UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(Dd) OF THE SECURITIES EXCHANGE ACT OF 1934

for the quarterly period ended ~~September~~June 30, ~~2003~~2004

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

for the Transition Period from __________ to __________

0-18962
(Commission File Number)

CYGNUS, INC.

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		94-2978092 (I.R.S. Employer Identification No.)

400 Penobscot Drive Redwood City, California (Address of principal executive offices)		94063-4719 (Zip Code)

(650) 369-4300
(Registrant’s telephone number, including area code)

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 o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes o No x

As of ~~November~~August 1110, ~~2003~~2004, there were 3841,~~480~~009,~~253~~251 shares of the Registrant’s common stock outstanding.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
	Item 1. Finacial Statements
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		Notes to the Condensed Consolidated Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II. OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

CYGNUS, INC.

INDEX

PART I. FINANCIAL INFORMATION
Item 1:	Financial Statements	~~Financial Statements~~
		Condensed Consolidated Statements of Operations for the three-month and nine-month periods ended September 30, 2003 and 2002 (unaudited)		1
	Condensed Consolidated Statements of Operations for the three months and six months ended June 30, 2004 and 2003 (unaudited)		1
		Condensed Consolidated Balance Sheets at September 30, 2003 and December 31, 2002 (unaudited)		2
	Condensed Consolidated Balance Sheets at June 30, 2004 (unaudited) and December 31, 2003		2
		Condensed Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2003 and 2002 (unaudited)		3
	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003 (unaudited)		3
	Notes to the Condensed Consolidated Financial Statements (unaudited)	~~Notes to the Condensed Consolidated Financial Statements (unaudited)~~	4	4
Item 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	~~Management’s Discussion and Analysis of Financial Condition and Results of Operations~~	9	13
Item 3:	Quantitative and Qualitative Disclosures About Market Risk	~~Quantitative and Qualitative Disclosures About Market Risk~~	22	34
Item 4:	Controls and Procedures	~~Controls and Procedures~~	22	34
PART II. OTHER INFORMATION
Item 1:	Legal Proceedings	~~Legal Proceedings~~	23	35
Item 6:		Exhibits and Reports on Form 8-K		35
Item 4:	Submission of Matters to a Vote of Security Holders		23
SIGNATURES				37
Item 6:	Exhibits and Reports on Form 8-K		23
EXHIBIT INDEX				38
SIGNATURES			25
EXHIBIT INDEX			26
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

Cygnus, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS ~~(In thousands, except per share data) (unaudited)~~

		Three Months ended September 30,						Nine Months ended September 30,
		2003			2002			2003			2002
Revenues:
	Net product revenues	$	1,035		$	1,454		$	1,770		$	1,788
	Contract revenues		65			104			217			352
	Total revenues		1,100			1,558			1,987			2,140
Costs and expenses:
	Costs of product revenues		7,520			1,276			12,584			3,619
	Research and development		860			4,542			4,116			12,143
	Sales, marketing, general and administrative		1,296			5,160			5,430			14,347
	Total costs and expenses		9,676			10,978			22,130			30,109
Loss from operations			(8,576	)		(9,420	)		(20,143	)		(27,969	)
	Interest and other income (expense), net		25			68			103			183
	Interest expense		(516	)		(850	)		(1,628	)		(2,508	)
Loss before income taxes			(9,067	)		(10,202	)		(21,668	)		(30,294	)
Provision for income taxes			—			4			2			22
Net loss		$	(9,067	)	$	(10,206	)	$	(21,670	)	$	(30,316	)
Net loss per share, basic and diluted		$	(0.24	)	$	(0.27	)	$	(0.56	)	$	(0.81	)
Shares used in computation of amounts per share, basic and diluted			38,480			38,362			38,479			37,281

(In thousands, except per share data)
(unaudited)

(See accompanying notes.)


	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
Revenues:
Net product revenues	$	47		$	438		$	93		$	735
Contract revenues		—			101			—			152

Total revenues		47			539			93			887
Costs and expenses:
Costs of product revenues		47			3,271			163			5,064
Research and development		—			1,561			—			3,256
Sales, marketing, general and administrative		2,516			1,978			5,463			4,134

Total costs and expenses		2,563			6,810			5,626			12,454

Loss from operations		(2,516	)		(6,271	)		(5,533	)		(11,567	)
Interest and other income/(expense), net		31			36			98			78
Interest expense		(1	)		(557	)		(428	)		(1,112	)
Gain from Sankyo Pharma settlement		60			—			132			—
Gain on early retirement of Convertible Debentures		—			—			2,891			—

Loss before income taxes		(2,426	)		(6,792	)		(2,840	)		(12,601	)
Provision for income taxes		—			1			—			2

Net loss	$	(2,426	)	$	(6,793	)	$	(2,840	)	$	(12,603	)

Net loss per share, basic and diluted	$	(0.06	)	$	(0.18	)	$	(0.07	)	$	(0.33	)

Shares used in computation of amounts per share, basic and diluted		41,009			38,479			39,879			38,479

1See accompanying notes.

~~Table of Contents~~1

Cygnus,Table Inc. CONDENSEDof CONSOLIDATED BALANCE SHEETS ( In thousands, except per share data ) Contents

			September 30,			December 31,
			2003			2002
			(unaudited)			(Note)
ASSETS:
Current assets:
	Cash and cash equivalents		$	8,281		$	23,415
	Short-term investments			800			3,202
	Accounts receivable from Sankyo Pharma			188			497
	Inventory			2,709			6,628
	Current portion of employee notes receivable			79			57
	Other current assets			1,226			1,172
		Total current assets		13,283			34,971
Equipment and improvements:
	Manufacturing, office and laboratory equipment			14,107			15,626
	Leasehold improvements			610			610
				14,717			16,236
	Less accumulated depreciation and amortization			(11,080	)		(11,189	)
		Net equipment and improvements		3,637			5,047
Long-term portion of employee notes receivable				27			105
Deferred financing cost				2			108
Other assets				308			246
		TOTAL ASSETS	$	17,257		$	40,477
LIABILITIES AND STOCKHOLDERS’ NET CAPITAL DEFICIENCY:
Current liabilities:
	Accounts payable		$	1,120		$	2,518
	Accrued compensation			635			2,628
	Other accrued liabilities			580			606
	Reserve for replacement product due to Sankyo Pharma			1,375			—
	Advances from Sankyo Pharma			3,282			1,382
	Deferred revenues from Sankyo Pharma			25,000			25,000
	Deferred revenues from Sankyo Pharma net of deferred costs of product shipments			9,041			8,198
	Current portion of amount due to Sankyo Pharma			6,770			—
	Current portion of convertible debentures			18,281			4,000
	Current portion of capital lease obligations			77			77
	Current portion of arbitration obligation			4,000			3,000
		Total current liabilities		70,161			47,409
Long-term portion of arbitration obligation				8,000			12,000
Long-term portion of convertible debentures, net of discount of $979 in 2003 and $1,902 in 2002				1,021			16,379
Long-term portion of amount due to Sankyo Pharma				2,324			7,237
Long-term portion of capital lease obligations and other long term liabilities				41			74
Commitments and contingencies
Stockholders’ net capital deficiency:
	Preferred stock, $0.001 par value: 5,000 shares authorized; no shares issued and outstanding			—			—
	Common stock, $0.001 par value: 95,000 shares authorized; issued and outstanding: 38,480 and 38,479 shares at September 30, 2003 and December 31, 2002, respectively			38			38
	Additional paid-in capital			254,093			254,091
	Accumulated deficit			(318,421	)		(296,751	)
		Stockholders’ net capital deficiency		(64,290	)		(42,622	)
		TOTAL LIABILITIES AND STOCKHOLDERS’ NET CAPITAL DEFICIENCY	$	17,257		$	40,477

Cygnus, Inc.

~~Note:~~CONDENSED ~~The~~CONSOLIDATED ~~condensed~~BALANCE ~~consolidated~~SHEETS ( ~~balance~~In ~~sheet at December 31~~thousands, ~~2002~~except ~~has~~per ~~been~~share ~~derived~~data ~~from the audited consolidated financial~~) ~~statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.~~

(See accompanying notes.)


	June 30,			December 31,
	2004			2003
	(unaudited)			(Note)
ASSETS:
Current assets:
Cash and cash equivalents	$	14,544		$	33,483
Inventory		22			62
Current portion of employee notes receivable		—			25
Other current assets		668			750

Total current assets		15,234			34,320
Equipment and improvements:
Manufacturing, office and laboratory equipment		11,176			11,908
Leasehold improvements		295			377

		11,471			12,285
Less accumulated depreciation and amortization		(9,042	)		(9,080	)

Net equipment and improvements		2,429			3,205
Long-term portion of employee notes receivable		—			15
Other assets		167			167

TOTAL ASSETS	$	17,830		$	37,707

LIABILITIES AND STOCKHOLDERS’ EQUITY:
Current liabilities:
Accounts payable	$	479		$	814
Accrued compensation		303			381
Other accrued liabilities		213			505
Current portion of Convertible Debentures		—			14,281
Current portion of capital lease obligations		34			74
Current portion of arbitration obligation		4,500			—

Total current liabilities		5,529			16,055
Long-term portion of arbitration obligation		7,000			11,500
Long-term portion of Convertible Debentures, net of discount of $709 in 2003		—			3,291
Other long-term liabilities		56			39
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.001 par value: 5,000 shares authorized; no shares issued and outstanding		—			—
Common stock, $0.001 par value: 95,000 shares authorized; issued and outstanding: 41,009 and 38,480 shares at June 30, 2004 and December 31, 2003, respectively		41			38
Additional paid-in capital		255,353			254,093
Accumulated deficit		(250,149	)		(247,309	)

Stockholders’ equity		5,245			6,822

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	17,830		$	37,707

2Note: The condensed consolidated balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

~~Table~~See ofaccompanying ~~Contents~~notes.

~~Cygnus, Inc.~~2 ~~CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (unaudited)~~

				Nine Months Ended September 30,
				2003			2002
Cash flows from operating activities:
	Net loss			$	(21,670	)	$	(30,316	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Depreciation and amortization			1,518			1,555
		Loss on sale of equipment			—			24
		Write-off of inventory and prepaid materials			5,988			1,066
		Amortization of deferred financing costs			1,055			1,076
		Stock-based compensation			1			35
	Changes in operating assets and liabilities:
		Accounts receivable from Sankyo Pharma			309			(1,780	)
		Inventory			(1,238	)		(4,850	)
		Other assets			(915	)		(147	)
		Accounts payable and other current liabilities			(1,424	)		3,968
		Reserve for replacement product due to Sankyo Pharma			1,375			—
		Advances from Sankyo Pharma			1,900			—
		Accrued compensation			(1,993	)		(58	)
		Deferred revenues from Sankyo Pharma			—			19,975
		Deferred revenues net of deferred costs of product shipments from Sankyo Pharma			843			2,539
		Deferred revenues net of deferred costs of product shipments from end users			—			225
		Arbitration obligation			(3,000	)		(8,390	)
		Amount due to Sankyo Pharma			1,857			1,360
		Other long-term liabilities			24			—
			Net cash used in operating activities		(15,370	)		(13,718	)
Cash flows from investing activities:
	Capital expenditures				(108	)		(563	)
	Purchases of investments				(800	)		(10,247	)
	Sales of investments				3,200			12,350
	Maturities of investments				—			1,567
			Net cash provided by investing activities		2,292			3,107
Cash flows from financing activities:
	Issuance of common stock				1			15,742
	Principal payments of convertible debentures				(2,000	)		—
	Principal payments of capital lease obligations				(57	)		(51	)
			Net cash provided by/(used in) financing activities		(2,056	)		15,691
Net increase/decrease in cash and cash equivalents					(15,134	)		5,080
Cash and cash equivalents at beginning of the period					23,415			17,142
Cash and cash equivalents at end of the period				$	8,281		$	22,222

~~(See~~Cygnus, ~~accompanying notes~~Inc.)

3CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (unaudited)


	Six Months Ended June 30,
	2004			2003
Cash flows from operating activities:
Net loss	$	(2,840	)	$	(12,603	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		748			1,094
Loss on disposal of equipment		28			—
Amortization of deferred financing costs		282			717
Stock-based compensation		—			1
Employee notes receivable		40			46
Accrued interest on Convertible Debentures		144			—
Gain on early retirement of Convertible Debentures		(2,891	)		—
Changes in operating assets and liabilities:
Accounts receivable from Sankyo Pharma		—			252
Inventory		40			(792	)
Other assets		(25	)		(1,214	)
Accounts payable and other accrued liabilities		(627	)		380
Accrued compensation		(78	)		(1,251	)
Advances from Sankyo Pharma		—			1,034
Deferred revenues from Sankyo Pharma net of deferred costs of product shipments		—			260
Amount due to Sankyo Pharma		—			1,352
Arbitration obligation		—			(3,000	)
Other long-term liabilities		17			10

Net cash used in operating activities		(5,162	)		(13,714	)

Cash flows from investing activities:
Capital expenditures		—			(56	)
Purchases of investments		—			(800	)
Sales of investments		—			3,200

Net cash provided by investing activities		—			2,344

Cash flows from financing activities:
Issuance of common stock		13			1
Principal payment of Convertible Debentures		(13,750	)		(2,000	)
Payments of capital lease obligations		(40	)		(37	)

Net cash used in financing activities		(13,777	)		(2,036	)

Net decrease in cash and cash equivalents		(18,939	)		(13,406	)
Cash and cash equivalents at the beginning of the period		33,483			23,415

Cash and cash equivalents at the end of the period	$	14,544		$	10,009

Supplemental Cash Flow Data:
Value of stock issued in connection with early retirement of Convertible Debentures	$	1,295		$	—

~~Cygnus,~~See ~~Inc~~accompanying notes.

~~Notes to the Condensed Consolidated Financial Statements (unaudited)~~3

1.Table Basis of PresentationContents

~~The interim condensed consolidated financial statements of~~ Cygnus, Inc. ~~and its subsidiaries (the “Company,” “Cygnus,” “us,” “we,” “our,” etc.)~~ ~~included herein have been prepared by the Company, without audit, pursuant to~~ the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been condensed or omitted. The interim condensed consolidated financial statements reflect, in the opinion of Cygnus management, all normal and recurring adjustments that management believes necessary for a fair presentation of the financial position as of the reported dates and the results of operations for the respective periods presented. Interim financial results are not necessarily indicative of results for a full year. Certain prior period amounts in the condensed consolidated financial statements have been reclassified to conform with the current period presentation. The condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes for the year ended December 31, 2002 included in our 2002 Annual Report on Form 10-K, as amended by Form 10-K/A.

2.Notes ~~Litigation~~to ~~with~~the ~~Sankyo~~Condensed ~~Pharma~~Consolidated ~~Inc.~~Financial ~~and~~Statements ~~Sankyo Co., Ltd.~~(unaudited)

On October 2, 2003, Sankyo Pharma Inc. (“Sankyo Pharma”) stated that they were stopping performance of their contractual obligations under our Sales, Marketing and Distribution Agreement and related contracts. In addition, Sankyo Pharma acknowledged that they had not paid invoices owed to us and informed us that they had no intention of remitting payment for such amounts. As of October 10, 2003, these invoices total over $6.0 million. Sankyo Pharma stated that they were relying on California Commercial Code, Section 2609(1~~) as a purported legal basis for ceasing performance of their contractual obligations~~. ~~Section 2609(1)~~Basis ~~generally gives parties the right to demand adequate assurance~~ of ~~due performance by the counterparty of their contractual~~Presentation ~~obligations if reasonable grounds of insecurity arise with respect to~~ ~~performance by the counterparty. Sankyo Pharma has stated that they had~~ ~~grounds for insecurity regarding our financial position and our ability to~~ ~~perform under the Sales, Marketing and Distribution Agreement and related contracts we have with Sankyo Pharma.~~

OnThe ~~October 6,~~interim ~~2003,~~condensed weconsolidated ~~filed~~financial astatements ~~complaint in the Superior Court~~ of ~~the~~Cygnus, Inc. ~~State~~and ofits ~~California~~subsidiaries ~~for~~ (the ~~County~~“Company,” of“Cygnus,” ~~San Mateo against Sankyo Pharma and its Japanese parent company Sankyo Co.~~“us,” ~~Ltd. (~~“~~Sankyo~~we,” ~~Japan~~“our,” etc.) included ~~for~~herein ~~breach~~have ofbeen ~~contract~~prepared ~~and~~by ~~intentional interference~~the ~~with~~Company, ~~contract~~without ~~relating~~audit, topursuant to the ~~sales,~~rules ~~marketing~~ and ~~distribution~~regulations of ~~our~~ ~~GlucoWatch® Biographer products. During~~ the ~~initial~~Securities ~~12-year~~and ~~term~~Exchange ofCommission ~~our~~(SEC). ~~Sales,~~Certain ~~Marketing~~information and ~~Distribution~~footnote ~~Agreement~~disclosures ~~with~~normally ~~Sankyo~~included ~~Pharma,~~in ~~there are no~~annual ~~termination~~financial ~~rights~~statements ~~except~~prepared in ~~very~~accordance ~~specific~~with ~~circumstances,~~accounting ~~none of which, we~~principles ~~believe,~~generally ~~has~~accepted ~~occurred.~~in Wethe ~~are~~United ~~seeking~~States ~~substantial~~(GAAP) have ~~compensatory~~been ~~damages~~condensed ~~and other~~or ~~relief~~omitted. The ~~litigation~~interim incondensed ~~which~~consolidated wefinancial ~~are~~statements ~~currently~~reflect ~~involved~~in ~~may~~the ~~affect,~~opinion ~~among~~of ~~other~~Cygnus ~~things,~~management ~~our~~all ~~ability to sell~~adjustments, ~~market~~consisting ~~and~~only ~~distribute~~of ~~our~~normal ~~products~~and inrecurring ~~the United States~~adjustments, ~~our~~that ~~financing~~management ~~activities,~~believes ~~the~~necessary ~~retention~~for ofa ~~personnel~~fair ~~and~~presentation ~~our~~of the ~~ability~~financial toposition ~~continue~~ as aof ~~going~~the ~~concern.~~reported Wedates ~~cannot~~and ~~predict~~the ~~with~~results ~~certainty~~of ~~the~~operations for ~~eventual~~the ~~outcome~~respective ofperiods ~~pending~~presented. ~~litigation,~~Interim ~~which~~financial ~~may~~results ~~result~~are innot anecessarily indicative ~~significant~~of ~~adverse~~results ~~jury~~for ~~verdict~~a orfull ~~punitive~~year. ~~damages award,~~Certain orprior aperiod ~~judgment~~amounts ~~that~~in ~~certain~~the condensed ofconsolidated ~~our~~financial ~~allegations~~statements ~~are~~have ~~invalid~~been ~~or unenforceable.~~reclassified ~~Furthermore,~~to ~~this~~conform with ~~kind~~the ofcurrent ~~litigation~~period ~~could~~presentation. beThe ~~very~~condensed ~~costly~~consolidated ~~and~~financial ~~divert~~statements ~~our~~should ~~management’s~~be ~~attention~~read ~~and~~in ~~resources,~~conjunction ~~and~~with ~~any~~the ~~adverse~~audited ~~determination~~consolidated infinancial ~~this~~statements ~~litigation,~~and orrelated ~~delay~~notes infor ~~resolving~~the ~~this~~year ~~litigation~~ended December 31, ~~may cause us to~~2003 ~~cease~~included ~~operations~~in ~~and/or~~our ~~seek~~2003 ~~protection~~Annual ~~under~~Report ~~the~~on ~~bankruptcy~~Form ~~laws~~10-K.

~~On October 9, 2003, we announced a reduction in force of approximately 60% of our work force as a result of Sankyo Pharma’s decision to stop performing under its contracts with us~~2. WeSignificant ~~have~~Accounting ~~suspended our manufacturing activities~~Policies ~~and research and development efforts for future products. We are not likely to~~ ~~continue to manufacture current products or develop new products in the near~~ ~~future. According to Sankyo Pharma, however, they are currently warehousing~~ ~~inventory approximating two years’ sales of our products, and these products remain available for sale in the United States.~~

OnAccounting ~~October 16, 2003, we responded to Sankyo Pharma’s request~~ for ~~assurances~~ ~~under~~Stock-Based ~~California Commercial Code, Section 2609(1). Sankyo Pharma~~Compensation ~~had notified us, as well as certain health care professionals, that they will~~ ~~continue to provide marketing, sales, and distribution support for our~~ ~~GlucoWatch G2 Biographer; however, given their decision to stop performance~~ under their contracts with us and our litigation, the commercial status of our products in the United States is unclear. We have begun looking at alternative sales, marketing and distribution approaches for our products.

4 We issue stock options to our employees and outside directors and provide them the right to purchase our stock pursuant to stockholder-approved stock option programs. We account for our stock-based compensation plans under the intrinsic-value method of accounting as defined by Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees,” and related interpretations. We have elected to follow APB 25 in accounting for our employee stock options because the alternative fair value accounting provided for under Financial Accounting Standards Board (FASB) Statement No. 123 (FAS 123), “Accounting for Stock Based Compensation,” requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of our employee and director stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized for these grants.

~~Table~~ On May 13, 2004, we accelerated the vesting of ~~Contents~~all employee stock options with exercise prices in excess of the then-current market price. The vesting of a total of 1.2 million stock options with a weighted average exercise price of $1.36 was accelerated. We did not record any compensation expense associated with this acceleration of options because the intrinsic value of the options at the date of acceleration was not in excess of the original intrinsic value of the options.

OnFor ~~November 6,~~purposes ~~2003,~~of ~~Sankyo~~disclosure ~~Pharma~~pursuant ~~filed~~to anFAS ~~answer and cross-claims against us for declaratory relief~~123, ~~breach~~as ofamended ~~contract,~~by ~~and~~FASB Statement ~~defamation~~No. 148 We(FAS ~~have not~~148), ~~yet~~“Accounting ~~filed~~for aStock-Based ~~response~~Compensation to— Transition ~~these~~and ~~claims.~~Disclosure,” Wethe ~~believe~~estimated ~~that~~fair wevalue ~~have meritorious defenses to the causes~~ of ~~action~~employee ~~asserted against us by Sankyo Pharma,~~ and wedirector ~~intend~~stock tooptions ~~vigorously defend ourselves against these claims. This litigation~~ is in ~~its~~amortized ~~early~~to ~~stages,~~expense ~~however,~~over ~~and~~the isvesting ~~therefore~~periods ~~inherently~~of ~~difficult~~the ~~to assess~~options.

WeThe ~~have~~following ~~incurred~~table ~~substantial~~illustrates ~~operating~~the ~~losses~~effect ~~and~~on ~~negative~~net ~~cash~~loss ~~flows from operations since our inception,~~ and wenet ~~have~~loss ~~used cash from equity and debt to~~per ~~supplement~~share ~~our~~if ~~operating cash flow requirements. As of September 30, 2003,~~ we had ~~cash,~~applied ~~cash~~the ~~equivalents,~~fair ~~and~~value ~~investments~~recognition provisions of ~~$9.1 million.~~FAS We123 ~~expect~~ to ~~incur~~stock-based ~~additional~~employee ~~losses~~and ~~from~~director ~~operations~~compensation (in ~~the~~thousands, ~~foreseeable~~except ~~future.~~per share amounts):

With Sankyo Pharma’s decision to stop performing under our Sales, Marketing and Distribution Agreement and related contracts, and their refusal both to pay receivables in excess of $6.0 million and to honor the balance of their binding purchase commitment to pay us $28.4 ~~million in cash between~~ October 1, 2003 and March 31, 2004, we will need to conserve cash and find ways to generate additional cash to finance our operations. Our ability to continue as a going concern is dependent on our ability to generate sufficient cash flow to fund our operations and meet our debt and other obligations on a timely basis. Our plans both to conserve and generate cash include further reduction of our expenses and raising additional capital. There is no certainty, however, that we will be able to undertake such measures or that additional funds will be available to us. In addition, we do not believe we will be able to generate additional cash from product sales in any significant amounts in the near term since Sankyo has been, as a practical matter, our only distribution channel. We are currently pursuing various strategic options, including but not limited to pursuing a new partnership and/or selling some or all of our assets and intellectual property. If substantial additional resources are not available, we may need to cease our operations and/or seek protection under the bankruptcy laws. These conditions raise substantial doubt about our ability to continue as a going concern after March 31, 2004.

TheTable financial statements, as discussed in these footnotes, do not include all adjustments necessary to reflect the possible future effects on the recoverability and classification of assets or the amounts and classifications of liabilities that might result from the resolution of the matter described above. Contents

3. Significant Accounting Policies


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2004			2003			2004			2003
Net loss, as reported	$	(2,426	)	$	(6,793	)	$	(2,840	)	$	(12,603	)
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards	$	(465	)	$	(212	)	$	(675	)	$	(667	)

Pro forma net loss	$	(2,891	)	$	(7,005	)	$	(3,515	)	$	(13,270	)

Net loss per share, basic and diluted, as reported	$	(0.06	)	$	(0.18	)	$	(0.07	)	$	(0.33	)
Pro forma net loss per share, basic and diluted	$	(0.07	)	$	(0.18	)	$	(0.09	)	$	(0.34	)

~~Accounting~~ Due to the acceleration of the vesting of employee stock options with exercise prices in excess of the then-current market price, we recorded an additional pro forma expense of $352,000 for ~~Stock~~the three and six months ended June 30, 2004, which is included in the $465,000 and $675,000, respectively, of the stock-~~Based~~based ~~Compensation~~employee compensation expenses shown in the table above.

WeFor ~~issue~~the ~~stock~~three ~~options~~months toended ~~our~~June 30, ~~employees~~2004 and ~~outside~~2003, ~~directors~~the ~~and~~weighted ~~provide~~average ~~them~~grant ~~the~~date ~~right~~fair tovalue ~~purchase~~per ~~our~~share ~~stock pursuant to stockholder-approved stock option programs. We account~~ for ~~our~~ stock~~-based~~ ~~compensation~~options ~~plans~~granted ~~under~~during ~~the intrinsic-value~~these ~~method of accounting as defined by Accounting Principles Board~~periods ~~Opinion~~was No$0. 2521 ~~(APB~~and ~~25)~~$0.35, ~~“Accounting~~respectively. ~~for~~For ~~Stock~~the ~~Issued~~six tomonths ~~Employees~~ended June 30,” 2004 and ~~related~~2003, ~~interpretations.~~the ~~For~~weighted ~~purposes~~average ofgrant ~~disclosures~~date ~~pursuant~~fair tovalue ~~Financial Accounting~~per ~~Standards~~share ~~Board~~for ~~(FASB) Statement~~stock ~~No. 123 (FAS 123), “Accounting for~~options ~~Stock~~granted ~~Based~~during ~~Compensation,”~~these asperiods ~~amended~~was by$0.30 ~~FASB~~and ~~Statement~~$0.23, Norespectively. ~~148~~ ~~(FAS~~The ~~148), “Accounting~~fair value for ~~Stock-Based~~the ~~Compensation—Transition~~options ~~and~~was ~~Disclosure,” the~~ estimated ~~fair~~at ~~value~~the date of ~~employee~~grant ~~and~~using ~~director~~the ~~stock~~Black-Scholes option ~~options~~valuation ismodel ~~amortized~~with ~~to expense over~~ the ~~options’~~following ~~vesting~~weighted-average ~~period.~~assumptions:

The following table illustrates the effect on net loss and net loss per share if we had applied the fair-value recognition provisions of FAS 123 to stock-based employee and director compensation (in thousands, except per share amounts):


	Three Months Ended						Six Months Ended
	June 30,						June 30
	2004			2003			2004			2003
Risk-free interest rate		2.64	%		2.79	%		2.35	%		2.93	%
Volatility		1.69			0.91			1.68			0.89
Dividend yield		0			0			0			0
Expected life (years)		2			5			2			3

5 Effective January 8, 2003, our Board of Directors suspended the Amended 1991 Employee Stock Purchase Plan, as last amended and restated February 12, 2002, because our stock had been delisted from trading on the Nasdaq National Market. Thus, no shares were purchased pursuant to the Employee Stock Purchase Plan during 2004 and 2003.

