UNITED STATES


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON
      D.C. 20549**





**FORM
      10-QSB**




**{x} QUARTERLY
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**




**For
      the quarterly period ended September30,
      2006**




**{
      } TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934**


(No
      Fee
      Required)





For
      the
      transition period from ________________ to




Commission
      file number 333-102629


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





**Dyadic
      International, Inc.**


(Exact
      name of small business issuer as specified in its charter)


****


**Delaware**
            **45-0486747**(State
                or other jurisdiction of incorporation or
                organization)
            (I.R.S.
                Employer Identification No.)**140 Intracoastal Pointe
              Drive, Suite 404, Jupiter, Florida**
            **33477**(Address
                of principal executive offices)
            (Zip
                Code)




**(561)
      743-8333**


(Issuer’s
      telephone number)





Check
      whether the issuer (1) filed all reports required to be filed by Section 13
      or
      15(d) of the Exchange Act during the past 12 months (or for such shorter period
      that the registrant was required to file such reports), and (2) has been subject
      to such filing requirements for the past 90 days. Yes { x } No { }





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act): Yes
      { };
      No {X}





As
      of November 10, 2006, there were 26,940,506shares of registrant’s common stock outstanding, par value $.001
      (including 180,229
      shares held in escrow).





Transitional
      Small Business Disclosure Format (Check One): Yes { }; No {X}











**TABLE
      OF CONTENTS**














**PART
                I. FINANCIAL INFORMATION**
            
            PageItem
                1.
            Financial
                Statements (Unaudited)Condensed
                Consolidated Balance Sheet - September 30, 2006
            3Condensed
                Consolidated Statements of Operations - Three-Months and Nine-Months
                ended September 30, 2006 and 2005
            4Condensed
                Consolidated Statements of Cash Flows - Nine-Months ended September
                30, 2006 and 2005
            5Notes
                to Condensed Consolidated Financial Statements
            6Item
                2.
            Management's
                Discussion and Analysis or Plan of Operation
            19Item
                3.
            Controls
                and Procedures
            38**PART
                II. OTHER INFORMATION**Item
                6.
            Exhibits
            38Signatures
            39

































**2**


PART
      I.
      FINANCIAL INFORMATION


***Item
      1. Financial Statements (Unaudited)***




**Dyadic
      International, Inc.**


**Condensed
      Consolidated Balance Sheet**


**September
      30, 2006**


**(Unaudited)**


AssetsCurrent
                assets:Cash
                and cash equivalents
            
            $
            9,436,613Accounts
                receivable, net of allowance for uncollectible accounts of
                $598,953
            
            
            2,976,433Inventory
            
            
            6,280,197Prepaid
                expenses and other current assets
            
            
            1,253,298Total
                current assets
            
            
            19,946,541Fixed
                assets, net
            
            
            1,818,991Intangible
                assets, net
            
            
            109,079Goodwill
            
            
            1,808,458Other
                assets
            
            
            67,448Total
                assets
            
            $
            23,750,517Liabilities
                and stockholders’ equityCurrent
                liabilities:Accounts
                payable
            
            $
            1,694,717Accrued
                expenses
            
            
            1,586,756Accrued
                interest - shareholder
            
            
            48,897Income
                taxes payable
            
            
            100,539Total
                current liabilities
            
            
            3,430,909Long-term
                liabilities:Note
                payable to stockholder
            
            
            2,367,305Other
                liabilities
            
            
            74,078Total
                long-term liabilities
            
            
            2,441,383Total
                liabilities
            
            
            5,872,292Stockholders’
                equity:Preferred
                stock, $.0001 par value:Authorized
                shares - 5,000,000; none issued and outstanding
            
            
            --Common
                stock, $.001 par value,Authorized
                shares - 100,000,000; issued and outstanding - 24,623,525
            
            
            24,624Additional
                paid-in capital
            
            
            59,770,752Notes
                receivable from exercise of stock options
            
            
            (212,500
            )Accumulated
                deficit
            
            
            (41,704,651
            )Total
                stockholders’ equity
            
            
            17,878,225Total
                liabilities and stockholders’ equity
            
            $
            23,750,517





*See
      accompanying notes.*




**3**





**Dyadic
      International, Inc.**


**Condensed
      Consolidated Statements of Operations**


**(Unaudited)**








**Three-Months
                Ended**
            
            **Nine-Months
                Ended****September
                30,**
            
            **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                sales
            
            $
            4,204,771
            
            $
            4,140,145
            
            $
            12,000,093
            
            $
            11,862,582Cost
                of goods sold
            
            
            2,893,037
            
            
            3,317,956
            
            
            8,726,450
            
            
            9,513,604Gross
                profit
            
            
            1,311,734
            
            
            822,189
            
            
            3,273,643
            
            
            2,348,978Expenses:Research
                and development
            
            
            997,791
            
            
            1,020,105
            
            
            2,895,749
            
            
            3,529,268Selling
                and marketing
            
            
            924,476
            
            
            809,824
            
            
            2,540,355
            
            
            1,996,221General
                and administrative
            
            
            1,728,772
            
            
            1,412,625
            
            
            5,140,510
            
            
            4,311,875Foreign
                currency exchangelosses
                (gains), net
            
            
            14,535
            
            
            9,127
            
            
            111,277
            
            
            (27,354
            )Total
                expenses
            
            
            3,665,574
            
            
            3,251,681
            
            
            10,687,891
            
            
            9,810,010Loss
                from operations
            
            
            (2,353,840
            )
            
            (2,429,492
            )
            
            (7,414,248
            )
            
            (7,461,032
            )Other
                income (expense):Interest expense
            
            
            (70,218
            )
            
            (177,184
            )
            
            (517,969
            )
            
            (526,945
            )Investment income, net
            
            
            104,065
            
            
            109,232
            
            
            293,916
            
            
            132,490Minority interest
            
            
            --
            
            
            (24,805
            )
            
            (13,355
            )
            
            (35,376
            )Other income, net
            
            
            1,328
            
            
            5,637
            
            
            12,949
            
            
            1,621Total
                other income (expense)
            
            
            35,175
            
            
            (87,120
            )
            
            (224,459
            )
            
            (428,210
            )Loss
                before income taxes
            
            
            (2,318,665
            )
            
            (2,516,612
            )
            
            (7,638,707
            )
            
            (7,889,242
            )Provision
                for income taxes
            
            
            25,351
            
            
            15,387
            
            
            58,227
            
            
            43,265Net
                loss
            
            $
            (2,344,016
            )
            $
            (2,531,999
            )
            $
            (7,696,934
            )
            $
            (7,932,507
            )Net
                loss per common share:Basic
                and diluted
            
            $
            (0.10
            )
            $
            (0.11
            )
            $
            (0.33
            )
            $
            (0.36
            )Weighted
                average common sharesused
                in calculating net loss per share:Basic
                and diluted
            
            
            24,565,671
            
            
            22,251,105
            
            
            23,582,285
            
            
            22,084,352














*See
      accompanying notes.*




**4**


**Dyadic
      International, Inc.**


**Condensed
      Consolidated Statements of Cash Flows**


**(Unaudited)**


**Nine-Months
                Ended September 30,****2006**
            
            **2005****Operating
                activities**Net
                loss
            
            $
            (7,696,934
            )
            $
            (7,932,507
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization of fixed assets
            
            
            182,605
            
            
            385,656Amortization
                of intangible and other assets
            
            
            39,096
            
            
            55,104Amortization
                of costs related to modification of notes payable to
                stockholder
            
            
            313,500
            
            
            278,352Minority
                interest
            
            
            13,355
            
            
            35,375Provision
                for doubtful accounts
            
            
            68,215
            
            
            151,716Loss
                on asset disposal
            
            
            1,706
            
            
            --Stock
                issued to officer
            
            
            50,000
            
            
            2,448Stock
                issued for consulting services
            
            
            530,821
            
            
            66,500Compensation
                expense on stock option grants
            
            
            625,958
            
            
            50,566Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            (175,481
            )
            
            292,001Inventory
            
            
            (866,639
            )
            
            1,448,982Prepaid
                expenses and other current assets
            
            
            (448,670
            )
            
            268,382Other
                assets
            
            
            64,832
            
            
            41,575Accounts
                payable
            
            
            (900,613
            )
            
            (1,428,888
            )Accrued
                expenses
            
            
            372,519
            
            
            107,835Accrued
                interest payable to stockholders
            
            
            (20,470
            )
            
            (40,436
            )Deferred
                revenue
            
            
            --
            
            
            (75,000
            )Income
                taxes payable
            
            
            46,433
            
            
            43,770Short
                term notes payable
            
            
            (267,590
            )
            
            --Other
                liabilities
            
            
            (32,607
            )
            
            (1,358
            )Total
                adjustments
            
            
            (403,030
            )
            
            1,682,580Net
                cash used in operating activities
            
            
            (8,099,964
            )
            
            (6,249,927
            )**Investing
                activities**Purchases
                of fixed assets, net
            
            
            (463,427
            )
            
            (356,252
            )Purchase
                of minority interest
            
            
            (375,000
            )
            
            --Release
                of restricted cash deposit
            
            
            34,887
            
            
            --Net
                cash used in investing activities
            
            
            (803,540
            )
            
            (356,252
            )**Financing
                activities**Proceeds
                from stock warrant exercises
            
            
            5,037,348
            
            
            --Proceeds
                from stock option exercises
            
            
            1,152,920
            
            
            --Payment
                for issuance costs related to private offering
            
            
            --
            
            
            (97,764
            )Net
                cash provided by (used in) financing activities
            
            
            6,190,268
            
            
            (97,764
            )Net
                decrease in cash and cash equivalents
            
            
            (2,713,236
            )
            
            (6,703,943
            )Cash
                and cash equivalents at beginning of period
            
            
            12,149,848
            
            
            20,510,650Cash
                and cash equivalents at end of period
            
            $
            9,436,613
            
            $
            13,806,707Less
                restricted cash
            
            
            --
            
            
            (34,658
            )Unrestricted
                cash and cash equivalents
            
            $
            9,436,613
            
            $
            13,772,049**Noncash
                investing and financing activities:**Fair
                value of common stock issued for land purchase
            
            $
            --
            
            $
            861,861Fair
                value of common stock issued for minority interest
                purchase
            
            $
            1,328,131
            
            $
            --Common
                stock issued for conversion of convertible notes payable to stockholders
                at an exercise price of $3.33
            
            $
            1,577,872
            
            $
            --


*See
      accompanying notes.*


**5**






**Dyadic
      International, Inc.**


**Notes
      to Condensed Consolidated Financial StatementsSeptember 30,
      2006**


**(Unaudited)**








**1.
      Basis of Presentation and Summary of Significant Accounting
      Policies**





*General*





Dyadic
      International, Inc. (the “Company” or “Dyadic”), is a global biotechnology
      company based in Jupiter, Florida, with operations in the United States of
      America, Hong Kong and mainland China, Poland and The Netherlands. The Company
      is engaged in research and development, the collaborative licensing of its
      patented and other proprietary technologies to develop and manufacture
      biological products and the manufacture and sale of industrial enzymes and
      other
      proteins for the industrial, biorefinery and pharmaceutical industries,
      including:





·
            the
                textile, pulp & paper, animal feed, alcohol, starch, and food and
                beverage industries, where Dyadic currently sells more than 45 liquid
                and
                dry enzyme products to more than 200 industrial customers in approximately
                50 countries which it refers to as its Enzyme Business;





·
            enzymes
                and related biotechnological processes for use in converting various
                agricultural products (e.g. corn), agricultural residue products
                (e.g.
                dried distillers grains (DDG’s), wheat straw, and sugar cane
                bagasse) and forestry industry residues (e.g. wood pulp and chips)
                into fermentable sugars, which can then be used in the production
                of
                traditional and cellulosic ethanol, as well as other products currently
                derived from petroleum, such as plastics and polymers, which it
                collectively refers to as “Biorefinery Products”;
                and





·
            human
                therapeutic protein candidates, with focus on antibodies, for use
                by
                pharmaceutical and biotechnology companies in pre-clinical and clinical
                drug development applications and commercialization following drug
                approval, which it refers to as its BioSciences Business.





Using
      information gathered from the C1 (our patented *Chrysosporium
      lucknowense* fungus)
      genome sequence that was performed in 2005 and from the subsequent annotation
      currently being performed in collaboration with Scripps-Florida, Dyadic intends
      to further improve its capabilities for production of therapeutics and other
      foreign proteins in C1. The first phase of the annotation has demonstrated
      over 11,000 genes in C1. As many as 120 of those genes have been found to
      encode the processes that could positively or negatively affect protein
      production (i.e. gene expression, protein secretion, protein degradation, and
      protein folding) as well as the production of enzymes with uses in a number
      of
      industries. Using the genetic tools developed for C1, those processes
      potentially can be altered, identified and modified in such a way as to improve
      the yields and range of proteins produced in C1.





*Basis
      of Presentation*





The
      accompanying unaudited condensed consolidated financial statements have been
      prepared in accordance with U.S. generally accepted accounting principles for
      interim information and with the United States Securities and Exchange
      Commission’s (the “SEC”) instructions to Form 10-QSB and Regulation S-B.
      Accordingly, they do not include all of the information and footnotes required
      by U.S. generally accepted accounting principles for complete financial
      statements. In the opinion of management, all adjustments of a normal and
      recurring nature considered necessary for a fair presentation have been
      included. Operating results for the three-month and nine-month periods ended
      September 30, 2006 may not necessarily be indicative of the results that may
      be
      expected for the year ending December 31, 2006.





For
      further information, refer to Dyadic International, Inc.’s audited consolidated
      financial statements and footnotes thereto included in its Annual Report on
      Form
      10-KSB for the year ended December 31, 2005, as filed with the SEC.




**6**


*Historical
      Results of Operations*





The
      Company has incurred losses from operations during the last several years,
      which
      have resulted in an accumulated deficit of approximately $41.7 million as of
      September 30, 2006. The Company attributes these operating results to
      discretionary research and development expenditures to improve the Company’s
      patented C1 Host Technology, which may have utility across broad and as of
      yet,
      untapped markets. Operating losses have also been the result of the expansion
      of
      the Company’s operations and administrative support staff as a newly public
      company engaged in enzyme biotech research, and its increased sales and
      marketing spending to expose new products to the marketplace. In order to
      advance its science and to develop new products, the Company has continued
      to
      incur discretionary research and development expenditures during 2005 and
      through 2006. The Company believes these discretionary research and development
      expenditures will continue in 2007 and beyond as the Company considers potential
      collaborative relationships.




The
      Company believes that there will be sufficient capital to fund its operations
      and meet its obligations for the next twelve months. The Company has
      historically built up its inventory levels in the first half of the year as
      a
      result of its contract manufacturer’s annual hiatus for vacation and
      maintenance, which occurred this year in September and October. For the
      nine-month period ended September 30, 2006, inventory increased by approximately
      $867,000, which the Company intends to utilize during the fourth quarter of
      2006, which will result in reduced cash disbursements for inventory during
      the
      fourth quarter of 2006.





On
      October 26, 2006, Dyadic International, Inc. and its wholly-owned subsidiary
      Dyadic International (USA), Inc. (together referred to as the “Company” or
“Dyadic”) signed a Research and Development Agreement and a Securities Purchase
      Agreement with Abengoa Bioenergy R&D, Inc. focusing on research and
      development. Under the terms of the Securities Purchase Agreement, Abengoa
      invested $10 million in Dyadic, for which it was issued 2,136,752 shares of
      Dyadic Common Stock. Subsequent to the closing, which occurred on November
      8,
      2006, under certain circumstances, additional securities of the Company may
      be
      issuable to Abengoa (see Note 6, Subsequent Events for full disclosure of the
      transaction).





The
      Company has established a number of flexible contractual relationships in the
      areas of manufacturing and research and development, enabling it to adjust
      spending in those areas as necessary, to achieve the objectives of its business
      plan, and manage both its resources and cash utilization rate. The Company
      has
      historically funded losses from operations with proceeds from external
      borrowings, borrowings from its stockholders, and sales of preferred and common
      equity securities. Additional funds may be needed and raised through public
      or
      private debt and/or equity financings or a combination of the foregoing,
      exercise or conversion of equity instruments, collaborative relationships,
      licensing or selling of certain technologies or other arrangements. Additional
      funding, if sought, may not be available at all, or may not be available on
      terms acceptable to the Company. Further, any additional equity financing may
      be
      dilutive to stockholders, and debt financing, if available, may involve
      restrictive covenants. Failure to raise capital when needed may harm the
      Company’s operations, financial condition and cash flows.





*Recent
      Accounting Pronouncements*





As
      discussed in Note 3 *,* Share-Based
      Compensation, the Company adopted Financial Accounting Standards Board (FASB)
      No. 123(R) effective January 1, 2006 using the “modified prospective”
method. The Company recognized share-based compensation expense for its
      share-based stock option awards of approximately $185,000 and $626,000 during
      the three-month and nine-month periods ended September 30, 2006, respectively
      which was calculated under the provisions of FAS 123(R) The Company estimates
      that, based on current share-based awards granted to date, share-based
      compensation expense related to all unvested stock options outstanding for
      fiscal 2006 will be approximately $843,000.




In
        May
        2005, the
        Financial Accounting Standards Board (FASB) issued Statement
        of Financial Accounting Standards (SFAS) No. 154, *Accounting
        Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB
        Statement No. 3* (SFAS
        154).  This Statement replaces APB Opinion No. 20, *Accounting
        Changes* ,
        and
        SFAS No. 3, *Reporting
        Accounting Changes in Interim Financial Statements* ,
        and
        changes the requirements for the accounting for and reporting of a change
        in
        accounting principle and error corrections.  This Statement applies to all
        voluntary changes in accounting principle.  It also applies to changes
        required by an accounting pronouncement in the unusual instance that the
        pronouncement does not include specific transition provisions.  When a
        pronouncement includes specific transition provisions, those provisions should
        be followed.  SFAS 154 is effective for accounting changes and corrections
        of errors made in fiscal years beginning after December 15, 2005.  Earlier
        application was permitted for accounting changes and corrections of errors
        made
        occurring in fiscal years beginning after September 1, 2005.  The Company
        adopted this standard on January 1, 2006. The
        adoption of this standard did not have a significant impact on the Company’s
        consolidated financial position, results of operations or cash
        flows.


