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UNITED STATES SECURITIES AND EXCHANGE COMMISSION



WASHINGTON, D.C. 20549



FORM 10-K



(MARK ONE)



[ x ] Annual Report Pursuant
to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Fiscal Year Ended December 31, 2004.



or



[  ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Transition Period from  to
.



Commission File Number: 000-31633



KOSAN BIOSCIENCES INCORPORATED

(Exact name of registrant as specified in its charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|DELAWARE                                                       |  | 94-3217016                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification
No.)



3832 BAY CENTER PLACE, HAYWARD,
CALIFORNIA 94545

(address of principal executive offices)



(510) 732-8400

(Registrants
telephone number, including area code)



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



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

COMMON STOCK, $.001 PAR VALUE PER SHARE



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



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



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



The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $144,470,792 as of June 30, 2004, based upon the closing sale price on the Nasdaq National Market reported for such date. The
determination of affiliate status for the purposes of this calculation is not necessarily a conclusive determination for other purposes. The calculation excludes approximately 10,656,794 shares held by directors, officers and stockholders whose
ownership exceeded five percent of the registrants outstanding Common Stock as of June 30, 2004. Exclusion of these shares should not be construed to indicate that such person controls, is controlled by or is under common control with the
registrant.



The number of shares of common stock of the registrant outstanding at February 28, 2005 was 29,097,833 shares.



DOCUMENTS INCORPORATED BY REFERENCE



Certain portions of the registrants Proxy Statement in connection with the registrants 2005 Annual Meeting of Stockholders, to be filed with the Securities and Exchange
Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report on Form 10-K, are incorporated by reference into Part III of this report.



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Kosan Biosciences Incorporated

Form 10-K

For the Fiscal Year Ended December 31, 2004



TABLE OF CONTENTS



|                     |  |                                                                                                                |  |     
|-------------------- |  | -------------------------------------------------------------------------------------------------------------- |  | ----
|                     |  |                                                                                                                |  | Page
|                     |  | PART I                                                                                                         |  |     
|Item 1.              |  | Business                                                                                                       |  | 3   
|Item 2.              |  | Properties                                                                                                     |  | 34  
|Item 3.              |  | Legal Proceedings                                                                                              |  | 34  
|Item 4.              |  | Submission of Matters to a Vote of Security Holders                                                            |  | 34  
|                     |  |                                                                                                               
|                     |  | PART II                                                                                                        |  |     
|Item 5.              |  | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Repurchases of Equity Securities |  | 35  
|Item 6.              |  | Selected Financial Data                                                                                        |  | 36  
|Item 7.              |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                          |  | 37  
|Item 7A.             |  | Quantitative and Qualitative Disclosures about Market Risk                                                     |  | 47  
|Item 8.              |  | Financial Statements and Supplementary Data                                                                    |  | 47  
|Item 9.              |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                           |  | 47  
|Item 9A.             |  | Controls and Procedures                                                                                        |  | 48  
|Item 9B.             |  | Other Information                                                                                              |  | 49  
|                     |  |                                                                                                               
|                     |  | PART III                                                                                                       |  |     
|Item 10.             |  | Directors and Executive Officers of the Registrant                                                             |  | 50  
|Item 11.             |  | Executive Compensation                                                                                         |  | 50  
|Item 12.             |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters                 |  | 50  
|Item 13.             |  | Certain Relationships and Related Transactions                                                                 |  | 50  
|Item 14.             |  | Principal Accounting Fees and Services                                                                         |  | 50  
|                     |  |                                                                                                               
|                     |  | PART IV                                                                                                        |  |     
|Item 15.             |  | Exhibits and Financial Statement Schedules                                                                     |  | 52  
|Signatures           |  | 55                                                                                                            
|Financial Statements |  | F-1                                                                                                           



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PART I



Forward-Looking Statements and Risk Factors

This annual report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and within the meaning of Section
21E of the Securities Exchange Act of 1934, as amended, which are subject to the safe harbor created by those sections. These forward-looking statements include, but are not limited to, the statements identified in Item 1.
Business under the heading Forward-Looking Statements. In some cases, forward-looking statements can be identified by words such as expect, anticipate, intend, believe,
hope, assume, estimate, plan, will and other similar words and expressions. In addition, any statements that refer to expectations, projections or other characterizations of future events
or circumstances are forward-looking statements.



These forward-looking statements
involve risks and uncertainties, including the risks discussed in Item 1. BusinessRisks Factors That May Affect Results of Operations and Financial Condition, that could cause our actual results to differ materially from those in
the forward-looking statements. We undertake no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this report. The risks discussed in Item 1. BusinessRisks
Factors That May Affect Results of Operations and Financial Condition and elsewhere in this report should be considered in evaluating our prospects and future financial performance.



ITEM 1. BUSINESS

Overview

We are a biotechnology company developing drug candidates from an important class of natural product compounds known as polyketides. Polyketides are naturally made in very small amounts in certain microorganisms and are difficult to make or
modify chemically. Using our expertise and proprietary technologies, we are able to create, modify and produce polyketides in a variety of ways. Because polyketides have been a rich source of marketed drugs, creating novel polyketides and having the
capability to more cost-effectively produce polyketides should provide us with a pipeline of potential drug candidates that address existing or potential large markets. We have two first-in-class, polyketide-derived agents in Phase II and Phase Ib
clinical trials for the treatment of cancer: KOS-862 (Epothilone D) and 17-AAG, a geldanamycin analog and Hsp90 inhibitor.



Our lead drug candidate, KOS-862, is an epothilone with a mechanism of action similar to taxanes, one of the most successful classes of anti-tumor agents introduced in the last
decade. We are co-developing KOS-862, as well as a second-generation epothilone, KOS-1584, with Hoffmann-La Roche, Inc. and F. Hoffmann-La Roche Ltd., collectively Roche, and have U.S. co-promotion rights to any resulting epothilones that receive
regulatory approval for marketing. KOS-862 is in Phase II and Phase Ib clinical trials, and KOS-1584 is in a Phase I clinical trial.



The most advanced compound in our Hsp90 (heat shock protein 90) inhibitor program, 17-AAG, has a novel mechanism of action targeting multiple pathways involved in cancer cell
growth and survival. We are collaborating with the National Cancer Institute, or NCI, a component of the National Institutes of Health, or NIH, in the development of 17-AAG and other analogs of geldanamycin, a polyketide, for the treatment of
cancer. 17-AAG is in Phase II and Phase Ib combination clinical trials being conducted by the NCI. We are testing a proprietary formulation of 17-AAG, KOS-953, in Phase I and Phase Ib clinical trials. In addition, in collaboration with the NCI, we
are developing KOS-1022 (DMAG), a second-generation geldanamycin analog, in Phase I clinical trials.



We also have additional polyketide-based product candidates in our pipeline, including compounds for cancer, gastrointestinal motility and infectious disease that are undergoing preclinical evaluation, as well as several early
stage product research and technology development programs. These programs seek to alter the structure of high-value polyketide pharmaceuticals to confer advantageous properties, to use heterologous over-expression to improve production and to
discover new polyketide structures for important unmet clinical needs.



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KOSAN BIOSCIENCES



We were incorporated under the laws of the state of California in January 1995 and commenced operations in 1996. In July 2000, we were reincorporated under the laws of the state of
Delaware.



Overview of Polyketides

Polyketides are complex natural products produced by certain microorganisms. There are about 10,000 known polyketides, from which numerous pharmaceutical products in many
therapeutic areas have been derived. We focus on polyketides because of their demonstrated ability to address large markets and to treat many different disease conditions. The following table lists some of the important polyketides and their uses.



Selected Polyketide Products and Their Uses



|                            |  |                     
|--------------------------- |  | --------------------
|Product (Trade Name)        |  | Use                 
|Azithromycin (Zithromax)    |  | Antibacterial       
|Clarithromycin (Biaxin)     |  | Antibacterial       
|Erythromycin                |  | Antibacterial       
|Telithromycin (Ketek)       |  | Antibacterial       
|Rifamycin (Rifampin)        |  | Antibacterial       
|Tetracycline                |  | Antibacterial       
|Doxorubicin (Adriamycin)    |  | Anticancer          
|Amphotericin B              |  | Antifungal          
|Lovastatin (Mevacor)        |  | Cholesterol-lowering
|Pravastatin (Pravacol)      |  | Cholesterol-lowering
|Simvastatin (Zocor)         |  | Cholesterol-lowering
|Tacrolimus (FK506, Prograf) |  | Immunosuppressant   
|Sirolimus (Rapamycin)       |  | Immunosuppressant   
|Spinosad                    |  | Insecticide         
|Avermectin                  |  | Veterinary Product  



Unlike most classes of compounds, different
polyketides often have unrelated structures. The common features that link the polyketides as a class are the sequence of reactions by which they are formed and the intermediate compounds made in these reactions. Each polyketide is produced by a
unique polyketide synthase, or PKS, which is a large enzyme composed of many component enzymes. There are two types of PKSs, modular and iterative. We focus primarily on modular PKSs. Modular PKSs contain many enzymes, each of which is used only
once during polyketide production, while iterative PKSs may use some enzymes several times. Erythromycin is an example of a polyketide made by a modular PKS. Erythromycin is not only a valuable antibiotic product, but it is also used in the
production of the antibiotics azithromycin and clarithromycin.



A modular PKS is composed
of multiple proteins. The instructions for making these proteins are contained in the DNA, or genome, of the microorganism that produces the modular PKS. Each protein has its own set of instructions, which is called the gene for the protein. The
complete set of genes for a modular PKS that produces a polyketide is called a gene cluster. When any gene of a polyketide gene cluster is identified, the entire cluster can usually be easily obtained. We accomplish this by using recombinant DNA
technology, which is a set of techniques that enables scientists to combine or alter DNA from different organisms.



The synthesis of a polyketide essentially involves the linking of a number of small building block compounds to form the larger polyketide. A modular PKS can be functionally
subdivided into units called modules, each of which is responsible for a single building block used in the synthesis. Synthesis begins at the first module, called the loading module, located at one end of the PKS, and continues to the end through
multiple extender modules, each of which



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adds and modifies another building block. This process creates a chain of building blocks that forms the polyketide; in many instances, the chain is linked to itself
to form a ring. Because each module codes for one building block, the number of modules in a PKS codes for the size of the polyketide. Each module contains three essential enzyme activities responsible for connecting the polyketide building blocks.
One of these activities selects which building block (there are at least four different building blocks) is used, and the other two are involved in linking the building block to the growing chain and passing the chain to the next module. A module
may also have one, two or three additional enzymes that modify the building blocks once they are incorporated into the chain.



The structure of a polyketide can therefore be viewed as being determined by the types, order and number of modules in a modular PKS. The types of modules dictate which building
blocks are used, the order of the modules dictates the sequence of building blocks and the number of modules dictates the number of building blocks in, or size of, the polyketide. Modifying, adding or deleting modules results in specific and
predictable changes to the structure of the polyketide. Polyketides may also be made by sophisticated duplicate synthesis techniques, or by a combination of chemical and biological techniques.



Our Strategy

Our goal is to create a pipeline of drug candidates that can be advanced into clinical trials and developed into commercialized drugs. Our focus is on drug candidates that address
existing or potential large markets. Our strategy includes the following components:



Maximize Value, Minimize Risk. Our principal programs are focused on the development of improved versions of known compounds or drugs and increasing the efficiency of large-scale production of polyketides. By improving the properties
of known compounds, we believe we can create novel products that take advantage of the known utility, safety, development path and market for existing drugs to reduce the risk and time required for development. By improving the efficiency of
large-scale production, we can more cost-effectively access promising compounds that cannot be obtained from nature in sufficient quantities to permit development and commercialization.



Establish Collaborative Relationships. We have a collaboration with Roche to co-develop and to commercialize our anticancer product candidates,
KOS-862 and KOS-1584, for the treatment of cancer. We have a collaboration with the NCI to clinically develop 17-AAG (including KOS-953) and KOS-1022 (DMAG) for the treatment of cancer. We plan to establish additional collaborative relationships
with pharmaceutical companies and other research and development organizations to help us advance product candidates into or through clinical trials and to the market, obtain additional product candidates and apply our technologies to create new
polyketides and develop large-scale production systems.



Acquire Complementary
Technologies and Products. We have license agreements with Stanford University in the area of polyketide genetic engineering, the Sloan-Kettering Institute for Cancer Research, or Sloan-Kettering, in the area of epothilones and with the NCI in
the area of geldanamycin analogs. We may acquire or license additional complementary technologies or product candidates from others.



Enhance Leadership Position of Our Technology Platform. We intend to expand and enhance our technologies by continuing in-house research activities on polyketide
biosynthesis and chemical synthesis. We plan to continue to extend the reach of our technologies through strategic alliances or acquisitions. We plan to broaden and protect our intellectual property portfolio and in-license patents that complement
our core technologies and products.



Product Development
Opportunities

Our primary programs are currently directed at discovery and development of polyketides for cancer, gastrointestinal motility disorders and infectious
disease. These programs were selected because they represent opportunities where our technologies could improve upon existing products or fill unmet needs and because each addresses existing or potential large markets.



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KOSAN BIOSCIENCES



Cancer

Epothilones

Epothilones are polyketides that inhibit cancer cells by the same mechanism as a class of cytotoxic drugs known as taxanes, including paclitaxel, marketed as Taxol® by Bristol-Myers Squibb Company, and docetaxel, marketed as Taxotere® by Aventis Pharmaceuticals, Inc. In 2004, worldwide net sales of taxanes were approximately $2.8 billion. The epothilones may address a key
limitation of the taxane class because they are active against taxane-resistant human tumor cell lines in in vitro and in vivo animal models, as well as being active against taxane-sensitive human tumors cells in these models.



In September 2002, we entered into an agreement with Roche to jointly develop KOS-862,
our lead epothilone product candidate, and other epothilones. KOS-862 is being evaluated in Phase II clinical trials in advanced breast and prostate cancers with Roche. These Phase II studies are Simon two-stage design trials that have an interim
review and decision point following the completion of stage one before advancing to stage two. We are conducting the prostate cancer trial at multiple centers in North America, and Roche is conducting the breast cancer trial at multiple centers. In
addition to the Phase II monotherapy trials, KOS-862 is being evaluated in Phase Ib clinical trials in combination with Gemzar®, Paraplatin® and
Herceptin®, three standard-of-care anticancer chemotherapeutics. KOS-1584 is our
second-generation Epothilone D anticancer product candidate that we are developing in collaboration with Roche. In December 2004, we initiated a Phase I clinical trial of KOS-1584 in solid tumors. Roche is responsible for the majority of the costs
of the epothilone clinical trials conducted under our collaboration and is funding all of the KOS-862 and KOS-1584 clinical trials other than the KOS-862 prostate cancer clinical trial, which we are currently funding. Competing epothilones in
clinical development include those being developed by Bristol-Myers Squibb (reported to be in Phase III clinical trials), Novartis AG (reported to be in Phase II clinical trials) and Schering AG (reported to be in Phase I clinical trials). The
following table summarizes the current development status of our epothilone program.



|                  |  |                                    |  |         |  |                     |  |                           
|----------------- |  | ---------------------------------- |  | ------- |  | ------------------- |  | --------------------------
|Product Candidate |  | Description                        |  | Sponsor |  | Phase ofDevelopment |  | Initiation ofCurrent Phase
|KOS-862           |  | Metastatic breast cancer           |  | Roche   |  | Phase II            |  | Q2 2004                   
|                  |  | Hormone-refractory prostate cancer |  | Kosan   |  | Phase II            |  | Q1 2005                   
|                  |  | Combination with Gemzar®           |  | Kosan   |  | Phase Ib            |  | Q1 2004                   
|                  |  | Combination with Paraplatin®       |  | Kosan   |  | Phase Ib            |  | Q3 2004                   
|                  |  | Combination with Herceptin®        |  | Roche   |  | Phase Ib            |  | Q3 2004                   
|KOS-1584          |  | Solid tumors                       |  | Kosan   |  | Phase I             |  | Q4 2004                   



Hsp90 Inhibitors

We are developing analogs of the polyketide geldanamycin that have been shown to cause the degradation of numerous proteins involved in the growth and survival of cancer cells.
These compounds bind to and disrupt the function of Hsp90 (heat shock protein 90). Hsp90 is a molecular chaperone in cells that maintains the stability and function of client proteins implicated in signal transduction as well
as the proliferation, angiogenesis and metastasis of tumors. By preventing Hsp90 from protecting its clients, geldanamycin analogs cause their degradation. By simultaneously depleting multiple proteins involved in the genesis and
maintenance of cancer cells, geldanamycin analogs may serve as chemotherapeutic agents in a number of cancers. Moreover, preclinical studies demonstrate that these compounds are synergistic with certain other inhibitors of the signal transduction
client proteins, as well as several conventional anticancer agents.



In October 2002, we
entered into two Cooperative Research and Development Agreements (CRADAs) with the NIH to collaborate with the NCI on the clinical development of 17-AAG and the development of geldanamycin analogs. We are collaborating with the NCI to develop
analogs of geldanamycin, a polyketide, for the treatment of



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cancer. Our lead geldanamycin candidate, 17-AAG, an analog of geldanamycin, is being evaluated in Phase II and Phase Ib clinical trials sponsored by the NCI. We have
developed a new formulation of 17-AAG (KOS-953) that we believe addresses a limitation of the first generation formulation. We initiated self-funded Phase I and Phase Ib clinical trials of KOS-953 during 2004. KOS-953 is being evaluated as
monotherapy in multiple myeloma and in combination with Velcade®. Two Phase Ib
clinical trials in combination with both Herceptin® and Gleevec® are also ongoing. In 2004, 17-AAG received orphan drug status from both the European Medicines
Agency (EMEA) and the U.S. Food and Drug Administration (FDA) for the treatment of two hematologic cancers, chronic myelogenous leukemia and multiple myeloma. In addition, we are collaborating with the NCI on developing KOS-1022, a highly-potent,
water-soluble and orally-active analog of geldanamycin, for which Phase I clinical trials in advanced malignancies with intravenous administration were initiated in 2004. Under a Kosan-sponsored IND that was filed in December 2004, we plan to
initiate Phase I clinical trials of KOS-1022 in hematologic malignancies in the first half of 2005. We plan to submit during 2005 an IND filing to support clinical trials with oral administration of KOS-1022. Under the terms of the CRADAs, we are
responsible for the provision of sufficient quantities of clinical materials necessary to conduct the clinical trials funded by the NCI of 17-AAG and other geldanamycin analogs, and we have the option, at our expense, to conduct our own clinical
trials of 17-AAG and geldanamycin analogs in addition to those funded by the NCI. The following table summarizes the current development status of our Hsp90 inhibitor program.



|                                           |  |                                        |  |         |  |                     |  |                           
|------------------------------------------ |  | -------------------------------------- |  | ------- |  | ------------------- |  | --------------------------
|Product Candidate                          |  | Description                            |  | Sponsor |  | Phase ofDevelopment |  | Initiation ofCurrent Phase
|17-AAG                                     |  | Melanoma                               |  | NCI     |  | Phase II            |  | Q3 2004                   
|                                           |  | Breast cancer                          |  | NCI     |  | Phase II            |  | Q4 2004                   
|                                           |  | Renal cancer                           |  | NCI     |  | Phase II            |  | Q4 2004                   
|                                           |  | Lymphoma                               |  | NCI     |  | Phase II            |  | Q1 2005                   
|                                           |  | Combination with Gemcitabine/Cisplatin |  | NCI     |  | Phase Ib            |  | Q4 2002                   
|                                           |  | Combination with Taxotere®             |  | NCI     |  | Phase Ib            |  | Q2 2003                   
|                                           |  | Combination with Gleevec®              |  | NCI     |  | Phase Ib            |  | Q2 2003                   
|                                           |  | Combination with Paclitaxel            |  | NCI     |  | Phase Ib            |  | Q2 2004                   
|                                           |  | Combination with AraC                  |  | NCI     |  | Phase Ib            |  | Q4 2004                   
|                                           |  | Combination with Velcade®              |  | NCI     |  | Phase Ib            |  | Q1 2005                   
|KOS-953 (proprietaryformulation of 17-AAG) |  | Multiple myeloma                       |  | Kosan   |  | Phase I             |  | Q3 2004                   
|                                           |  | Combination with Herceptin®            |  | Kosan   |  | Phase Ib            |  | Q4 2004                   
|                                           |  | Combination with Velcade®              |  | Kosan   |  | Phase Ib            |  | Q4 2004                   
|                                           |  | Combination with Gleevec®              |  | Kosan   |  | Phase Ib            |  | Q1 2005                   
|KOS-1022 (DMAG)                            |  | Advanced malignancies                  |  | NCI     |  | Phase I             |  | Q3 2004                   
|                                           |  | Hematologic malignancies (Planned)     |  | Kosan   |  | Phase I             |  | 2005                      



Gastrointestinal Motility

One of the actions of erythromycin is stimulation of gastrointestinal movement, or GI motility. Erythromycin-derived compounds, called motilin agonists, may be useful to treat
diseases such as gastroparesis and other conditions in which GI motility is impaired or needs to be increased. Some erythromycin analogs have been effective after a single dose but were found to be ineffective after multiple-dose regimens, also
known as tachyphylaxis. We have made and tested in preclinical models several series of motilin agonists that stimulate GI motility with minimal tachyphylaxis and from which the unnecessary antibiotic activity of erythromycin has been eliminated. We
are currently evaluating a number of these compounds in advanced preclinical studies and plan to enter clinical trials with one of our motilin agonist compounds in 2006.



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KOSAN BIOSCIENCES



Ketolide Antibiotics

Macrolides are clinically important antibiotics that have been used
for the treatment of many infectious diseases for more than 40 years. Today, an estimated 45 million people in the U.S. have acne, a highly visible bacterial infection of the skin. As the use of existing antibiotics continues, there has been
increasing bacterial resistance to these treatments, driving the need in the topical market to develop new and more effective antibiotics. With few novel agents, there exists an opportunity for an effective and safe treatment in the acne market.
Ketolides, analogs of the polyketide erythromycin and a class of macrolide antibiotics, not only possess the potency and spectrum of activity shown by current antibiotics, such as erythromycin, clindamycin and tetracycline, but also are effective
against some of these resistant organisms. We have generated several proprietary ketolides including our lead ketolide candidate, KOS-1835, and plan to advance the product candidate into clinical trials as a potential topical treatment of skin, ear
and eye infections.



Early-Stage Programs

We have three early-stage research programs, based on polyketides. Two are focused on anticancer agents and one is focused on infectious disease. We plan to evaluate these
early-stage research programs in 2005 with the intent to advance one or more of these programs into preclinical development in 2006.



Our Technology Platform

Our technology platform has five
components: polyketide gene alteration, chemo-biosynthesis, heterologous over-expression, polyketide gene synthesis and polyketide chemical synthesis. Together, our technologies enable us to modify, create and produce proprietary polyketides with
potential for development as valuable pharmaceutical products.



Polyketide Gene
Alteration

The structure of a polyketide is primarily determined by variation in the number, order and type of modules in the PKS. Our technologies enable us to
alter modules in a specific, directed manner, and thus we can make specific and predictable changes to the structure of a polyketide.



Polyketides are structurally complex compounds that are difficult to make or modify chemically. Because each building block of a polyketide is selected by a specific module of the
PKS, we use our technologies to make precise structural changes by altering the module that specifies the targeted building block. We use our technologies to improve properties of known, biologically active molecules. This can be done by using our
technology to change a portion of the polyketide that cannot be chemically modified to one that can, allowing us to make subsequent chemical modifications not otherwise practicable. We can also make changes in the structure of existing proprietary
polyketide products to create a new polyketide proprietary to us.



We also are developing
the capability to synthesize polyketide genes to facilitate biosynthetic production and to avoid the need to isolate polyketide synthase genes, or DNA, from nature.



Chemo-Biosynthesis

We incorporate chemically synthesized
fragments into complicated polyketide structures, permitting changes in the polyketide structures and properties in ways that have not been achieved by any other process. Microorganisms containing this modified PKS are fed our chemically synthesized
fragments that substitute for the natural building-block intermediate.



Heterologous
Over-Expression

We can isolate a polyketide gene cluster from one organism and transfer it to another. This is important because many polyketides are produced by
microorganisms that are difficult or slow to grow, or in which recombinant DNA



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methods have not been developed. In addition, polyketides are often produced in small amounts in organisms that naturally produce them, which can limit their
commercial development. We have modified microorganisms, such as S. coelicolor, M. xanthus and E. coli,for efficient polyketide manipulation and production. Our proprietary technologies allow us to transfer polyketide
genes to these microorganisms to enable easier manipulation and increased production of polyketides necessary for commercialization.



Polyketide Gene Synthesis

We have developed advanced methods to complete the chemical
synthesis of large genes, such as those that encode polyketides. We have used these genes to produce several polyketide synthase genes, and we are using them to create a novel approach toward combinatorial biosynthesis.



Polyketide Chemical Synthesis

We have developed state-of-the-art capabilities to chemically synthesize polyketides and to generate chemical analogs of polyketide structures. This enables us to use total chemical synthesis as an alternative to polyketide
gene alteration in order to obtain novel compounds and to combine chemical and biosynthetic approaches for production when appropriate.



