                                                                 2003                 2002                  2001
                                                           -----------------    -----------------     -----------------
Revenues:
                                                                                          
     Contracts, Licensing, Milestones and Grants             $    1,037,000     $     1,782,000      $       1,112,000

Expenses:

     Research & Development                                      19,750,000          14,347,000              8,007,000
     General & Administrative                                     5,722,000           5,458,000              5,067,000
                                                           ----------------    ----------------      -----------------

                    Total Expenses                               25,472,000          19,805,000             13,074,000
                                                           ----------------    ----------------      -----------------

Operating Loss                                                 (24,435,000)         (18,023,000)           (11,962,000)

Other income and expenses:
     Interest income, dividends, realized
         gains, and other income                                    452,000             724,000                842,000
     Interest expense                                              (297,000)           (144,000)               (26,000)
                                                           ----------------    ----------------      -----------------

Net Loss                                                   $    (24,280,000)   $    (17,443,000)     $     (11,146,000)
                                                           ================    ================      =================


Net loss per common share - basic and diluted              $          (0.65)   $          (0.64)     $           (0.51)

Weighted average number of common
     shares outstanding - basic and diluted                      37,426,034          27,350,835             22,038,067




See notes to consolidated financial statements                               F-4





DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001




                                                                                                               UNEARNED
                                                                                        ADDITIONAL           PORTION OF
                                                                                         PAID-IN            COMPENSATORY
                                                                 COMMON STOCK            CAPITAL            STOCK OPTIONS
                                                          ------------------------------------------------------------------
                                                              SHARES       AMOUNT
                                                          ------------------------------------------------------------------
                                                                                                  
BALANCE - JANUARY 1, 2001                                     20,871,112    $21,000      $60,891,000          ($347,000)
                                                          ------------------------------------------------------------------
Comprehensive loss:
Net loss
Other comprehensive loss - unrealized loss on
    marketable securities available-for-sale
Total comprehensive loss

Exercise of stock options                                          6,224                       2,000
Common Stock issued in payment for services                       10,902                      42,000
Compensation charge on modification of  options                                              109,000
Compensatory stock options and warrants granted/earned                                       325,000             83,000
Common Stock issued in April 2001 private financing              296,560                     998,000
Common Stock and warrants issued in                            3,562,759      4,000        7,256,000
    October 2001 private financing
Common Stock and warrants issued in December 2001                             1,000        3,540,000
                                                                 791,905
Placement agent warrant exercise                                   6,831
Purchase of Treasury Stock
                                                          ------------------------------------------------------------------
BALANCE - DECEMBER 31, 2001                                   25,546,293     26,000       73,163,000           (264,000)
                                                          ------------------------------------------------------------------
Comprehensive loss:
Net loss
Other comprehensive loss - unrealized gain on
    marketable securities available-for-sale
Total comprehensive loss
Exercise of stock options                                         77,925                      60,000
Common Stock issued in lieu of payment for services                6,086                      26,000
Compensation charge on modification of options                                               171,000
Compensation charge on vesting of options and warrants                                        63,000            169,000
Common Stock issued in March 2002 private financing              821,862                   2,666,000
Private financing expenses                                                                    (5,000)
Common Stock issued in November 2002 private financing         6,397,517      7,000       11,937,000
Change in value of Class H warrants                                                         (618,000)
Exercise of warrants                                               6,843
                                                          ------------------------------------------------------------------
BALANCE - DECEMBER 31, 2002                                   32,856,526     33,000       87,463,000            (95,000)
                                                          ------------------------------------------------------------------
Comprehensive loss:
Net loss
Other comprehensive loss - unrealized loss on
    marketable securities available-for-sale
Total comprehensive loss
Exercise of stock options                                        993,001      1,000        1,940,000
Exercise of warrants                                           3,789,875      4,000        6,846,000
Compensatory stock options and warrants granted/earned                                        20,000            (17,000)
Compensation charge on modification of options                                                                   75,000
Compensation charge on vesting of options and warrants                                        79,000             25,000
Earned portion of compensatory stock options                                                                     10,000
Common Stock issued in June 2003 private financing             4,997,882      5,000       25,925,000
Common Stock issued in 401k Match                                 21,333                      86,000
Change in value of Class H warrants                                                           50,000
Purchase of Treasury Stock
                                                          ------------------------------------------------------------------
BALANCE - DECEMBER 31, 2003                                   42,658,617    $43,000     $122,409,000            ($2,000)
                                                          ==================================================================


                                                                                                     ACCUMULATED
                                                                                                         OTHER
                                                          ACCUMULATED                               COMPREHENSIVE
                                                            DEFICIT             TREASURY STOCK           LOSS              TOTAL
                                                      ---------------------------------------------------------------------------
                                                                            SHARES        AMOUNT
                                                      ---------------------------------------------------------------------------
                                                                                                       
BALANCE - JANUARY 1, 2001                                ($43,989,000)    -26,743       ($213,000)         $73,000    $16,436,000
                                                      ---------------------------------------------------------------------------
Comprehensive loss:
Net loss                                                  (11,146,000)                                                (11,146,000)
Other comprehensive loss - unrealized loss on                                                               (1,000)        (1,000)
    marketable securities available-for-sale
Total comprehensive loss
                                                                                                                      (11,147,000)
Exercise of stock options                                                                                                   2,000
Common Stock issued in payment for services                                                                                42,000
Compensation charge on modification of  options                                                                           109,000
Compensatory stock options and warrants granted/earned                                                                    408,000
Common Stock issued in April 2001 private financing                                                                       998,000
Common Stock and warrants issued in                                                                                     7,260,000
    October 2001 private financing
Common Stock and warrants issued in December 2001                                                                       3,541,000