In
      September 2006, the FASB adopted Statement No. 157, *Fair
      Value Measurements* (FAS
      157). FAS 157 provides enhanced guidance for using fair value to measure assets
      and liabilities. The standard also responds to investors’ requests for expanded
      information about the extent to which companies measure assets and liabilities
      at fair value, the information used to measure fair value, and the effect of
      fair value measurements on earnings. The standard


**7**




applies
      whenever other standards require (or permit) assets or liabilities to be
      measured at fair value. The standard does not expand the use of fair value
      in
      any new circumstances. FAS 157 is effective for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Early adoption
      is permitted. The Company does not believe that the adoption of FAS 157 will
      have an impact on its consolidated results of operations, financial condition
      or
      cash flows.




In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108,
“ *Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements* ”
(“SAB
      108”), which is effective for fiscal years ending after November 15, 2006.
      SAB 108 provides guidance on the consideration of the effects of prior year
      immaterial misstatements in quantifying current year misstatements for the
      purpose of a materiality assessment on both the balance sheet and income
      statement. SAB 108 would require restatement of prior year financial statements
      for current year misstatements even if the revisions are immaterial to those
      prior years, if the correction would be material to the current year. SAB 108
      allows for the cumulative effect of the initial application to be made to
      beginning retained earnings. The
      Company is currently assessing the effect of adopting SAB 108, but does not
      expect that it will have a material effect on its consolidated
      results of operations, financial condition or cash flows .





In
      June
      2006, the FASB issued Interpretation No. 48, “ *Accounting
      for Uncertainty in Income Taxes - an interpretation of FASB Statement
      No. 109* ”
(FIN
      48). FIN 48 prescribes a recognition threshold and measurement attribute for
      financial statement recognition and measurement of a tax position taken or
      expected to be taken in a tax return, and also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure, and transition. FIN 48 is effective for fiscal years
      beginning after December 15, 2006. The Company does not believe that the
      adoption of FIN 48 will have an impact on its consolidated results of
      operations, financial condition or cash flows.





*Use
      of Estimates*





The
      preparation of condensed consolidated financial statements in conformity with
      U.S. generally accepted accounting principles requires management to make
      estimates and assumptions that affect the amounts reported in the condensed
      consolidated financial statements. Actual results could differ from those
      estimates.





*Net
      Loss Per Share*





Basic
      and
      diluted net loss per share have been computed using the weighted-average number
      of shares of common stock outstanding during the periods presented.





The
      following potentially dilutive securities were not included in the calculation
      of diluted net loss per share as they were anti-dilutive for the respective
      periods presented:




**Three-Months
                and Nine-Months Ended September 30,****2006**
            
            **2005**Instruments
                to purchase common stock:Stock
                options outstanding pursuant to the 2001 EquityCompensation
                Plan
            
            
            3,054,261
            
            
            1,666,789Other
                stock options
            
            
            --
            
            
            65,000Warrants
                outstanding
            
            
            5,841,413
            
            
            6,952,776Common
                stock issuable pursuant to conversion features related
                to subordinated convertible notes payable
            
            
            --
            
            
            473,835Total
                shares of common stock considered anti-dilutive
            
            
            8,895,674
            
            
            9,158,400





There
      are
      contingently issuable shares under an agreement to conduct research and
      development activities on behalf of the Company pursuant to the arrangement
      described in Note 3 Share-Based Compensation - Common Stock Issuances, of which
      180,229 shares are also excluded from the calculation of diluted net loss per
      share for the three-month and nine-month periods ended September 30, 2006 and
      300,300 shares are also excluded from the calculation of


**8**




diluted
      net loss per share for the three-month and nine-month periods ended September
      30, 2005. Such shares of common stock are unearned, nonvested, restricted shares
      that will be considered outstanding once earned under the agreement. As of
      September 30, 2006, 120,071 shares have been earned and are outstanding. None
      were earned or outstanding at September 30, 2005.




*Concentrations*





The
      Company's credit risks consist primarily of uncollateralized accounts receivable
      from customers in the textile, pulp & paper, animal feed and other
      industries. The Company performs periodic credit evaluations of its customers'
      financial condition and provides allowances for doubtful accounts as required.





During
      the nine-month period ended September 30, 2006 there was one customer that
      accounted for approximately 9.4% of net sales. During the nine-month period
      ended September 30, 2005, there were two customers that accounted for
      approximately 10.3% and 9.4%, respectively, of net sales. There were two
      customers as of September 30, 2006, whose trade receivable balances equaled
      or
      exceeded 5% of total receivables, representing approximately 15.3% and 6.8%,
      respectively, of total accounts receivable. The loss of business from one or
      a
      combination of the Company’s significant customers and/or the failure to realize
      the accounts receivable attributable to one or more of the Company’s significant
      customers could adversely affect its operations, financial condition and cash
      flows.





*Inventory*





Inventory
      consists of raw materials and finished goods, including enzymes used in the
      industrial, chemical and agricultural markets, and is stated at the lower of
      cost or market using the average cost method. Finished goods include raw
      materials and manufacturing costs, substantially all of which are incurred
      pursuant to agreements with independent manufacturers. Provisions have been
      made
      to reduce excess or obsolete inventory to net realizable value.





At
      September 30, 2006, inventory consisted of the following:





Finished
                goods
            
            $
            5,012,691Raw
                materials
            
            
            1,267,506Total
                inventory
            
            $
            6,280,197




*Goodwill*





To
      apply
      the provisions of Statement of Financial Accounting Standards (SFAS) No.142, *Goodwill
      and Other Intangible Assets* (SFAS
      142) *,* the
      Company is required to identify its reporting units. Based on an analysis of
      economic characteristics and how the Company operates its business, the Company
      has designated its geographic locations as its reporting units: the United
      States (which includes the Company's subsidiary in Poland), The Netherlands,
      Hong Kong and mainland China. All goodwill is associated with the Hong Kong
      reporting unit.





On
      April
      28, 2006, the Company and its then 82.5% majority owned Asian Subsidiary entered
      into a satisfaction and purchase agreement with the Asian Subsidiary’s two
      minority shareholders, its managing director and one of its other key employees,
      effective as of January 1, 2006. The minority shareholders received $375,000
      in
      cash and 212,501 shares of unregistered common stock of the Company in
      consideration for: (i) the transfer to the Company of all of the Asian
      Subsidiary’s shares (representing 17.5% of its outstanding shares) held by the
      minority shareholders, bringing the Company’s ownership in the Asian Subsidiary
      to 100% and relieving the Company’s minority interest liability of approximately
      $117,000; (ii) a release of the Company for, among other things, a potential
      $405,000 contingent obligation to the managing director incident to the
      Company’s purchase of its initial majority interest in the Asian Subsidiary in
      1998; and (iii) the cancellation of all indebtedness of the Asian Subsidiary
      owed to the minority shareholders in the amount of approximately $172,000 of
      principal and $70,000 of accrued interest, as of the effective date. The
      Company’s shares were valued at approximately $1,328,000 based on the fair
      market value of the Company’s common stock on April 28, 2006, the measurement
      date for accounting purposes. The Company recorded approximately $1,341,000
      of
      goodwill related to the transaction, bringing the net goodwill balance at
      September 30, 2006 to approximately $1,808,000, which is reflected in the
      accompanying condensed consolidated balance sheet. Effective May 1, 2006, the
      Company is recording 100% of the Asian Subsidiary’s operating results in the
      accompanying condensed consolidated statements of operations.





In
      accordance with the provisions of SFAS 142, the Company performed an impairment
      review of its goodwill, which was completed as of June 30, 2006. This test
      involved the use of estimates to determine the fair value of the Company's
      Asian
      reporting unit and the comparison of fair value to the carrying value of the
      reporting unit. The impairment review resulted in no goodwill impairment charge.


**9**




*Revenue
        Recognition*
 
 The
        Company recognizes revenues in accordance with Staff Accounting Bulletin
        (SAB)
        No 104, *Revenue
        Recognition in Financial Statements* (SAB
        104). SAB 104 sets forth four basic criteria that must be met before SEC
        registrants can recognize revenue. These criteria are: persuasive evidence
        of an
        arrangement must exist; delivery had to have taken place or services had
        to have
        been rendered; the seller's price to the buyer should be fixed or determinable;
        and collectibility of the receivable should be reasonably assured. Sales
        not
        meeting any of the aforementioned criteria are deferred. The Company recognizes
        revenue when title passes to the customer, based upon the specified freight
        terms for the respective sale. Sales are comprised of gross revenues less
        provisions for expected customer returns, if any. Reserves for estimated
        returns
        and inventory credits are established by the Company, if necessary, concurrently
        with the recognition of revenue. The amounts of reserves are established
        based
        upon consideration of a variety of factors, including estimates based on
        historical returns.




Amounts
      billed to customers in sales transactions related to shipping and handling,
      represent revenues earned for the goods provided and are included in net sales.
      Costs of shipping and handling are included in cost of products
      sold.





Revenue
      received for research and development is recognized as the Company meets its
      obligations under the related agreement. The Company recognized research and
      development revenue of approximately $12,500 during the three-month and
      nine-month periods ended September 30, 2006. The Company recognized no research
      and development revenue during the three-month period ended September 30, 2005
      and $75,000 of research and development revenue during the nine-month period
      ended September 30, 2005, respectively.





*Research
      and Development*





Research
      and development costs related to both present and future products are charged
      to
      operations when incurred.





*Foreign
      Currency Translation*





The
      financial statements of the Company's foreign subsidiaries have been translated
      into United States dollars in accordance with SFAS No. 52, *Foreign
      Currency Translation* .
      Assets
      and liabilities of the Company's foreign subsidiaries are translated at
      period-end exchange rates, and revenues and expenses are translated at average
      rates prevailing during the period. Certain accounts receivable from customers
      are collected and certain accounts payable to vendors are payable in currencies
      other than the functional currencies of the Company and its subsidiaries. These
      amounts are adjusted to reflect period-end exchange rates. Net translation
      adjustments and realized exchange gains and losses are included as a component
      of foreign currency exchange (gains) losses, net, in the accompanying condensed
      consolidated statements of operations.





*Reclassifications*





Certain
      prior year amounts have been reclassified to conform to the current year
      presentation. These reclassifications had no effect on net loss as previously
      reported or net loss per common share.





**2.
      Notes Payable**





*Long
      Term Note Payable*





Long
      term
      note payable to stockholder consisted of the following at September 30, 2006:




Loan
                payable with a rate of 8% as of September 30, 2006 to Mark A. Emalfarb
                Trust(Bridge
                Loan), secured by all assets of the Company, in the original principalamount
                of $3,000,000, principal and accrued interest due January 1, 2008.Accrued
                interest of $239,941 included in principal balance. Net of unamortizedbeneficial
                conversion feature of $57,636.
            
            $
            2,367,305







**10**


*Bridge
        Loan*
 
 The
        Company has a $3.0 million revolving loan (the “Bridge Loan”) with the Mark A.
        Emalfarb Trust, bearing interest at 8% per annum, with all unpaid principal
        and
        interest originally due on January 1, 2007. The Bridge Loan is collateralized
        by
        a security interest in all of the Company's assets. The Bridge Loan balance
        as
        of September 30, 2006 was $2,367,305, which is reflected net of the remaining
        unamortized portion of a beneficial conversion feature of
        $57,636.




On
      April
      30, 2006, the then maturity date of the Bridge Loan was extended from January
      1,
      2007 to January 1, 2008. The then remaining unamortized portion of $76,848
      of
      the beneficial conversion feature related to the modified Bridge Loan Warrants
      is being amortized through the new maturity date.





Approximately
        $12,000 and $29,000 was amortized to interest expense during the three-month
        periods ended September 30, 2006 and 2005, respectively and $58,000 and $86,000
        was amortized to interest expense during the nine-month periods ended September
        30, 2006 and 2005, respectively. Interest expense on the Bridge Loan excluding
        the amortization of the beneficial conversion feature, was approximately
        $49,000
        and $145,000 for each of the three-month and nine-month periods ended September
        30, 2006 and 2005, respectively.





*Convertible
      Notes Payable*





On
      May 1,
      2006, the Mark A. Emalfarb Trust received 251,298 shares of common stock upon
      the conversion in full of its convertible note which had combined principal
      and
      accrued interest of $836,824 as of that date. On May 1, 2006, the Francisco
      Trust received 222,537 shares of common stock upon the conversion in full of
      its
      convertible note which had combined principal and accrued interest of $741,048
      as of that date. As a result of the conversions, a total of approximately $1.6
      million of notes payable to stockholders, bearing interest at 6% per annum
      was
      relieved. The balances of the related beneficial conversion features were fully
      expensed in April 2006 resulting in an adjustment of approximately $171,000
      to
      interest expense.





During
      the three-month period ended September 30, 2006 there was no amortization to
      interest expense related to the beneficial conversion features and approximately
      $256,000 was amortized to interest expense during the nine-month period ended
      September 30, 2006. Approximately $64,000 and $192,000 was amortized to interest
      expense during the three-month and nine-month periods ended September 30, 2005,
      respectively.





During
      the three-month period ended September 30, 2006 there was no interest expense
      related to the convertible notes while there was approximately $31,000 of
      related interest expense for the nine-month period ended September 30, 2006.
      Interest expense was approximately $24,000 and $71,000 for the three-month
      and
      nine-month periods ended September 30, 2005, respectively.





The
      Mark
      A. Emalfarb Trust and Francisco Trust are major stockholders of the Company
      and
      are trusts whose beneficiaries are the Company's President and Chief Executive
      Officer, and the wife and children of Mark A. Emalfarb, respectively.





*Notes
      Payable - Minority Shareholders*





On
      April
      28, 2006, the Company purchased the remaining 17.5% of shares held by the two
      minority shareholders of its Asian subsidiary, giving the Company 100% ownership
      of that subsidiary (see Note 3, Share-Based Compensation, Common Stock
      Issuances). The minority shareholders received $375,000 in cash and 212,501
      shares of unregistered Dyadic common stock in consideration for, among other
      things, the cancellation of the subordinated notes under which the Company
      owed
      the minority shareholders approximately $172,000 of principal and $70,000 of
      accrued interest; relief of the Company’s minority interest liability of
      approximately $117,000; and a release of the Company for a potential $405,000
      contingent obligation to the managing director incident to the Company’s
      purchase of its initial majority interest in the Asian Subsidiary in
      1998.




Interest
      expense on the subordinated notes payable to the minority stockholders of the
      Asian subsidiary was approximately $2,600 for the three-month period ended
      September 30, 2005, and was approximately $3,400 and $7,700 for the nine-month
      periods ended September 30, 2006 and 2005, respectively. There was no interest
      expense for the three-month period ended September 30, 2006 related to these
      subordinated notes.





**3.
      Share-Based Compensation**





In
      January 2006, the Company adopted SFAS 123(R), *Share-Based
      Payment,* which is
      a revision of SFAS 123, *Accounting
      for Share-based Compensation* .
      SFAS
      123(R) supersedes Accounting Principles Board Opinion (“APB”) No. 25, *Accounting
      for Stock Issued to Employees* (APB
      25) *,* and
      amends SFAS No. 95, *Statement
      of Cash Flows* .
      Generally, the approach in SFAS 123(R) is similar to the approach described
      in
      SFAS 123. However, SFAS 123(R) requires


**11**


all
        share-based payments to employees, including grants of employee stock options,
        to be recognized in the statement of operations based on their fair values.
        Pro
        forma disclosure, which has previously been used by the Company, is no longer
        an
        alternative.
  The
        Company adopted the fair value recognition provisions of SFAS 123(R), using
        the
        modified prospective transition method. Under this transition method,
        compensation expense includes options vesting for share-based payments granted
        prior to, but not vested as of December 31, 2005, based on the grant date
        fair
        value estimated in accordance with the original provisions of SFAS 123 and
        share-based payments granted after December 31, 2005, based
        on
        the grant date fair value estimated in accordance with the provisions of
        SFAS
        123(R). Because this transition method was selected, results of prior periods
        have not been restated.




Prior
      to
      January 1, 2006, the Company accounted for share-based employee compensation
      plans using the intrinsic value method of accounting in accordance with APB
      25
      and its related interpretations. Under the provisions of APB 25, no compensation
      expense was recognized when stock options were granted with exercise prices
      equal to or greater than market value on the date of grant.





On
        December 15, 2005, the Board of Directors of the Company approved the
        acceleration of vesting for the unvested portion of all outstanding employee
        incentive stock options awarded from May 2001 to December 15, 2005 under
        the
        2001 Equity Compensation Plan (the “2001 Equity Plan”), as amended. While the
        Company typically issues options that vest equally over four years, as a
        result
        of this vesting acceleration, stock options to purchase approximately 1.2
        million shares of the Company’s common stock, of which approximately 600,000
        were then held by the Company’s executive officers and directors, became
        immediately exercisable. The exercise prices of the affected stock options
        ranged from $1.90 to $5.93 and the closing price of the Company’s common stock
        on December 15, 2005, was $1.75.





The
      purpose of the accelerated vesting was to provide a non-cash benefit to the
      Company’s employees and to eliminate future compensation expense the Company
      would otherwise recognize in its statements of operations with respect to these
      accelerated options upon the adoption of SFAS 123(R). The estimated future
      compensation expense associated with these accelerated options that would have
      been recognized in the Company’s statements of operations upon implementation of
      SFAS 123(R) is approximately $1.3 million. All option grants made on and after
      January 1, 2006 are accounted for in accordance with SFAS 123(R).




The
      Company’s 2001 Equity Plan and 2006 Option Plan (see below) are each considered
      to be compensatory plans under SFAS 123(R).





***Description
      of Equity Plans***





***Amended
      and Restated 2001 Equity Compensation Plan***





Effective
      May 2001, the Company adopted the Dyadic International, Inc. 2001 Equity
      Compensation Plan (the “2001 Equity Plan”) under which 1,302,989 shares of
      common stock were reserved for issuance. In September 2004, by written consent,
      the Company's Board of Directors and stockholders approved an increase in the
      authorized number of shares of common stock under the 2001 Equity Plan from
      1,302,989 to 5,152,447. All employees, as well as members of the Company's
      Board
      of Directors and Key Advisors, as defined, are eligible to participate in the
      2001 Equity Plan. Under the 2001 Equity Plan, the Company may issue incentive
      stock options and nonqualified stock options to purchase shares of common stock,
      or the Company may issue shares of common stock. Such shares, if issued, may
      be
      subject to restrictions, as disclosed in the 2001 Equity Plan. In addition
      to
      stock options and stock grants, the 2001 Equity Plan allows for the issuance
      of
      Performance Units to an employee or Key Advisor. Each Performance Unit
      represents the right to receive an amount, in cash or in the Company's common
      stock, as determined by a committee of the Company's board of directors, based
      on the value of the Performance Unit, if established performance goals are
      met.