Research and Development Expenses

Our research and development
activities consist primarily of salaries and other personnel-related expenses, clinical trial-related services performed by clinical research organizations and research institutions and other outside service providers, licensing-related expenses,
lab consumables and facility-related expenses. We group these activities into two major categories: research and preclinical and clinical development. Our research and development expenses were approximately $40.2 million in
2004, $36.8 million in 2003 and $28.4 million in 2002.



Intellectual Property

Our intellectual property consists of patents, copyrights, trade secrets and know-how. Our ability to compete effectively depends in
large part on our ability to obtain patents for our technologies and products, maintain trade secrets and operate without infringing the rights of others and prevent others from infringing our proprietary rights. We will be able to protect our
technologies from unauthorized use by third parties only to the extent that they are covered by valid and enforceable patents, or are effectively maintained as trade secrets. Accordingly, patents or other proprietary rights are an essential element
of our business. As of December 31, 2004, we owned or were exclusively licensed under approximately 97 patents and 139 patent applications in the U.S., approximately eight patents and 39 patent applications in Europe and approximately three patents
and 38 patent applications in Japan. In determining these numbers, we do not count European or Japanese patent applications until they enter the national or regional stage from a Patent Cooperation Treaty filing, and when a European patent
application issues, we count only one patent regardless of the number of validation countries. We also own or are exclusively licensed under patents and patent applications in other countries and pursue patent protection for each case in countries
where we believe it is commercially reasonable and advantageous to do so.



Our policy is
to file patent applications to protect technology and compounds commercially important to our business. We also rely on trade secrets to protect our technology where patent protection is deemed inappropriate or unobtainable. We protect our
proprietary technology and processes, in part, by confidentiality agreements with our employees, consultants, collaborators and certain contractors. There can be no assurance that our confidential trade secret information will not be disclosed, that
others will not independently develop substantially equivalent proprietary information and techniques or that we can meaningfully protect our proprietary information.



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KOSAN BIOSCIENCES



Collaborative Research, Development and License Agreements

Roche

In September 2002, we signed a research and collaboration agreement with Roche. Under the terms of the agreement, Roche has worldwide exclusive
rights to market and sell KOS-862 and other epothilones in the field of oncology, and we will co-develop and have the right to co-promote the products in the United States. The principal focus of the collaboration is the clinical development and
marketing of KOS-862 and a second-generation epothilone, KOS-1584.



Under the agreement,
we are entitled to receive clinical development funding for our activities under the collaboration, process and back-up development program funding at specified levels and milestone payments based upon achievement of clinical, regulatory and
commercial events. Roche is responsible for the majority of the costs of the epothilone clinical trials conducted under our collaboration and is funding all of the KOS-862 and KOS-1584 clinical trials other than the KOS-862 prostate cancer clinical
trial, which we are funding. We estimate that these types of cash payments could total up to $220 million, based upon our current expectations for program expenses and assuming successful development and commercialization of one product that
achieves each milestone event. As of December 31, 2004, we had received approximately $63.4 million related to this collaboration. In addition, we are entitled to receive royalties on any sales of collaboration products. We have the option to
increase our royalties by contributing to development costs and by co-promotion of products resulting from the collaboration in the United States.



Pursuant to this agreement, we recognized approximately $20.5 million and $26.9 million of contract revenue in 2004 and 2003, respectively. Such amounts, excluding the ratable
portion of an initial fee and milestones, approximated research and development expenses under this collaboration agreement. Included in 2004 revenue was $6.0 million in non-recurring milestones achieved under the agreement and the ratable portion
of the $25 million initial fee that is being recognized through the second half of 2009, the estimated clinical development period. In December 2004, upon the commencement of a Phase I clinical trial of KOS-1584, our second-generation Epothilone D,
we extended the estimated clinical development period from the second half of 2007, which was initially estimated when we entered into the collaboration with Roche in 2002, to the second half of 2009. Our initial estimate of the clinical development
period contemplated development of one product candidate, KOS-862.



Either party may
terminate the agreement at any time for the other partys uncured material breach of the agreement. Roche may terminate the agreement as a whole for cause relating to the success of the program (not needing to relate to any breach
by us). Roche may also terminate the agreement as a whole or in part for convenience. Upon such a termination by Roche for cause or convenience, the licensed rights would revert to us in the terminated territories, and Roche would be required to
provide us with certain license rights, data and other assistance to take over the previously licensed products in the terminated territories. Unless earlier terminated, the agreement will remain in effect for the life of the relevant patents or a
specified number of years from product launch.



Sloan-Kettering Institute for Cancer
Research

Effective August 2000, we signed a research and license agreement with Sloan-Kettering relating to epothilones. Under the agreement, we used our
technologies to produce KOS-862 and work collaboratively with Sloan-Kettering to develop compounds and production methods. Under the agreement, each party licensed the other party for activities as part of the collaborative program. In addition,
Sloan-Kettering granted us a license for all further development and commercialization of compounds selected by us in accordance with the agreement.



Under the agreement, we paid Sloan-Kettering an initial license fee and funding for the collaborative research program and are required to pay annual maintenance fees and patent
fees during the term of the agreement. In addition, we



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must pay Sloan-Kettering milestone payments if clinical development milestones are reached, royalty payments based on net sales of products covered by the
collaboration, and a share of some sublicensing revenues.



We may terminate the agreement
in whole or on a product-by-product basis at any time. Either party may terminate the agreement upon the material breach of the agreement by the other party. Upon termination, all licenses granted by one party to the other revert to the granting
party, and we are required to transfer to Sloan-Kettering any marketing authorizations, data and regulatory filings with respect to any compounds for which we do not retain rights under the agreement. Unless earlier terminated, the agreement will
remain in effect for the life of the relevant patents or a specified number of years from product launch. Effective September 2002, we received a consent from Sloan-Kettering to enter into a sublicense agreement with Roche and amended the research
and license agreement with Sloan-Kettering to harmonize it with the collaboration agreement with Roche.



In 2003, we were in a dispute and litigation with Sloan-Kettering regarding whether certain epothilone analogs developed in Sloan-Kettering laboratories during our collaboration were exclusively licensed to us, the amount of
research funding due Sloan-Kettering under the contract and Sloan-Ketterings right to terminate it. Effective September 2003, we settled the dispute and litigation. Under the terms of the settlement, we and Sloan-Kettering agreed that rights
to the disputed epothilone analogs are included in the exclusive license to us under the August 2000 research and license agreement, and that so long as we make the payments required under the settlement, Sloan-Kettering will not have the right to
terminate that agreement on the basis of any alleged breach prior to the settlement. The settlement agreement provided for an upfront payment to Sloan-Kettering and additional payments upon the achievement of certain development milestones. In
addition, under the settlement, we are obliged to undertake certain development activities with the previously disputed analogs.



Stanford University

Effective March 1996, we entered into an exclusive license agreement
with the Board of Trustees of the Leland Stanford Junior University, or Stanford University, for certain technology and related patent rights and materials for the recombinant production of novel polyketides. Under the terms of the agreement, we
paid a license issue fee to Stanford University, and we pay annual maintenance fees and patent fees, make milestone payments based on achievement of specified events with licensed products, pay royalties on net sales of products claimed in or
originating from the licensed technology and pay a share of some sublicensing fees. In March 2000, we amended the agreement to provide us an exclusive option to acquire an exclusive or non-exclusive license to future patents or patent applications
that are related to certain technology developed by one of our founders, Chaitan S. Khosla, Ph.D., related to polyketides or their production, and chosen by Stanford University in its discretion. Under the March 2000 amendment, we paid an issue fee
in preferred stock that was subsequently converted to common stock in our initial public offering, and we are obligated to pay an option fee for each patent or patent application included in our option rights. We are also obligated to pay Stanford
University a license fee and an annual fee, as well as royalties on net sales and a share of some sublicensing fees under the original agreement, with respect to each patent or patent application for which we exercise our option. Effective September
2002, we received a consent from Stanford University to enter into a sublicense agreement with Roche and amended the research and license agreement to harmonize it with the collaboration agreement with Roche and effect certain other changes.



National Institutes of Health/NCI

Effective October 2002, we entered into two CRADAs with the NIH. Under these agreements, we will collaborate with the NCI in the clinical development of 17-AAG and the development
of other geldanamycin analogs, including DMAG. We have the option to obtain exclusive licenses under patents claiming inventions made in the collaborations under standard NIH licensing terms. Under the CRADAs, we must conduct various activities,
including providing quantities of the drugs for the preclinical studies and clinical trials, and a specified number of personnel to the



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programs. The clinical trials of 17-AAG and other analogs are or will be sponsored by the NCI in collaboration with us or by us solely. Unless earlier terminated, the term of the
collaborative programs is currently scheduled for four years in total, but may be adjusted as the programs proceed by agreement with NIH. Either party may unilaterally terminate either or both of the agreements; provided that if we elect to
terminate, we will still be required to meet certain obligations to supply licensed product to NIH.



Under a November 2002 license agreement with the NIH, we obtained exclusive commercial rights under patent rights relating to the geldanamycin analogs being developed under the CRADAs. Initially, our license is limited to
specified medical fields of use, including treatment of cancer, and the prevention of undesired cell growth or its deleterious effects, such as the prevention of restenosis and neurodegenerative diseases. We intend to include several additional
fields of use to the license, subject to NIHs approval. We have paid the NIH an up-front fee and will owe annual minimum royalties, patent fees, royalties based on net sales of licensed products, milestone payments if clinical development
milestones are reached and a portion of our sublicensing revenues. Our license could terminate if we are not diligent in developing licensed products or otherwise default in performing our material obligations under the agreement and fail to cure
the deficiency. We may terminate the agreement on a country-by-country basis. The agreement contains standard NIH licensing terms. Unless the agreement is earlier terminated, our license will remain in effect for the life of the licensed patents.



In connection with our collaboration and license agreements for the years ended December
31, 2004, 2003 and 2002, we have expensed approximately $1.0 million, $2.5 million and $1.5 million, respectively, as research and development expenses.



Competition

The pharmaceutical and biotechnology industries are
intensely competitive. Many companies, including biotechnology, chemical and pharmaceutical companies, are actively engaged in research and development of drugs for the treatment of the same diseases and conditions as our potential product
candidates. Many of these companies have substantially greater financial and other resources, larger research and development staffs and more extensive marketing and manufacturing organizations than we do. In addition, some of them have considerable
experience in preclinical testing, clinical trials and other regulatory approval procedures. There are also academic institutions, governmental agencies and other research organizations that are conducting research in areas in which we are working.
They may also market commercial products, either on their own or through collaborative efforts.



We face significant competition from large pharmaceutical companies that are pursuing the same or similar technologies, including polyketide manipulation, as the technologies used by us in our drug discovery and production efforts. For
example, a number of companies have cloned polyketide synthase genes and claimed or described in patents or publications those genes or technology to modify them or express them in heterologous hosts using recombinant DNA technology. Such companies
include, for example, Abbott Laboratories (erythromycin, niddamycin); Dow Agrosciences (spinosyn); Eli Lilly and Company (tylosin, spiramycin); Novartis (soraphen, epothilone); and Merck (avermectin, lovastatin). We also face competition from
biotechnology companies and academic researchers that engage in research similar to our own. For example, Biotica Ltd. is a biotechnology company that has published patent applications, issued patents and entered into collaborations with
pharmaceutical companies relating to efforts to modify polyketide synthase genes using recombinant DNA technology.



We expect to encounter significant competition for any of the pharmaceutical products we develop. Companies that complete clinical trials, obtain required regulatory approvals and
commence commercial sales of their products before their competitors may achieve a significant competitive advantage. We are aware that many other companies or institutions are pursuing the development of drugs and technologies directly targeted at
applications for which we are



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developing our drug compounds. Competing epothilones in clinical development include those being developed by Bristol-Myers Squibb (reported to be in Phase III
clinical trials), Novartis AG (reported to be in Phase II clinical trials) and Schering AG (reported to be in Phase I clinical trials). In Hsp90 inhibitors, Conforma Therapeutics has initiated Phase I clinical trials with its formulation of 17-AAG.
In gastrointestinal motility, Chugai Pharmaceuticals has a motilide compound in clinical trials. Thus, it is likely that, even if we are successful in developing any of our product candidates, one or more of these compounds of our competitors will
be approved and marketed as products before our own. This could place us and our collaborators at a significant disadvantage, especially if our compounds do not have superior properties or cost advantages, and could prevent us from realizing
significant commercial benefit from such products.



Developments by others may render our
drug candidates or technologies obsolete or noncompetitive. We face and will continue to face intense competition from other companies for collaborative arrangements with pharmaceutical and biotechnology companies, for establishing relationships
with academic and research institutions and for licenses to additional technologies. These competitors, either alone or with their collaborative partners, may succeed in developing technologies or products that are more effective than ours.



To compete successfully we must develop proprietary positions and patented drugs for
therapeutic markets that have not been satisfactorily addressed by conventional research strategies and, in the process, expand our technical expertise. We must also successfully pursue our technologies and product candidates outside the scope of
proprietary rights of others, or succeed in obtaining licenses under proprietary rights that we are unable to avoid. Our potential products, even if successfully tested and developed, may not be adopted by physicians over other products and may not
offer economically feasible alternatives to other therapies.



Government Regulation

The FDA and comparable regulatory agencies in state and local jurisdictions and in foreign countries impose substantial requirements
upon the clinical development, manufacture and marketing of pharmaceutical products. These agencies and other federal, state and local entities regulate research and development activities and the testing, manufacture, quality control, safety,
effectiveness, labeling, storage, record keeping, approval, advertising and promotion of our potential products.



The process required by the FDA before our products may be marketed in the United States generally involves the following:



| |  |  | preclinical laboratory and animal tests;
| | - |  | ----------------------------------------



| |  |  | submission of an IND application, which must become effective before clinical trials may begin;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | adequate and well-controlled human clinical trials to establish the safety and efficacy of the proposed drug for its intended use; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------



| |  |  | FDA approval of a new drug application, or NDA, or biologics license application, or BLA.
| | - |  | -----------------------------------------------------------------------------------------



The testing and approval process requires substantial time, effort and financial resources, and we cannot be certain that any approvals for any of our
potential products will be granted on a timely basis, if at all.



Prior to commencing
clinical trials, which are typically conducted in three sequential phases, we must submit an IND application to the FDA. The IND automatically becomes effective 30 days after receipt by the FDA, unless the FDA, within the 30-day time period, raises
concerns or questions about the conduct of the trial. In such a case, the IND sponsor and the FDA must resolve any outstanding concerns before the clinical trial can begin. Our submission of an IND may not result in FDA authorization to commence a
clinical trial. Further, an independent institutional review



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board at the medical center proposing to conduct a clinical trial must review and approve the plan for the clinical trial before it commences.



We may not successfully complete any of the three phases of testing of any of our potential products
within any specific time period, if at all. Furthermore, the FDA, an institutional review board or the trial sponsor may suspend a clinical trial at any time on various grounds, including a finding that the subjects or patients are being exposed to
an unacceptable health risk.



The results of product development, preclinical studies and
clinical trials are submitted to the FDA as part of an NDA or BLA. The FDA may deny an NDA or BLA if the applicable regulatory criteria are not satisfied or may require additional clinical data. Even if such data are submitted, the FDA may
ultimately decide that the NDA or BLA does not satisfy the criteria for approval. Once issued, the FDA may withdraw product approval if compliance with regulatory standards is not maintained or if problems occur after the product reaches the market.
In addition, the FDA may require testing and surveillance programs to monitor the effect of approved products that have been commercialized, and the FDA has the power to prevent or limit further marketing of a product based on the results of these
post-marketing programs.



Satisfaction of FDA requirements or similar requirements of
state, local and foreign regulatory agencies typically takes several years, and the actual time required may vary substantially, based upon the type, complexity and novelty of the product or indication. Government regulation may delay or prevent
marketing of potential products or for new indications for a considerable period of time and impose costly procedures upon our activities. Success in early-stage clinical trials does not assure success in later-stage clinical trials. Data obtained
from clinical activities are not always conclusive and may be susceptible to varying interpretations that could delay, limit or prevent regulatory approval. Even if a product receives regulatory approval, the approval may be significantly limited to
specific indications and dosages. Further, even after regulatory approval is obtained, later discovery of previously unknown problems with a product may result in restrictions on the product or even complete withdrawal of the product from the
market. Delays in obtaining, or failures to obtain, additional regulatory approvals for any of our products would have a material adverse effect on our business.



Any products manufactured or distributed by us pursuant to FDA approvals are subject to continuing regulation by the FDA, including record-keeping
requirements and reporting of adverse experiences with the drug. Drug manufacturers and their subcontractors are required to register their establishments with the FDA and certain state agencies, and are subject to periodic unannounced inspections
by the FDA and certain state agencies for compliance with good manufacturing practices, which impose certain procedural and documentation requirements upon us and our third-party manufacturers. We cannot be certain that we or our suppliers will be
able to comply with the good manufacturing practices regulations and other FDA regulatory requirements.



Outside the United States, our ability to market a product is contingent upon receiving a marketing authorization from the appropriate regulatory authorities. The requirements governing the conduct of clinical trials, marketing
authorization, pricing and reimbursement vary widely from country to country. At present, foreign marketing authorizations are applied for at a national level, although within the European Union, or EU, registration procedures are available to
companies wishing to market a product in more than one EU member state. If the regulatory authority is satisfied that adequate evidence of safety, quality and efficacy has been presented, a marketing authorization will be granted. This foreign
regulatory approval process involves all of the risks associated with FDA clearance and may be influenced by FDA actions with respect to the product.



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Forward-Looking Statements

This annual report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and within the meaning of Section 21E of the Securities Exchange Act of 1934, as
amended, which are subject to the safe harbor created by those sections. These forward-looking statements include, but are not limited to, statements about:



| |  |  | our strategy to use our technologies to create new polyketides, make improved versions of known polyketide pharmaceuticals, increase the efficiency of large-scale production of polyketides
and advance selected drug candidates into and through clinical trials and into the market;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our plans to establish additional collaborative relationships with large pharmaceutical companies and other research and development organizations to help us obtain our drug candidates or
advance them into or through clinical trials and to the market, apply our technologies to create new polyketides and develop large-scale production systems;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our plans to expand and enhance our technologies, extend the reach of our technologies, broaden and protect our intellectual property portfolio and in-license patents that complement our core
technologies;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our plans with respect to announcements of clinical data, IND submissions, initiations of clinical trials and advancement of our early stage research programs into preclinical studies;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | sufficiency of our cash resources, including our belief that our existing cash and investment securities and anticipated cash flow from our existing collaboration will be sufficient to
support our current operating plan into the second half of 2006;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our estimates used in preparing our financial statements, including the carrying values of assets and liabilities that are not readily apparent from other sources; estimated clinical
development periods for certain revenue recognized under our collaborations; and estimated future stock-based compensation expenses;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our beliefs that the accounting policies identified in this report are the critical accounting policies that affect our more significant judgments and estimates used in the preparation of our
financial statements;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the expected duration of our current and future clinical trials; and
| | - |  | --------------------------------------------------------------------



| |  |  | the principal amounts of our investments and equipment loans by expected maturity and related weighted average interest rates at December 31, 2004.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------



In some case, forward-looking statements can be identified by words such as expect,
anticipate, intend, believe, hope, assume, estimate, plan, will and other similar words and expressions. In addition, any statements that refer to
expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Discussions containing these forward-looking statements may be found throughout this annual report on Form 10-K, including the
sections entitled Business and Managements Discussion and Analysis of Financial Condition and Results of Operations. These forward-looking statements involve risks and uncertainties, including the risks discussed below
under the heading Risks Factors That May Affect Results of Operations and Financial Condition, that could cause our actual results to differ materially from those in the forward-looking statements. We undertake no obligation to publicly
release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document. The risks discussed below under the heading Risks Factors That May Affect Results of Operations and Financial
Condition and elsewhere in this report should be considered in evaluating our prospects and future financial performance.



Risk Factors That May Affect Results of Operations and Financial Condition

You should carefully consider the risks described below, together with all of the other information included in this report, in considering our business and prospects. The risks and uncertainties described below are not the
only ones facing us. Additional



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risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. The occurrence of any of the following risks
could harm our business, financial condition or results of operations.



We have a
history of net losses and may never become profitable.

We commenced operations in 1996 and are still in an early stage of development. We have not commercialized any
products, and we have incurred significant losses to date. As of December 31, 2004, we had an accumulated deficit of approximately $101.2 million. To date, our revenues have been primarily from collaborations and government grant awards. Our
expenses have consisted principally of costs incurred in research and development and from general and administrative costs associated with our operations. We have incurred net losses since our inception, including net losses of approximately $22.1
million in 2004, $9.7 million in 2003 and $20.9 million in 2002. We expect our expenses to increase and to continue to incur operating losses for at least the next several years as we continue our research and development efforts for our drug
candidates and research programs. The amount of time necessary to successfully commercialize any of our drug candidates successfully is long and uncertain, and successful commercialization may not occur at all. As a result, we may never become
profitable.



We expect that additional financing will be required, and an inability to
obtain the capital necessary to fund our operations on acceptable terms or at all would threaten the continued operation of our business.

We expect that additional
financing will be required in the future to fund operations. We do not know whether additional financing will be available when needed, or that, if available, we will obtain financing on favorable terms. We have consumed substantial amounts of cash
to date and expect capital outlays and operating expenditures to increase over the next several years as we expand our infrastructure and research and development activities.



We may raise additional financing through public or private equity offerings, debt financings, additional corporate collaboration or licensing
arrangements or any combination of the foregoing or other arrangements. To the extent we raise additional capital by issuing equity securities or other equity-related financing, our stockholders may experience dilution. Debt financing, if available,
may subject us to restrictive covenants and significant interest costs. To the extent that we raise additional funds through collaboration and licensing arrangements, it may be necessary to relinquish some rights to our technologies, product
candidates or marketing territories. If we are unable to raise sufficient funds when needed, our business, financial condition and results of operations would be materially harmed, and we may not be able to continue developing our products or may
need to relinquish rights to product candidates at an earlier stage of development or on less favorable terms than we would otherwise choose. See Item 7. Managements Discussion and Analysis of Financial Condition and Result of
OperationsLiquidity and Capital Resources.



We believe that
our existing cash and investment securities and anticipated cash flow from our existing collaboration with Roche will be sufficient to support our current operating plan into the second half of 2006, although we may choose to obtain additional
financing from time to time. We have based this estimate on assumptions that may prove to be wrong. Our future capital uses and requirements depend on numerous forward-looking factors, including the following:



| |  |  | our ability to establish any new collaborations, our rights and obligations under any new collaboration agreements and our ability to generate revenues under any new collaborations;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the progress, number and costs of our research programs;
| | - |  | --------------------------------------------------------



| |  |  | the extent to which clinical and other development activities are funded by our current collaborators, Roche and the NCI;
| | - |  | -------------------------------------------------------------------------------------------------------------------------



| |  |  | the progress, success and costs of preclinical testing and clinical trials of our drug candidates;
| | - |  | --------------------------------------------------------------------------------------------------



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| |  |  | our ability to maintain or extend our existing collaborations with Roche and the NCI;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | the costs and timing of obtaining, enforcing and defending patent and other intellectual property rights;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | any need to obtain licenses to additional patents or other intellectual property in order to use, import, manufacture, market or sell our product candidates;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to obtain regulatory approvals for our product candidates and the costs and timing of doing so;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | any need to expand our manufacturing capabilities;
| | - |  | --------------------------------------------------



| |  |  | any need to build commercial infrastructure to market our products; and
| | - |  | -----------------------------------------------------------------------



| |  |  | expenses associated with any possible future litigation.
| | - |  | --------------------------------------------------------



If our current collaborations are unsuccessful or if conflicts develop with our collaborators, our research and development efforts could be delayed, curtailed or terminated, our
revenues could significantly decrease and our operations may be adversely affected.

We have a corporate research and commercialization collaboration with Roche in
the field of epothilones. We also have collaborations with, or have licenses to technology and compounds from, several research groups, including Sloan-Kettering in the field of epothilones, the NCI in the field of geldanamycin analogs and Stanford
University in the field of polyketide technology. The agreements permit our collaborators or licensors to terminate the agreements under certain circumstances. We may not be able to maintain or extend these collaborations or license agreements on
acceptable terms, if at all. If we do not maintain, extend or replace our corporate collaboration with Roche, our research and development efforts could be delayed, our revenues would significantly decrease and our operations could be adversely
affected. If we are unable to maintain our research collaborations or if our license agreements are terminated, our research and development efforts could be delayed, curtailed or terminated or we could lose our rights to use the licensed technology
and compounds.