Placement agent warrant exercise                                                                                                -
Purchase of Treasury Stock                                                (11,500)        (26,000)                        (26,000)
                                                      ---------------------------------------------------------------------------
BALANCE - DECEMBER 31, 2001                               (55,135,000)    (38,243)       (239,000)          72,000     17,623,000
                                                      ---------------------------------------------------------------------------
Comprehensive loss:
Net loss                                                  (17,443,000)                                                (17,443,000)
Other comprehensive loss - unrealized gain on                                                              105,000        105,000
    marketable securities available-for-sale
Total comprehensive loss                                                                                              (17,338,000)
Exercise of stock options                                                                                                  60,000
Common Stock issued in lieu of payment for services                                                                        26,000
Compensation charge on modification of options                                                                            171,000
Compensation charge on vesting of options and warrants                                                                    232,000
Common Stock issued in March 2002 private financing                                                                     2,666,000
Private financing expenses                                                                                                 (5,000)
Common Stock issued in November 2002 private financing                                                                 11,944,000
Change in value of Class H warrants                                                                                      (618,000)
Exercise of warrants                                                                                                            -
                                                      ---------------------------------------------------------------------------
BALANCE - DECEMBER 31, 2002                               (72,578,000)    (38,243)       (239,000)         177,000     14,761,000
                                                      ---------------------------------------------------------------------------
Comprehensive loss:
Net loss                                                  (24,280,000)                                                (24,280,000)
Other comprehensive loss - unrealized loss on                                                             (177,000)      (177,000)
    marketable securities available-for-sale
Total comprehensive loss                                                                                              (24,457,000)
Exercise of stock options                                                                                               1,941,000
Exercise of warrants                                                                                                    6,850,000
Compensatory stock options and warrants granted/earned                                                                      3,000
Compensation charge on modification of options                                                                             75,000
Compensation charge on vesting of options and warrants                                                                    104,000
Earned portion of compensatory stock options                                                                               10,000
Common Stock issued in June 2003 private financing                                                                     25,930,000
Common Stock issued in 401k Match                                                                                          86,000
Change in value of Class H warrants                                                                                        50,000
Purchase of Treasury Stock                                               (128,936)     (1,050,000)                     (1,050,000)
                                                      ---------------------------------------------------------------------------
BALANCE - DECEMBER 31, 2003                              ($96,858,000)   (167,179)    ($1,289,000)             $ -    $24,303,000
                                                      ===========================================================================



See notes to consolidated financial statements                               F-5





DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS





                                                                                               Year Ended
                                                                                               December 31,


                                                                                2003               2002              2001
                                                                        ------------------  -----------------   ---------------
Cash flow from operating activities:
                                                                                                        
Net loss                                                                  $   (24,280,000)    $  (17,443,000)    $ (11,146,000)
Adjustments to reconcile net loss to net cash used
 in operating activities:
      Depreciation and amortization                                               416,000            285,000           205,000
      Realized (gains) losses on marketable securities                           (114,000)          (174,000)           55,000
      Compensatory stock options                                                  192,000            403,000           517,000
      Stock issued in 401(k) match                                                 86,000                 --                --
      Expenses paid using treasury stock and Common Stock                              --             26,000            42,000
      Changes in:
                  Prepaid expenses, inventory and other current assets           (340,000)         1,255,000          (876,000)
                  Accounts payable and accrued expenses                         1,197,000          1,263,000          (632,000)
                  Other assets                                                    103,000            (40,000)          (18,000)
      Proceeds from research and development                                           --                                   --
           collaborative agreements                                                                1,833,000
      Amortization of deferred revenue                                           (721,000)        (1,055,000)         (791,000)
                                                                        ------------------  -----------------   ---------------
                  Net cash used in operating activities                       (23,461,000)       (13,647,000)      (12,644,000)
                                                                        ------------------  -----------------   ---------------
Cash flow from investing activities:
Purchase of property and equipment                                               (606,000)          (227,000)         (257,000)
Loan to related party                                                                  --                 --          (200,000)
Related party loan payments received                                                2,000              2,000             1,000
Purchase of marketable securities                                                (284,000)        (8,569,000)      (10,676,000)
Proceeds from sale or maturity of marketable securities                        10,873,000         11,134,000         9,269,000
                                                                        ------------------  -----------------   ---------------
                  Net cash provided by (used in) investing activities           9,985,000          2,340,000        (1,863,000)
                                                                        ------------------  -----------------   ---------------
Cash flow from financing activities:
Proceeds from issuance of securities, net of expenses                          34,721,000         14,665,000        11,033,000
Proceeds from credit facility with corporate partner                              986,000          1,450,000                --
Purchase of treasury stock                                                     (1,050,000)                --           (26,000)
Principal payments under capital lease obligation                                (259,000)           (66,000)          (23,000)
                                                                        ------------------  -----------------   ---------------
                  Net cash provided by financing activities                    34,398,000         16,049,000        10,984,000
                                                                        ------------------  -----------------   ---------------
Net increase (decrease) in cash and cash equivalents                           20,922,000          4,742,000        (3,523,000)