The
      2001
      Equity Plan was amended and restated effective as of January 1, 2005 by the
      Company’s board of directors on April 1, 2006 and approved by the Company’s
      stockholders at the 2006 Annual Meeting of Stockholders in June 2006 to (a)
      reduce the number of shares of common stock available for issuance under the
      plan to 4,478,475 shares from 5,152,447 shares (b) to conform certain provisions
      of the plan to the requirements of Section 409A of the Internal Revenue Code
      of
      1986, as amended, and (c) to increase the maximum limitation of shares that
      may
      be subject to awards granted under the plan to any one individual for any fiscal
      year during the term of the plan to 1,200,000 shares from 100,000 shares.





***2006
      Stock Option Plan***





The
      Dyadic International, Inc. 2006 Stock Option Plan (the “2006 Option Plan”) was
      adopted by the Company’s board of directors in April 2006 and approved by
      stockholders at the 2006 Annual Meeting of Stockholders in June 2006.
      The
      purpose of the 2006 Option Plan is to retain and attract key management,
      employees, nonemployee directors and consultants by providing those persons
      with
      a proprietary interest in the Company. The compensation committee


**12**




will
      administer the 2006 Option Plan and may grant stock options, which may be
      incentive stock options or nonqualified stock options that do not comply with
      Section 422 of the Internal Revenue Code. Under the 2006 Option Plan, 2,700,000
      shares of common stock have been reserved for issuance. As of September 30,
      2006, there were no stock options outstanding under the plan.


The
      2001
      Equity Plan and the 2006 Option Plan are sometimes collectively referred to
      as
      the “Equity Compensation Plans”.




The
      Company recognized non-cash share-based compensation expense for its share-based
      awards of approximately $185,000 and $30,000 during the three-month periods
      ended September 30, 2006 and 2005, respectively, and approximately $626,000
      and
      $51,000, for the nine-month periods ended September 30, 2006 and 2005,
      respectively. Total share-based compensation expense was allocated among the
      following expense categories:









(In
                thousands)
            
            **Three-Months
                Ended****September
                30**
            
            **Nine-Months
                Ended September 30****2006**
            
            **2005**
            
            **2006**
            
            **2005**General
                and administrative
            
            $
            137
            
            $
            23
            
            $
            459
            
            $
            36Research
                and development
            
            
            10
            
            
            7
            
            
            94
            
            
            15Cost
                of goods sold
            
            
            11
            
            
            --
            
            
            21
            
            
            --Selling
                and marketing
            
            
            27
            
            
            --
            
            
            52
            
            
            --$
            185
            
            $
            30
            
            $
            626
            
            $
            51





Under
      the
      modified prospective method of transition under SFAS 123(R), the Company is
      not
      required to restate its prior period financial statements to reflect expensing
      of share-based compensation under the new standard. Therefore, the results
      for
      the three-months and nine-months ended September 30, 2006 are not comparable
      to
      the same periods in the prior year.




The
      Company has determined its share-based compensation expense under SFAS 123(R)
      for the three-months and nine-months ended September 30, 2006 as follows:




***Valuation
      of Stock Options***




Share-based
      compensation related to stock options is determined using the single option
      approach under the Black-Scholes valuation model. The fair value of options
      determined under SFAS 123(R) is amortized to expense over the vesting periods
      of
      the underlying options, generally four years.




The
      fair
      value of stock option awards for the three-months and nine-months ended
      September 30, 2006 was estimated on the date of grant using the assumptions
      in
      the following table. The expected volatility in this model is based on the
      historical volatility of the Company’s stock. The risk-free interest rate is
      based on the U.S. Treasury yield curve in effect at the time awards are granted,
      based on maturities which approximate the expected life of the options. The
      expected life of the options granted is estimated using the historical exercise
      behavior of employees. The expected dividend rate takes into account the absence
      of any historical payments and the Board of Director’s intention to retain all
      earnings, if any, for future operations and expansion.




**Three-Months
                Ended**
            
            **Nine-Months
                Ended****September
                30, 2006**
            
            **September
                30, 2006**Average
                Risk-Free Interest Rate
            
            
            4.90
            %
            
            4.71
            %Dividend
                Yield
            
            
            0
            %
            
            0
            %Average
                Volatility Factor
            
            
            79
            %
            
            73
            %Average
                Option Life
            
            
            5
                Yrs
            
            
            5
                Yrs










**13**
 
 ***Equity
          Compensation Plans Awards Activity***
  Information
          with respect to the Company’s Equity Compensation Plans and grants of 65,000
          options to nonemployees prior to the Company’s adoption of either of the Equity
          Compensation Plans is as follows:


**Shares**
            
            **Weighted-Average
                Exercise Price Per Share**
            
            **Aggregate
                Intrinsic Value**Outstanding
                at December 31, 2005
            
            
            1,662,639
            
            $
            3.61
            
            $
            --Granted
            
            
            1,702,722
            
            
            4.61
            
            
            --Exercised
            
            
            (281,100
            )
            
            4.10
            
            
            --Expired
            
            
            (12,500
            )
            
            4.50
            
            
            --Cancelled
            
            
            (17,500
            )
            
            4.40
            
            
            --Outstanding
                at September 30, 2006
            
            
            3,054,261
            
            $
            4.11
            
            $
            1,957,363Exercisable
                at September 30, 2006
            
            
            1,318,443
            
            $
            3.60
            
            $
            1,089,649





The
      weighted average grant date fair value of options granted during the
      three-months and nine-months ended September 30, 2006 was $4.49 and $2.71 per
      share, respectively.





A
      further
      detail of the options outstanding as of September 30, 2006 is set forth as
      follows:





**Range
                of Exercise Prices**
            
            **Options
                Outstanding**
            
            **Weighted-Average
                Remaining Life in Years**
            
            **Weighted-Average
                Exercise Price Per Share**
            
            **Options
                Exercisable**
            
            **Weighted-Average
                Exercise Price Per Share**$1.83
                - $2.90
            
            
            415,567
            
            
            3.94
            
            $
            2.46
            
            
            287,254
            
            $
            2.472.96
                - 3.80
            
            
            1,186,911
            
            
            3.70
            
            
            3.23
            
            
            712,939
            
            
            3.394.39
                - 4.66
            
            
            678,250
            
            
            6.96
            
            
            4.57
            
            
            213,250
            
            
            4.515.92
                - 7.13
            
            
            773,533
            
            
            4.36
            
            
            5.96
            
            
            105,000
            
            
            6.223,054,261
            
            
            4.62
            
            $
            4.11
            
            
            1,318,443
            
            $
            3.60




***Unrecognized
      Share-Based Compensation Expense***




As
      of
      September 30, 2006, there was $2,335,000 of total unrecognized compensation
      expense related to nonvested share-based compensation arrangements granted
      under
      the equity incentive plan. This expense is expected to be recognized over a
      weighted-average period of 2.0 years as follows:




Fiscal
                Year 2006 (October 1, 2006 to December 31, 2006)
            
            $
            217,000Fiscal
                Year 2007
            
            
            712,000Fiscal
                Year 2008
            
            
            696,000Fiscal
                Year 2009
            
            
            626,000Fiscal
                Year 2010
            
            
            84,000$
            2,335,000




***Prior
      Year Three and Nine-month Periods Ended September 30, 2005 Pro forma Disclosure
      of Share-Based Compensation Expense***




The
      following table sets forth the pro forma disclosure of the Company’s net loss
      and net loss per share for the prior year three and nine-month periods ended
      September 30, 2005 assuming the estimated fair value of the options were
      calculated pursuant to SFAS 123 and amortized to expense over the option-vesting
      period:




**14**





**Three-Months
                Ended September 30,**
            
            **Nine-Months**
              **Ended**
              **September
                30,****2005**
            
            **2005**Net
                loss applicable to holders of common stock, as reported for basic
                and
                diluted calculations
            
            $
            (2,531,999
            )
            $
            (7,932,507
            )Deduct:
                Total share-based employee compensation expense determined under
                fair
                value based method for all awards1
            
            
            (109,560
            )
            
            (205,206
            )Pro
                forma net loss applicable to holders of common stock, basic and diluted
                calculations
            
            $
            (2,641,559
            )
            $
            (8,137,713
            )Basic
                and diluted net loss per common share, as reported
            
            $
            (0.11
            )
            $
            (0.36
            )Basic
                and diluted pro forma net loss per common share
            
            $
            (0.12
            )
            $
            (0.37
            )


1 A
      Black-Scholes option-pricing model was used to develop the fair values of the
      options granted.





Pro
      forma
      information regarding net loss and net loss per share was been determined as
      if
      the Company had accounted for its employee stock options and stock purchase
      plan
      under the fair value method of SFAS 123.





***Common
      Stock Issuances***





During
      the three-months ended September 30, 2006, the Company issued 42,310 shares
      of
      common stock pursuant to a Development Agreement with a third party for services
      rendered to the Company for research and development projects. The original
      term
      of the Development Agreement was a 26-month period ending September 30, 2006.
      In
      December 2004, the term was extended to December 31, 2006. The Company placed
      300,300 shares of common stock in escrow which is being issued to the third
      party as earned during the contractual period, at which time they will be deemed
      to be outstanding. Per the Development Agreement, the price used to calculate
      the number of shares issued was set at $3.33 per share. The stated value of
      the
      services rendered is then divided by the share price of $3.33 to determine
      the
      number of shares earned. The Company has recognized approximately $211,000
      and
      $531,000 for the three-month and nine-month periods ended September 30, 2006,
      respectively, based on the fair market value of the Company’s common stock on
      the measurement dates. The number of shares held in escrow as of September
      30,
      2006 is 180,229 and an aggregate of 120,071 shares have been earned to
      date.





On
      April
      28, 2006, the Company and its then 82.5% majority owned Asian Subsidiary entered
      into a satisfaction and purchase agreement with the Asian Subsidiary’s two
      minority shareholders, its managing director and one of its other key employees,
      effective as of January 1, 2006. The minority shareholders received $375,000
      in
      cash and 212,501 shares of unregistered common stock of the Company (see Note
      1
      - Basis of Presentation and Summary of Significant Accounting Policies, *Goodwill* ).
      The
      Company’s shares were valued at approximately $1,328,000 based on the fair
      market value of the Company’s common stock on April 28, 2006, the measurement
      date for accounting purposes. As of May 1, 2006, the Company is recording 100%
      of the Asian Subsidiary’s operating results in the accompanying condensed
      consolidated statements of operations.





On
      May 1,
      2006, the Company’s two largest stockholders, the Mark A. Emalfarb Trust and the
      Francisco Trust U/A/D February 28, 1996 (the “Francisco Trust”), increased their
      stock ownership in the Company by 251,298 and 222,537 shares of common stock,
      respectively, as a result of converting in full their convertible promissory
      notes due January 1, 2007, at an exercise price of $3.33 per share. A total
      of
      approximately $1.6 million of notes and interest payable to stockholders,
      bearing interest at 6% per annum was converted. The balances of the related
      beneficial conversion features were fully expensed in April 2006 resulting
      in an
      adjustment of approximately $171,000 to interest expense.





The
      Francisco Trust has as its beneficiaries the wife and children of Mark A.
      Emalfarb, the Chief Executive Officer, President and Chairman of the Company.


**15**




During
      the three-month period ended September 30, 2006, the Company received an
      aggregate of approximately $344,000 in proceeds from the exercises of the
      following instruments: warrants to purchase an aggregate of 21,261 shares of
      common stock, at an exercise price of $5.50 per share and stock options to
      purchase an aggregate of 52,850 shares of common stock, granted under the Equity
      Plan, with exercise prices ranging from $2.40 to $4.50 per share. During the
      nine-month period ended September 30, 2006, the Company received an aggregate
      of
      approximately $6,190,000, respectively, in proceeds from the exercises of the
      following instruments: (i) warrants to purchase an aggregate of 495,460 shares
      of common stock, at an exercise price of $3.33 per share, (ii) warrants to
      purchase an aggregate of 615,903 shares of common stock for an exercise price
      of
      $5.50 per share, (iii) stock options to purchase an aggregate of 281,100 shares
      of common stock, granted under the Equity Plan, with exercise prices ranging
      from $2.08 to $4.50 per share, and (iv) stock options to purchase an aggregate
      of 65,000 shares of common stock, granted prior to the Equity Plan, with an
      exercise price of $4.50 per share.





**4.
      Commitments and Contingencies**





**Litigation,
      Claims and Assessments**





In
      the
      opinion of management, there are no known pending legal proceedings that would
      have a material effect on the Company's financial position, results of
      operations or cash flows.





**5.
      Segment Data Information**





Operating
      segments are defined as components of an enterprise engaging in business
      activities about which separate financial information is available that is
      evaluated regularly by the chief operating decision maker or group in deciding
      how to allocate resources and in assessing performance. Utilizing these
      criteria, the Company has identified its reportable segments based on the
      geographical markets they serve, which is consistent with how the Company
      operates and reports internally.




The
      Company has three reportable segments: U.S. operations, Asian operations and
      Netherlands operations. The U.S. reportable segment includes a subsidiary in
      Poland that is considered auxiliary and integral to the U.S. operations. The
      accounting policies for the segments are the same as those described in the
      basis of presentation and summary of significant accounting policies. The
      Company accounts for intersegment sales (which are eliminated in consolidation)
      as if the sales were to third parties, that is, at current market prices. The
      U.S. operating segment is a developer, manufacturer and distributor of enzyme
      products, proteins, peptides and other bio-molecules derived from genes, and
      a
      collaborative licensor of enabling proprietary technology for the development
      and manufacturing of biological products and use in research and development.
      The Asian operating segment is engaged in the manufacturing and distribution
      of
      chemical and enzyme products to the textile and pulp & paper industries. The
      Netherlands operating segment is also a developer of enzyme products, proteins,
      peptides and other bio-molecules derived from genes and to date has invested
      solely in research and development activities.




The
      following table summarizes the Company's segment information:








**Three-Months
                Ended September 30, 2006****U.S.
                Operating Segment**
            
            **Asian
                Operating Segment**
            
            **Netherlands
                Operating Segment**
            
            **Eliminations**
            
            **Totals**Net
                Sales:External
                customers
            
            $
            2,519,450
            
            $
            1,685,321
            
            $
            --
            
            $
            --
            
            $
            4,204,771Intersegment
            
            
            247,931
            
            
            164,945
            
            
            --
            
            
            (412,876
            )
            
            --Total
                net sales
            
            
            2,767,381
            
            
            1,850,266
            
            
            --
            
            
            (412,876
            )
            
            4,204,771(Loss)
                income from operations
            
            
            (2,275,608
            )
            
            93,783
            
            
            (168,300
            )
            
            (3,715
            )
            
            (2,353,840
            )Interest
                expense
            
            
            (65,138
            )
            
            (20,990
            )
            
            --
            
            
            15,910
            
            
            (70,218
            )Investment
                income, net
            
            
            119,351
            
            
            604
            
            
            20
            
            
            (15,910
            )
            
            104,065Depreciation
                and amortization
            
            
            36,717
            
            
            26,823
            
            
            1,474
            
            
            --
            
            
            65,014Capital
                expenditures
            
            
            68,622
            
            
            17,063
            
            
            717
            
            
            --
            
            
            86,402





**16**


**Three-Months
                Ended September 30, 2005****U.S.
                Operating Segment**
            
            **Asian
                Operating Segment**
            
            **Netherlands
                Operating Segment**
            
            **Eliminations**
            
            **Totals**Net
                Sales:External
                customers
            
            $
            2,434,564
            
            $
            1,705,581
            
            $
            --
            
            $
            --
            
            $
            4,140,145Intersegment
            
            
            199,035
            
            
            --
            
            
            --
            
            
            (199,035
            )
            
            --Total
                net sales
            
            
            2,633,599
            
            
            1,705,581
            
            
            --
            
            
            (199,035
            )
            
            4,140,145(Loss)
                income from operations
            
            
            (2,368,632
            )
            
            168,927
            
            
            (269,388
            )
            
            39,600
            
            
            (2,429,493
            )Interest
                expense (a)
            
            
            (124,267
            )
            
            (17,585
            )
            
            (46,143
            )
            
            10,811
            
            
            (177,184
            )Investment
                income, net
            
            
            119,835
            
            
            202
            
            
            6
            
            
            (10,811
            )
            
            109,232Depreciation
                and amortization
            
            
            20,558
            
            
            18,956
            
            
            100,990
            
            
            --
            
            
            140,504Capital
                expenditures
            
            
            72,822
            
            
            80,878
            
            
            --
            
            
            --
            
            
            153,700


(a)
      Interest expense relating to the purchase by the U.S. operating segment of
      manufacturing equipment was allocated to the Netherlands
      operating segment.