We do not control the amount and timing of resources that our
collaborators devote to our programs or potential products, nor the scope, content and timing of the efforts that they conduct or permit under the collaborations. As a result, we do not know if our collaborators will dedicate sufficient resources or
if the development or commercialization efforts by our corporate partners will be successful. We also do not know if the development or commercialization efforts by our collaborators will be the same as those we would choose to devote if we solely
controlled the development and commercialization of our programs and product candidates. In particular, in our collaboration with Roche, we do not control the amount and timing of resources that Roche devotes to the epothilone program beyond limited
funding for certain Kosan activities specified under the contract, and we do not control the scope, content and timing of the preclinical studies, clinical trials and other development efforts that Roche conducts or permits under the program. In our
collaboration with the NCI, we do not control the selection, conduct, timing and resources provided to clinical trials of geldanamycin analogs sponsored by the NCI. For these reasons, we may choose to undertake product development efforts that are
within the scope of our collaborations at our own expense. We also do not know whether our current collaborative partners or future collaborative partners, if any, might pursue alternative technologies or develop alternative products either on their
own or in collaboration with others, including our competitors, as a means for developing treatments for the diseases targeted by collaborative arrangements with us. In addition, business combinations or significant changes in a collaborators
business strategy may adversely affect a collaborators willingness or ability to continue the collaboration with us.



Failure by our corporate partners to develop or commercialize a compound or product for which they have rights from us could materially harm our business, financial condition and
results of operations. For example, if Roche does not successfully develop and commercialize a product from our epothilone program, we may not receive any future milestone payments and will not receive any royalties under our collaboration with
Roche.



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If our collaborators fail to conduct the collaborative activities successfully and in a timely manner or if they or our licensors breach or terminate their agreements with us, the
development or commercialization of the affected product candidates, technology or research program could be delayed or terminated. If any of our existing collaboration agreements are terminated, we may be required to seek new collaborators or to
undertake product development and commercialization at our own expense. This may limit the number of product candidates we will be able to develop and commercialize, significantly increase our capital requirements and reduce the likelihood of
successful product introduction. Disputes might also arise with collaborators or licensors concerning rights to particular compounds or technologies. If we are unable to resolve these disputes in our favor, we could lose our rights to use those
compounds or technologies.



If we fail to enter into new collaborative agreements in the
future, our business and operations would be negatively impacted.

Our strategy depends upon the formation and sustainability of multiple collaborative arrangements
and license agreements with third parties. We expect to rely on these arrangements for not only financial resources, but also for expertise that we expect to need in the future relating to clinical trials, manufacturing, sales and marketing, and for
license and technology rights. Although we have established collaborative arrangements and various license agreements, we do not know if we will be able to establish additional arrangements on favorable terms, or whether current or any future
collaborative arrangements will ultimately be successful. There have been, and may continue to be, a significant number of business combinations among large pharmaceutical companies that have resulted, and may continue to result, in a reduced number
of potential future corporate collaborators, which may limit our ability to find partners who will work with us in developing and commercializing our drug candidates. If we do not enter into new collaborative agreements, we may be required to
curtail, suspend or terminate research and development programs and therefore our ability to generate revenues from these programs will be adversely affected. Our ability to start new research and development programs may also be materially harmed.



Our potential products are in an early stage of development, and substantial additional
effort and expense will be necessary for development.

Our drug candidates are in early stages of research and development. We may not be able to develop products
that prove to be safe and effective, meet applicable regulatory standards, are capable of being manufactured at reasonable costs or can be marketed successfully. All of the potential products that we are currently developing will require significant
development and investment, including extensive preclinical and clinical testing, before we can submit any application for regulatory approval.



Our products must satisfy rigorous standards of safety and efficacy before they can be approved by the FDA and international regulatory authorities for commercial use. We will need
to conduct significant additional research, preclinical testing and clinical trials before we can determine if our products are sufficiently safe and effective to file with the FDA and other regulatory agencies for product approval. Clinical trials
are expensive, and therefore, significant amounts of money will need to be spent testing our products.



In addition, significant time and investment will be required to try to develop manufacturing processes for our products so that they are economical to manufacture on a commercial scale and satisfactory to the FDA and other
governmental authorities.



The progress and results of our animal and human testing are
highly uncertain.

We must provide the FDA and foreign regulatory authorities with clinical data that demonstrate the safety and efficacy of our products before they
can be approved for commercial sale. As a result, commercialization of our product candidates depends upon successful completion of preclinical and clinical trials. Preclinical testing and clinical



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development are long, expensive and uncertain processes. It may take us a number of years to complete our testing, and failure can occur at any stage of testing. For
example, in November 2004, we discontinued a Phase II clinical study of KOS-862 in non-small cell lung cancer because the study did not meet the primary objective of tumor response in the first stage of a two stage clinical trial, and in June 2004,
we discontinued a Phase II clinical study of KOS-862 in colorectal cancer due to unanticipated cumulative drug toxicities in patients who had previously been treated with the cancer treatment oxaliplatin. We could experience similar failures in
other current or future clinical testing of our product candidates.



Success in
preclinical testing and early clinical trials does not ensure that later clinical trials will be successful, and interim results of trials do not necessarily predict final results. A number of companies in the pharmaceutical and biotechnology
industry, including Kosan, have suffered significant setbacks in advanced clinical trials, even after promising results in earlier trials. Also, preclinical and clinical data can be interpreted in different ways, which could delay, limit or prevent
further testing or regulatory approval.



We do not know whether clinical trials of our
product candidates (including ongoing and anticipated clinical trials of KOS-862, KOS-1584, 17-AAG, KOS-953, KOS-1022 or other product candidates) will begin on time or whether any of our clinical trials will be completed on schedule, or at all.
Negative or inconclusive results or adverse medical events during a clinical trial could cause a clinical trial to be suspended, repeated or terminated. Certain of the clinical trials of our product candidates are designed to include two stages,
with the decision whether to proceed to the second stage dependent on results obtained in the first stage. Failure to achieve predetermined response rates as defined in the protocol may result in the decision not to proceed into the second stage of
the related trial.



We have four product candidates in human clinical trials for the
treatment of cancer, KOS-862, KOS-1584, KOS-953 and KOS-1022. Anticancer drugs generally have a narrow therapeutic window between efficacy and toxicity. If unacceptable toxicity is observed in a clinical trial, the trial may be terminated at an
early stage. For example, in June 2004, we discontinued a Phase II clinical study of KOS-862 in colorectal cancer due to unanticipated cumulative drug toxicities in patients who had previously been treated with the cancer treatment oxaliplatin.



Completion of clinical trials may take several years or more. The length of time
generally varies substantially according to the type, complexity, novelty and intended use of the drug candidate. Our clinical trials (including ongoing and anticipated clinical trials of KOS-862, KOS-1584, 17-AAG, KOS-953, KOS-1022 or other product
candidates) may be suspended at any time, if we, the FDA, or other regulatory authorities believe the patients participating in our studies are exposed to unacceptable health risks. Our ability to commence or timely complete clinical trials may be
adversely affected by many factors, including:



| |  |  | ineffectiveness of the study compound, or perceptions by physicians that the compound is not effective for a particular indication;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | inability to manufacture sufficient quantities of compound for use in clinical trials;
| | - |  | --------------------------------------------------------------------------------------



| |  |  | a failure to obtain approval from the FDA, other regulatory authorities or an investigational sites investigational review board to conduct a clinical trial;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | inability to reach agreement with a sufficient number of investigational sites to conduct a study;
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | slower than expected rate of patient recruitment or inability to recruit a sufficient number of patients;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | adverse medical events or the death of patients during a clinical trial, even if caused by the advanced status of their disease or medical problems that are not related to our product
candidates;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | inconclusive or negative results from the clinical trial;
| | - |  | ---------------------------------------------------------



| |  |  | competing clinical trials in the same or similar indication;
| | - |  | ------------------------------------------------------------



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| |  |  | third-party clinical investigators failing to perform our clinical trials on our anticipated schedule or consistent with a clinical trial protocol, and other third-party organizations not
performing data collection and analysis in a timely or accurate manner; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a decision by the FDA or other governmental authorities to require suspension of a clinical study.
| | - |  | --------------------------------------------------------------------------------------------------



Our product development costs will increase if we have delays in testing or approvals or if we need to perform more or larger clinical trials than
planned. If the delays are significant, our financial results and the commercial prospects for our products will be harmed, and our ability to become profitable will be adversely affected. If any clinical trials of our product candidates (including
ongoing and anticipated clinical trials of KOS-862, KOS-1584, 17-AAG, KOS-953, KOS-1022 or other product candidates) are not successful, our business, financial condition and results of operations will be harmed.



If we are not able to obtain required regulatory approvals, we will not be able to commercialize our
product candidates, and our ability to generate revenue will be materially impaired.

Our product candidates and the activities associated with their development,
manufacture and commercialization are subject to comprehensive regulation by the FDA and other regulatory agencies in the United States, and by comparable authorities in other countries. Our products may not be commercialized unless and until our
collaborators or we obtain regulatory approval from the FDA or foreign governmental authorities to do so. The process of obtaining regulatory approvals is expensive, often takes many years, if approval is obtained at all, and can vary substantially
based upon the type, complexity and novelty of the product candidates involved. We have not received regulatory approval to market any of our product candidates in any jurisdiction and, although our personnel have experience from working at other
companies, we as a company have no experience in preparing and filing the applications necessary to gain regulatory approvals to commercialize our products. This lack of experience may impede our ability to obtain FDA or other foreign regulatory
approvals to commercialize our products in a timely manner, if at all.



Changes in the
regulatory approval policy during the development period, changes in or the enactment of additional regulations or statutes, or changes in regulatory review for each submitted product application, may cause delays in the approval or rejection of an
application. Furthermore, the approval procedure and the time required to obtain approval varies among countries and can involve additional testing beyond that required by the FDA. Approval by one regulatory authority does not ensure approval by
regulatory authorities in other jurisdictions.



The FDA and other regulatory authorities
have substantial discretion in the approval process and may refuse to accept any application or may decide that our data is insufficient for approval and require additional preclinical, clinical or other studies or modifications to the manufacturing
processes or facilities or quality control procedures for our products. Any clinical trial may fail to produce results satisfactory to the FDA or other regulatory authorities. Preclinical and clinical data can be interpreted in different ways, which
could delay, limit or prevent regulatory approval. Furthermore, even if we file an application with the FDA or other regulatory authorities for marketing approval of a product candidate, it may not result in marketing approval from the FDA or other
regulatory authorities.



We do not know whether clinical trials for our product
candidates (including ongoing and anticipated clinical trials of KOS-862, KOS-1584, 17-AAG, KOS-953, KOS-1022 or other product candidates) will demonstrate safety and efficacy sufficient to obtain the requisite regulatory approvals or will result in
marketable products. Our failure to adequately demonstrate the safety and efficacy of our products under development will prevent receipt of FDA and foreign approvals and, ultimately, commercialization of our products.



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We rely on third parties to conduct our clinical trials, and those third parties may not perform satisfactorily.

We do not have the ability to independently conduct clinical trials for our products, and we rely on third parties such as contract research organizations, medical institutions and
clinical investigators to perform this function. We also rely on Roche to conduct certain clinical trials for KOS-862 and potentially KOS-1584 and the NCI to conduct certain clinical trials for 17-AAG and KOS-1022. We may rely on future
collaborators to conduct clinical trials for our product candidates. If any of these third parties do not successfully carry out their obligations or meet expected deadlines, clinical trials may be extended, delayed or terminated, and our product
candidates may not receive regulatory approval or be successfully commercialized.



Even
if any of our product candidates receives regulatory approval, we may still face significant development and regulatory difficulties.

Even if the FDA or other
regulatory authorities approves a product candidate, the approval may impose significant restrictions on the indicated uses, conditions for use, labeling, advertising, promotion, marketing and/or production of such product, and may impose ongoing
requirements for post-approval studies, including additional research and development and clinical trials. In addition, regulatory agencies subject a product, its manufacturer and the manufacturers facilities to continual review and periodic
inspections. If a regulatory agency discovers previously unknown problems with a product, including adverse events of unanticipated severity or frequency, or problems with the facility where the product is manufactured, a regulatory agency may
impose restrictions on that product, our collaborators or us, including requiring withdrawal of the product from the market.



If any of our approved products, our collaborators or we fail to comply with applicable regulatory requirements, a regulatory authority may take various actions, including:



| |  |  | issuing warning letters;
| | - |  | ------------------------



| |  |  | imposing civil or criminal penalties;
| | - |  | -------------------------------------



| |  |  | suspending regulatory approval;
| | - |  | -------------------------------



| |  |  | refusing to approve pending applications or supplements to approved applications filed by us or our collaborators;
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | imposing restrictions on operations, including costly new manufacturing requirements; or
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | seizing or detaining products or requiring a product recall.
| | - |  | ------------------------------------------------------------



Manufacturing difficulties could delay or preclude commercialization of our products and substantially increase our expenses.

Currently, we are the sole manufacturer of the active pharmaceutical ingredient for KOS-862, we rely on a contract manufacturer for the active pharmaceutical ingredient for
KOS-1584 and we use a single outside contractor to formulate drug product for KOS-862 and KOS-1584. We currently maintain limited inventories of the active pharmaceutical ingredient for KOS-862 and KOS-1584 at our facilities in Hayward, California.
We currently maintain limited inventories of formulated drug product for KOS-862 and KOS-1584 at our facilities in Hayward, California and at the facilities of an outside contractor. Limited inventories of formulated drug product for KOS-862 are
also maintained by Roche.



In our geldanamycin program, we currently use a single
manufacturer to make the active pharmaceutical ingredients for 17-AAG (including KOS-953) and KOS-1022. We formulate drug product for 17-AAG, KOS-953 and KOS-1022 both at our own facility and through a contract manufacturer. We currently maintain a
limited inventory of 17-AAG,



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KOS-953 and KOS-1022 at our facilities in Hayward, California and at the facilities of an outside contractor. The NCI is not obligated to maintain an inventory of either the active
pharmaceutical ingredient or formulated drug product for 17-AAG or KOS-1022.



If any of
our or our contract manufacturers manufacturing or inventory facilities encounter delays, are destroyed or otherwise become unavailable to us, then the clinical development of our product candidates (including KOS-862, KOS-1584, 17-AAG,
KOS-953 and KOS-1022) or submissions for their regulatory approval, and therefore commercialization, could be delayed or precluded. Adverse effects would be particularly acute if problems arise with our sole sourcing or inventory relationships.
Because our manufacturing processes and those of our contractors are complex and subject to a lengthy regulatory approval process, alternative qualified production capacity may not be available on a timely basis or at all.



A number of factors could cause prolonged interruptions in the manufacturing and supply of our
products, including:



| |  |  | the inability of a supplier to provide raw materials or key intermediates used for manufacture of our products;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | equipment malfunctions or failures;
| | - |  | -----------------------------------



| |  |  | the inability to manufacture in accordance with current good manufacturing practices;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | the delay of product shipments due to U.S. custom regulations or third-party carriers used to transport our products, and damage to our products while they are in transit;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in FDA or other regulatory authority requirements or standards that require modifications to the manufacturing processes or facilities used in the production of our products;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | action by the FDA or other regulatory authorities to suspend production of one or more of our products; or
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | difficulties in scaling-up production of our products for large clinical trials or commercial supply.
| | - |  | -----------------------------------------------------------------------------------------------------



While our manufacturing personnel have extensive experience from working at other companies, we as a company have no experience manufacturing products
for commercial sale. We may encounter difficulties in attempting to scale-up our manufacturing processes and facilities. We may not be able to achieve such scale-up in a timely manner or at a commercially reasonable cost, if at all. In addition, our
facilities in Hayward, California are located within the San Francisco Bay Area, an area that is subject periodically to earthquakes. Our access to any key intermediates, active pharmaceutical ingredient or formulated drug product for our product
candidates sourced or inventoried solely through our facilities in Hayward may be subject to interruption in the event of an earthquake.



As discussed above, we rely upon outside contractors to manufacture and supply to us key intermediates, active pharmaceutical ingredients and formulated drug product for our
product candidates. Our dependence upon others for the manufacture of our product candidates and components thereof may adversely affect our ability to continue in a timely manner clinical development of our product candidates and may adversely
affect any future profit margins and our ability to commercialize any products that we may develop on a timely and competitive basis. Dependence on contract manufacturers involve a number of additional risks, many of which are outside of our
control, including:



| |  |  | failure of a contract manufacturer to manufacture products to our specifications or to deliver products in the quantities or timeframe that we require;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | failure of a contract manufacturer to comply with current good manufacturing practices or other regulatory requirements;
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | a decision by the FDA or other regulatory authorities not to approve our use of a particular contract manufacturer to supply our products;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | intellectual property rights to any improvements in a manufacturing process or new manufacturing processes being owned by or shared with a contract manufacturer; or
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | termination of an agreement with a contract manufacturer or increased prices charged by a contract manufacturer.
| | - |  | ----------------------------------------------------------------------------------------------------------------



Any of these factors could cause us to delay or suspend clinical trials, regulatory submissions or commercialization of our products and could result
in significantly increased costs.



In addition, our future contract manufacturers may not
be in the United States, and we currently utilize a contract manufacturer located outside the United States. Consequently, we may face additional manufacturing difficulties due to a number of potential factors, including importation and customs
issues, political uncertainties and a potentially limited ability to enforce our contractual rights against parties not located within the United States.



Any inability to protect our proprietary technologies could significantly harm our business and ability to successfully commercialize product candidates.

Our commercial success will depend in part on our ability to obtain patents and maintain adequate protection of other intellectual property for our technologies and products in the
United States and other countries and prevent others from infringing our proprietary rights. If we do not adequately protect our intellectual property, competitors may be able to use our technologies and erode or negate any competitive advantage we
may have. The laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States, and we may encounter significant problems in protecting our proprietary rights in these countries.



We will be able to protect our proprietary rights from unauthorized use by third parties only to the
extent that our proprietary technologies and products are covered by valid and enforceable patents or are effectively maintained as trade secrets. However, the patent positions of biotechnology companies, including our patent position, involve
complex legal and factual questions, and, therefore, we cannot predict with certainty whether our patent applications will be approved or any resulting patents will be enforced. Patents may be challenged, deemed unenforceable, invalidated or
circumvented. Thus, any patents that we own or license from third parties may not provide protection against competitors.



The degree of future protection for our proprietary rights is uncertain, and we cannot ensure that:



| |  |  | we or our licensors were the first to make the inventions covered by each of our pending patent applications;
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | we or our licensors were the first to file patent applications for these inventions;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | others will not independently develop similar or alternative technologies or duplicate any of our technologies;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | any of our or our licensors pending patent applications will result in issued patents;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | any of our or our licensors patents will be valid or enforceable;
| | - |  | ------------------------------------------------------------------



| |  |  | any patents issued to us or our licensors and collaborators will provide a basis for commercially viable products, will provide us with any competitive advantages or will not be challenged by
third parties;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | we will develop additional proprietary technologies that are patentable; or
| | - |  | ---------------------------------------------------------------------------



| |  |  | the patents of others will not have an adverse effect on our business.
| | - |  | ----------------------------------------------------------------------



We apply for patents covering our technologies and drug candidates, as we deem appropriate. However, we may fail to apply for patents on important technologies or products in a
timely fashion or at all. Our existing patents and any



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future patents we obtain may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products and technologies. For example, our
lead product in our geldanamycin analog program, 17-AAG, is not covered by a composition of matter patent, and thus others could develop products containing 17-AAG. We are aware of at least one other company that has been developing product
candidates containing 17-AAG. Other competitors may be currently developing, or may in the future develop, products containing 17-AAG. In addition, we generally do not control the patent prosecution of technology that we license from others.
Accordingly, we are unable to exercise the same degree of control over this intellectual property as we would over our own.



In addition to patents, we rely on trade secrets and proprietary know-how. We have taken measures to protect our confidential information and trade secrets. However, these measures
may not provide adequate protection. We seek to protect our confidential information and trade secrets by entering into confidentiality agreements with employees, collaborators, consultants and others. Nevertheless, parties may breach these
agreements or competitors may otherwise obtain or independently develop our trade secrets.



Claims by third-parties of intellectual property infringement would require us to spend time and money and could deprive us of valuable rights needed to develop or commercialize our products.

Our commercial success depends significantly on not infringing the patents and proprietary rights of other parties and not breaching any licenses that we have entered into with
regard to our technologies and products. Other parties may currently or in the future possess intellectual property rights covering drug candidates that we are developing or desire to develop and genes, gene fragments, compounds and technologies we
use or may wish to use. Any infringement of patent rights or violation of other proprietary rights may require us to obtain a license from another party, forego product development or commercialization or face lawsuits or other claims.



The biotechnology industry is characterized by extensive litigation regarding patents and other
intellectual property rights. We are aware of patents and published patent applications that, if valid, and if we are unsuccessful in circumventing or acquiring the rights to these patents, may block our ability to commercialize products based on
the drug candidates that we are developing or pursue our PKS (polyketide synthase) gene manipulation and production technologies. We cannot be sure that other parties have not filed for or been issued relevant patents that could affect our ability
to obtain patents or successfully operate our business. Others may challenge our patent or other intellectual property rights or sue us for patent infringement, misappropriation of their intellectual property rights or breach of license agreements.
We may be required to commence legal proceedings to resolve our patent or other intellectual property rights. An adverse determination in any litigation or in administrative proceeding to which we may become a party could subject us to significant
liabilities, result in our patents being deemed invalid, unenforceable or revoked, require us to license disputed rights from others or to cease using the disputed technology. In addition, our involvement in any of these proceedings may cause us to
incur substantial costs and result in diversion of management and technical personnel.



We are aware of a significant number of patents and patent applications relating to aspects of our technologies and compounds filed by, and issued to, other parties. Others have filed patent applications or have been granted patents
claiming inventions also claimed or licensed by us, and we may have to participate in an interference or other proceeding before a patent agency or court to determine priority of invention or which party was first to invent and, thus, the right to a
patent for these inventions. For example, we believe one or more interferences may be declared between patents and applications we own or have exclusively licensed and patents and applications owned by Novartis relating to epothilone biosynthetic
genes and Epothilone D; patent applications believed by us to be licensed to Bristol-Myers Squibb relating to epothilones; and patents and applications owned by Abbott Laboratories and Biotica Ltd. relating to erythromycin polyketide synthase genes,
methods for altering polyketide synthase genes and



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erythromycin analogs. Biotica Ltd. has filed an opposition against one of our European patents related to the recombinant production of polyketides; we have filed a
response and a hearing has been scheduled at the European Patent Office in the first half of 2005. In addition, the European Patent Office has recently granted European patents to the German Research Centre for Biotechnology (GBF), which we believe
to be licensed to Bristol-Myers Squibb and, if valid in individual European countries, would cover Epothilone D in those countries. Formal oppositions to these patents have been filed with the European Patent Office and we expect a response by GBF
to those oppositions beginning the second half of 2005. We are also aware that the United States Patent Office has recently issued a Notice of Allowance to a patent application owned by Oregon State University, which relates to KOS-1584. A
proceeding or a lawsuit in which we are alleged to have infringed an issued patent could result in substantial cost to us even if the outcome is favorable, and if the outcome is unfavorable, we could be required to license the other partys
rights, on terms that may be unfavorable to us, or cease using the technology. Even if successful on priority grounds, an interference may result in loss of claims based on patentability grounds raised in the interference. Although patent and
intellectual property disputes in the biotechnology area are often settled through licensing or similar arrangements, costs associated with these arrangements may be substantial and could include ongoing royalties. Furthermore, we cannot be certain
that a license would be available to us on satisfactory terms, if at all. Companies and others developing products that could compete with our product candidates, such as Bristol-Myers Squibb and Novartis in the area of potential epothilone
products, may be particularly unwilling to grant us a license at any price.



Other
parties may obtain patents in the future and claim that the use of our technologies infringes these patents or that we are employing their proprietary technology without authorization. We could incur substantial costs and diversion of management and
technical personnel in defending ourselves against any claims that the use of our technologies infringes any patents, defending ourselves against any claim that we are employing any proprietary technology without authorization or enforcing our
patents against others. Furthermore, parties making claims against us may be able to obtain injunctive or other equitable relief that could effectively block our ability to develop, commercialize and sell products, and could result in the award of
substantial damages against us. In the event of a successful claim of infringement against us, we may be required to:



| |  |  | pay substantial damages;
| | - |  | ------------------------



| |  |  | stop using certain products and methods;
| | - |  | ----------------------------------------



| |  |  | develop non-infringing products and methods; and
| | - |  | ------------------------------------------------



| |  |  | obtain one or more licenses from other parties.
| | - |  | -----------------------------------------------



We may not be able to obtain licenses from other parties at a reasonable cost, or at all. If we are not able to obtain necessary licenses at a reasonable cost or at all, we could
encounter substantial delays in product introductions while we attempt to develop alternative methods and products, which we may not be able to accomplish.



Litigation or the failure to obtain licenses could prevent us from manufacturing or commercializing products and could materially harm our business, financial condition and results
of operation.



If we are unable to recruit and retain skilled employees and consultants,
we may not be able to successfully operate our business.

Retaining our current employees and recruiting qualified scientific personnel to perform future research and
development work, as well as manufacturing and key management personnel, will be critical to our success. We may also need to hire personnel with expertise in clinical testing, government regulation, marketing, law and finance. Competition is
intense among biotechnology, pharmaceutical and healthcare companies, universities and non-profit research institutions for experienced scientists and other personnel, and we may not be able to retain or recruit



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sufficient skilled personnel on acceptable terms to allow us to pursue collaborations and develop our products and core technologies to the extent otherwise possible.



