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The following is an excerpt from a 10KSB SEC Filing, filed by CELLEGY PHARMACEUTICALS INC on 3/31/1998.
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ADAMIS PHARMACEUTICALS CORP - 10KSB - 19980331 - BUSINESS

ITEM 1: BUSINESS

Overview

Cellegy Pharmaceuticals, Inc. ("Cellegy" or the "Company") is a biopharmaceutical company engaged in the development of prescription drugs and cosmeceuticals to address a variety of diseases and conditions utilizing its patented transdermal and topical delivery technologies. The Company was incorporated in California in 1989. Cellegy is developing several prescription drugs, including Anogesic(R), a nitroglycerin-based product for the treatment of anal fissures and hemorrhoids, and a transdermal testosterone gel for the treatment of hypogonadism, a condition that frequently results in lethargy and reduced libido in men above the age of 40. Cellegy's Glylorin(TM) is a novel treatment for certain forms of ichthyosis, a debilitating skin disease, as well as for other severe dry skin conditions. Glylorin has been licensed by Cellegy to Glaxo Wellcome Inc. ("Glaxo"), which is currently conducting clinical trials in the United States. In addition to its prescription drugs, Cellegy is testing and developing a line of non-prescription cosmeceutical products which the Company believes will reverse the signs of skin aging and address the skin care needs of an affluent and aging population.

The Company's principal technologies consist of PERMEATE and CELLEDIRM. PERMEATE is a patented topical drug delivery system which has been found in preclinical evaluations to permit delivery of larger or insoluble drugs into the blood stream or into the skin itself. These drugs include peptides that the Company believes are not deliverable using alternative methods employed in currently approved transdermal systems. CELLEDIRM is a group of compounds identified by Cellegy's scientists which have been found in preclinical evaluations to reduce or eliminate irritation caused by many substances that come into contact with the skin. The Company's CELLEDIRM technology is being developed as an adjunct to the PERMEATE technology to mitigate skin irritation problems associated with transdermal drug delivery and to improve existing topically applied drugs and cosmeceutical products.

The Company has not yet completed the development nor has it commercialized any of its products. In addition, the Company's business involves many risks and uncertainties that could affect the Company's future financial positions or results of operations. For further information regarding some of those factors, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Factors That May Affect Future Operating Results".

This Annual Report includes forward-looking statements. Words such as "believes," "anticipates," "expects," "intends" and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. These forward-looking statements concern matters that involve risks and uncertainties, including, but not limited to, those set forth below, that could cause actual results to differ materially from those in the forward-looking statements. The matters set forth below should be carefully considered when evaluating the Company's business and prospects.

Background

Skin Biology

Cellegy's technologies and products have been developed based on an expert knowledge of the biology and physical function of the skin, particularly the epidermis. The epidermis is comprised mainly of cells known as keratinocytes that are continually regenerated and move toward the skin surface where they flatten, lose their nucleus, and become the outermost layer of the epidermis, the stratum corneum. The stratum corneum acts as a protective barrier against physical injuries and disease, and regulates the loss of moisture from the body. It consists of an array of flattened cells suspended in highly organized lipid structures, similar conceptually to a brick and mortar arrangement. Most importantly, these lipids regulate the permeability properties of the skin and, therefore, the movement of topically applied drugs into the body.

In addition to its physical role as barrier, the epidermis is biologically active, capable of initiating a full inflammatory reaction (characterized by redness and swelling). Normally, this process is a protective reaction in response to various noxious stimuli such as sunlight, irritants or mechanical injury (i.e. abrasions and burns). The same reaction, however, can result following the topical application of many drugs.

Similarly, certain dermatologic diseases can also be linked to environmental influences. Psoriasis, for example, which is characterized by inflammation and accelerated growth of the epidermis, can sometimes be triggered by a simple cut or abrasion to the skin. Nonetheless, despite material differences in appearance and symptoms, this disease and the other inflammatory reactions described above all share fundamental similarities in the underlying biological processes mediated by the epidermis.

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Core Technology

Cellegy's focus on the biological functioning of the skin has permitted development of two novel technologies: (i) PERMEATE, which appears to be capable of enhancing the delivery of drugs applied to the skin for systemic delivery or for the treatment of local skin conditions, and (ii) CELLEDIRM, which appears to be capable of mitigating the irritation and inflammation caused when drugs, solvents and other substances come into contact with the skin.

PERMEATE Drug Delivery Technology

PERMEATE is a patented technology which employs bioactive permeation enhancers to permit the passage of larger molecule drugs into or through the skin. This technology consists of a variety of methods to manipulate the three primary lipids which characterize the properties of the stratum corneum:
cholesterol, ceramides and free fatty acids. Normal barrier function requires a specific critical ratio of these three lipids. The Company has shown that its newly identified enhancers can alter these lipid ratios to increase the permeability of the skin by inhibiting specific enzymes responsible for the synthesis of these lipids, or by inducing defects in the rigid lipid structures of the stratum corneum.

Cellegy's PERMEATE system has the potential of being able to open the stratum corneum barrier wider than previously believed possible, and to keep it open longer than conventional solvent approaches. This has been found in preclinical studies to facilitate the permeation of larger or more insoluble drugs into the skin or into the bloodstream. Further, Cellegy's PERMEATE technology potentially enables transdermal delivery of such drugs without using energy dependent systems, such as iontophoresis, electroporation, ultrasound or laser. Cellegy's studies to date have also shown that these enhancers can exert their effect when formulated as topical creams or gels or in conventional transdermal patches.

The Company's research findings include the evaluation of selected PERMEATE systems in conjunction with the following drugs: testosterone, vasopressin, luteinizing hormone releasing hormone ("LHRH"), lidocaine, cimetidine, hydrocortisone and caffeine. Experimental findings with these drugs indicated that in animal models PERMEATE was capable of delivering up to ten times more drug than attainable using conventional solvent approaches. Further, two of these compounds (LHRH and vasopressin), delivered using the Company's PERMEATE technology, are peptides which, to the Company's knowledge, have never before been delivered transdermally using conventional solvent technologies. The molecular weights of LHRH and vasopressin (approximately 1000 and 1200, respectively) are significantly greater than the molecular weights of drugs delivered using currently approved transdermal patches (no more than approximately 400 molecular weight).

CELLEDIRM Technology

CELLEDIRM (Cellegy's Dermal Inflammatory Response Modulators) is a group of compounds identified by Cellegy's scientists that have been found to be capable of reducing the inflammation associated with the topical application of drugs, solvents or other physiologically active substances. These compounds consist of specially processed or purified excipients that have been shown in preclinical studies to significantly reduce skin inflammation following challenge with a number of irritating or allergenic substances.

The Company has conducted a number of research studies investigating the utility of CELLEDIRM in mitigating the symptoms of skin inflammation. These compounds have been shown to reduce inflammation by up to 40% in animal models challenged with either a potent irritant or an allergen. These effects are comparable to those achieved with topical corticosteroids.