**Nine-Months
                Ended September 30, 2006****U.S.
                Operating Segment**
            
            **Asian
                Operating Segment**
            
            **Netherlands
                Operating Segment**
            
            **Eliminations**
            
            **Totals**Net
                Sales:External
                customers
            
            $
            7,241,563
            
            $
            4,758,530
            
            $
            --
            
            $
            --
            
            $
            12,000,093Intersegment
            
            
            796,219
            
            
            164,945
            
            
            --
            
            
            (961,164
            )
            
            --Total
                net sales
            
            
            8,037,782
            
            
            4,923,475
            
            
            --
            
            
            (961,164
            )
            
            12,000,093(Loss)
                income from operations
            
            
            (7,091,214
            )
            
            229,898
            
            
            (531,953
            )
            
            (20,979
            )
            
            (7,414,248
            )Interest
                expense
            
            
            (505,248
            )
            
            (53,323
            )
            
            --
            
            
            40,602
            
            
            (517,969
            )Investment
                income, net
            
            
            333,006
            
            
            1,459
            
            
            53
            
            
            (40,602
            )
            
            293,916Depreciation
                and amortization
            
            
            100,857
            
            
            77,775
            
            
            3,973
            
            
            --
            
            
            182,605Capital
                expenditures
            
            
            348,389
            
            
            65,046
            
            
            43,581
            
            
            --
            
            
            457,016Total
                assets at September 30, 2006
            
            
            23,693,189
            
            
            5,458,599
            
            
            135,948
            
            
            (5,537,219
            )
            
            23,750,517




**Nine-Months
                Ended September 30, 2005****U.S.
                Operating Segment**
            
            **Asian
                Operating Segment**
            
            **Netherlands
                Operating Segment**
            
            **Eliminations**
            
            **Totals**Net
                Sales:External
                customers
            
            $
            7,338,607
            
            $
            4,523,975
            
            $
            --
            
            $
            --
            
            $
            11,862,582Intersegment
            
            
            585,566
            
            
            --
            
            
            --
            
            
            (585,566
            )
            
            --Total
                net sales
            
            
            7,924,173
            
            
            4,523,975
            
            
            --
            
            
            (585,566
            )
            
            11,862,582(Loss)
                income from operations
            
            
            (7,061,925
            )
            
            284,131
            
            
            (749,373
            )
            
            66,135
            
            
            (7,461,032
            )Interest
                expense (a)
            
            
            (386,345
            )
            
            (47,678
            )
            
            (125,001
            )
            
            32,079
            
            
            (526,945
            )Investment
                income, net
            
            
            164,065
            
            
            490
            
            
            14
            
            
            (32,079
            )
            
            132,490Depreciation
                and amortization
            
            
            59,098
            
            
            39,507
            
            
            287,051
            
            
            --
            
            
            385,656Capital
                expenditures (b)
            
            
            1,075,096
            
            
            127,097
            
            
            15,919
            
            
            --
            
            
            1,218,113Total
                assets at September 30, 2005
            
            
            23,935,709
            
            
            3,097,062
            
            
            117,582
            
            
            (2,559,135
            )
            
            24,591,218


(a)
      Interest expense relating to the purchase by the U.S. operating segment of
      manufacturing equipment was allocated to the Netherlands
      operating segment.


(b)
      Includes non-cash expenditure of approximately $862,000.


**17**


**6.
      Subsequent Event**




On
      October 26, 2006, Dyadic International, Inc. and its wholly-owned subsidiary
      Dyadic International (USA), Inc. (together referred to as the “Company” or
“Dyadic”), entered into a Securities Purchase Agreement (the “Securities
      Purchase Agreement”) with Abengoa Bioenergy R&D, Inc. (“ Abengoa”), a
      subsidiary of Abengoa Bioenergy Company. The Company also entered into a
      non-exclusive Research and Development Agreement with Abengoa pertaining to
      the
      conduct of a research and development (“R&D”) program to be completed over a
      period of up to three and one-half years, under which the Company will seek
      to
      apply its proprietary technologies to the development of cost-effective enzyme
      mixtures and related processing and manufacturing technologies for commercial
      application in Abengoa’s bioethanol (cellulosic ethanol) production process (the
“R&D Agreement”).





Under
      the
      terms of the Securities Purchase Agreement, Abengoa invested $10 million in
      the
      Company, for which it was issued 2,136,752 shares of Dyadic Common Stock at
      $4.68 per share (the closing share price on October 25, 2006, as reported on
      the
      American Stock Exchange (“AMEX”)). Subsequent to the closing, which occurred on
      November 8, 2006 , under certain circumstances, additional securities of the
      Company may be issuable to Abengoa.


The
      Company will use the proceeds from this private sale to fund the performance
      of
      its R&D obligations under the R&D Agreement over a three and a half year
      period, under which it will seek to apply its proprietary technologies to the
      development of one or more enzyme mixtures and related processing and
      manufacturing technologies customized to Abengoa’s proprietary biomass
      substrates. The R&D Agreement contemplates that the Company will perform
      both (i) research of general application to the cellulosic ethanol field
      furthering the Company’s extensive research & development and large-scale
      manufacturing technologies for producing large volumes of low cost cellulases,
      xylanases and other hemicellulases and (ii) research of specific applications
      for the achievement of the goals of the Abengoa R&D Program to develop an
      economically viable commercial process for the production of large volumes
      of
      effective, low cost enzyme mixtures for the proprietary biomass substrates
      of
      specific interest to Abengoa. In general, the Company is granted exclusive
      ownership of all intellectual property it develops in connection with its
      performance obligation under the R&D Agreement.




Under
      the
      terms of the R&D Agreement, if the Company successfully develops one or more
      enzyme mixtures and related processing and manufacturing technologies for
      Abengoa and Abengoa exercises an option to license on a non-exclusive
      basis such technologies, the Company will be entitled to receive license fees,
      technology transfer fees and royalties on ethanol production by Abengoa
      affiliates, which will be recognized as earned.





Further,
      under the Securities Purchase Agreement, the Company has agreed to use the
      $10
      million to fund its performance of certain foundational and applications
      research in the cellulosic ethanol field and to spend not less than $10.0
      million (the “R&D Spending Obligation”) over the course of the “R&D
      Spend Measurement Period” (the
      period commencing on the Agreement Date and ending three years following
      Steering Committee approval of the initial Statement of Work for calendar year
      2007), during
      which Dyadic is to perform research (the amount so expended by Dyadic being
      referred to as the “Applicable R&D Spend”). If the Company breaches its
      R&D Spending Obligation, in addition to certain royalty-free, non-exclusive
      licensing rights which would be granted to Abengoa, the Company is obligated,
      at
      Abengoa’s election, to either (x) issue Additional Shares or (y) remit to
      Abengoa a cash sum, in either instance having a dollar value equal to the amount
      by which $10.0 million exceeds the dollar value of the Applicable R&D Spend,
      and if shares are used, they are valued at the greater of (x) $4.68 per share
      or
      (y) the closing selling price of the shares on the AMEX on the last trading
      day
      in the R&D Spend Measurement Period.





If
      within
      six months following the date of closing the Company has not entered into a
      specified type of transaction involving the sale of its securities totaling
      at
      least $20 million in gross proceeds, then Abengoa is entitled to receive
      three-year warrants to purchase 427,351 shares at an exercise price of $5.85.
      If
      the sale of securities totaling at least $20 million is at a price lower than
      $4.68 per share, Abengoa is entitled to have additional shares issued to them
      so
      that their investment is at the same price. If the sale of securities includes
      warrants, Abengoa’s pro rata warrant coverage and other warrant terms are to be
      the same as those in the securities transaction rather than the warrant terms
      discussed above.





The
      foregoing description of the Securities Purchase Agreement and the R&D
      Agreement is qualified in its entirety by reference to the Company’s Current
      Report on Form 8-K dated October 26, 2006, as filed with the SEC on November
      1,
      2006.


**18**


***Item*** ** ***2.*** ** ***Management’s
      Discussion and Analysis or Plan of Operation***





The
      following should be read in conjunction with Management's Discussion and
      Analysis of Financial Condition and Results of Operations included in the
      Company's Annual Report on Form 10-KSB for the year ended December 31,
      2005.





The
      term
“the Company”, “Dyadic”, “we”, “us” or “our” refers to Dyadic International,
      Inc. and its consolidated subsidiaries, unless the context otherwise
      implies.





This
      Quarterly Report on Form 10-QSB contains forward-looking statements within
      the
      meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
      Securities Exchange Act of 1934, that involve substantial risks and
      uncertainties. Forward-looking statements can be identified by the fact that
      they do not relate strictly to historical or current facts. They use words
      such
      as “may”, “will”, “expect”, “intend”, “anticipate”, “believe”, “estimate”,
“continue”, “project”, “plan”, “shall”, “should”, and other similar words. You
      should read statements that contain these words carefully because they discuss
      our future expectations, making projections of our future results of operations
      or our financial condition or state other "forward-looking" information.
      Forward-looking statements involve known and unknown risks and uncertainties
      that may cause the actual results, performance or achievements of our Company
      to
      be materially different from those that may be expressed or implied by such
      statements. Important factors that could cause the actual results, performance
      or achievements of the Company to differ materially from the Company’s
      forward-looking statements include (i) assumptions or cautionary factors
      discussed in connection with a particular forward-looking statement or elsewhere
      in this Form 10-QSB, or (ii) cautionary factors set forth in our Annual Report
      on Form 10-KSB for the year ended December 31, 2005, including the section
      titled “Description of Business - Risk Factors That May Affect Future Results,”
and in our subsequent filings made from time to time with the Securities and
      Exchange Commission. All forward-looking statements attributable to the Company
      are expressly qualified in their entirety by these and other factors. Except
      as
      required by law or regulation, we do not undertake any obligation to publicly
      update forward-looking statements to reflect events or circumstances after
      the
      date on which the statement is made or to reflect the occurrence of
      unanticipated events.





*General*





We
      are a
      global biotechnology company engaged in research and development, manufacture
      and sale of enzymes, other proteins, peptides and other biomolecules derived
      from genes, as well as the collaborative licensing of our enabling patented
      and
      other proprietary technologies. We use our patented and other proprietary
      technologies to develop and manufacture biological products, and intend to
      collaboratively license them for research, development and manufacturing of
      biological products, for three categories of applications:




·
            enzymes
                and other biological products for a variety of industrial and commercial
                applications, such as in the textile, pulp & paper, animal feed,
                alcohol, starch, and food and beverage industries, where we currently
                sell
                more than 45 liquid and dry enzyme products to more than 200 industrial
                customers in approximately 50 countries, which we refer to as our
                Enzyme
                Business;





·
            enzymes
                and related biotechnological processes for use in converting various
                agricultural products (e.g. corn), agricultural residue products
                (e.g.
                dried distillers grains (DDG), wheat straw, and sugar cane
                bagasse) and forestry industry residues (e.g. wood pulp and chips)
                into fermentable sugars, which can then be used in the production
                of
                traditional and cellulosic ethanol, as well as other products currently
                derived from petroleum, such as plastics and polymers, which we
                collectively refer to as “Biorefinery Products”;
                and





·
            human
                therapeutic protein candidates, with focus on antibodies, for use
                by
                pharmaceutical and biotechnology companies in pre-clinical and clinical
                drug development applications and commercialization following drug
                approval, which we refer to as our BioSciences Business.





As
      more
      and more industries come to appreciate the financial, process efficiencies,
      environmental and other advantages of applying biological solutions such as
      enzymes to their manufacturing processes in lieu of chemicals and other
      materials which may have negative environmental consequences, we expect many
      new
      market opportunities to emerge for our proprietary technologies. These
      opportunities include biofuels (such as ethanol, butanol and diesel), plastics,
      polymers, antibodies, therapeutic proteins and commercial enzymes in industries,
      in addition to our legacy textile businesses (such as pulp & paper, animal
      feed, and brewing).





We
      have
      developed and use a number of proprietary fungal strains to produce enzymes,
      but
      the one on which we have principally focused is a patented system for protein
      production, or protein expression, which we call the C1 Expression System.
      This
      system is based on our patented *Chrysosporium
      lucknowense* fungus,
      known as C1, a host production organism which has been genetically altered
      to
      express homologous and heterologous genes to produce targeted protein products.
      We discovered the C1 microorganism in the mid-1990's and initially developed
      it,
      without the application of molecular biology, to produce neutral cellulases
      for
      our textile manufacturing customers.


**19**


By
      1998,
      we began to apply molecular genetics and other proprietary biotechnology tools
      to C1 to create a technology, which we refer to as the C1 Host Technology.
      We
      consider the C1 Expression Technology to be fully-developed in that we now
      have
      completed all of the tools required for expressing genes in C1, inserting new
      genes into C1, and removing unwanted genes from C1. The C1 Expression Technology
      has been used for about three years for the manufacture of enzyme products
      we
      currently sell for use in textile, pulp & paper, and other industries. We
      also continue to believe that the C1 Expression Technology may be useful for
      the
      expression of therapeutic proteins and have recently been encouraged by some
      of
      the results of our developmental efforts to that end. For example, the C1
      Expression Technology has already demonstrated its ability to produce proteins,
      including biologically-active full-length antibodies. In addition, a human
      antibody was expressed at nearly 400 milligrams per liter yield level in an
      unoptimized C1 strain and without performing any traditional fermentation
      process development work to improve the yield, which together have the promise
      of improving the antibody production yields significantly. The biological
      activity of the antibody expressed in C1 was confirmed using the cell-based
      assays commonly employed by the biotechnology and pharmaceutical companies.
      Furthermore, the antibody made in C1 was found to have a biological activity
      level comparable to its human counterpart.





Another
      recent C1 technology development concerns the over-expression of multiple genes
      in C1 host cell, which could be particularly useful in low-cost manufacturing
      of
      enzyme mixes required for cellulosic ethanol and other Biorefinery Product
      applications.





The
      C1
      Host Technology, once fully developed, is expected to be capable of performing:




·
            two
                screening functions for:





o
            the
                discovery of genes and the proteins they express; and


o
            the
                identification of improved protein variants resulting from modifications
                to their genes; and




·
            three
                expression functions for:




o
            the
                expression of enzymes, other proteins or other biomolecules (e.g.,
                chemical intermediates, biopolymers, etc.) in commercial volumes
                for
                industrial enzyme applications;




o
            the
                expression of human antibodies and other therapeutic proteins in
                small
                volumes for pre-clinical testing and clinical trials; and





o
            the
                expression of human antibodies and other therapeutic proteins for
                drugs in
                commercial volumes.





We
      have
      been, over the last several years, principally focused on the expression
      capabilities of the C1 Host Technology. These efforts culminated in our first
      commercially successful application - our C1 Expression System.





To
      more
      fully exploit the C1 Expression Technology and to identify new products for
      production in C1, the genomic sequence of C1 was determined in 2005 under
      contract with Agencourt Biosciences. (Sequencing can determine whether complete
      gene families, new gene members absent in other fungi or more diverse ones
      have
      been identified (e.g. (per)-oxidase family or search for glycosylation
      enzymes)). Using the information gathered from the C1 genome sequence and from
      the subsequent annotation currently being performed in collaboration with
      Scripps-Florida, Dyadic intends to improve C1’s capabilities for production of
      therapeutics and other foreign proteins. The first phase of the annotation
      has demonstrated over 11,000 genes in C1. As many as 120 genes have been
      found to encode the processes that could positively or negatively affect protein
      production (i.e. gene expression, protein secretion, protein degradation, and
      protein folding) as well as the production of enzymes with uses in a number
      of
      industries. Using the genetic tools developed for C1, those processes can
      be better altered, identified and modified in such a way as to improve the
      yields and range of proteins produced in C1. We anticipate that having the
      sequence of these genes will accelerate the development of various products
      using the C1 Host Technology. For example, based on the genome sequence, we
      have
      identified potential genes for improved tools for strain development and
      regulatory proteins for cellulase induction. We believe it is possible that
      more
      advanced searches for promoter elements could also be started using
      sophisticated search algorithms.





Taken
      together, the molecular biological tools, the annotated genome information
      and
      the ability of the C1 strain to be grown at low viscosity and manipulated in
      microtiter dishes all the way up to 150,000 liter fermenters, we expect C1
      to be
      used to accelerate the pace of protein product development for Dyadic as well
      as
      its customers and potential corporate partners.





**20**


We
          believe, however, even larger market opportunities will exist for our C1
          Expression System when the technology is more fully developed. For example,
          we
          have invested heavily over the past decade in research and development
          (“R&D”) for cellulases, xylanases and other hemicellulases for a wide
          variety of applications. Some of these enzymes, as well as others in our
          R&D
          pipeline, may be able to convert agricultural residue products and energy
          crops
          (lignocellulosic substrates) into fermentable sugars, which in turn can
          be used
          to produce ethanol and other chemicals that have historically been
          petroleum-derived. Recently, scientists working for Dyadic purified seven
          cellulase and hemicellulase components from C1 and tested mixtures of these
          enzymes against cellulosic substrates for their ability to convert those
          substrates to fermentable sugar. It was shown that these enzyme mixtures
          could
          rapidly and efficiently degrade these substrates, and we anticipate that
          these
          results will guide us in the development of strains and processes for the
          production of ethanol from lignocellulosic biomass. These results were
          presented
          at the BIO World Congress for Industrial Biotechnology and Bioprocessing
          in July
          2006, were the subject of a patent application, and have been submitted
          to the *Biotechnology
          and Bioengineering* journal,
          who is currently reviewing our submission.


In
      addition to C1, we have a stable of well-characterized fungal strains and
      enzymes from those strains from which we have identified and characterized
      a
      number of these activities. We believe that the combination of these R&D
      efforts and our C1 Host Technology position us to address opportunities in
      the
      alternative fuel market.





On
      October 26, 2006, we entered into a Securities Purchase Agreement (the
“Securities Purchase Agreement”) with Abengoa Bioenergy R&D, Inc.
      (“Abengoa”), a subsidiary of Abengoa Bioenergy Company. The Company also entered
      into a non-exclusive Research and Development Agreement with Abengoa pertaining
      to the conduct of a research and development (“R&D”) program to be completed
      over a period of up to three and one-half years, under which the Company will
      seek to apply its proprietary technologies to the development of cost-effective
      enzyme mixtures and related processing and manufacturing technologies for
      commercial application in Abengoa’s bioethanol (cellulosic ethanol) production
      process (the “R&D Agreement”).





Under
      the
      terms of the Securities Purchase Agreement, Abengoa invested $10 million in
      Dyadic, for which it was issued 2,136,752 shares of Dyadic common stock at
      $4.68
      per share (the closing share price on October 25, 2006, as reported on the
      American Stock Exchange (“AMEX”)).. Subsequent to the closing, which occurred on
      November 8, 2006, under certain circumstances, additional Dyadic securities
      may
      be issuable to Abengoa.




We
      will
      use the proceeds from this private sale to fund the performance of our R&D
      obligations under the R&D Agreement over a three and a half year period,
      under which we will seek to apply our proprietary technologies to the
      development of one or more enzyme mixtures and related processing and
      manufacturing technologies customized to Abengoa’s proprietary biomass
      substrates. The R&D Agreement contemplates that we will perform both (i)
      research of general application to the cellulosic ethanol field furthering
      its
      extensive research & development and large-scale manufacturing technologies
      for producing large volumes of low cost cellulases, xylanases and other
      hemicellulases and (ii) research of specific applications for the achievement
      of
      the goals of the Abengoa R&D Program to develop an economically viable
      commercial process for the production of large volumes of effective, low cost
      enzyme mixtures for the proprietary biomass substrates of specific interest
      to
      Abengoa. In general, Dyadic is granted exclusive ownership of all intellectual
      property it develops in connection with its performance obligation under the
      R&D Agreement.