In December 2004, the Financial Accounting Standards Board, or FASB, issued Statement No. 123
(revised 2004) Share-Based Payment, or SFAS 123R, which will require us to record a charge to earnings for the compensation cost relating to share-based payment transactions, including stock options and employee stock purchase plans,
effective July 1, 2005. We are currently evaluating option valuation methodologies and assumptions permitted by the FASB for purposes of implementing the change in accounting treatment. This change will have a negative impact on our financial
results. For an illustration of the effect of such a change in our recent financial results, see Note 1 to the Notes to Financial StatementsSummary of Significant Accounting Policies: Stock Options Plans. In addition, new regulations
implemented by The Nasdaq National Market requiring shareholder approval for all stock option plans, as well as new regulations implemented by the New York Stock Exchange prohibiting NYSE member organizations from giving a proxy to vote on
equity-compensation plans unless the beneficial owner of the shares has given voting instructions, could make it more difficult for us to grant options to employees in the future. To the extent that new regulations make it more difficult or
expensive to grant stock options to employees, we may incur increased compensation costs, change our equity compensation strategy or find it difficult to attract, retain and motivate employees, each of which could materially and adversely affect our
business.



We face intense competition from large pharmaceutical companies, biotechnology
companies and academic groups.

We face, and will continue to face, intense competition from organizations such as large biotechnology and pharmaceutical companies,
as well as academic and research institutions and government agencies, that are pursuing competing technologies and products. These organizations may develop or currently possess technologies or products that are superior alternatives to ours. For
example, competing epothilones in clinical development include those being developed by Bristol-Myers Squibb (reported to be in Phase III clinical trials), Novartis AG (reported to be in Phase II clinical trials) and Schering AG (reported to be in
Phase I clinical trials). In Hsp90 inhibitors, Conforma Therapeutics has initiated Phase I clinical trials with their formulation of 17-AAG. Further, our competitors in the polyketide gene-engineering field may be more effective at implementing
their technologies to develop commercial products or may hold or develop patents or other proprietary rights that may prevent us from practicing our technologies and pursuing our programs. Some of these competitors have entered into collaborations
with leading companies within our target markets to produce polyketides for commercial purposes.



Any products that we develop through our technologies will compete in multiple, highly competitive markets. Development of pharmaceutical products requires significant investment and resources. Many of the organizations competing with us in
the markets for such products have greater capital resources, research and development and marketing staffs, facilities and capabilities, and greater experience in discovery and developing drugs, obtaining regulatory approvals and product
manufacturing and marketing. Accordingly, our competitors may succeed in more rapidly developing and marketing technologies and products that are more effective than our technologies and products or that would render our products or technologies
obsolete or noncompetitive.



We believe that our ability to successfully compete will
depend on, among other things:



| |  |  | our ability to develop novel compounds with attractive pharmaceutical properties and to secure and protect intellectual property rights based on our innovations;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the efficacy, safety and reliability of our product candidates;
| | - |  | ---------------------------------------------------------------



| |  |  | the speed at which we develop our product candidates;
| | - |  | -----------------------------------------------------



| |  |  | our ability to design and successfully execute appropriate clinical trials;
| | - |  | ---------------------------------------------------------------------------



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| |  |  | the timing and scope of regulatory approvals;
| | - |  | ---------------------------------------------



| |  |  | our ability to manufacture and sell commercial quantities of future products to the market; and
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | acceptance of future products by physicians and other healthcare providers.
| | - |  | ---------------------------------------------------------------------------



If we face product liability claims, these claims will divert our managements time and we will incur litigation costs, and if we are held liable, our business, financial
condition and results of operation may be materially harmed.

We face an inherent business risk of liability claims in the event that the use of our potential
products in clinical trials or otherwise, or any other products manufactured in our facility, results in personal injury or death. Even though we have obtained product liability insurance, it may not be sufficient to cover claims that may be made
against us. Product liability insurance is expensive, difficult to obtain and may not be available in the future on acceptable terms, if at all. Any claims against us, regardless of their merit, could materially and adversely affect our business,
financial condition and results of operation, because litigation related to these claims would strain our financial resources in addition to consuming the time and attention of our management. If we are sued for any injuries caused by our products
or products manufactured at our facility, our liability could exceed our total assets.



We use hazardous chemicals and radioactive and biological materials in our business. Any claims relating to improper handling, storage or disposal of these materials could be time consuming and costly.

Our research and development processes involve the controlled use of hazardous materials, including hazardous chemicals and radioactive and biological materials. Some of these
materials may be novel, including bacteria with novel properties and bacteria that produce biologically active compounds. Our operations also produce hazardous waste products. We cannot eliminate the risk of accidental contamination or discharge and
any resultant injury from these materials. Federal, state and local laws and regulations govern the use, manufacture, storage, handling and disposal of these materials. We could be subject to civil damages in the event of an improper or unauthorized
release of, or exposure of individuals to, hazardous materials. In addition, we could be sued for injury or contamination that results from our use or the use by third parties or our collaborators of these materials, and our liability may exceed our
total assets. Compliance with environmental laws and regulations may be expensive, and current or future environmental regulations may impair our research, development or commercialization efforts.



We have a stockholders rights plan and anti-takeover provisions in our corporate charter documents that
may result in outcomes with which you do not agree.

Our board of directors has the authority to issue up to 10,000,000 shares of preferred stock and to determine the
rights, preferences, privileges and restrictions of those shares without further vote or action by our stockholders. The rights of the holders of any preferred stock that may be issued in the future may adversely affect the rights of the holders of
common stock. The issuance of preferred stock could make it more difficult for third parties to acquire a majority of our outstanding voting stock.



Our certificate of incorporation provides for staggered terms for the members of the board of directors and prevents our stockholders from acting by written consent. These
provisions and other provisions of our bylaws and of Delaware law applicable to us could delay or make more difficult a merger, tender offer or proxy contest involving us. This could reduce the price that investors might be willing to pay for shares
of our common stock and result in the market price being lower than it would be without these provisions. In addition, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making
it more difficult for stockholders to replace members of our board of directors. This is because our board of directors is responsible for appointing the members of our management team.



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We have adopted a rights agreement under which all stockholders have the right to purchase shares of a new series of preferred stock at an exercise price of $70.00 per one
one-hundredth of a share, if a person acquires more than 20% of our common stock. The rights plan could make it more difficult for a person to acquire a majority of our outstanding voting stock. The rights plan could also reduce the price that
investors might be willing to pay for shares of our common stock and result in the market price being lower than it would be without the rights plan. In addition, the existence of the rights plan itself may deter a potential acquiror from acquiring
us. As a result, either by operation of the rights plan or by its potential deterrent effect, mergers and acquisitions of us that our stockholders may consider in their best interests may not occur.



Some of our existing stockholders can exert control over us and may not make decisions that are in the
best interest of all stockholders.

Our officers, directors and their affiliates together controlled approximately 26% of our outstanding common stock as of December
31, 2004. As a result, these stockholders, if they act together, are able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval, including the election of directors and approval of
significant corporate transactions. This concentration of ownership may delay or prevent a change in control of us and might affect the market price of our common stock, even when a change may be in the best interests of all stockholders. In
addition, the interests of this concentration of ownership may not always coincide with our interests or the interests of other stockholders, and accordingly, they could cause us to enter into transactions or agreements, which we would not otherwise
consider.



Our stock price has been, and may continue to be, extremely volatile.

The trading price of our common stock has been, and is likely to continue to be, highly volatile. During the period from December 31, 2003 through December 31, 2004,
our common stock traded between $5.71 and $14.77 on the Nasdaq National Market. The trading price of our common stock could be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including:



| |  |  | announcements of technological developments in research by us or our competitors;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | delay or failure in initiating, conducting, completing or analyzing clinical trials or unsatisfactory design or results of these trials by our collaborators or us;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | developments in clinical trials for potentially competitive product candidates;
| | - |  | -------------------------------------------------------------------------------



| |  |  | changes in the United States or foreign health care systems or regulations;
| | - |  | ---------------------------------------------------------------------------



| |  |  | regulatory approvals for competitive product candidates or delays or failures by our collaborators or us in obtaining regulatory approvals for our product candidates;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | new products or services introduced or announced by us or our competitors;
| | - |  | --------------------------------------------------------------------------



| |  |  | published reports by securities analysts;
| | - |  | -----------------------------------------



| |  |  | announcements of expirations, terminations or amendments of collaborations, licenses or government research grants, or announcements that we have entered into new collaboration, licensing or
similar arrangements;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | departures of key personnel;
| | - |  | ----------------------------



| |  |  | developments or disputes as to patent or other proprietary rights;
| | - |  | ------------------------------------------------------------------



| |  |  | litigation or an unfavorable outcome in litigation;
| | - |  | ---------------------------------------------------



| |  |  | sales of our common stock;
| | - |  | --------------------------



| |  |  | announcements of, and actual or anticipated fluctuations in, our financial results; and
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | economic and other external factors, disasters or crises.
| | - |  | ---------------------------------------------------------



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In addition, the stock market in general, and the Nasdaq National Market and the market for biotechnology companies in particular,
has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may seriously harm the market price of our common
stock, regardless of our operating performance. In the past, following periods of volatility in the market price of a companys securities, securities class-action litigation has often been instituted against that company. If this type of
litigation were instituted against us, we would be faced with substantial costs and managements attention and resources would be diverted, which could in turn seriously harm our business, financial condition and results of operations.



We expect that our quarterly results of operations will fluctuate, and this fluctuation
could cause our stock price to decline, creating investor losses.

Our quarterly operating results have fluctuated in the past and are likely to do so in the future.
These fluctuations could cause our stock price to fluctuate significantly or decline. Some of the factors that could cause our operating results to fluctuate include:



| |  |  | expiration or termination of research contracts with collaborators or government research grants, which may not be renewed or replaced;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the success rate of our efforts leading to milestone payments and royalties under our collaboration agreement with Roche or any future collaboration or license agreements;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the timing and willingness of collaborators to develop and commercialize our products;
| | - |  | --------------------------------------------------------------------------------------



| |  |  | general and industry specific economic conditions, which may affect our collaborators research and development expenditures; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | costs and expenses related to any litigation or administrative proceedings in which we may be involved.
| | - |  | -------------------------------------------------------------------------------------------------------



We expect a large portion of our expenses to be relatively fixed, including expenses for facilities, equipment and personnel. Accordingly, if revenues
decline or do not grow due to expiration, termination or amendment of current or future collaboration agreements, licenses or government research grants, failure to obtain new contracts or other factors, we may not be able to reduce our operating
expenses correspondingly. In addition, we expect operating expenses to continue to increase. Failure to achieve anticipated levels of revenues could therefore significantly harm our operating results for a particular fiscal period.



Due to the possibility of fluctuations in our revenues and expenses, we believe that quarter-to-quarter
comparisons of our operating results are not a good indication of our future performance. Our operating results in some quarters may not meet the expectations of stock market analysts and investors. In that case, our stock price would probably
decline.



Changes in the accounting treatment of stock options will adversely affect our
results of operations.

Changes in the accounting treatment of stock options will require us to account for employee stock options as compensation expense on our
financial statements. In December 2004, the Financial Accounting Standards Board, or FASB, issued Statement No. 123 (revised 2004) Share-Based Payment, or SFAS 123R, which will require us to record a charge to earnings for the
compensation cost relating to share-based payment transactions, including stock options and employee stock purchase plans, effective July 1, 2005. We are currently evaluating option valuation methodologies and assumptions permitted by the FASB for
purposes of implementing the change in accounting treatment. This change will have a negative impact on our financial results. For an illustration of the effect of such a change in our recent financial results, see Note 1 to the Notes to Financial
StatementsSummary of Significant Accounting Policies: Stock Options Plans.



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KOSAN BIOSCIENCES



If we are unable to favorably assess the effectiveness of internal controls over financial reporting, or if our independent auditors are unable to provide an unqualified
attestation report on our assessment, our stock price could be adversely affected.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, on an annual basis, our
management is required to report on, and our independent auditors to attest to, the effectiveness of our internal controls over financial reporting. The rules governing the standards that must be met for management to make its annual assessment are
complex and require significant documentation and testing. While our internal controls over financial reporting were deemed effective by both our management and our independent auditors as of December 31, 2004, there may be changes in our systems,
processes or operations that will effect the effectiveness of internal controls in the future. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Our future assessments of internal
controls may continue to result in increased expenses and the devotion of significant management resources. If we cannot favorably assess the effectiveness of our internal controls over financial reporting in the future, or if our independent
auditors are unable to provide an unqualified attestation report on our assessment, investor confidence and our stock price could be adversely affected.



Employees

As of February 28, 2005, we had 136 full-time
employees, 55 of whom hold Ph.D. degrees and 108 of whom were engaged in research and development activities. None of our employees is represented by a collective bargaining agreement, nor have we experienced any work stoppage. We believe that our
relations with our employees are good.



Directors and
Executive and Other Officers of the Registrant

Our directors and executive and other officers, and their ages as of March 15, 2005, are as follows:



|                                    |  |     |  |                                                                
|----------------------------------- |  | --- |  | ---------------------------------------------------------------
|Name                                |  | Age |  | Title                                                          
|Daniel V. Santi, M.D., Ph.D.        |  | 63  |  | Chairman and Chief Executive Officer                           
|Robert G. Johnson, Jr., M.D., Ph.D. |  | 53  |  | Executive Vice President, Development and Chief Medical Officer
|Susan M. Kanaya                     |  | 42  |  | Senior Vice President, Finance and Chief Financial Officer     
|Bruce E. MacMillan                  |  | 53  |  | Senior Vice President, General Counsel and Secretary           
|Pieter Timmermans, Ph.D.            |  | 55  |  | Senior Vice President, Preclinical Development                 
|Bruce A. Chabner, M.D.              |  | 64  |  | Director                                                       
|Peter Davis, Ph.D.                  |  | 60  |  | Director                                                       
|Jean Deleage, Ph.D.                 |  | 64  |  | Director                                                       
|Charles J. Homcy, M.D.              |  | 56  |  | Director                                                       
|Chaitan S. Khosla, Ph.D.            |  | 40  |  | Director                                                       
|Christopher T. Walsh, Ph.D.         |  | 61  |  | Director                                                       



Daniel V. Santi, M.D., Ph.D., is one of
our co-founders and has served as Chairman of the Board of Directors since our inception in January 1995 and as our Chief Executive Officer since November 1998. Until his retirement in January 2001, Dr. Santi was on leave of absence from his
position as Professor of Biochemistry and Biophysics, and of Pharmaceutical Chemistry at University of California, San Francisco, a position that he held since 1974. Dr. Santi was one of the original members of the Scientific Advisory Boards of
Chiron Corporation and Mitotix, Inc., and has served as a consultant to several large pharmaceutical companies. In 1988, Dr. Santi founded and served as Chairman of the Board of Directors of Protos, Inc., a biotechnology firm and a subsidiary of
Chiron Corporation, which was merged



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with Chiron in 1992. Dr. Santi was also founder and Chairman of Parnassus Pharmaceuticals. Dr. Santi has published over 275 scientific papers and is inventor on many
patents in combinatorial chemistry and other areas. Dr. Santi received a B.S. in pharmacy from the State University of New York, an M.D. from the University of California, San Francisco and a Ph.D. in medicinal chemistry from the State University of
New York.



Robert G. Johnson, Jr., M.D., Ph.D., has served as our Executive Vice
President, Development since April 2004 and as our Chief Medical Officer since January 2003. From January 2002 to April 2004, Dr. Johnson served as Senior Vice President, Medical Affairs and Corporate Development and from September 2000 to January
2002, Dr. Johnson served as Vice President, Medical Affairs and Corporate Development. From 1998 to September 2000, Dr. Johnson was employed by Chiron Corporation, where he served as Vice President, Pharmacology and Preclinical Affairs through 1999
and most recently as Vice President, Corporate Development. From 1991 to 1998, Dr. Johnson was Director of Pharmacology at Merck & Co., Inc., a pharmaceutical company. In addition, Dr. Johnson was a member of the faculty at the University of
Pennsylvania from 1987 to 1991 and at Harvard Medical School from 1985 to 1987. Dr. Johnson received his B.A. and Ph.D. in biophysics and his M.D. from the University of Pennsylvania.



Susan M. Kanaya has served as our Senior Vice President, Finance and Chief Financial Officer since January 2002 and was our Secretary from June
2001 to June 2004. From November 1999 to January 2002, Ms. Kanaya served as our Vice President, Finance and Chief Financial Officer. From 1994 to November 1999, Ms. Kanaya was employed by SUGEN, Inc., a publicly held biotechnology company that was
acquired by Pharmacia in 1999, most recently serving as Vice President, Finance and Treasurer. Before joining SUGEN, Ms. Kanaya was the Controller at 50/50 Micro Electronics, Inc., an electronics company, and at Power Up Software Corporation, a
computer software company. Ms. Kanaya received a B.S. in business administration from the University of California, Berkeley.



Bruce E. MacMillanhas served as our Senior Vice President, General Counsel and Secretary since June 2004. From 2003 to June 2004, Mr. MacMillan was an independent
consultant. From 2002 to 2003, Mr. MacMillan was Vice President and General Counsel at Caliper Technologies. From 2000 to 2002, Mr. MacMillan was an independent consultant to technology companies. From April 1999 to 2000, Mr. MacMillan was Vice
President and General Counsel at SUGEN, Inc. From January 1991 to April 1999 Mr. MacMillan served as Associate General Counsel for Raychem Corporation, an electronics and telecommunications component business. Mr. MacMillan was also General Counsel
for Ericsson-Raynet, a joint venture between Raychem and Telefonaktiebolaget L.M. Ericsson. Prior to that he was in private practice for 10 years. Mr. MacMillan holds a B.A. in Economics and an M.B.A. from University of California, Berkeley, and a
J.D. from University of California, Hastings College of Law.



Pieter
Timmermans, Ph.D.,has served as our Senior Vice President, Preclinical Development since January 2005. From August 2004 to January 2005, Dr. Timmermans served as Vice President, Pharmacology and Preclinical Development at Amgen Inc. subsequent
to its acquisition of Tularik Inc. From 1997 to 2004, Dr. Timmermans held the same position at Tularik. Previously, he served in various management positions at The DuPont Merck Pharmaceutical Company and E.I. du Pont de Nemours & Company. He
also was Associate Professor in Pharmacology at the University of Amsterdam. The author of more than 580 scientific publications, Dr. Timmermans holds a Ph.D. in molecular pharmacology and a B.S. in chemistry, mathematics, physics and biology from
Leiden State University in the Netherlands.



Bruce A. Chabner, M.D., has served as
a director since September 2001. Dr. Chabner has served as the Chief of Hematology/Oncology at the Massachusetts General Hospital and as Professor of Medicine at Harvard Medical School since 1995. Dr. Chabner has also served as the Associate
Director for Clinical Science of the Dana-Farber/Harvard Cancer Center since 1999 and has held numerous academic appointments, including the position of Director of the Division of Cancer Treatment of the National Cancer Institute from 1982 to 1995.
Dr. Chabner has received



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KOSAN BIOSCIENCES



numerous awards, including Phi Beta Kappa, Alpha Omega Alpha, the Public Health Services Distinguished Service Medal, the Karnofsky Award of the American Society for Clinical
Oncology and the Bruce F. Cain Award for Drug Development of the American Association for Cancer Research. Dr. Chabner received a B.A. from Yale College and an M.D. from Harvard Medical School.



Peter Davis, Ph.D., has served as a director since April 1998. Since 2002, Dr. Davis has worked
as an independent consultant to a number of companies. Dr. Davis served as president of DNA Plant Technologies Corp., an agriculture biotechnology company, from 2001 to 2002. Dr. Davis was a member of the Executive Committee of Pulsar International,
S.A., a management consultant company and an affiliate of A.G. Biotech Capital, from 1993 to 2001. From 1975 to 1993, Dr. Davis was a faculty and staff member of the Wharton School of the University of Pennsylvania. His primary appointments included
Director of the Applied Research Center and Director of Executive Education. He is a member of the board of directors of several private companies. Dr. Davis received a B.A. in physics from Cambridge University, a Masters Degree in operations
research from the London School of Economics and a Ph.D. in operations research from the Wharton School.



Jean Deleage, Ph.D.,has served as a director since April 1996. Dr. Deleage is a founder and managing director of Alta Partners, a venture capital firm investing in information technologies and life science companies.
Alta Partners was formed in 1996. In 1979, Dr. Deleage founded, and was a managing partner of Burr, Egan, Deleage & Co., a major venture capital firm in San Francisco and Boston. Dr. Deleage was a member of Sofinnovas initial team, a
venture capital organization in Paris, and in 1976 formed Sofinnova, Inc. (the U.S. subsidiary of Sofinnova). Dr. Deleage is presently a member of the board of directors of Rigel Pharmaceuticals, Inc., Xcyte Therapies, Inc. and several private
companies. In 1984, Dr. Deleage was awarded the Ordre National du Merite, and in 1993, he was awarded the Legion of Honor from the French government in recognition of his career accomplishments. Dr. Deleage received a Masters Degree in
electrical engineering from Ecole Superieurie dElectricite and a Ph.D. in economics from the University of Paris, Sorbonne.



Charles J. Homcy, M.D., has served as a director since April 2003. Since November 2003, Dr. Homcy has served as Chief Executive Officer of Portola Pharmaceuticals,
Inc., a biopharmaceutical company. From January 2003 to November 2003, Dr. Homcy served as Senior Research and Development Advisor of Millennium Pharmaceuticals. From February 2002 to December 2002, Dr. Homcy served as the President of Research and
Development at Millennium Pharmaceuticals. From 1995 to February 2002, he served as Executive Vice President, Research and Development of COR Therapeutics, Inc., where he served as a member of the board of directors from 1998 to February 2002. From
1994 to March 1995, Dr. Homcy was President of the Medical Research Division of American Cyanamid Company-Lederle Laboratories (now a division of Wyeth-Ayerst Laboratories). From 1990 to 1994, Dr. Homcy was Executive Director of the Cardiovascular
and Central Nervous System Research Section at Lederle Laboratories. Dr. Homcy currently serves on the boards of directors of Millennium Pharmaceuticals and Cytokinetics, Incorporated, a biopharmaceutical company. Dr. Homcy received his B.A. and his
M.D degrees from the Johns Hopkins University in Baltimore



Chaitan S. Khosla,
Ph.D., is one of our co-founders and has served as a director since our inception in January 1995. Dr. Khosla has been a Professor of Chemical Engineering, Chemistry and Biochemistry at Stanford University since 2001 and has been a faculty
member since 1992. Dr. Khosla is the chairman of our Scientific Advisory Board. Dr. Khosla is the inventor of the combinatorial biosynthesis technology that we licensed from Stanford University. He is the recipient of several awards, including
the 1999 Alan T. Waterman award by the National Science Foundation, the 1999 Eli Lilly Award in biological chemistry and the 2000 ACS Award in pure chemistry. Dr. Khosla is the author of over 150 publications and is an inventor on numerous patents.
Dr. Khosla received a B.S. Tech. from the Indian Institute of Technology, Bombay, India and a Ph.D. from the California Institute of Technology.



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Christopher T. Walsh, Ph.D., has served as a director since April 1996. Dr. Walsh has been the Hamilton Kuhn Professor of
Biological Chemistry and Molecular Pharmacology at Harvard Medical School since 1991 and formerly was President of the Dana-Farber Cancer Institute and Chairman of the Department of Biological Chemistry and Molecular Pharmacology at Harvard Medical
School. He has performed extensive research in enzyme stereochemistry, reaction mechanisms and the mechanisms of action of anti-infective and immunosuppressive agents. From 1996 until July 2003, Dr. Walsh served as co-chairman of our Scientific
Advisory Board. Dr. Walsh is also a member of the board of directors of Vicuron Inc. and several private companies. Dr. Walsh received an A.B. in biology from Harvard University and a Ph.D. in life sciences from The Rockefeller University, New York.



Scientific Advisory Board

The following individuals are members of our Scientific Advisory Board, or SAB:



Chaitan S. Khosla, Ph.D., is the chairman of our SAB and a member of our board of directors.



Paul S. Anderson, Ph.D., has extensive experience in the field of drug discovery and development. Dr. Andersen recently retired from
Bristol-Myers Squibb, where he held the position of Vice President, Drug Discovery.



Homer A. Boushey, M.D., is a Professor of Medicine at the University of California, San Francisco. Dr. Boushey is an expert in clinical research on the causes and treatment of asthma and serves as Principal Investigator for
University of California, San Franciscos Asthma Clinical Research Center.



David
E. Cane, Ph.D., is Professor of Chemistry and Biochemistry at Brown University. Dr. Cane is an expert in the biosynthesis of natural products, with particular emphasis on macrolide polyketides and terpenes.



Samuel J. Danishefsky, Ph.D., is Professor of Chemistry at Columbia University. Dr. Danishefsky
is an expert in synthetic organic chemistry.