The Company expects its proprietary CELLEDIRM technology to complement its PERMEATE drug delivery system and to provide a unique platform for the development of novel topical products which could benefit from the anti-inflammatory or anti-allergic activities of CELLEDIRM. Since the active ingredients within CELLEDIRM are either GRAS (generally regarded as safe) or used as excipients in various pharmaceutical or cosmetic products, the Company believes the use of these compounds will not lengthen the United States Food and Drug Administration ("FDA") review time of therapeutic drug products in which they are used. Accordingly, the Company plans to utilize these compounds in the near-term development of its testosterone and other prescription products.

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Product Opportunities

Drug Delivery

Transdermal delivery involves the topical administration of drugs to the skin for the treatment of systemic diseases or localized skin conditions, generally using patches. Transdermal delivery systems may offer significant advantages over many conventional oral dosage forms and most parenteral (injectable) dosage forms. Those advantages include increased convenience, less pain (compared to injections), improved patient compliance, and potentially reduced side effects. Transdermal delivery systems can also offer certain advantages to pharmaceutical companies, including brand extension, product differentiation and additional patent protection.

Transdermal delivery has historically been limited to those drugs which are small in size, highly potent and can easily penetrate the skin due to their physical and chemical characteristics. Specifically, the Company believes that drugs with molecular weights larger than 400, or those drugs requiring daily doses greater than five milligrams or that are too lipid soluble, will be difficult to deliver transdermally. Although many companies have experimented with different transdermal drug delivery methods, they have enjoyed only limited success. Of all the prescription drugs in the United States, less than ten drugs are currently approved by the FDA for transdermal administration. Although reasonably successful compared with other non-oral routes of drug administration (for example, nasal, implants or liposomal-based systems), transdermal delivery has proved more difficult than initially anticipated.

The principal reason for the limited number of transdermal products relates to irritation caused by solvents designed to ease the passage of drugs through the skin. These solvents dissolve the lipid-rich stratum corneum membranes, while many also damage the keratinocytes, permitting the passage of the therapeutic agent into the lower levels of the skin, where it can be absorbed into the bloodstream. However, the interaction of the solvents with the metabolically active stratum corneum and the resulting inflammatory responses have been greater than anticipated. Several currently marketed transdermal patches utilize these solvents with, in many cases, high incidence of adverse skin reactions.

Recent efforts to expand the number and type of drugs delivered transdermally include the use of iontophoresis (mild electrical charges) or ultrasound waves in order to help drive the drug through the skin. While these approaches may prove successful for a few drugs, the Company believes that the resulting inflammatory skin reactions and higher product costs are likely to limit the use of these techniques.

With the advent of biotechnology, the discovery and development of larger molecular size drugs (including proteins, peptides and oligonucleotides) has increased significantly. As many of these potentially breakthrough new drugs are amenable only to injectable administration, the Company believes that transdermal methods to deliver these products represent an increasingly large commercial opportunity. Cellegy's approach to this challenge has been to develop novel technologies which (i) do not rely on solvent permeation enhancers, (ii) increase the size of molecules deliverable through the skin and (iii) mitigate skin irritation.

Prescription Products

Cellegy further seeks to capitalize on its knowledge of skin biology to develop treatments for serious and most common skin diseases. The Company plans to use its PERMEATE and CELLEDIRM technologies to develop products which it believes will provide significant advantages over existing therapeutics.

Consumer and Cosmeceutical Products

Cellegy researchers are developing consumer and cosmeceutical products that fortify the protective function of the skin barrier and may improve the skin's ability to protect against environmental and occupational skin damage, thus preventing and/or reversing the signs of aging. Studies conducted to date by Cellegy and its collaborators suggest that these products may help alleviate inflamed skin conditions, as well as help reverse signs of photoaging, including pigmentation and wrinkling.

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Products Under Development

Prescription Topical Products

Glylorin

Glylorin is a product developed by Dr. Carl Thornfeldt, Cellegy's founder and Chairman. The product is being developed for skin conditions which range from mild to severe, including congenital primary ichthyosis ("CPI"), ichthyoses vulgaris ("IV") and seborrheic dermatitis. After successfully completing Phase II clinical trials and commencing Phase III clinical trials in January 1996, Cellegy licensed Glylorin to Glaxo in November 1996. Glaxo is one of the world's largest pharmaceutical companies and a leader in the field of dermatology.

Congenital Primary Ichthyosis

Ichthyosis is a family of related incurable skin diseases characterized by a severe scaling of the skin that frequently affects large areas of the body. In all forms of ichthyosis, skin cells form a rigid, thick surface layer of scales that often discolor and crack. CPI is a group of the most severe and debilitating forms of ichthyosis, affecting all age and ethnic groups. Many of the most severely afflicted infants die shortly after birth from dehydration, hypothermia and microbes, which enter through the damaged epidermis. Victims of the disease are currently treated with greases, emollients and Lac-Hydrin (not approved for treatment of CPI), which provide only limited benefits, or with oral and topical retinoids, which have a risk of significant toxicity. Approximately 100,000 people in the United States and at least an equal number of persons outside the United States are afflicted with CPI. This treatment has been granted Orphan Drug status by the FDA.

In March 1998, the Company announced the results of a double-blind, placebo controlled Phase III clinical trial to evaluate the effectiveness of Glylorin in non-bullous congenital ichthyosiform erythroderma ("n-CIE"), a form of CPI. The study group included approximately 82 patients and was conducted at 23 clinical sites in the United States. Utilizing the statistical method that was established in the original protocol for the trial, improvement in scaling, the primary outcome variable, did not show statistical significance compared with the vehicle (or placebo) compound. However, in the trial, which was conducted by Cellegy's licensee, Glaxo, the investigators' global assessment scores showed that 43% of the patients improved overall by more than 50% over time compared with only 19% of those receiving the vehicle. Moreover, when all the observations of each patient over the 12 week study were analyzed using a different statistical method, a significant improvement compared with vehicle was observed for some outcome variables, including scaling at all timepoints. Glaxo has not determined if it will repeat this Phase III study.

Ichthyosis Vulgaris

Glaxo is currently conducting clinical trials for the treatment of IV, a milder form of ichthyosis, which affects approximately one million people in the United States. The disease is characterized by severe dry skin and scaling (although not as thick as the scaling present in CPI). Lac-Hydrin, the only currently approved prescription product for the treatment of IV, has certain side effects, including irritation and stinging on thinner skin areas such as the face. In addition, the product is not indicated for pediatric use. Glaxo is currently conducting a Phase II clinical trial for IV. The results of this trial are expected by mid-year 1998.