Reference
      is made to Note 6, Subsequent Events, to our financial statements included
      elsewhere in this Report for further information concerning the Securities
      Purchase Agreement and the R&D Agreement.




The
      foregoing description of the Securities Purchase Agreement and the R&D
      Agreement is qualified in its entirety by reference to Dyadic’s Current Report
      on Form 8-K dated October 26, 2006, as filed with the SEC on November 1,
      2006.





We
      also
      believe our C1 Expression System can be successfully harnessed to help solve
      the
      protein expression problem confronting the global drug industry - the
      difficulty, despite enormous historic investment, of cost-effectively and
      expeditiously harnessing existing genomic knowledge to develop new specialized
      biological products, or therapeutic proteins. We have been developing our C1
      Expression System for many years and continue to develop it to serve the drug
      industry in the discovery, development and production of human therapeutic
      proteins, with our primary focus on enabling pharmaceutical and biotechnology
      companies to not only successfully carry on the development of drugs from their
      gene discoveries, but also to manufacture those drugs at economically viable
      costs. Within therapeutic proteins, the production of antibodies is an area
      of
      special focus for us in view of the large number of antibodies in pharmaceutical
      companies’ R&D pipelines for which a reliable and cost-effective production
      process capable of producing large volumes is required. Still in the development
      stage, we refer to these activities as our BioSciences Business.




**21**




Although
      the reprogramming of the C1 host is targeted at improving the production of
      biopharmaceuticals from human genes (which remains a significant focus of our
      commercialization strategy for the C1 Expression System), one side benefit
      of
      this core technology development program will be to further improve the
      capabilities of C1 to make even larger quantities of enzymes and other proteins
      associated with genes from diverse living organisms, such as fungi other than
      C1, yeast, bacteria, algae and plants. We believe that this is likely to help
      us
      generate revenues in the shorter term by cost-effective production of enzymes
      and other proteins of commercial interest to potential business partners in
      sectors such as pulp & paper, agriculture, textile, food and animal feed. We
      have begun to mine the C1 genome for genes of interest and have identified
      genes
      for enzymes that have the potential to become new products for several
      industries, such as textile, pulp & paper, energy, food and animal feed.




We
      have
      also been developing the screening potential of our C1 Host Technology for
      gene
      discovery and the identification of protein variants resulting from
      modifications to their genes, which we refer to as our C1 Screening System.
      These efforts include a collaborative relationship with a Netherlands-based
      scientific organization, TNO Quality of Life (f/k/a TNO Nutrition and Food
      Research Institute), and the establishment of a wholly-owned subsidiary, Dyadic
      Nederland BV, which has engaged in, and partially completed, the development
      of
      a fully-automated fungal high throughput screening system, or HTS system for
      which we are seeking new collaboration partners to help us complete. We believe
      that if our BioSciences Business' application of our C1 Expression System and
      our C1 Screening System can each be perfected, we will be able to offer a
      potentially unique end-to-end solution for drug companies as well as chemicals
      and bioenergy companies: a single host production organism usable throughout
      the
      discovery, pre-clinical and clinical testing and commercial production phases
      of
      drug development that would greatly increase drug development efficiency,
      economy and speed to market, as well as the probability of developing a
      discovery lead into a product, because the need for switching host cells during
      different phases of R&D will be minimized. By the same reasoning, we believe
      that the C1 Host Technology is expected to benefit the development of industrial
      or specialty enzyme products by allowing discovery, improvement, development
      and
      large-scale manufacturing in a single host organism, which should result in
      shorter inception-to-commercialization time and greater probability of success.




In
      October 2006, we were granted U.S. patent 7,122,330, "High-Throughput Screening
      of Expressed DNA Libraries in Filamentous Fungi," by the U.S. Patent and
      Trademark Office. This patent grant will expand the patent protection for
      Dyadic's C1 Host Technology Platform and broad claims covering a number of
      other
      industrially relevant fungi for applications in cellulosic ethanol and other
      key
      markets. Currently, we own 4 issued U.S. patents, 27 issued and 2 allowed
      International patents and 50 U.S. and International filed and pending patent
      applications which we believe provide broad protection for our C1 Expression
      System, our underlying C1 Host Technology, our C1 Screening System and their
      products and commercial applications.




During
      the nine-months ended September 30, 2006, we have received an aggregate of
      approximately $6,190,000 in proceeds from the exercises of warrants and stock
      options. The proceeds have significantly reduced the net amount of cash the
      Company used during the second and third quarters of 2006, thereby improving
      our
      working capital available to support future operations.





During
      2006, we have been conducting an increasing number of new pulp & paper
      customer plant trials and our goal is to convert a number of these trials
      into significant and sustained levels of pulp & paper enzyme sales. We have
      worked with several existing pulp & paper customers to generate product
      trial data for our use in selling Bleach-boosting, Bio-refining and De-inking
      products to other global companies. As we had expected, the sales cycle for
      capturing new customer accounts is a long one (often 6 months to 18 months,
      or
      longer), though we have nonetheless been able to commence mill trials with
      several key potential customers over the past year. Our experience so far has
      shown that this industry is somewhat resistant to change and that the time
      between initial mill trials and ongoing sales can be long. The industry is
      somewhat fragmented with significant differences between mill to mill and region
      to region. Our products have been proven to work as demonstrated by our
      commercial sales into the pulp & paper industry, but because of the
      diversity in how mills operate and in the raw materials they use, tailored
      products are generally required at each mill and additional R&D is required
      to address specific mill needs.





In
      March
      2006, we secured our first order of our proprietary enzymes from a North
      American paper manufacturer. During the three-month period ended September
      30,
      2006 we added our second pulp & paper customer in Brazil and our first pulp
& paper customer in Chile. As a result, we remain optimistic that the Latin
      American market remains a promising geographical region for us. We continue
      to
      estimate the addressable market for our enzyme technology in the pulp &
paper industry to be approximately $1.0 billion. It will be imperative for
      us to
      continue to improve our current technology, as well as develop new enzyme
      systems, in order to realize the full potential of this market.





We
      have
      also focused some of our efforts on other industries and expect to pursue these
      other industries, such as food and animal feed in a possible collaborative
      effort with third parties. To assist us in our endeavors in the animal feed
      market in Europe and elsewhere, we have hired a sales consultant with
      significant experience and expertise in this industry, who began in April 2006
      to help identify and articulate our marketing and commercial strategy. Obtaining
      European Union approval for these products which could take two years or longer
      may also help increase sales in this area. Historically, we have sold into
      this
      industry without any sales support staff and it is our


**22**


expectation
            that this addition will increase our sales effort in the animal feed
            market in
            2007. Our expectations for increased animal feed industry sales during
            the
            latter part of 2006 have been negatively affected by the incidence of
            bird flu
            throughout the Far East and other parts of the world.  It is anticipated
            that continued containment of this out break will allow continued increase
            in
            sales to this market. There is no guarantee, however, that our sales will
            increase significantly or in the time frame that we anticipate.
  We
            have
            invested heavily over the past decade in R&D for cellulases, xylanases and
            other hemicellulases for a wide variety of applications. Some of these
            enzymes,
            as well as others in our R&D pipeline, may be applicable to the conversion
            of agricultural residue products and energy crops (lignocellulosic substrates)
            and forestry industry residues into fermentable sugars, which in turn
            can be
            used to produce ethanol and other chemicals that have historically been
            petroleum-derived. We have a stable of well characterized fungal strains
            and
            enzymes which we believe demonstrate the required activities to achieve
            the
            conversions. We believe that our C1 Host Technology or other proprietary
            technologies, coupled with our R&D efforts, will enable us to offer products
            that address energy problems more effectively and economically. Collectively,
            we
            believe we have resources with significant expertise in this area, including
            our
            Scientific Advisory Board members, our strategic collaborations with
            leading
            scientific organizations such as Moscow State University and the Russian
            Academy
            of Sciences as well as our employees, including the addition of a Chief
            Scientific Officer in March of 2006.
  In
        2006,
        we have begun to shift some of our focus to energy market opportunities and
        the
        need for alternative fuels such as cellulosic ethanol. We have invested
        significant resources over the past decade in the development of our C1 and
        other technologies for the production of cellulases, xylanases and other
        hemicellulases. Some of these enzymes, as well as others currently in
        development, may be applicable in the conversion of agricultural and forestry
        industry residues such as dry distillers grains (DDG), corn stover, wheat
        straw,
        sugar cane bagasse, and wood chips and waste from pulp & paper mills, into
        fermentable sugars, which in turn can be used to produce ethanol and other
        chemicals historically derived from petroleum. The current U.S. biofuels
        market
        (corn starch to ethanol) is currently estimated to be over $12 billion (4.3
        billion gallons of ethanol at a current contract price of $2.70 per gallon). The
        current market for amylases in this corn to ethanol conversion market is
        in the
        hundreds of millions of dollars. Additional corn to ethanol production capacity
        is becoming available from many manufacturers and it is estimated by the
        Renewable Fuels Association that by 2007 there will be approximately a 6.3
        billion gallon capacity in the U.S. While this is a significant increase
        over
        current capacity, this represents less than 5% of the U.S. transportation
        fuel
        requirement. It is estimated that conversion of corn starch to ethanol could
        provide between 5-10% of U.S. transportation fuel needs, though greater use
        of
        corn-derived ethanol could potentially disrupt the food and feed corn markets.
        The U.S. Dept of Energy has estimated that the U.S. has enough annual biomass
        for ethanol conversion to replace approximately 30% of our transportation
        fuels.
        Thus, significant expansion of ethanol capacity above existing levels will
        necessitate the use of agricultural residue feedstock (e.g. corn stover,
        wheat
        straw, sugar cane bagasse, wood chips and waste from pulp & paper mills) and
        energy crops. Such biomass requires the use of cellulase and hemicellulase
        enzymes for the conversion of biomass into fermentable sugars. Depending
        on the
        market share and feedstock involved, the potential for enzymes alone in the
        cellulosic to ethanol market is estimated to be in the hundreds of millions
        of
        dollars.





Currently,
      ethanol producers sell DDG, the corn mash byproduct from ethanol, for use as
      animal feed. We are applying our C1Host Technology and other technologies
      to discover, develop and manufacture enzymes which we believe will result in
      increased recovery of fermentable sugars from DDG. Working with the Iowa Corn
      Promotion Board on a Department of Energy funded program, we have been providing
      enzymes to convert cellulose and hemicellulose, which comprise as much as half
      of the weight of DDG, to fermentable sugars. These sugars can be utilized to
      produce additional ethanol and other chemicals that have historically been
      petroleum-derived.  We are looking to further develop the technology to
      convert DDG and other agricultural bioproducts into fermentable sugars by
      applying for additional government grants and through strategic collaborations
      with partners with complementary technologies.  We have begun to expand our
      R&D programs to develop and manufacture enzymes that will be more effective
      in converting these byproducts into larger volumes of lower cost fermentable
      sugars, thereby lowering the cost of cellulosic ethanol production. We have
      been
      testing a number of multicomponent enzyme products, including both commercial
      products and others in development, for their ability to convert various sources
      of untreated and pretreated lignocellulosic biomass substrates to fermentable
      sugars. Using these enzymes and the expression tools that have been developed,
      we believe Dyadic may be one of a small number of companies able to produce
      the
      necessary enzymes for an efficient and economical biomass to fermentable sugar
      process. In collaboration with appropriate partners, those sugars would then
      be
      converted to ethanol, other fuels, or chemical feed stocks. To this end, we
      are
      engaged in multiple active sets of discussions with prospective industry
      collaboration partners and others, to assist us in these efforts. We believe
      that this may be a significant market opportunity for us as a technology
      provider.





On
      October 26, 2006, we entered into a Securities Purchase Agreement (the
“Securities Purchase Agreement”) with Abengoa Bioenergy R&D, Inc.
      (“Abengoa”), a subsidiary of Abengoa Bioenergy Company. The Company also entered
      into a non-exclusive Research and Development Agreement with Abengoa pertaining
      to the conduct of a research and development (“R&D”) program to be completed
      over a period of up to three and one-half years, under which the Company will
      seek to apply its proprietary technologies to the development of cost-effective
      enzyme mixtures and related processing and manufacturing technologies for
      commercial application in Abengoa’s bioethanol (cellulosic ethanol) production
      process (the “R&D Agreement”).


**23**


Under
            the
            terms of the Securities Purchase Agreement, Abengoa invested $10 million
            in
            Dyadic, for which it was issued 2,136,752 shares of Dyadic common stock.
            Subsequent to the closing, which occurred on November 8, 2006, under
            certain
            circumstances, additional Dyadic securities may be issuable to Abengoa.
 The
          R&D Agreement contemplates that we will perform both foundational research
          of general application to the cellulosic ethanol field furthering our 14
          plus
          years of research & development and large-scale manufacturing technologies
          of producing large volumes of low cost cellulases, xylanases and other
          hemicellulases as well as specific applications research for the achievement
          of
          the goals of Abengoa’s program to develop an economically viable commercial
          process for the production of large volumes of effective, low cost enzyme
          mixtures for the proprietary biomass substrates of interest to Abengoa.
          If we
          successfully develop one or more enzyme mixtures and related processing
          and
          manufacturing technologies for Abengoa and Abengoa exercises an option
          to license on a non-exclusive basis such technologies, we will be entitled
          to receive license fees, technology transfer fees and royalties on ethanol
          production by Abengoa affiliates.
 Reference
        is made to Note 6, Subsequent Events, to our financial statements included
        elsewhere in this Report for further information concerning the Securities
        Purchase Agreement and the R&D Agreement.
  The
        foregoing description of the Securities Purchase Agreement and the R&D
        Agreement is qualified in its entirety by reference to Dyadic’s Current Report
        on Form 8-K dated October 26, 2006, as filed with the SEC on November 1,
        2006.  
 We
          derive
          almost all of our sales from our Enzyme Business, and have thus far generated
          only nominal sales from our BioSciences Business. We have an accumulated
          deficit
          at September 30, 2006 of approximately $41.7 million. These losses resulted
          primarily from expenses associated with research and development activities
          and
          general and administrative expenses. To become profitable, we must continue
          to
          grow our Enzyme Business (see Sales & Marketing Strategy below) and/or
          generate significant revenue from our Biorefinery Products and our BioSciences
          Business, either directly or through potential future license agreements
          and
          collaborative partnerships with industrial and drug companies, respectively.


For
      additional information on Dyadic’s history, refer to Management's Discussion and
      Analysis of Financial Condition and Results of Operations included in the
      Company's Annual Report on Form 10-KSB for the year ended December 31,
      2005.





*Research
      and Development - C1 Host Technology*





We completed
      a genomic sequencing project performed by Agencourt Bioscience to
      sequence the DNA of our C1 host organism in March 2005. Leveraging
      the information gained from the Agencourt C1 genome sequencing project, we
      have
      identified by manual searches over one hundred genes of potential commercial
      interest. To more fully realize the potential of the genomic sequence, it will
      be necessary to annotate the genome. On March 31, 2006, we announced the
      engagement of The Scripps Research Institute to work with Dyadic scientists
      to
      provide a comprehensive annotation of the C1 genome. We expect that the
      annotation will provide tools for identifying and classifying genes, their
      corresponding proteins, and metabolic pathways in a searchable and user-friendly
      format. These tools would allow us to identify additional commercial enzyme
      product leads, including improved cellulases and hemicellulases for use in
      textile, pulp & paper, food and animal feed applications, and for the
      production of ethanol from lignocellulosic biomass. We anticipate that this
      annotation will also allow us to identify genes that influence the physiology
      of
      protein production in C1. Modification of these genes or their expression is
      expected to lead to improvements in the C1 Host Technology, the C1 Expression
      System and the C1 Screening System, making them more robust and versatile.
      Those
      improvements would likely enable them to produce a wider variety of proteins
      at
      higher yields and at lower cost. The annotation project is currently in progress
      and we have already begun to receive preliminary information on the genome
      structure of C1. Over
      11,000 genes have been located and are in the process of being
      identified. As many as 120 of those genes have been found to encode the
      processes that could positively or negatively affect protein production (i.e.
      gene expression, protein secretion, protein degradation, and protein folding)
      as
      well as the production of enzymes with uses in a number of industries. The
      Company anticipates that having the sequence of these genes will accelerate
      the
      development of various products using the C1 Host Technology. For example,
      based
      on the genome sequence, potential genes for improved tools for strain
      development and regulatory proteins for cellulase induction have been
      identified.





This
      initial annotation was accomplished using a number of computer
      algorithms. We are now beginning the process of further refining the
      computer-called genes through manual annotation.  We believe it is
      possible that more advanced searches for promoter elements could also be started
      using sophisticated search algorithms. As the annotation program progresses,
      we
      expect to build a comprehensive genetic and biochemical blueprint of C1
      by continually referencing our genomic data and data derived from the
      genome against databases of known genes, proteins, and metabolic
      pathways. The blueprint will be readily searchable and user-friendly,
      allowing Dyadic to identify numerous products of potential commercial interest
      as well as genes and proteins affecting protein production process in C1, with
      the goal of improving the versatility and robustness of the C1 Host Technology.