Sir David A. Hopwood, Ph.D., is
Professor and Head of the Genetics Department at John Innes Institute, Norwich, U.K. Dr. Hopwood is an expert in streptomyces genetics, molecular biology and the genetic manipulation of polyketide genes.



Jack F. Kirsch, Ph.D., is a Professor of Chemistry, Biochemistry and Molecular Biology at the
University of California, Berkeley. Dr. Kirsch is an expert in the physical organic chemistry of proteins and enzyme kinetics.



Ivan M. Kompis, Ph.D., has an extensive background in natural products chemistry, in particular antibacterial agents. Dr. Kompis recently retired from Hoffmann-La Roche,
where he held the position of Deputy Director of the Department of Infectious Diseases since 1987.



Mohamed A. Marahiel, Ph.D., is Professor of Biochemistry at Philipps University, Marburg, Germany. Dr. Marahiel is an expert in the field of non-ribosomal peptide biosynthesis.



Theo L. Peeters, Ph.D., is Professor at the University of Leuven, Belgium, and chairman of the
Belgian Gastroenterology Research Group. He is an expert in the regulation of the contractility of gastrointestinal system.



Edward A. Sausville, M.D., Ph.D., is Associate Director for Clinical Research of the Greenbaum Cancer Center of the University of Maryland, Professor of Medicine and
Pharmacology in the University of Maryland School of Medicine, and Adjunct Professor in the University of Maryland School of Pharmacy. Dr. Sausvilles areas of expertise include cancer biology, and cancer drug development and therapy.



Haruo Seto, Ph.D., is Professor Emeritus, University of Tokyo, Japan. Dr. Seto
has an extensive background in the structure, biosynthesis and screening of antibiotics.



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KOSAN BIOSCIENCES



Amos B. Smith, III, Ph.D., is the Rhodes-Thompson Professor of Chemistry at the University of Pennsylvania. Dr. Smith is an expert in natural products synthesis, bioorganic
chemistry and materials science.



Jon S. Thorson, Ph.D., is Professor of
Pharmaceutical Sciences at the University of Wisconsin, Madison. He is an expert in the biosynthesis of natural products, with emphasis on pluramycins, enediynes, indolocarbazoles and natural product glycosylation.



Available Information

We maintain a website at www.kosan.com; however, information found on, or that can be accessed through, our website is not incorporated by reference into this report. We
make available free of charge on or through our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange
Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Further, a copy of this report is located at the SECs Public Reference Room at 450 Fifth Street, NW, Washington, D.C. 20549.
Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements, and other information regarding our filings, at
www.sec.gov.



In 2002, we adopted a code of ethics that applies to our employees,
officers and directors and in February 2004, we amended and restated the code. We have posted the text of our code of ethics on our website at www.kosan.com in connection with Investor Relations materials. In addition, we intend
to promptly disclose (1) the nature of any amendment to our code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions and (2) the
nature of any waiver, including an implicit waiver, from a provision of our code of ethics that is granted to one of these specified officers, the name of such person who is granted the waiver and the date of the waiver on our website in the future.



ITEM 2. PROPERTIES

Our facilities consist of approximately 118,000 square feet of research and office space located in Hayward, California,
of which approximately 44,000, 69,000 and 5,000 square feet are leased to us until 2013, 2008 and 2005, respectively. We have an option to renew our lease on the 44,000 square foot facility for one additional period of five years and an option to
renew our lease on the 69,000 square foot facility for two additional periods of five years.



ITEM 3. LEGAL PROCEEDINGS

None.



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

None.



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PART II



ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER REPURCHASES OF EQUITY SECURITIES



Market for Registrants Common Equity

Our common stock has
traded on the Nasdaq National Market since our initial public offering on October 5, 2000 under the symbol KOSN. Prior to such time, there was no public market for our common stock. The following table shows the high and low sales prices
per share of our common stock as reported on the Nasdaq National Market for the periods indicated:



|               |  |      |       |     |   |       |  |      |  |                |  |     |       |  |   |     
|-------------- |  | ---- | ----- | --- | - | ----- |  | ---- |  | -------------- |  | --- | ----- |  | - | ----
|2004           |  | High |       | Low |   |       |  | 2003 |  | High           |  | Low
|Fourth Quarter |  | $    | 7.11  |     | $ | 5.76  |  |      |  | Fourth Quarter |  | $   | 10.30 |  | $ | 8.15
|Third Quarter  |  | $    | 8.00  |     | $ | 5.71  |  |      |  | Third Quarter  |  | $   | 8.81  |  | $ | 5.90
|Second Quarter |  | $    | 14.77 |     | $ | 7.73  |  |      |  | Second Quarter |  | $   | 7.57  |  | $ | 4.44
|First Quarter  |  | $    | 14.17 |     | $ | 10.00 |  |      |  | First Quarter  |  | $   | 6.25  |  | $ | 4.42



As of February 28, 2005, there were
approximately 100 record holders of our common stock. We have never declared or paid dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate
paying any cash dividends in the foreseeable future.



Use of Proceeds From Sales of Registered Securities

Our initial public offering of common stock was effected through a Registration Statement on Form S-1
(File No. 333-33372) that was declared effective by the SEC on October 4, 2000. All 5,750,000 shares of common stock offered, inclusive of 750,000 shares of common stock subject to the underwriters over-allotment option, were sold at a price
per share of $14.00 for gross proceeds of approximately $80.5 million.



We paid a total
of approximately $5.6 million in underwriting discounts and commissions, and other costs and expenses, other than underwriting discounts and commissions, were approximately $1.5 million. After deducting the underwriting discounts and commissions and
the offering costs and expenses, we received net proceeds from our initial public offering of common stock of approximately $73.4 million.



As of December 31, 2004, all net offering proceeds have been applied with approximately $8.2 million used to purchase property and equipment and approximately $65.2 million used
for general corporate purposes.



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ITEM 6. SELECTED FINANCIAL DATA

The statement of operations data for each of the years ended December 31, 2004, 2003 and 2002, and the
balance sheet data as of December 31, 2004 and 2003, have been derived from our audited financial statements included elsewhere in this Annual Report on Form 10-K that have been audited by Ernst & Young LLP, independent registered public
accounting firm. We have derived the statement of operations data for the years ended December 31, 2001 and 2000, and the balance sheet data as of December 31, 2002, 2001 and 2000 from our audited financial statements that are not included in this
Annual Report on Form 10-K. Our historical results are not necessarily indicative of results to be expected for any future period. The data presented below have been derived from financial statements that have been prepared in accordance with
accounting principles generally accepted in the United States and should be read with our financial statements, including the notes, and with Item 7. Managements Discussion and Analysis of Financial Condition and Results of
Operations included elsewhere in this Annual Report on Form 10-K.



|                                                                          |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|(in thousands, except per share data)                                     |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                          |  | Year Ended December 31, |        
|                                                                          |  | 2004                    |         |   | 2003 |   |         | 2002 |  |   | 2001    |   |  | 2000 |        
|STATEMENT OF OPERATIONS DATA:                                             |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Contract revenue                                                          |  | $                       | 20,493  |   |      | $ | 28,482  |      |  | $ | 7,269   |   |  | $    | 3,522   |   |  | $ | 3,784   |  
|Grant revenue                                                             |  |                         | 2,399   |   |      |   | 2,907   |      |  |   | 2,334   |   |  |      | 1,654   |   |  |   | 446     |  
|                                                                          |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total revenues                                                            |  |                         | 22,892  |   |      |   | 31,389  |      |  |   | 9,603   |   |  |      | 5,176   |   |  |   | 4,230   |  
|Operating expenses:                                                       |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Research and development (1)                                              |  |                         | 40,175  |   |      |   | 36,789  |      |  |   | 28,378  |   |  |      | 25,533  |   |  |   | 17,579  |  
|General and administrative (1)                                            |  |                         | 5,934   |   |      |   | 5,137   |      |  |   | 4,932   |   |  |      | 5,202   |   |  |   | 4,171   |  
|                                                                          |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total operating expenses                                                  |  |                         | 46,109  |   |      |   | 41,926  |      |  |   | 33,310  |   |  |      | 30,735  |   |  |   | 21,750  |  
|                                                                          |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Loss from operations                                                      |  |                         | (23,217 | ) |      |   | (10,537 | )    |  |   | (23,707 | ) |  |      | (25,559 | ) |  |   | (17,520 | )
|Interest and other income, net                                            |  |                         | 1,091   |   |      |   | 869     |      |  |   | 2,843   |   |  |      | 3,686   |   |  |   | 2,444   |  
|                                                                          |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net loss                                                                  |  |                         | (22,126 | ) |      |   | (9,668  | )    |  |   | (20,864 | ) |  |      | (21,873 | ) |  |   | (15,076 | )
|Deemed dividend upon issuance of Series C convertible preferred stock     |  |                         |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   | (11,267 | )
|                                                                          |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net loss attributable to common stockholders                              |  | $                       | (22,126 | ) |      | $ | (9,668  | )    |  | $ | (20,864 | ) |  | $    | (21,873 | ) |  | $ | (26,343 | )
|                                                                          |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Basic and diluted net loss per common share                               |  | $                       | (0.77   | ) |      | $ | (0.38   | )    |  | $ | (0.84   | ) |  | $    | (0.91   | ) |  | $ | (2.81   | )
|                                                                          |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Shares used in computing basic and diluted net loss per common share      |  |                         | 28,913  |   |      |   | 25,567  |      |  |   | 24,906  |   |  |      | 24,164  |   |  |   | 9,387   |  
|(1)    Includes non-cash charges for stock-based compensation as follows: | 
|(in thousands, except per share data)                                     |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                          |  | Year Ended December 31, |        
|                                                                          |  | 2004                    |         |   | 2003 |   |         | 2002 |  |   | 2001    |   |  | 2000 |        
|Research and development                                                  |  | $                       | 594     |   |      | $ | 695     |      |  | $ | 2,782   |   |  | $    | 5,452   |   |  | $ | 6,507   |  
|General and administrative                                                |  |                         | 163     |   |      |   | 232     |      |  |   | 656     |   |  |      | 1,273   |   |  |   | 1,703   |  
|                                                                          |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                          |  | $                       | 757     |   |      | $ | 927     |      |  | $ | 3,438   |   |  | $    | 6,725   |   |  | $ | 8,210   |  
|                                                                          |  |                         |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  



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|                                                                    |  |                         |          |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|------------------------------------------------------------------- |  | ----------------------- | -------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|(in thousands, except per share data)                               |  |                         |          |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                    |  | Year Ended December 31, |         
|                                                                    |  | 2004                    |          |   | 2003 |   |         | 2002 |  |   | 2001    |   |  | 2000 |        
|BALANCE SHEET DATA:                                                 |  |                         |          |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Cash, cash equivalents and short-term investments                   |  | $                       | 67,560   |   |      | $ | 81,459  |      |  | $ | 53,451  |   |  | $    | 77,441  |   |  | $ | 85,738  |  
|Working capital                                                     |  |                         | 60,276   |   |      |   | 75,773  |      |  |   | 48,748  |   |  |      | 72,405  |   |  |   | 82,043  |  
|Long-term investments                                               |  |                         | 15,833   |   |      |   | 23,840  |      |  |   | 27,087  |   |  |      | 12,902  |   |  |   | 17,003  |  
|Total assets                                                        |  |                         | 96,613   |   |      |   | 123,189 |      |  |   | 91,590  |   |  |      | 95,812  |   |  |   | 107,571 |  
|Deferred revenue, current portion                                   |  |                         | 3,277    |   |      |   | 5,625   |      |  |   | 2,500   |   |  |      | 999     |   |  |   | 619     |  
|Deferred revenue, less current portion                              |  |                         | 12,153   |   |      |   | 15,234  |      |  |   | 9,271   |   |  |      |        |   |  |   |        |  
|Capital lease obligations and equipment loans, less current portion |  |                         | 2,283    |   |      |   | 2,701   |      |  |   | 1,796   |   |  |      | 1,568   |   |  |   | 1,975   |  
|Accumulated deficit                                                 |  |                         | (101,200 | ) |      |   | (79,074 | )    |  |   | (69,406 | ) |  |      | (48,542 | ) |  |   | (26,669 | )
|Stockholders equity                                                |  |                         | 69,186   |   |      |   | 89,452  |      |  |   | 70,840  |   |  |      | 88,591  |   |  |   | 101,365 |  



Recent
Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R). SFAS 123R requires
that the compensation cost relating to share-based payment transactions be recognized in financial statements. The cost will be measured based on the fair value of the instruments issued. SFAS 123R covers a wide range of share-based compensation
arrangements including stock options and employee stock purchase plans. SFAS 123R replaces SFAS 123 and supersedes APB Opinion No. 25 (APB 25). As originally issued in 1995, SFAS 123 established as preferable the fair-value-based method
of accounting for share-based payment transactions with employees. However, that Statement permitted entities the option of continuing to apply the guidance in APB 25, as long as the footnotes to financial statements disclosed what net income would
have been had the preferable fair-value-based method been used. We plan to adopt SFAS 123R in our fiscal quarter ending September 30, 2005. We expect that the adoption of SFAS 123R will have a significant impact on our financial statements in that
fiscal quarter and future periods but we cannot reasonably estimate the impact of adoption because we expect certain assumptions that can significantly affect the calculation of the value share-based payments to employees to change in 2005.



In March 2004, the FASB issued Emerging Issues Task Force No 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments, or EITF 03-1, which determines the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or
held-to-maturity under Statement 115 (including individual securities and investments in mutual funds), and investments accounted for under the cost method or the equity method. We adopted EITF 03-1 in our fiscal quarter ended March 31, 2004.



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

The following discussion and analysis
should be read with Selected Financial Data and our financial statements and notes included elsewhere in this Annual Report on Form 10-K. The discussion in this Annual Report on Form 10-K contains forward-looking statements that involve
risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. The cautionary statements made in this Annual Report on Form 10-K should be read as applying to all related forward-looking statements wherever they
appear in this Annual Report on Form 10-K. Our actual results could differ materially from those discussed here. Factors that could cause or contribute to these differences include those discussed in Item 1. BusinessRisk Factors That May
Affect Results of Operations and Financial Condition and elsewhere in this Annual Report on Form 10-K.



We are a biotechnology company developing drug candidates from an important class of natural compounds known as polyketides. We have proprietary technologies for the manipulation
of polyketides, a rich source of pharmaceutical



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KOSAN BIOSCIENCES



products. We use our platform technologies to develop product candidates that target large pharmaceutical markets. We have two first-in-class anticancer agents in Phase II and
Phase Ib clinical trials, both of which have follow-on compounds in Phase I clinical trials. Following is the status of our product candidates.



| |  |  | KOS-862 (Epothilone D). In collaboration with Hoffmann-La Roche Inc. and F. Hoffmann-La Roche Ltd., collectively Roche, we are testing KOS-862, a potential anticancer agent, in Phase II and
Phase Ib clinical trials. The two current Phase II studies are Simon two-stage design trials that have an interim review and decision point following the completion of stage one before advancing to stage two. The Phase II clinical trial in breast
cancer is currently in stage one, with a review and decision point expected in the first half of 2005. A Phase II clinical trial in prostate cancer commenced stage one in the first quarter of 2005, with a review and decision point expected in the
second half of 2005. In June 2004, the Phase II clinical trial of KOS-862 in colorectal cancer was discontinued due to unanticipated cumulative drug toxicities in patients who had been previously treated with the cancer treatment, oxaliplatin. In
the fourth quarter of 2004, the Phase II clinical trial of KOS-862 in non-small cell lung cancer was discontinued as it did not meet the primary objective of tumor response in the first stage of the Simon two-stage trial design. The three Phase Ib
trials are traditional dose-escalating trials in combination with other chemotherapeutic agents.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | KOS-1584 (2nd generation Epothilone D). In December 2004, in collaboration with Roche, we initiated a Phase I clinical trial in solid tumors of our second-generation epothilone product
candidate, KOS-1584, as an anticancer agent.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 17-AAG (Geldanamycin analog). The original formulation of 17-AAG is being evaluated in multiple Phase II and Phase Ib clinical trials sponsored by the NCI under a CRADA between us and the NCI
Cancer Therapy Evaluation Program, or CTEP.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | KOS-953 (Proprietary formulation of 17-AAG). We are also developing our own proprietary formulation of 17-AAG, which we refer to as KOS-953. KOS-953 is in Phase I clinical trials as
monotherapy in multiple myeloma, and we expect to announce preliminary results in mid-2005. In Phase Ib clinical trials, KOS-953 is being used in combination with Velcade®, Herceptin® and Gleevec®; we expect to announce preliminary
results from one or both of these trials in the second half of 2005.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | KOS-1022 (2nd generation Geldanamycin analog, DMAG). In collaboration with the NCI, we are developing KOS-1022, for which Phase I clinical trials in solid tumors were initiated in 2004. Under
a Kosan-sponsored IND that was filed in December 2004, we plan to initiate Phase I clinical trials of KOS-1022 in hematologic malignancies in the first half of 2005.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We also have additional product candidates in the areas of gastrointestinal motility and infectious disease that are undergoing preclinical evaluation
and several early stage product and research technology development programs largely based on polyketides.



We have incurred significant losses since our inception. As of December 31, 2004, our accumulated deficit was $101.2 million. We expect to incur additional operating losses over the next several years as we continue to develop
our technologies and fund internal product research and development.



Critical Accounting Policies and Management Estimates

Our discussion and analysis of our financial condition and results of operations are
based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to our research and development collaborations,



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investments, deferred tax assets and their related valuation allowance, financing operations and contingencies. We base our estimates on historical experience and on
various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual
results may differ from these estimates.



We believe the following critical accounting
policies, which have been reviewed by our Audit Committee, affect our more significant judgments and estimates used in the preparation of our financial statements.



Revenue Recognition

We recognize license and other up-front
fees over the estimated research and development term of the agreement. If the agreement does not have a specified research and development term, we must apply judgment in determining the appropriate level of recognition. As of December 31, 2004, we
had $15.4 million in deferred revenue, representing the unamortized balance of the $25.0 million initial fee received in connection with our collaboration with Roche. This initial fee is being amortized through the second half of 2009, the current
estimated clinical development period. In December 2004, upon the commencement of a Phase I clinical trial of KOS-1584, our second-generation Epothilone D compound, we determined that the estimated clinical development period extended from the
second half of 2007, which was initially estimated when we entered into the collaboration with Roche in 2002, to the second half of 2009. Our initial estimate of the clinical development period contemplated development of one product candidate,
KOS-862. The change in our estimate has resulted in a further deferral of the unrecognized portion of the initial fee. Any changes in our estimate will result in either an acceleration or further deferral of the related revenue recognition.



Clinical Trial Accruals

Over the next year, the clinical trials of our epothilone and geldanamycin analog programs will significantly increase our development expenditures. Research and development
expenditures are expensed as incurred. Our expenses related to clinical trials are based on estimates of the services received and efforts expended pursuant to contracts with multiple research institutions and clinical research organizations that
conduct and manage clinical trials on our behalf. The financial terms of these agreements are established prior to the initiation of the related clinical trial, thus establishing the basis of our estimates. However, these terms may be subject to
amendment due to changes in the scope and length of the related clinical trial. Expenses related to clinical trials generally are accrued based on the level of patient enrollment and activity according to the protocol. We monitor patient enrollment
levels and related activity and adjust our estimates accordingly. The process by which we currently estimate our clinical trial accruals is consistent with prior periods and, in the past, there have not been significant adjustments of the actual
results to our estimates.



Stock-Based Compensation

Stock-based compensation expense for options granted to non-employees has been determined as the fair value of the consideration received or the fair value of the equity
instruments issued, whichever is more reliably measured. We recognized other stock-based compensation for non-employees of approximately $605,000 in 2004, $619,000 in 2003, and $1.4 million in 2002. In addition, assuming no changes, we expect to
recognize other stock-based compensation in connection with stock options granted to non-employees of approximately $512,000 in 2005, $153,000 in 2006, $119,000 in 2007 and $22,000 in 2008. The measurement of stock-based compensation to
non-employees is subject to periodic adjustment as the underlying securities vest. As such, changes to these future period measurements could be substantial should we experience significant changes in our stock price. For example, a 50% increase in
the price of our stock, from that of December 31, 2004, would translate into an approximately 66% increase in the related estimated expenses above. See Notes 1 and 9 of our financial statements.



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In December 2004, the Financial Accounting Standards Board, or FASB, issued Statement No. 123 (revised 2004), Share-Based Payment, or SFAS 123R, which will require us
to record a charge to earnings for the compensation cost relating to share-based payment transactions, including stock options and employee stock purchase plans, effective July 1, 2005. We are currently evaluating option valuation methodologies and
assumptions permitted by the FASB for purposes of implementing the change in accounting treatment. This change will have a negative impact on our financial results. For an illustration of the effect of such a change in our recent financial results,
see Note 1 to the Notes to Financial StatementsSummary of Significant Accounting Policies: Stock Options Plans. The adoption of SFAS 123Rs fair value method will have a significant impact on our results of operations, although it will
have no impact on our overall financial position. The amounts related to SFAS 123R cannot be predicted at this time because it will depend will vary due to certain factors, including but not limited to, the number of new option grants and purchases
made under the employee stock purchase plan, employee terminations, and changes in our stock price, and related assumptions. We plan to adopt SFAS 123R on July 1, 2005.



Results of Operations

Years
Ended December 31, 2004, 2003 and 2002

Revenue



|                                   |  |                          |        |                       |   |        |  |           |       |  |           |    |  |     |  
|---------------------------------- |  | ------------------------ | ------ | --------------------- | - | ------ |  | --------- | ----- |  | --------- | -- |  | --- | -
|(in thousands, except percentages) |  |                          |        |                       |   |        |  |           |       |  |           |    |  |     |  
|                                   |  | Years Ended December 31, |        | Annual Percent Change |  
|                                   |  | 2004                     |        | 2003                  |   | 2002   |  | 2004/2003 |       |  | 2003/2002 |   
|Contract revenue                   |  | $                        | 20,493 |                       | $ | 28,482 |  | $         | 7,269 |  | (28       | )% |  | 292 | %
|Grant revenue                      |  |                          | 2,399  |                       |   | 2,907  |  |           | 2,334 |  | (17       | )% |  | 25  | %
|                                   |  |                          |        |                       |   |        |  |           |       |  |           |    |  |     |  
|Total revenues                     |  | $                        | 22,892 |                       | $ | 31,389 |  | $         | 9,603 |  | (27       | )% |  | 227 | %



Revenues for the years ended December 31, 2004,
2003 and 2002 were approximately $22.9 million, $31.4 million and $9.6 million, respectively. Revenues in 2004 consisted primarily of contract revenue recognized under our development and commercialization agreement with Roche and funded research
related to government grant awards. Revenues in 2003 and 2002 consisted primarily of contract revenue recognized under our development and commercialization agreement with Roche, our former collaboration agreement with Johnson & Johnson
Pharmaceutical Research and Development LLC, or J&JPRD, and funded research related to government grant awards.



The decrease in revenues of approximately 27%, or $8.5 million, in 2004 compared to 2003 was the result of the following:



| |  |  | approximately $6.0 million in decreased non-recurring milestones from Roche;
| | - |  | ----------------------------------------------------------------------------



| |  |  | approximately $4.0 million in decreased research funding due to Roches fulfillment of its obligation in 2004 to fund an epothilone analog research program and production related
activities;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $1.1 million in decreased contract revenues related to our former collaboration agreement with J&JPRD;
| | - |  | --------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $508,000 in decreased grant revenue related to the timing of government grant awards in 2004;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | partially offset by approximately $3.1 million in additional amortization related to the ratable portion of the initial fee from Roche and increased KOS-862 and KOS-1584 clinical-related
contract revenue.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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The increase in revenues of approximately 227%, or $21.8 million, in 2003 compared to 2002 was the result of the following:



| |  |  | approximately $9.9 million in increased research funding due to a full year of reimbursement of expenses related to epothilone analog research and production related activities from Roche;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $7.2 million in increased amortization related to the ratable portion of the initial fee from Roche and increased KOS-862 clinical-related contract revenue;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $6.0 million in increased non-recurring milestones from Roche;
| | - |  | ----------------------------------------------------------------------------



| |  |  | approximately $573,000 due to additional government grants awarded in 2003;
| | - |  | ---------------------------------------------------------------------------



| |  |  | partially offset by approximately $1.8 million in decreased contract revenues related to our former collaboration agreement with J&JPRD.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------



If we do not maintain or extend our agreement with our Roche, our revenues will significantly decrease
unless we enter into additional collaborations that provide substantial revenues.



Research and Development Expenses

For the years ended December 31, 2004, 2003 and 2002, our research and development expenses were approximately
$40.2 million, $36.8 million and $28.4 million, respectively. Our research and development activities consist primarily of salaries and other personnel-related expenses, clinical trial-related services performed by clinical research organizations
and research institutions and other outside service providers, licensing-related expenses, lab consumables and facility-related expenses. We group these activities into two major categories: research and preclinical and clinical
development.