Seborrheic Dermatitis

Another disease condition targeted by Glaxo for Glylorin is seborrheic dermatitis, a condition characterized by skin redness, flaking and itching, It is most commonly found on the scalp and afflicts approximately seven million people in the United States, primarily among the very young and the elderly. Pending the results of the IV program, Glaxo intends to initiate additional trials to study Glylorin in the treatment of this very common, but difficult to control, condition.

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Anogesic

One of the Company's leading product candidates is Anogesic, a topical prescription product for the treatment of anal fissures and hemorrhoids. Anogesic is a unique, nitroglycerin-based product which, based on published studies for over 400 patients, appears to effectively heal anal fissures and is capable of dramatically reducing the pain of hemorrhoids. In a clinical study published in The Lancet it was shown that nitroglycerin promotes healing in over two thirds of patients who would have required rectal surgery. The Company has met with the FDA to finalize the Phase III clinical trial protocol and plans to begin a Phase III trial for anal fissures by mid-year 1998 and a Phase III trial for hemorrhoids by year-end 1998 or early in 1999.

Anal fissures are painful tears in the tissue of the anal mucosa and are common conditions affecting men and women of all age groups. Of the approximately 200,000 new cases of anal fissures each year, more than half require painful and expensive surgical intervention to treat these conditions, which sometimes leave patients incontinent. A thrombosed external hemorrhoid is a dilated, swollen vein at the margin of the anus, resulting from clotting blood formed within the dilated external hemorrhoidal veins. In the United States alone, approximately nine million patients seek treatment from physicians for hemorrhoids each year, and the Company believes that a significant number of additional people suffering from this condition do not seek medical treatment.

Current drug therapies include anesthetics and anti-inflammatory agents that only partially relieve the symptoms of the conditions. Even though current treatments are only partially effective, sales of products currently used to treat anal fissures and hemorrhoids are estimated to be more than $500 million in the United States, Europe and Japan. Surgical procedures represent substantial additional expenditures related to these conditions.

Anogesic is a proprietary formulation that includes nitroglycerin, a drug that has been used for many years in the treatment of certain heart diseases. Once administered, nitroglycerin results in relaxation of the sphincter muscles, which rapidly relieves pain and promotes the healing of the anal fissure or hemorrhoid. Anogesic also incorporates the Company's proprietary CELLEDIRM technology to assist in mitigating the inflammation present in these conditions. Anogesic is protected by two broad U.S. patents both of which were issued last year, the most recent in December 1997. In addition, numerous patent applications have been filed in overseas markets.

The Company expects that the Phase III trials, if successful, will generate the data required for applying for regulatory approval in the United States and Europe. The Phase III clinical trials for anal fissures will include about 350 patients in several study centers. Patients will receive one of three strengths of Anogesic or placebo. The product will be administered on a daily basis until the patient's fissure is cured, up to a maximum administration period of eight weeks. The patient will then be observed for an additional period to determine whether any relapse occurs.

Testosterone Gel (male hormone replacement therapy)

The Company is currently developing a transdermal testosterone gel to address a condition increasingly referred to as "male andropause", which results from an age-related decline in the body's production of the sex hormone testosterone. Low levels of testosterone can result in such clinical symptoms as lethargy, depression and a decline in libido. In severely deficient cases, loss of muscle and bone mass can occur. Approximately 5 million men in the United States, primarily in the aging (over 40) male population group, have lower than normal levels of testosterone, a condition known as hypogonadism.

There are a number of companies currently marketing testosterone in several different product forms in domestic and certain international markets. Cellegy believes that a major market opportunity exists for an improved product, as the side effects and patient inconveniences associated with the currently marketed products have limited their use to less than 5% of potential patients. Current product forms include orals, injectables and transdermal patches.

Cellegy's patchless testosterone gel will incorporate the Company's CELLEDIRM technology. The gel product is expected to permit a once-a-day application of a metered dose to a small area of the skin without the irritation associated with current patch products. The gel is anticipated to be transparent, rapid drying and non-staining. Based on preclinical studies to date, the Company believes its proprietary transdermal gel formulation is capable of delivering therapeutic levels of testosterone with reduced side effects and in a more convenient dosage

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form compared with other currently marketed products. Preclinical and human pharmacokinetic studies demonstrated transdermal testosterone delivery into the bloodstream at levels comparable to a leading patch product.

The Company plans to commence an additional pharmacokinetic study during 1998, using various testosterone gel formulations. If the study is successful, Phase III human trials for the treatment of hypogonadism are planned to begin late in 1998. The Company believes that due to well documented toxicology and efficacy data regarding the use of testosterone, regulatory approval of its transdermal testosterone gel may be achieved more quickly than would normally be associated with a new chemical entity.

Testosterone Gel (female hormone replacement therapy)

In women, the ovaries and adrenal glands continue to synthesize testosterone after menopause, although the rate of production may diminish by as much as 50%. Normal blood concentrations of testosterone in women range from 10 to 20 times less than that of men. Nevertheless, in both sexes, testosterone plays a key role in building muscle or bone tissue, and the maintenance of sexual drive.

Cellegy's testosterone gel product (for the treatment of hypogonadism) is being designed so that the dose can be readily reduced and customized to restore normal testosterone levels in women. The Company believes that this change may be accomplished by reducing the amount of gel delivered via a metered dose without a significant change in the product formulation. Thus, the Company believes that the same formulation can be developed and tested for use in both hypogonadism and menopause. Clinical studies for this indication are planned to commence once the initial studies in hypogonadal males are completed.

Estrogen-Testosterone Gel (female hormone replacement therapy)

Cellegy's third planned product in the area of hormone replacement therapy is a combination estrogen-testosterone gel utilizing the Company's proprietary PERMEATE and CELLEDIRM technologies, designed to simultaneously restore the natural levels of both hormones in elderly or menopausal women. The Company believes that this product will offer significant advantages over the patches in terms of reduced side effects and patient convenience. The combination formulation is in the research stage with clinical trials planned following development of the mono-therapy testosterone products.

Immunosuppressive Drug (psoriasis)

Psoriasis is a relatively common disease affecting approximately four million people in the United States. This intractable condition is characterized by inflammation and accelerated growth of the epidermis resulting in dull red, scaly plaques distributed over various skin locations. The disease can be activated by infection and barrier damage. A large percentage of patients on extant therapies are not satisfactorily relieved of psoriatic symptoms and are constantly seeking more effective therapy.

Cellegy is in preclinical development of a product for the treatment of psoriasis that is expected to employ an FDA-approved immunosuppressive drug in a topical formulation designed specifically for local delivery into psoriatic lesions. This product will utilize the Company's proprietary PERMEATE technology to keep the barrier of psoriatic lesions open for delivery of the therapeutic agent. If successfully developed, healing will be accomplished with minimal systemic effect and without the toxicities generally associated with immunosuppressive drugs.