**24**


With
          historically high petroleum prices, there has been an increased global
          interest
          in biofuels from both the public and politicians. Reflecting this sentiment,
          President Bush proposed in his State of the Union Address on January 31,
          2006
          the Advanced Energy Initiative, which could amount to a 22% increase in
          the
          Department of Energy's funding for clean energy research. The proposal
          calls for
          the 2007 Federal Budget to include $150 million for research into new methods
          for making ethanol, not just from corn kernels (which is the current method),
          but also from wood chips, corn stover, wheat straw, switchgrass and other
          sources of lignocellulosic biomass. President Bush has set a goal to make
          this
          cellulosic biomass based ethanol cost-competitive and commercially viable
          within
          six years.
 Making
        ethanol from lignocellulosic biomass requires cellulase and hemicellulase
        enzymes, a market segment in which Dyadic has been a producer since the early
        1990's. Filamentous fungi are widely known to be the most prolific producers
        of
        such enzymes in their natural state to breakdown various agricultural
        lignocellulosic matters into fermentable sugars, which can be further converted
        into ethanol. We believe that our existing portfolio of enzymes from C1 and
        other proprietary fungi, as well as a large number of cellulase and
        hemicellulase enzymes in the C1 genome and others could play a significant
        role
        in realizing the President's goal of launching cellulosic ethanol within
        six
        years. We also expect to bring to bear the power of our integrated patented
        C1
        Host Technology gene discovery and expression technology - a unique and powerful
        proprietary tool set - in order to find and develop novel and highly efficient
        enzymes for producing ethanol from lignocellulosic biomass. If we are successful
        in this endeavor, we believe we could play a significant role in the industry's
        achievement of its goal to eventually extract 80 billion gallons of ethanol
        from
        the more than one billion tons of lignocellulosic biomass that is available
        to
        be produced in the U.S., according to the U.S. Department of Energy. That
        is
        estimated to be enough to cover approximately one third of the transportation
        fuel needs in the U.S., which would represent a significant improvement over
        the
        approximate maximum of 5% - 10% of energy needs that can be met with corn
        derived ethanol. Our role would be to supply enzymes to meet the needs of
        the
        cellulosic ethanol producers and/or become a business partner in the production
        of ethanol itself.


We
      are
      also developing our C1 Host Technology to facilitate the discovery, development
      and large-scale production of human antibodies and other high-value therapeutic
      proteins. One of the major hurdles in the development of our C1 Expression
      System for the production of heterologous proteins has been degradation of
      the
      expressed proteins by proteases normally produced by C1. As a result of our
      focused effort to identify, clone the genes for, and eliminate those proteases,
      we have generated strains with very low levels of protease as compared to the
      original host strains. For example, a human antibody was expressed at nearly
      400
      milligrams per liter yield level in an unoptimized C1 strain and without
      performing any traditional fermentation process development work to improve
      the
      yield, which together have the promise of improving the antibody production
      yields significantly. The biological activity of the antibody expressed in
      C1
      was confirmed using the cell-based assays commonly employed by the biotechnology
      and pharmaceutical companies. Furthermore, the antibody made in C1 was found
      to
      have a biological activity level comparable to its human counterpart.





Another
      recent C1 technology development concerns the over-expression of multiple genes
      in C1 host cell, which could be particularly useful in low-cost manufacturing
      of
      enzyme mixes required for cellulosic ethanol and other Biorefinery Product
      applications.





With
      the
      addition of Dr. Glenn E. Nedwin as our Chief Scientific Officer and President
      of
      our BioSciences Business, we have begun to focus on a search for industry
      collaboration partners and others to assist us in the funding and development
      of
      multiple enzyme products for this ethanol market. We have recently achieved
      the
      first of what we hope to be many collaborations in the field of cellulosic
      ethanol.




On
      October 26, 2006, we entered into a Securities Purchase Agreement (the
“Securities Purchase Agreement”) with Abengoa Bioenergy R&D, Inc.
      (“Abengoa”), a subsidiary of Abengoa Bioenergy Company. We also entered into a
      non-exclusive Research and Development Agreement with Abengoa pertaining to
      the
      conduct of a research and development (“R&D”) program to be completed over a
      period of up to three and one-half years, under which we will seek to apply
      our
      proprietary technologies to the development of cost-effective enzyme mixtures
      and related processing and manufacturing technologies for commercial application
      in Abengoa’s bioethanol (cellulosic ethanol) production process (the “R&D
      Agreement”).




Under
      the
      terms of the Securities Purchase Agreement, Abengoa invested $10 million in
      Dyadic, for which it was issued 2,136,752 shares of Dyadic Common Stock at
      $4.68
      per share (the closing share price on October 25, 2006, as reported on the
      American Stock Exchange (“AMEX”)). Subsequent to the closing, which occurred on
      November 8, 2006, under certain circumstances, additional securities may be
      issuable to Abengoa.




We
      will
      use the proceeds from this private sale to fund the performance of our R&D
      obligations under the R&D Agreement over a three and a half year period,
      under which we will seek to apply our proprietary technologies to the
      development of one or more enzyme mixtures and related processing and
      manufacturing technologies customized to Abengoa’s proprietary biomass
      substrates. The R&D Agreement contemplates that we will perform both (i)
      research of general application to the cellulosic ethanol field furthering
      our
      extensive research & development and large-scale manufacturing technologies
      for producing large volumes of low cost cellulases, xylanases and other


**25**


hemicellulases
        and (ii) research of specific applications for the achievement of the goals
        of
        the Abengoa R&D Program to develop an economically viable commercial process
        for the production of large volumes of effective, low cost enzyme mixtures
        for
        the proprietary biomass substrates of specific interest to Abengoa. In general,
        Dyadic is granted exclusive ownership of all intellectual property it develops
        in connection with its performance obligation under the R&D Agreement.
  Under
        the
        terms of the R&D Agreement, if we successfully develop one or more enzyme
        mixtures and related processing and manufacturing technologies for Abengoa
        and Abengoa exercises an option to license on a non-exclusive basis
        such technologies, we will be entitled to receive license fees, technology
        transfer fees and royalties on ethanol production by Abengoa affiliates,
        which
        will be recorded when earned.




If
      within
      six months following the date of closing we have not entered into a specified
      type of transaction involving the sale of our securities totaling at least
      $20
      million in gross proceeds, then Abengoa is entitled to receive three-year
      warrants to purchase 427,351 shares at an exercise price of $5.85. If the sale
      of securities totaling at least $20 million is at a price lower than $4.68
      per
      share, Abengoa is entitled to have additional shares issued to them so that
      their investment is at the same price. If the sale of securities includes
      warrants, Abengoa’s pro rata warrant coverage and other warrant terms are to be
      the same as those in the securities transaction rather than the warrant terms
      discussed above.




Abengoa
      is considered to be the second largest ethanol producer in the world and a
      leader in the fields of both corn-derived and cellulose-derived ethanol
      production. Dyadic’s collaborative relationship with Abengoa is expected to
      leverage Dyadic’s patented C1 platform enzyme technology to enable commercial
      development of biomass derived ethanol. The development of large-scale enzyme
      production systems and manufacturing processes for use in the production of
      abundant low cost fermentable sugars from biomass, with initial focus on
      cellulosic ethanol production, is a primary goal of the Abengoa R&D Program,
      though we can offer no assurance that this R&D Program will be successful in
      achieving this goal.




We
      believe that additional collaboration partners will stand to benefit not only
      from access to Dyadic’s technologies specific to their area of interest but also
      from our core technology development programs that are fundamental to efficient
      production of ethanol, other biofuels, polymers and other chemicals from
      biomass, thereby reducing our dependence on foreign oil.




Based
      on
      the foregoing and other R&D initiatives we continue to
      pursue
      in 2006, we expect to incur significant costs
      funding our R&D initiatives, including costs related to enhancements
      to our core
      technologies, expansion of our infrastructure to carry out our R&D efforts,
      and product development.  If
      certain projects continue to show promise, such as the discovery, development
      and large-scale production of human antibodies, and new and better enzymes
      for
      converting DDG’s and/or other agricultural feedstocks such as sugarcane bagasse,
      wheat straw, corn stover, citrus peel, pulp waste, etc., we may need to
      accelerate those projects and therefore will require increased R&D funding.
      The source of the funding may be from our cash resources, private and public
      debt and/or equity financings or a combination of the foregoing, partnerships
      with third party entities, other strategic relationships like Abengoa, or a
      combination of one
      or more of the foregoing. As a result, we expect to continue to incur losses
      as
      we further develop our C1
      Expression and Screening Systems, and build other required infrastructure to
      exploit our C1 Host Technology, our C1 Expression System, our C1 Screening
      System and our other technologies .
      There
      can be no assurance that our efforts with regard to these objectives will be
      successful.





*Sales
      & Marketing Strategy - Enzymes*





One
      of our top priorities during 2005 was to sharply expand the
      introduction of our pulp & paper enzyme products to that industry.
      While we believe these products offer a strong value proposition for this
      industry, we made a strategic decision to penetrate this market with an acute
      sensitivity to the fact that our target customer decision-makers are responsible
      for physical plants costing, in many instances, several hundred million dollars
      or more, and are accustomed to dealing with highly technical sales teams with
      strong support competencies, following long-term trials of new products.
      Accordingly, we assembled a team of seasoned sales and marketing
      executives and technical salesmen with extensive pulp & paper industry
      experience and contacts in promoting and maintaining sales relationships
      involving substantial on-going sales and technical servicing. The addition
      of
      the sales and marketing personnel occurred throughout the third quarter of
      2005,
      and accordingly, we do not expect to see significant sales dollars from these
      additions until 2007. However, in the first nine months of 2006, pulp &
paper sales did increase to 18% of net sales as compared to 11% for the
      comparable period in 2005. Sales for the nine-month period ended September
      30,
      2006 were approximately $2,100,000 compared to approximately $1,286,000 for
      the
      nine-month period ended September 30, 2005, an increase of 63%. Pulp & paper
      sales for the three-month period ended September 30, 2006 increased 72% over
      the
      comparable period in 2005, representing 21% of net sales in 2006 versus 13%
      in
      2005. Management believes this improvement in pulp and paper sales will continue
      into 2007 and possibly beyond as new and existing mill trials are converted
      to
      sales, however, there can be no assurance that such trends will continue at
      the
      current rate or at all.




**26**


During
      2006, we are continuing to expand our pulp & paper sales and marketing
      initiatives, as we work to capture both an increasing number of new customer
      trials and convert existing and new customer trials into significant and
      sustained levels of pulp & paper product sales. As a next step, we are
      working to expand our indirect sales force through the selective addition of
      distributors in key regions of the world and by training the sales forces of
      our
      new and existing distributors. We continue to estimate the addressable
      market for our existing enzyme products in the pulp & paper industry and
      potential enzyme products for the pulp & paper industry currently in our
      research and development pipeline to be approximately $1.0 billion. It will
      be
      imperative for us to continue to improve our current technology, as well as
      develop new enzyme systems, in order to realize the full potential of this
      market.




We
      have
      worked with several existing
      pulp & paper customers to generate product trial data for
      our
      use in selling Bleach - boosting,
      Bio-refining and De-inking products to other
      global companies .
      As we
      had expected, the sales
      cycle for
      capturing new customer accounts is a long one
      (often 6 months to 18 months, or longer), though
      we have nonetheless been
      able to commence mill trials with
      several key potential customers over the
      past year .
      Our
      experience so far has shown that this industry is somewhat resistant to change
      and that the time between initial mill trials and ongoing sales can be long.
      The
      industry is somewhat fragmented with significant differences between mill to
      mill and region to region. Our products have been proven to work as demonstrated
      by our commercial sales into the pulp & paper industry, but because of the
      diversity in how mills operate and in the raw materials they use, tailored
      products are generally required at each mill and additional R&D is required
      to address specific mill needs.





Our
      marketing and field efforts were recently recognized by recording our first
      sale
      of our pulp & paper enzymes in the United States during the three-month
      period ended March 31, 2006. Some of the benefits that this paper mill has
      realized from the use of our enzymes include increased paper production of
      up to
      8%, a reduction in paper basis weights of up to 4%, and significant reductions
      in refiner energy consumption. Our marketing and field efforts were also
      recognized during the three-month period ended September 30, 2006, when we
      added
      our second pulp & paper customer in Brazil and our first pulp & paper
      customer in Chile. As a result, we remain optimistic that the Latin American
      market remains a promising geographical region for us. We are, however,
      beginning to experience increased competition in the pulp & paper
      industry.





The animal
      feed market has
      represented approximately 7% and 6% of our Enzyme
      Business net
      sales
      in 2005 and 2004, respectively. For
      the
      first nine months of 2006 and of 2005, animal feed sales represented 8% of
      net
      sales, respectively. During 2006, animal feed sales have been negatively
      affected by the incidence of bird flu throughout the Far East and other parts
      of
      the world.  It is anticipated that continued containment of this outbreak
      will allow continued increase in sales to this market. We continue to fund
      the registration of our existing products in
      the
      European Union (the largest market) and development of new products for these
      applications in the
      European Union ( the largest
      market) ,
      and
      expect material growth in this market over the
      next two to three years. We also expect to be able to focus additional product
      development and sales efforts
      in other markets , such as
      energy, starch and brewery markets,
      as a consequence of recruitment of additional personnel charged with direct
      responsibility for overseeing the registration
      of our products
      and greater
      focused attention on these
      market opportunities.





To
      assist
      us in our efforts in the animal feed market in Europe and elsewhere, we have
      hired a sales consultant with significant experience and expertise in this
      industry who began April 1, 2006. Historically, we have sold in this industry
      without any sales support dedicated to this market, and it is our expectation
      that this addition will increase our sales in the animal feed market in 2007.
      There is no guarantee, however, that our sales will increase significantly
      or in
      the time frame that we anticipate.





**Results
      of Operations for the Three-Months Ended September 30, 2006 Compared to the
      Three-Months Ended September 30, 2005**





The
      following table sets forth the amount of increase or decrease represented by
      certain items reflected in the Company's condensed consolidated statements
      of
      operations in comparing the three-months ended September 30, 2006 to the
      three-months ended September 30, 2005 (in thousands):





**27**


**Three-Months
                Ended**
              **September
                30,**(In
                thousands)
            
            **2006**
            
            **2005**
            
            **Increase
                (Decrease)**Net
                sales
            
            $
            4,205
            
            $
            4,140
            
            $
            65Cost
                of goods sold
            
            
            2,893
            
            
            3,318
            
            
            (425
            )Gross
                profit
            
            
            1,312
            
            
            822
            
            
            490Operating
                expenses:Research and development
            
            
            998
            
            
            1,020
            
            
            (22
            )Selling and marketing
            
            
            924
            
            
            810
            
            
            114General and administrative
            
            
            1,729
            
            
            1,413
            
            
            316Foreign currency exchange losses (gains), net
            
            
            15
            
            
            9
            
            
            63,666
            
            
            3,252
            
            
            414Loss
                from operations
            
            
            (2,354
            )
            
            (2,430
            )
            
            76Other
                income (expense):Interest expense
            
            
            (70
            )
            
            (177
            )
            
            107Investment income, net
            
            
            104
            
            
            109
            
            
            (5
            )Minority interest
            
            
            --
            
            
            (25
            )
            
            25Other income, net
            
            
            1
            
            
            6
            
            
            (5
            )Total
                other expense
            
            
            35
            
            
            (87
            )
            
            122Loss
                before income taxes
            
            
            (2,319
            )
            
            (2,517
            )
            
            198Provision
                for income taxes
            
            
            (25
            )
            
            (15
            )
            
            (10
            )Net
                loss
            
            $
            (2,344
            )
            $
            (2,532
            )
            $
            188








**Net
      Sales**





The
      following table reflects the Company’s net sales by industry for the three-month
      periods ended September 30, 2006 and 2005 (in thousands):




**Three-Months
                Ended September 30,**(In
                thousands)
            
            **2006**
            
            **%**
            
            **2005**
            
            **%**
            
            **Increase
                / (Decrease)**
            
            **%**Textile
            
            $
            2,419
            
            
            58
            %
            $
            2,790
            
            
            67
            %
            $
            (371
            )
            
            (13
            %)Animal
                Feed
            
            
            382
            
            
            9
            %
            
            354
            
            
            9
            %
            
            28
            
            
            8
            %Pulp
                & Paper
            
            
            899
            
            
            21
            %
            
            522
            
            
            13
            %
            
            377
            
            
            72
            %Others
                (5 industries)
            
            
            492
            
            
            12
            %
            
            474
            
            
            11
            %
            
            18
            
            
            4
            %Total
                Industrial Enzymes
            
            $
            4,192
            
            
            100
            %
            $
            4,140
            
            
            100
            %
            $
            52
            
            
            1
            %Bioscience
            
            
            13
            
            
            *
            %
            
            --
            
            
            0
            %
            
            13
            
            
            100
            %$
            4,205
            
            
            100
            %
            $
            4,140
            
            
            100
            %
            $
            65
            
            
            2
            %


*
      Less
      than 1%





For
      the
      three-months ended September 30, 2006, we generated net sales of approximately
      $4,205,000, compared to net sales of approximately $4,140,000 for the
      three-months ended September 30, 2005, an increase of approximately $65,000.
      This increase is primarily due to the approximately $52,000 increase in
      industrial enzyme revenues. Sales to pulp & paper, animal feed and other
      industries increased approximately $423,000 in the aggregate which is reduced
      by
      the decrease in sales of approximately $371,000 to the textile industry.
      Additionally, there was approximately $13,000 of bioscience revenue which also
      contributed to the $65,000 increase. Pulp & paper sales for the three-month
      period ended September 30, 2006 increased 72% over the comparable period in
      2005, representing 21% of net sales in 2006 versus 13% in 2005.




**28**


To
      what
      degree our net sales from the textiles market will continue to decline in the
      future will depend not only on that market’s dynamics, but also on the extent to
      which pricing pressure created by our competitors continues. Our success in
      developing new products and our ability to lower our production costs will
      also
      have an impact.  We believe our sales will resume growth when new products
      being developed from our C1 Host Technology and other technologies for new
      markets (e.g. pulp & paper, food and animal feed) begin to achieve
      penetration and other new products are introduced both to existing and other
      new
      markets. We continue to support our textile customers, directing the necessary
      resources to customer support and R&D innovation to maintain market share in
      this segment. To this end, we launched eight new products into the Textile
      market during the third quarter of 2006. The Textile market is one of the core
      markets for our Enzyme Business
      and we expect that these products, which are the result of our continued
      research & development in support of this core market, will help to
      stabilize and ultimately enable us to recapture some of our market share. A
      number of customers have received samples and preliminary wash trials have
      generated positive results. However, we intend to exercise discipline over
      the
      application of resources to the textiles market (which is characterized by
      low
      profit margins and intense competition) relative to other higher profit and
      larger market opportunities we identify, the initial effects of which are
      beginning to be seen. Nonetheless, the markets for a number of our new products
      are generally characterized by longer sales cycles for reasons relating to
      various factors, such as required governmental registration processes (e.g.
      food
      and animal feed enzymes in Europe) and required product trials at customers’
facilities of multi-month durations or longer (e.g. pulp & paper, starch,
      alcohol, ethanol), and we can, therefore, offer no guidance as to when, or
      if,
      these new products will penetrate those markets.