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

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2003			2002			2003			2002
Net loss, as reported	$	(9,067	)	$	(10,206	)	$	(21,670	)	$	(30,316	)
Deduct: Stock-based employee compensation expense determined under the fair-value method for all awards	$	(334)		$	129		$	(1,001	)	$	(2,252	)
Pro forma net loss	$	(9,401	)	$	(10,077	)	$	(22,671	)	$	(32,568	)
Net loss per share, basic and diluted, as reported	$	(0.24	)	$	(0.27	)	$	(0.56	)	$	(0.81	)
Net loss per share, basic and diluted, pro forma	$	(0.24	)	$	(0.26	)	$	(0.59	)	$	(0.87	)

Use of Estimates

NoThe ~~stock-based~~preparation ~~employee~~of ~~compensation~~financial ~~was~~statements ~~included~~in conformity with accounting principles generally accepted in ~~net~~the ~~loss,~~United asStates ~~reported~~requires management to make ~~for~~estimates and assumptions that affect the ~~three~~amounts reported in the financial statements and ~~nine~~accompanying ~~months~~notes. ~~ended~~Actual ~~September,~~results ~~2003~~could ~~and~~materially ~~2002~~differ from those estimates.

~~Pro~~Due ~~forma~~to ~~information~~the ~~regarding~~current ~~net~~uncertainty ~~loss~~surrounding ~~and~~our ~~net~~business ~~loss per share is required by FAS 123~~situation, ~~which also requires that~~ the ~~information be determined as~~ ifrealization weof ~~had~~values ~~accounted~~ for our ~~employee stock options granted under the fair~~long-~~value method~~lived ofassets ~~FAS~~is ~~123.~~based ~~For~~on ~~the three months ended September 30, 2003 and 2002, the~~significant ~~estimated grant date fair value for stock options granted was $1,000 and $0, respectively~~estimates. ~~For the nine months ended September 30, 2003 and 2002, the~~ ~~estimated grant date fair value for stock options granted was $649,000 and $3.2~~ ~~million, respectively. The fair value for the options was estimated at the date~~ ~~of grant using a Black-Scholes option valuation model with the following weighted-average assumptions:~~

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Risk-free interest rate		2.97	%		2.93	%		2.92	%		2.93	%
Volatility		0.91			0.87			0.89			0.87
Dividend yield		0			0			0			0
Expected life (years)		5			5			3			5

EffectiveTable January 8, 2003, the Board of Directors suspended the Amended 1991 Employee Stock Purchase Plan, as last amended and restated February 12, 2002, because our stock had been delisted from trading on the Nasdaq National Market. Thus, no shares were purchased pursuant to the Employee Stock Purchase Plan during the three and nine months ended September 30, 2003. The valuation related to the shares granted pursuant to the Employee Stock Purchase Plan in 2002 was calculated using the following variables: Contents

	Nine Months Ended September 30,
	2003		2002
Risk-free interest rate		N/A		1.13	%
Volatility		N/A		1.25	%
Dividend yield		N/A		0
Expected life (years)		N/A		0.5

Revenue Recognition

~~The~~Product ~~Black-Scholes~~revenues ~~option~~are ~~valuation~~generated ~~model~~upon ~~was developed for use in estimating~~ the ~~fair~~sale ~~value~~ of ~~traded~~our ~~options~~GlucoWatch ~~that have no vesting restrictions~~G2® Biographer and ~~are~~accessories ~~fully~~in ~~transferable. In addition, option valuation models require~~ the ~~input~~ ofUnited ~~highly~~States ~~subjective~~and ~~assumptions, including~~ the ~~expected~~United ~~stock-price volatility~~Kingdom. ~~Because our employee stock options have characteristics~~The ~~significantly~~GlucoWatch® ~~different~~Biographer ~~from~~systems ~~those~~consist of ~~traded~~two ~~options,~~integrated ~~and~~parts: ~~because~~the ~~changes in~~durable ~~the~~Biographer ~~subjective~~and ~~input assumptions can materially affect~~ the ~~fair-value estimate~~disposable, in ~~management’s opinion the existing models do not necessarily provide a reliable~~ single-use ~~measure of the fair value of our employee stock options~~AutoSensor.

~~Any~~Product ~~stock~~sales ~~options~~are ~~and~~recorded ~~warrants~~when ~~granted~~all toof ~~consultants~~the ~~and~~following ~~other~~conditions have been ~~non-employees~~met: ~~are~~product ~~accounted~~has ~~for~~been atshipped, ~~fair~~transfer ~~value~~of title has taken place, ~~determined~~there byis persuasive ~~using~~evidence of an arrangement, the price is fixed or determinable, and ~~Black-Scholes~~collection ~~valuation~~is ~~model~~reasonably assured. In fiscal year 2003, revenues in ~~accordance~~the ~~with~~United States ~~the~~generated ~~Emerging~~from ~~Issues~~our ~~Task~~shipments of product to Sankyo Pharma for resale ~~Force~~under ~~(EITF) Consensus~~our ~~No. 96~~now-18terminated Sales, ~~“Accounting~~Marketing ~~for~~and ~~Equity~~Distribution ~~Investments~~Agreement ~~that~~were deferred ~~are~~until the product was sold by Sankyo Pharma to its third-party ~~issued~~customers, because the net price of our product sales to ~~other~~Sankyo ~~than~~Pharma ~~Employees~~was subject to certain contractual pricing adjustments. Product revenues recorded by us for ~~Acquiring,~~the orfirst inthree ~~Conjunction~~calendar ~~with~~quarters ~~Selling~~of 2003 were net of these ~~Goods~~adjustments; however, orproduct ~~Services.”~~revenues ~~These~~recorded ~~options~~for ~~are~~the fourth quarter ended December 31, 2003 were not subject to ~~periodic~~such ~~revaluation~~adjustments because our Sales, ~~over~~Marketing ~~their~~and ~~vesting~~Distribution ~~terms~~Agreement with Sankyo Pharma had been terminated pursuant to the Global Resolution. ~~The~~Revenues ~~assumptions~~generated ~~used~~from our shipments of sample and practice Biographers to ~~value~~Sankyo ~~stock-based~~Pharma ~~awards~~were recognized when all the above conditions were met, typically upon delivery of these products to ~~consultants~~Sankyo Pharma, ~~are~~as ~~similar~~the sales of such products were not subject to ~~those~~future ~~used~~pricing adjustments. Product revenues for the three and six months ended June 30, 2004 have primarily been generated from the sale of our products in the United Kingdom.

6 With regard to product sales that are made directly by us to third parties, from time to time, we have allowed customers to return product for credit. In such instances, we deferred revenue until the return period expired. We offer a one-year warranty on our Biographer from the date of sale to the end-user customer. We accrue for estimated warranty costs and other allowances when the revenues from product sales are recognized. The warranty costs recorded to date have not been significant and are within historical estimates. We periodically assess the adequacy of our recorded warranty liability and adjust the amount as necessary.

~~Table~~ Our contract revenues relate to payments received pursuant to research grants and contracts. Revenues were recognized based on the performance requirements of ~~Contents~~the grant or contract and as reimbursable expenses were incurred.

~~for~~Accounting ~~employees, except~~ for ~~the~~Impairment ~~expected life for which the contractual life~~ of ~~the~~Long-Lived ~~awards is used instead of the~~Assets ~~estimated useful life.~~

~~Use~~ We review equipment and improvements and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of ~~Estimates~~an asset may not be recoverable. Recoverability is measured by comparison of the carrying amount of the assets to the future net cash flows that the assets are expected to generate. If such assets are considered to be impaired, the impairment is recognized and is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets, evaluated by considering the present value of future net cash flows. No impairment charges were recorded during the first six months of 2004. We do not anticipate using our production equipment in the near term. We have concluded that its current carrying amounts would be recoverable if we were to enter into a strategic alliance. We may also use this equipment in research and development efforts, if any. As a result, we have not recognized any impairment against these assets at June 30, 2004. We will continue to evaluate the realizable value of these assets, which may result in future adjustments.

~~The~~Net ~~preparation~~Loss ofPer ~~financial statements in conformity with accounting~~Share ~~principles generally accepted in the United States requires management to make~~ ~~estimates and assumptions that affect the amounts reported in the financial~~ ~~statements and accompanying notes. Actual results could materially differ from~~ ~~those estimates.~~

~~Due~~Basic toand ~~the~~diluted ~~early~~net ~~stage~~loss ofper ~~our~~share ~~product~~are ~~commercialization~~computed ~~activities,~~using the ~~estimates~~ ~~required in inventory valuation, including production yields and~~weighted ~~normal~~average ~~capacity,~~number ~~labor~~of ~~costs~~shares ~~incurred~~of incommon ~~the~~stock ~~production~~outstanding. ofShares ~~each~~issuable ~~unit~~from ~~and~~any ~~overhead~~stock ~~costs applicable to manufacturing operations~~options, ~~are inherently uncertain~~warrants, ~~thus~~and ~~actual~~Convertible ~~results~~Debentures ~~may~~are ~~differ~~excluded from ~~those estimates. Write-offs for~~the ~~potential~~diluted ~~obsolescence~~loss orper ~~for~~share ~~inventories in excess of demand and estimates for replacement costs of any stale-dated AutoSensor inventory held by Sankyo Pharma are also determined based on significant estimates~~computation, ~~which~~as ~~may~~their beeffect ~~significantly impacted~~is ~~by our litigation with Sankyo Pharma and Sankyo Japan~~anti-dilutive.

~~Revenue Recognition~~6

ProductTable revenues are generated upon the sale of our GlucoWatch Biographer and GlucoWatch® G2™ Biographers and related accessories in the United States and the United Kingdom. The GlucoWatch Biographer systems consist of two integrated parts: the durable Biographer and the disposable, single-use AutoSensor. After the initial sales of the Biographers, revenues will continue to be recorded upon the sale of additional AutoSensors and accessories to support the installed base of Biographers. Contents

Product sales are recorded when all of the following conditions have been met: product has been shipped, transfer of title has taken place, there is persuasive evidence of an arrangement, the price is fixed or determinable, and collection is reasonably assured3. ~~Revenues~~Financing ~~generated from our shipments of~~Instruments ~~sample and practice Biographers are recognized when all the above conditions~~ ~~are met, typically upon delivery of these products to Sankyo Pharma, as the~~ ~~sales of such products are not subject to future pricing adjustments. With~~ regard to product sales that were made directly by us to third parties, from time to time we allowed customers to return product for credit. In such instances, we deferred revenue until the return period expired. We accrue for estimated warranty costs and other allowances when the revenues from product sales are recognized. The warranty expenses recorded to date have not been significant and are within historical estimates. Revenues in the United States generated from our shipments of product to Sankyo Pharma for resale under our Sales, Marketing and Distribution Agreement were deferred until the product was sold by Sankyo Pharma to its third-party customers, because the net price of our product sales to Sankyo Pharma was subject to certain pricing adjustments, such as rebates, discounts and certain fees offered or paid by Sankyo Pharma to its third-party customers.

~~For~~Convertible ~~the three and nine months ended September 30, 2003, $2.2 million and~~Debentures ~~$6.5 million of revenues were deferred, respectively. The costs of product~~ ~~revenues associated with these shipments are also deferred until the revenues~~ ~~are recognized. For the three and nine months ended September 30, 2003, $1.2~~ million and $4.2 million of such costs were deferred, respectively. In addition, for the three and nine months ended September 30, 2003, deferred costs of $0 and $821,000, respectively, were recorded for AutoSensors we estimated we would have had to replace due to stale-dating throughout the next twelve months. As of September 30, 2003, total revenues of $17.1 million were deferred, along with associated costs of $8.1 million. The net amount of $9.0 million is included on our condensed consolidated balance sheet as of September 30, 2003, under the caption “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments.” This balance was $8.2 million as of December 31, 2002.

IfOn ~~Sankyo~~March 23, ~~Pharma~~2004, ~~had~~we ~~continued~~entered tointo ~~perform~~an ~~under~~Exchange ~~our~~Agreement ~~Sales,~~with ~~Marketing and~~our ~~Distribution~~debenture ~~Agreement~~holders and ~~related~~retired ~~contracts,~~all weof ~~would~~our ~~have~~outstanding ~~been~~Convertible ~~responsible for~~Debentures ~~replacing any AutoSensors~~ in ~~Sankyo Pharma’s inventory that became~~ ~~stale-dated~~exchange ~~(had~~for ~~less~~an ~~than~~aggregate ~~six months~~ of ~~shelf life remaining)~~$13.8 million ~~Revenue recognition~~in iscash ~~not~~and ~~impacted~~2.5 million byshares ~~the replacement~~ of ~~stale-dated AutoSensors~~ ~~because~~our ~~revenues~~common ~~related~~stock tovalued ~~these~~at ~~AutoSensors~~$1.3 million. ~~will~~As ~~not~~of ~~yet~~March 22, ~~have~~2004, ~~been~~the principal ~~recognized.~~and ~~The~~accrued ~~costs~~interest ofon ~~product~~the ~~revenues,~~Convertible ~~however,~~Debentures ~~would~~totaled ~~ultimately~~$18.4 million. ~~have~~As ~~increased~~part byof the ~~cost~~early retirement of ~~the~~our ~~replacement~~Convertible ~~AutoSensors.~~Debentures ~~Based~~and onwarrants ~~Sankyo Pharma’s~~to ~~inventory~~purchase ~~and~~ our ~~estimates~~common ofstock ~~Sankyo~~that ~~Pharma’s~~had ~~sales~~been issued to ~~its~~the ~~third-party customers~~debenture holders, we also ~~accrued~~eliminated the ~~estimated~~remaining ~~costs~~balances of ~~replacing~~our ~~stale-dated~~debt ~~AutoSensors during~~issuance ~~the~~costs ~~second quarter~~and ~~of 2003~~debt discount. ~~Such~~We ~~additional~~recorded ~~cost~~a ~~accruals~~non-cash ~~amounted~~net togain of $12.49 million~~, of~~ ~~which~~from ~~approximately~~the ~~$821,000~~early retirement isof ~~included~~our asConvertible aDebentures ~~component~~in ofthe ~~“Deferred revenues~~six ~~from~~months ~~Sankyo~~ended ~~Pharma~~June 30, ~~net~~2004. As ofpart ~~deferred costs~~ of ~~product~~the ~~shipments”~~Exchange ~~and~~Agreement, ~~the remaining~~we ~~$554,000,~~terminated the ~~amount~~registration byrights agreement ~~which~~associated with the ~~original~~Convertible ~~cost~~Debentures and ~~replacement cost of~~ the ~~AutoSensors~~security ~~would~~interests in ~~have~~our ~~exceeded~~assets ~~revenues,~~held ~~has~~by ~~been~~the ~~recorded~~debenture ~~as additional~~holders. ~~costs~~The offollowing ~~product~~table ~~revenues~~shows ~~because~~ the calculation ~~total~~of ~~cost~~this ofnon-cash ~~the~~net ~~original~~gain, in thousands.


Accrued principal and interest at March 22, 2004	$	18,425
Less:
Cash paid on retirement		13,750
Valuation of shares issued on retirement		1,295
Write-off of debt issuance and discount costs		489

Net gain	$	2,891

~~Table~~ Equity ~~of Contents~~Line

~~AutoSensors~~ On ~~and~~March 24, ~~the~~2004, ~~estimated~~we ~~cost~~notified ofour ~~the~~counterparty ~~replacement~~that ~~AutoSensors~~we were ~~expected to~~electing ~~exceed our sales price of these products~~ to ~~Sankyo Pharma. Due to the~~ ~~uncertainty~~terminate of our ~~litigation~~remaining ~~with~~equity ~~Sankyo~~line ~~Pharma and Sankyo Japan~~agreement, wewhich ~~have~~had ~~not accrued~~a ~~any~~commitment ~~additional costs associated with stale-dated AutoSensors for the~~period ~~three~~ending ~~months ended September~~December 3031, ~~2003~~2004. ~~Whether we will eventually need to~~ ~~replace any stale-dated AutoSensors depends upon the resolution of our dispute~~ ~~with Sankyo Pharma and Sankyo Japan.~~

~~Our contract revenues may include up-front and/or interim milestone payments from co-promotion; sales, marketing and distribution; and development agreements~~4. ~~Milestone~~Global ~~payments~~Resolution are recorded as revenue based on the provisions of the underlying agreement and the estimated period of continuing obligations, generally the contract term. No revenues are recognized for such milestones if there is any potential that these milestones may have to be repaid. All milestone payments received ($25.0 million) pursuant to our contractual arrangements with Sankyo have been deferred, since the milestone payments may need to be repaid if the agreement is terminated prior to April 2005 because (1) we cannot supply product for a specified period of time, or (2) our product is recalled or withdrawn from the market for a specified period of time, or (3) there is a change of control and our successor in interest terminated our agreement with Sankyo Pharma~~. Because these conditions could occur and the~~ ~~payments might need to be repaid at any time, we are required to report the~~ ~~deferred amounts as current deferred revenue until the potential for repayment~~ ~~expires in 2005. Consequently, if the contractual relationship had run its full~~ term, the milestone amounts would have been recognized as revenue beginning in 2005 and continuing over the remaining term of the initial 12-year agreement with Sankyo Pharma; thus, in 2005, we would have expected to record the accumulated revenue of $7.8 million and thereafter would have recorded proportional amounts of the deferred revenue of approximately $521,000 per quarter over the remaining 9 years. In light of the litigation with Sankyo Pharma and Sankyo Japan, however, the timing of revenue recognition for the milestones may be subject to adjustment.

~~Our~~On ~~contract~~December 23, ~~revenues~~2003, we entered into an Agreement for Global Resolution and Mutual Release of All Claims (“Global Resolution”) with Sankyo Pharma Inc. (“Sankyo Pharma”) that resolved and dismissed our pending litigation, and terminated our July 8, 2002 Sales, Marketing and Distribution Agreement and all other contractual arrangements. The Global Resolution provided for Sankyo Pharma to pay us $30.0 million and also ~~include~~specified that neither party owed any payments ~~received~~outstanding ~~pursuant~~at the time of the Global Resolution to ~~research~~the other party, ~~grants.~~thus ~~Revenues~~allowing ~~are~~us ~~recognized~~to ~~based~~write onoff certain liabilities and assets, resulting in a total net gain of $75.8 million in the ~~performance~~three ~~requirements~~and twelve months ended December 31, 2003. Furthermore, Sankyo Pharma transferred title to us of more than 20,000 GlucoWatch G2® Biographers and more than 1.0 million AutoSensors that we had previously sold and shipped to them. Sankyo Pharma provided certain transition services related to distribution and customer services until June 30, 2004, and we were entitled to receive 30% of all monies received from product sales during this transition period. The amount received in the three ~~grant~~and ~~contract~~six months ended June 30, 2004 was $60,000 and $132,000, respectively, and has been recorded as ~~reimbursable~~“Gain ~~expenses~~from ~~are~~Sankyo ~~incurred~~Pharma Settlement” in our statement of operations.

We evaluate the collectability of our trade receivables based on our customers’ abilities to meet their financial obligations and generally do not require collateral. We determine amounts to be past due based on the terms and conditions set forth in the purchase agreements. At September 30, 2003, we have receivables from Sankyo Pharma of $5.~~2 million,~~ ~~which are past due and~~Inventory ~~which Sankyo Pharma has refused to pay. For financial statement presentation~~ ~~purposes, at September 30, 2003, we have offset the receivables for prepayments~~ ~~due at the time of order ($5.1 million at September 30, 2003) against “Advances~~ ~~from Sankyo Pharma” in the current liability section of our condensed consolidated balance sheet.~~

~~Accounting~~ Inventory ~~for~~is ~~Impairment~~stated orat ~~Disposal~~standard cost, adjusted to approximate the lower of actual ~~Long~~cost (first-~~Lived~~in, ~~Assets~~first-out method) or market, after appropriate consideration has been given to obsolescence and inventory in excess of anticipated future demand. Our inventory of $22,000 and $62,000 at June 30, 2004 and December 31, 2003, respectively, consists of finished goods for sale in the United Kingdom.

~~We review equipment and improvements and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable~~6. ~~Recoverability~~Arbitration ~~is measured~~Obligation ~~by comparison of carrying amount of the assets to future net cash flows that~~ ~~the assets are expected to generate. If such assets are considered to be~~ ~~impaired, the impairment is recognized and is measured as the amount by which~~ the carrying amount of the assets exceeds the fair value of the assets, evaluated by considering the present value of future net cash flows. In light of the litigation with Sankyo Pharma and Sankyo Japan, the carrying amounts of these assets may be subject to future adjustments.

~~Net~~ As ~~Loss~~of ~~Per~~June 30, ~~Share~~2004, we had $11.5 million in remaining arbitration obligation payments resulting from our 1997 arbitration with Sanofi, S.A., now Sanofi-Synthelabo. Of this $11.5 million, $4.5 million is due in February 2005, $4.0 million is due in February 2006, and $3.0 million is due in February 2007. We have also entered into Security Agreements granting Sanofi-Synthelabo a subordinate security interest in all of our assets, including our

~~Basic and diluted net loss per share are computed using the weighted~~7 average number of shares of common stock outstanding. Shares issuable from stock options, warrants and convertible debentures are excluded from the diluted loss per share computation, as their effect is anti-dilutive.

RecentTable Accountingof Pronouncements Contents

~~In May 2003, the FASB issued Statement No~~U. ~~150~~S. ~~(FAS~~patents ~~150), “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities~~ and ~~Equity,”~~ ~~which~~patent ~~will~~applications ~~become~~then ~~effective~~existing ~~for financial instruments entered into~~ or ~~modified~~ ~~after~~thereafter ~~May 31~~arising, to ~~2003.~~secure Weour doobligation ~~not~~under ~~expect~~ the ~~adoption~~Amendment ~~of FAS 150~~ to ~~have a~~the ~~material~~Final ~~effect on our financial condition or results of operations~~Award.

87. Sale of Drug Delivery Business

~~Table~~ On December 15, 1999, we completed the sale of ~~Contents~~substantially all of our drug delivery business segment assets to Ortho-McNeil Pharmaceutical, Inc. (“Ortho-McNeil”), a Johnson & Johnson company. Under the terms of our agreement, Ortho-McNeil was subject to paying up to an additional $55.0 million in cash, contingent on the achievement of certain milestones. Of this $55.0 million, $20.0 million was not paid to us because certain Ortho-McNeil technical and regulatory accomplishments relating to the Ortho Evra® (Johnson & Johnson, New Brunswick, New Jersey) contraceptive patch were not met, and $34.6 million is under dispute. Both parties have retained outside legal counsel and, on February 23, 2004, we invoked the mediation provisions set forth in our Asset Purchase Agreement. Thereafter, the parties agreed to waive the mediation provisions and to enter into binding arbitration as set forth in our Asset Purchase Agreement and, on April 15, 2004, we provided notice of arbitration to Ortho-McNeil. The parties are in the process of selecting a panel of arbitrators.

~~4. Comprehensive Loss~~8

UnrealizedTable gains or losses on investments for the three and nine months ended September 30, 2003 and 2002 were not material, and total comprehensive loss approximated net loss for each of these periods. Contents

5Item 2. ~~Inventory~~Management’s Discussion and Analysis of Financial Condition and Results of Operations.

~~Inventory~~Some isof ~~stated~~the atstatements ~~standard~~in ~~cost~~this ~~adjusted~~report, toincluding ~~approximate~~in the ~~lower~~documents incorporated ofby reference, are forward-looking statements that involve risks ~~actual~~and ~~cost~~uncertainties. ~~(first~~These forward-looking statements include statements about our plans, objectives, expectations, intentions and assumptions and other statements contained in this report, ~~first~~including ~~out~~in ~~method)~~the ordocuments ~~market~~incorporated ~~cost~~by reference, ~~after~~that ~~appropriate~~are not statements of historical fact. Forward-looking ~~consideration~~statements ~~has~~include ~~been~~but ~~given~~are not limited to ~~obsolescence~~statements ~~and~~about ~~inventory~~our ability to enter into a strategic alliance or to be acquired in ~~excess~~the near future; the capabilities and potential of the GlucoWatch G2 Biographer business; our ~~anticipated~~ability to achieve market acceptance of the GlucoWatch G2 Biographer; our ability to manufacture the GlucoWatch G2 Biographer; our plans for other commercialization alliances; and the speed and potential results of the regulatory process. In some cases, you can identify these statements by words such as “may,” “will,” “should,” “estimates,” “predicts,” “potential,” “continues,” “strategy,” “believes,” “anticipates,” “plans,” “expects,” “intends” and similar expressions. We cannot guarantee future ~~demand~~results, levels of activity, performance or achievements. Our actual results and the timing of certain events may differ significantly from the results and timing discussed in this report, including those under “Risk Factors” herein, as well as in the documents incorporated by reference. All forward-looking statements included in this report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements.

~~In light of our litigation with Sankyo Pharma and Sankyo Japan and our~~Overview ~~subsequent reduction in force, as well as Sankyo Pharma reporting to us that~~ ~~they are holding approximately a two-year supply of inventory of product and their~~ ~~instructions to stop shipments of any additional product to them, it is~~ unlikely that we will continue to manufacture any product in the near future. We have determined that we will not be able to realize the value of our remaining raw materials and work-in-process inventories and have thereof written off approximately $4.9 million of this inventory that was not either subsequently shipped to Sankyo Pharma or converted to finished goods. The finished goods inventory amounts may be subject to future adjustments based on the results of our litigation. We will continue to evaluate the realizable value of our finished goods inventory.

~~Inventory~~We athave developed and manufactured frequent, automatic and non-invasive glucose monitoring devices. Our devices are designed to provide more data to individuals and their physicians and enable them to make better-informed decisions on how to manage diabetes. We began the U.S. market launch of our first-generation GlucoWatch® Biographer on April 15, 2002. On March 21, 2002, the U.S. Food and Drug Administration (FDA) approved our second-generation product, the GlucoWatch G2® Biographer and, on September 3016, ~~2003~~2002, ~~consisted~~this product was launched in the United States under our now-terminated Sales, Marketing and Distribution Agreement with Sankyo Pharma. On August 28, 2002, we received approval from the FDA of our supplemental pre-market approval (PMA) application for use of the ~~following~~GlucoWatch G2 Biographer by children and adolescents (inages ~~thousands~~7 to 17):. On December 4, 2003, we announced that the FDA approved our third-generation product. Compared with our second-generation product, this improved Biographer and AutoSensor system focuses on enhancing customer satisfaction and ease of use; however, it is not yet commercially available.

	September 30, 2003		December 31, 2002
Raw materials	$	1,199	$	5,162
Work-in-process		0		1,098
Finished goods		1,510		368
Total	$	2,709	$	6,628

We have been seeking a comprehensive sales, marketing and distribution partner since October 2003; however, there are no interested parties at this time. We are exploring the possibility of selling the Company to a third party, and we have retained First Albany Capital Inc. to act as our exclusive financial advisor in connection with a possible merger, consolidation, reorganization, business combination, sale of a substantial portion of our assets or sale of more than 50% of our stock, or acquisition of the Company. First Albany will receive fees that are customary for this type of transaction, including a market-rate contingent fee in the event that such a transaction is consummated. Our Biographer products have not yet been widely accepted by the market due, we believe, to a combination of factors, including adoption barriers for new technology, the need for a paradigm shift in the management of diabetes, lack of widespread medical reimbursement, and the pricing and performance characteristics of the device. We do not have the resources or infrastructure to perform the full range of functions necessary to successfully market and sell our products. Our products require a sizeable sales force to create product awareness and provide education to health care professionals and end-user customers, a managed care sales force to work with national and regional health plans to secure medical reimbursement, significant advertising and promotional resources, a variety of customer support and education programs, a technical support group, logistics and distribution expertise and personnel, and marketing management resources and personnel. Thus, we must enter into a strategic alliance or be acquired in the near future, if we or our successor is to continue to sell the Biographer products. We are not currently manufacturing our G2 Biographer or our third-generation product and are not conducting research and development on new products at this time. In the event that we are unsuccessful in our efforts and our product sales do not significantly increase, we may need to liquidate the Company or sell some or all of its assets.

~~Approximately~~On ~~$1.3~~June ~~million~~29, of2004, ~~our~~we ~~finished~~dissolved ~~goods~~Cygnus ~~inventory at September 30~~(UK) Limited, ~~2003~~a ~~was~~wholly ~~product in transit to Sankyo Pharma and an additional~~owned ~~$236,000~~subsidiary of ~~our~~ ~~September 30~~Cygnus, ~~2003~~Inc. ~~raw materials inventory balance was converted to finished goods~~ in ~~early~~the ~~October~~United ~~2003 and shipped to Sankyo Pharma~~Kingdom.

~~Additionally, in light of our litigation with Sankyo Pharma and their~~9 instructions to us to stop all product shipments and the likelihood that we will not continue to manufacture any product in the near future, we have written off $831,000 in prepaid component orders to one of our sole source component suppliers. This amount was included in “Other current assets” on our condensed consolidated balance sheet.