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Cosmeceutical Products

Cosmeceuticals (a hybrid of the words cosmetics and pharmaceuticals) are products that contain active ingredients which, when applied to the skin, will enhance appearance. Cosmeceuticals that satisfy the legal definition of a cosmetic under the Food Drug & Cosmetic Act, and that are not also drugs under that statute, are not subject to the same FDA regulations as drug products. Such cosmeceuticals may be marketed to consumers without prior approval by the FDA and without requiring a prescription from a physician. Cellegy also intends to use its formulation expertise to improve existing non-prescription topical medications.

Anti-Wrinkling Products*

The Company's most advanced cosmeceutical is an anti-wrinkling product which, based on human studies to date, appears to mitigate the visible effects of photoaging and skin wrinkling. Cellegy's anti-wrinkling product will be included in a line of products that the Company believes has a different mechanism of action which is expected to produce greater improvement to the skin's appearance and cause less irritation than current market leading products.

Signs of aging and photoaging usually become visible when people reach their early thirties, with fine wrinkling, loss of suppleness and elasticity of the skin becoming apparent. In subsequent decades, there is further deterioration marked by coarse wrinkles, irregular increased pigmentation, and thinning of the skin. Many of the skin changes associated with aging are due to ultraviolet light exposure, referred to as "photoaging." At the retail level, the non-prescription market for products which are used to mitigate the effects of aging and photodamage upon the skin is estimated to be in excess of $1 billion in annual sales in the United States and growing at approximately 14% per year. The current high performance cosmeceutical anti-wrinkling market in the United States consists of a few broad categories of products, utilizing the following actives: retinoids, alpha and beta hydroxy acids and anti-oxidants.

Many of the currently marketed cosmeceutical products contain low concentrations of one or more of the above mentioned active ingredients and, to the Company's knowledge, their efficacy has not generally been supported by clinical studies. Low concentrations of the active ingredients are frequently employed in order to avoid side effects which can include stinging, redness and skin irritation, which generally increase with the concentration of active ingredient used. However, the low concentrations of the active ingredient generally limit the efficacy of the products.

Cellegy's high performance anti-wrinkling products incorporate CELLEDIRM, together with an active ingredient having multi-action capability exhibiting many of the attributes of the cosmeceutical products with the active ingredients listed above. Certain human studies already completed and others in progress will provide comparative data versus certain leading cosmeceutical products. If development continues successfully, the Company believes the product line could be available for launch late this year or early in 1999. Cellegy will focus its marketing efforts on the professional market segment (dermatologists, cosmetic and plastic surgeons), capitalizing on the Company's research and human studies and its expertise in skin biology.


* References in this Report to "anti-wrinkling," "anti-wrinkling products" or the "anti-wrinkling market" are intended to refer to a product category that the Company believes is generally understood in the marketplace or to products in that category, and are not intended to describe any claims that the Company's cosmeceutical products act in any way other than as cosmetics as defined under applicable laws. The term "cosmeceuticals" refers to products that, if they satisfy the definition of a cosmetic under applicable federal laws and if they are not also drugs under those laws, are not subject to the same requirements as drug products. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Factors That May Affect Future Operating Results -- Possible FDA Regulation of Cosmeceutical Products as Drugs" and "Government Regulation."

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Consumer Products for the Skin

The Company has completed development of certain other consumer skin care and non-prescription therapeutic products, including moisturizers and body creams, and is continuing to develop formulations in other related skin care consumer product categories. These products utilize certain of the Company's proprietary formulations. These formulations were tested for their moisturizing properties in humans compared with a leading commercial product. Results showed that the Cellegy formulations had more than a 50% higher moisturization effect 12 hours after application than the leading product tested. The Company may incorporate these products in its cosmeceutical line for dispensing physicians or sell the products to consumer products companies who will market them under their own brand names through traditional, non-physician channels.

The Company's research and development expenses were $3,786,000 in 1997 and $2,712,000 in 1996. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations."

Marketing and Commercialization Strategy

Cellegy intends to become a leader in the field of transdermal drug delivery and in the development and marketing of specialty pharmaceutical and cosmeceutical products that are applied to the skin. Key elements of its business and commercialization strategy include the following:

Lower Risk Strategy for Selecting Product Candidates for Development. The Company does not intend to focus its product development efforts on development of new chemical entities. Instead, the Company will focus on applying its proprietary technologies in the following three areas:

(1) development of improved topical and transdermal formulations or new uses of FDA-approved pharmaceutical compounds for which marketing exclusivity or patent rights have expired or are near expiration;

(2) development of topical or transdermal formulations of new chemical entities in partnership with pharmaceutical or biotechnology companies; and

(3) development of new cosmeceutical products that address the skin care needs of an increasing number of affluent middle-aged and older people.

Leveraging of Corporate Alliances. Cellegy plans to enter into strategic alliances with established pharmaceutical companies for the development of certain products. These alliances generally will provide research or clinical funding and other support during the product development process. Cellegy's partners generally will provide established and trained marketing and sales forces.

Internal Focus on the Dermatology Market. Cellegy plans to retain exclusive or co-marketing/co-promotion rights in the United States to dermatological and related uses of the products it develops, while out-licensing rights for other uses. It may retain commercial rights to dermatological and other specialty pharmaceutical uses of products developed under partner sponsored research collaborations. The Company ultimately plans to market the dermatologic and cosmeceutical products it develops, either through the utilization of contract sales representatives or through the establishment of its own sales force.

Acquisition of Complementary Products. Although Cellegy is focusing primarily on the development of its own products and technologies, the Company may opportunistically acquire products, technologies or companies with products and distribution capabilities consistent with its commercial objectives.

Patents and Trade Secrets

The Company's success depends, in part, on its ability to obtain patent protection for its products and methods, both in the United States and in other countries. The patent position of companies engaged in businesses such as the Company's business generally is uncertain and involves complex legal and factual questions. There is a substantial backlog of patent applications at the USPTO. Patents in the United States are issued to the party that is first to invent the claimed invention. Since patent applications in the United States are maintained in secrecy until

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patents issue, the Company cannot be certain that it was the first inventor of the invention covered by its pending patent applications or patents or that it was the first to file patent applications for such inventions. Further, issued patents can later be held invalid by the patent office issuing the patent or by a court. There can be no assurance that any patent applications relating to the Company's products or methods will issue as patents, or, if issued, that the patents will not be challenged, invalidated, or circumvented or that the rights granted thereunder will provide a competitive advantage to the Company. In addition, many other entities are engaged in research and product development efforts in drug delivery, skin biology and cosmeceutical fields that may overlap with the Company's currently anticipated and future products. A substantial number of patents have been issued to such companies, and such companies may have filed applications for, or may have been issued patents or may obtain additional patents and proprietary rights relating to, products or processes competitive with those of the Company. Such entities may currently have, or may obtain in the future, legally blocking proprietary rights, including patent rights, in one or more products or methods under development or consideration by the Company. These rights may prevent the Company from commercializing technology, or may require the Company to obtain a license from the entity to practice the technology. There can be no assurance that the Company will be able to obtain any such licenses that may be required on commercially reasonable terms, if at all, or that the patents underlying any such licenses will be valid or enforceable. Moreover, the laws of certain foreign countries do not protect intellectual property rights relating to United States patents as extensively as those rights are protected in the United States. The issuance of a patent in one country does not assure the issuance of a patent with similar claims in another country, and claim interpretation and infringement laws vary among countries, so the extent of any patent protection is uncertain and may vary in different countries. As with other companies in the pharmaceutical industry, the Company is subject to the risk that persons located in such countries will engage in development, marketing or sales activities of products that would infringe the Company's patent rights if such activities were in the United States.