**Cost
      of Goods Sold**





For
      the
      three-months ended September 30, 2006, cost of goods sold was approximately
      $2,893,000, or 69% of net sales, as compared to approximately $3,318,000, or
      80%
      of net sales for the three-months ended September 30, 2005, a decrease of
      approximately $425,000. The improvement in cost of goods sold is largely a
      result of the shift in sales from the textile industry to higher margin
      industries such as pulp & paper, animal feed and others such as brewing and
      alcohol, which represents approximately $282,000 of the decrease. Other factors
      that contributed to the decrease were indirect cost variances related to the
      allocation of overhead to inventory based on the timing of our production at
      our
      third party manufacturer.





**Research
      and Development**




For
      the
      three-months ended September 30, 2006, research and development expenses were
      approximately $998,000, or 24% of net sales, as compared to approximately
      $1,020,000, or 25% of net sales for the three-months ended September 30, 2005,
      representing a decrease of approximately $22,000.




Research
      and development costs incurred by type of project were as follows (in
      thousands):





(In
                thousands)
            
            **Three-Months
                Ended September 30,****2006**
            
            **2005**Internal
                development
            
            $
            301
            
            $
            478Collaborations
            
            
            697
            
            
            542$
            998
            
            $
            1,020








Research
      and development costs based upon type of cost were as follows (in
      thousands):





(In
                thousands)
            
            **Three-Months
                Ended**
              **September
                30,****2006**
            
            **2005**Personnel
                related
            
            $
            199
            
            $
            276Laboratory
                and supplies
            
            
            35
            
            
            38Outside
                services
            
            
            697
            
            
            542Equipment
                and depreciation
            
            
            6
            
            
            111Facilities,
                overhead and other
            
            
            61
            
            
            53$
            998
            
            $
            1,020





**29**


**Selling
      and Marketing**





For
      the
      three-months ended September 30, 2006, selling and marketing expenses were
      approximately $924,000, or 22% of net sales, compared to approximately $810,000,
      or 20% of net sales for the three-months ended September 30, 2005, representing
      an increase of approximately $114,000. This increase is primarily attributable
      to samples and supplies expenses of approximately $59,000 incurred for new
      and
      ongoing pulp & paper trials. Additionally, approximately $47,000 of
      stock-based compensation expense was incurred related to stock options granted
      in 2006 under the provisions of FAS No. 123(R).





**General
      and Administrative**





For
      the
      three-months ended September 30, 2006, general and administrative expenses
      were
      approximately $1,729,000, or 41% of net sales, compared to approximately
      $1,413,000, or 34% of net sales for the three-months ended September 30, 2005,
      representing an increase of approximately $316,000. This increase is
      attributable to several factors, including an increase in salaries and wages
      of
      approximately $86,000 due to the addition of two new employees, including Dr.
      Glenn Nedwin, our Chief Scientific Officer and President of our BioSciences
      Business, approximately $135,000 in additional stock option compensation expense
      which is a result of the adoption of FAS No. 123(R), approximately $52,000
      related to public relations consultants and approximately $65,000 related to
      changes in allocations of expenses between research and development and sales
      and marketing.


**Foreign
        Currency Exchange Gains (Losses), Net**
  For
      the
      three-months ended September 30, 2006, the Company incurred a net foreign
      currency exchange loss of approximately $15,000 as compared to a net loss of
      approximately $9,000 for the three-months ended September 30, 2005. The $6,000
      change is the result of a shift in the proportion of sales transactions to
      expenditure transactions that are denominated in a foreign currency coupled
      with
      the timing of the settlement of the transactions. A large portion of our
      business is transacted with foreign customers and vendors in foreign currency
      denominations. Accordingly, fluctuations in foreign currency exchange rates,
      primarily relating to the Euro, can greatly impact the amount of foreign
      currency gains (losses) we recognize in future periods relating to these
      transactions. We do not, and have no current plans to, engage in foreign
      currency exchange hedging transactions.





**Other
      Income (Expense)**




*Interest
      Expense*




For
      the
      three-months ended September 30, 2006, interest expense was approximately
      $70,000 as compared to approximately $177,000 for the three-months ended
      September 30, 2005, representing a decrease of approximately $107,000. The
      decrease is the result of a reduction in the amortization of the beneficial
      conversion feature as well as interest payable related to the convertible
      stockholders notes payable of approximately $88,000, which were fully expensed
      in the second quarter of 2006 due to the conversion of the notes to common
      stock
      on May 1, 2006. In addition, a reduction in the amortization of the beneficial
      conversion feature of approximately $17,000 related to the Bridge Loan is a
      result of the new amortization period from the extension of the due date to
      January 1, 2008.




*Investment Income, Net*




For
      the
      three-months ended September 30, 2006 and 2005, income from investments in
      money
      market funds was approximately $104,000 and $109,000, respectively. The decrease
      in income from investments in money market funds for the three-months ended
      September 30, 2006 was attributable to maintaining lower money market balances,
      partially offset by increased yields due to higher interest rates.





*Provision
      for Income Taxes*




We
      have
      no provision for U.S. income taxes as we have incurred operating losses in
      all
      periods presented and provide full valuation allowances against the resulting
      tax benefits. For the three-months ended September 30, 2006, we had a foreign
      income tax provision of approximately $25,000 compared to approximately $15,000
      for the three-months ended September 30, 2005, which is primarily attributable
      to our Asian subsidiary, which operates in Hong Kong and mainland China.





**Results
      of Operations for the Nine-Months Ended September 30, 2006 Compared to the
      Nine-Months Ended September 30, 2005**





The
      following table sets forth the amount of increase or decrease represented by
      certain items reflected in the Company's condensed consolidated statements
      of
      operations in comparing the nine-months ended September 30, 2006 to the
      nine-months ended September 30, 2005 (in thousands):


**30**


**Nine-Months
                Ended**
              **September
                30,**(In
                thousands)
            
            **2006**
            
            **2005**
            
            **Increase
                (Decrease)**Net
                sales
            
            $
            12,000
            
            $
            11,863
            
            $
            137Cost
                of goods sold
            
            
            8,727
            
            
            9,514
            
            
            (787
            )Gross
                profit
            
            
            3,273
            
            
            2,349
            
            
            924Operating
                expenses:Research and development
            
            
            2,896
            
            
            3,529
            
            
            (633
            )Selling and marketing
            
            
            2,540
            
            
            1,996
            
            
            544General and administrative
            
            
            5,141
            
            
            4,312
            
            
            829Foreign currency exchange losses (gains), net
            
            
            111
            
            
            (27
            )
            
            13810,688
            
            
            9,810
            
            
            878Loss
                from operations
            
            
            (7,415
            )
            
            (7,461
            )
            
            46Other
                income (expense):Interest expense
            
            
            (518
            )
            
            (527
            )
            
            9Investment income, net
            
            
            294
            
            
            132
            
            
            162Minority interest
            
            
            (13
            )
            
            (35
            )
            
            22Other income, net
            
            
            13
            
            
            2
            
            
            11Total
                other expense
            
            
            (224
            )
            
            (428
            )
            
            204Loss
                before income taxes
            
            
            (7,639
            )
            
            (7,889
            )
            
            250Provision
                for income taxes
            
            
            (58
            )
            
            (43
            )
            
            (15
            )Net
                loss
            
            $
            (7,697
            )
            $
            (7,932
            )
            $
            235





**Net
      Sales**





The
      following table reflects the Company’s net sales by industry for the nine-month
      periods ended September 30, 2006 and 2005 (in thousands):




**Nine-Months
                Ended September 30,**(In
                thousands)
            
            **2006**
            ****
            **%**
            ****
            **2005**
            ****
            **%**
            ****
            **Increase
                / (Decrease)**
            ****
            **%**Textile
            
            $
            7,762
            
            
            65
            %
            $
            8,592
            
            
            72
            %
            $
            (830
            )
            
            (10
            %)Animal
                Feed
            
            
            1,011
            
            
            8
            %
            
            904
            
            
            8
            %
            
            107
            
            
            12
            %Pulp
                & Paper
            
            
            2,100
            
            
            18
            %
            
            1,286
            
            
            11
            %
            
            814
            
            
            63
            %Others
                (5 industries)
            
            
            1,114
            
            
            9
            %
            
            1,006
            
            
            8
            %
            
            108
            
            
            11
            %Total
                Industrial Enzymes
            
            $
            11,987
            
            
            100
            %
            $
            11,788
            
            
            99
            %
            $
            199
            
            
            2
            %Bioscience
            
            
            13
            
            
            *
            %
            
            75
            
            
            1
            %
            
            (62
            )
            
            (83
            %)$
            12,000
            
            
            100
            %
            $
            11,863
            
            
            100
            %
            $
            137
            
            
            1
            %


*
      Less
      than 1%




For
      the
      nine-months ended September 30, 2006, we generated net sales of approximately
      $12,000,000, compared to net sales of approximately $11,863,000 for the
      nine-months ended September 30, 2005, an increase of approximately $137,000.
      This increase in net sales reflects the Company’s efforts to transition its
      revenue base from the lower margin textile enzymes to higher margin areas such
      as enzymes for the pulp & paper (a 63% increase over the 2005 comparable
      period), animal feed and other industries, which in the aggregate, represents
      an
      increase in net sales in these industries of 32% over sales for the nine-months
      ended September 30, 2005 (or 35% of net sales versus


**31**


27%).
      This increase is offset by the continuing margin pressure experienced in the
      textile industry and aggressive pricing by competitors which has created a
      strong downward pressure on pricing, and has caused the Company’s sales to the
      textiles market to decrease (65% vs. 72% for the nine-months ended September
      30,
      2006 and 2005, respectively, as a percentage of net sales) as well as a decrease
      in Bioscience revenue during the nine-month period ended September 30, 2006.
      The
      Company is not currently generating Bioscience revenues on a regular basis.




To
      what
      degree our net sales from the textiles market will continue to decline in the
      future will depend not only on that market’s dynamics, but also on the extent to
      which pricing pressure created by our competitors continues. Our success in
      developing new products and our ability to lower our production costs will
      also
      have an impact. We believe our sales will resume growth when new products being
      developed from our C1 Host Technology and other technologies for new markets
      (e.g. pulp & paper, food and animal feed) begin to achieve penetration and
      other new products are introduced both to existing and other new markets. We
      continue to support our textile customers, directing the necessary resources
      to
      customer support and R&D innovation to maintain market share in this
      segment. To this end, we launched eight new products into the textile market
      during the third quarter of 2006. The textile market is one of the core markets
      for our Enzyme Business
      and we expect that these products, which are the result of our continued
      research & development in support of this core market, will help to
      stabilize and ultimately enable us to recapture some of our market share. A
      number of customers have received samples and preliminary wash trials have
      generated positive results. However, we intend to exercise discipline over
      the
      application of resources to the textiles market (which is characterized by
      low
      profit margins and intense competition) relative to other higher profit and
      larger market opportunities we identify, the initial effects of which are
      beginning to be seen. Nonetheless, the markets for a number of our new products
      are generally characterized by longer sales cycles for reasons relating to
      various factors, such as required governmental registration processes (e.g.
      food
      and animal feed enzymes in Europe) and required product trials at customers’
facilities of multi-month durations or longer (e.g. pulp & paper, starch,
      alcohol, ethanol), and we can, therefore, offer no guidance as to when, or
      if,
      these new products will penetrate those markets.




**Cost
      of Goods Sold**





For
      the
      nine-months ended September 30, 2006, cost of goods sold was approximately
      $8,727,000, or 73% of net sales, as compared to approximately $9,514,000, or
      80%
      of net sales for the nine-months ended September 30, 2005. The improvement
      in
      cost of goods sold is largely a result of the shift in sales from the textile
      industry to higher margin industries such as pulp & paper, animal feed and
      others such as brewing and alcohol, which represents approximately $497,000
      of
      the decrease. Other factors that contributed to the decrease were indirect
      cost
      variances related to the allocation of overhead to inventory based on the timing
      of our production at our third party manufacturer. In addition, during the
      nine-months ended September 30, 2005, the Company recorded an increase in the
      inventory provision of approximately $337,000, with no comparable amount during
      the nine-months ended September 30, 2006.





**Research
      and Development**




For
      the
      nine-months ended September 30, 2006, research and development expenses were
      approximately 2,896,000, or 24% of net sales, as compared to approximately
      $3,529,000, or 30% of net sales for the nine-months ended September 30, 2005,
      representing a decrease of approximately $633,000. In March 2005, we completed
      a
      genomic sequencing project with Agencourt Bioscience to sequence our C1 host
      organism, which contributed significantly to the higher expense in the
      nine-month period ended September 30, 2005. With
      the
      completion of this project, we have begun to identify a large variety of novel
      commercially useful genes that were previously unavailable to us, which should
      greatly assist our ability to accelerate our product development efforts and
      further improve
      the efficiencies of our C1 Host Technology for making proteins and enzymes
      for
      diverse markets, including pharmaceuticals, textiles, pulp & paper, animal
      feed, and food. To more fully realize the potential of the genomic sequence, it
      will be necessary to annotate the genome.




On
      March
      31, 2006, we announced the engagement of The Scripps Research Institute to
      work
      with Dyadic scientists to provide a comprehensive annotation of the C1 genome.
      In a preliminary survey, over
      11,000 genes have been indicated which are now in the process of being
      identified. As many as 120 of those genes have been found to encode the
      processes that could positively or negatively affect protein production (i.e.
      gene expression, protein secretion, protein degradation, and protein folding)
      as
      well as the production of enzymes with uses in a number of industries. The
      Company anticipates that having the sequence of these genes will accelerate
      the
      development of various products using the C1 Host Technology. For example,
      based
      on the genome sequence, potential genes for improved tools for strain
      development and regulatory proteins for cellulase induction have been
      identified.





This
      initial annotation was accomplished using a number of available computer
      algorithms.  We are now beginning the process of further refining the
      computer-called genes through
      improved customized algorithms and manual annotation.  We believe it is possible that more advanced searches for
      promoter elements could also be started using sophisticated search algorithms.
      As the annotation program progresses, we expect to build a comprehensive genetic
      and biochemical blueprint of C1 by  continually referencing our genomic
      data and data derived from the genome against databases of known genes,
      proteins, and metabolic pathways. We expect that the


**32**


annotation
      program will provide tools for identifying and classifying genes, their
      corresponding proteins, and metabolic pathways in a searchableand
      user-friendly format. These tools will allow us to identify additional andcompletely new commercial enzyme product leads, including improved
      cellulases and hemicellulases for use in textile, pulp & paper, food and
      animal feed applications, and enzymes for the production of ethanol or other
      chemical bulk products from lignocellulosic biomass. We anticipate that
      annotation also will allow Dyadic to identify genes that influence the
      physiology and thus efficiency and versatility of protein production in C1.
      Modification of these genes or their expression will lead to improvements in
      the
      C1 Expression and Screening Systems, making them more robust and versatile.
      Those improvements will also
      include development of even better tools than already available for use in
      reliable and robust strain and process development programs, which in turn,
      are
      expected to lead
      to
      Systems able to produce a wider variety of proteins at higher yields within
      shorter timelines and at
      lower cost. The annotation project is currently in progress and we have already
      begun to receive preliminary information on the genome structure of C1 benefiting
      our research and product development programs.





Another
      contributing factor to our decrease in R&D expense was the reduction in
      depreciation expense due to the full depreciation of certain R&D equipment
      at the end of 2005 which contributed approximately $283,000. During the
      nine-month period ended September 30, 2006, approximately $531,000 of the
      $1,882,000 collaboration expense was paid with shares of common stock that
      have
      been held in escrow per the terms of a Development
      Agreement with a third party for services rendered to the Company for research
      and development projects (see Note 3, Share-Based Compensation, to the condensed
      consolidated financial statements included elsewhere in this
      Report).





Research
      and development costs incurred by type of project were as follows (in
      thousands):





(In
                thousands)
            
            **Nine-Months
                Ended**
              **September
                30,****2006**
            
            **2005**Internal
                development
            
            $
            1,014
            
            $
            1,443Collaborations
            
            
            1,882
            
            
            2,086$
            2,896
            
            $
            3,529








Research
      and development costs based upon type of cost were as follows (in
      thousands):








(In
                thousands)
            
            **Nine-Months
                Ended**
              **September
                30,****2006**
            
            **2005**Personnel
                related
            
            $
            605
            
            $
            820Laboratory
                and supplies
            
            
            90
            
            
            145Outside
                services
            
            
            1,882
            
            
            2,086Equipment
                and depreciation
            
            
            21
            
            
            305Facilities,
                overhead and other
            
            
            298
            
            
            173$
            2,896
            
            $
            3,529





**Selling
      and Marketing**





For
      the
      nine-months ended September 30, 2006, selling and marketing expenses were
      approximately $2,540,000, or 21% of net sales, compared to approximately
      $1,996,000, or 17% of net sales for the nine-months ended September 30, 2005,
      representing an increase of approximately $544,000. This increase is
      attributable to several factors, including an increase in salaries and wages
      of
      approximately $142,000, approximately $47,000 in additional stock-based
      compensation expense which is a result of the adoption of FAS No. 123(R), and
      increased travel expense and commission of approximately $199,000, due to the
      addition of nine employees in the latter half of 2005 including a Vice President
      of Sales & Marketing - Enzymes, and the addition of contract labor as well
      as technical sales representatives to our Asian subsidiary. These additions
      are
      a part of the substantial investment both in personnel and other initiatives
      we
      have made to expand our sales, marketing and product development efforts.
      Approximately $74,000 related to changes in allocations of expenses between
      selling and marketing and general and administrative.







**33**


**General
        and Administrative**
 
 For
        the
        nine-months ended September 30, 2006, general and administrative expenses
        were
        approximately $5,141,000, or 43% of net sales, compared to approximately
        $4,312,000, or 36% of net sales for the nine-months ended September 30, 2005,
        representing an increase of approximately $829,000. This increase is
        attributable to several factors, including an increase in salaries and wages
        of
        approximately $384,000 due to the addition of two new employees, including
        Dr.
        Glenn Nedwin, our Chief Scientific Officer and President of our BioSciences
        Business, approximately $458,000 in additional stock-based compensation expense
        which is a result of the adoption of FAS No. 123(R), approximately $201,000
        related to changes in allocations of expenses between research and development
        and sales and marketing and a net reduction of approximately $114,000 for
        consulting fees.