The costs associated with research and preclinical and clinical
development activities approximated the following:



|                                   |  |                          |        |                       |   |        |  |           |        |  |           |    |  |    |  
|---------------------------------- |  | ------------------------ | ------ | --------------------- | - | ------ |  | --------- | ------ |  | --------- | -- |  | -- | -
|(in thousands, except percentages) |  |                          |        |                       |   |        |  |           |        |  |           |    |  |    |  
|                                   |  | Years Ended December 31, |        | Annual Percent Change |  
|                                   |  | 2004                     |        | 2003                  |   | 2002   |  | 2004/2003 |        |  | 2003/2002 |   
|                                   |  |                          |        |                      
|Research and preclinical           |  | $                        | 22,642 |                       | $ | 22,751 |  | $         | 19,530 |  | (1        | )% |  | 17 | %
|Clinical development               |  |                          | 17,533 |                       |   | 14,038 |  |           | 8,848  |  | 25        | %  |  | 59 | %
|                                   |  |                          |        |                       |   |        |  |           |        |  |           |    |  |    |  
|Total research and development     |  | $                        | 40,175 |                       | $ | 36,789 |  | $         | 28,378 |  | 9         | %  |  | 30 | %



The increase of 9%, or approximately $3.4
million, in research and development expenses for the year ended December 31, 2004 compared to the same period in 2003 was primarily due to the following:



| |  |  | approximately $3.7 million in increased outside services related to the advancement of KOS-862 into Phase II and Phase Ib clinical trials, KOS-1584 into a Phase I clinical trial, KOS-953 into
Phase I and Phase Ib clinical trials and the related production of clinical material;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $1.7 million in increased research and development salaries and other personnel-related expenses;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | approximately $1.0 million in increased allocated facility and expansion costs;
| | - |  | -------------------------------------------------------------------------------



| |  |  | partially offset by approximately $2.9 million in lower licensing-related expenses due to the settlement of the litigation with Sloan-Kettering in 2003 and $100,000 in decreased stock-based
compensation.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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KOSAN BIOSCIENCES



The increase of 30%, or approximately $8.4 million, in research and development expenses for the year ended December 31, 2003 compared to the same period in 2002 was primarily due
to the following:



| |  |  | approximately $4.1 million in increased outside services related to the advancement of KOS-862 into Phase II clinical trials, the related production of clinical material, and preclinical
development of our epothilone and geldanamycin analogs;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $2.7 million associated with higher licensing-related expenses and the settlement of the litigation with Sloan-Kettering;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $2.2 million in increased research and development salaries and other personnel-related expenses due to internal growth;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $1.5 million in higher allocated facilities and expansion costs;
| | - |  | ------------------------------------------------------------------------------



| |  |  | partially offset by approximately $2.1 million in decreased stock-based compensation.
| | - |  | -------------------------------------------------------------------------------------



We allocate salary-driven and space-use-driven overhead expenses to research and development and to general and administrative expenses based on salaries and space-utilization by
each respective area. Our research and development employees decreased to 109 in 2004 from 110 in 2003. In 2004, we experienced increased salary and personnel-related expenses resulting from a controlled shift from research-skilled employees to more
development-skilled employees as we continue to advance our product candidates into clinical development. We expect our research and development expenses will increase substantially as KOS-862, KOS-1584, KOS-953 and KOS-1022 advance further into the
clinic, and as we advance our research programs into later stages of development.



The table below summarizes the current development status of our most advanced product candidates:



|                                            |  |                                        |  |         |  |                      |  |                           
|------------------------------------------- |  | -------------------------------------- |  | ------- |  | -------------------- |  | --------------------------
|Product Candidate                           |  | Description                            |  | Sponsor |  | Phase of Development |  | Initiation ofCurrent Phase
|KOS-862                                     |  | Metastatic breast cancer               |  | Roche   |  | Phase II             |  | Q2 2004                   
|                                            |  | Hormone-refractory prostate cancer     |  | Kosan   |  | Phase II             |  | Q1 2005                   
|                                            |  | Combination with Gemzar®               |  | Kosan   |  | Phase Ib             |  | Q1 2004                   
|                                            |  | Combination with Paraplatin®           |  | Kosan   |  | Phase Ib             |  | Q3 2004                   
|                                            |  | Combination with Herceptin®            |  | Roche   |  | Phase Ib             |  | Q3 2004                   
|KOS-1584                                    |  | Solid tumors                           |  | Kosan   |  | Phase I              |  | Q4 2004                   
|17-AAG                                      |  | Melanoma                               |  | NCI     |  | Phase II             |  | Q3 2004                   
|                                            |  | Breast cancer                          |  | NCI     |  | Phase II             |  | Q4 2004                   
|                                            |  | Renal cancer                           |  | NCI     |  | Phase II             |  | Q4 2004                   
|                                            |  | Lymphoma                               |  | NCI     |  | Phase II             |  | Q1 2005                   
|                                            |  | Combination with Gemcitabine/Cisplatin |  | NCI     |  | Phase Ib             |  | Q4 2002                   
|                                            |  | Combination with Taxotere®             |  | NCI     |  | Phase Ib             |  | Q2 2003                   
|                                            |  | Combination with Gleevec®              |  | NCI     |  | Phase Ib             |  | Q2 2003                   
|                                            |  | Combination with Paclitaxel            |  | NCI     |  | Phase Ib             |  | Q2 2004                   
|                                            |  | Combination with AraC                  |  | NCI     |  | Phase Ib             |  | Q4 2004                   
|                                            |  | Combination with Velcade®              |  | NCI     |  | Phase Ib             |  | Q1 2005                   
|KOS-953 (proprietary formulation of 17-AAG) |  | Multiple myeloma                       |  | Kosan   |  | Phase I              |  | Q3 2004                   
|                                            |  | Combination with Herceptin®            |  | Kosan   |  | Phase Ib             |  | Q4 2004                   
|                                            |  | Combination with Velcade®              |  | Kosan   |  | Phase Ib             |  | Q4 2004                   
|                                            |  | Combination with Gleevec®              |  | Kosan   |  | Phase Ib             |  | Q1 2005                   
|KOS-1022 (DMAG)                             |  | Advanced malignancies                  |  | NCI     |  | Phase I              |  | Q3 2004                   
|                                            |  | Hematologic malignancies (Planned)     |  | Kosan   |  | Phase I              |  | 2005                      



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Phase I clinical trials generally are expected to last between 12 and 18 months, Phase II clinical trials are expected to last
between 18 and 24 months and Phase III clinical trials are expected to last between 24 and 42 months. The length of clinical development depends on the specific disease and patient population. For drug candidates that are in preclinical development,
the timing of an IND filing varies significantly and is difficult to predict and therefore not reflected in the table above.



Roche is responsible for the majority of the costs of the epothilone clinical trials conducted under our collaboration and is funding all of the KOS-862 and KOS-1584 clinical
trials other than the KOS-862 prostate cancer trial, which we are currently funding. We are responsible at our cost to supply 17-AAG for clinical trials sponsored by the NCI under the CRADAs, and the NCI is responsible for the remainder of the costs
of these trials through Phase II. In addition, we are sponsoring other clinical trials of KOS-953 and plan to sponsor KOS-1022 clinical trials at our sole expense. Our research and development expenses do not reflect the costs incurred by our
partners, Roche or the NCI, associated with the clinical trials they are conducting in connection with our epothilone and Hsp90 inhibitor programs, respectively.



General and Administrative Expenses

For the years ended
December 31, 2004, 2003 and 2002, general and administrative expenses were approximately $5.9 million, $5.1 million and $4.9 million, respectively.



|                                   |  |                          |       |                       |   |       |  |           |       |  |           |   |  |   |  
|---------------------------------- |  | ------------------------ | ----- | --------------------- | - | ----- |  | --------- | ----- |  | --------- | - |  | - | -
|(in thousands, except percentages) |  |                          |       |                       |   |       |  |           |       |  |           |   |  |   |  
|                                   |  | Years Ended December 31, |       | Annual Percent Change |  
|                                   |  | 2004                     |       | 2003                  |   | 2002  |  | 2004/2003 |       |  | 2003/2002 |  
|General and administrative         |  | $                        | 5,934 |                       | $ | 5,137 |  | $         | 4,932 |  | 16        | % |  | 4 | %



The increase of 16%, or approximately $797,000,
in general and administrative expenses in 2004 compared to 2003 was primarily due to the following:



| |  |  | approximately $535,000 in increased employee-related expenses to support our expanding research and development activities;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $150,000 in increased professional and outside services for corporate governance and Sarbanes-Oxley related expenses;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $127,000 in increased business development and consulting expenses;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | approximately $53,000 in increased facility-related allocations in connection with the expansion of our facilities;
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | partially offset by approximately $68,000 in lower stock-based compensation that resulted from the full amortization of deferred compensation in 2004.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



The increase of 4%, or approximately $205,000, in general and administrative expenses in 2003 compared
to 2002 was primarily due to the following:



| |  |  | approximately $321,000 in increased employee-related expenses to support our expanding research and development activities;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $169,000 in increased professional and outside services for corporate governance and Sarbanes-Oxley related expenses;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | approximately $138,000 in increased facility-related allocations in connection with the expansion of our facilities;
| | - |  | --------------------------------------------------------------------------------------------------------------------



| |  |  | partially offset by approximately $424,000 in lower stock-based compensation that resulted from the reversal of deferred compensation expenses in connection with employee terminations.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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KOSAN BIOSCIENCES



The number of our general and administrative employees increased to 25 at December 31, 2004 as compared to 22 at December 31, 2003. We expect our general and administrative
expenses will increase in the future to support the continued growth of our research and development efforts.



Interest Income, Interest Expense and Gain on the Recovery of Investment



|                                   |  |                          |       |   |                       |   |       |      |  |   |           |   |  |           |   |  |      |   
|---------------------------------- |  | ------------------------ | ----- | - | --------------------- | - | ----- | ---- |  | - | --------- | - |  | --------- | - |  | ---- | --
|(in thousands, except percentages) |  |                          |       |   |                       |   |       |      |  |   |           |   |  |           |   |  |      |   
|                                   |  | Years Ended December 31, |       |   | Annual Percent Change |  
|                                   |  | 2004                     |       |   | 2003                  |   |       | 2002 |  |   | 2004/2003 |   |  | 2003/2002 |  
|Interest income                    |  | $                        | 1,434 |   |                       | $ | 1,206 |      |  | $ | 2,209     |   |  | 19        | % |  | (45  | )%
|Interest expense                   |  |                          | (343  | ) |                       |   | (337  | )    |  |   | (356      | ) |  | 2         | % |  | (5   | )%
|Gain on the recovery of investment |  |                          |      |   |                       |   |      |      |  |   | 990       |   |  |          |   |  | (100 | )%
|                                   |  |                          |       |   |                       |   |       |      |  |   |           |   |  |           |   |  |      |   
|Other income, net                  |  | $                        | 1,091 |   |                       | $ | 869   |      |  | $ | 2,843     |   |  | 26        | % |  | (69  | )%



Interest Income.Interest income
increased to approximately $1.4 million in 2004 from approximately $1.2 million in 2003. This increase was primarily due to higher average investment balances that resulted from our registered direct offering in December 2003. Interest income
decreased to approximately $1.2 million in 2003 from approximately $2.2 million in 2002. This decrease was due to lower average investment balances and lower investment yields associated with the declining interest rate environment in 2003.



Interest Expense. Interest expense increased to approximately $343,000 in 2004
from approximately $337,000 in 2003. This increase was due to additional equipment debt financing and an increasing rate environment during 2004, which resulted in a higher average debt balance at higher average interest rates. Interest expense
decreased to $337,000 in 2003 from $356,000 in 2002. This decrease resulted from the scheduled repayment of existing debt at higher average interest rates, partially offset by additional equipment debt financing at lower average interest rates in
2003. We expect our interest expense will increase in the future resulting from additional property and equipment-related debt financings in the increasing interest rate environment.



Gain on the Recovery of Investment. At June 30, 2001, we determined that an other-than-temporary decline in the fair value of our investment in
short-term commercial paper of Southern California Edison, a utility company, had occurred. Accordingly, we recorded approximately $990,000 loss on the related write-down in the carrying value of the investment. In March 2002, the security was fully
repaid. Thus, we recorded a realized gain on the investment of approximately $990,000 for the year ended December 31, 2002.



Provision for Income Taxes

We incurred net operating losses in
the years ended December 31, 2004, 2003 and 2002 and consequently did not pay federal or state income taxes. As of December 31, 2004, we had federal net operating loss carryforwards of approximately $65.3 million. We also had federal research and
development tax credit carryforwards of approximately $2.6 million. If not utilized, the net operating losses and credit carryforwards will expire at various dates beginning in 2010 through 2024. As of December 31, 2004, we had state net operating
loss carryforwards and state research and development tax credit carryforwards of approximately $36.8 million and $2.7 million, resprectively. The state net operating loss carryforwards will expire at various dates beginning in the year 2005 through
2014, if not utilized. The state research and development carryforwards do not expire. Use of the net operating losses and credits may be subject to a substantial annual limitation due to the change in ownership provisions of the Internal Revenue
Code of 1986, as amended, and similar state provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization. See Note 11 of our financial statements.



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Liquidity and Capital Resources

Since inception we have financed our operations primarily through sales of our convertible preferred stock and common stock, contract payments received under our corporate collaboration agreements and government grant awards,
interest income and equipment financing arrangements. As of December 31, 2004, we had received approximately $149.7 million from the sales of convertible preferred and common stock, approximately $91.8 million from contract payments received under
our corporate collaboration agreements and government grant awards, approximately $14.1 million from interest income and approximately $11.7 million from equipment financing arrangements. As of December 31, 2004, we had approximately $83.4 million
in cash and investments, compared to approximately $105.3 million as of December 31, 2003. Our funds are currently invested in U.S. Treasury and government agency obligations and corporate obligations.



Cash used in operating activities was approximately $18.2 million in 2004, compared to cash provided by
operations of approximately $1.9 million in 2003. Our net loss of approximately $22.1 million in 2004 was partially offset by non-cash expenses of approximately $5.0 million related to stock-based compensation, depreciation and amortization of
property and equipment and investment premiums and discounts, partially offset by an approximately $1.0 million decrease in assets and liabilities primarily due to recognition of deferred revenue related to the upfront payment from Roche, partially
offset by an increase in receivable collections from Roche, net of payments related to our settlement agreement with Sloan-Kettering. We do not anticipate generating cash from operating activities for the next several years. Our net loss of
approximately $9.7 million in 2003 was offset by the receipt of the second of two $12.5 million installments of an initial fee from Roche and non-cash expenses of approximately $4.6 million related to stock-based compensation, depreciation and
amortization of property and equipment investment premiums and discounts, partially offset by an approximately $5.1 million increase in accounts receivable primarily due to contract revenue and a milestone related to our Roche collaboration.



Our investing activities, excluding changes in our investments, for the year ended
December 31, 2004, used cash of approximately $2.3 million, compared to approximately $4.3 million in 2003, reflecting approximately $1.9 million related to the purchase of additional laboratory and office equipment and approximately $354,000
related to the renovation of our facilities. Investing activities in 2003, excluding changes in our investments, reflected approximately $1.9 million related to the renovation and expansion of our facilities and approximately $2.4 million related to
the purchase of additional laboratory and office equipment. We expect to continue our purchases of equipment and leasehold improvements in 2005 related to the enhancement and expansion of our leased facilities.



Cash provided by financing activities was approximately $729,000 for the year ended December 31, 2004,
compared to approximately $28.6 million in 2003. Financing activities in 2004 included approximately $1.3 million of equipment debt financing and $1.5 million in proceeds from the sale of our common stock through stock option exercises and stock
purchases made under our 2000 Employee Stock Purchase Plan, offset by $2.1 million of scheduled payments on new and existing debt. Financing activities in 2003 included approximately $26.0 million net proceeds from the sale of our common stock in a
registered direct offering in December 2003, $3.1 million of equipment financing, net of scheduled payments on new and existing debt, and $776,000 related to proceeds from the repayment of notes receivable from stockholders.



In April 2004, we entered into a $3.5 million equipment line of credit agreement for facility
improvements and capital purchases, which expires in April 2005. As of December 31, 2004, we had utilized approximately $800,000 of the line of credit leaving approximately $2.7 million available for future draws.



We believe that our existing cash and investment securities and anticipated cash flow from our existing
collaboration with Roche will be sufficient to support our current operating plan into the second half of 2006. We may, however,



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KOSAN BIOSCIENCES



choose to obtain additional financing from time to time, or focus our spending on priority programs to provide for the proper alignment of resources and maintenance of sufficient
levels of financial reserves. We have based this estimate on assumptions that may prove to be wrong. Our future capital uses and requirements depend on numerous forward-looking factors, including the following:



| |  |  | our ability to establish any new collaborations, our rights and obligations under any new collaboration agreements and our ability to generate revenues under any new collaborations;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the progress, number and costs of our research programs;
| | - |  | --------------------------------------------------------



| |  |  | the extent to which clinical and other development activities are funded by our current collaborators, Roche and the NCI;
| | - |  | -------------------------------------------------------------------------------------------------------------------------



| |  |  | the progress, success and costs of preclinical testing and clinical trials of our drug candidates;
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | our ability to maintain or extend our existing collaborations with Roche and the NCI;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | the costs and timing of obtaining, enforcing and defending patent and other intellectual property rights;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | any need to obtain licenses to additional patents or other intellectual property in order to use, import, manufacture, market or sell our product candidates;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to obtain regulatory approvals for our product candidates and the costs and timing of doing so;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | any need to expand our manufacturing capabilities;
| | - |  | --------------------------------------------------



| |  |  | any need to build commercial infrastructure to market our products; and
| | - |  | -----------------------------------------------------------------------



| |  |  | expenses associated with any possible future litigation.
| | - |  | --------------------------------------------------------



In addition, we review from time to time potential opportunities to expand our technologies or add to our portfolio of drug candidates. In the future, we may need further capital
in order to acquire or invest in technologies, products or businesses.



We expect that
additional financing will be required in the future to fund operations. We expect to finance future cash needs through the sale of equity securities, strategic collaborations, government grant awards and debt financing. In September 2003, we filed a
registration statement on Form S-3 to offer to sell common stock in one or more offerings up to a dollar amount of $75.0 million. In December 2003, we completed a registered direct offering of 3,115,000 shares of common stock at a price of $9.00 per
share. We received approximately $26.0 million in net proceeds after placement agent fees and other offering costs. As of December 31, 2004, approximately $47.0 million remained available on the Form S-3. In December 2004, we filed an additional
registration statement on Form S-3 to offer to sell common stock and/or warrants in one or more offerings up to a dollar amount of $50.0 million. In aggregate, approximately $97.0 million remained available on both Forms S-3. We have no current
commitments to offer and sell any securities that may be offered or sold pursuant to such registration statement. Additional financing or collaboration and licensing arrangements may not be available when needed or, if available, may not be on terms
favorable to us or our stockholders. Insufficient funds may require us to delay, scale back or eliminate some or all of our research or development programs, to lose rights under existing licenses or to relinquish greater or all rights to product
candidates at an earlier stage of development or on less favorable terms than we would otherwise choose or may adversely affect our ability to operate as a going concern. If additional funds are obtained by issuing equity securities, substantial
dilution to existing stockholders may result. In addition, see Item 1. BusinessRisk Factors That May Affect Results of Operations and Financial Condition.



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Our obligations and commitments to make future payments under contracts, such as debt and lease agreements, and under contingent
commitments are as follows:



|                                   |  |                        |        |                 |   |           |  |           |       |              |   |       |  |   |      
|---------------------------------- |  | ---------------------- | ------ | --------------- | - | --------- |  | --------- | ----- | ------------ | - | ----- |  | - | -----
|(in thousands)                     |  |                        |        |                 |   |           |  |           |       |              |   |       |  |   |      
|                                   |  | Payments Due by Period
|                                   |  | Total                  |        | Less than1 Year |   | 1-3 Years |  | 4-5 Years |       | After5 Years
|Equipment financing obligations    |  | $                      | 4,590  |                 | $ | 2,157     |  | $         | 2,298 |              | $ | 135   |  | $ |     
|Operating leases                   |  |                        | 10,868 |                 |   | 1,609     |  |           | 3,303 |              |   | 2,251 |  |   | 3,705
|                                   |  |                        |        |                 |   |           |  |           |       |              |   |       |  |   |      
|Total contractual cash obligations |  | $                      | 15,458 |                 | $ | 3,766     |  | $         | 5,601 |              | $ | 2,386 |  | $ | 3,705
|                                   |  |                        |        |                 |   |           |  |           |       |              |   |       |  |   |      



Off-Balance
Sheet Arrangements

As of December 31, 2004, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.



ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of our investment activities is to preserve
principal while at the same time maximize the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may
cause the principal amount of the investments to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and investments in a variety of securities, including commercial paper, money market funds,
government and non-government debt securities and investment-grade corporate obligations. Although changes in interest rates may affect the fair value of our portfolio and cause unrealized gains and losses, such gains and losses would not be
realized unless the investments were sold prior to maturity. Through our money managers, we maintain risk management control systems to monitor interest rate risk. The risk management control systems use analytical techniques, including sensitivity
analysis. If market interest rates were to increase by 100 basis points, or 1%, at December 31, 2004 rates, the fair value of our portfolio would decline by approximately $421,000 on that date.



The table below presents the principal amounts of our investments and equipment loans by expected
maturity and related weighted average interest rates at December 31, 2004:



|                                                 |  |      |        |   |      |   |       |      |  |   |      |   |  |      |      |       |  |   |            |  |   |        |   |  |   |       
|------------------------------------------------ |  | ---- | ------ | - | ---- | - | ----- | ---- |  | - | ---- | - |  | ---- | ---- | ----- |  | - | ---------- |  | - | ------ | - |  | - | ------
|(in thousands, except interest rate information) |  |      |        |   |      |   |       |      |  |   |      |   |  |      |      |       |  |   |            |  |   |        |   |  |   |       
|                                                 |  | 2005 |        |   | 2006 |   |       | 2007 |  |   | 2008 |   |  | 2009 |      | Total |  |   | Fair Value
|Debt securities:                                 |  |      |        |   |      |   |       |      |  |   |      |   |  |      |      |       |  |   |            |  |   |        |   |  |   |       
|U.S. agency notes                                |  | $    | 38,778 |   |      | $ | 7,000 |      |  | $ |     |   |  | $    |     |       |  | $ |           |  | $ | 45,778 |   |  | $ | 45,586
|Corporate bonds                                  |  |      | 16,179 |   |      |   | 8,035 |      |  |   |     |   |  |      |     |       |  |   |           |  |   | 24,214 |   |  |   | 24,030
|Average interest rate                            |  |      | 1.64   | % |      |   | 2.38  | %    |  |   |     |   |  |      |     |       |  |   |           |  |   | 1.80   | % |  |   |      
|Equipment financing                              |  |      | 1,916  |   |      |   | 1,434 |      |  |   | 718  |   |  |      | 131  |       |  |   |           |  |   | 4,199  |   |  |   | 4,199 
|Average interest rate                            |  |      | 7.45   | % |      |   | 7.27  | %    |  |   | 7.27 | % |  |      | 7.58 | %     |  |   |           |  |   | 7.36   | % |  |   |      



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The report of Independent Auditors, Financial Statements and Notes to Financial
Statements begin on page F-1 and are incorporated herein by reference.



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

None.



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ITEM 9A. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures. Based on their evaluation as of December 31, 2004,
our chief executive officer and chief financial officer have concluded that the Companys disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange
Act)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the Securities and
Exchange Commissions rules and forms.



Managements Annual Report on
Internal Control over Financial Reporting. We are responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Under the supervision and with the
participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.



Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in
reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use or disposition of the Companys assets that could have a material effect on the financial statements.



Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.



Based on our evaluation under the framework in Internal ControlsIntegrated Framework, our
management concluded that our internal control over financial reporting was effective as of December 31, 2004.



Our independent registered public accounting firm, Ernst & Young LLP has audited the financial statements included in this Annual Report on Form 10-K and has issued a report on managements assessment of our internal
control over financial reporting as well as on the effectiveness of our internal control over financial reporting. The attestation report of Ernst & Young, the registered public accounting firm, on managements assessment of internal
control over financial reporting and on the audit of the financial statements is incorporated by reference from Item 8 of this Annual Report on Form 10-K.



Changes in Internal Controls over Financial Reporting. There were no changes in our internal controls over financial reporting (as defined in Rule 13a-15(f) under the
Exchange Act) during the quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



Limitations on the Effectiveness of Controls. The Companys management, including our chief executive officer and chief financial officer,
does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not



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absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource
constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of
fraud, if any, within the Company have been detected.



ITEM 9B. OTHER INFORMATION

Not applicable.



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PART III

KOSAN BIOSCIENCES



ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information concerning our directors will be contained in our definitive Proxy
Statement with respect to our 2005 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission not later than April 30, 2005 (the Proxy Statement), under the caption Proposal 1Election of
Directors and is incorporated herein by reference. See also Item 1. BusinessDirectors and Executive and Other Officers of the Registrant. Information concerning the composition of our audit committee, our audit committee
financial experts and procedures for the nomination of directors are incorporated herein by reference to our Proxy Statement. Information concerning compliance with Section 16(a) of the Exchange Act will be contained in our Proxy Statement under the
caption Section 16(a) Beneficial Ownership Reporting Compliance and is incorporated herein by reference. Information concerning our executive officers is contained in this Annual Report on Form 10-K under Item 1.
BusinessDirectors and Executive and Other Officers of the Registrant. Information concerning our Code of Ethics is contained in this Annual Report on Form 10-K under Item 1. BusinessAvailable Information.