Several of the Company's products are based on existing compounds with a history of use in humans but which are being developed by the Company for new therapeutic use in skin diseases unrelated to the systemic diseases for which the compounds were previously approved. The Company cannot obtain composition patent claims on the compound itself, and will instead need to rely on patent claims, if any, directed to use of the compound to treat certain conditions or to specific formulations. The Company will not be able to prevent a competitor from using that formulation or compound for a different purpose. No assurance can be given that any additional patents will be issued to the Company, that the protection of any patents that may be issued in the future will be significant, or that current or future patents will be held valid if subsequently challenged.

The agreements with the University of California pursuant to which the Company has exclusive license rights to certain barrier repair and drug delivery and other technology contain certain development and performance milestones which the Company must satisfy in order to retain such rights. While the Company currently believes it will be able to satisfy the revised milestone dates, a loss of rights to these technologies could have a material adverse effect on the Company.

The Company has thirteen issued and three allowed United States patents, many issued foreign patents and pending patent applications for the use of certain compounds to treat common or severe inflammatory dermatologic diseases including dermatitis, psoriasis, rosacea and acne, as well as disorders such as various ichthyoses, signs and symptoms of skin aging and premalignant actinic keratoses. Three issued United States patents and more than twenty patent applications relate to the Company's Glylorin product for the treatment of ichthyosis and certain other skin diseases and conditions. Two allowed United States patent and more than ten patent applications relate to the drug delivery technology licensed from the University of California, and one issued United States patent and at least ten patent applications relate to the barrier repair technology licensed from the University of California. Additional patent applications are being prepared for filing that will cover methods or products currently under development. Corresponding patent applications for most of the Company's issued United States patents have been filed in countries of importance to the Company located in major world markets, including certain countries in Europe, Australia, South Korea, Japan, Mexico and Canada.

Federal patent law provides that for any inventions that have been developed with government funding that are the subject of a license, the government has the right to require the assignor or the licensee to grant a license to third parties upon the occurrence of certain events, such as if the government determines that no effective steps have been taken to achieve practical application of the invention, or if health or safety needs or requirements for public use are not reasonably satisfied.

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The Company's policy is to protect its technology by, among other things, filing patent applications for technology that it considers important to the development of its business. The Company intends to file additional patent applications, when appropriate, relating to its technology, improvements to its technology and to specific products that it develops. It is impossible to anticipate the breadth or degree of protection that any such patents will afford, or whether the Company can meaningfully protect its rights to its unpatented trade secrets. The Company also relies upon unpatented trade secrets and know-how, and no assurance can be given that others will not independently develop substantially equivalent proprietary information and techniques, or otherwise gain access to the Company's trade secrets or disclose such technology, or that the Company can meaningfully protect its rights to its unpatented trade secrets. It is the Company's policy to require its employees to execute an invention assignment and confidentiality agreement upon employment. Cellegy's consultants are required to execute a confidentiality agreement upon the commencement of their consultancy to the Company. Each agreement provides that all confidential information developed or made known to the employee or consultant during the course of employment or consultancy will be kept confidential and not disclosed to third parties except in specific circumstances. The invention assignment generally provides that all inventions conceived by the employee shall be the exclusive property of the Company. In addition, it is the Company's policy to require the collaborators and potential collaborators to enter into confidentiality agreements. There can be no assurance, however, that these agreements will provide meaningful protection for the Company's trade secrets.

Product Acquisitions

In December 1997, the Company acquired patent and related intellectual property rights relating to Anogesic (the "Agreement"), a topical product candidate for the treatment of anal fissures and hemorrhoids from Neptune Pharmaceutical Corporation. Under the terms of the Agreement, the Company issued 429,752 shares of Common Stock to Neptune on December 31, 1997. Upon the signing of a letter of intent on November 3, 1997, 33,057 shares of Common Stock had been issued to Neptune. The Agreement calls for a series of additional payments, payable in shares of Common Stock, upon successful completion of various milestones which, if achieved, would occur over the next several years. The Agreement does not provide for the payment by the Company of any future product royalties in connection with sales of Anogesic.

Principal License Agreements

Glaxo. In November 1996, the Company entered into an agreement with Glaxo for licensing rights to Glylorin, Cellegy's lipid compound for the treatment of ichthyosis. Under the terms of the agreement, Cellegy provided Glaxo with an exclusive license of patent rights and know-how covering Glylorin in most of the world's major markets. In exchange for this license, Cellegy received from Glaxo an initial license fee payment and could potentially receive future milestone payments (upon achievement of the specified milestones), as well as a royalty on net sales assuming successful completion of product development and market launch. The agreement provides that Glaxo will assume responsibility for and the associated costs of all future development and commercialization, including certain development costs incurred prior to the date of the agreement. Through December 31, 1997, the Company had recognized total revenues of approximately $1.1 million relating to licensing fees and development funding under the agreement. There can be no assurances, however, that the Company will receive any additional payments from Glaxo.

University of California. In October 1993, the Company entered into a license agreement with the University of California (the "Licensor") providing for an exclusive, worldwide, royalty bearing license, subject to customary government rights, for patent rights relating to barrier repair formulations jointly held by the Licensor and the Company, in consideration of the issuance to the Licensor of certain shares of preferred stock (which subsequently converted into shares of Common Stock) and the payment by the Company of a licensing fee. In March 1994, the Company entered into a second exclusive, worldwide, royalty bearing license agreement with the Licensor for patent rights, jointly held by the Licensor and Cellegy, relating to drug delivery technologies, in consideration of the payment by the Company of a licensing fee, and an annual maintenance fee payable each year until the Company is commercially selling a licensed product. Both agreements require the Company to pay the Licensor royalties based on net sales of consumer and prescription products (with minimum annual royalty payment). The Company has the right to grant sublicenses to third parties under both agreements. In May and October 1997, the Licensor and the Company amended these agreements. The amendments, among other things, modified and extended certain development and commercialization milestones contained in the original agreements. The revised milestones are tied to the achievement of certain clinical, regulatory or product commercialization goals over the

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next several years. Although there can be no assurance that such goals will be achieved, the Company believes its development programs in place will result in the satisfaction of such milestones.