PriorTable to the approval by the FDA of our products and our commercial processes, material was generally charged to research and development expenses upon receipt and was not carried as inventory in the financial statements. Accordingly, inventory values at September 30, 2003 and December 31, 2002 and the costs of product revenues for the three and nine months ended September 30, 2003 and 2002 do not include such previously expensed or written off obsolete material. Our costs of product revenues for the three months ended September 30, 2003 and 2002 would have been $130,000 and $834,000 higher, respectively, had we not utilized some of this previously expensed material in our production process. For the nine months ended September 30, 2003 and 2002, these costs would have been $379,000 and $1.2 million higher, respectively, for the same reason. Contents

6 On June 30, 2004, we assumed responsibility for certain transition services relating to distribution and customer service for our products that were previously provided by Sankyo Pharma pursuant to our Agreement for Global Resolution and Mutual Release of All Claims. ~~Financing~~Certain ~~Instruments~~customer service functions, such as product information request fulfillment and medical/professional inquiries, that were previously provided by Sankyo Pharma are now being handled by us internally.

~~Convertible~~ On ~~Debentures~~July 1, 2004, we entered into a non-exclusive distribution agreement for the G2 Biographer in the United States with Diabetic Promotions, a direct mail supplier of diabetic products. Additionally, on July 14, 2004, we announced a special one-time low pricing offer for our G2 Biographers and AutoSensors in the United States, expiring upon the earlier of December 31, 2004 or when 10,000 G2 Biographers and 500,000 AutoSensors have been sold. As of July 22, 2004, the expiration dating for our AutoSensors has been extended from 24 months to 36 months based on data obtained under an FDA-approved stability testing protocol.

~~Pursuant~~Critical toAccounting ~~the August 21, 2002 amendment to our Convertible Debentures,~~Policies ~~we paid $2.0 million in principal to the debenture holders on June 26, 2003, as~~ ~~the holders had not converted any shares of stock. As of~~ ~~September 30, 2003, the principal due to the debenture holders was $20.3~~ million. Under our amended Convertible Debentures, we are required to make a second $2.0 million payment on December 31, 2003. These payments result in the maturity dates of equal amounts of the remaining principal being extended for one year. Thus, the $2.0 million paid in June 2003 both reduced the amount of principal owed and extended the maturity date for $2.0 million from June 29, 2004 to June 29, 2005.

9 The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates. Although there are numerous policies associated with the preparation of our financial statements, the following policies are currently considered critical because of the level of management’s estimates and judgments required.

~~Table~~ Revenue ~~of Contents~~Recognition

~~Additionally,~~Product werevenues ~~may,~~are atgenerated ~~our~~upon ~~discretion,~~the ~~make~~sale ~~additional~~of ~~prepayments~~our ~~with~~GlucoWatch G2 noBiographer ~~penalty,~~ and ~~such~~accessories ~~prepayments~~in ~~will~~the ~~also~~United ~~extend~~States and the ~~maturity~~United ~~dates~~Kingdom. ~~of equal~~The ~~amounts~~GlucoWatch ofBiographer ~~remaining~~systems ~~principal.~~consist As of ~~September 30,~~two ~~2003,~~integrated ~~without~~parts: ~~prepayments,~~the durable ~~$14.4 million~~Biographer inand ~~principal~~the ~~is due June 29~~disposable, ~~2004,~~single-use $3AutoSensor.~~9 million~~ inWe ~~principal~~do ~~is due~~not ~~September 29,~~expect ~~2004,~~any significant ~~and~~product ~~$2.0 million~~revenues in ~~principal~~2004 isunless ~~due~~we ~~June 29,~~enter ~~2005 (resulting~~into ~~from~~a ~~the~~strategic ~~mandatory $2~~alliance.~~0 million payment made in June 2003).~~

7 Product sales are recorded when all of the following conditions have been met: product has been shipped, transfer of title has taken place, there is persuasive evidence of an arrangement, the price is fixed or determinable, and collection is reasonably assured. ~~Contractual~~In ~~Arrangements~~fiscal year 2003, revenues in the United States generated from our shipments of product to Sankyo Pharma for resale under our now-terminated Sales, Marketing and Distribution Agreement were deferred until the product was sold by Sankyo Pharma to its third-party customers, because the net price of our product sales to Sankyo Pharma was subject to certain contractual pricing adjustments. Product revenues recorded by us for the first three calendar quarters of 2003 were net of these adjustments; however, product revenues recorded for the fourth quarter ended December 31, 2003 were not subject to such adjustments because our Sales, Marketing and Distribution Agreement with Sankyo Pharma had been terminated pursuant to the Global Resolution. Revenues generated from our shipments of sample and practice Biographers to Sankyo Pharma were recognized when all the above conditions were met, typically upon delivery of these products to Sankyo Pharma, as the sales of such products were not subject to future pricing adjustments. Product revenues for the three and six months ended June 30, 2004 have primarily been generated from the sale of our products in the United Kingdom.

WeWith ~~are~~regard ~~currently~~to inproduct ~~litigation~~sales ~~with~~that ~~Sankyo~~are ~~Pharma~~made ~~and~~directly ~~Sankyo~~by ~~Japan relating~~us to ~~our~~third parties, ~~contractual~~from ~~arrangements.~~time Onto ~~July 8~~time, ~~2002,~~ we ~~had~~have ~~entered~~allowed ~~into a~~customers ~~Sales,~~to ~~Marketing~~return ~~and~~product ~~Distribution Agreement with Sankyo Pharma that~~for ~~superseded~~credit. ~~and~~In ~~replaced~~such ~~our prior November 28~~instances, ~~2001~~we ~~Co-Promotion~~deferred ~~Agreement~~revenue ~~with them.~~until ~~Under~~ the ~~new~~return ~~agreement,~~period ~~Sankyo~~expired. We ~~Pharma~~accrue ~~was responsible~~ for ~~sales, marketing,~~estimated ~~managed~~warranty ~~care~~costs and ~~government~~other ~~contracting,~~allowances ~~and~~when ~~distribution~~the ~~of our~~revenues ~~GlucoWatch~~from G2product ~~Biographer~~sales ~~and~~are ~~our~~recognized. ~~other~~The ~~similar~~warranty ~~glucose~~expenses ~~monitoring~~recorded ~~products~~to ~~for~~date have anot ~~period~~been ofsignificant ~~12 years~~and ~~beginning~~are onwithin ~~April 1,~~historical ~~2002~~estimates. ~~Under~~Our ~~our~~contract ~~Sales, Marketing and~~revenues ~~Distribution~~relate ~~Agreement, Sankyo Pharma was required~~ to ~~provide~~payments areceived ~~specialty~~pursuant ~~sales force of 100 people,~~ to ~~conduct~~research agrants ~~specified number~~ and ~~type~~contracts. ~~of product details~~Revenues towere ~~physicians,~~recognized ~~and~~based toon ~~utilize all of its large national primary care sales force during~~ the ~~term~~performance requirements of the ~~agreement.~~grant ~~Under~~or ~~this new agreement, Sankyo Pharma~~contract ~~was~~and ~~also~~as ~~required~~reimbursable toexpenses ~~pay~~were ~~us an additional $15~~incurred.~~0 million~~ inWe ~~milestone~~currently ~~payments, thus~~are ~~bringing~~not ~~total milestone payments, including milestone payments received~~performing work under ~~the~~any ~~November~~SBIR ~~2001~~grant ~~Co-Promotion~~or ~~Agreement~~contract, toand ~~$25.0 million,~~thus ~~all~~we ofdo ~~which has~~not ~~been~~expect ~~received.~~any ~~In addition, on March 19, 2003 Sankyo Pharma committed to~~contract ~~purchase~~revenues ain ~~specific amount of product for~~ the ~~period~~near ~~June 2003 through March 2004~~future.

~~For its sales, marketing and distribution activities, Sankyo Pharma was~~10 entitled to a margin equivalent to a predetermined percentage of Sankyo Pharma’s net sales to its third-party customers. For Sankyo Pharma to receive its specified margin, the following calculations were made. First, Sankyo Pharma’s net sales were determined by subtracting certain allowed deductions such as rebates, discounts and fees, including TheraCom, Inc.’s costs for product dispensing and patient reimbursement services, from Sankyo Pharma’s gross sales. (TheraCom is a third party with whom Sankyo has contracted to provide product dispensing and patient reimbursement services for our products.) Next, the amount that Sankyo Pharma paid us for the products we shipped to them was subtracted from Sankyo Pharma’s net sales. The sales and marketing commission we owed to Sankyo Pharma was then calculated so that Sankyo Pharma received its specified margin. In periods when the allowed deductions were high relative to Sankyo Pharma’s sales to its third-party customers, the effect of Sankyo Pharma’s being entitled to receive this specified margin was that we might report no, or negative, net product revenues for that period. The predetermined percentage was 15% for net sales in the first year after our first-generation Biographer launch. Beginning April 1, 2003 and continuing for one year, this predetermined percentage increased to 30%. Thereafter, for the remainder of the initial 12-year term of our agreement, the predetermined percentage would have been 40%; however, commencing on January 1, 2007, if Sankyo Pharma’s net sales were to have exceeded $225.0 million in any given calendar year, then the predetermined percentage would have increased to 45% for one year following the given calendar year that sales exceeded this specified amount. Payment of a quarterly sales and marketing commission, which constitutes a portion of this predetermined percentage to which Sankyo Pharma was entitled, for the years 2002 through 2004 can be deferred until at least 2005 and, under certain circumstances, to 2008. As of September 30, 2003, total sales and marketing commissions of $2.3 million have been accrued, the payment of which has been deferred and is included on our condensed consolidated balance sheet under the caption “Long-term portion of amount due to Sankyo Pharma.” These amounts may be subject to adjustments in the future, depending upon the resolution on our litigation with Sankyo Pharma and Sankyo Japan.

Furthermore,Table we are no longer obligated to spend promotional funds, as was required in our prior November 28, 2001 Co-Promotion Agreement; however, for 2002, we were required to reimburse Sankyo Pharma for their actual promotional expenses of $6.7 million, and we have a contractual right to defer the payment of such reimbursement to Sankyo Pharma until second quarter 2004. This amount was included in our results of operations for the year ended December 31, 2002. The $6.7 million, together with an amount we owe Sankyo Pharma for customer rebates, is included on our condensed consolidated balance sheet as of September 30, 2003, under the caption “Current portion of amount due to Sankyo Pharma.” These amounts may be subject to adjustments in the future, depending upon the resolution of our litigation with Sankyo Pharma and Sankyo Japan. If the deferral of our commissions and promotional funds had reached a certain specified dollar amount, Sankyo Pharma would have then had a first security interest in certain of our U.S. patents. Our commission deferral and our promotional funds did not reach that specified dollar amount as of September 30, 2003. Contents

10 Inventory Valuation

~~Table~~ Inventory is stated at standard cost, adjusted to approximate the lower of actual ~~Contents~~cost (first-in, first-out method) or market, after appropriate consideration has been given to obsolescence and inventory in excess of anticipated future demand. Our inventory of $22,000 and $62,000 at June 30, 2004 and December 31, 2003, respectively, consists of finished goods for sale in the United Kingdom.

~~All~~Impairment ~~assets and liabilities related to Sankyo Pharma as~~ of ~~September 30, 2003~~Long-Lived ~~that may be subject to future adjustments depending upon the resolution of~~Assets ~~our litigation with Sankyo Pharma and Sankyo Japan are as follows (in~~ ~~thousands):~~

Current assets:
	Accounts receivable from Sankyo Pharma		$	188
Current liabilities:
	Reserve for replacement product due to Sankyo Pharma		$	1,375
		Advances from Sankyo Pharma		3,282
		Deferred revenues from Sankyo Pharma		25,000
		Deferred revenues from Sankyo Pharma net of deferred costs of product shipments		9,041
		Current portion of amount due to Sankyo Pharma		6,770
Total current liabilities related to Sankyo Pharma			$	45,468
Long-term liabilities:
		Long-term portion of amount due to Sankyo Pharma	$	2,324

We review equipment and improvements and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparison of the carrying amount of the assets to the future net cash flows that the assets are expected to generate. If such assets are considered to be impaired, the impairment is recognized and is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets, evaluated by considering the present value of future net cash flows. No impairment charges were recorded in the six months ended June 30, 2004. We do not anticipate using our production equipment in the near term. We have concluded that its current carrying amounts would be recoverable if we were to enter into a strategic alliance. We may also use this equipment in research and development efforts, if any. As a result, we have not recognized any impairment against these assets at June 30, 2004. We will continue to evaluate the realizable value of these assets, which may result in future adjustments.

8.Results ~~Preferred~~of ~~Share Purchase Rights Plan~~Operations

Our ~~Stockholder~~results ~~Rights~~of ~~Plan~~operations ~~(“Plan”)~~have ~~expired~~fluctuated onfrom ~~September 21,~~period ~~2003.~~to period and are ~~Previously,~~expected ~~pursuant~~to continue to ~~the~~fluctuate ~~Plan,~~in the ~~Board~~future ofbased ~~Directors~~upon ~~had~~the ~~declared~~progress aand ~~dividend~~ultimate ~~distribution~~outcome of ~~one~~our ~~Preferred~~attempts ~~Share~~to ~~Purchase~~secure ~~Right~~alternative strategic options (~~“Right”~~including, but not limited to, a merger with or acquisition by a third party), the demand for ~~each~~our products, our product revenues and costs of product ~~outstanding~~revenues, ~~share~~as well as the level of our expenses during any given period. Historical results should not be viewed as indicative of future operating results. We are also subject to risks common ~~stock,~~to ~~issuable~~companies onin orour ~~after~~industry ~~October 18,~~and in ~~1993~~our current position, including risks inherent in our need to enter into a ~~stockholders~~strategic alliance or to be acquired in the near future; enforcement of ~~record~~our patents and proprietary rights; need for future capital, particularly in light of our stock currently being listed on ~~that~~the ~~date.~~OTC ~~All~~Bulletin ~~such~~Board; ~~Rights~~potential competition; and uncertainty of future regulatory approvals. We have experienced ~~expired~~operating losses since our inception, and we expect to continue to incur operating losses in 2004. At June 30, 2004, our accumulated deficit and our stockholders’ equity were $250.1 million and $5.2 million, respectively.

9.Comparison ~~Arbitration~~for ~~Award~~the ~~Obligation~~Three Months and Six Months Ended June 30, 2004 and 2003

OnNet ~~December 11,~~product ~~1997,~~revenues for the ~~International~~three ~~Court~~months ofended ~~Arbitration issued a Final Award~~June 30, ~~which~~2004 ~~was not appealable, in an arbitration matter between Sanofi,~~were ~~S.A.~~$47, ~~now Sanofi-Synthelabo~~000, ~~and~~compared ~~Cygnus related~~ to ~~transdermal hormone replacement therapy systems. This Final Award against Cygnus of~~ $~~37.0 million was~~438,000 ~~entered as a judgment of the United States District Court~~ for the ~~Northern District~~three ofmonths ~~California.~~ended AnJune 30, ~~initial payment of $14~~2003.~~0 million~~ ~~was made within 14~~Net ~~days~~product ofrevenues ~~the Final Award and in 1997 we accrued an aggregate remaining liability of $23.0 million~~ for the ~~following~~six ~~obligations:~~months ~~(i)~~ended June ~~payments~~30, of2004 anwere ~~aggregate amount~~$93,000, ~~equal~~ compared to $~~17.0 million~~735,000 ~~as royalty payments~~ for the ~~period~~six ~~2001~~months ~~through 2005,~~ended ~~payable 60~~June ~~days~~30, ~~after~~2003. ~~the~~Most ~~end~~ of ~~each~~our ~~fiscal~~net ~~year ($2.0 million of which~~product ~~was~~revenues ~~paid~~recognized ~~in February 2002~~ for the ~~year~~three ~~2001,~~months ~~$3.0 million~~and ofsix ~~which~~months isended toJune 30, be2004 ~~paid~~resulted ~~for~~from ~~the~~sales ~~year 2002, $4.0 million~~ of ~~which~~our isGlucoWatch toG2 beBiographers ~~paid~~in ~~for~~ the ~~year~~United ~~2003,~~Kingdom; ~~$4.0 million~~however, ofour ~~which~~net isproduct torevenues ~~be paid~~ for the ~~year~~three ~~2004~~months and ~~$4.0 million~~six ofmonths ~~which~~ended ~~is to be paid for the year 2005)~~June 30, ~~and~~2003 ~~(ii) a~~included ~~convertible~~revenues ~~promissory~~recognized ~~note bearing~~from ~~interest at 6~~U.~~5% per annum in the principal amount of $6~~S.~~0 million, issued~~ insales ~~December 1997, which was paid in full in cash with accrued annual interest~~ of ~~$390,000~~our inproducts ~~January 2002. The underlying agreement, which was the~~to ~~subject~~Sankyo ~~matter~~Pharma ofunder ~~the~~our ~~arbitration, was~~ now-terminated ~~on December 15~~Sales, ~~1999.~~Marketing Asand ofDistribution ~~September 30,~~Agreement. ~~2003,~~We ~~the~~do ~~aggregate~~not ~~amount~~expect ~~payable~~any ~~under~~significant ~~this~~product ~~obligation~~revenues ~~was $12.0 million,~~in of2004 ~~which~~unless ~~$4.0 million~~we enter isinto ~~included~~a instrategic ~~our current obligations~~alliance.

~~Effective~~Contract ~~November 3,~~revenues ~~2003, we entered into agreements with Sanofi-Synthelabo to extend by one year the periods of time~~ for ~~payment of~~ the ~~remaining~~ ~~arbitration~~three ~~obligations.~~months ~~Under~~ended ~~the Amendment to the Final Arbitration Award, the accrued aggregate remaining liability of $12.0~~June ~~million for the years 2003~~30, 2004 ~~and~~were ~~2005 will be paid as follows, respectively: (i)~~ $4.0 ~~million is due February 2005~~, ~~(ii) $4.0 million is due February 2006 and~~ ~~(iii)~~compared $4.0 million is due February 2007, and Sanofi-Synthelabo has the possibility of receiving accelerated payments in the event we receive a lump-sum cash payment from our dispute with Sankyo Pharma and Sankyo Japan. Specifically, in the event that we receive a lump-sum cash payment in an amount greater than or equal to $~~25.0 million but less than or equal to $50.0 million~~101, ~~then (i) $500,~~000 offor ~~such~~the ~~payment~~three ~~would~~months beended ~~immediately payable to Sanofi-Synthelabo, (ii)~~June ~~$4.5 million would be due in February~~30, ~~2005, (iii) $4~~2003.~~0 million~~ ~~would be due in~~Contract ~~February,~~revenues ~~2005,~~for ~~(iii) $4.0 million~~the ~~would~~six bemonths ~~due~~ended ~~in February, 2006, and (iv)~~June ~~$3.0 million would be due in February 2007. If~~30, ~~however,~~2004 wewere ~~receive a lump-sum cash payment in an amount greater than~~ $~~50.~~0 ~~million but less than or equal to $75.0 million~~, ~~then~~compared ~~(i) $1.0 million of such payment would be immediately payable~~ to ~~Sanofi-Synthelabo, (ii)~~ $~~5.0 million would be due in February~~152, ~~2005,~~000 ~~(iii) $4.0 million~~for ~~would~~the besix ~~due~~months inended ~~February, 2006, and (iv)~~June ~~$2.0 million would be due in February 2007. If we receive a lump-sum cash payment in an amount greater than $75.0 million but less than or equal to $125.0 million~~30, ~~then~~ ~~(i) $4~~2003.~~0 million~~ ofContract ~~such~~revenues ~~payment~~for ~~would~~the bethree ~~immediately~~months ~~payable to Sanofi-Synthelabo,~~ and ~~(ii) $8.0 million~~six ~~would be~~months ~~due~~ended ~~in February, 2005. Finally, if we receive a lump-sum cash payment in an amount of greater than $125.0~~June ~~million~~30, ~~then $12.0,~~2003 ~~representing~~included ~~the~~revenues ~~entire~~related ~~payment due~~ to ~~Sanofi-Synthelabo, would~~our beNIH ~~immediately payable. In the event that we receive a lump-sum~~SBIR ~~payment~~Phase ~~from~~II ~~Sankyo~~grant, ~~Pharma~~ and~~/or~~ ~~Sankyo~~revenues ~~Japan~~were ~~after~~recognized ~~February~~as ~~2005, then~~research weactivities ~~will pay a catch-up payment under whichever of the~~were ~~above-described situations has occurred~~performed. We ~~also~~currently ~~entered~~are ~~into~~not aperforming ~~Security~~work ~~Agreement granting~~under ~~Sanofi-Synthelabo~~any aSBIR ~~subordinate~~grants ~~security interest in all of our~~or ~~assets~~contracts, ~~(other than U.S. Patents~~ and ~~patent~~thus ~~applications~~we ~~then~~do ~~existing~~not ~~or thereafter~~expect ~~arising)~~any tocontract ~~secure~~revenues ~~our~~in ~~obligations under~~ the ~~Amendment~~near ~~to the Final Award~~future.

11 Costs of product revenues for the three months ended June 30, 2004 were $47,000, compared to $3.3 million for the three months ended June 30, 2003. Costs of product revenues for the six months ended June 30, 2004 were $163,000, compared to $5.1 million for the six months ended June 30, 2003. This decrease is a result of our reduced product revenues and suspension of our manufacturing efforts while we seek to enter into a strategic alliance. Costs of product revenues include material, labor, and other product costs associated with manufacturing our products. Costs of product revenues for the three and six months ended June 30, 2004 also included charges of

~~Table of Contents~~11

10.Table Sale of Drug Delivery BusinessContents

~~On December 15~~$19,000 ~~1999,~~and ~~we completed the sale of substantially all of our drug delivery business segment assets to Ortho-McNeil Pharmaceutical~~$114, ~~Inc. (“Ortho-McNeil”)~~000, ~~a Johnson & Johnson company. Under the terms of our agreement~~respectively, ~~Ortho-McNeil~~pursuant ~~was subject~~ to ~~paying~~our ~~up to an additional~~ $~~55.0 million in cash~~150,000 ~~contingent on the achievement of certain milestones. These potential~~minimum ~~milestone~~royalties ~~payments~~payable ~~are~~to ~~dependent upon~~ the ~~achievement~~University ~~by Ortho-McNeil~~ of ~~certain~~ ~~technical~~California ~~and~~for ~~regulatory~~the ~~accomplishments~~year ~~and~~2004. ~~timely~~It ~~submissions of~~is ~~regulatory~~estimated ~~documents~~that ~~related to~~ the ~~Ortho~~balance ~~Evra® (Johnson & Johnson, New Brunswick, New Jersey) transdermal contraceptive patch. The achievement~~ of ~~these~~ ~~milestones are not within our control. Of this~~ $~~55.0 million~~36,000 ~~$22.5 million~~for ~~potential~~our ~~payments~~2004 ~~were~~minimum ~~not~~royalties ~~received~~will ~~because certain Ortho-McNeil~~be ~~accomplishments~~covered ~~were~~by ~~not~~margins ~~met,~~generated ~~resulting~~ in ~~$32.5 million~~future ~~left in potential milestone payments~~quarters. OfCosts ~~this~~of ~~amount,~~product ~~$30 million~~revenues ~~was dependent on Ortho-McNeil~~for ~~achieving~~the ~~certain~~three ~~accomplishments~~months ~~in 2002. In response to our multiple requests for information~~ and ~~documentation~~six ~~relating~~months toended ~~the status of activities related to these milestone payments~~June 30, ~~Ortho-McNeil~~2003 ~~responded~~also ~~that~~included ~~they did not~~underabsorbed ~~achieve~~indirect ~~the~~overhead ~~necessary~~associated ~~accomplishments~~with ~~and~~building ~~that,~~up inour ~~their~~manufacturing ~~opinion,~~capacity ~~they did not~~to ~~owe~~meet usthen-expected ~~$30~~future volumes.~~0 million.~~ ~~Both~~We ~~parties~~expect ~~have~~our ~~retained~~costs ~~outside~~of ~~legal~~product ~~counsel,~~revenues ~~and we~~to ~~are~~be ~~evaluating~~minimal ~~potential courses of action. The remaining $2.5 million~~ in ~~potential~~ ~~milestone~~2004 ~~payments~~unless ~~may~~we beenter ~~payable~~into toa usstrategic ~~through 2005~~alliance.

11 Research and development expenses for the three months ended June 30, 2004 were $0, compared to $1.6 million ~~Warranties~~for the three months ended June 30, 2003. Research and ~~Indemnification~~development expenses for the six months ended June 30, 2004 were $0, compared to $3.3 million for the six months ended June 30, 2003. We have discontinued our research and development efforts and do not foresee commencing such activities until and unless we enter into a strategic alliance, although we have retained a limited number of personnel in this area in contemplation of entering into a strategic alliance or being acquired. The costs of these personnel are included in our sales, marketing, general and administrative expenses. For the three months and six months ended June 30, 2003, research and development expenses included costs for scientific and product development personnel, material used in the development and validation of high-capacity manufacturing processes, consultants, clinical trials, supplies, maintenance of our quality system, and depreciation of equipment used in research and product development.

WeSales, ~~offer~~marketing, ageneral ~~one-year~~and ~~warranty~~administrative onexpenses ~~our~~for ~~Biographer~~the ~~from~~three ~~the~~months ended ~~date~~June 30, of2004 ~~sale~~were $2.5 million, compared to $2.0 million for the ~~end-user~~three months ~~customer~~ended June 30, 2003. WeSales, ~~accrue~~marketing, general and administrative expenses for ~~estimated~~the ~~warranty~~six ~~costs~~months ~~and~~ended ~~other~~June 30, 2004 were $5.5 million, compared to ~~allowances~~$4.1 million ~~when~~for the ~~revenues~~six ~~from~~months ~~product~~ended ~~sales~~June 30, ~~are recognized~~2003. ~~The~~This ~~warranty~~increase is a result ~~costs~~of ~~recorded~~maintaining topersonnel ~~date~~and ~~have~~capacity ~~not~~to ~~been~~resume ~~significant~~manufacturing and research and development efforts in the future if we are ~~within~~successful ~~historical~~in entering into a ~~estimates~~strategic alliance. We ~~periodically~~do ~~assess~~not ~~the~~expect ~~adequacy~~any ofsignificant ~~our~~changes ~~recorded~~in ~~warranty~~these expenses ~~liability~~unless ~~and~~we ~~adjust~~secure ~~the~~such ~~amount~~an ~~as necessary~~alliance.

WeInterest ~~enter~~and ~~into~~other ~~indemnification~~income/(expense), ~~provisions~~net ~~under~~for ~~our agreements with other companies in~~ the ~~ordinary~~three ~~course~~months ofended ~~business~~June 30, ~~typically~~2004 ~~with~~was ~~business partners~~$31, ~~suppliers~~000, ~~clinical~~compared ~~sites,~~to ~~contractors~~$36,000 ~~etc.~~for ~~Under~~the ~~these~~three ~~provisions,~~months weended June 30, ~~generally~~2003. ~~indemnify~~Interest and ~~hold~~other ~~harmless~~income/(expense), ~~the~~net ~~indemnified party~~ for ~~losses suffered or incurred by~~ the ~~indemnified~~six ~~party~~months asended ~~a result of our activities and/or~~June ~~product~~30, ~~liabilities.~~2004 ~~These~~was ~~indemnification~~$98,000, ~~provisions~~compared ~~generally~~to ~~survive termination~~$78,000 offor the ~~underlying~~six ~~agreements.~~months Inended ~~some cases~~June 30, ~~the maximum potential~~ ~~amount of future payments we could be required to make under these indemnification provisions are unlimited~~2003. ~~The~~Although ~~estimated fair value of~~ the ~~indemnity~~ ~~obligations~~yields ofwere ~~these~~slightly ~~agreements~~lower isfor ~~minimal.~~the ~~Accordingly,~~three wemonths ~~have~~and nosix ~~liabilities~~months ~~recorded~~ended ~~for~~June 30, ~~these~~2004, ~~agreements~~our asaverage ofcash ~~September 30,~~balance ~~2003,~~was ~~and~~higher wefor ~~have~~the current ~~not~~periods ~~incurred~~when ~~material~~compared ~~costs~~ to ~~defend~~the ~~lawsuits~~three ormonths ~~settle~~and ~~claims~~six ~~related~~months ~~to these~~ended ~~indemnification~~June 30, ~~provisions~~2003.