ITEM 11. EXECUTIVE COMPENSATION

Information concerning executive compensation will be contained in our Proxy Statement under the caption
Executive Compensation and is incorporated herein by reference.



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

Information concerning the security
ownership of certain beneficial owners and management will be contained in our Proxy Statement under the caption Security Ownership of Certain Beneficial Owners and Management and is incorporated herein by reference.



The following table summarizes the securities for issuance under our equity compensation plans as of
December 31, 2004.



|                                                       |  |                                                                                         |  |                                                                         |      |                                                                                          |        
|------------------------------------------------------ |  | --------------------------------------------------------------------------------------- |  | ----------------------------------------------------------------------- | ---- | ---------------------------------------------------------------------------------------- | -------
|Plan Category                                          |  | Number of Securitiesto be Issued UponExercise ofOutstanding Options,Warrants and Rights |  | Weighted AverageExercise Price ofOutstandingOptions, Warrantsand Rights |      | Number of SecuritiesRemaining Availablefor Future IssuanceUnder EquityCompensation Plans
|Equity compensation plans approved by stockholders     |  | 4,875,864                                                                               |  | $                                                                       | 8.03 |                                                                                          | 270,443
|Equity compensation plans not approved by stockholders |  |                                                                                        |  |                                                                         |     |                                                                                          |       
|                                                       |  |                                                                                         |  |                                                                         |      |                                                                                          |        
|Total                                                  |  | 4,875,864                                                                               |  | $                                                                       | 8.03 |                                                                                          | 270,443
|                                                       |  |                                                                                         |  |                                                                         |      |                                                                                          |        



ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information concerning certain relationships will be contained in our Proxy
Statement under the caption Certain Relationships and Related Transactions and is incorporated herein by reference.



ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Audit Fees.Information concerning audit fees will be contained in our Proxy
Statement under the caption Audit Fees and is incorporated herein by reference.



Audit-Related Fees.Information concerning audit-related fees will be contained in our Proxy Statement under the caption Audit-Related Fees and is incorporated herein by reference.



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Tax Fees.Information concerning tax fees will be contained in our Proxy Statement under the caption Tax Fees
and is incorporated herein by reference.



All Other Fees. Information concerning
other fees paid to our auditors will be contained in our Proxy Statement under the caption All Other Fees and is incorporated herein by reference.



Pre-Approval Policies and Procedures.Information concerning pre-approval policies and procedures will be contained in our Proxy Statement under the caption
Pre-Approval Policies and Procedures and is incorporated herein by reference.



Consistent with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002, we are responsible for disclosing the non-audit services approved by our Audit Committee to be performed by
Ernst & Young LLP, our external auditor. Non-audit services are defined as services other than those provided in connection with an audit or a review of our financial statements. In the period covered by this report, our Audit Committee
pre-approved the following non-audit services rendered, currently being rendered, or to be rendered, to us by Ernst & Young LLP:



| |  |  | all work required to be performed by Ernst & Young LLP in connection with preparing and giving consents required to be given in connection with our filings with the Securities and
Exchange Commission;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | all work required to be performed by Ernst & Young LLP in connection with tax preparation services and the Sarbanes-Oxley Act of 2002 implementation services.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------



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PART IV

KOSAN BIOSCIENCES



ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES



(a) The
following documents are filed or incorporated by reference as part of this Annual Report:



| | (1) | Financial Statements:
| | --- | ---------------------



Report of Independent Registered Public Accounting Firm, Ernst & Young LLP

Balance SheetsDecember 31, 2004 and 2003

Statements of OperationsYears Ended December 31, 2004, 2003, and 2002

Statement of Changes in Stockholders EquityYears Ended December 31, 2004, 2003 and 2002

Statements of Cash FlowsYears Ended December 31, 2004, 2003 and 2002

Notes to Financial Statements



| | (2) | Financial Statement Schedules:
| | --- | ------------------------------



None



| | (3) | Exhibits:
| | --- | ---------



|            |  |                                                                                                                                                                                                                                                                                                                                                           
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                               
|            | 
|3.1         |  | Amended and Restated Certificate of Incorporation of Registrant. (1)                                                                                                                                                                                                                                                                                      
|            | 
|3.2         |  | Amended and Restated Bylaws of Registrant. (2)                                                                                                                                                                                                                                                                                                            
|            | 
|4.1         |  | Specimen Registrants Common Stock Certificate. (3)                                                                                                                                                                                                                                                                                                       
|            | 
|4.2         |  | Third Amended and Restated Registration Rights Agreement, dated March 30, 2000, between Registrant and certain stockholders. (3)                                                                                                                                                                                                                          
|            | 
|4.3         |  | Registrants Certificate of Designation of Series A Junior Preferred Stock. (4)                                                                                                                                                                                                                                                                           
|            | 
|10.1        |  | Form of Indemnification Agreement entered into by Registrant with each of its directors and executive officers. (3)                                                                                                                                                                                                                                       
|            | 
|10.2        |  | 1996 Stock Option Plan, as amended. (3)*                                                                                                                                                                                                                                                                                                                  
|            | 
|10.3        |  | 2000 Employee Stock Purchase Plan and related agreements. (3)*                                                                                                                                                                                                                                                                                            
|            | 
|10.4        |  | 2000 Non-Employee Director Stock Option Plan and related agreements, as amended. (5)*                                                                                                                                                                                                                                                                     
|            | 
|10.5        |  | Amended and Restated Consulting Agreement between Registrant and Chaitan Khosla, Ph.D., dated December 7, 1998. (3)*                                                                                                                                                                                                                                      
|            | 
|10.6       |  | Research and License Agreement between Registrant and The Sloan-Kettering Institute for Cancer Research, dated August 25, 2000. (3)                                                                                                                                                                                                                       
|            | 
|10.7       |  | Consent and Amendment to the License Agreement, effective as of September 16, 2002, by and between Registrant and The Sloan-Kettering Institute for Cancer Research. (6)                                                                                                                                                                                  
|            | 
|10.8       |  | Settlement Agreement, entered into September 19, 2003, by and between Registrant and The Sloan-Kettering Institute for Cancer Research. (7)                                                                                                                                                                                                               
|            | 
|10.9       |  | License Agreement between Registrant and The Board of Trustees of The Leland Stanford Junior University, dated March 11, 1996. (3)                                                                                                                                                                                                                        
|            | 
|10.10      |  | Amendment No.1 to License Agreement with the Board of Trustees of The Leland Stanford Junior University, dated March 1996; Letter to Mona Wan to confirm the agreement between Registrant and the Board
of Trustees of The Leland Stanford Junior University, dated September 21, 1998; and Amendment No.3 to License Agreement, dated March 10, 2000. (3)



52



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|            |  |                                                                                                                                                                                    
|----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                        
|            | 
|10.11      |  | Consent and Amendment to the License Agreement, effective as of September 16, 2002, by and between Registrant and Stanford University. (6)                                         
|            | 
|10.12      |  | License Agreement between Registrant and President and Fellows of Harvard College, dated December 2, 1998. (3)                                                                     
|            | 
|10.13       |  | Sublease Agreement between Registrant and Lynx Therapeutics, Inc., dated January 6, 1999. (3)                                                                                      
|            | 
|10.14       |  | Consent to Sublease Agreement between Spieker Properties L.P. and Lynx Therapeutics, Inc., dated September 17, 1999. (3)                                                           
|            | 
|10.15       |  | Master Loan and Security Agreement between Registrant and Finova Technology Finance, Inc., dated August 25, 1998. (3)                                                              
|            | 
|10.16       |  | Commitment Letter between Registrant and Finova Technology Finance, Inc., dated August 24, 1998. (3)                                                                               
|            | 
|10.17       |  | Commitment Letter between Registrant and Finova Capital Corporation, dated January 6, 2000. (3)                                                                                    
|            | 
|10.18       |  | Employment Agreement between Registrant and Daniel V. Santi, M.D., Ph.D., dated November 1, 1998. (3)*                                                                             
|            | 
|10.19       |  | Employment Agreement between Registrant and Susan M. Kanaya, dated October 11, 1999. (3)*                                                                                          
|            | 
|10.20       |  | Form of Series C Stock Purchase Agreement between the Registrant and certain investors, dated March 30, 2000. (3)                                                                  
|            | 
|10.21       |  | Employment Agreement between Registrant and Robert G. Johnson, Jr., dated September 5, 2000. (3)*                                                                                  
|            | 
|10.22       |  | Master Loan and Security Agreement No.84325 and associated Prepayment Agreement, by and between Registrant and Wells Fargo Equipment Finance, Inc., dated July 9, 2001. (8)        
|            | 
|10.23       |  | Rights Agreement, dated as of October 5, 2001, between Registrant and Mellon Investor Services, LLC. (4)                                                                           
|            | 
|10.24       |  | Amendment to Restated Promissory Note from Stockholder by and between Registrant and Daniel V. Santi, M.D., Ph.D., dated December 23, 2001. (9)*                                   
|            | 
|10.25       |  | Lease Agreement, dated as of June 7, 2002, by and between EOP-Industrial Portfolio, L.L.C. and Registrant. (5)                                                                     
|            | 
|10.26       |  | Landlord Consent to Assignment and Assumption of Lease, dated as of June 20, 2002, by and among EOP-Industrial Portfolio, L.L.C., Aventis Pharmaceuticals, Inc. and Registrant. (5)
|            | 
|10.27      |  | Collaborative Research, Development and Commercialization Agreement, dated as of September 19, 2002, by and between Registrant and Hoffmann-La Roche, Inc. (6)                     
|            | 
|10.28       |  | Amendment to Collaborative Research, Development and Commercialization Agreement, effective July 1, 2004, by and between Registrant and Hoffmann-La Roche Inc. (10)                
|            | 
|10.29       |  | Employment Agreement between Registrant and Bruce E. MacMillan dated June 18, 2004. (11)*                                                                                          
|            | 
|10.30       |  | Transition Separation and Consulting Agreement between Registrant and Michael S. Ostrach dated August 4, 2004. (10)*                                                               



53



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KOSAN BIOSCIENCES



|            |  |                                                                                                                                                                                                                                                   
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                       
|            | 
|10.31       |  | Non-Employee Director Compensation Arrangements. (13)*                                                                                                                                                                                            
|            | 
|10.32       |  | Executive Compensation Arrangements.                                                                                                                                                                                                              
|            | 
|23.1        |  | Consent of Independent Registered Public Accounting Firm, Ernst &Young LLP.                                                                                                                                                                       
|            | 
|24.1        |  | Power of Attorney (included in signature page hereto).                                                                                                                                                                                            
|            | 
|31.1        |  | Certification required by Rule 13a-14(a) or Rule 15d-14(a).                                                                                                                                                                                       
|            | 
|31.2        |  | Certification required by Rule 13a-14(a) or Rule 15d-14(a).                                                                                                                                                                                       
|            | 
|32.1        |  | Certification by the Chief Executive Officer and Chief Financial Officer of Kosan Biosciences Incorporated, as required by Rule 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the
United States Code (18 U.S.C. 1350). (12)

---

|(1) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended June 30, 2001.
|--- | -----------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended June 30, 2003.
|--- | -----------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated herein by reference to an exhibit of our Registration Statement on Form S-1, Registration No. 333-33732.
|--- | ---------------------------------------------------------------------------------------------------------------------

|(4) | Incorporated herein by reference to an exhibit of our current report on Form 8-K filed on October 15, 2001.
|--- | -----------------------------------------------------------------------------------------------------------

|(5) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended June 30, 2002.
|--- | -----------------------------------------------------------------------------------------------------------------------

|(6) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended September 30, 2002.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|(7) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended September 30, 2003.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|(8) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended September 30, 2001.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|(9) | Incorporated herein by reference to an exhibit of our annual report on Form 10-K for the year ended December 31, 2001.
|--- | ----------------------------------------------------------------------------------------------------------------------

|(10) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended September 30, 2004.(11)
|---- | --------------------------------------------------------------------------------------------------------------------------------

|(11) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended June 30, 2004.
|---- | -----------------------------------------------------------------------------------------------------------------------

|(12) | This certification accompanies this annual report on Form 10-K and shall not be deemed filed by Registrant for purposes of Section 18 of the Exchange Act.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

|(13) | Incorporated herein by reference to the information contained in our Definitive Proxy Statement on Schedule 14A, as filed with the Securities and Exchange Commission on April 16, 2004,
under the heading Executive CompensationDirector Compensation.
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Confidential treatment has been granted with respect to certain portions of this exhibit. Omitted portions have been filed separately with the Securities and Exchange Commission.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|* | Represents a management or director compensation plan.
|- | ------------------------------------------------------



54



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##### Table of Contents

SIGNATURES



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



|               |  |                                |  |                                     
|-------------- |  | ------------------------------ |  | ------------------------------------
|               |  | Kosan Biosciences Incorporated
|               |  |                               
|March 14, 2005 |  | By:                            |  | /s/ Daniel V. Santi, M.D., Ph.D.    
|               |  |                                |  | Daniel V. Santi, M.D., Ph.D.        
|               |  |                                |  | Chairman and Chief Executive Officer



POWER OF ATTORNEY



KNOW TO ALL PERSONS BY THESE PRESENTS, that the persons whose signatures appear below each severally
constitutes and appoints Daniel V. Santi, M.D., Ph.D. and Susan M. Kanaya or either of them, his or her true and lawful attorneys-in-fact and agents, with full powers of substitution and re-substitution, for him or her and in his or her name, place
and stead, in any and all capacities to sign any and all amendments to this Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto
the attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he or she might or could
do in person, hereby ratifying and confirming all that the attorneys-in-fact and agents, or either of them, or their, his or her substitutes or substitute, may lawfully do or cause to be done by virtue hereof.



Pursuant to the requirements of the Exchange Act, this Report on Form 10-K has been signed by the
following persons on behalf of the registrant and in the capacities and on the dates indicated.



|                                                             |  |                                                                                                         |  |               
|------------------------------------------------------------ |  | ------------------------------------------------------------------------------------------------------- |  | --------------
|Signature                                                    |  | Title                                                                                                   |  | Date          
|                                                             |  |                                                                                                        
|/s/ Daniel V. Santi, M.D., Ph.D.Daniel
V. Santi, M.D., Ph.D. |  | Chairman and Chief Executive Officer (Principal Executive Officer)                                      |  | March 14, 2005
|                                                             |  |                                                                                                        
|/s/ Susan M. KanayaSusan M.
Kanaya                           |  | Senior Vice President, Finance and Chief Financial Officer (Principal Financial and Accounting Officer) |  | March 14, 2005
|                                                             |  |                                                                                                        
|/s/ Bruce A. Chabner, M.D.Bruce A.
Chabner, M.D.             |  | Director                                                                                                |  | March 14, 2005
|                                                             |  |                                                                                                        
|/s/ Peter Davis, Ph.D.Peter Davis,
Ph.D.                     |  | Director                                                                                                |  | March 14, 2005
|                                                             |  |                                                                                                        
|/s/ Jean Deleage, Ph.D.Jean Deleage,
Ph.D.                   |  | Director                                                                                                |  | March 14, 2005
|                                                             |  |                                                                                                        
|/s/ Charles J. Homcy, Ph.D.Charles J.
Homcy, Ph.D.           |  | Director                                                                                                |  | March 14, 2005



55



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KOSAN BIOSCIENCES



|                                                           |  |          |  |               
|---------------------------------------------------------- |  | -------- |  | --------------
|Signature                                                  |  | Title    |  | Date          
|                                                           |  |         
|/s/ Chaitan S. Khosla, Ph.D.Chaitan S.
Khosla, Ph.D.       |  | Director |  | March 14, 2005
|                                                           |  |         
|/s/ Christopher T. Walsh, Ph.D.Christopher T. Walsh, Ph.D. |  | Director |  | March 14, 2005



56



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Kosan Biosciences Incorporated



INDEX TO
FINANCIAL STATEMENTS



|                                                                                |  |    
|------------------------------------------------------------------------------- |  | ---
|Reports of Independent Registered Public Accounting Firm, Ernst & Young LLP     |  | F-2
|Balance SheetsDecember 31, 2004 and 2003                                       |  | F-4
|Statements of OperationsYears ended December 31, 2004, 2003 and 2002           |  | F-5
|Statements of Stockholders EquityYears ended December 31, 2004, 2003 and 2002 |  | F-6
|Statements of Cash FlowsYears ended December 31, 2004, 2003 and 2002           |  | F-7
|Notes to Financial Statements                                                   |  | F-8



F-1



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##### Table of Contents

REPORT OF ERNST & YOUNG LLP,

INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors and Stockholders

Kosan Biosciences Incorporated



We have audited the accompanying
balance sheets of Kosan Biosciences Incorporated as of December 31, 2004 and 2003, and the related statements of operations, stockholders equity and cash flows for each of the three years in the period ended December 31, 2004. These financial
statements are the responsibility of Kosan Biosciences Incorporateds management. Our responsibility is to express an opinion on these financial statements based on our audits.



We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable
basis for our opinion.



In our opinion, the financial statements referred to above
present fairly, in all material respects, the financial position of Kosan Biosciences Incorporated at December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004,
in conformity with U.S. generally accepted accounting principles.



We also have audited,
in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Kosan Biosciences Incorporateds internal control over financial reporting as of December 31, 2004, based on criteria
established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2005 expressed an unqualified opinion thereon.



/s/ ERNST & YOUNG LLP



Palo Alto, California

March 9, 2005



F-2



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##### Table of Contents

REPORT OF ERNST & YOUNG LLP,

INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of
Directors and Stockholders

Kosan Biosciences Incorporated



We have audited managements assessment, included in the Managements Annual Report on Internal Control Over Financial Reporting included in Item 9A, that Kosan
Biosciences Incorporated maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (the COSO criteria). Kosan Biosciences Incorporateds management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over
financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the Companys internal control over financial reporting based on our audit.



We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining
an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered
necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.



A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes
in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection
of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.



Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to
future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.



In our opinion, managements assessment that Kosan Biosciences Incorporated maintained effective
internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Kosan Biosciences Incorporated maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2004, based on the COSO criteria.



We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets of Kosan Biosciences Incorporated as of December 31, 2004 and 2003, and the related
statements of operations, stockholders equity and cash flows for each of the three years in the period ended December 31, 2004 and our report dated March 9,2005 expressed an unqualified opinion thereon.



/s/ ERNST & YOUNG LLP



Palo Alto, California

March 9, 2005



F-3



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##### Table of Contents

Kosan Biosciences Incorporated



BALANCE SHEETS

(in thousands, except share and per share data)



|                                                                                                                                                                                                            |  |              |          |   |      |   |         |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | -------- | - | ---- | - | ------- | -
|                                                                                                                                                                                                            |  | December 31, |         
|                                                                                                                                                                                                            |  | 2004         |          |   | 2003 |  
|ASSETS                                                                                                                                                                                                      |  |              |          |   |      |   |         |  
|Current assets:                                                                                                                                                                                             |  |              |          |   |      |   |         |  
|Cash and cash equivalents                                                                                                                                                                                   |  | $            | 13,777   |   |      | $ | 31,491  |  
|Short-term investments                                                                                                                                                                                      |  |              | 53,783   |   |      |   | 49,968  |  
|Accounts and other receivables                                                                                                                                                                              |  |              | 4,447    |   |      |   | 9,022   |  
|Prepaid and other current assets                                                                                                                                                                            |  |              | 1,260    |   |      |   | 1,094   |  
|                                                                                                                                                                                                            |  |              |          |   |      |   |         |  
|Total current assets                                                                                                                                                                                        |  |              | 73,267   |   |      |   | 91,575  |  
|Property and equipment, net                                                                                                                                                                                 |  |              | 7,159    |   |      |   | 7,317   |  
|Long-term investments                                                                                                                                                                                       |  |              | 15,833   |   |      |   | 23,840  |  
|Other assets and notes receivable from related parties                                                                                                                                                      |  |              | 354      |   |      |   | 457     |  
|                                                                                                                                                                                                            |  |              |          |   |      |   |         |  
|Total assets                                                                                                                                                                                                |  | $            | 96,613   |   |      | $ | 123,189 |  
|                                                                                                                                                                                                            |  |              |          |   |      |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                        |  |              |          |   |      |   |         |  
|Current liabilities:                                                                                                                                                                                        |  |              |          |   |      |   |         |  
|Accounts payable                                                                                                                                                                                            |  | $            | 1,343    |   |      | $ | 1,298   |  
|Accrued liabilities                                                                                                                                                                                         |  |              | 6,455    |   |      |   | 7,025   |  
|Current portion of deferred revenue                                                                                                                                                                         |  |              | 3,277    |   |      |   | 5,625   |  
|Current portion of equipment loans                                                                                                                                                                          |  |              | 1,916    |   |      |   | 1,854   |  
|                                                                                                                                                                                                            |  |              |          |   |      |   |         |  
|Total current liabilities                                                                                                                                                                                   |  |              | 12,991   |   |      |   | 15,802  |  
|Deferred revenue, less current portion                                                                                                                                                                      |  |              | 12,153   |   |      |   | 15,234  |  
|Equipment loans, less current portion                                                                                                                                                                       |  |              | 2,283    |   |      |   | 2,701   |  
|Commitments                                                                                                                                                                                                 |  |              |          |   |      |   |         |  
|Stockholders equity:                                                                                                                                                                                       |  |              |          |   |      |   |         |  
|Convertible preferred stock, $0.001 par value, 10,000,000 shares authorized, 1,000,000 shares designated as Series A junior preferred stock, no shares
issued and outstanding at December 31, 2004 and 2003 |  |              |         |   |      |   |        |  
|Common stock, $0.001 par value, 100,000,000 shares authorized, 29,096,333 and 28,752,535 shares issued and outstanding at December 31, 2004 and 2003,
respectively                                          |  |              | 29       |   |      |   | 29      |  
|Additional paid-in capital                                                                                                                                                                                  |  |              | 170,735  |   |      |   | 168,668 |  
|Deferred stock-based compensation                                                                                                                                                                           |  |              |         |   |      |   | (192    | )
|Accumulated other comprehensive income                                                                                                                                                                      |  |              | (378     | ) |      |   | 21      |  
|Accumulated deficit                                                                                                                                                                                         |  |              | (101,200 | ) |      |   | (79,074 | )
|                                                                                                                                                                                                            |  |              |          |   |      |   |         |  
|Total stockholders equity                                                                                                                                                                                  |  |              | 69,186   |   |      |   | 89,452  |  
|                                                                                                                                                                                                            |  |              |          |   |      |   |         |  
|Total liabilities and stockholders equity                                                                                                                                                                  |  | $            | 96,613   |   |      | $ | 123,189 |  
|                                                                                                                                                                                                            |  |              |          |   |      |   |         |  



See accompanying notes.



F-4



---

##### Table of Contents

Kosan Biosciences Incorporated



STATEMENTS OF
OPERATIONS

(in thousands, except per share data)



|                                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|-------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                     |  | Year Ended December 31, |        
|                                                                     |  | 2004                    |         |   | 2003 |   |         | 2002 | 
|Revenues:                                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Contract revenue                                                     |  | $                       | 20,493  |   |      | $ | 28,482  |      |  | $ | 7,269   |  
|Grant revenue                                                        |  |                         | 2,399   |   |      |   | 2,907   |      |  |   | 2,334   |  
|                                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Total revenues                                                       |  |                         | 22,892  |   |      |   | 31,389  |      |  |   | 9,603   |  
|Operating expenses:                                                  |  |                         |         |   |      |   |         |      |  |   |         |  
|Research and development                                             |  |                         | 40,175  |   |      |   | 36,789  |      |  |   | 28,378  |  
|General and administrative                                           |  |                         | 5,934   |   |      |   | 5,137   |      |  |   | 4,932   |  
|                                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Total operating expenses                                             |  |                         | 46,109  |   |      |   | 41,926  |      |  |   | 33,310  |  
|                                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Loss from operations                                                 |  |                         | (23,217 | ) |      |   | (10,537 | )    |  |   | (23,707 | )
|Interest income                                                      |  |                         | 1,434   |   |      |   | 1,206   |      |  |   | 2,209   |  
|Interest expense                                                     |  |                         | (343    | ) |      |   | (337    | )    |  |   | (356    | )
|Gain on the recovery of investment                                   |  |                         |        |   |      |   |        |      |  |   | 990     |  
|                                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Net loss                                                             |  | $                       | (22,126 | ) |      | $ | (9,668  | )    |  | $ | (20,864 | )
|                                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic and diluted net loss per common share                          |  | $                       | (0.77   | ) |      | $ | (0.38   | )    |  | $ | (0.84   | )
|                                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Shares used in computing basic and diluted net loss per common share |  |                         | 28,913  |   |      |   | 25,567  |      |  |   | 24,906  |  







See accompanying notes.