Neutrogena. In April 1992, the Company entered into the License Option Agreement (the "License Option Agreement"), the Azelaic Acid OTC License Agreement (the "Azelaic Acid Agreement") and the Metabolic Moisturizer OTC License Agreement (the "Metabolic Moisturizer Agreement"), with Neutrogena Corporation ("Neutrogena"). The Azelaic Acid Agreement was terminated and replaced by the Patent License Agreement effective June 1, 1994 (the "Patent License Agreement"). Pursuant to the Patent License Agreement, Neutrogena paid the Company $1.0 million for an exclusive, royalty-free license for certain azelaic acid uses for both prescription and consumer products in most major markets of the world. In July 1997, Neutrogena and the Company terminated the Metabolic Moisturizer Agreement and the License Option Agreement (except as it related to azelaic acid), and the metabolic moisturizer technology that had been licensed to Neutrogena was returned to the Company. The Company agreed to continue prosecution of patents related to azelaic acid on behalf of Neutrogena and will be reimbursed by Neutrogena for legal costs, up to a certain limit.

Government Regulation

FDA Requirements for Human Drugs. The research, testing, manufacturing, labeling, distribution, and marketing of drug products are extensively regulated by numerous governmental authorities in the United States and other countries. In the United States, drugs are subject to rigorous FDA regulation. The Food, Drug and Cosmetic Act (the "FD&C Act") and the regulations promulgated thereunder, and other federal and state regulations govern, among other things, the research, development, testing, manufacture, distribution, storage, record keeping, labeling, advertising, promotion and marketing of pharmaceutical products. The process of developing and obtaining approval for a new pharmaceutical product within this regulatory framework requires a number of years and the expenditure of substantial resources. There can be no assurance that necessary approvals will be obtained on a timely basis, if at all. Moreover, additional government regulations may be established that could prevent or delay regulatory approval of the Company's products. Delays in obtaining regulatory approvals could have a material adverse effect on the Company. If the Company fails to comply with applicable regulatory requirements for marketing drugs, or if the Company's cosmeceutical products are deemed to be drugs by the FDA, the Company could be subject to administrative or judicially imposed sanctions such as warning letters, fines, products recalls or seizures, injunctions against production, distribution, sales, or marketing, delays in obtaining marketing authorizations or the refusal of the government to grant such approvals, suspensions and withdrawals of previously granted approvals, civil penalties and criminal prosecution of the Company, its officers or its employees.

The steps ordinarily required before a new pharmaceutical product may be marketed in the United States include: (i) preclinical laboratory tests, animal studies and formulation studies; (ii) the submission to the FDA of an Investigational New Drug Application ("IND") , which must become effective before clinical testing may commence; (iii) adequate and well-controlled clinical trials to establish the safety and efficacy of the product for its proposed indication; (iv) the submission of a New Drug Application ("NDA") to the FDA; and (v) FDA review and approval of the NDA prior to any commercial sale or shipment of the drug. Preclinical tests include laboratory evaluation of product chemistry and formulation, as well as animal studies to assess the potential safety and functionality of the product. Compounds must be produced according to the FDA's current Good Manufacturing Practice ("cGMP") requirements, and preclinical tests must be conducted in compliance with the FDA's Good Laboratory Practice regulations. The results of preclinical testing are submitted to the FDA as part of an IND. A 30-day waiting period after the filing of each IND is required prior to the commencement of clinical testing in humans. If the FDA has not commented upon or questioned the IND within this 30-day period, clinical studies may begin. If the FDA has comments or questions, the questions must be answered to the satisfaction of the FDA before initial clinical testing can begin. In addition, the FDA may, at any time, impose a clinical hold on ongoing clinical trials. If the FDA imposes a clinical hold, clinical trials may not commence or recommence without FDA authorization and then only under terms authorized by the FDA. In some instances, the IND application process can result in substantial delay and expense.

Clinical trials involve the administration of the investigational product to healthy volunteers or patients under the supervision of a qualified investigator. Clinical trials must be conducted in accordance with good clinical practice ("GCP") requirements under protocols detailing the objectives of the study, the parameters to be used in monitoring safety and the effectiveness criteria to be evaluated. Each protocol must be submitted to the FDA as part of the IND. Further, each clinical study must be conducted under the auspices of an independent Institutional

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Review Board ("IRB") at the institution at which the study will be conducted. The IRB will consider, among other things, ethical issues, the safety of human subjects and the possible liability of the institution. Clinical trials to support NDAs are typically conducted in three sequential phases, which may overlap. In Phase I, the initial introduction of the drug into healthy human subjects or patients, the drug generally is tested to assess metabolism, pharmacokinetics, pharmacological action and safety, including side effects associated with increasing doses, and if possible, to gain early evidence on effectiveness. Phase II usually involves studies in a limited patient population to (i) determine the efficacy of the drug for a specific indication, (ii) determine dosage tolerance and optimal dosage and (iii) identify possible short-term adverse effects and safety risks. If a compound is found to be effective and to have an acceptable safety profile in Phase II evaluations, Phase III trials are undertaken to further evaluate clinical efficacy, usually (although not necessarily) in comparison with a placebo or approved treatment and to further test for safety within an expanded patient population at geographically dispersed clinical study sites. A clinical trial may combine the elements of more than one phase, and typically two or more Phase III studies are required. The designation of a clinical trial as being in a particular phase is not necessarily indicative that such a trial will be sufficient to satisfy the requirements of a particular phase. For example, no assurance can be given that a Phase III clinical trial will be sufficient to support an NDA without further clinical trials. There can be no assurance that Phase I, Phase II or Phase III testing will be completed within any specific time period, if at all, with respect to any of the Company's products subject to such testing.