12 Interest expense for the three months ended June 30, 2004 was $1,000, compared to $557,000 for the three months ended June 30, 2003. ~~Subsequent~~Interest ~~Events~~expense for the six months ended June 30, 2004 was $428,000, compared to $1.1 million for the six months ended June 30, 2003. Included in interest expense for the six months ended June 30, 2004 and 2003 was the interest accrued on our Convertible Debentures and the amortization of the value of the warrants issued in connection with financing agreements. Interest expense decreased for the three months and six months ended June 30, 2004 as a result of the lower principal balance on our Convertible Debentures during the periods and the retirement of this debt on March 23, 2004.

OnGain ~~October 2,~~from ~~2003,~~ Sankyo Pharma ~~informed~~settlement usfor ~~that~~the ~~they~~three ~~were~~months ~~stopping~~ended June 30, ~~performance~~2004 ofwas ~~their~~$60,000 ~~contractual~~and ~~obligations~~was ~~under our Sales~~$132,000 ~~Marketing~~for ~~and Distribution~~the ~~Agreement~~six ~~and~~months ~~related~~ended ~~contracts. On October~~June 630, ~~2003,~~2004. During wethe ~~filed~~transition ~~a lawsuit~~period ~~against~~in which Sankyo Pharma ~~and~~provided ~~Sankyo Japan for breach of contract and~~certain ~~intentional~~distribution ~~interference with contract relating to the sales, marketing~~ and ~~distribution~~ ofcustomer ~~our GlucoWatch Biographer products. On October 9~~services, ~~2003,~~ we ~~announced~~ awere ~~reduction~~entitled into ~~force of approximately 60~~30% of ~~our~~all ~~work~~monies received ~~force~~for asproducts ~~a result~~sold ofby Sankyo Pharma’s. ~~decision~~Amounts toreceived ~~stop~~were ~~performing~~recorded ~~under~~as additional ~~its~~“Gain ~~contracts~~from ~~with us.~~Sankyo ~~(See~~Pharma ~~Note~~settlement” 2.in ~~“Current~~our ~~Litigation~~statement ~~with~~of ~~Sankyo~~operations. This ~~Pharma~~transition ~~Inc.~~period ~~and~~ended ~~Sankyo~~on ~~Co.~~June 30, ~~Ltd~~ 2004.”)

OnGain ~~October 15,~~on ~~2003,~~early weretirement ~~terminated~~of ~~our~~Convertible ~~second~~Debentures ~~building~~for ~~lease~~the ~~that~~three ~~would~~months ~~have~~and ~~run~~six ~~through~~months ~~December~~ended ~~2003~~June 30, ~~which~~2004 wewas ~~had~~$0 ~~previously~~and ~~subleased to Maxygen, Inc~~$2. ~~We received full payment from Maxygen~~9 million, ~~Inc~~respectively. ~~for this early termination,~~The ~~and~~following intable ~~turn~~shows ~~paid~~ the ~~remaining~~calculation ~~lease~~of ~~amount~~this tonon-cash ~~the~~net ~~property~~gain, ~~owner.~~in ~~This early~~thousands: ~~termination was unrelated to our litigation with Sankyo Pharma and Sankyo~~ ~~Japan.~~

Effective November 3, 2003, we entered into agreements with Sanofi-Synthelabo to extend by one year the periods of time for payment of the remaining arbitration obligations with certain accelerations if we receive a lump-sum cash payment from Sankyo Pharma and/or Sankyo Japan and to grant Sanofi-Synthelabo a subordinate security interest in all of our assets (other than U.S. Patents and patent applications then existing or thereafter arising) to secure our obligations. (See Note 9. “Arbitration Award Obligation.”)


Accrued principal and interest at March 22, 2004	$	18,425
Less:
Cash paid on retirement		13,750
Valuation of shares issued on retirement		1,295
Write-off of debt issuance and discount costs		489

Net gain	$	2,891

~~Item 2.~~Liquidity ~~Management’s Discussion~~ and ~~Analysis~~Capital ~~of Financial Condition and Results of Operations.~~Resources

~~Some~~As of ~~the statements in this report~~June 30, ~~including in the documents incorporated by reference~~2004, ~~are forward-looking statements that involve risks and uncertainties. These forward-looking statements include statements about~~ our ~~plans~~cash, ~~objectives,~~cash ~~expectations,~~equivalents ~~intentions~~ and ~~assumptions~~investments ~~and other~~totaled ~~statements contained in this report, including in the documents incorporated by reference, that are not statements of historical fact~~$14. ~~Forward-looking statements include, but are not limited to, statements about our allegations and expectations regarding our contracts with Sankyo Pharma Inc~~5 million.~~; the decision~~ ~~by Sankyo Pharma to stop performing under its contracts with us and the~~ ~~interference of such contracts by Sankyo Co., Ltd., the Japanese parent~~ company; the capabilities and potential of the GlucoWatch Biographer business; our ability to manufacture and commercially scale up the GlucoWatch Biographer; our plans for commercialization alliances; our ability to achieve market acceptance of the GlucoWatch Biographer; and the speed and potential results of the regulatory process. In some cases, you can identify these statements by words such as “may,” “will,” “should,” “estimates,” “predicts,” “potential,” “continues,” “strategy,” “believes,” “anticipates,” “plans,” “expects,” “intends” and similar expressions. We cannot guarantee future results, levels of activity, performance or achievements. Our actual results and the timing of certain events may differ significantly from the results and timing discussed in this report, including those under “Risk Factors” herein, as well as in the documents incorporated by reference.

~~General~~ Net cash used in operating activities for the six months ended June 30, 2004 was $5.2 million, compared to net cash used in operating activities of $13.7 million for the six months ended June 30, 2003. Cash used in operating activities for the six months ended June 30, 2004 was primarily due to the net loss from operations of $2.8 million, which included a non-cash net gain of $2.9 million from the early retirement of our Convertible Debentures. Cash used in operating activities for the six months ended June 30, 2003 was primarily due to a net loss from operations of $12.6 million and our Sanofi-Synthelabo payments totaling $3.0 million.

WeNet ~~develop,~~cash ~~manufacture~~provided ~~and~~by ~~commercialize~~investing ~~new~~activities ~~and~~for ~~improved~~the ~~glucose monitoring~~six ~~devices.~~months ~~Our~~ended ~~products are designed to provide more data to~~June ~~individuals~~30, ~~and~~2004 ~~their~~was ~~physicians and enable them to make better-informed decisions on how to manage diabetes~~$0. WeNet ~~began~~cash ~~the~~provided ~~U.S.~~by ~~market~~investing ~~launch~~activities of ~~our first-generation GlucoWatch® Biographer on April 15, 2002~~$2. ~~On March~~3 ~~21,~~million ~~2002,~~for the ~~U.S.~~six ~~Food~~months ~~and~~ended ~~Drug Administration (FDA)~~June ~~approved our second generation product~~30, ~~the~~2003 ~~GlucoWatch®~~resulted ~~G2™~~primarily ~~Biographer. On August 28, 2002, we received approval~~ from the ~~FDA~~net ofsales ~~our supplemental pre-market approval (PMA) application for use~~ of ~~the GlucoWatch G2 Biographer by children and adolescents (ages 7 to~~ ~~17)~~investments.

WeNet ~~launched~~cash ~~the~~used ~~GlucoWatch~~in G2financing ~~Biographer~~activities intotaled $13.8 million for the ~~United~~six months ~~States~~ended onJune 30, ~~September 16~~2004, ~~2002~~substantially ~~under~~all ~~our~~of ~~Sales,~~which ~~Marketing~~resulted ~~and~~from ~~Distribution~~the retirement ~~Agreement~~of ~~with~~our ~~Sankyo Pharma~~Convertible ~~Inc~~Debentures. ~~(“Sankyo~~Net ~~Pharma”),~~cash aused ~~wholly~~in ~~owned~~financing Uactivities totaled $2.S.0 ~~subsidiary~~for ofthe ~~Sankyo~~six ~~Co., Ltd.~~months ~~(“Sankyo~~ended ~~Japan”)~~June 30, a2003 ~~Japanese pharmaceutical~~ and ~~medical~~reflected ~~products~~the ~~company.~~payment ~~Sankyo~~to ~~Pharma~~our ~~contracted~~Convertible ~~with~~Debenture ~~TheraCom,~~holders ~~Inc., a subsidiary~~ of ~~AdvancePCS, to provide product dispensing and patient reimbursement services for our products~~$2.0 million.

OnAs ~~October~~of June 230, ~~2003~~2004, ~~Sankyo~~our ~~Pharma informed us that they were stopping performance of their~~ contractual obligations ~~under our Sales, Marketing and Distribution Agreement and related contracts. On October 6, 2003, we filed a lawsuit against Sankyo Pharma and Sankyo Japan~~ for ~~breach of contract and intentional interference with contract relating to~~ the ~~sales,~~next ~~marketing~~seven ~~and~~years ~~distribution~~were ofas ~~our~~follows ~~GlucoWatch~~(in ~~Biographer products. On October 9~~thousands, ~~2003,~~except ~~we announced~~for anote ~~reduction in force of approximately 60% of our work force as a~~(1)): ~~result of Sankyo Pharma’s decision to stop performing under its contracts with~~ ~~us.~~

The GlucoWatch Biographer and GlucoWatch G2 Biographer are the only products approved by the FDA that provide frequent, automatic and non-invasive measurement of glucose levels. We believe our products represent the most significant commercial technological advancement in self-monitoring of glucose levels since the advent, approximately 20 years ago, of finger-stick blood glucose measurement. Our GlucoWatch Biographer systems consist of two components: a durable component known as the Biographer and a consumable component known as the AutoSensor. The GlucoWatch Biographers use a low electrical current to extract glucose molecules through the skin, using patented sampling processes. The glucose is extracted from interstitial fluid, which surrounds cells, rather than from blood, eliminating the need for multiple finger pricks to provide frequent glucose readings. The Biographers can be worn on the forearm like a watch and function like a computer, analyzing and responding to data received from the AutoSensors. The AutoSensors use proprietary biosensor technology and snap into the back of the Biographers. The AutoSensors are calibrated with a standard blood glucose measurement after a warm-up period and then frequently, automatically and non-invasively extract and measure glucose for their duration period before requiring replacement.


			Amounts Due
			Less than
Contractual Obligations	Total		1 year		1-3 years		3-7 years
Capital lease obligations	$	37	$	37	$	—	$	—
Operating lease obligation		4,289		844		1,757		1,688
Arbitration obligation (Sanofi-Synthelabo)		11,500		4,500		7,000		—
University of California minimum royalties(1)		1,348		148		400		800
Other purchase obligations		540		240		300		—

Total	$	17,714	$	5,769	$	9,457	$	2,488

~~Current~~(1)These ~~methods~~payments ~~for~~are ~~measuring~~due ~~glucose,~~under inour ~~which~~Exclusive ~~skin~~License isAgreement, ~~lanced~~effective January 31, 1995, as amended, and athey ~~blood~~terminate upon expiration of the ~~sample~~last-to-expire ispatent ~~obtained~~licensed ~~for~~under ~~measurement~~this agreement. This expiration date is January 18, ~~are~~2011. ~~painful~~Of ~~and~~the ~~inconvenient~~$150,000 tominimum royalties due for the ~~user.~~year 2004, ~~Because~~$2,000 ofhas ~~this,~~been ~~the~~paid ~~vast~~and ~~majority~~$148,000 is due, of ~~people~~which ~~with~~$112,000 ~~diabetes~~has dobeen accrued as of June 30, 2004.

13 The level of cash used in operating activities during previous periods is not necessarily indicative of the level of future cash usage. Our long-term cash and capital expenditure requirements will depend upon numerous factors, including but not limited to (i) costs associated with seeking and entering into a strategic alliance or acquisition; (ii) additional expenditures to support the manufacture of new products, including conversion of existing G2 Biographers into third-generation Biographers; (iii) the progress of our research and development programs, if any; (iv) the time required to obtain any future regulatory approvals; and (v) possible expansion into new markets.

~~Table~~ As of ~~Contents~~June 30, 2004, we had existing cash, cash equivalents and investments of $14.5 million. However, we have incurred significant net operating losses since our inception, including a loss from operations of $2.8 million for the six months ended June 30, 2004. We have incurred negative cash flows from operations since our inception. At June 30, 2004, our accumulated deficit was $250.1 million and our stockholders’ equity was $5.2 million.

~~not~~ As ~~perform~~of ~~the frequent~~June 30, ~~glucose testing that is necessary to provide adequate information to manage diabetes~~2004, ~~despite~~based ~~substantial~~upon ~~clinical~~current ~~evidence~~expectations ~~of the benefits of more intensive diabetes management. We believe there is an unmet medical need~~ for ~~a device~~operating ~~that can provide~~ losses and ~~track~~projected ~~frequent glucose readings automatically and non~~short-~~invasively.~~term ~~Our~~expenditures, ~~GlucoWatch~~we ~~Biographers~~believe ~~enable~~that ~~people~~existing ~~with~~cash, ~~diabetes and~~cash ~~their~~equivalents, ~~physicians to identify trends~~ and ~~track~~investments ~~patterns~~of in$14.5 million ~~fluctuating~~will ~~glucose levels that would~~ be ~~difficult~~sufficient to ~~detect~~meet ~~with current testing techniques alone.~~our ~~Although~~existing ~~our~~operating ~~GlucoWatch~~expenses, ~~Biographers~~contractual ~~are~~obligations, ~~not intended to replace existing painful~~ and ~~inconvenient~~capital ~~testing methods and~~expenditure requirements, inif ~~the United Sates~~any, ~~are classified~~at asleast ~~adjunctive~~through ~~devices~~March 31, we2005. ~~believe~~Although ~~the~~there ~~GlucoWatch~~has ~~Biographers will~~been ~~lead~~a tosubstantial ~~better-informed~~reduction ~~decisions~~in ~~regarding~~our ~~the~~headcount, ~~way~~suspension ~~individuals~~of ~~manage~~manufacturing ~~their~~and ~~diabetes.~~related ~~Users~~reduction ~~must~~in ~~first~~costs ~~calibrate~~of ~~the~~product ~~GlucoWatch~~revenues ~~Biographers~~and ~~with~~research aand ~~blood~~development ~~glucose~~activities, ~~measurement~~ and ~~must~~other ~~make~~cost-cutting ~~major decisions~~measures, ~~such~~we asalso ~~insulin~~expect ~~dosing, based on blood glucose measurements, but they are able~~ to ~~identify~~receive ~~trends and~~minimal ~~track~~cash ~~patterns~~from byfuture ~~monitoring~~product ~~glucose~~revenues ~~levels~~without onfirst ~~a more frequent and automatic~~entering ~~basis than would be the case if they could only use existing finger stick or~~ ~~other blood glucose measurement devices.~~

~~Major Developments Since September 30, 2003~~13

OnTable October 2, 2003, Sankyo Pharma stated that they were stopping performance of their contractual obligations under our Sales, Marketing and Distribution Agreement and related contracts. In addition, Sankyo Pharma acknowledged that they had not paid invoices owed to us and informed us that they had no intention of remitting payment for such amounts. As of October 10, 2003, these invoices total over $6.0 million. Sankyo Pharma stated that they were relying on California Commercial Code, Section 2609(1) as a purported legal basis for ceasing performance of their contractual obligations. Section 2609(1) generally gives parties the right to demand adequate assurance of due performance by the counterparty of their contractual obligations if reasonable grounds of insecurity arise with respect to performance by the counterparty. Sankyo Pharma has stated that they had grounds for insecurity regarding our financial position and our ability to perform under the Sales, Marketing and Distribution Agreement and related contracts we have with Sankyo Pharma. Contents

Oninto ~~October 6, 2003, we filed~~ a ~~complaint~~strategic in the Superior Court of the State of California for the County of San Mateo against Sankyo Pharma and Sankyo Japan for breach of contract and intentional interference with contract relating to the sales, marketing and distribution of our GlucoWatch Biographer productsalliance. ~~During~~It ~~the~~is ~~initial~~likely ~~12-year term of our Sales~~that, ~~Marketing~~if ~~and Distribution Agreement with Sankyo Pharma, there are no termination rights except in very specific circumstances, none of which,~~ we ~~believe,~~do ~~has~~not ~~occurred. We~~enter ~~are~~into seeking substantial compensatory damages and other relief. The litigation in which we are currently involved may affect, among other things, our ability to sell, market and distribute our products in the United States, our financing activities, and the retention of our remaining personnel. We cannot predict with certainty the eventual outcome of the pending litigation, which may result in a ~~significant~~ ~~adverse~~strategic ~~jury~~alliance ~~verdict~~ or ~~punitive~~are ~~damages~~not ~~award,~~acquired orwithin a ~~judgment~~reasonable ~~that~~period ~~certain~~ of ~~our~~ ~~allegations~~time ~~are invalid~~ or ~~unenforceable. This kind of litigation could be~~do ~~very~~not ~~costly~~generate ~~and~~sufficient ~~will~~product ~~divert our management’s attention and resources~~revenues, ~~and~~we ~~any adverse~~will ~~determination~~require inadditional ~~this litigation, or delay in resolving this~~financing ~~litigation,~~and ~~may~~there ~~cause~~can usbe tono ~~cease~~assurance ~~our~~that ~~operations~~such ~~and/or~~financing ~~seek~~will ~~protection~~be ~~under the bankruptcy laws~~available.

OnRISK ~~October 9, 2003, we announced a reduction in force of approximately 60%~~FACTORS ~~of our work force as a result of Sankyo Pharma’s decision to stop performing~~ ~~under its contracts with us. We have suspended our manufacturing activities~~ ~~and research and development efforts for future products. We are not likely to~~ continue to manufacture current products or develop new products in the near future. According to Sankyo Pharma, however, they are currently warehousing inventory approximating two years’ sales of our products, and these products remain available for sale in the United States.

OnIn ~~October 15,~~determining ~~2003,~~whether weto ~~terminated~~invest in our ~~second~~common ~~building~~stock, ~~lease~~you ~~that~~should ~~would~~carefully ~~have~~consider ~~run~~the ~~through~~information ~~December~~below ~~2003,~~in ~~which~~addition weto ~~had~~all ~~previously~~other ~~subleased~~information provided to you ~~Maxygen~~in this report, ~~Inc.~~ Weincluding ~~received~~the ~~full~~information ~~payment~~incorporated ~~from~~by ~~Maxygen,~~reference ~~Inc~~in this report. ~~for~~The statements under this ~~early~~caption ~~termination, and~~are inintended ~~turn~~to ~~paid~~serve ~~the~~as ~~remaining~~cautionary statements ~~lease~~within ~~amount~~the tomeaning of the ~~property~~Private ~~owner.~~Securities ~~This~~Litigation ~~early~~Reform Act ~~termination~~of ~~was~~1995. ~~unrelated~~The following information is not intended to ~~our~~limit ~~litigation~~in ~~with~~any ~~Sankyo~~way ~~Pharma~~the characterization ~~and~~of ~~Sankyo~~other statements or information under other captions as ~~Japan~~cautionary statements for such purpose.

OnRisks ~~October 16,~~Related ~~2003, we responded~~ to ~~Sankyo~~Our ~~Pharma’s request for~~Business ~~assurances under California Commercial Code, Section 2609(1). Sankyo Pharma~~ ~~had notified us, as well as certain health care professionals, that they will~~ ~~continue to provide marketing, sales, and distribution support for our~~ GlucoWatch G2 Biographer; however, given their decision to stop performing under their contracts with us and our litigation, the commercial status of our products in the United States is unclear. We have begun looking at alternative sales, marketing and distribution approaches for our products.

14 We must enter into a strategic alliance or be acquired in the near future.

~~Table~~ We ofdo ~~Contents~~not have the cash resources or infrastructure to perform sales, marketing and distribution functions ourselves. Under our current situation, we must conserve and generate cash to finance our operations. Our ability to continue as a going concern beyond March 31, 2005 is dependent on our ability to generate sufficient cash flow to fund our operations and meet our debt and other obligations on a timely basis and to continue to keep expenses as low as possible. There is no certainty, however, that we will be able to generate sufficient cash or to keep our expenses low enough.

OnWe ~~October 31,~~continue ~~2003,~~to weevaluate ~~completed~~alternative ~~our~~means ~~PMA~~of ~~supplement~~financing ~~submission~~ to ~~the~~meet ~~FDA for~~ our ~~third-generation product. This improved Biographer and AutoSensor~~needs ~~system~~on ~~reduces~~terms ~~the~~that ~~number~~are ofacceptable ~~skipped glucose measurements while maintaining the accuracy of the glucose data reported~~ to ~~the user and also increases the percentage of successful calibrations after the two-hour warm-up period~~us. ~~We expect that this system will receive FDA approval in first quarter 2004~~However, ~~although~~ ~~there~~we ~~can~~may be nounable ~~assurances~~to ~~that~~obtain necessary ~~this~~financing ~~approval~~on ~~will~~favorable ~~occur~~terms inor ~~this time frame, it~~ at all. ~~Additionally~~For example, ~~the~~we ~~FDA~~may isneed ~~currently~~to enter ~~reviewing~~into ~~our PMA~~financing ~~supplement~~arrangements ~~for~~or ~~pre-treatment~~modify ~~with~~our ~~certain~~existing ~~topical~~payment ~~corticosteroids~~obligations that ~~show~~may ainclude ~~reduction~~sales inof ~~skin~~our ~~irritation~~common ~~while~~stock ~~maintaining~~at ~~the accuracy~~significant ofdiscounts ~~our~~to ~~products.~~the market Weprice, ~~cannot~~as ~~predict~~well ~~when~~as ~~this~~causing ~~supplement~~significant ~~will be~~dilution ~~approved,~~to ifour ~~at all~~existing stockholders.

~~Effective~~We ~~November 3,~~have ~~2003,~~been weseeking ~~entered~~a ~~into~~comprehensive ~~agreements~~sales, ~~with Sanofi-Synthelabo~~marketing toand ~~extend~~distribution partner bysince ~~one~~October 2003; ~~year~~however, ~~the~~there ~~periods~~are ofno ~~time~~interested ~~for~~parties ~~payment~~at ~~of the~~this ~~remaining~~time. ~~arbitration~~We ~~obligations~~are ~~pursuant~~exploring to the ~~Final~~possibility ~~Award~~of ~~issued~~selling ~~against Cygnus by~~ the ~~International~~Company ~~Court of Arbitration in December 1997 relating~~ to ~~royalties~~ ~~for~~a ~~transdermal hormone replacement therapy systems. Under the~~third ~~Amendment to the Final Arbitration Award~~party, ~~the accrued aggregate remaining liability of $12.0 million for the years 2003, 2004~~ and ~~2005~~we ~~will~~have beretained ~~paid~~First ~~as follows,~~Albany ~~respectively:~~Capital ~~(i) $4~~Inc.~~0 million~~ isto ~~due~~act ~~February~~as ~~2005,~~our ~~(ii) $4.0~~exclusive ~~million~~financial isadvisor ~~due~~in ~~February~~connection ~~2006~~with ~~and~~a ~~(iii)~~possible ~~$4.0 million is due February 2007~~merger, ~~and~~consolidation, ~~Sanofi-Synthelabo~~reorganization, ~~has~~business ~~the~~combination, ~~possibility~~sale of ~~receiving~~a ~~accelerated~~substantial ~~payments~~portion inof ~~the~~our ~~event~~assets weor ~~receive~~sale aof ~~lump-sum~~more ~~cash~~than ~~payment~~50% ~~from~~of our ~~dispute~~stock, ~~with~~or ~~Sankyo~~acquisition ~~Pharma and~~of ~~Sankyo~~the ~~Japan~~Company. There Wecan ~~also~~be ~~entered~~no ~~into~~assurance athat ~~Security~~the ~~Agreement~~Company ~~granting Sanofi-Synthelabo~~will abe ~~subordinate~~purchased ~~security~~or ~~interest~~that inanother strategic ~~all~~alliance ofcan ~~our~~be ~~assets~~obtained ~~(other than U.S. Patents~~ and ~~patent~~additionally ~~applications~~whether ~~then~~any ~~existing~~successor ~~or thereafter arising)~~would tocontinue ~~secure~~with our ~~obligations~~Biographer ~~under the Amendment to the Final Award~~products.

OnIf ~~November 6,~~we ~~2003,~~cannot ~~Sankyo~~enter ~~Pharma~~into ~~filed~~a anstrategic ~~answer~~alliance ~~and~~or ~~cross-claims against~~be usacquired ~~for~~in ~~declaratory~~the ~~relief~~near future, ~~breach~~we ofwill ~~contract,~~need ~~and~~to ~~defamation.~~sell Wesome ~~have not~~or ~~yet~~all ~~filed~~of aour ~~response~~assets, toincluding ~~these~~our intellectual ~~claims.~~property, Wein ~~believe~~which ~~that~~Sanofi-Synthelabo wehas ~~have~~a ~~meritorious defenses~~security interest, to meet ~~the~~our ~~causes~~debt ofobligations. ~~action~~If ~~asserted~~substantial ~~against~~additional usresources byare ~~Sankyo Pharma~~not available, ~~and~~ we ~~intend~~ tomay ~~vigorously~~need ~~defend~~to ~~ourselves~~cease ~~against~~our ~~these~~operations ~~claims. This litigation is in its early stages, however,~~ and isseek ~~therefore~~protection ~~inherently~~under ~~difficult~~the bankruptcy ~~to assess~~laws.

We ~~have~~may ~~incurred~~be ~~substantial~~unable ~~operating~~to ~~losses~~satisfy ~~and~~our ~~negative~~contractual ~~cash~~obligations ~~flows~~and ~~from~~fixed charges. ~~operations~~If ~~since~~we ~~our~~cannot ~~inception,~~pay ~~and~~amounts wedue ~~have~~under ~~used~~these ~~cash~~obligations, ~~from~~we ~~equity~~may ~~and~~need ~~debt~~ to sell ~~supplement~~equity ~~our~~securities, ~~operating~~sell ~~cash~~all ~~flow~~or ~~requirements.~~a Asportion of ~~September 30,~~our ~~2003~~assets, ~~we had~~or ~~cash,~~cease ~~cash~~our ~~equivalents,~~ operations and ~~investments~~seek ofprotection ~~$9.1 million.~~under ~~We expect to incur additional losses from operations in~~ the ~~foreseeable~~bankruptcy ~~future~~laws.

~~With~~As ~~Sankyo~~of ~~Pharma’s decision to stop performing under our Sales~~June 30, ~~Marketing~~ ~~and Distribution Agreement and related contracts~~2004, ~~and~~we ~~their~~had ~~refusal both~~total toliabilities ~~pay receivables in excess~~ of $612.06 million, ~~and to honor the balance~~ of which ~~their~~$5.5 million ~~binding~~were ~~purchase~~current ~~commitment~~liabilities. toWe ~~pay~~owe us $2811.45 million ~~in cash between~~to ~~October 1~~Sanofi-Synthelabo, ~~2003~~payable ~~and~~from ~~March~~February ~~31,~~2005 ~~2004, we will need~~ to ~~conserve~~February 2007, ~~cash~~ and ~~find ways~~$4.5 tomillion ~~generate~~of ~~additional~~this ~~cash~~amount tois ~~finance~~included ~~our~~in ~~operations~~current liabilities. Our ability to ~~continue~~meet asour acontractual ~~going~~obligations ~~concern~~and isother ~~dependent~~liabilities ondepends upon our ~~ability~~future performance, towhich ~~generate~~will ~~sufficient~~depend ~~cash~~upon ~~flow to~~financial, ~~fund~~business ~~our operations~~ and ~~meet~~other ~~our~~factors, ~~debt~~many of ~~and~~which ~~other~~are ~~obligations~~beyond onour ~~a timely basis~~control. ~~Our~~We ~~plans~~may ~~both~~fail to ~~conserve and~~ generate sufficient cash ~~include~~flows in ~~further~~the ~~reduction of~~future ~~our~~to ~~expenses~~cover ~~and~~our ~~raising~~fixed ~~additional~~charges ~~capital.~~or ~~There~~to issatisfy noour ~~certainty,~~contractual ~~however~~obligations. Historically, ~~that~~ we ~~will~~have beexperienced ~~able~~significant tonegative ~~undertake~~cash ~~such measures or that additional~~flows ~~funds~~from ~~will be available to us~~operations. InIf ~~addition,~~ we docannot ~~not believe we will be able to~~ generate ~~additional~~sufficient cash ~~from~~flows ~~product sales~~ in ~~any~~the ~~significant~~future ~~amounts in~~to ~~the~~permit ~~near~~us ~~term~~to ~~since~~satisfy ~~Sankyo~~our ~~has~~contractual ~~been,~~obligations asor ato ~~practical~~cover ~~matter,~~ our ~~only distribution~~fixed ~~channel. We are currently pursuing various strategic options,~~charges ~~including~~or, ~~but~~we ~~not~~may ~~limited~~need to ~~pursuing~~sell aequity ~~new~~securities ~~partnership and/~~or ~~selling~~sell ~~some~~all or ~~all~~ a portion of our assets ~~and intellectual property~~. IfWe ~~substantial~~may ~~additional resources are~~ not ~~available,~~successfully wecomplete ~~may~~any ~~need~~of tothese ~~cease~~courses ~~our~~of ~~operations~~action. ~~and/or~~In ~~seek~~the ~~protection~~event ~~under~~of ~~the~~insolvency, bankruptcy, ~~laws.~~liquidation, ~~These~~reorganization, ~~conditions~~dissolution ~~raise substantial doubt~~or ~~about~~winding-up of our ~~ability~~business toor ~~continue~~upon asdefault aor ~~going~~acceleration ~~concern~~related ~~after~~to ~~March 31~~our obligations, ~~2004.~~our assets would

~~Critical Accounting Policies~~14

TheTable preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates. Although there are numerous policies associated with the preparation of our financial statements, the following policies are currently considered critical because of the level of management’s estimates and judgments required. Contents

~~Revenue~~first ~~Recognition~~be available to pay the amounts due under our obligations. Holders of our common stock would only receive any assets remaining after satisfaction in full of all obligations and preferred stock liquidation preferences, if any.