Cash and cash equivalents - beginning of year                                   8,500,000          3,758,000         7,281,000
                                                                        ------------------  -----------------   ---------------
Cash and cash equivalents - end of year                                   $    29,422,000     $    8,500,000     $   3,758,000
                                                                        ==================  =================   ===============
Supplementary disclosure of cash flows information:
Interest Paid                                                             $       167,000     $       88,000     $      26,000

Noncash transactions:
Class H warrants issued/revalued                                          $        50,000     $     (618,000)    $     768,000
Equipment acquired through capitalized lease                                      908,000            434,000            52,000
Unrealized gain (loss) on marketable securities                                  (177,000)           105,000            (1,000)



See notes to consolidated financial statements.                              F-6



DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

NOTE 1 - THE COMPANY AND BASIS OF PRESENTATION

Discovery Laboratories, Inc. is a biopharmaceutical company developing its
proprietary surfactant technology as Surfactant Replacement Therapies for
respiratory diseases including Respiratory Distress Syndromes in infants and
adults, Acute Lung Injury, asthma, Chronic Obstructive Pulmonary Disease and
upper airway disorders. Surfactants are compositions produced naturally in the
lungs and essential for breathing. Discovery's technology produces an engineered
version of natural human lung surfactant that is designed to provide the
essential properties of human lung surfactant. Discovery believes that through
its technology, pulmonary surfactants have the potential, for the first time, to
be developed into a series of respiratory therapies for critical care and other
hospitalized patients where there are few or no approved therapies available.

Discovery recently completed two Phase 3 clinical trials of Surfaxin(R), the
Company's lead product, for the treatment of Respiratory Distress Syndrome in
premature infants and is preparing to file new drug applications with the Food
and Drug Administration and other regulatory authorities in the rest of the
world. Discovery's Surfactant Replacement Therapy is also in a Phase 2 clinical
trial for Acute Respiratory Distress Syndrome in adults and a Phase 3 and Phase
2 clinical trial for Meconium Aspiration Syndrome in full-term infants.
Discovery recently completed a successful Phase 1b clinical trial and is
currently preparing to initiate a follow-on Phase 2 clinical trial evaluating
the safety, tolerability and efficacy of its humanized lung surfactant,
delivered as an inhaled aerosol (development name DSC-104), to treat patients
with asthma.

HISTORICAL FOUNDING TRANSACTIONS

The Company, formerly known as Ansan Pharmaceuticals, Inc. ("Ansan"), was
incorporated in Delaware on November 6, 1992. In November 1997, Ansan merged
with the predecessor company, Discovery Laboratories, Inc.
("Predecessor Discovery"), in a transaction accounted for as a reverse
acquisition with Predecessor Discovery as the acquirer for financial reporting
purposes. In October 1996, the Company invested in the stock of Acute
Therapeutics, Inc., a Delaware corporation ("ATI"). Such investment represented
75% of the voting securities of ATI. At the time of the investment, ATI held the
technology underlying the Company's proprietary humanized lung surfactant
technology and employed or engaged the management developing such technology.
Many of such management remain members of the Company's current management. In
June 1998, ATI merged with and into the Company at which time, the Company's
primary business objective was the development of the Company's proprietary
humanized lung surfactant technology. The Company currently maintains one
subsidiary, which is inactive.

MANAGEMENT'S PLANS AND FINANCINGS

The Company was considered to be a development-stage company through December
31, 2002. With the completion of two Phase 3 clinical trials in 2003, the
Company is no longer considered a development-stage enterprise. The Company has
incurred substantial losses since inception. To date, the Company has funded its
operations primarily through the issuance of equity and through strategic
alliances. The Company expects to continue to expend substantial amounts for
continued product research, development and commercialization activities for the
foreseeable future. Management's plans with respect to funding this development
are to secure additional equity, if possible, and to secure additional strategic
alliances that will provide available cash funding for operations and to focus
on increased commercialization efforts this year. Continuation of the Company is
dependent on its ability to obtain additional financing and, ultimately, on its
ability to achieve profitable operations. There is no assurance, however, that
such financing will be available or that the Company's efforts ultimately will
be successful.


                                                                             F-7



DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

    CASH AND CASH EQUIVALENTS

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

    AVAILABLE-FOR-SALE MARKETABLE SECURITIES

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

    PROPERTY AND EQUIPMENT

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

    USE OF ESTIMATES

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

    LONG-LIVED ASSETS

         Under Statement of Financial Accounting Standards (SFAS) No. 144, the
         Company is required to recognize an impairment loss only if the
         carrying amount of a long-lived asset is not recoverable from its
         undiscounted cash flows and measure any impairment loss as the
         difference between the carrying amount and the fair value of the asset.
         No impairment was recorded during the years ended December 31, 2003 and
         2002, as management of the Company believes the sum of its future
         undiscounted cash flows will exceed the carrying amount of the assets.

    RESEARCH AND DEVELOPMENT

         Research and development costs are charged to operations as incurred.