New and Abbreviated New Drug Applications. After completion of the required clinical testing, generally an NDA is submitted. FDA approval of the NDA (or, in the alternative, an Abbreviated New Drug Application ("ANDA"), as described below) is required before marketing may begin in the United States. The NDA must include the results of extensive clinical and other testing and the compilation of data relating to the product's chemistry, pharmacology and manufacture, the cost of all of which is substantial. The FDA reviews all NDAs submitted before it accepts them for filing and may request additional information rather than filing an NDA. In such an event, the NDA must be resubmitted with the additional information and, again, is subject to review before filing. Once the submission is accepted for filing, the FDA begins an in-depth review of the NDA. Under the FD&C Act, the FDA has 180 days in which to review the NDA and respond to the applicant, although in practice the process generally takes longer. The review process is often extended significantly by FDA requests for additional information or clarification. The FDA may refer the application to the appropriate advisory committee, typically a panel of clinicians, for review, evaluation and a recommendation as to whether the application should be approved. The FDA is not bound by the recommendation of an advisory committee. During the review process, the FDA generally will conduct an inspection of the relevant drug manufacturing facilities and clinical sites to ensure that the facilities are in compliance with applicable cGMP and GCP requirements. If FDA evaluations of the NDA application, manufacturing facilities, and clinical sites are favorable, the FDA may issue either an approval letter or an approvable letter, which contains a number of conditions that must be met in order to secure approval of the NDA. When and if those conditions have been met to the FDA's satisfaction, the FDA will issue an approval letter, authorizing commercial marketing of the drug for certain specific indications. If the FDA's evaluation of the NDA submission or manufacturing facilities is not favorable, the FDA may refuse to approve the NDA or issue a not approvable letter, outlining the deficiencies in the submission and often requiring additional testing or information. Notwithstanding the submission of any requested additional data or information in response to an approvable or not approvable letter, the FDA ultimately may decide that the application does not satisfy the regulatory criteria for approval. Even if FDA approval is obtained, a marketed drug product and its manufacturer are subject to continual review and inspection, and later discovery of previously unknown problems with the product or manufacturer may result in restrictions or sanctions on such product or manufacturer, including withdrawal of the product from the market, and other enforcement actions. The FDA may also require postmarketing testing and surveillance programs to continuously monitor the drug's usage and effects. Side effects resulting from the use of drug products may prevent or limit the further marketing of products.

Certain of the Company's mid and late term products utilize its drug delivery technology formulated with an active ingredient that is included in a drug product that is already the subject of an NDA approved by the FDA. In connection with obtaining FDA approval of such Company products which require an NDA, it is possible in certain instances that clinical and preclinical testing requirements may not be as extensive. Limited additional data about the safety or effectiveness of the proposed new drug formulation, along with chemistry and manufacturing information and public information about the active ingredient, may be satisfactory for product approval. Consequently, the new product formulation may receive marketing approval more rapidly than a traditional full NDA, although there can be no assurance that a product will be granted such treatment by the FDA.

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Once patent and other statutory protections covering a drug approved under an NDA have expired or have been demonstrated not to apply, a generic equivalent to that drug may be approved under an ANDA. An ANDA is ordinarily based upon bioequivalence data that demonstrate that the rate and extent of absorption of the active drug ingredient of the generic drug, usually measured in the blood stream, is equivalent to that of the drug approved under an NDA. The demonstration of bioequivalence and, therefore, ANDA approval, generally requires less time than safety and efficacy studies and NDA approval.

Until an NDA or ANDA is actually approved, there can be no assurance that the information requested and submitted will be considered adequate by the FDA to justify approval. It is impossible to anticipate the amount of time that will be required to obtain approval from the FDA to market any product.

Orphan Drug Designation. Under the Orphan Drug Act, the FDA may grant orphan drug designation to drugs intended to treat a "rare disease or condition," which generally is a disease or condition that affects populations of fewer than 200,000 individuals in the United States. Orphan drug designation must be requested before submitting an NDA. After the FDA grants orphan drug designation, the generic identity of the therapeutic agent and its potential orphan use are publicized by the FDA. Under current law, orphan drug designation confers upon the first company to receive FDA approval to market such designated drug United States marketing exclusivity for the designated drug and indication for a period of seven years following approval of the NDA, subject to certain limitations.

Orphan drug designation does not convey any advantage in, or shorten the duration of, the regulatory approval process. Although obtaining FDA approval to market a product with an orphan drug designation can be advantageous, there can be no assurance that the scope of protection or the seven years of market exclusivity that is currently afforded by orphan drug designation and marketing approval will remain in effect in the future.

Possible Regulation of Cosmeceutical Products as Drugs. "Cosmeceuticals" are not defined in the FD&C Act. The FDA has not defined the term by regulation and may consider use of the term to imply drug- like qualities. The FDA will regulate a particular cosmeceutical product as a drug or a cosmetic (or both a drug and a cosmetic) depending primarily upon the manufacturer's intended use for such product. Such intent may be determined from labeling, advertising, promotional and marketing materials, and any other source attributable to the manufacturer or its employees, representatives or agents. Under the FD&C Act, drugs are articles intended for use in the diagnosis, cure, mitigation, treatment or prevention of disease or to affect the structure or function of the body. By comparison, cosmetic products are defined as articles intended to be rubbed, poured, sprinkled or sprayed on, introduced into or otherwise applied to the body for cleansing, beautifying, promoting attractiveness or altering its appearance. Some products, however, may satisfy the definition of a drug and a cosmetic, and the FDA has generally regulated as drugs products that are intended to have a physiological effect on the body, for example, to alter the skin in more than a temporary way. Unlike drugs, products that constitute cosmetics (but not drugs as well) under the FD&C Act do not require premarket review or approval of the FDA, but cosmetics must be safe under normal conditions of use, and comply with FDA labeling and manufacturing requirements. Furthermore, the Federal Trade Commission ("FTC"), as well as state and local authorities, oversees the advertising of cosmetic products and prohibits false, misleading, deceptive or unsubstantiated advertising. The FTC has the authority to seek a number of remedies against a company that it believes fails to comply with its requirements, including, but not limited to, preliminary injunctive relief.

The Company plans to label, market, promote, advertise and distribute its cosmeceutical products with claims intended to be within the statutory definition of cosmetic. There can be no assurance, however, that the FDA will not determine that some or all of the Company's cosmeceutical products are drugs, and are therefore subject to more stringent regulatory oversight, including premarket approval, based on their intended use or ingredients.

The FDA has at times in the past contended, and may in the future contend, that one or more cosmeceutical products, including the Company's or competitors' anti-wrinkling products that are currently marketed or may in the future be marketed, are not cosmetics but instead are subject to regulation as drugs. Even if the FDA were not ultimately to prevail with regard to such a contention, such a claim by the FDA could have a material adverse effect on the Company's ability to market its proposed cosmeceutical products and could significantly delay or prohibit marketing of such products. The extent to which different kinds of current or future cosmeceutical products of the Company or its competitors are subject to FDA regulation as drugs, and the extent to which the FDA will seek to become more active in regulating cosmeceutical products, such as products that compete in the

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anti-wrinkling market, is uncertain, but will depend in part on the claims made for the cosmeceuticals by their manufacturers and marketers. See "Business -- Government Regulation." The inability of the Company to market its proposed cosmeceutical products as cosmetics without prior FDA approval could have a material adverse effect on the Company's business and financial condition.