~~Product~~We ~~revenues~~have ~~are~~historically ~~generated~~incurred ~~upon~~substantial ~~the~~losses, ~~sale~~have ofa ~~our~~history ~~GlucoWatch Biographer~~of ~~and~~operating ~~GlucoWatch~~losses, ~~G2 Biographers~~ and ~~related~~have ~~accessories~~an inaccumulated ~~the United States and the United Kingdom~~deficit. ~~The~~We ~~GlucoWatch~~expect ~~Biographer systems consist of two integrated~~continued ~~parts:~~operating ~~the durable Biographer and the disposable, single-use AutoSensor~~losses. ~~After~~ ~~the~~

15 We had a net loss of $2.8 million for the six months ended June 30, 2004. At June 30, 2004, our accumulated deficit and stockholders’ equity were $250.1 million and $5.2 million, respectively. We have experienced operating losses since our inception, and we expect to continue to incur operating losses at least until we have significant product sales, if we ever do. We may fail in our efforts to enter into a strategic alliance or to be acquired in the near future. Our Biographer products may never gain market acceptance, and we may never generate significant revenues or achieve profitability.

~~Table~~ We ofhave ~~Contents~~recently experienced a significant reduction in our workforce, which has had a material impact on our ability to manufacture our products and conduct research and development on future products.

~~initial~~ On ~~sales~~October 9, 2003, we announced a reduction in force of approximately 60% of our workforce and, as of June 30, 2004, we had 24 employees. Because of the magnitude ~~Biographers~~of the workforce reductions, ~~revenues~~these ~~will~~layoffs ~~continue~~have had a material adverse impact on our ability to bemanufacture ~~recorded~~our products and our ability to ~~upon~~conduct research and development and to expand our operations in the ~~sale~~future to meet the potential needs of ~~additional~~our ~~AutoSensors~~customers. As a result of this reduction in force, we are not currently producing any products and ~~accessories~~our manufacturing and research and development operations have been suspended. Additionally, if we were to ~~support~~enter into a strategic alliance or are acquired in the near future, we ~~installed~~or ~~base~~our successor would need to hire additional employees to learn core competencies in Biographer manufacturing and research and development. We or our successor may fail in efforts to hire such employees or to learn the level of ~~Biographers~~expertise that we possessed in these areas prior to our reductions in force.

~~Product~~If ~~sales~~we are recorded when all of the following conditions have been met: product has been shipped, transfer of title has taken place, there is persuasive evidence of an arrangement, the price is fixed or determinable, and collection is reasonably assured. Revenues generated from our shipments of sample and practice Biographers are recognized when all the above conditions are met, typically upon delivery of these products to ~~Sankyo~~recommence ~~Pharma~~manufacturing, aswe ~~the sales~~may ~~of such products are~~ not ~~subject~~be toable ~~future pricing adjustments. With regard~~ to ~~product~~do ~~sales~~so ~~that~~in ~~were made directly by us to third parties, from~~a ~~time~~timely toor ~~time~~cost-effective wemanner ~~allowed customers to return product for credit. In such instances, we deferred revenue until the return period expired. We accrue for estimated warranty costs~~ and ~~other~~also ~~allowances~~may ~~when the revenues from product sales are recognized. The warranty expenses recorded to date have~~ not ~~been significant~~be ~~and~~able ~~are within historical estimates. Revenues in the United States generated from our shipments of product~~ to ~~Sankyo~~obtain ~~Pharma for resale under our Sales, Marketing and Distribution Agreement were deferred until~~ the ~~product was~~ ~~sold~~necessary byBiographer ~~Sankyo Pharma to its third-party customers, because the net price of our product sales to Sankyo Pharma was subject to certain pricing adjustments, such as rebates, discounts~~ and ~~certain~~AutoSensor ~~fees~~components ~~offered~~from ~~or paid by Sankyo Pharma to its~~ third-party ~~customers~~suppliers.

~~Our~~Prior ~~contract~~to ~~revenues~~suspension ~~may~~of ~~include~~our ~~up-front and/or interim milestone payments from co-promotion; sales~~manufacturing, ~~marketing~~we ~~and~~had ~~distribution;~~very ~~and~~limited ~~development~~medical ~~agreements.~~device ~~Milestone~~manufacturing ~~payments~~experience ~~are~~and ~~recorded~~depended ason ~~revenue~~third-party ~~based~~suppliers onfor the ~~provisions~~ manufacturing of ~~the~~our ~~underlying~~Biographer ~~agreement~~ and ~~the~~AutoSensor ~~estimated~~components. ~~period~~We ofwere ~~continuing obligations,~~responsible ~~generally~~for manufacturing the ~~contract~~GlucoWatch ~~term.~~Biographer Ifand ~~Sankyo~~we ~~Pharma~~contracted ~~had~~with ~~continued~~a ~~to perform under~~third ~~our Sales~~party, ~~Marketing~~Corium ~~and Distribution Agreement and related contracts~~International, ~~the $25~~Inc.~~0 million~~ into ~~milestones~~manufacture ~~already~~our ~~received~~AutoSensors. ~~under the Co-Promotion Agreement and the Sales~~Thus, ~~Marketing~~we ~~and Distribution Agreement was to be recognized as~~were ~~revenue~~dependent ~~over~~upon ~~the~~Corium ~~initial~~International ~~12-year~~for ~~term~~such ofmanufacturing. ~~our~~Our ~~contractual~~products ~~relationship (from~~must ~~April 1,~~be ~~2002~~manufactured ~~until~~in ~~April 1,~~compliance ~~2014),~~ with noregulatory ~~recognition of revenue until April 1~~requirements, ~~2005,~~in ~~since~~a ~~the~~timely ~~milestone payments might have needed to be repaid before~~manner ~~then~~and ifin ~~the~~sufficient ~~agreement~~quantities, ~~was~~while ~~terminated~~maintaining ~~because~~product ~~(1) we~~performance ~~could~~and ~~not supply product~~quality ~~for~~and a ~~specified~~commercially ~~period~~feasible cost of ~~time,~~manufacturing. orGiven ~~(2) our product was recalled or withdrawn from~~ the ~~market~~current ~~for a specified period~~ suspension of ~~time~~manufacturing, orit ~~(3) there~~will ~~was~~take atime ~~change of control~~ and ~~our~~extra ~~successor~~resources inif ~~interest~~we ~~terminated~~are ~~our~~to ~~agreement with Sankyo~~recommence ~~Pharma~~such manufacturing. ~~Consequently~~Furthermore, ifwe ~~the~~may ~~agreement~~encounter ~~had~~additional ~~run~~problems ~~its~~if ~~full~~we commence ~~initial~~commercial ~~term~~manufacturing of ~~12 years,~~our ~~the~~third-generation ~~milestone~~product, ~~amounts would have been recognized~~ as ~~revenue~~we ~~beginning~~have ~~April 1,~~not ~~2005~~manufactured ~~and~~this ~~continuing~~product ~~over~~in ~~the~~large ~~remaining 12 years~~quantities. InAlternatively, ~~light~~we ofmay ~~the~~decide ~~litigation~~to ~~with~~convert ~~Sankyo~~existing ~~Pharma~~G2 ~~and~~Biographers ~~Sankyo~~into ~~Japan~~third-generation Biographers, ~~the~~but ~~timing of revenue~~we ~~recognition~~may ~~for~~not ~~the~~be ~~milestones~~successful ~~may~~in beour ~~subject~~attempts to ~~adjustment~~do so.

Our ~~contract~~Biographer ~~revenues~~and ~~also~~AutoSensor ~~include~~were ~~payments~~manufactured ~~received~~from ~~pursuant~~components purchased from outside suppliers, most of which were our single source for such components. Some of these companies are small enterprises that may encounter financial difficulties because of their size. Prior to ~~research~~our suspension of ~~grants~~manufacturing, we were notified by one of our sole-source component suppliers that they were encountering financial difficulties. ~~Revenues~~Although we have maintained our existing supply contracts with such third parties (e.g., Hydrogel Design Systems, Inc., Key Tronic Corporation, Sanmina Corporation and E.I. du Pont de Nemours and Company, among others), we do not have contracts with all our suppliers and, given the suspension in our manufacturing, even suppliers with contracts would perhaps need additional time and resources to produce such components were we to instruct them to recommence supply. Even after recommencing manufacturing, if we are ~~recognized~~able ~~based~~to ondo so (and there is no assurance that we will be able to do so), if we cannot, for whatever reason, obtain these components from our suppliers or if the ~~performance~~components obtained from these suppliers do not pass quality standards, we will be required to obtain the components from alternative suppliers. Additionally, in the event a current supplier is unable to meet our component requirements, we might not be able to rapidly find another supplier of the particular component or an alternative ~~grant~~supply ~~contract~~of ~~and~~the asparticular ~~reimbursable~~component ~~expenses~~at ~~are~~the ~~incurred~~same price or lead time. Any interruption in the supply of Biographer or AutoSensor

~~Inventory Valuation~~15

InventoryTable is stated at standard cost adjusted to approximate the lower of actual cost (first-in, first-out method) or market, after appropriate consideration is given to obsolescence and inventory in excess of anticipated future demand. However, due to the early stage of our product commercialization activities, the estimates required in inventory valuation, including production yields and normal capacity, labor costs incurred in the production of each unit and overhead costs applicable to manufacturing operations, are inherently uncertain. Thus, actual results may differ from those estimates. Also, the valuation of our inventory, as well as reserves for replacement costs for stale-dated AutoSensors held by Sankyo Pharma, depends significantly upon estimates related to our litigation with Sankyo Pharma and Sankyo Japan, and these estimates may substantially change over the course of the litigation. Contents

~~Prior~~components toor ~~the~~excessive ~~approval~~pricing ~~by the FDA~~ of ~~our~~these ~~product~~components ~~and~~could ~~our~~prevent ~~commercial processes,~~us ~~material was generally charged to research and development expenses~~from ~~upon~~manufacturing ~~receipt~~our ~~and~~products ~~was not carried as inventory~~ in the ~~financial~~future ~~statements. Accordingly,~~or atcould ~~and~~adversely ~~for~~affect ~~the~~our ~~nine months ended September 30, 2003, inventory values and the costs of product revenues do not include previously expensed material~~margins.

~~Impairment~~ Third-party manufacturing contractors and component suppliers may, for competitive reasons, support directly or indirectly a company or product that competes with one of ~~Long~~our products. If such a third party terminates an arrangement, cannot fund or otherwise satisfy its obligations under its arrangements or disputes or breaches a contractual commitment, then we would likely be required to seek an alternative third-~~Lived~~party ~~Assets~~manufacturer or supplier. If we were unable to find a replacement third party, our capital requirements could increase substantially and our business and financial condition could be materially adversely affected. If we were required to develop our own capabilities, we would continue to incur significant start-up expenses and we would compete with other companies that have experienced and well-funded operations.

16 To date, our products have not been widely accepted by the market and there is substantial uncertainty relating to product availability, warranty fulfillment, and the like.

~~Table~~ We have focused our efforts on a line of ~~Contents~~frequent, automatic and non-invasive glucose monitoring devices based on novel technologies. To date, the market has not widely accepted our continuous-type monitoring products that measure glucose from interstitial fluid, perhaps because our products are different from the established blood glucose episodic (“non-continuous”) monitors commercially available and also require additional workload and training. In addition, because our products are based on novel technologies, there can be no assurance that unforeseen problems will not develop with these technologies or that we will be able to successfully address technological challenges that we may encounter.

WeGiven ~~review~~the ~~equipment~~uncertainty ~~and~~of ~~improvements~~whether ~~and~~we ~~other~~will ~~long-lived~~enter ~~assets~~into ~~for impairment~~a ~~whenever~~strategic ~~events~~ alliance or ~~changes~~be inacquired, ~~circumstances~~physicians ~~indicate that the carrying amount of an asset~~ may ~~not~~ be ~~recoverable.~~hesitant ~~Recoverability~~to isprescribe ~~measured by~~our ~~comparison~~products offor ~~carrying~~their patients ~~amount~~and ofpatients ~~the~~may ~~assets~~be reluctant to ~~future~~buy ~~net~~our ~~cash~~products. ~~flows~~Our ~~that~~financial ~~the~~situation ~~assets~~has ~~are~~already ~~expected~~caused tosubstantial ~~generate.~~uncertainty Ifrelating ~~such assets are considered~~ to beproduct ~~impaired~~availability, ~~the~~warranty ~~impairment is recognized and is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets~~fulfillment, ~~evaluated~~ ~~by considering the present value of future net cash flows. In light of our litigation with Sankyo Pharma~~ and ~~Sankyo Japan,~~ the ~~amount of these assets may be subject to future adjustments~~like.

~~Results~~ If patients do not receive reimbursement from third-party health care payors, we may be unsuccessful in selling our products to a broad range of customers, ~~Operations~~and we ourselves do not have the capabilities to seek reimbursement for our products.

~~Our~~Successful ~~results~~commercialization of ~~operations~~our ~~have~~products ~~fluctuated~~will ~~from~~depend ~~period~~in tolarge ~~period~~part ~~and are~~on ~~expected~~whether topatients ~~continue~~who topurchase ~~fluctuate~~our inproducts ~~the~~will ~~future~~be ~~based~~reimbursed ~~upon~~for the ~~progress and~~expense ~~ultimate~~by ~~outcome~~third-party ofpayors, ~~our~~which ~~litigation~~include ~~with~~private ~~Sankyo~~insurance ~~Pharma~~plans, Medicare, Medicaid and ~~Sankyo~~other ~~Japan,~~federal ~~the demand~~health ~~for~~care programs. Currently, our products, ~~product~~do ~~revenues~~not have ~~and~~widespread ~~our~~reimbursement. ~~costs~~Third-party ofpayor ~~product~~reimbursement ~~revenues,~~for asour products ~~well~~are asoccurring ~~the~~on ~~level~~a ofplan-by-plan ~~our~~and ~~expenses~~often ~~during~~case-by-case ~~any~~basis. ~~given~~There ~~period.~~can ~~Historical~~be ~~results~~no ~~should~~assurance ~~not~~that besuch ~~viewed~~reimbursement aswill ~~indicative~~be ofavailable ~~future~~in ~~operating~~a ~~results.~~sufficient Wetime ~~are also~~frame, ~~subject~~or toat ~~risks~~all. ~~common~~To toobtain ~~companies~~such inreimbursement, ~~our~~we ~~industry~~will ~~and~~need atto ~~our~~have ~~stage~~a ofpartner who has ~~development,~~substantial ~~including~~expertise ~~risks~~and ~~inherent~~resources in ~~our~~managed ~~litigation~~care ~~with~~so ~~Sankyo~~as ~~Pharma~~to ~~and~~work with ~~Sankyo~~third-party ~~Japan~~health ~~and~~care ~~our~~payor ~~need~~organizations to ~~find~~obtain ~~alternative~~broad ~~approaches~~reimbursement coverage. ~~for~~We do not have the ~~sales~~resources, ~~marketing~~ ~~and~~expertise ~~distribution~~or ofinfrastructure ~~our~~to ~~products~~perform such infunctions ~~the~~ourselves. ~~United~~Third-party ~~States;~~payors, ~~enforcement~~including ~~of our~~federal ~~patents~~health care programs and ~~proprietary~~managed ~~rights;~~care ~~need~~and ~~for~~other ~~future~~private ~~capital~~insurance plans, ~~particularly~~are inincreasingly ~~light~~seeking ofto ~~our~~contain ~~stock~~health ~~currently~~care ~~being~~costs ~~listed~~by onlimiting the ~~OTC~~coverage ~~Bulletin~~of, ~~Board;~~and ~~potential~~the ~~competition;~~amount ~~and~~of ~~uncertainty~~reimbursement offor, ~~future~~new ~~regulatory~~diagnostic ~~approvals~~products. WeAs ~~have~~a result, adequate ~~experienced~~levels ~~operating~~of ~~losses~~reimbursement ~~since~~may ~~our~~not ~~inception,~~be ~~and~~available wefor ~~expect~~patients, tomany ~~continue~~of towhom may ~~incur~~therefore ~~operating~~not ~~losses~~purchase atour ~~least~~products. ~~until~~If wemeaningful ~~have~~reimbursement ~~significant~~from third-party ~~product~~payors ~~sales~~is not available, or if wethe process of obtaining such ~~ever~~reimbursement ~~do.~~takes Wetoo ~~had~~long, awe ~~net~~may ~~loss~~not ofbe ~~$21.7 million~~able ~~for~~to ~~the~~achieve ~~nine~~a ~~months~~level ~~ended~~of ~~September~~market ~~30,~~acceptance ~~2003.~~of Atour ~~September 30~~products, ~~2003,~~and ~~our~~we ~~accumulated~~may ~~deficit~~not ~~and~~be ~~our~~able ~~stockholders’~~to maintain price levels ~~net~~sufficient ~~capital~~to ~~deficiency~~realize ~~were~~an ~~$318.4 million~~adequate ~~and~~return ~~$64.3 million,~~on ~~respectively~~our investment.

~~Comparison~~ Our ~~for~~product pipeline is severely limited, so the ~~Three~~failure ~~Months~~of ~~and~~the ~~Nine~~market ~~Months~~to accept ~~Ended~~our ~~September 30,~~glucose ~~2003~~monitoring ~~and~~products could result in the failure of our ~~2002~~entire business.

~~Net~~We ~~product~~are ~~revenues~~exclusively ~~for~~focused ~~the~~on ~~three~~a ~~months~~line ~~ended~~of ~~September 30~~frequent, ~~2003~~automatic ~~were~~and ~~$1.0 million,~~non-invasive ~~compared~~glucose tomonitoring $1devices.~~5 million~~ ~~for~~To ~~the~~be ~~three months ended September 30~~successful, ~~2002.~~ ~~Net~~we ~~product~~will ~~revenues~~need ~~for the nine months ended September 30, 2003 were $1.8 million, compared~~ to ~~$1.8 million for the nine months ended September 30,~~ ~~2002.~~continue ~~Net product revenues recognized for the three months and nine months ended September 30, 2003 resulted from sales by Sankyo Pharma~~ to ~~its third-party~~develop ~~customers~~glucose ofmonitoring ~~our~~products ~~GlucoWatch~~that ~~Biographers~~address in the ~~United~~needs ~~States, which~~of ~~had~~people ~~been deferred in previous periods in accordance~~ with ~~our~~diabetes; ~~revenue recognition policy~~however, asin ~~well~~light asof ~~from~~ our ~~sales~~recent toreduction ~~Sankyo~~in ~~Pharma~~force ~~of practice~~ and ~~sample~~expenses ~~Biographers.~~associated ~~Net~~with product ~~revenues~~research ~~for the three months ended September 30, 2002~~ and ~~nine months ended September 30~~development, ~~2002 resulted from~~ our ~~initial sales~~ability ~~of the GlucoWatch Biographer in the United States and the United Kingdom.~~to ~~Although~~produce ~~the~~new ~~revenues~~products ~~recognized~~has ~~for~~been ~~the~~materially ~~nine months ended September 30, 2003 and 2002 were similar, revenues for a greater number of AutoSensors were recognized for the nine months ended September 30, 2003~~impaired. ~~Most~~Our ofthird-generation ~~the~~ product ~~revenues~~has inbeen ~~2003~~approved ~~related to sales~~ by ~~Sankyo~~the ~~Pharma recognized net of sales and marketing commissions~~FDA, ~~however,~~but ~~most~~we ofcurrently ~~the~~cannot ~~AutoSensor~~make ~~sales~~plans ~~recognized~~ for ~~the~~its ~~nine~~commercialization ~~months~~or ~~ended September 30, 2002 were~~ for ~~direct~~converting ~~sales~~our byG2 usBiographers to ~~end~~third-~~user~~generation ~~customers.~~products ~~Our~~unless ~~recognized revenue was significantly reduced by sales and marketing commissions~~ we ~~owed~~enter tointo ~~Sankyo~~a ~~for~~strategic ~~their~~alliance ~~increased~~or ~~responsibilities~~are acquired in ~~2003.~~ ~~Deferred sales and marketing commissions for~~ the ~~nine months ended~~near ~~September 30, 2003 were $1.8 million, compared to $167,000 for the nine months~~future; ~~ended September 30, 2002.~~

~~Unit shipments of the GlucoWatch Biographers for the three and nine months~~16 ended September 30, 2003 were 2,346 and 7,558, respectively. For the three months ended September 30, 2003, substantially all of the Biographers were sample Biographers sold to Sankyo Pharma. During the three and nine months ended September 30, 2003, we shipped approximately 413,000 AutoSensors and 891,000 AutoSensors, respectively, substantially all of which were shipped to Sankyo Pharma. The total invoice amount of our Biographer, AutoSensor and accessory shipments for the three and nine months ended September 30, 2003 was $2.9 million and $7.6 million, respectively. In accordance with our revenue recognition policy, however, for the three and nine months ended September 30, 2003, we have deferred product revenues related to product shipments of approximately $2.2 million and $6.5 million, respectively. The amount of deferred product revenues recognized as revenues is subject to further adjustments for commissions owed to Sankyo Pharma and other pricing adjustments.

ContractTable revenues for the three months ended September 30, 2003 were $65,000, compared to $104,000 for the three months ended September 30, 2002. Contract revenues for the nine months ended September 30, 2003 were $217,000, compared to $352,000 for the nine months ended September 30, 2002. Contract revenues for the three months ended September 30, 2003 and 2002 were related to our National Institutes of Health (NIH) Small Contents

17however, a successor may choose to discontinue our Biographer products. Furthermore, without additional resources, we are not currently able to work on developing future glucose monitoring products.

~~Table~~ We ofmay ~~Contents~~be subject to product recalls or product liability claims that are costly to defend and could limit our ability to sell our products in the future or could damage our reputation.

~~Business~~ The ~~Innovative~~design, ~~Research~~development, ~~(SBIR)~~manufacture and use of our medical products ~~Phase~~involve Ian &inherent IIrisk ~~grant.~~of ~~Revenues~~product ~~related~~recalls toand ~~our~~product ~~NIH~~liability ~~grant~~claims ~~are~~and associated ~~recognized~~adverse aspublicity. Makers of medical products may face substantial ~~research~~liability ~~activities~~for ~~are~~damages ~~performed~~in the event of product failure or allegations that the product caused harm. ~~The~~Product ~~decrease~~liability insurance is ~~due~~expensive and, although we presently have such insurance, it is difficult to ~~the~~maintain ~~amount~~as ~~set~~well as to expand ~~forth~~coverage under it. We may become subject to product liability claims, our current insurance may not cover such claims and adequate insurance may not be available on acceptable terms in the ~~grant~~future. We also could be held liable for damages ~~each~~in ~~period~~excess of ~~time~~the limits of our insurance coverage. Regardless of insurance coverage, any claim or product recall could result in us stopping to sell our products and could create significant adverse publicity that might harm our credibility and decrease market acceptance of our products.

~~Costs~~We ofmay ~~product~~not ~~revenues~~continue ~~for the three months ended September 30, 2003 were $7.5 million, compared~~ to ~~$1.3 million~~receive ~~for~~regulatory ~~the~~approval ~~three months ended September 30, 2002. Costs~~ of ~~product~~our ~~revenues~~products ~~for the nine months ended~~from ~~September 30, 2003 were $12.6 million, compared to $3.6 million for~~ the ~~nine months~~FDA ~~ended~~or ~~September 30,~~foreign ~~2002~~agencies. ~~Costs~~If ofwe ~~product~~do ~~revenues~~not ~~for~~receive ~~the~~regulatory ~~three~~approval ~~months ended~~from ~~September 30, 2003 consisted of material, underabsorbed indirect overhead (including~~ an ~~$831~~ agency,~~000~~ ~~write-off~~we ofwill ~~prepaid~~not ~~component~~be ~~orders~~able to ~~one~~sell of our ~~sole~~ ~~source component suppliers) and other production costs associated with the manufacturing of our~~ products ~~and~~or agenerate ~~write-off~~revenue ofin ~~approximately $4.9 million of~~that ~~inventory resulting from Sankyo Pharma~~agency’s ~~decision to stop performing under our Sales, Marketing and Distribution Agreement and related contracts as well as their instructions to stop product shipment to them~~jurisdiction. ~~Costs of product revenues~~ ~~were also higher for the three and nine months ended September 30, 2003 because~~ ~~costs were recognized on a greater number of AutoSensors compared to the~~ ~~equivalent periods of 2002.~~

The ~~consumable~~design, ~~components of our device~~manufacturing, ~~the AutoSensors~~labeling, ~~currently~~distribution ~~have shelf~~and ~~lives~~marketing of 18our products ~~and~~are ~~24 months,~~subject ~~depending~~to ~~upon~~extensive ~~when~~and arigorous ~~lot~~government ~~was~~regulation ~~produced.~~in ~~Under~~ the United ~~terms~~States ofand ~~our~~certain ~~agreement~~other ~~with~~countries ~~Sankyo~~where ~~Pharma,~~the ifprocess ~~requested,~~of weobtaining ~~were~~and maintaining required to ~~replace~~regulatory ~~AutoSensors~~clearance ~~that~~or ~~they~~approvals ~~have~~is ~~not~~lengthy, ~~sold~~ expensive and ~~that~~uncertain. ~~become~~The ~~stale-dated (have~~FDA ~~less~~may ~~than~~not ~~six~~approve ~~months~~additional offuture ~~shelf~~enhancements ~~life remaining). Based on Sankyo Pharma’s~~and ~~inventory~~possible ~~and~~manufacturing ~~our~~changes, ~~estimates~~if ofany, ~~Sankyo Pharma’s sales~~ to ~~its~~the ~~third-party customers,~~Biographers weand ~~have~~the ~~accrued estimated costs of replacing stale-dated~~ AutoSensors inor ~~the~~it ~~second~~may ~~quarter~~require ofus ~~2003. Such additional cost accruals amounted~~ to ~~$1.4 million,~~file ofone ~~which~~or ~~approximately~~more ~~$821,000~~new isPMA ~~included~~applications asrather ~~a component of~~than ~~“Deferred~~allowing ~~revenues~~us ~~from~~to ~~Sankyo~~supplement ~~Pharma~~our ~~net~~existing ofPMA ~~deferred~~application. ~~costs~~Even ofif ~~product shipments” and~~ the ~~remaining~~FDA ~~$554,000, the amount by which the original cost~~grants ~~and~~us ~~replacement~~expedited ~~cost~~review ofstatus ~~the~~on ~~AutoSensors~~an ~~would~~application ~~exceed~~for ~~revenues~~approval, ~~has~~obtaining ~~been~~approval ~~recorded as additional costs~~ of ~~product~~a ~~revenues~~PMA ~~because~~or ~~the~~a ~~total~~PMA ~~cost~~supplement ofcould ~~the original~~take ~~AutoSensors~~a ~~and~~substantial ~~the~~period ~~estimated cost~~ of ~~the~~time, ~~replacement~~and ~~AutoSensors were~~the ~~expected~~FDA tomay ~~exceed~~not ~~our~~ultimately ~~sales~~grant ~~price~~such ~~of these products to Sankyo Pharma~~approval. ~~These additional~~Moreover, ~~costs~~even ~~have~~if ~~been included in costs of product revenues for the nine~~regulatory ~~months~~approval ~~ended~~is ~~September 30~~granted, ~~2003.~~such ~~Whether~~approval wemay ~~will~~include ~~need~~significant tolimitations ~~replace any~~on ~~stale-dated~~intended ~~AutoSensors~~uses ~~depends~~for ~~upon~~which ~~the~~any ~~resolution~~such ofproducts ~~our~~could ~~dispute~~be ~~with Sankyo Pharma and Sankyo Japan~~marketed.