    REVENUE RECOGNITION - RESEARCH AND DEVELOPMENT COLLABORATIVE AGREEMENTS

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


                                                                             F-8



DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

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

    STOCK-BASED COMPENSATION

         The Financial Accounting Standards Board has issued Statement of
         Financial Accounting Standards ("SFAS") No. 148, "Accounting for
         Stock-Based Compensation - Transition and Disclosure". SFAS No. 148
         amends SFAS No. 123, "Accounting for Stock-Based Compensation" to
         provide alternative methods of transition to a voluntary change to the
         fair value based method of accounting for stock-based employee
         compensation. In addition, SFAS No. 148 amends the disclosure
         requirements of SFAS 123 to require prominent disclosure in both annual
         and interim financial statements about the method of accounting for
         stock-based employee compensation and the effect of the method used on
         the reported results. The Company continues to account for its stock
         option plans in accordance with Accounting Principles Board Opinion No.
         25, "Accounting for Stock Options Issued to Employees" and,
         accordingly, recognizes compensation expense for the difference between
         the fair value of the underlying Common Stock and the exercise price of
         the option at the date of grant. The effect of applying SFAS No. 148 on
         pro forma net loss is not necessarily representative of the effects on
         reported net income or loss for future years due to, among other
         things, (i) the vesting period of the stock options and (ii) the fair
         value of additional stock options in future years. Had compensation
         cost for the Company's stock option plans been determined based upon
         the fair value of the options at the grant date of awards under the
         plans consistent with the methodology prescribed under SFAS No. 148,
         the pro forma net loss for the years ended December 31, 2003, 2002, and
         2001 would have been as follows:



                                                   Years Ended December 31,
                                         2003               2002               2001
                                  ----------------   -----------------   -----------------
                                                                      
Net Loss as reported              $    (24,280,000)  $    (17,443,000)   $    (11,146,000)
Additional stock-based employee
compensation                      $     (3,738,000)  $     (2,264,000)   $     (2,090,000)
                                  ----------------   -----------------   -----------------

Pro forma net loss                $    (28,018,000)  $    (19,707,000)   $    (13,236,000)
                                  ================   =================   =================
Pro forma net loss per share      $          (0.75)  $          (0.72)   $          (0.60)



The weighted average fair value of the options granted were estimated on the
date of grant using the Black-Scholes option-pricing model with the following
weighted average assumptions:



                                                   Years Ended December 31,
                                         2003               2002               2001
                                  ----------------   -----------------   -----------------
                                                                      
Expected dividend yield                   0%                  0%                  0%
Expected stock price volatility          86%                 95%                118%
Risk-free interest rate                 2.4%                2.5%                  4%
Expected option term                 3.5 years           3.5 years           3.5 years



                                                                             F-9


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

    NET LOSS PER COMMON SHARE

         Net loss per common  share is computed  pursuant to the  provisions  of
         SFAS No.  128,  "Earnings  per  Share",  and is  based on the  weighted
         average number of common shares  outstanding  for the periods.  For the
         years ended December 31, 2003, 2002, and 2001, 8,753,000, 4,032,000 and
         5,211,000 common shares,  respectively,  are potentially  issuable upon
         the exercise of certain of the Company's stock options and warrants and
         are not included in the calculation of net loss per share as the effect
         would be anti-dilutive.

    RECLASSIFICATION

         Certain prior year balances have been  reclassified to conform with the
current presentation.

NOTE 3 - INVESTMENTS

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

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

Included in the net loss for the years ended  December 31, 2003,  2002, and 2001
were gross realized gains on available-for-sale securities of $114,000, $183,000
and $219,000 and gross realized losses of $0, $9,000 and $274,000, respectively.

NOTE 4 - NOTE RECEIVABLE

Note receivable  pertains to a $200,000,  7% per annum mortgagor's note due from
an executive of the Company.  This note is secured by a mortgage agreement dated
July 24, 2001.  The note calls for monthly  payments of  principal  and interest
over a 360-month period. The principal balance  outstanding at December 31, 2003
and 2002 was approximately $195,000 and $197,000, respectively.

NOTE 5 - PROPERTY AND EQUIPMENT

Property and  equipment  as of December  31, 2003 and 2002 was  comprised of the
following:

                                                       December 31,
                                                2003                 2002
                                           ---------------    ----------------
Leasehold Improvements                     $       174,000    $        144,000
Furniture                                          314,000             239,000
Equipment                                        2,217,000           1,600,000
Construction in Progress                           792,000                  --
                                           ---------------    ----------------
                                                 3,497,000           1,983,000

Accumulated Depreciation                        (1,083,000)           (752,000)
                                           ---------------    ----------------

                                                $2,414,000    $      1,231,000
                                           ===============    ================

                                                                            F-10


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

Depreciation  expense for the years ended December 31, 2003,  2002, and 2001 was
$331,000, $252,000, and $184,000, respectively.

The  equipment  balance at December 31, 2003 and 2002  includes  $1,468,000  and
$559,000,  respectively,  of property  subject to a capital  lease.  The related
accumulated depreciation was $194,000 and $57,000 at December 31, 2003 and 2002,
respectively.

The balance of Construction in Progress  primarily consists of new manufacturing
equipment  related to the  enhancement  of our  manufacturing  capabilities  for
Surfaxin.  As of  December  31,  2003  and  2002,  the  Company  had  additional
construction   commitments   outstanding  totaling  approximately  $554,000  and
$188,000, respectively.