OTC Monograph. Most over the counter ("OTC") drug products marketed in the United States are not subjected to the FD&C Act's premarket approval requirements. In 1972, the FDA instituted the ongoing OTC Drug Review to evaluate the safety and effectiveness of OTC drugs then on the market. Through this process, the FDA issues monographs that set forth the specific active ingredients, dosages, indications and labeling statements for OTC drugs that the FDA will consider generally recognized as safe and effective and therefore not subject to premarket approval. For certain categories of OTC drugs not yet subject to a final monograph, the FDA usually will not take regulatory action against such a product unless failure to do so poses a potential health hazard to consumers. OTC drugs not covered by pending or final OTC monographs, however, are subject to premarket review and approval by the FDA through the NDA/ANDA mechanism. Even if the Company seeks FDA approval of a product for OTC consumer sales, the FDA could instead require that the product be distributed by prescription only. Such a requirement could delay for several years, or indefinitely, distribution of the Company's products directly to consumers.

Manufacturing. Each domestic drug manufacturing facility must be registered with the FDA. Domestic drug and, to a lesser extent, cosmetic manufacturing establishments are subject to routine inspection by the FDA and other regulatory authorities and must comply with cGMP requirements (albeit less extensive ones for cosmetics than for drugs). Drug manufacturing facilities located in California must be licensed by the State of California in compliance with local regulatory requirements. The Company intends to use contract manufacturers that operate in conformance with these requirements to produce its compounds and finished products in commercial quantities. There can be no assurance that manufacturing or quality control problems will not arise at the manufacturing plants of the Company's contract manufacturers or that such manufacturers will be able to maintain the compliance with the FDA's cGMP requirements necessary to continue manufacturing the Company's products.

Foreign Regulation of Drugs. Whether or not FDA approval has been obtained, approval of a product by comparable regulatory authorities may be necessary in foreign countries before the commencement of marketing of the product in such countries. The approval procedure varies among countries, can involve additional testing, and the time required may differ from that required for FDA approval. Although there are some procedures for unified filings for certain European countries, in general each country has its own procedures and requirements, many of which are time consuming and expensive. Thus, there can be substantial delays in obtaining required approvals from both the FDA and foreign regulatory authorities after the relevant applications are filed. The Company expects to rely principally on corporate partners, licensees and contract research organizations, along with Company expertise, to obtain foreign governmental approval in foreign countries of drug formulations utilizing its compounds.

Other Government Regulation. In addition to regulations enforced by the FDA, the Company also is subject to regulation under the Occupational Safety and Health Act, the Environmental Protection Act, the Toxic Substances Control Act, the Resource Conservation and Recovery Act and other similar federal and state laws regarding, among other things, occupational safety, the use and handling of radioisotopes, environmental protection and hazardous substance control. In connection with its research and development activities and any manufacturing of clinical trial materials in which the Company may engage, the Company is subject to federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge, handling and disposal of certain materials and wastes. Although the Company believes that it has complied with these laws and regulations in all material respects and has not been required to take any action to correct any noncompliance, there can be no assurance that the Company will not be required to incur significant costs to comply with environmental and health and safety regulations in the future. The Company's research and development involves the controlled use of hazardous materials, chemicals, and various radioactive compounds. Although the Company believes that its safety procedures for handling and disposing of such materials comply with the standards prescribed by state and federal regulations, the risk of accidental contamination or injury from these materials cannot be completely eliminated. In the event of such an accident, the Company could be held liable for any damages that result and any such liability could exceed the resources of the Company. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Factors That May Affect Future Operating Results - Environmental Regulation."

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Health Care Reform. In the United States, there have been, and the Company expects there will continue to be, a number of federal and state proposals to implement cost controls and other health care regulatory measures. Future legislation could result in a substantial restructuring of the health care delivery system. Nevertheless, the Company believes that employer-driven reform with managed care and capitation will continue even without government intervention and may significantly affect health care delivery and costs. While the Company cannot predict whether any legislative or regulatory proposals will be adopted or the effect such proposals may have on its business, the uncertainty of such proposals could have an adverse effect on the Company's ability to raise capital and to identify and reach agreements with potential partners, and the adoption of such proposals could have an adverse effect on the Company. For example, such changes could have the effect of reducing the number of independent practicing dermatologists, which might reduce the number of prescriptions written for products such as some of the Company's potential products. In addition, the Company believes that many high-volume purchasers and consumers of health care are demanding changes in the pricing and delivery of products and services. The effect of any such changes on the Company's business are unpredictable. One of the Company's potential products, such as its drug delivery products, might have the effect of reducing the overall cost of delivering therapeutic compounds compared to existing delivery techniques, and sales of such products might benefit from regulatory changes focusing on controlling health care costs. Nevertheless, any such reform, if adopted, and ongoing changes in the industry, could adversely affect the pricing of therapeutic products in the United States or the amount of reimbursement available from governmental agencies or third-party insurers, and consequently could have a material adverse effect upon the Company. In both domestic and foreign markets, sales of the Company's therapeutic products, if any, will depend in part on the availability of reimbursement from third-party payors, such as government and private insurance plans and other organizations. Third-party payors and others increasingly are challenging the prices charged for medical products and services. There can be no assurance that the Company's products will be considered cost effective, that reimbursement will be available or, if available, that the payor's reimbursement policies will not adversely affect the Company's ability to sell its products on a profitable basis. Other aspects of the business in which the Company is engaged could also be affected. The Company cannot predict the outcome of any government or industry reform initiatives or the impact thereof on the Company's financial position or results of operations.

Competition

The pharmaceutical industry is subject to rapid and significant technological change. In the development and marketing of topical prescription drugs, cosmeceutical and skin care products, and drug delivery systems, Cellegy faces intense competition. Competitors of the Company in the United States and abroad are numerous and include, among others, major pharmaceutical, cosmetic, chemical, consumer product, and biotechnology companies, specialized firms, universities and other research institutions. There can be no assurance that the Company's competitors will not succeed in developing technologies and products that are more effective than any which are being developed by the Company or that would render the Company's technology and potential products obsolete and noncompetitive. Many of these competitors have substantially greater financial and technical resources, production and marketing capabilities and regulatory experience than the Company. In addition, many of the Company's competitors have significantly greater experience than the Company in preclinical testing and human clinical trials of pharmaceutical products and in obtaining FDA and other regulatory approvals of products for use in health care. The Company also competes with universities developing drug delivery technologies and with several companies which have been formed to develop unique delivery systems. In addition, these companies and academic and research institutions compete with Cellegy in recruiting and retaining highly qualified scientific and management personnel.

Competition in the markets in which the Company expects to compete is generally based on performance characteristics and, to a lesser extent, price. There can be no assurance that the Company's products under development will be able to compete successfully with existing or new commercial products.

Employees

As of March 23, 1998, the Company had twenty-three full-time and three part-time employees. Eighteen of these employees, of whom three are M.D.s and another six are Ph.D.s, are engaged in research and development. In addition, the Company utilizes the services of several professional consultants, as well as contract manufacturing and research organizations to supplement its internal staff's activities. None of the Company's

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employees is represented by a labor union. The Company has experienced no work stoppages and believes that its employee relations are good.

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