~~Under~~A ~~normal~~medical ~~commercial~~device ~~circumstances~~and its manufacturer are subject to continual review after approval, weand ~~would~~later ~~expect~~discovery ~~our~~of previously unknown problems with a product ~~margin~~or the manufacturing process may result in restrictions on such product toor ~~vary~~the manufacturer, including withdrawal of the product from ~~period~~the market. Failure to ~~period~~comply ~~due~~with toapplicable ~~the~~regulatory ~~mix~~requirements may result in, among other things, fines, suspensions of ~~products~~regulatory ~~sold~~approvals, iproduct recalls, operating restrictions and criminal prosecution.e In addition, new government regulations may be established that could delay or prevent regulatory approval of our potential products. We are also subject to federal, state and local ~~Biographers~~regulations regarding workplace safety, ~~AutoSensors~~environmental protection and ~~accessories~~hazardous material controls, among others, and ~~demand~~failure ~~fluctuations~~to incomply ~~the~~with these regulations ~~utilization~~may ofresult ~~our~~in ~~manufacturing~~similar ~~facilities~~consequences.

~~For~~If ~~the three months ended September 30, 2003,~~ we ~~deferred~~fail ~~costs of product revenues of approximately $1.2 million related~~ to ~~product shipped~~adequately ~~during~~protect ~~this period, and these costs appear as a component of “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” in the liability section of~~ our ~~condensed~~intellectual ~~consolidated balance sheet. For the nine months ended September 30~~property, ~~2003, we deferred costs of product revenues of approximately $4.2 million related to deferred product revenues shipped and of approximately $821,000 related to~~ our ~~estimate for stale-dated AutoSensor replacement. Costs~~ ofcompetitive ~~product~~position ~~revenues~~could ~~did~~be ~~not include certain material and other product costs previously written off as research and development or obsolete expenses~~harmed. ~~If we~~ ~~were to have included material and other product costs previously written off~~ ~~that were later used in the manufacture of our product, our costs of product~~ revenues at current production levels would have been $130,000 greater than the reported amounts for the three months ended September 30, 2003 and $834,000 greater than the reported amounts for the three months ended September 30, 2002. For the nine months ended September 30, 2003 and 2002, these costs would have been $379,000 and $1.2 million higher, respectively. Manufacturing costs included in the cost of each unit are greater at low unit volumes, such as have occurred during initial commercialization in the United States. Any future adjustments of “Deferred revenues from Sankyo Pharma net of deferred costs of product shipments” reflected on our condensed consolidated balance sheet at September 30, 2003 will depend upon the resolution of our dispute with Sankyo Pharma and Sankyo Japan.

AsDevelopment and protection of ~~September 30,~~our ~~2003,~~intellectual ~~total~~property ~~revenues~~are ofcritical ~~$17~~to our business.~~1 million~~ ~~were~~If ~~deferred~~we do not adequately protect our intellectual property, both ~~along~~in ~~with~~the ~~associated~~United ~~costs~~States ofand ~~$8.1 million.~~abroad, ~~The~~competitors ~~net~~may ~~amount~~be ofable ~~$9.0 million~~to isuse our ~~included~~technologies. onOur ~~our~~success ~~condensed~~depends ~~consolidated~~in ~~balance~~part ~~sheet~~on asour ofability ~~September 30,~~to ~~2003,~~obtain patent ~~under~~protection ~~the~~for ~~caption~~our ~~“Deferred~~products ~~revenues~~and ~~from~~processes ~~Sankyo~~in ~~Pharma~~both ~~net~~the ofUnited ~~deferred~~States ~~costs~~and other ofcountries, ~~product~~protect ~~shipments.”~~trade ~~This~~secrets, ~~balance~~and ~~was~~prevent ~~$8.2 million~~others asfrom ofinfringing ~~December 31,~~on ~~2002~~our proprietary rights.

~~Research~~There are numerous risks and ~~development~~uncertainties ~~expenses~~that ~~for~~we ~~the~~face ~~three~~with ~~months~~respect ~~ended~~to our ~~September 30~~patents and other proprietary rights. Currently, some pending patent ~~2003~~applications ~~were~~in ~~$860~~the United States are maintained in secrecy until issuance,~~000,~~ ~~compared~~and publication toof ~~$4.5 million~~discoveries ~~for~~in the ~~three~~scientific ~~months~~or ~~ended~~patent literature tends to lag ~~September 30~~behind actual discovery by several months. Thus, ~~2002~~we may not have been the first to file patent applications on our inventions. ~~Research~~Our ~~and~~patent ~~development~~applications ~~expenses~~may ~~for~~not ~~the~~issue ~~nine~~into ~~months~~any ~~ended~~patents. ~~September 30~~Once granted, ~~2003~~the ~~were~~claims $4of any issued patents may not afford meaningful protection for our technologies or products.~~1 million~~ In addition, patents ~~compared~~issued to ~~$12.1 million~~ us or our licensors may not provide competitive advantages for ~~the~~our ~~nine~~products ~~months~~or ~~ended~~may ~~September 30~~be challenged by our competitors and subsequently narrowed, ~~2002~~invalidated or circumvented. ~~Research~~Competitors ~~and~~may also independently ~~development~~develop ~~expenses~~similar ~~have~~or ~~decreased~~alternative astechnologies ~~our~~or ~~focus~~duplicate onany ~~our~~of ~~commercialization~~our technologies.

1817

~~efforts~~ Litigation, ~~has~~interference ~~increased~~proceedings, ~~allowing~~oppositions, usre-examinations, toor other ~~spend~~proceedings ~~less~~that onwe ~~material~~may ~~costs~~become ~~related~~involved in with respect to our ~~manufacturing~~proprietary ~~scale-up~~technologies ~~and~~could ~~process~~result ~~development.~~in Insubstantial ~~addition,~~cost weto ~~reversed~~us. ~~our~~Patent ~~bonus~~litigation ~~accrual~~is ~~for~~widespread ~~2003~~in our industry, ~~which~~and ~~had~~any ~~been~~patent ~~$358,000~~litigation atcould ~~June 30,~~harm our ~~2003~~business. NoCostly ~~bonuses are~~litigation ~~expected~~might be necessary to beprotect ~~paid~~our ~~for~~proprietary rights, ~~2003.~~and Wewe ~~expect~~may anot ~~reduction~~have inthe ~~research~~required ~~and~~resources to pursue such litigation or ~~development~~to ~~expenses~~protect our rights. An adverse outcome in litigation with respect to the validity ~~future~~of any of our patents could subject us to significant liabilities to third parties, ~~given~~divert the ~~recent~~attention ~~reduction~~of inmanagement ~~force~~and ~~due~~technical personnel from other business concerns, require disputed rights to be licensed to or from ~~Sankyo~~third ~~Pharma’s~~parties ~~decision~~or require us to ~~stop~~cease ~~performing~~using ~~under~~a ~~our~~product ~~Sales,~~or ~~Marketing~~technology ~~and~~or lose our ~~Distribution~~exclusive ~~Agreement~~rights ~~and~~with ~~related~~respect ~~contracts~~to such technology.

~~Sales,~~We ~~marketing,~~also ~~general~~rely ~~and~~upon ~~administrative~~trade ~~expenses~~secrets, ~~for~~proprietary ~~the~~know-how ~~three~~and ~~months~~continuing ~~ended~~technological ~~September 30,~~innovation ~~2003~~to ~~were~~remain $1competitive.~~3 million,~~ ~~compared~~Confidentiality toagreements ~~$5.2 million for the~~with ~~three~~our ~~months ended September 30~~employees, ~~2002.~~consultants ~~Sales, marketing, general~~ and ~~administrative~~ ~~expenses~~other ~~for~~third ~~the~~parties ~~nine~~with ~~months~~access ~~ended September 30, 2003 were $5.4 million, compared~~ to ~~$14.3 million for the nine months ended September 30,~~proprietary ~~2002.~~information ~~This~~could ~~decrease~~be ~~was primarily due to the assumption by Sankyo Pharma of product promotion~~breached, ~~education,~~ and ~~training~~we ~~programs~~might ~~for~~not ~~health~~have ~~care professionals~~adequate ~~and~~remedies ~~patients, as required under our agreement. In addition, we reversed our bonus accrual~~ for ~~2003, which had been $340,000 at June 30, 2003.~~any Nosuch ~~bonuses are expected to be paid for 2003~~breach. ~~Given~~Additionally, our ~~litigation~~trade ~~with~~secrets ~~Sankyo Pharma~~ and ~~Sankyo~~know-how ~~Japan,~~could ~~we expect an increase in our legal expenses in the~~otherwise ~~future;~~become ~~however,~~known ~~our~~or ~~overall~~be ~~sales,~~independently ~~marketing,~~developed ~~general~~by ~~and~~third ~~administrative expenses are expected to decrease, given the recent reduction in force and other cost-cutting measures~~parties.

~~Interest~~Our ~~and~~products ~~other~~could ~~income~~infringe ~~(expense),~~on ~~net for~~ the ~~three~~intellectual ~~months~~property ~~ended September 30,~~rights ~~2003~~of ~~was $25~~others,~~000,~~ possibly ~~compared~~causing us to ~~$68,000~~engage ~~for~~in ~~the~~costly ~~three~~litigation ~~months ended September 30, 2002. Interest~~ and ~~other income (expense)~~, ~~net~~if ~~for~~we ~~the~~are ~~nine~~not ~~months ended September 30~~successful, ~~2003~~causing ~~was~~us ~~$103,000, compared~~ to ~~$183,000~~pay ~~for~~substantial ~~the~~damages ~~nine months~~and ~~ended~~prohibiting ~~September 30,~~us ~~2002. This decrease was primarily due to the lower~~from ~~yields~~selling onour ~~a lower average balance invested~~products.

~~Interest~~Third ~~expense~~parties ~~for~~may ~~the~~assert ~~three~~infringement ~~months~~or ~~ended~~other ~~September 30,~~intellectual ~~2003 was~~property ~~$516,000,~~claims ~~compared~~against tous ~~$850,000~~based ~~for~~on ~~the~~their ~~three~~patents ~~months~~or ~~ended~~other ~~September 30,~~intellectual ~~2002~~property claims. ~~Interest~~We ~~expense~~may ~~for~~have ~~the~~to ~~nine~~pay ~~months~~substantial ~~ended September 30~~damages, ~~2003~~possibly ~~was~~including ~~$1.6 million~~treble damages, ~~compared~~ ~~to $2.5 million~~ for past ~~the~~infringement ~~nine~~if ~~months~~it ~~ended~~is ~~September 30,~~ultimately ~~2002. Included~~determined inthat ~~interest~~our ~~expense~~products ~~for~~infringe ~~the~~a third ~~nine~~party’s ~~months~~patents. ~~ended September 30~~Furthermore, ~~2003~~we ~~and 2002~~may ~~were~~be ~~the~~prohibited ~~interest~~from ~~accrued~~selling on our products ~~convertible~~before ~~debentures~~we ~~and~~obtain ~~the amortization~~a oflicense ~~the~~that, ~~value~~if ofavailable ~~the~~at ~~warrants~~all, ~~issued~~may inrequire ~~connection~~us to ~~with~~pay ~~our financing~~substantial ~~agreements~~royalties. ~~The~~Even ~~decrease~~if isinfringement ~~primarily~~claims ~~attributable~~against tous ~~the reduction~~are ofwithout ~~the~~merit, ~~interest~~defending ~~rates~~a onlawsuit ~~our~~takes ~~convertible~~significant ~~debentures~~time, ~~from~~may ~~8.5%~~be toexpensive ~~3.5%,~~and ~~effective~~may ~~October 1,~~divert ~~2002,~~management’s ~~based~~attention onfrom ~~our~~other ~~August 21,~~business ~~2002~~concerns ~~amendment~~and toalso ~~the~~divert ~~Convertible~~efforts ~~Debenture~~of ~~and~~our ~~Warrant~~technical ~~Purchase Agreement~~personnel.

~~Provision~~If ~~for~~any ~~income~~of ~~taxes~~our license agreements or other contracts for intellectual property related to ~~U.K.~~our ~~taxes~~products onare ~~income~~terminated inor ~~the~~made ~~three~~non-exclusive, our ~~and~~ability ~~nine~~to ~~months~~develop, ~~ended~~manufacture ~~September 30,~~or ~~2003~~market ~~and~~our ~~2002~~products ~~was~~may ~~not~~be ~~material~~materially impaired.

~~Liquidity~~ We have entered into agreements with third parties, including The Regents of the University of California, for licenses of certain intellectual property related to the Biographers and ~~Capital~~the ~~Resources~~AutoSensors. Pursuant to these agreements, we have been granted rights to certain technologies related to our products. These agreements impose on us specific obligations, including, in the case of the University of California, license fees, royalty payments, and commercialization milestones. If we fail to meet our obligations under any of these agreements, the license or other rights may be terminated or, in the case of an exclusive arrangement, be made non-exclusive. Additionally, in the event we decide to seek bankruptcy protection, patent holders who license their technology to us, including the University of California, may assert rights to terminate their licenses with us or to contest the transfer or sale of such licenses in the bankruptcy process. Although we would challenge any such assertions, there can be no assurance that our challenge would be successful. If any such license or other right is terminated, we may lose our ability to incorporate the applicable technology into our products or to use such technology in the manufacture of our products, possibly impairing our ability to produce or market the GlucoWatch G2 Biographer or other products. If any such license or other right is made non-exclusive, we may be unable to prevent others from developing, manufacturing and marketing devices based on the same or similar technologies.

AsWe ofmay ~~September 30,~~be ~~2003,~~unable ~~our~~to ~~cash,~~build ~~cash~~brand ~~equivalents~~loyalty because our trademarks and ~~investments~~trade ~~totaled~~names $9may not be effectively protected.~~1 million.~~

~~Net~~Our ~~cash~~registered ~~used~~or inunregistered ~~operating~~trademarks ~~activities~~or ~~for~~trade ~~the~~names, ~~nine~~such ~~months~~as ~~ended September~~the ~~30,~~marks ~~2003~~“GlucoWatch” ~~was~~and ~~$15.4 million~~“G2,” ~~compared~~may tobe ~~net~~challenged, ~~cash~~canceled, ~~used~~infringed ~~of $13.7 million for the~~upon, ~~nine~~circumvented, ~~months~~declared ~~ended~~generic ~~September 30,~~or ~~2002.~~determined ~~Cash~~to ~~used~~be ininfringing ~~operating~~on ~~activities~~other ~~during~~marks. ~~the~~We ~~nine~~may ~~months~~not ~~ended~~be ~~September 30,~~able ~~2003~~to ~~was~~protect ~~primarily~~our ~~due~~rights to ~~the~~these ~~net~~trademarks ~~loss from operations of $21.7 million~~ and ~~our~~trade ~~Sanofi-Synthelabo arbitration payments~~names, ~~totaling~~without ~~$3.0 million,~~which ~~partially~~we ~~offset~~may bybe ~~non-cash~~unable ~~charges~~to ofbuild $2brand loyalty.~~6 million~~ ~~of depreciation~~Brand ~~and~~recognition ~~amortization~~is critical ofto ~~fixed~~establish ~~assets~~our ~~and~~products ~~financing~~in ~~costs, and~~ the ~~write-off~~ ofmarketplace, ~~$6.0 million~~especially ofif ~~inventory~~we commercialize ~~and~~future ~~prepaid~~enhancements ~~materials~~to inour ~~2003~~products. ~~Cash~~Moreover, ~~used~~if inour trademarks ~~operating~~are ~~activities~~found ~~during~~to ~~the~~infringe ~~nine~~on ~~months~~marks ~~ended~~belonging ~~September 30,~~to ~~2002~~third ~~was primarily~~parties, ~~due~~we tomay ~~the~~be ~~net~~forced ~~loss~~to market ~~from~~our ~~operations~~products ofunder ~~$30.3 million~~a ~~and~~different ~~our Sanofi-Synthelabo~~name, ~~arbitration~~possibly ~~payments~~requiring ~~totaling~~a ~~$8.4 million,~~costly ~~partially offset~~and bydifficult anre-branding ~~increase~~effort, inand ~~deferred~~we ~~revenue~~could ofbe ~~$20.0 million~~ordered ~~and~~to ~~deferred~~pay ~~margin~~damages ~~on shipments~~to ofa $2third party.~~8 million.~~

~~Net cash provided by investing activities of $2.3 million for the nine~~18 months ended September 30, 2003 resulted primarily from the net sales and maturities of investments of $2.4 million, offset by capital expenditures of $108,000. Net cash provided by investing activities of $3.1 million for the nine months ended September 30, 2002 resulted primarily from the net sales and maturities of investments of $3.7 million offset, by capital expenditures of $563,000.

NetTable cash used in financing activities totaled $2.1 million for the nine months ended September 30, 2003 and reflected the payment to our Convertible Debenture holders of $2.0 million. Net cash provided by financing activities totaled $15.7 million for the nine months ended September 30, 2002 and related primarily to net proceeds of $14.7 million from our 2002 public stock offering. Contents

19 We do business on a very limited basis in the United Kingdom and do not have any plans to enter other international markets; thus, the success of our business depends on our success in the U.S. market.

~~Table~~ We ofcurrently ~~Contents~~sell the GlucoWatch G2 Biographer on a very limited basis in the United Kingdom, which has a National Health Service (NHS); our products are not currently reimbursed by the NHS. We have established a contract with a third-party authorized representative in the United Kingdom, and the product-ordering, logistics, and technical-support functions, although minimal, are handled by us. If we are unable to support these necessary functions or generate sufficient revenues from such sales, we may not be able to continue to sell our products in the United Kingdom. We may never be able to secure necessary commercialization agreements in countries other than the United States and the United Kingdom, despite the fact that we have CE certification in the European Community. If we are unable to secure these necessary agreements for other countries, we may not be able to sell our products or, even if such sales are possible, to broadly launch our products in other countries.

~~The~~Risks ~~level~~Related ofto ~~cash used in operating activities during previous periods is not necessarily indicative of the level of future cash usage.~~ Our ~~long-term~~Industry ~~cash and capital expenditure requirements will depend upon numerous factors,~~ ~~including but not limited to (i) costs and results of our litigation with~~ ~~Sankyo Pharma and Sankyo Japan, (ii) costs associated with seeking and~~ obtaining alternative approaches for the sales, marketing and distribution of our products in the United States, (iii) the amount of prepayments, if any, to our Convertible Debenture holders, (iv) the time required to obtain regulatory approvals, (v) additional expenditures to support the manufacture of new products, if and when approved, (vi) the progress of our research and development programs, if any, and (vii) possible expansion into new markets and acquisitions of products and technologies.

20 Intense competition in the market for glucose diagnostic products could prevent us from increasing or sustaining our revenues and prevent us from achieving or sustaining profitability.

~~Table~~ The medical device industry, particularly the market encompassing our GlucoWatch G2 Biographer, is intensely competitive, and we compete with other providers of ~~Contents~~personal glucose monitors. Currently, the market is dominated by blood glucose monitoring products sold by a few major companies. These companies have established products and distribution channels. In addition, several companies are marketing alternative-site devices to monitor glucose levels in a painless manner or in a manner involving less pain than that associated with finger sticking. Furthermore, companies are developing a variety of methods to extract interstitial fluid and measure the glucose concentration therein, as well as developing devices to monitor glucose on a frequent and automatic basis. At least one such product is now under review by the FDA, and an alarms-only product recently received FDA approval. Another technology that some companies are pursuing utilizes infrared spectroscopy, which uses radiation to measure glucose levels. There can be no assurance that other products will not be accepted more readily in the marketplace than the GlucoWatch Biographer or will not render our current or future devices noncompetitive or obsolete. Additionally, the GlucoWatch G2 Biographer or our third-generation product may fail to replace any currently used devices or systems.

AsFurthermore, a number of ~~September 30~~companies have developed or are seeking to develop new diabetes drugs or treatments that could reduce or eliminate demand for all glucose monitoring systems. In addition, ~~2003~~many of our competitors and potential competitors have substantially greater resources, larger research and development staffs and facilities and significantly greater experience in developing, manufacturing and marketing glucose monitoring devices than we do. Competition within the glucose monitoring industry could result in price reductions for glucose monitoring devices such that we may not be able to sell our ~~contractual~~products ~~obligations~~at ~~are~~a asprice ~~follows:~~level adequate for us to realize a return on our investment.

~~(In~~ Competition ~~thousands)~~for qualified personnel exists in our industry and in northern California. If we are unable to retain or hire key personnel, we may not be able to sustain or grow our business.

	Total		Less than 1 year		1-3 years		4-6 years
Contractual Obligations
Convertible debentures(1)	$	20,281	$	18,281	$	2,000	$
Interest expenses on convertible debentures		602		550		52		—
Capital lease obligations		106		87		19		—
Operating leases(2)		4,978		899		1,722		2,357
Arbitration obligations(3)		12,000		4,000		8,000		—
Amounts to Sankyo Pharma(4)		9,094		6,770		2,324		—
Unconditional purchase obligations		875		875		—		—
Total contractual cash obligations	$	47,936	$	31,462	$	14,117	$	2,357

Our ability to continue as an ongoing business and to enter into a strategic alliance or to be acquired in the near future depends significantly upon retaining our remaining key personnel, which is difficult in light of our current business situation. In the event that we find such a alliance or are acquired and we or our successor recommences Biographer manufacturing and research and development, we or our successor will need to attract highly qualified personnel in these areas. Substantial competition exists for such personnel, and we or our successor may not be able to attract and retain these individuals. We compete with numerous pharmaceutical, health care and software companies, as well as universities and non-profit research organizations, in the northern California business area. The loss of key personnel or our inability to hire and retain additional qualified personnel in the future could prevent us from maintaining our business. There can be no assurance that we will continue to be able to attract and retain sufficient qualified personnel.

(1)		Our convertible debentures may be converted into common stock prior to their maturity date, at the option of the parties under certain circumstances, therefore these debentures may not require use of capital resources. Additionally, mandatory payments and discretionary prepayments will result in equal amounts of principal repayments being extended one year. Thus, the $2.0 million paid in June 2003 both reduced the amount of principal owed and extended the maturity date for $2.0 million from June 29, 2004 to June 29, 2005. If we are not able to make planned prepayments on our convertible debentures prior to June 29, 2004 and/or September 29, 2004, we will not be able to take further advantage or our ability to extend the maturity dates on like amounts of principal with each prepayment.
(2)		Future minimum lease payments under our operating leases, exclusive of sublease income.
(3)		Effective November 3, 2003, we entered into an Amendment to the Final Award with Sanofi-Synthelabo that extends the due dates for the remaining arbitration payments by one-year periods with certain accelerations if we receive a lump-sum cash payment from Sankyo Pharma and/or Sankyo Japan. Specifically, in the event that we receive a lump-sum cash payment in an amount greater than or equal to $25.0 million but less than or equal to $50.0 million, then (i) $500,000 of such payment would be immediately payable to Sanofi-Synthelabo, (ii) $4.5 million would be due in February, 2005, (iii) $4.0 million would be due in February, 2006, and (iv) $3.0 million would be due in February, 2007. If, however, we receive a lump-sum cash payment in an amount greater than $50.0 million but less than or equal to $75.0 million, then (i) $1.0 million of such payment would be immediately payable to Sanofi-Synthelabo, (ii) $5.0 million would be due in February, 2005, (iii) $4.0 million would be due in February, 2006, and (iv) $2.0 million would be due in February, 2007. If we receive a lump-sum cash payment in an amount greater than $75.0 million but less than or equal to $125.0 million, then (i) $4.0 million of such payment would be immediately payable to Sanofi-Synthelabo, and (ii) $8.0 million would be due in February, 2005. Finally, if we receive a lump-sum cash payment in an amount of greater than $125.0 million, then $12.0, representing the entire payment due to Sanofi-Synthelabo, would be immediately payable. In the event that we receive a lump-sum payment from Sankyo Pharma and/or Sankyo Japan after February 2005, then we will pay a catch-up payment under whichever of the above-described situations has occurred. If no such accelerations occur and had these extensions been reflected on this table, no arbitration amounts would be due in less than one year, $8.0 million would be due in one to three years, and $4.0 million would be due in four to six years.
(4)		Under our Sales, Marketing and Distribution Agreement with Sankyo Pharma, we were required to reimburse Sankyo Pharma for $6.8 million in promotional expenses and customer rebates incurred on our behalf, but we had a contractual right to defer the payment of such reimbursement to Sankyo Pharma until second quarter 2004. In addition, $2.3 million of sales commissions to Sankyo Pharma could have been deferred until at least 2005 and, under certain circumstances, to 2008. In light of our litigation, payment and timing of these liabilities cannot be predicted.

WeTable have incurred substantial operating losses and negative cash flows from operations since our inception, and we have used cash from equity and debt to supplement our operating cash flow requirements. As of September 30, 2003, we had cash, cash equivalents, and investments of $9.1 million. We expect to incur additional losses from operations in the foreseeable future. Contents

~~With~~Risks ~~Sankyo~~Related ~~Pharma’s decision~~ to stop performing under our Sales, Marketing and Distribution Agreement and related contracts, and their refusal both to pay receivables in excess of $6.0 million and to honor the balance of their binding purchase commitment to pay us $28.4 million in cash between October 1, 2003 and March 31, 2004, we will need to conserve cash and find ways to generate additional cash to finance our operations. Our ~~ability~~Common ~~to continue~~Stock ~~as a going concern is dependent on our ability to generate sufficient cash flow~~ ~~to fund our operations and meet our debt and other obligations on a timely~~ basis. Our plans both to conserve and generate cash include further reduction of our expenses and raising additional capital. There is no certainty, however, that we will be able to undertake such measures or that additional funds will be available to us. In addition, we do not believe we will be able to generate additional cash from product sales in any significant amounts in the near term since Sankyo has been, as a practical matter, our only distribution channel. We are currently pursuing various strategic options, including but not limited to pursuing a new partnership and/or selling some or all of our assets and intellectual

21 Our common stock is subject to the requirements for penny stocks, which could adversely affect our stockholders’ ability to sell and the market price of their shares.

~~Table~~ Our stock fits the definition of ~~Contents~~a penny stock. The Securities Exchange Act of 1934, as amended, defines a penny stock as any equity security that is not traded on a national securities exchange or authorized for quotation on the Nasdaq National Market and that has a market price of less than $5.00 per share, with certain exceptions. Penny stocks are subject to Rule 15(g) under the Securities and Exchange Act of 1934, as amended, which imposes additional sales practice disclosure and market-making requirements on broker/dealers who sell or make a market in such securities. The rules require that, prior to a transaction in a penny stock not otherwise exempt from the rules, the broker/dealer must:

~~property.~~• Ifdeliver ~~substantial~~a ~~additional~~standardized ~~resources~~risk ~~are~~disclosure ~~not~~document ~~available, we~~that ~~may~~provides ~~need~~information toabout ~~cease~~penny ~~our~~stocks ~~operations~~ and~~/or~~ ~~seek~~the ~~protection~~risks ~~under~~in the ~~bankruptcy laws.~~penny ~~These~~stock ~~conditions raise substantial doubt about our ability to continue as a going concern after March 31, 2004.~~ market;

22 • provide the customer with current bid and offer quotations for the penny stock;

~~Table~~• disclose the compensation of ~~Contents~~the broker/dealer and its salesperson in connection with the transaction;

~~RISK~~• ~~FACTORS~~ provide the customer monthly account statements showing the market value of each penny stock held in the customer’s account; and

In• ~~determining~~make ~~whether~~a tospecial ~~invest~~written indetermination ~~our~~that ~~common stock, you should carefully consider~~ the ~~information~~penny ~~below~~stock inis ~~addition~~a tosuitable ~~all~~investment ~~other~~for ~~information provided to you in this report, including~~ the ~~information~~customer ~~incorporated~~and byreceive ~~reference in this report. The statements under this caption are intended to serve as cautionary statements within~~ the ~~meaning~~customer’s ofwritten ~~the~~agreement ~~Private Securities Litigation Reform Act of 1995. The following information is not intended~~ to ~~limit in any way~~ the ~~characterization~~ ~~of other statements or information under other captions as cautionary statements for such purpose~~transaction.

~~Risks~~ These ~~Related~~requirements may have the effect of reducing the liquidity and trading volume of our stock. As a result, it may be more difficult for stockholders to ~~Our~~sell ~~Business~~their shares of our stock and these requirements may adversely affect the price other investors are willing to pay for our stock.