NOTE 6 - INCOME TAXES

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

The  reconciliation  of the income tax benefit computed at the Federal statutory
rates to the  Company's  recorded  tax benefit for the years ended  December 31,
2003, 2002, and 2001 are as follows:



                                                                   December 31,
                                                 2003                 2002             2001
                                            --------------        ------------     ------------
                                                                         
Income tax benefit, statutory rates         $    8,255,000        $  5,938,000     $  3,783,000
State taxes on income,
  net of federal benefit                         2,015,000           1,088,000          698,000
Research and development tax credit                441,000             274,000           90,000
Other                                               92,000            (755,000)           3,000
                                            --------------        ------------     ------------
Income tax benefit                              10,803,000           6,545,000        4,574,000
Valuation allowance                            (10,803,000)         (6,545,000)      (4,574,000)
                                            --------------        ------------     ------------
Income tax benefit                          $           --        $         --     $         --
                                            ==============        ============     ============


The tax effects of temporary  differences  that give rise to deferred tax assets
and deferred tax liabilities, at December 31, 2003 and 2002, are as follows:


                                                                             December 31,
                                                                     2003               2002
                                                                  ------------     ------------
                                                                            
Long-term deferred tax assets:
     Net operating loss carryforwards
          (federal and state)                                     $ 36,500,000     $ 25,526,000

     Research and development tax credits
                                                                     1,868,000        1,225,000
     Other Accrued                                                      70,000               --
      Deferred Revenue                                                 273,000               --
     Capitalized research and development
                                                                       122,000          222,000
                                                                  ------------     ------------
Total long-term deferred tax assets                                 38,833,000       26,973,000
                                                                  ------------     ------------

Long-term deferred tax liabilities:
     Property and equipment                                          (272,000)         (108,000)
                                                                  ------------     ------------
Net deferred tax assets
                                                                    38,561,000       26,865,000
Less:  valuation allowance
                                                                  (38,561,000)      (26,865,000)
                                                                  ------------     ------------
                                                                  $         --     $         --
                                                                  ============     ============



                                                                            F-11


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

The Company was in a net  deferred  tax asset  position at December 31, 2003 and
2002 before the consideration of a valuation allowance. Due to the fact that the
Company  has never  realized a profit,  management  has fully  reserved  the net
deferred tax asset since realization is not assured.

At December 31, 2003 and 2002, the Company had available carryforward net
operating losses for Federal tax purposes of approximately $91,585,000 and
$65,112,000, respectively, and a research and development tax credit
carryforward of $1,868,000 and $1,225,000, respectively. The Federal net
operating loss and research and development tax credit carryforwards expire
beginning in 2009 and continuing through 2022. At December 31, 2003, the Company
had available carryforward net operating losses of $2,627,000 related to stock
based compensation. Additionally, at December 31, 2003 and 2002, the Company had
available carryforward losses of approximately $82,483,000 and $51,385,000,
respectively, for state tax purposes. The utilization of the Federal net
operating loss carryforwards is subject to annual limitations in accordance with
Section 382 of the Internal Revenue Code. Certain state carryforward net
operating losses are also subject to annual limitations.

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


NOTE 7 - LICENSE, RESEARCH FUNDING, AND COMMERCIALIZATION AGREEMENTS

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

The Company has accounted for the license fees  associated  with this new Esteve
collaboration  and  the  Esteve  collaboration  entered  into  in  October  1999
(including the premium paid for Common Stock), the reimbursement of research and
development  expenditures,  and the advance  payment for Surfaxin  received from
Esteve to be used in  clinical  trials  as  deferred  revenue.  The  balance  in
deferred revenue at December 31, 2003 relates entirely to the license  agreement
with Esteve for which the Company will  recognize  revenue using a straight line
method  through the  anticipated  date of FDA  approval  for the first  Surfaxin
neonatal indication.

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

                                                                            F-12



DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

PharmaBio also committed to provide the Company with a secured  revolving credit
facility (the "Credit Facility"),  primarily for use to pay pre-launch marketing
services to be provided by Quintiles,  subject to the Company satisfying certain
conditions,  for up to $8.5  million,  which may be  increased to $10 million in
specified  circumstances.  To the  extent the Credit  Facility  availability  is
increased to greater than $8.5 million, for each $1 million dollar increase, the
amount of shares of Common Stock issuable  pursuant to the Class H warrants will
be increased by approximately  38,000 shares.  Principal  amounts owed under the
Credit Facility may be paid out of the proceeds of milestone payments to be paid
by PharmaBio to the Company at certain intervals upon the achievement of certain
corporate  milestones by the Company. At December 31, 2003 and 2002,  $2,436,000
and $1,450,000, respectively, was outstanding under the Credit Facility.

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

The Company  and The Scripps  Research  Institute  ("Scripps")  are parties to a
research funding and option agreement which expires in February 2005, subject to
termination  by the Company at any time with 90 days prior  notice.  Pursuant to
this agreement,  the Company is obligated to fund a portion of Scripps' research
efforts and thereby has the option to acquire an exclusive  worldwide license to
the  technology  developed  from the  research  program  during  the term of the
agreement. Scripps owns all of the technology that it developed pursuant to work
performed  under the agreement.  To the extent the Company does not exercise its
option to technology developed under the agreement, the Company has the right to
receive 50% of the net royalty income  received by Scripps for  inventions  that
are  jointly  developed  under the  agreement.  Payments  to Scripps  under this
agreement  were  $649,000,  $572,000  and  $508,000  in 2003,  2002,  and  2001,
respectively.

NOTE 8 - STOCKHOLDERS' EQUITY

2003 SHELF REGISTRATION STATEMENT

On December 19, 2003, the Company filed a Form S-3 shelf registration  statement
with the Securities and Exchange  Commission  ("SEC") for the proposed  offering
from time to time of up to 6,500,000 shares of its Common Stock. The Company has
no immediate plans to sell its securities under the shelf registration, however,
since the  registration  statement has been  declared  effective by the SEC, the
Company  will be able to issue the  securities  from time to time in response to
market  conditions or other  circumstances  on terms and conditions that will be
determined at such time.