**Foreign
        Currency Exchange Gains (Losses), Net**
  For
      the
      nine-months ended September 30, 2006, the Company incurred a net foreign
      currency exchange loss of approximately $111,000 as compared to a net gain
      of
      approximately $27,000 for the nine-months ended September 30, 2005. The $138,000
      change is the result of a shift in the proportion of sales transactions to
      expenditure transactions that are denominated in a foreign currency coupled
      with
      the timing of the settlement of the transactions. A large portion of our
      business is transacted with foreign customers and vendors in foreign currency
      denominations. Accordingly, fluctuations in foreign currency exchange rates,
      primarily relating to the Euro, can greatly impact the amount of foreign
      currency gains (losses) we recognize in future periods relating to these
      transactions. We do not, and have no current plans to, engage in foreign
      currency exchange hedging transactions.





**Other
      Income (Expense)**




*Interest
      Expense*





For
      the
      nine-months ended September 30, 2006, interest expense was approximately
      $518,000 as compared to approximately $527,000 for the nine-months ended
      September 30, 2005, representing a decrease of approximately $9,000.




*Investment Income, Net*




For
      the
      nine-months ended September 30, 2006 and 2005, income from investments in money
      market funds was approximately $294,000 and $132,000 respectively. The net
      proceeds from the private placement offering completed in early November 2004,
      were invested in money market funds as of December 31, 2004. During the
      three-months ended March 31, 2005, all remaining proceeds were placed in
      short-term investments, which were subsequently sold, resulting in a net
      investment loss of approximately $72,000, and then reinvested in money market
      funds during the second and third quarters 2005, resulting in net investment
      income of approximately $204,000, the net effect being a $132,000 gain. The
      increase in income from investments in money market funds for the nine-months
      ended September 30, 2006 was attributable to increased yields due to higher
      interest rates.





*Provision
      for Income Taxes*




We
      have
      no provision for U.S. income taxes as we have incurred operating losses in
      all
      periods presented and provide full valuation allowances against the resulting
      tax benefits. For the nine-months ended September 30, 2006, we had a foreign
      income tax provision of approximately $58,000 compared to approximately $43,000
      for the nine-months ended September 30, 2005, which is primarily attributable
      to
      our Asian subsidiary, which operates in Hong Kong and mainland China.




**Non-Cash,
      Share-Based Compensation Charges**




In
      January 2006 we adopted Financial Accounting Standards Board Statement (“FASB”),
      Statement of Accounting Standard (“SFAS”) No. 123(R), *Share-Based
      Payment,* which
      requires all share-based payments to employees and non-employee directors,
      including stock option grants, to be recognized in the statement of operations
      based on their fair values. Pro forma disclosure, which we previously used,
      is
      no longer an alternative.




Prior
      to
      January 1, 2006, we accounted for share-based employee compensation plans
      using the intrinsic value method of accounting in accordance with Accounting
      Principles Board Opinion, or APB, No. 25, *Accounting
      for Stock Issued to Employees* (APB
      25),
      and its related interpretations. Under the provisions of APB 25, no compensation
      expense was recognized when stock options were granted with exercise prices
      equal to or greater than market value on the date of grant.


**34**


We
      recognized share-based compensation expense for our share-based awards of
      approximately $185,000 and $30,000 during the three-month periods ended
      September 30, 2006 and 2005, respectively, and approximately $626,000 and
      $51,000, for the nine-month periods ended September 30, 2006 and 2005,
      respectively. These charges had no impact on our reported cash flows. Total
      share-based compensation expense was allocated among the following expense
      categories:







(In
                thousands)
            
            **Three-Months
                Ended****September
                30**
            
            **Nine-Months
                Ended September 30****2006**
            
            **2005**
            
            **2006**
            
            **2005**General
                and administrative (1)
            
            $
            137
            
            $
            23
            
            $
            459
            
            $
            36Research
                and development
            
            
            10
            
            
            7
            
            
            94
            
            
            15Cost
                of goods sold
            
            
            11
            
            
            --
            
            
            21
            
            
            --Selling
                and marketing
            
            
            27
            
            
            --
            
            
            52
            
            
            --$
            185
            
            $
            30
            
            $
            626
            
            $
            51




( 1 )
      The
      three-month and nine-month periods ended September 30, 2006 include a reversal
      of $111,432, of which $101,482 was originally recorded during the second quarter
      of 2006 and $9,949 was recorded during the first quarter of 2006. The reversal
      relates to changes in the probabilities of achieving certain benchmarks related
      to the performance-based stock options.




Under
      the
      modified prospective method of transition under SFAS 123(R), we are not required
      to restate our prior period financial statements to reflect expensing of
      share-based compensation under the new standard. Therefore, the results for
      the
      three-months and nine-months ended September 30, 2006 are not comparable to
      the
      same periods in the prior year.





On
      December 15, 2005, our Board of Directors approved the acceleration of vesting
      for the unvested portion of all outstanding employee incentive stock options
      awarded from May 2001 to present under the 2001 Equity Plan, as amended. While
      the Company typically issues options that vest equally over four years, as
      a
      result of this vesting acceleration, stock options to purchase approximately
      1.2
      million shares of the Company’s common stock, of which approximately 600,000
      were then held by the Company’s executive officers and directors, became
      immediately exercisable. The exercise prices of the affected stock options
      ranged from $1.90 to $5.93 and the closing price of the Company’s common stock
      on December 15, 2005, was $1.75.




The
      purpose of the accelerated vesting was to provide a non-cash benefit to the
      Company’s employees and to eliminate future compensation expense we would
      otherwise recognize in our statements of operations with respect to these
      accelerated options upon the adoption of SFAS 123(R). The estimated future
      compensation expense associated with these accelerated options that would have
      been recognized in the Company’s statements of operations upon implementation of
      SFAS 123(R) is approximately $1.3 million.





**Liquidity
      and Capital Resources**





*Capital
      Raising Activities*




Since
      inception, the Company has financed operations primarily with proceeds from
      the
      sales of the products from its Enzyme Business, external borrowings, borrowings
      from its stockholders and sales of preferred and common equity
      securities




On
      April
      30, 2006, the maturity date of the Bridge Loan (see Note 2 to our condensed
      consolidated financial statements) was extended from January 1, 2007 to January
      1, 2008. The remaining unamortized portion of $76,848 of the beneficial
      conversion feature related to the modified Bridge Loan Warrants will be
      amortized through the new maturity date.





On
      May 1,
      2006, the Mark A. Emalfarb Trust received 251,298 shares of common stock upon
      the conversion in full of its convertible note which had combined principal
      and
      accrued interest of $836,824 on that date. On May 1, 2006, the Francisco Trust
      received 222,537 shares of common stock upon the conversion in full of its
      convertible note which had combined principal and accrued interest of $741,048
      on that date. As a result of the conversions, a total of approximately $1.6
      million of notes payable to stockholders, bearing interest at 6% per annum
      was
      relieved. The balances of the related beneficial conversion features were fully
      expensed in April 2006 resulting in an adjustment of approximately $171,000
      to
      interest expense.


**35**


On
      October 26, 2006, we entered into a Securities Purchase Agreement (the
“Securities Purchase Agreement”) with Abengoa Bioenergy R&D, Inc.
      (“Abengoa”), a subsidiary of Abengoa Bioenergy Company. We also entered into a
      non-exclusive Research and Development Agreement with Abengoa pertaining to
      the
      conduct of a research and development (“R&D”) program to be completed over a
      period of up to three and one-half years, under which we will seek to apply
      our
      proprietary technologies to the development of cost-effective enzyme mixtures
      and related processing and manufacturing technologies for commercial application
      in Abengoa’s bioethanol (cellulosic ethanol) production process (the “R&D
      Agreement”).




Under
      the
      terms of the Securities Purchase Agreement, Abengoa invested $10 million in
      Dyadic, for which it was issued 2,136,752 shares of Dyadic Common Stock at
      $4.68
      per share (the closing share price on October 25, 2006, as reported on the
      American Stock Exchange (“AMEX”)). Subsequent to the closing, which occurred on
      November 8, 2006, under certain circumstances, additional Dyadic securities
      may
      be issuable to Abengoa.




Pursuant
      to the parties' Securities Purchase Agreement, Dyadic agreed to file a
      registration statement with the U.S. Securities and Exchange Commission covering
      the resale of the shares issued at closing, as well as the additional shares,
      if
      any, issuable after the closing.




If
      within
      six months following the date of closing Dyadic has not entered into a specified
      type of transaction involving the sale of its securities totaling at least
      $20
      million in gross proceeds, then Abengoa is entitled to receive three-year
      warrants to purchase 427,351 shares at an exercise price of $5.85. If the sale
      of securities totaling at least $20 million is at a price lower than $4.68
      per
      share, Abengoa is entitled to have additional shares issued to them so that
      their investment is at the same price. If the sale of securities includes
      warrants, Abengoa’s pro rata warrant coverage and other warrant terms are to be
      the same as those in the securities transaction rather than the warrant terms
      discussed above.




Reference
      is made to Note 6, Subsequent Events, to the condensed consolidated financial
      statements included elsewhere in this Report for further information concerning
      the Securities Purchase Agreement and the R&D Agreement.




The
      foregoing description of the Securities Purchase Agreement and the R&D
      Agreement is qualified in its entirety by reference to the Company’s Current
      Report on Form 8-K dated October 26, 2006, as filed with the SEC on November
      1,
      2006.





*Cash
      Flow*




*Operating
      Activities*




As
      reflected in our condensed consolidated statements of cash flows, we have
      incurred losses from operations during the nine-month periods ending September
      30, 2006 and 2005, resulting in net cash used in operating activities of
      approximately $8,100,000 and $6,250,000, respectively. The increase in net
      cash
      used in operating activities was primarily due to our net loss of approximately
      $7,697,000. Other contributing factors include: the temporary outlay of cash
      for
      Value Added Tax (VAT) of approximately $1,020,000 related to our operations
      in
      Poland, of which we received approximately $610,000 payment on during the third
      quarter 2006, and the historical buildup of our inventory levels in the first
      half of the year as a result of our contract manufacturer’s annual hiatus for
      vacation and maintenance, which will occur this year in September and October.
      During the nine-month period ended September 30, 2006, inventory increased
      by
      approximately $870,000, which we intend to utilize during the latter part of
      the
      year, and in particular, the fourth quarter of 2006, which, in combination
      with
      reduced production, will result in reduced cash disbursements for raw
      materials.





*Investing
      Activities*





For
      the
      nine-months ended September 30, 2006, net cash used in investing activities
      was
      approximately $804,000 as compared to approximately $356,000 for the nine-months
      ended September 30, 2005, which relates to purchases of fixed assets of
      approximately $457,000 and $356,000 for the nine-months ended September 30,
      2006
      and 2005, respectively. The increase was primarily due to the purchase of
      manufacturing equipment located at our contract manufacturer in Poland as well
      as asset additions due to the expansion of the Jupiter office. In addition,
      $375,000 was paid to the minority shareholders of our Asian subsidiary as part
      of a purchase and settlement agreement (see Note 3 to the accompanying condensed
      consolidated financial statements).





*Financing
      Activities*




**36**


For
      the
      nine-month periods ended September 30, 2005, our net cash used in financing
      activities was approximately $98,000, for payment of issuance costs related
      to
      the October 2004 private offering. Net cash provided by financing activities
      for
      the nine-months ended September 30, 2006 was approximately $6,190,000 from
      the
      exercise of stock options and warrants (see *Financial
      Condition and Liquidity at September 30, 2006*below).


*Financial
      Condition and Liquidity at September 30, 2006*





As
      of
      September 30, 2006, stockholders' equity was approximately $17,878,000 and
      we
      had a total of approximately $9,437,000 in cash and cash equivalents. Our
      outstanding indebtedness was approximately $2,367,000 as of September 30, 2006,
      and consisted of the Bridge Loan.





During
      the three-month period ended September 30, 2006, we received an aggregate of
      approximately $344,000 in proceeds from the exercises of the following
      instruments: warrants to purchase an aggregate of 21,261 shares of common stock,
      at an exercise price of $5.50 per share and stock options to purchase an
      aggregate of 52,850 shares of common stock, granted under the Equity Plan,
      with
      exercise prices ranging from $2.40 to $4.50 per share. During the nine-month
      period ended September 30, 2006, we received an aggregate of approximately
      $6,190,000, respectively, in proceeds from the exercises of the following
      instruments: (i) warrants to purchase an aggregate of 495,460 shares of common
      stock, at an exercise price of $3.33 per share, (ii) warrants to purchase an
      aggregate of 615,903 shares of common stock for an exercise price of $5.50
      per
      share, (iii) stock options to purchase an aggregate of 216,100 shares of common
      stock, granted under the Equity Plan, with exercise prices ranging from $2.08
      to
      $4.50 per share, and (iv) stock options to purchase an aggregate of 65,000
      shares of common stock, granted prior to the Equity Plan, with an exercise
      price
      of $4.50 per share.





On
      May 1,
      2006, our two largest stockholders, the Mark A. Emalfarb Trust and the Francisco
      Trust U/A/D February 28, 1996 (the “Francisco Trust”), increased their stock
      ownership in the Company by 251,298 and 222,537 shares of common stock,
      respectively, as a result of converting in full their convertible promissory
      notes due January 1, 2007, at an exercise price of $3.33 per share. As a result
      of the conversions, a total of approximately $1,600,000 of notes payable to
      stockholders, bearing interest at 6% per annum was relieved. This represents
      a
      future annual reduction in interest expense of approximately $95,000. The
      balances of the related beneficial conversion features were fully expensed
      in
      April 2006 resulting in a one time adjustment of approximately $171,000 to
      interest expense. The Francisco Trust has as its beneficiaries the wife and
      children of Mark A. Emalfarb, the Chief Executive Officer, President and
      Chairman of the Company.





We
      have a
      development agreement with a third party through December 31, 2006, under which
      we are required to utilize, and the third party has committed to provide
      research and development assistance valued at approximately $1.25 million.
      The
      consideration for these services includes 300,300 shares of our common stock,
      and cash, $250,000 of which was paid upon execution of the agreement. Pursuant
      to the agreement, the 300,300 shares of common stock were placed in escrow
      and
      are being issued to the third party as earned during the contractual period,
      at
      which time they will be deemed to be outstanding. At September 30, 2006, 120,071
      shares of common stock were earned and are outstanding for services rendered
      under this agreement.





*Funding
      of Future Operations*




We
      believe that our operating losses will continue in 2006. In addition, our future
      capital requirements will be substantial. We believe that we will have
      sufficient capital to fund our operations and meet our obligations for the
      next
      twelve months, based on current sales volumes and proceeds from the recent
      warrant and stock option exercises. We currently have a Value Added Tax (VAT)
      receivable of approximately $756,000 related to our operations in Poland that
      we
      anticipate receiving payment on, and which is included in prepaid expenses
      and
      other current assets in the accompanying condensed consolidated balance sheet.
      We have historically built up our inventory levels in the first half of the
      year
      as a result of our contract manufacturer’s annual hiatus for vacation and
      maintenance, which occurred this year in September and October. For the
      nine-month period ended September 30, 2006, inventory increased by approximately
      $867,000, which we intend to utilize during the fourth quarter of 2006, which
      will result in reduced cash disbursements for inventory during the fourth
      quarter of 2006.





We
      have
      established a number of flexible contractual relationships in the areas of
      manufacturing and research and development, enabling us to adjust spending
      in
      those areas as necessary, to achieve the objectives of our business plan, and
      manage both our resources and cash utilization rate. It is possible that we
      will
      seek additional financing within this timeframe. We have historically funded
      losses from operations with proceeds from external borrowings, borrowings from
      our stockholders, and sales of preferred and common equity securities. We may
      raise additional funds through public or private debt and/or equity financings
      or a combination of the foregoing, exercise or conversion of equity instruments,
      collaborative relationships, licensing or selling of certain technologies or
      other arrangements. Additional funding, if sought, may not be available at
      all,
      or may not be available on terms acceptable to us. Further, any additional
      equity financing may be dilutive to stockholders, and debt financing, if
      available, may involve restrictive covenants. Our failure to raise capital
      when
      needed may harm our business and operating results.







**37**


***Off-Balance
        Sheet Arrangements***
  We
        do not
        have any off-balance sheet arrangements .




ITEM
      3.
      CONTROLS AND PROCEDURES





(a)
      Evaluation of Disclosure Controls and Procedures





As
      required by Rule 13a-15 under the Securities Exchange Act of 1934, as of the
      end
      of the period covered by this Quarterly Report, the Company carried out an
      evaluation under the supervision and with the participation of the Company’s
      management, including the Company’s Chief Executive Officer and Chief Financial
      Officer, of the effectiveness of the design and operation of the Company’s
      disclosure controls and procedures.  Based upon that evaluation, the Chief
      Executive Officer and Chief Financial Officer concluded that the Company’s
      disclosure controls and procedures were effective as of September 30,
      2006.





(b)
      Changes in Internal Controls





There
      were no changes in the Company's internal controls over financial reporting
      identified in connection with the evaluation required by paragraph (d) of
      Exchange Act Rules 13a-15 and 15d-15 that occurred during the quarter ended
      September 30, 2006 that have materially affected, or are reasonably likely
      to
      materially affect, the Company's internal control over financial
      reporting.




**PART
      II. OTHER INFORMATION**





ITEM
      6.
      EXHIBITS





**A)**
            **Index
                to Exhibits**


Exhibits
            Description
                of Documents31.1
            Certification
                of Chief Executive Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002 (1)31.2
            Certification
                of Chief Financial Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002 (1)32.1
            Certification
                of Chief Executive Officer required by 18 U.S.C. Section 1350 (as
                adopted
                pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)
                (1)32.2
            Certification
                of Chief Financial Officer required by 18 U.S.C. Section 1350 (as
                adopted
                pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)
                (1)


(1)
            Filed
                herewith.











**38**








SIGNATURES





In
      accordance with the requirements of the Exchange Act, Dyadic International,
      Inc.
      caused this report to be signed on its behalf by the undersigned, thereunto
      duly
      authorized.








DYADIC
                INTERNATIONAL, INC.(Registrant)Date:
                November 10, 2006
            By:
                /s/ Mark A. EmalfarbMark
                A. EmalfarbChief
                Executive OfficerDate:
                November 10, 2006
            By:
                /s/ Wayne MoorWayne
                MoorChief
                Financial Officer







39