WeOur ~~were~~stock ~~dependent~~price onis ~~Sankyo~~volatile ~~Pharma to sell, market~~ and ~~distribute~~stockholders ~~our products~~may innot ~~the~~be ~~United~~able ~~States. In light of Sankyo Pharma’s decision~~ to ~~stop~~resell ~~performing~~Cygnus ~~under~~shares ~~our~~at ~~Sales,~~or ~~Marketing~~above ~~and~~the ~~Distribution~~price ~~Agreement~~they ~~and related contracts~~paid, ~~our~~or ~~business~~at ~~has been materially adversely affected and we may not be able to continue our operations~~all.

~~Under~~The ~~our~~market ~~July 8,~~price ~~2002~~for ~~Sales,~~shares ~~Marketing~~of ~~and~~our ~~Distribution~~common ~~Agreement~~stock ~~with Sankyo~~has ~~Pharma,~~been wehighly ~~were~~volatile. Factors ~~totally~~such ~~dependent~~as ~~upon~~new ~~Sankyo~~product ~~Pharma~~introductions ~~for~~by ~~the~~our ~~sales~~competitors, ~~marketing~~ ~~and distribution of~~ our ~~products~~ability ~~in the United States. On October 2,~~to ~~2003,~~enter ~~Sankyo~~into ~~Pharma~~a ~~informed~~strategic usalliance ofor ~~their decision~~ to ~~stop~~be ~~performing~~acquired ~~under~~in the ~~Sales,~~ ~~Marketing~~near ~~and~~future, ~~Distribution Agreement and related contracts. Their~~sales ~~unilateral~~levels ~~decision~~of ~~has materially adversely affected~~ our ~~business. Furthermore~~products, ~~Sankyo~~litigation ~~Pharma’s~~outcomes, ~~refusal~~regulatory ~~both~~approvals toor ~~pay~~delays ~~receivables~~or recalls ~~in excess~~ of ~~$6.0 million~~our ~~and~~products toor ~~honor~~those ~~the balance~~ of ~~their~~our ~~binding~~competitors, ~~purchase~~developments ~~commitment~~relating to our ~~pay~~patents ~~us $28.4 million~~or inproprietary ~~cash~~rights ~~between~~or ~~October 1,~~those ~~2003~~of ~~and~~our ~~March 31~~competitors, ~~2004~~results ~~has caused~~of ~~material~~clinical ~~financial~~trials ~~and~~for ~~commercial~~products ~~harm~~of to our ~~business.~~competitors, ~~We entered into our contracts with Sankyo Pharma rather than develop~~ and~~/or~~ ~~expand such capabilities in~~period-~~house. Because Sankyo Pharma has decided~~ to ~~stop performing~~-period ~~under~~fluctuations ~~their contracts with us, we are currently unable to successfully commercialize our products~~ in ~~the~~financial ~~United~~results ~~States. Furthermore, we~~ may ~~experience~~ ~~delays~~have ina ~~commercialization~~significant ~~due~~impact toon the ~~necessity~~market price of ~~seeking~~our ~~an alternative~~common ~~third~~stock. ~~party~~Additionally, orfollowing ~~parties~~periods toof ~~perform~~volatility ~~the~~in ~~functions previously handled~~the bymarket ~~Sankyo~~price ~~Pharma~~for ora wecompany’s ~~may~~securities, ~~need~~securities toclass ~~develop~~action ~~these~~litigation ~~capabilities ourselves at~~may ~~considerable~~be ~~expense~~instituted. ~~Developing~~Such ~~such~~litigation ~~capabilities~~could ~~ourselves~~result ~~is not possible~~ in ~~the~~substantial ~~near~~costs ~~term,~~to inus ~~light of our recent 60% reduction in work force~~ and ~~our~~ ~~need~~further todivert ~~conserve cash as a result of Sankyo Pharma~~management’s ~~decision~~attention toand ~~stop performing under its contracts with us~~resources.

~~Under~~Issuances ~~our~~by ~~current~~us situation, we must conserve and generate cash to finance our operations. Our ability to continue as a going concern is dependent on our ability to generate sufficient cash flow to fund our operations and meet our debt and other obligations on a timely basis. Our plans both to conserve and generate cash include further reduction of ~~our~~authorized ~~expenses~~preferred ~~and~~stock ~~raising~~can ~~additional capital.~~have ~~There~~adverse ~~is no certainty~~effects, ~~however, that we will be able to undertake~~ such measures or that additional funds will be available to us. In addition, we do not believe we will be able to generate additional cash from product sales in any significant amounts in the near term since Sankyo has been, as a practical matter, our only distribution channel. We are currently pursuing various strategic options, including ~~but~~dilution ~~not limited to pursuing a new partnership~~ and~~/or~~ ~~selling~~discouragement ~~some or all~~ of ~~our assets and intellectual property~~takeovers. ~~If substantial additional resources are not available, we may need to cease our~~ ~~operations and/or seek protection under the bankruptcy laws. These conditions~~ ~~raise substantial doubt about our ability to continue as a going concern after March 31, 2004.~~

WeOur ~~continue~~certificate ~~to evaluate alternative means~~ of ~~financing~~incorporation tocontains ~~meet~~certain ~~our~~provisions ~~needs on terms~~ that ~~are~~may delay ~~acceptable~~or toprevent usa takeover. ~~However,~~The weCompany ~~may~~currently behas ~~unable~~5.0 million toshares ~~obtain~~of ~~necessary~~authorized ~~financing~~and onunissued ~~favorable~~preferred ~~terms or at all~~stock. ~~For~~Our ~~example,~~Board weof ~~may~~Directors ~~need~~has tothe ~~enter~~authority ~~into~~to ~~financing~~determine ~~arrangements~~the orprice, ~~modify~~rights, ~~our~~preferences ~~existing~~and ~~payment obligations~~restrictions, ~~that~~including ~~may~~voting ~~include~~and ~~sales~~conversion rights, of ~~our~~these ~~common~~shares ~~stock~~without atany ~~significant~~further action ~~discounts~~or tovote by the ~~market~~ ~~price~~stockholders. ToThe ~~obtain~~rights ~~such~~of ~~funding~~the orholders ~~modifications,~~of wecommon ~~may need to~~stock ~~relinquish~~will ~~rights~~be subject to, ~~our~~and ~~remaining~~may ~~assets.~~be Inadversely ~~addition~~affected by, wethe ~~have~~rights ~~discussed~~of the ~~possibility~~ holders of ~~reducing~~preferred ~~the~~stock ~~minimum~~that ~~conversion~~may ~~price~~be issued in ~~effect~~the ~~for~~future. ~~our~~Such provisions could ~~Convertible~~adversely ~~Debentures,~~affect ~~which~~the ~~would~~holders ~~cause~~of ~~significant~~common ~~dilution~~stock toin ~~our~~a ~~existing stockholders,~~variety ~~although~~of ~~neither~~ways, weincluding ~~nor~~by potentially ~~the~~discouraging, ~~Debenture~~delaying ~~holders~~or ~~have~~preventing ~~committed~~a ~~to any~~takeover ~~such~~of ~~amendment~~the orCompany ~~conversion~~and by todiluting ~~date~~stockholder ownership.

~~The~~Provisions ~~outcome~~ of, our charter documents and ~~costs~~Delaware ~~relating~~law tomay inhibit a takeover, ~~our~~thus ~~litigation~~limiting ~~with~~the ~~Sankyo~~price ~~Pharma~~investors might be willing to pay in the ~~and~~future ~~Sankyo~~for ~~Japan~~our ~~are~~common ~~uncertain~~stock.

OnProvisions ~~October 6,~~in ~~2003,~~our weRestated ~~filed~~Certificate aof ~~complaint~~Incorporation inand ~~the~~Bylaws ~~Superior~~may have ~~Court of~~ the ~~State~~ effect of ~~California~~delaying ~~for~~or ~~the~~preventing ~~County~~an acquisition of ~~San~~the ~~Mateo~~Company ~~against~~or ~~Sankyo~~a merger ~~Pharma~~in ~~and Sankyo~~which ~~Japan~~we ~~for~~are ~~breach~~not ofthe ~~contract~~surviving company and ~~intentional~~may ~~interference~~otherwise ~~with~~prevent or ~~contract~~slow ~~relating~~changes toin ~~the~~our ~~sales,~~Board ~~marketing~~of Directors and ~~distribution~~management. ofIn ~~our GlucoWatch~~addition, ~~Biographer~~because ~~products.~~we are Onincorporated ~~November 6,~~in

2320

~~2003~~Delaware, ~~Sankyo Pharma filed an answer and cross-claims against us for declaratory relief, breach of contract, and defamation. We have not yet filed a response to these claims. We believe that~~ we ~~have~~are ~~meritorious~~governed ~~defenses~~by to the ~~causes~~provisions of ~~action~~Section 203 ~~asserted against~~of usthe ~~by Sankyo Pharma, and we intend to vigorously defend ourselves~~Delaware ~~against~~General ~~these~~Corporation ~~claims~~Law. ~~This~~These ~~litigation~~provisions iscould indiscourage ~~its~~an ~~early~~acquisition ~~stages, however, and is~~of ~~therefore inherently difficult to assess. The litigation in which we are currently involved and~~ the ~~reduction~~Company inor ~~force may affect, among~~ other ~~things, our~~change ~~ability to sell, market and distribute our products~~ in ~~the~~control ~~United~~transaction ~~States, our financing activities, the retention of personnel~~ and ~~our~~thereby ~~ability to~~negatively ~~continue~~impact ~~as a going concern. We cannot predict with certainty~~ the ~~eventual outcome~~price ~~of pending litigation, which may result in a significant adverse jury verdict or punitive damages award, or a judgment~~ that ~~certain~~investors ofmight ~~our allegations are invalid or unenforceable. Furthermore, this kind of litigation could~~ be ~~very~~willing ~~costly~~to ~~and~~pay ~~divert our management’s attention and resources, and any adverse determination~~ in ~~this litigation,~~the orfuture ~~delay~~for ~~in resolving this litigation, may cause us to cease~~ our ~~operations~~common ~~and/or seek protection under the bankruptcy laws~~stock.

We ~~have~~do ~~recently~~not ~~experienced~~pay acash ~~significant~~dividends ~~reduction~~and indo ~~our~~not ~~workforce,~~anticipate paying any dividends in ~~which~~the ~~has~~future, ~~had~~so aany ~~material~~short-term ~~impact~~return on ~~our~~a ~~ability~~stockholder’s toinvestment ~~manufacture~~will ~~our~~depend on ~~products~~the ~~and conduct~~market ~~research~~price ~~and~~of ~~development~~our onshares, ~~future~~which ~~products~~is volatile.

OnWe ~~October 9,~~have ~~2003,~~never wepaid ~~announced~~any acash ~~reduction~~dividends inon ~~force of approximately 60% of~~ our ~~workforce~~stock. asWe aanticipate ~~result~~that ~~of Sankyo Pharma’s decision to stop performing~~we ~~under~~will ~~their~~retain ~~contracts~~our ~~with~~earnings, ~~us.~~if ~~Because of the magnitude of the workforce reductions~~any, ~~these~~to ~~layoffs~~support ~~have~~operations ~~had~~and ato ~~material~~finance ~~adverse impact on~~ our ~~ability to~~ ~~manufacture~~business. ~~our~~Therefore, ~~products~~we ~~and~~do ~~our~~not ~~ability~~expect to ~~conduct~~pay ~~research~~cash ~~and~~dividends ~~development and to expand our operations~~ in the foreseeable future. toAny ~~meet~~short-term ~~the~~return ~~needs~~on ~~of our customers. As~~ a ~~result~~stockholder’s ofinvestment ~~this~~will ~~reduction~~depend inonly ~~force,~~on the wemarket ~~are~~price ~~not~~of ~~currently~~our ~~producing~~shares ~~any products~~ and ~~our~~the ~~manufacturing~~stockholder’s ~~operations~~ability ~~have~~to ~~been~~liquidate ~~suspended~~their investment.

~~We have incurred substantial losses, have a history of operating losses,~~21 ~~have an accumulated deficit and stockholders’ net capital deficiency and expect continued operating losses.~~

WeTable had a net loss of $21.7 million for the nine months ended September 30, 2003. At September 30, 2003, our accumulated deficit and stockholders’ net capital deficiency were $318.4 million and $64.3 million, respectively. We have experienced operating losses since our inception, and we expect to continue to incur operating losses at least until we have significant product sales, if we ever do. We may fail in our efforts to secure replacement sales, marketing and distribution functions in the United States in light of Sankyo Pharma’s decision to stop performing under our Sales, Marketing and Distribution Agreement and related contracts. Our products may never gain market acceptance, and we may never generate significant revenues or achieve profitability. Contents

WeItem ~~believe, as a practical matter, we will not be able to draw on our remaining equity line agreement for the foreseeable future~~3. ~~Additionally,~~Quantitative ~~our equity line may be suspended or terminated~~ and weQualitative ~~may~~Disclosures ~~not~~About beMarket ~~able to replace it~~Risk. ~~If adequate funds are not available or are not available on acceptable terms, we may be unable to continue our operations.~~

InThe ~~order~~Company tohas ~~continue~~no ~~commercialization~~material ofchanges ~~our GlucoWatch Biographers, as well as continue~~ to ~~develop~~the ~~our~~disclosure ~~product~~made line, we will require substantial additional resources. We may seek additional funding through public or private financings, including debt or equity financings. Furthermore, since our stock is not listed on ~~either the Nasdaq National Market or Nasdaq SmallCap Market, our investors under the equity line agreement may elect to suspend or terminate~~ this agreement, in which case we will not be able to utilize the $29.0 million available under this equity line agreement. Even if these investors elect not to suspend or terminate our equity line agreement, we believe, as a practical matter~~, we will not be able to draw on the equity line agreement for the~~ foreseeable future. So long as we are not listed on a national exchange or quoted on the Nasdaq National Market or the SmallCap Market, we believe that it will not be practical for us to draw on our equity line in ~~light of (i)~~ the ~~penny~~ stock rules that require the underwriter to undertake relatively burdensome disclosure obligations in connection with issuances of penny stock securities such as ours, (ii) our need to individually comply with each stateCompany’s ~~blue~~ ~~sky~~Annual ~~laws~~Report ~~governing~~on ~~unlisted~~Form ~~securities~~10-K ~~issuances, and (iii) the relatively high level of dilution that issuances would have at current market prices~~ for ~~our~~ ~~stock. As a result, we may need to seek other financing arrangements. Any additional equity financings are likely to dilute~~ the ~~holdings~~year ofended ~~current stockholders. Debt financing~~December 31, ~~if available, may have restrictive covenants. We~~ ~~may not be able to obtain adequate funds when we need them from financial markets or other sources~~2003. ~~In particular, our ability to raise funds through the~~ ~~capital markets may be materially adversely affected as a result of our~~ litigation with Sankyo Pharma and Sankyo Japan. Even if funds are available, they may not be available on acceptable terms. If we cannot obtain sufficient additional funds, we may have to cease operations or declare bankruptcy or, at a minimum, delay, scale back or eliminate some or all of our ongoing activities or license or sell products or technologies.

24Item 4. Controls and Procedures.

~~Table~~ a) Evaluation of ~~Contents~~disclosure controls and procedures. Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures,” as defined in the Securities Exchange Act of 1934, as amended (the “Exchange Act”), Rules 13a-15e or 15d-15e as of the end of the period covered by this report (the “Evaluation Date”), have concluded that, as of the Evaluation Date, our disclosure controls and procedures were adequate based on the evaluation of these controls and procedures required by paragraph (b) of the Exchange Act Rules 13a-15 or 13d-15.

Web) ~~are~~Changes ~~highly~~in ~~leveraged~~internal ~~and~~controls. ~~may~~No bechange ~~unable~~in ~~to service~~ our ~~debt~~internal orcontrols ~~satisfy~~over ~~our~~financial ~~other~~reporting ~~obligations.~~identified Ifin weconnection ~~cannot~~with ~~pay~~the ~~amounts~~evaluation ~~due~~required ~~under our obligations, we~~by ~~may~~paragraph ~~need~~(d) of toExchange ~~refinance~~Act ~~all~~Rules 13a-15 or a15d-15 ~~portion~~that ofoccurred ~~our~~in ~~existing~~the ~~debt,~~six months ~~sell~~ended ~~equity securities~~June 30, ~~sell~~2004 ~~all~~has materially affected, or ais ~~portion~~reasonably oflikely ~~our~~to materially ~~assets~~affect, ~~cease~~ our ~~operations~~internal ~~and/or seek~~controls ~~protection~~over ~~under~~financial ~~the bankruptcy laws~~reporting.

~~As of September 30, 2003, we had total liabilities of $81.5 million (net~~22 of unamortized debt discount of $1.0 million), of which $70.2 million were current liabilities. This amount of $70.2 million includes $45.5 million related to Sankyo Pharma, including $25.0 million in deferred revenues from Sankyo Pharma and $9.0 million in deferred revenues from Sankyo Pharma net of deferred costs of product shipments. Our ability to meet our debt service obligations and other liabilities depends upon our future performance, which will depend upon financial, business and other factors, many of which are beyond our control. We may fail to generate sufficient cash flows in the future to cover our fixed charges or to permit us to satisfy any redemption obligations pursuant to our indebtedness. Historically, we have experienced significant negative cash flows from operations. If we cannot generate sufficient cash flows in the future to cover our fixed charges or to permit us to satisfy any redemption obligations pursuant to our indebtedness and we are unable to borrow sufficient funds under our credit facilities or from other sources, we may need to refinance all or a portion of our existing debt, sell equity securities or sell all or a portion of our assets. We may not successfully complete any of these courses of action. The degree to which we are leveraged could exacerbate limitations on our ability to obtain financing for working capital, commercialization of products or other purposes and could make us more vulnerable to industry downturns and competitive pressures. In the event of insolvency, bankruptcy, liquidation, reorganization, dissolution or winding-up of our business or upon default or acceleration related to our debt obligations, our assets would first be available to pay the amounts due under our debt obligations. Holders of our common stock would only receive any assets remaining after satisfaction in full of all indebtedness and preferred stock liquidation preferences, if any.

IfTable patients do not receive reimbursement from third-party health care payors, we may be unsuccessful in selling our products to a broad range of customers. Contents

~~Successful~~PART commercialization of our products will depend in large part on whether patients who purchase our products will be reimbursed for the expense by third-party payors, which include private insurance plans, Medicare, Medicaid and other federal health care programsII. ~~Currently,~~OTHER ~~our products do not~~INFORMATION ~~have widespread reimbursement. There can be no assurance that such~~ ~~reimbursement will be available in a sufficient time frame, or at all.~~ Furthermore, Sankyo Pharma had responsibility for this function under our Sales, Marketing and Distribution Agreement and had contracted with TheraCom, Inc. to assist customers on a patient-by-patient basis in obtaining reimbursement as well as utilizing its managed care group to work with third-party health care payor organizations in order to obtain broad reimbursement coverage. In light of Sankyo Pharma’s decision to stop performing under their contracts with us, we will need to find another approach to securing such reimbursement, or will need to rely on non-reimbursed sales only. Third-party payors, including federal health care programs and managed care and other private insurance plans, are increasingly seeking to contain health care costs by limiting the coverage of, and the amount of reimbursement for, new diagnostic products. As a result, adequate levels of reimbursement may not be available for patients, many of whom may therefore not purchase our products. If meaningful reimbursement from third-party payors is not available, we may not be able to achieve a level of market acceptance of our products, and we may not be able to maintain price levels sufficient to realize an adequate return on our investment. In the United States and other countries, the period of time needed to obtain approval for the reimbursement of our products to patients can be lengthy. We may need to delay the launch of our products in some countries until we have established eligibility for reimbursement. This delay could potentially harm our business.

~~We depend on third-party suppliers for the manufacturing of our Biographer and AutoSensor components~~Item 1. ~~Any~~Legal ~~interruption in the supply of system components or an increase in the pricing of these components could prevent us from manufacturing our products or adversely affect our margins~~Proceedings.

~~Our~~On ~~Biographer~~December 15, ~~and~~1999, ~~AutoSensor~~we ~~are~~completed ~~manufactured~~the ~~from~~sale ~~components~~of ~~purchased from~~substantially ~~outside~~all ~~suppliers, most~~ of ~~whom~~our drug ~~are~~delivery ~~our~~business ~~single~~segment ~~source~~assets ~~for~~to ~~such~~Ortho-McNeil ~~components~~Pharmaceutical, Inc. ~~Some~~(“Ortho-McNeil”). ofUnder ~~these~~the ~~companies~~terms ~~are~~of ~~small~~our ~~enterprises~~agreement, ~~that~~Ortho-McNeil ~~may~~was ~~encounter~~subject ~~financial~~to ~~difficulties~~paying ~~because~~up ofto ~~their~~an ~~size~~additional $55.0 million Wein ~~have~~cash, ~~been~~contingent ~~notified~~on bythe ~~one~~ achievement of ~~our~~certain ~~sole source~~milestones. ~~component~~Of ~~suppliers~~this ~~that~~$55.0 million, ~~they~~$20.0 million ~~are~~was ~~encountering~~not ~~financial~~paid ~~difficulties.~~to us ~~Prior~~because tocertain ~~Sankyo~~Ortho-McNeil ~~Pharma’s~~technical ~~decision~~and toregulatory ~~stop~~accomplishments ~~performing~~relating ~~under~~to ~~their~~the ~~contracts~~Ortho ~~with~~Evra® us(Johnson & Johnson, weNew ~~had~~Brunswick, ~~begun~~New ~~the~~Jersey) ~~process~~contraceptive patch ofwere ~~identifying~~not met, and ~~qualifying~~ an$34.6 million ~~alternative~~is ~~supplier~~under ~~for~~dispute. ~~this~~Both ~~component;~~parties ~~however,~~have retained weoutside ~~have~~legal ~~stopped these~~counsel ~~efforts~~and, inon ~~light~~February 23, of2004, we invoked the mediation ~~two-year~~provisions ~~inventory~~set ~~currently~~forth ~~warehoused~~in byour ~~Sankyo Pharma.~~Asset InPurchase ~~the~~Agreement. ~~future~~Thereafter, ifthe parties weagreed ~~are~~to ~~unable,~~waive ~~for~~the ~~whatever~~mediation ~~reason,~~provisions and to ~~obtain~~enter ~~these~~into binding ~~components~~arbitration ~~from~~as ~~our~~set ~~suppliers~~forth orin ifour ~~the~~Asset ~~components~~Purchase ~~obtained~~Agreement ~~from~~and, ~~these~~on April 15, ~~suppliers~~2004, dowe ~~not~~provided ~~pass~~notice ~~quality~~of ~~standards,~~arbitration weto ~~will~~Ortho-McNeil. beThe ~~required~~parties toare ~~obtain~~in the process of selecting a panel of arbitrators.

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

~~Table~~ On June 22, 2004, our Annual Meeting of ~~Contents~~Stockholders was held. The following Directors were re-elected at this meeting:

components from alternative suppliers. Additionally, in the event a current supplier is unable to meet our component requirements, we might not be able to rapidly find another supplier of the particular component or an alternative supply of the particular component at the same price or lead time. Sankyo Pharma has informed us that they currently are warehousing a two-year inventory of our products; however, an interruption in the supply of Biographer or AutoSensor components or excessive pricing of these components could prevent us from manufacturing our products in the future or could adversely affect our margins and significantly impact our ability to achieve a successful U.S. market penetration.


Directors	In Favor		Withheld
Frank T. Cary		37,684,445		613,031
John C Hodgman		37,734,316		563,160
André F. Marion		37,696,170		601,306
Richard G. Rogers		37,671,437		626,039
Walter B. Wriston		37,678,202		619,274

~~Third-party~~Other ~~suppliers~~matters ~~may,~~voted ~~for competitive reasons, support directly or~~upon: ~~indirectly a company or product that competes with one of our products. If such~~ a third-party supplier terminates an arrangement, cannot fund or otherwise satisfy its obligations under its arrangements or disputes or breaches a contractual commitment, then we would likely be required to seek an alternative third-party supplier. If we were unable to find a replacement third-party supplier, our capital requirements could increase substantially and our business and financial condition could be materially adversely affected. If we were required to develop our own capabilities, we would continue to incur significant start-up expenses and we would compete with other companies that have experienced and well-funded operations.

If we recommence product manufacturing in the future, we will continue to rely on existing supply agreements, including those with Hydrogel Design Systems, Inc., Key Tronic Corporation, Sanmina Corporation and E.I. du Pont de Nemours and Company, among others.

Votes

Broker

Affirmative

Negative

Abstain

Non-Votes

To ratify the re-appointment of Ernst & Young LLP to serve as the Company’s independent auditors.

37,846,330

316,909

134,237

-0-

~~Our~~Item ~~very~~6. ~~limited~~Exhibits ~~medical~~and ~~device~~Reports ~~manufacturing~~on ~~experience~~Form ~~may prevent us from successfully commercializing our product~~8-K.

We have suspended manufacturing in light of Sankyo Pharma’s decision to stop performing under their contracts with us, and we may encounter problems in recommencing manufacturing of our GlucoWatch Biographer and AutoSensors, particularly in light of our recent reduction in force. We were responsible for manufacturing the GlucoWatch Biographer and we contracted with a) third party, Corium International, to manufacture our AutoSensors. Thus, we were dependent upon Corium International for such manufacturing. Our GlucoWatch Biographers and AutoSensors have been manufactured for commercial sale on a limited basis, and we have no experience manufacturing the volumes that would be necessary for us to achieve significant commercial sales. In the past, we initially experienced problems in scaling up our now-discontinued transdermal drug delivery products. There can be no assurance that similar problems will not be encountered in the future with our Biographers, our AutoSensors and our potential future products, if any. To successfully commercialize the Biographer and the AutoSensors, we will have to manufacture these products in compliance with regulatory requirements, in a timely manner and in sufficient quantities, while maintaining performance and quality of the products and a commercially feasible cost of manufacturing. There can be no assurance that we will be able to expand and then maintain reliable, full-scale manufacturing of the Biographer and the AutoSensors at commercially reasonable prices if we were to recommence product manufacturing. Manufacturers often encounter difficulties in scaling up production of new products, including problems involving product performance, production yields, quality control and assurance and personnel staffing levels. In addition, manufacturing facilities will be subject to extensive regulations, including those of the FDA, international quality standards and other regulatory requirements. Because we have contracted with a third party for manufacturing our AutoSensors, there are normal business risks associated with outsourcing this function to a third party. Difficulties encountered in manufacturing scale-up or failure by us or a third party to implement and maintain manufacturing facilities in accordance with FDA regulations, international quality standards or other regulatory requirements could result in a delay or termination of production, which could have a material adverse effect on our business, financial condition and results of operations. Exhibits

~~Due~~The tofollowing ~~the~~exhibits early stage of our product commercialization activities, the estimates required in inventory valuation, including production yields and normal capacity, labor costs incurred in the production of each unit and overhead costs applicable to manufacturing operations, are ~~inherently uncertain,~~filed ~~thus~~herewith ~~actual results may differ from those estimates. Write-offs for potential obsolescence~~ or ~~for~~incorporated ~~inventories in excess of demand and estimates for replacement costs of any stale-dated AutoSensor inventory held~~ by ~~Sankyo Pharma~~reference: ~~are also determined based on~~ ~~significant estimates, which may be significantly impacted by our~~ ~~litigation with Sankyo Pharma and Sankyo Japan.~~


3.01		Bylaws of the Registrant, as amended, incorporated by reference to Exhibit 3.01 of the Registrant’s Form 10-Q for the three months ended June 30, 2002.

3.02		Restated Articles of Incorporation of the Registrant, as amended to date, incorporated by reference to Exhibit 3.02 of the Registrant’s Form 10-Q for the three months ended June 30, 2002.

4.01		Specimen of Common Stock Certificate of the Registrant, incorporated by reference to Exhibit 4.1 of the Registrant’s Registration Statement on Form S-1 (File No. 33-38363) filed on December 21, 1990 (Form S-1).

31.1		Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rule 13a-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rule 13a-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

~~Table of Contents~~23

OurTable productsof are based on new technology and may not be accepted by the market. This uncertainty has been compounded by Sankyo Pharma’s decision to stop performing under their contracts with us. Contents

We were focusing our efforts on a line of frequent, automatic and non-invasive glucose monitoring devices based on novel technologies prior to the litigation with Sankyo Pharma and Sankyo Japan. Sankyo Pharma has been solely responsible for the marketing of our products in the United States. Given Sankyo Pharma’s decision to stop performing under their contracts with us, physicians may be hesitant to prescribe our products for their patients. Our litigation has already caused substantial uncertainty relating to product availability, warranty fulfillment, and the like. Furthermore, the market may not accept our products, given that they are different from the established finger-stick blood glucose monitors currently on the market. In addition, because our products are based on novel technologies, there can be no assurance that unforeseen problems will not develop with these technologies or that we will be able to successfully address technological challenges that we may encounter.