2003 PRIVATE PLACEMENT

In June  2003,  the  Company  completed  the  sale of  securities  in a  private
placement to selected institutional and accredited investors for net proceeds of
approximately  $259.9  million.  The Company issued  4,997,882  shares of Common
Stock and 999,577 Class A Investor  warrants to purchase  shares of Common Stock
at an exercise price of $6.875 per share.  The Class A Investor  warrants have a
seven-year term. As of December 31, 2003,  approximately  955,000 of the Class A
Investor warrants remain unexercised.

2002 PRIVATE PLACEMENT

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


                                                                            F-13


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

2001 PRIVATE PLACEMENTS

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

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

COMMON SHARES RESERVED FOR ISSUANCE

As of December  31, 2003 and 2002,  the  Company has  reserved  shares of Common
Stock for issuance as follows:

                                                          December 31,
                                                   2003                2002
                                               -----------          ----------

Stock option plans                               5,587,000           4,908,000
401(k) discretionary match                         129,000                  --
2003 Shelf Registration Statement                6,500,000                  --
Placement agent and underwriter warrants         1,017,000           1,610,000
Class C warrants (1999 private placement)               --              57,000
Class E warrants (2000 private placement)          549,000             581,000
Class F warrants (2001 private placement)               --             713,000
Class G warrants (2001 Quintiles Alliance)         357,000             357,000
Class H warrants (2001 Quintiles Credit Facility)  565,000             565,000
Class I warrants (2002 private placement)               --           2,879,000
Class A warrants (2003 private placement)          955,000                  --
Other warrants                                          --              75,000
                                               -----------          ----------

                                                16,659,000          11,745,000

TREASURY STOCK/COMMON STOCK ISSUED FOR SERVICES

The Company has a stock  repurchase  program wherein the Company may buy its own
shares on the open  market  and use such  shares to  settle  indebtedness.  Such
shares are accounted for as treasury stock.

During  2003,  the  Company   acquired   128,936  shares  of  Common  Stock  for
approximately  $1,050,000  from a related  party in payment for the  exercise of
certain stock options  available to the related party. Such shares are accounted
for as treasury stock.

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


                                                                            F-14


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

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

NOTE 9 - STOCK OPTIONS

In March 1998, the Company adopted its 1998 Stock Incentive Plan, which includes
three equity programs (the "1998 Plan").  Under the  Discretionary  Option Grant
Program,  options  to  acquire  shares of the  Common  Stock may be  granted  to
eligible  persons who are employees,  non-employee  directors,  consultants  and
other  independent  advisors.  Pursuant  to the  Stock  Issuance  Program,  such
eligible  persons may be issued shares of the Common Stock.  Under the Automatic
Option Grant Program, eligible non-employee directors will automatically receive
option  grants at  periodic  intervals  at an  exercise  price equal to the fair
market value per share on the date of the grant.  Options granted under the 1998
Plan expire no later than 10 years from the date of the grant.

The  1998  Plan  was  successively  amended  at each of the  Annual  Meeting  of
Stockholders  for the years 2003, 2002, and 2001, to increase the maximum number
of shares of Common Stock  reserved  for  issuance  over the term of the plan by
1,420,000  shares,  1,000,000 shares and 1,150,000 shares,  respectively.  After
giving  effect to these  amendments,  there are  currently  6,570,000  shares of
Common Stock  reserved for issuance over the term of the plan.  In addition,  in
2002 the  Board of  Directors  approved  amendments  to the 1998  Plan  that (i)
increased  the  exercise  price of  options  granted to  non-employee  directors
pursuant to the  Automatic  Option  Grant  Program  from 60% to 100% of the fair
market  value  per  share on the date of the  grant  and (ii)  removed  the Plan
Administrator's  authority  to  effect  the  cancellation  and  regrant  of  any
outstanding options under the Discretionary Option Grant Program.

A summary of the Company's stock option  activity and related  information is as
follows:



                                                                                                  Weighted Average
                                                                            Weighted Average          Remaining
                                   Price Per Share          Shares           Exercise Price       Contractual Life
                                 --------------------    --------------    -------------------   --------------------
                                                                                        
Balance at January 1, 2001         $0.0026 - $7.00           3,106,166           $3.42               8.37 years

Options granted                      2.10 - 5.25             1,255,000            2.55
Options exercised                   0.3205 - 0.87               (6,224)           0.47
Options forfeited                    2.10 - 5.19              (107,983)           4.13
                                                         --------------
Balance at December 31, 2001        0.0026 - 7.00            4,246,959            3.15               8.01 years

Options granted                      1.26 - 3.65             1,786,000            2.14
Options exercised                   0.0821 - 2.10              (77,925)           0.77
Options forfeited                   .3205 - 7.00              (349,850)           3.34
                                                         --------------
Balance at December 31, 2002       0.0026 - 5.375            5,605,184            2.85               7.81 years

Options granted                      1.70 - 9.17             1,111,750            6.75
Options exercised                   0.0026 - 4.22             (993,001)           1.95
Options forfeited                   0.1923 - 5.06             (168,611)           2.76
                                                         --------------
Balance at December 31, 2003        0.0026 - 9.17            5,555,322            3.80               7.44 years



                                                                            F-15


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

The  following  table  provides  further  detail  with  regard  to  the  options
outstanding and exercisable at December 31, 2003:


                                                       Weighted            Weighted Average
                                                     Average Price             Remaining
    Price per share             Shares                 per Share            Contractual Life
- -------------------------  ------------------  --------------------  --------------------------
                                                                  