32.1		Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

b)		Current Reports on Form 8-K

		None.

~~We may be subject to product recalls or product liability claims that are~~24 ~~costly to defend and could limit our ability to sell our products in the future or could damage our reputation.~~

TheTable design, development, manufacture and use of our medical products involve an inherent risk of product recalls and product liability claims and associated adverse publicity. Makers of medical products may face substantial liability for damages in the event of product failure or allegations that the product caused harm. Product liability insurance is expensive and, although we presently have such insurance, it is difficult to maintain as well as to expand coverage under it. We may become subject to product liability claims, our current insurance may not cover potential claims and adequate insurance may not be available on acceptable terms in the future. We also could be held liable for damages in excess of the limits of our insurance coverage. Regardless of insurance coverage, any claim or product recall could result in non-compliance with FDA regulations, force us to stop selling our products and create significant adverse publicity that could harm our credibility and decrease market acceptance of our products. Contents

~~Our product pipeline is severely limited, so the failure of our glucose~~SIGNATURES ~~monitoring products could result in the failure of our entire business.~~

WePursuant ~~are exclusively focused on a line of frequent, automatic and non-invasive glucose monitoring devices. This narrow range of products subjects us~~ to the ~~risk~~requirements of ~~not~~the ~~having~~Securities ~~alternative~~Exchange ~~sources~~Act of ~~revenue~~1934, ~~if we are unable to~~the ~~commercialize~~Registrant ~~these~~has ~~products.~~duly Wecaused ~~may~~this ~~not~~report to be ~~successful~~signed ~~with~~on aits ~~non-diversified line~~behalf ofby ~~products. A failure of our initial products could cut off our only potential source of revenue and result in~~ the ~~failure of our entire business,~~ asundersigned, ~~could~~thereunto ~~the~~duly ~~failure of any of our future products~~authorized.

To be successful, we will need to continue to develop glucose monitoring products that address the needs of people with diabetes; however, in light of our recent reduction in force and expenses associated with our litigation with Sankyo Pharma and Sankyo Japan, our ability to develop new products has been materially impaired. From time to time, we have experienced delays or setbacks in the development of certain of our products. For example, in the past, we experienced development delays in the miniaturization of the first-generation GlucoWatch Biographer. There can be no assurance that we will be able to successfully address problems that may arise during development and commercialization processes. In addition, there can be no assurance that GlucoWatch Biographer enhancements or future products can or will be successfully developed, prove to be safe and effective in clinical trials, meet applicable regulatory standards, be manufactured in commercial quantities at a reasonable cost, be marketed successfully or achieve market acceptance. If our future development programs, if any, are not successfully completed, required regulatory approvals or clearances are not obtained or products for which approvals or clearances are obtained are not commercially successful, our business, financial condition and results of operations may be materially adversely affected


	CYGNUS, INC.

Date: August 13, 2004	By:	/s/ John C Hodgman

		John C Hodgman
		Chairman, President and Chief Executive Officer
		(Principal Executive Officer)

Date: August 13, 2004	By:	/s/ Craig W. Carlson

		Craig W. Carlson
		Chief Operating Officer and Chief Financial Officer
		(Principal Accounting Officer)

~~We may not continue to receive regulatory approval of our products from~~25 ~~the FDA or foreign agencies. If we do not receive regulatory approval from an agency, we will not be able to sell our products or generate revenue in that agency’s jurisdiction.~~

TheTable design, manufacturing, labeling, distribution and marketing of our products are subject to extensive and rigorous government regulation in the United States and certain other countries, where the process of obtaining and maintaining required regulatory clearance or approvals is lengthy, expensive and uncertain. Our third-generation product is currently under review by the FDA. The FDA may not approve this new product or additional future enhancements and possible manufacturing changes to the Biographers and the AutoSensors or it may require us to Contents

27EXHIBIT INDEX


Exhibit
Number		Description
31.1		Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rule 13a-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rule 13a-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

~~file one or more new PMA applications~~26 rather than allowing us to supplement our existing PMA application. Even if the FDA grants us expedited review status on an application for approval, obtaining approval of a PMA or a PMA supplement could take a substantial period of time, and the FDA may not ultimately grant such approval. Moreover, even if regulatory approval is granted, such approval may include significant limitations on intended uses for which any such products could be marketed.

A medical device and its manufacturer are subject to continual review after approval, and later discovery of previously unknown problems with a product or the manufacturing process may result in restrictions on such product or the manufacturer, including withdrawal of the product from the market. Failure to comply with applicable regulatory requirements may result in, among other things, fines, suspensions of regulatory approvals, product recalls, operating restrictions and criminal prosecution. In addition, new government regulations may be established that could delay or prevent regulatory approval of our potential products. We are also subject to federal, state and local regulations regarding workplace safety, environmental protection and hazardous material controls, among others, and failure to comply with these regulations may result in similar consequences.

In order for us to market our products in foreign jurisdictions, we and our distributors and agents must obtain required regulatory registrations or approvals and otherwise comply with extensive regulations regarding safety, efficacy and quality in those jurisdictions. Specifically, certain foreign regulatory bodies have adopted various regulations governing product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. These regulations vary from country to country. There can be no assurance that we will obtain required regulatory registrations or approvals in such countries or that we will not be required to incur significant costs in obtaining or maintaining such regulatory registrations or approvals. Delays in obtaining any registrations or approvals required to market our products, failure to receive these registrations or approvals or future loss of previously obtained registrations or approvals could have a material adverse effect on our business, financial condition and results of operations.

If we fail to adequately protect our intellectual property, our competitive position could be harmed.

Development and protection of our intellectual property are critical to our business. If we do not adequately protect our intellectual property, both in the United States and abroad, competitors may be able to use our technologies. Our success depends in part on our ability to:

• obtain patent protection for our products and processes in both the United States and other countries; • protect trade secrets; and • prevent others from infringing on our proprietary rights.

There are numerous risks and uncertainties that we face with respect to our patents and other proprietary rights. Currently, most pending patent applications in the United States are maintained in secrecy until issuance, and publication of discoveries in the scientific or patent literature tends to lag behind actual discovery by several months. Thus, we may not have been the first to file patent applications on our inventions. Our patent applications may not issue into any patents. Once granted, the claims of any issued patents may not afford meaningful protection for our technologies or products. In addition, patents issued to us or our licensors may not provide competitive advantages for our products or may be challenged by our competitors and subsequently narrowed, invalidated or circumvented. Competitors may also independently develop similar or alternative technologies or duplicate any of our technologies.

Litigation, interference proceedings, oppositions or other proceedings that we may become involved in with respect to our proprietary technologies could result in substantial cost to us. Patent litigation is widespread in our industry, and any patent litigation could harm our business. Costly litigation might be necessary to protect our proprietary rights, and we may not have the required resources to pursue such litigation or to protect our rights. An adverse outcome in litigation with respect to the validity of any of our patents could subject us to significant liabilities to third parties, divert the attention of management and technical personnel from other business and development concerns, require disputed rights to be licensed to or from third parties or require us to cease using a product or technology or lose our exclusive rights with respect to such technology.

We also rely upon trade secrets, proprietary know-how and continuing technological innovation to remain competitive. Confidentiality agreements with our employees, consultants and corporate partners with access to proprietary information could be breached, and we might not have adequate remedies for any such breach.

Additionally, our trade secrets and know-how could otherwise become known or be independently developed by third parties.

Our products could infringe on the intellectual property rights of others, possibly causing us to engage in costly litigation and, if we are not successful, causing us to pay substantial damages and prohibiting us from selling our products.

Third parties may assert infringement or other intellectual property claims against us based on their patents or other intellectual property claims. We may have to pay substantial damages, possibly including treble damages, for past infringement if it is ultimately determined that our products infringe a third party’s patents. Furthermore, we may be prohibited from selling our products before we obtain a license that, if available at all, may require us to pay substantial royalties. Even if infringement claims against us are without merit, defending a lawsuit takes significant time, may be expensive and may divert management’s attention from other business concerns and also divert efforts of our technical personnel.

We may be unable to build brand loyalty because our trademarks and trade names may not be protected.

Our registered or unregistered trademarks or trade names, such as the marks “GlucoWatch” and “G2,” may be challenged, canceled, infringed upon, circumvented, declared generic or determined to be infringing on other marks. We may not be able to protect our rights to these trademarks and trade names, without which we may be unable to build brand loyalty. Brand recognition is critical to our short-term and long-term marketing strategies, especially as we commercialize future enhancements to our products. Moreover, if our trademarks are found to infringe on marks belonging to third parties, we may be forced to market our products under a different name, possibly requiring a costly and difficult re-branding effort, and we could be ordered to pay damages to a third party.

If any of our license agreements or other contracts for intellectual property related to our products are terminated or made non-exclusive, our ability to develop, manufacture or market our products may be materially impaired.

We have entered into agreements with various third parties, including The Regents of the University of California, for licenses of certain intellectual property related to the Biographers and the AutoSensors. Pursuant to these agreements, we have been granted rights to certain technologies related to our products. These agreements impose on us specific obligations, including, in the case of the University of California, license, royalty payments and commercialization milestones. If we fail to meet our obligations under any of these agreements, the license or other rights may be terminated or, in the case of an exclusive arrangement, be made non-exclusive. Additionally, in the event we decide to seek bankruptcy protection, patent holders who license their technology to us, including the University of California, may assert rights to terminate their licenses with us or to contest the transfer or sale of such licenses in the bankruptcy process. Although we would challenge any such assertions, there can be no assurances that our challenge would be successful. If any such license or other right is terminated, we may lose our ability to incorporate the applicable technology into our products or to use such technology in the manufacture of our products, possibly impairing our ability to produce or market the GlucoWatch Biographer or other products. If any such license or other right is made non-exclusive, we may be unable to prevent others from developing, manufacturing and marketing devices based on the same or similar technologies.

We do business on a limited basis in the United Kingdom and may not enter other international markets; thus, the success of our business depends on our success in the U.S. market.

We currently market and sell the GlucoWatch G2 Biographer on a limited basis in the United Kingdom, which has a National Health Service (NHS); our products are not currently reimbursed by the NHS. We have established a contract with a third-party authorized representative in the United Kingdom, although the product ordering, logistics, and technical support functions are handled by us. If we are unable to support these necessary functions, we may not be able to sell our products or generate revenue in the United Kingdom.

We may never be able to secure necessary commercialization agreements in countries other than the United States and the United Kingdom, despite the fact that we have CE certification in the European Community. If we are unable to secure these necessary agreements for other countries, we may not be able to sell our products or, even if such sales are possible, to broadly launch our products in other countries. Even if we do expand into other international markets, our operations there may be limited or disrupted by any or all of the following factors:

• obligations to comply with a wide variety of foreign laws and other regulatory requirements; • political or economic instability; • trade restrictions; • changes in tariffs; • restrictions on repatriating profits; • reduced protection for intellectual property rights; • potentially adverse tax consequences; • difficulties in staffing and managing international operations; and • fluctuating exchange rates.

Risks Related to Our Industry

Intense competition in the market for glucose diagnostic products could prevent us from increasing or sustaining our revenues and prevent us from achieving or sustaining profitability.

The medical device industry, particularly the market encompassing our GlucoWatch Biographer, is intensely competitive, and we will compete with other providers of personal glucose monitors. Currently the market is dominated by finger-stick blood glucose monitoring products sold by a few major companies. These companies have established products and distribution channels. In addition, several companies are marketing alternative-site devices to monitor glucose levels in a painless manner or in a manner involving less pain than that associated with finger sticking. Furthermore, companies are attempting to develop a variety of methods to extract interstitial fluid and measure the glucose concentration therein, as well as developing devices to monitor glucose on a frequent and automatic basis. Another technology that some companies are pursuing utilizes infrared spectroscopy, which uses radiation to measure glucose levels. There can be no assurance that other products will not be accepted more readily in the marketplace than the GlucoWatch Biographer or will not render our current or future devices noncompetitive or obsolete. Additionally, the GlucoWatch Biographer or our other enhanced products under development may fail to replace any currently used devices or systems.

Furthermore, a number of companies have developed or are seeking to develop new diabetes drugs or treatments that could reduce or eliminate demand for all glucose monitoring systems. In addition, many of our competitors and potential competitors have substantially greater resources, larger research and development staffs and facilities and significantly greater experience in developing, manufacturing and marketing glucose monitoring devices than we do. Competition within the glucose monitoring industry could result in price reductions for glucose monitoring devices such that we may not be able to sell our products at a price level adequate for us to realize a return on our investment.

Competition for qualified personnel exists in our industry and in northern California. If we are unable to retain or hire key personnel, we may not be able to sustain or grow our business.

Our ability to operate successfully and manage our potential future growth depends significantly upon retaining key scientific, manufacturing, technical, managerial and financial personnel, and also attracting and retaining additional highly qualified personnel in these areas. We face competition for such personnel, and we may not be able to attract and retain these individuals, particularly in light of the uncertainty surrounding our litigation with Sankyo Pharma and Sankyo Japan. We compete with numerous pharmaceutical, health care and software companies, as well as universities and non-profit research organizations, in the northern California business area. The loss of key personnel or our inability to hire and retain additional qualified personnel in the future could prevent us from sustaining or growing our business. There can be no assurance that we will continue to be able to attract and retain sufficient qualified personnel.

Risks Related to Our Common Stock

Our common stock is subject to the requirements for penny stocks, which could adversely affect our stockholders’ ability to sell and the market price of their shares.

Our stock fits the definition of a penny stock. The Securities Exchange Act of 1934, as amended, defines a penny stock as any equity security that is not traded on a national securities exchange or authorized for quotation on the Nasdaq National Market and that has a market price of less than $5.00 per share, with certain exceptions. Penny stocks are subject to Rule 15(g) under the Securities and Exchange Act of 1934, as amended, which imposes

additional sales practice disclosure and market-making requirements on broker/dealers who sell or make a market in such securities. The rules require that, prior to a transaction in a penny stock not otherwise exempt from the rules, the broker/dealer must:

• deliver a standardized risk disclosure document that provides information about penny stocks and the risks in the penny stock market; • provide the customer with current bid and offer quotations for the penny stock; • disclose the compensation of the broker/dealer and its salesperson in connection with the transaction; • provide the customer monthly account statements showing the market value of each penny stock held in the customer’s account; and • make a special written determination that the penny stock is a suitable investment for the customer and receive the customer’s written agreement to the transaction.

These requirements may have the effect of reducing the liquidity and trading volume of our stock. As a result, it may be more difficult for stockholders to sell their shares of our stock and these requirements may adversely affect the price other investors are willing to pay for our stock.

Our stock price is volatile and stockholders may not be able to resell Cygnus shares at or above the price they paid, or at all.

The market price for shares of our common stock has been highly volatile. Factors such as the current litigation with Sankyo Pharma and Sankyo Japan, performance of commercialization functions, new product introductions by our competitors, levels of sales to end-user customers, regulatory approvals or delays or recalls of our products or those of our competitors, developments relating to our patents or proprietary rights or those of our competitors, and the results of clinical trials for products of our competitors, as well as period-to-period fluctuations in financial results, may have a significant impact on the market price of the common stock. Additionally, following periods of volatility in the market price for a company’s securities, securities class action litigation may be instituted. Such litigation could result in substantial costs to us and further divert management’s attention and resources.

Additional issuances of our common stock pursuant to the conversion of the Convertible Debentures could greatly dilute the ownership interest of our existing stockholders and lower our stock price.

We have approximately 56.5 million authorized and unissued shares of common stock. As of September 30, 2003, we had $20.3 million outstanding under both the 8.5% Convertible Debentures due June 29, 2004, as amended, and the 8.5% Convertible Debentures due September 29, 2004, as amended. Under these Convertible Debentures, each month the holders of the Convertible Debentures may collectively convert up to $500,000 of said Convertible Debentures into common stock, subject to certain pricing and volume restrictions. In the event that the conversion price is more than $3.50 per share, the holders of the Convertible Debentures may convert more than the $500,000 monthly limit, subject to certain volume restrictions. The total number of shares that may be issued under the Convertible Debentures depends on the market price of our common stock at the time that the shares are sold.

From April 1, 2003 and for the remaining term of the Convertible Debentures, the conversion price, calculated using Bloomberg’s volume average pricing function or a similar pricing method, referred to as the VWAP, is equal to 107% of any VWAP that is less than or equal to $2.00 per share, and 101% of any VWAP greater than $2.00 per share, subject to the minimum conversion price of $1.054 per share. In no instance will the conversion price be less than $1.054 per share.

The following table illustrates hypothetically the effect that variations in the market price in our common stock and resulting variations in conversion prices would have on the number of shares issued in a one-month period:

Market Price	Conversion Price			Number of Shares Issued Based on a
Per Share	Per Share			$500,000 Maximum (one month)
$ 5.00	$	5.05			99,009
$ 3.50	$	3.54			141,242
$ 2.50	$	2.525			198,019
$ 1.50	$	1.605			311,625
$ 0.985	$	1.054	*		474,383
$ 0.50	$	1.054	*		474,383
$ 0.25	$	1.054	*		474,383
$ 0.15	$	1.054	*		474,383

* From April 1, 2003 for the remaining term of the Convertible Debentures, the conversion price will be at least $1.054 per share, regardless of the market price.

If we or our stockholders sell substantial amounts of our common stock, whether or not as part of a Convertible Debenture transaction, the market price of our common stock may fall. These sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. In addition, we have discussed the possibility of restructuring our payment schedule under the Convertible Debentures and possibly reducing the minimum conversion price in effect for our Convertible Debentures, which would cause significant dilution to our existing stockholders, although neither we nor the Debenture holders have committed to any such amendment or conversion to date.

Although it is highly unlikely that we will be able to draw on our equity line agreement, additional issuances of our common stock under the equity line agreement could greatly dilute the ownership interest of our existing stockholders and lower our stock price.

Since we are not currently listed on either the Nasdaq National Market or the SmallCap Market, the investors under our remaining equity line agreement may elect to suspend or terminate this agreement, in which case we would not be able to utilize the $29.0 million available under this equity line agreement. Even if these investors elect not to suspend or terminate this agreement, we believe, as a practical matter, we will not be able to draw on this equity line agreement for the foreseeable future. So long as we are not listed on a national exchange or quoted on the Nasdaq National Market or the SmallCap Market, we believe that it will not be practical for us to draw on our equity line in light of (i) the penny stock rules that require the underwriter to undertake relatively burdensome disclosure obligations in connection with issuances of penny stock securities such as ours, (ii) our need to individually comply with each state’s blue sky laws governing unlisted securities issuances, and (iii) the relatively high level of dilution that issuances would have at current market prices for our stock. However, in the event that we transfer back to the Nasdaq Stock Market, provided our equity line agreement has not been terminated or suspended prior to such transfer, the $29.0 million under this equity line agreement would become available to us again. In such instance, subject to certain requirements, we may then choose to sell up to $4.0 million of common stock per 30-day period (or $2.0 million of common stock per 15-day period) and our investors may then exercise their option to purchase, subject to our approval, up to an additional $3.0 million of common stock per 30-day period. The total number of shares that may be issued under our equity line agreement depends on the market price of our common stock at the time that the shares are sold, on whether we choose to sell shares and on the number of shares we choose to sell. The following table illustrates hypothetically the effect that variations in the market price in our common stock and resulting variations in sales prices would have on the number of shares issued in a 30-day period, assuming that we would choose to sell all possible shares under our equity line agreement.

	Number of Shares Issued Based on a $7.0
Price Per Share	Million Maximum (30-day period)
$5.00		1,400,000
$2.50		2,800,000
$1.00		7,000,000
$0.50		14,000,000
$0.25		28,000,000
$0.15		46,666,666

Under our equity line agreement, we have agreed to issue warrants to Cripple Creek Securities, LLC to purchase shares in an amount equal to 10% of the number of shares issued under the equity line agreement in any given year. The warrants are to be issued after the end of each calendar year and will be exercisable for five years from the date they are issued at an exercise price based on the weighted average price at which shares were sold during the preceding calendar year. Moreover, we have agreed to register the shares underlying these warrants to enable such shares to be freely resold immediately after the warrants are exercised.

In addition to issuances of common stock under our equity line agreement, if we or our stockholders sell substantial amounts of our common stock, including shares issued upon the exercise of outstanding options and warrants, the market price of our common stock may fall. These sales also may make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate.

Issuances by us of authorized preferred stock can have adverse effects, including dilution and discouragement of takeovers.

Our certificate of incorporation contains certain provisions that may delay or prevent a takeover. The Company currently has 5,000,000 shares of authorized and unissued Preferred Stock. Our Board of Directors has the authority to determine the price, rights, preferences and restrictions, including voting and conversion rights, of these shares without any further action or vote by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of preferred stock that may be issued in the future. Such provisions could adversely affect the holders of common stock in a variety of ways, including by potentially discouraging, delaying or preventing a takeover of Cygnus and by diluting stockholder ownership.

Provisions of our charter documents and Delaware law may inhibit a takeover, thus limiting the price investors might be willing to pay in the future for our common stock.

Provisions in our Restated Certificate of Incorporation and Bylaws may have the effect of delaying or preventing an acquisition of our Company or a merger in which we are not the surviving company and may otherwise prevent or slow changes in our Board of Directors and management. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law. These provisions could discourage an acquisition of our company or other change in control transaction and thereby negatively impact the price that investors might be willing to pay in the future for our common stock.

We do not pay cash dividends and do not anticipate paying any dividends in the future, so any short-term return on stockholders’ investment will depend on the market price of our shares, which is volatile.

We have never paid any cash dividends on our capital stock. We anticipate that we will retain our earnings, if any, to support operations and to finance the growth and development of our business. Therefore, we do not expect to pay cash dividends in the foreseeable future. Any short-term return on stockholders’ investment will depend only on the market price of our shares and stockholders’ ability to liquidate their investment.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

The Company has no material changes to the disclosure made on this matter in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2002.

Item 4. Controls and Procedures.

(a) Evaluation of disclosure controls and procedures. Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of Cygnus’ “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934, as amended, Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Quarterly Report on Form 10-Q based on such evaluation, we believe that there are adequate controls and procedures in place to ensure that information relating to the Company and our consolidated subsidiaries that is required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is properly disclosed as required by the Securities Exchange Act of 1934, as amended.

(b) Changes in internal controls. There were no significant changes in the internal controls over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

It should be noted that any system of controls, however well-designed and operated, can provide only reasonable and not absolute assurance that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

On October 2, 2003, Sankyo Pharma stated that they were stopping performance of their contractual obligations. In addition, Sankyo Pharma acknowledged that they had not paid invoices owed to us and informed us that they had no intention of remitting payment for such amounts. As of October 10, 2003, these invoices total over $6.0 million. Sankyo Pharma stated that they were relying on California Commercial Code, Section 2609(1) as a purported legal basis for ceasing performance of their contractual obligations. Section 2609(1) generally gives parties the right to demand adequate assurance of due performance by their counterparty of its contractual obligations if reasonable grounds of insecurity arise with respect to performance by the counterparty. Sankyo Pharma has stated that they had grounds for insecurity regarding our financial position and our ability to perform under the Sales, Marketing and Distribution Agreement and related contracts we have with Sankyo Pharma.

On October 6, 2003, we filed a complaint in the Superior Court of the State of California for the County of San Mateo against Sankyo Pharma and Sankyo Japan for breach of contract and intentional interference with contract relating to the sales, marketing and distribution of our GlucoWatch Biographer products. During the initial 12-year term of our Sales, Marketing and Distribution Agreement with Sankyo Pharma, there are no termination rights except in very specific circumstances, none of which, we believe, has occurred. We are seeking substantial compensatory damages and other relief. The litigation in which we are currently involved may affect, among other things, our ability to sell, market and distribute our products in the United States, our financing activities, the retention of our remaining personnel and our ability to continue as a going concern. We cannot predict with certainty the eventual outcome of the pending litigation, which may result in a significant adverse jury verdict or punitive damages award, or a judgment that certain of our allegations are invalid or unenforceable. This kind of litigation could be very costly and will divert our management’s attention and resources, and any adverse determination in this litigation, or delay in resolving this litigation, may cause us to cease operations and/or seek protection under the bankruptcy laws.

On October 9, 2003, we announced a reduction in force of approximately 60% of our work force as a result of Sankyo Pharma’s decision to stop performing under its contracts with us. We have suspended our manufacturing activities and research and development efforts for future products. We are not likely to continue to manufacture current products or develop new products in the near future. According to Sankyo Pharma, however, they are currently warehousing inventory approximating two years’ sales of our products, and these products remain available for sale in the United States.

On October 16, 2003, we responded to Sankyo Pharma’s request for assurances under California Commercial Code, Section 2609(1). Sankyo Pharma had notified us, as well as certain health care professionals, that they will continue to provide marketing, sales, and distribution support for our GlucoWatch G2 Biographer; however, given their decision to stop performing under their contracts with us and our litigation, the commercial status of our products in the United States is unclear. We have begun looking at alternative sales, marketing and distribution approaches for our products.

On November 6, 2003, Sankyo Pharma filed an answer and cross-claims against us for declaratory relief, breach of contract, and defamation. We have not yet filed a response to these claims. We believe that we have meritorious defenses to the causes of action asserted against us by Sankyo Pharma, and we intend to vigorously defend ourselves against these claims. This litigation is in its early stages, however, and is therefore inherently difficult to assess.

Item 6. Exhibits and Reports on Form 8-K.

a) Exhibits

The following exhibits are filed herewith or incorporated by reference:

3.01		Bylaws of the Registrant, as amended, incorporated by reference to Exhibit 3.01 of the Registrant’s Form 10-Q for the three months ended June 30, 2002.
3.02		Restated Articles of Incorporation of the Registrant, as amended to date, incorporated by reference to Exhibit 3.02 of Registrant’s Form 10-Q for the three months ended June 30, 2002.

4.01		Specimen of Common Stock Certificate of the Registrant, incorporated by reference to Exhibit 4.1 of the Registrant’s Registration Statement on Form S-1 (File No. 33-38363) filed on December 21, 1990 (Form S-1).
4.02		Amended and Restated Rights Agreement dated October 27, 1998 between the Registrant and ChaseMellon Shareholder Services, L.L.C. (the “Rights Agent” successor to Chemical Trust), which includes the Certificate of Determination for the Series A Junior Participating Preferred Stock as Exhibit A, the form of Rights Certificate as Exhibit B and the Summary of Rights to purchase Preferred Shares as Exhibit C, incorporated by reference to Exhibit 99.2 of the Registrant’s Form 8-A12B/A (File No. 0-18962) filed on December 14, 1998.
4.03		Registration Rights Agreement dated June 30, 1999 between the Registrant and Cripple Creek Securities, LLC, incorporated by reference to Exhibit 4.11 of the Registrant’s Form 10-Q for the three months ended June 30, 1999.
4.04		Registration Rights Agreement dated June 29, 1999 between the Registrant and the listed Investors on Schedule I thereto, incorporated by reference to Exhibit 4.12 of the Registrant’s Form 10-Q for the three months ended June 30, 1999.
4.05		Registration Rights Agreement dated October 1, 2001 between Cygnus, Inc. and Cripple Creek Securities, LLC, incorporated by reference to Exhibit 4.1 of the Registrant’s Registration Statement on Form S-3 (File No. 333-71524) filed on October 12, 2001.
31.1		Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rule 13a-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rule 13a-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

b) Current Reports on Form 8-K

The following Current Report on Form 8-K was filed during the three months ended September 30, 2003:

On August 14, 2003, we filed a Current Report on Form 8-K, reporting under Item 12 the Company’s financial results for the quarter ended June 30, 2003.

SIGNATURES

Pursuant to the requirements 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.

		CYGNUS, INC.
Date:	November 13, 2003	By:	/s/ John C Hodgman
			John C Hodgman
			Chairman, President and Chief Executive Officer
			(Principal Executive Officer)
Date:	November 13 , 2003	By:	/s/ Craig W. Carlson
			Craig W. Carlson
			Chief Operating Officer and Chief Financial Officer
			(Principal Accounting Officer)

EXHIBIT INDEX

Exhibit
Number		Description
31.1		Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rule 13a-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rule 13a-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Filing Compare · CYGNUS INC /DE/