  $0.0026 - $2.00               1,120,910               $1.56                7.60 years
    $2.01 - $4.00               2,029,614               $2.67                7.64 years
    $4.00 - $6.00               1,545,798               $4.62                5.82 years
    $6.01 - $8.00                 205,000               $7.28                9.65 years
   $8.01 - $10.00                 654,000               $8.09                9.70 years


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



                                                          December 31,
                                            2003              2002             2001
                                         ------------      -----------      -----------
                                                                     
       Weighted average exercise price      $2.09             $2.00            $2.11
           Weighted average fair value      $3.49             $3.33            $3.53


Included in the options  outstanding,  are options to purchase 117,200 shares of
Common Stock (at an exercise  price of $4.44)  granted  during 1998,  which vest
upon the Company  achieving  specified  milestones  and expire in June 2008.  In
December 2002, the related milestones were achieved.

In December  2002,  the Board of  Directors  approved the issuance of options to
management to purchase up to 800,000 shares of Common Stock at an exercise price
of $2.75 per  share.  Such  options  had been  subject  to the  approval  of the
Company's  shareholders,  which was obtained at the time of the Company's Annual
Meeting of Shareholders for 2003. Accordingly,  such options are now included in
the options  outstanding at December 31, 2002.  Such options shall vest in their
entirety  upon the fourth  anniversary  of the date of grant or at such  earlier
time, if ever, upon the receipt by the Company of a New Drug  Application  (NDA)
approval by the United  States Food and Drug  Administration  for  Surfaxin  for
either Respiratory  Distress Syndrome in premature infants,  Meconium Aspiration
Syndrome in full-term infants, or Acute Respiratory Distress Syndrome in adults.

In December  2003,  the Board of  Directors  approved the issuance of options to
management  to purchase up to  1,464,500  shares of Common  Stock at an exercise
price of $9.17 per share.  Such options are  expressly  subject to the requisite
approval  of the  Company's  shareholders,  to be  obtained  no  later  than the
Company's  Annual Meeting of Shareholders for 2004, for an amendment to the 1998
Plan  authorizing an increase in the number of shares issuable under the plan in
an  amount  equal to or  greater  than the  aggregate  amount  of such  options.
Accordingly,  such  options  are not  included  in the  options  outstanding  at
December  31,  2003.  Provided  the  shareholders  of the Company  approve  such
amendment, such options shall vest over a three year period from the date of the
grant.

NOTE 10 - 401(K) MATCH

The Company has a voluntary  401(k)  savings plan covering  eligible  employees.
Effective January 1, 2003, the Company allows for periodic discretionary matches
as a percentage  of each  participant's  contributions  in newly issued  Company
stock. The total match for the year ending December 31, 2003 was $119,000.


                                                                            F-16


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

NOTE 11 - COMMITMENTS

The  Company's  long-term   contractual   obligations  include  commitments  and
estimated purchase obligations entered into in the normal course of business.

Payments due under contractual obligations at December 31, 2003 are as follows:



                                                   2004        2005      2006        2007           Total
                                                ----------  ---------- ---------   ---------     ----------

                                                                                 
Credit facility with corporate partner (1)       2,436,000          --      --            --      2,436,000
Capital lease obligations (2)                      473,000     425,000   238,000     131,000      1,267,000
Operating lease obligations (3)                    530,000     291,000    28,000          --        849,000
Purchase obligations (4)                           554,000          --        --          --        554,000
Employment agreements (1)                        1,820,000   1,567,000        --          --      3,387,000
                                                ----------  ---------- ---------   ---------     ----------

                                  Total          5,813,000   2,283,000   266,000     131,000      8,493,000


(1)      See further discussion below.
(2)      Capital leases obligations primarily relate to a capital lease
         financing arrangement with General Electric Capital Corporation
         discussed below.
(3)      Operating lease obligations include property rental agreements
         discussed below.
(4)      Purchase obligations include commitments of equipment and services for
         the enhancement of our manufacturing capabilities for Surfaxin.

In addition to the contractual obligations above, the Company has future
milestone commitments, aggregating $2,750,000, and royalty obligations to Ortho
Pharmaceuticals, a wholly-owned subsidiary of Johnson & Johnson, Inc., related
to the Company's product licenses.

The Company has a secured revolving credit facility of up to $8.5 to $10 million
with PharmaBio to fund pre-marketing activities for a Surfaxin launch in the
United States. The credit facility is available for use until December 10, 2004,
and monies become available in three tranches upon satisfying certain
conditions. The Company has satisfied the conditions for availability of the
first two tranches and at December 31, 2003, the amount available under the
credit facility was approximately $5.7 million, of which $2.4 million was
outstanding. Interest on amounts advanced under the credit facility will be
payable quarterly in arrears. Outstanding principal and interest due under the
credit facility are due and payable on December 10, 2004. Although the Company
may be able to repay principal amounts owed under the credit facility from
proceeds of milestone payments to be paid by PharmaBio upon the achievement of
certain corporate milestones, there can be no assurance that the Company will
achieve any of these milestones prior to the repayment date, and doing so is not
likely unless the FDA expedites the review of the NDA for Surfaxin for the
treatment of Respiratory Distress Syndrome in premature infants that the Company
expects to file with the FDA in April 2004, and approves such NDA prior to
December 10, 2004. The Company is obligated to use a significant portion of the
funds borrowed under the credit facility for pre-launch marketing services to be
provided by Quintiles.

Th Company has a capital lease financing arrangement with the Life Science and
Technology Finance Division of General Electric Capital Corporation that
provides, subject to certain conditions, for up to $1 million in financing for
capital purchases. In 2003, the arrangement was increased to provide, subject to
certain conditions, up to an aggregate $4 million in financing for capital
purchases. As of December 31, 2003, approximately $962,000 was outstanding under
this financing arrangement.

At December 31, 2003, the Company had employment agreements with six officers
providing for an aggregate annual salary of $1,567,000. The agreements expire in
December 2005, however, commencing on January 1, 2006, and on each January 1st
thereafter, the term of these agreements shall automatically be extended for one
additional year, unless at least 90 days prior to such January 1st date, the
Company or the Executive shall have given notice that it does not wish to extend
the agreement. The Company also had employment agreements with two other
executives that provide for an aggregate annual salary of $340,000, which expire
in June and November 2004. All of the foregoing agreements provide for the
issuance of annual bonuses and the granting of options subject to approval by
the Board of Directors.


                                                                            F-17


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

At December 31, 2003, the Company leased office and laboratory space in
Doylestown, Pennsylvania under leases which expire in September 2004, March 2005
and September 2005. Additionally, the Company leased office and laboratory space
in Redwood City, California under a lease that expires February 2006 and office
space in Windsor, United Kingdom under a lease, which expired December 2003.
Payments made under these leases for the years ended December 31, 2003, 2002,
and 2001 were $590,000, $481,000 and $273,000 respectively.

Aggregate future minimum annual rents for these leases are as follows:

2004                                           $   530,000
2005                                               291,000
2006                                                28,000
                                               -----------
                                               $   849,000
                                               ===========

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

2004                                               473,000
2005                                               425,000
2006                                               238,000
2007                                               131,000
                                               -----------

                                                 1,267,000
Less amounts representing interest                (173,000)
                                               -----------
                                               $ 1,094,000
                                               ===========

NOTE 12 - RELATED PARTY TRANSACTIONS

In November  2001,  the Company  entered into an agreement  with  Clinical  Data
Management,  Inc.  (CDM),  replacing an earlier  similar  agreement,  to perform
duties  associated  with  processing  data for the  Company's  ongoing  clinical
trials.  Such  agreement  expired on November 14, 2002 pursuant to its terms and
the Company  has not entered  into any  further  arrangements  with CDM.  CDM is
wholly-owned  by the  spouse of the  Company's  President  and  Chief  Executive
Officer.  Payments  made to CDM and its owner for the years ended  December  31,
2002 and 2001 were approximately $289,000, $221,000 respectively.  There were no
such payments made in 2003.

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


                                                                            F-18


DISCOVERY LABORATORIES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements
December 31, 2003

NOTE 13 - SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

The following table contains unaudited  statement of operations  information for
each  quarter of 2003 and 2002.  The  operating  results for any quarter are not
necessarily indicative of results for any future period.



2003 QUARTERS ENDED:                                                (in thousands, except per share data)
- --------------------------------------------------------------------------------------------------------
                                                   Mar. 31    June 30   Sept. 30    Dec. 31    Total Year
                                                  --------    --------  --------   ---------   ----------

                                                                                
Revenues from collaborative agreements            $    393    $    263  $    198   $     183   $   1,037

Operating Expenses:
     Research and development                        3,844       4,011     5,096       6,799      19,750
     General and administrative                      1,167       1,137     1,375       2,043       5,722
                                                  --------    --------  --------   ---------   ---------
         Total expenses                              5,011       5,148     6,471       8,842      25,472
                                                  --------    --------  ---------  ---------   ---------
Operating loss                                      (4,618)     (4,885)   (6,273)     (8,659)    (24,435)

Other income and expense                               113          36        54         (48)        155
                                                  --------    --------  --------   ---------   ---------

Net loss                                          $ (4,505)   $ (4,849) $ (6,219)  $  (8,707)  $ (24,280)
                                                  ========    ========  ========   =========   =========

Net loss per common share -  basic and diluted   $   (0.14)   $  (0.14) $  (0.15)  $   (0.21)  $   (0.65)

Weighted average number of common
     shares outstanding                             32,857      33,487    41,084       42,391     37,426





2002 QUARTERS ENDED:                                                (in thousands, except per share data)
- ---------------------------------------------------------------------------------------------------------
                                                   Mar. 31    June 30   Sept. 30    Dec. 31    Total Year
                                                  --------    --------  --------   ---------   ----------

                                                                              
Revenues from collaborative agreements            $    237    $    783  $    368   $     394   $   1,782
                                                  --------    --------  --------   ---------   ---------

Operating Expenses:
     Research and development                        2,605       3,721     3,475       4,546      14,347
     General and administrative                      1,132       1,538     1,633       1,155       5,458
                                                  --------    --------  --------   ---------   ---------
         Total expenses                              3,737       5,259     5,108       5,701      19,805
                                                  --------    --------  --------   ---------   ---------
Operating loss                                      (3,500)     (4,476)   (4,740)     (5,307)    (18,023)

Other income and expense                               130         189       211          50         580
                                                  --------    --------  --------   ---------   ---------

Net loss                                          $ (3,370)   $ (4,287) $ (4,529)  $  (5,257)  $ (17,443)
                                                  ========    ========  ========   =========   =========

Net loss per common share -  basic and diluted     $ (0.13)   $  (0.16) $  (0.17)  $   (0.17)  $   (0.64)

Weighted average number of common
     shares outstanding                             25,834      26,394    26,441      30,717      27,351



                                                                            F-19