F-5



---

##### Table of Contents

Kosan Biosciences Incorporated



STATEMENT OF
STOCKHOLDERS EQUITY

(in thousands, except shares)



|                                                                                         |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  
|---------------------------------------------------------------------------------------- |  | --------------------------- |  | ------------ | - | ------------------------ | ---------- | - | ------------------------------- | - | -- | ------------------------------- | - | ------- | ------------------------------------------- |  | - | ----------------------- | - |  | ------------------- | ------ | - |  | - | ------ | - |  | - | -------- | - |  | - | ------- | -
|                                                                                         |  | Convertible Preferred Stock |  | Common Stock |   | AdditionalPaid-InCapital |            |   | NotesReceivableFromStockholders |   |    | DeferredStock-BasedCompensation |   |         | Accumulated OtherComprehensiveLoss/(Income) |  |   | TotalAccumulatedDeficit |   |  | StockholdersEquity |       
|                                                                                         |  | Shares                      |  | Amount       |   | Shares                   |            |   | Amount                          |   |    |                                 |   |         |                                            
|BALANCES AT DECEMBER 31, 2001                                                            |  |                            |  | $            |  |                          | 25,226,513 |   |                                 | $ | 25 |                                 | $ | 141,863 |                                             |  | $ | (1,541                  | ) |  | $                   | (4,430 | ) |  | $ | 1,216  |   |  | $ | (48,542  | ) |  | $ | 88,591  |  
|Issuance of common stock upon exercise of options for cash, net of repurchases           |  |                            |  |              |  |                          | 86,574     |   |                                 |   |   |                                 |   | 57      |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 57      |  
|Issuance of common stock under employee stock purchase plan                              |  |                            |  |              |  |                          | 98,349     |   |                                 |   |   |                                 |   | 484     |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 484     |  
|Repayment of stockholder notes, net of repurchase of unvested shares                     |  |                            |  |              |  |                          | (19,127    | ) |                                 |   |   |                                 |   | (122    | )                                           |  |   | 320                     |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 198     |  
|Reversal of deferred stock-based compensation from employee terminations                 |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   | (1,246  | )                                           |  |   |                        |   |  |                     | 1,246  |   |  |   |       |   |  |   |         |   |  |   |        |  
|Amortization of deferred stock-based compensation                                        |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     | 2,050  |   |  |   |       |   |  |   |         |   |  |   | 2,050   |  
|Other stock-based compensation                                                           |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   | 1,388   |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 1,388   |  
|Comprehensive income (loss):                                                             |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  
|Net loss                                                                                 |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   | (20,864  | ) |  |   | (20,864 | )
|Unrealized loss on available-for-sale securities, net                                    |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     |       |   |  |   | (1,064 | ) |  |   |         |   |  |   | (1,064  | )
|                                                                                         |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  
|Comprehensive loss                                                                       |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | (21,928 | )
|                                                                                         |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  
|BALANCES AT DECEMBER 31, 2002                                                            |  |                            |  | $            |  |                          | 25,392,309 |   |                                 | $ | 25 |                                 | $ | 142,424 |                                             |  | $ | (1,221                  | ) |  | $                   | (1,134 | ) |  | $ | 152    |   |  | $ | (69,406  | ) |  | $ | 70,840  |  
|Issuance of shares of common stock in a direct offering, net of offering costs of $2,082 |  |                            |  |              |  |                          | 3,115,000  |   |                                 |   | 3  |                                 |   | 25,950  |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 25,953  |  
|Issuance of common stock upon exercise of options for cash, net of repurchases           |  |                            |  |              |  |                          | 186,387    |   |                                 |   | 1  |                                 |   | 323     |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 324     |  
|Issuance of common stock under employee stock purchase plan                              |  |                            |  |              |  |                          | 132,649    |   |                                 |   |   |                                 |   | 516     |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 516     |  
|Repayment of stockholder notes                                                           |  |                            |  |              |  |                          | (73,810    | ) |                                 |   |   |                                 |   | (530    | )                                           |  |   | 1,221                   |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 691     |  
|Reversal of deferred stock-based compensation from employee terminations                 |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   | (634    | )                                           |  |   |                        |   |  |                     | 634    |   |  |   |       |   |  |   |         |   |  |   |        |  
|Amortization of deferred stock-based compensation                                        |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     | 308    |   |  |   |       |   |  |   |         |   |  |   | 308     |  
|Other stock-based compensation                                                           |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   | 619     |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 619     |  
|Comprehensive income (loss):                                                             |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  
|Net loss                                                                                 |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   | (9,668   | ) |  |   | (9,668  | )
|Unrealized loss on available-for-sale securities, net                                    |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     |       |   |  |   | (131   | ) |  |   |         |   |  |   | (131    | )
|                                                                                         |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  
|Comprehensive loss                                                                       |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | (9,799  | )
|                                                                                         |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  
|BALANCES AT DECEMBER 31, 2003                                                            |  |                            |  | $            |  |                          | 28,752,535 |   |                                 | $ | 29 |                                 | $ | 168,668 |                                             |  | $ |                        |   |  | $                   | (192   | ) |  | $ | 21     |   |  | $ | (79,074  | ) |  | $ | 89,452  |  
|Issuance of common stock upon exercise of options for cash, net of repurchases           |  |                            |  |              |  |                          | 234,412    |   |                                 |   |   |                                 |   | 872     |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 872     |  
|Issuance of common stock under employee stock purchase plan                              |  |                            |  |              |  |                          | 109,386    |   |                                 |   |   |                                 |   | 630     |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 630     |  
|Reversal of deferred stock-based compensation from employee terminations                 |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   | (40     | )                                           |  |   |                        |   |  |                     | 40     |   |  |   |       |   |  |   |         |   |  |   |        |  
|Amortization of deferred stock-based compensation                                        |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     | 152    |   |  |   |       |   |  |   |         |   |  |   | 152     |  
|Other stock-based compensation                                                           |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   | 605     |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | 605     |  
|Comprehensive income (loss):                                                             |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  
|Net loss                                                                                 |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   | (22,126  | ) |  |   | (22,126 | )
|Unrealized loss on available-for-sale securities, net                                    |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     |       |   |  |   | (399   | ) |  |   |         |   |  |   | (399    | )
|                                                                                         |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  
|Comprehensive loss                                                                       |  |                            |  |              |  |                          |           |   |                                 |   |   |                                 |   |        |                                             |  |   |                        |   |  |                     |       |   |  |   |       |   |  |   |         |   |  |   | (22,525 | )
|                                                                                         |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  
|BALANCES AT DECEMBER 31, 2004                                                            |  |                            |  | $            |  |                          | 29,096,333 |   |                                 | $ | 29 |                                 | $ | 170,735 |                                             |  | $ |                        |   |  | $                   |       |   |  | $ | (378   | ) |  | $ | (101,200 | ) |  | $ | 69,186  |  
|                                                                                         |  |                             |  |              |   |                          |            |   |                                 |   |    |                                 |   |         |                                             |  |   |                         |   |  |                     |        |   |  |   |        |   |  |   |          |   |  |   |         |  



See accompanying notes.



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##### Table of Contents

Kosan Biosciences Incorporated



STATEMENTS OF
CASH FLOWS

(in thousands)



|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|-------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | -------- | ---- |  | - | ------- | -
|                                                                                                         |  | Year Ended December 31, |        
|                                                                                                         |  | 2004                    |         |   | 2003 |   |          | 2002 | 
|OPERATING ACTIVITIES                                                                                     |  |                         |         |   |      |   |          |      |  |   |         |  
|Net loss                                                                                                 |  | $                       | (22,126 | ) |      | $ | (9,668   | )    |  | $ | (20,864 | )
|Adjustments to reconcile net loss to net cash (used in) provided by operating activities:                |  |                         |         |   |      |   |          |      |  |   |         |  
|Depreciation and amortization                                                                            |  |                         | 2,493   |   |      |   | 2,308    |      |  |   | 1,755   |  
|Amortization of investment premiums and discounts                                                        |  |                         | 1,715   |   |      |   | 1,351    |      |  |   | 559     |  
|Amortization of stock-based compensation                                                                 |  |                         | 152     |   |      |   | 308      |      |  |   | 2,050   |  
|Other stock-based compensation                                                                           |  |                         | 605     |   |      |   | 619      |      |  |   | 1,388   |  
|Gain on the recovery of investment                                                                       |  |                         |        |   |      |   |         |      |  |   | (990    | )
|Changes in assets and liabilities:                                                                       |  |                         |         |   |      |   |          |      |  |   |         |  
|Accounts and other receivables                                                                           |  |                         | 4,992   |   |      |   | (5,148   | )    |  |   | (3,874  | )
|Prepaid and other current assets                                                                         |  |                         | (166    | ) |      |   | 12       |      |  |   | (489    | )
|Other assets and notes receivable from related parties                                                   |  |                         | 103     |   |      |   | 162      |      |  |   | 581     |  
|Accounts payable and accrued liabilities                                                                 |  |                         | (525    | ) |      |   | 2,852    |      |  |   | 2,204   |  
|Deferred revenue                                                                                         |  |                         | (5,429  | ) |      |   | 9,088    |      |  |   | 10,772  |  
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|Net cash (used in) provided by operating activities                                                      |  |                         | (18,186 | ) |      |   | 1,884    |      |  |   | (6,908  | )
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|INVESTING ACTIVITIES                                                                                     |  |                         |         |   |      |   |          |      |  |   |         |  
|Acquisition of property and equipment                                                                    |  |                         | (2,335  | ) |      |   | (4,257   | )    |  |   | (3,556  | )
|Purchase of investments                                                                                  |  |                         | (72,905 | ) |      |   | (116,034 | )    |  |   | (70,930 | )
|Proceeds from maturity or sale of investments                                                            |  |                         | 74,983  |   |      |   | 99,091   |      |  |   | 83,732  |  
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|Net cash (used in) provided by investing activities                                                      |  |                         | (257    | ) |      |   | (21,200  | )    |  |   | 9,246   |  
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|FINANCING ACTIVITIES                                                                                     |  |                         |         |   |      |   |          |      |  |   |         |  
|Proceeds from issuance of common stock, net of repurchases and issuance costs                            |  |                         | 1,502   |   |      |   | 26,793   |      |  |   | 541     |  
|Proceeds from the repayment of notes receivable from stockholders, net of repurchases of unvested shares |  |                         |        |   |      |   | 776      |      |  |   | 198     |  
|Proceeds from equipment loans                                                                            |  |                         | 1,290   |   |      |   | 3,140    |      |  |   | 2,215   |  
|Principal payments under capital lease obligation and equipment loans                                    |  |                         | (2,063  | ) |      |   | (2,093   | )    |  |   | (1,662  | )
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|Net cash provided by financing activities                                                                |  |                         | 729     |   |      |   | 28,616   |      |  |   | 1,292   |  
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|Net (decrease) increase in cash and cash equivalents                                                     |  |                         | (17,714 | ) |      |   | 9,300    |      |  |   | 3,630   |  
|Cash and cash equivalents at beginning of period                                                         |  |                         | 31,491  |   |      |   | 22,191   |      |  |   | 18,561  |  
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|Cash and cash equivalents at end of period                                                               |  | $                       | 13,777  |   |      | $ | 31,491   |      |  | $ | 22,191  |  
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|SUPPLEMENTAL DISCLOSURES                                                                                 |  |                         |         |   |      |   |          |      |  |   |         |  
|Interest expense paid in cash                                                                            |  | $                       | 343     |   |      | $ | 337      |      |  | $ | 356     |  
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|NON-CASH INVESTING AND FINANCING ACTIVITIES                                                              |  |                         |         |   |      |   |          |      |  |   |         |  
|Accounts receivable due for equipment loan                                                               |  | $                       | 417     |   |      | $ |         |      |  | $ |        |  
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|Unrealized loss on investments, net                                                                      |  | $                       | (399    | ) |      | $ | (131     | )    |  | $ | (74     | )
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  
|Deferred stock-based compensation                                                                        |  | $                       | (40     | ) |      | $ | (634     | )    |  | $ | (1,246  | )
|                                                                                                         |  |                         |         |   |      |   |          |      |  |   |         |  



See accompanying notes.



F-7



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO
FINANCIAL STATEMENTS



1. ORGANIZATION AND SUMMARY OF
SIGNIFICANT ACCOUNTING POLICIES



Overview

Kosan Biosciences Incorporated (the Company) was incorporated under the laws of the State of California on January 6, 1995 and commenced operations in 1996. In July
2000, the Company was reincorporated under the laws of the state of Delaware. The Company has proprietary technologies for the manipulation of polyketides, a rich source of pharmaceutical products. The Company uses its platform technologies to
develop product candidates that target large pharmaceutical markets. In collaboration with Hoffmann-La Roche Inc. and F. Hoffmann-La Roche Ltd., collectively Roche, the Company is testing the polyketide KOS-862 (Epothilone D), a potential anticancer
agent, in Phase II and Phase Ib clinical trials.



The Company is also developing analogs
of geldanamycin, a polyketide, as anticancer agents in collaboration with the National Cancer Institute, or NCI, a component of the National Institutes of Health. The Companys lead compound, 17-AAG, an analog of geldanamycin, is being
evaluated in Phase II and Phase Ib combination clinical trials being sponsored by the NCI, under a Cooperative Research and Development Agreement between the Company and the NCI Cancer Therapy Evaluation Program. The Company has developed its own
proprietary formulation of 17-AAG, or KOS-953, that is in Phase I and Phase Ib clinical trials. The Company is also collaborating with the NCI on developing KOS-1022 (DMAG), for which Phase I clinical trials in advanced malignancies were initiated
in 2004. The Company also has additional product candidates in the areas of gastrointestinal motility and infectious disease that are undergoing preclinical evaluation and several early stage product and research technology development programs.



The Company has funded its operations primarily through sales of common stock and
convertible preferred stock, contract payments under its collaboration agreements, equipment financing arrangements and government grants.



Use of Estimates

The preparation of 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 financial statements and the accompanying notes. Actual results could differ from those
estimates.



Recent Accounting Pronouncement

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R). SFAS 123R requires that the compensation cost relating to
share-based payment transactions, including stock options and employee stock purchase plans, be recognized in the financial statements. The cost will be measured based on the fair value of the instruments issued. SFAS 123R replaces SFAS 123 and
supersedes APB Opinion No. 25 (APB 25). As originally issued in 1995, SFAS 123 established as preferable the fair-value-based method of accounting for share-based payment transactions with employees. However, that Statement permitted
entities the option of continuing to apply the guidance in APB 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used. The Company will be required to apply
SFAS 123R effective July 1, 2005 and is currently evaluating the impact SFAS 123R will have on its financial statements.



In March 2004, the FASB issued Emerging Issues Task Force No 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, or EITF
03-1, which determines the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under Statement 115 (including individual securities and investments in mutual
funds), and investments accounted for under the cost method or the equity method. The Company adopted EITF 03-1 in our fiscal quarter ended March 31, 2004.



F-8



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)



Cash Equivalents and Investments

The Company considers all highly liquid investments with a maturity from date of purchase of three months or less to be cash equivalents. The Company limits its concentration of
risk by diversifying its investments among a variety of issuers. All investment securities are classified as available-for-sale and are recorded at fair value based on quoted market prices, with unrealized gains and losses excluded from earnings and
reported in other comprehensive income/(loss). Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Realized gains and losses and declines in fair value that are deemed to be
other-than-temporary are reflected in earnings. The cost of securities sold is based on the specific identification method.



The Company holds a restricted investment consisting of a certificate of deposit of approximately $949,000 at December 31, 2004 and $903,000 at December 31, 2003. This investment
is carried at fair value and is restricted as to withdrawal under a letter of credit agreement related to a facility lease (see Note 6). This investment is held in the Companys name and is included in long-term investments on the
Companys financial statements.



We recognize an impairment charge when the decline
in the estimated fair value of a marketable security below the amortized cost is determined to be other-than-temporary. We consider various factors in determining whether to recognize an impairment charge, including the duration of time and the
severity to which the fair value has been less than our amortized cost, any adverse changes in the investees financial condition and our intent and ability to hold the marketable security for a period of time sufficient to allow for any
anticipated recovery in market value.



Property and
Equipment

Property and equipment are stated at cost, net of accumulated depreciation and amortization. Property and equipment are depreciated on a straight-line
basis over the estimated useful lives of three to five years. Leasehold improvements are amortized over the shorter of their estimated useful lives or the lease term.



Revenue Recognition

The Company
generates revenue under collaborative agreements with pharmaceutical companies and under research grants from the National Institutes of Health. The arrangements may include up front non-refundable fees, reimbursement for personnel and supply costs,
milestone payments for the achievement of defined collaboration objectives and royalties on potential sales of commercialized products. The Company recognizes revenue under these arrangements when (i) persuasive evidence of an arrangement exists;
(ii) delivery of the services, supplies or technology license has occurred; (iii) the price is fixed and determinable; and (iv) collectability is reasonably assured.



The Company recognizes license and other upfront and initial fees pursuant to research and development collaboration agreements over the estimated
research and development term of the respective agreement.



These estimated terms are
reviewed on a periodic basis and updated if the underlying assumptions are modified. Payments related to substantive performance milestones that are at risk at the initiation of an agreement are recognized upon successful completion of a performance
milestone event.



Contract revenues related to collaborative research and development
efforts are recognized as revenue as the related services are performed or delivered in accordance with contract terms. Such payments generally are made based on the number of full-time equivalent researchers assigned to the collaboration project
and the related research and development expenses incurred or as other deliverables under the contracts are fulfilled. Revenues related to government grants are recognized at the time a grant is awarded and as related research expenses are incurred.
Any amounts received in advance of performance are recorded as deferred revenue until earned.



F-9



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)



Research and Development

Research and development consists of costs incurred for Company-sponsored and collaborative research and development activities. These costs consist primarily of salaries and other
personnel-related expenses, including associated stock-based compensation, facility-related expenses, licensing-related expenses, depreciation of facilities and equipment, lab consumables, services performed by clinical research organizations and
research institutions and other outside service providers.



As our epothilone and
geldanamycin analog programs advance into and through Phase II clinical trials, the related costs will have a significant effect on the Companys research and development expenses. Expenses related to clinical trials generally are accrued based
on the level of patient enrollment and activity according to the protocol. The Company monitors patient enrollment level and related activity to the extent possible and adjusts estimates accordingly.



Research and development expenses under government grant awards and collaborative agreements
approximated the revenue recognized, excluding milestone, up-front and initial fees received under such arrangements.



Net Loss Per Share

Basic and diluted net loss per common share
have been computed using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase. Diluted net loss is not presented separately as the Company is in a net loss position and including
potentially dilutive securities in the loss per share computation would be antidilutive.



The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):



|                                                                                      |  |                         |         |   |      |   |        |      |  |   |         |  
|------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------ | ---- |  | - | ------- | -
|                                                                                      |  | Year Ended December 31, |        
|                                                                                      |  | 2004                    |         |   | 2003 |   |        | 2002 | 
|Net loss                                                                              |  | $                       | (22,126 | ) |      | $ | (9,668 | )    |  | $ | (20,864 | )
|                                                                                      |  |                         |         |   |      |   |        |      |  |   |         |  
|Weighted-average shares of common stock outstanding                                   |  |                         | 28,934  |   |      |   | 25,692 |      |  |   | 25,307  |  
|Less: weighted-average shares subject to repurchase                                   |  |                         | (21     | ) |      |   | (125   | )    |  |   | (401    | )
|                                                                                      |  |                         |         |   |      |   |        |      |  |   |         |  
|Weighted-average shares used in computing basic and diluted net loss per common share |  |                         | 28,913  |   |      |   | 25,567 |      |  |   | 24,906  |  
|                                                                                      |  |                         |         |   |      |   |        |      |  |   |         |  
|Basic and diluted net loss per common share                                           |  | $                       | (0.77   | ) |      | $ | (0.38  | )    |  | $ | (0.84   | )
|                                                                                      |  |                         |         |   |      |   |        |      |  |   |         |  



The Company has excluded all convertible
preferred stock, outstanding stock options and shares subject to repurchase from the calculation of diluted net loss per common share because all such securities are antidilutive for all applicable periods presented. The total number of outstanding
stock options excluded from the calculations of diluted net loss per share, prior to application of the treasury stock method for options, was 4,875,864, 3,905,054 and 3,080,345 for the years ended December 31, 2004, 2003 and 2002, respectively.
Such securities, had they been dilutive, would have been included in the computations of diluted net loss per share. See Note 9 for further information on these securities.



Stock-Based Compensation

The
Company accounts for common stock options granted to employees using the intrinsic value method as prescribed by APB 25, and related interpretations, and thus recognizes compensation expense for options granted



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)



with exercise prices less than the fair value of the Companys common stock on the date of the
grant. The Company elected to follow APB 25 because the alternative fair value accounting provided for under SFAS 123, as amended by SFAS 148, requires use of option valuation models that were not developed for use in valuing employee stock-based
awards. Deferred stock compensation calculated for options granted with exercise prices less than the deemed fair value is included as a reduction of stockholders equity and is amortized over the vesting period of the individual options,
generally four years, using the graded vesting method.



Pro forma net loss and net loss
per share information is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that statement. Prior to the Companys initial public offering, the fair value
of stock options was estimated at the date of grant using the minimum value method. The fair value subsequent to the initial public offering was valued using the Black-Scholes Model based on the actual stock closing price on the date of grant. The
effects of applying SFAS 123 for either recognizing compensation expense or providing pro forma disclosures are not likely to be representative of the effects on net income for future years.



The Companys valuation assumptions and pro forma information follows (in thousands, except
valuation assumptions and per share amounts):



|                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                          |  | Year Ended December 31, |        
|                                                                                                          |  | 2004                    |         |   | 2003 |   |         | 2002 | 
|Risk free interest rate                                                                                   |  |                         | 2.75    | % |      |   | 2.5     | %    |  |   | 3.7     | %
|Dividend yield                                                                                            |  |                         |        |   |      |   |        |      |  |   |        |  
|Expected life                                                                                             |  |                         | 4 years |   |      |   | 4 years |      |  |   | 4 years |  
|Volatility                                                                                                |  |                         | 70      | % |      |   | 70      | %    |  |   | 70      | %
|Net loss attributable to common stockholders, as reported                                                 |  | $                       | (22,126 | ) |      | $ | (9,668  | )    |  | $ | (20,864 | )
|Add: Stock-based employee compensation expense included in reported net loss                              |  |                         | 152     |   |      |   | 308     |      |  |   | 2,050   |  
|Deduct: Stock-based employee compensation expense determined under fair value based method for all awards |  |                         | (3,897  | ) |      |   | (2,631  | )    |  |   | (4,707  | )
|                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|Pro forma net loss                                                                                        |  | $                       | (25,871 | ) |      | $ | (11,991 | )    |  | $ | (23,521 | )
|                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic and diluted net loss per common share:                                                              |  |                         |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                               |  | $                       | (0.77   | ) |      | $ | (0.38   | )    |  | $ | (0.84   | )
|Pro forma                                                                                                 |  | $                       | (0.89   | ) |      | $ | (0.47   | )    |  | $ | (0.94   | )



Stock compensation expense for options granted
to non-employees has been determined in accordance with SFAS 123 and Emerging Issues Task Force (EITF) 96-18 as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably
measured. The measurement of stock-based compensation to non-employees is subject to periodic adjustment as the underlying securities vest. As such, changes to these measurements could be substantial should the Company experience significant changes
in its stock price.



Comprehensive Income/(Loss)

Comprehensive income is comprised of net income and other comprehensive income, which includes certain changes in equity that are excluded from net income. The
Company includes unrealized gains and losses on available-for-sale securities in other comprehensive income/(loss).



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Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)



Income Taxes

Since inception, the Company has recognized income taxes under the liability method. Deferred income taxes are recognized for differences between the financial statement and tax
basis of assets and liabilities at enacted statutory rates in effect for years in which the differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment
date. In addition, valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.



Segment Reporting

Statement of Financial Accounting Standards
No. 131, Disclosures about Segments of an Enterprise and Related Information,requires an enterprise to report segment information based on how management internally evaluates the operating performance of its business units (segments). The
Company has determined that it operates in only one segment. Accordingly, no segment disclosures have been included in the accompanying notes to the financial statements.



2. RESEARCH AND DEVELOPMENT AGREEMENTS



Roche

Effective September 2002,
the Company entered into a research and development collaboration agreement (the Agreement) with Hoffmann-La Roche, Inc. and F. Hoffmann-La Roche Ltd. (collectively Roche). Under the terms of the Agreement, Roche has
worldwide exclusive rights to market and sell KOS-862 (Epothilone D) and other epothilones (including KOS-1584) in the field of oncology, and the Company will co-develop and has the right to co-promote the product in the United States. The Agreement
provides for the Company to receive payments for the reimbursement of research and development expenditures, funding of a back-up program, achievement of clinical, regulatory and commercial milestones, development activities and royalties on sales
of collaboration products. Effective July 1, 2004, the Company entered into an amendment to the Agreement that provided for the reimbursement of costs that exceeded the previously stipulated amounts set forth in the Agreement. In addition, the
Company has the opportunity to increase its royalties through a buy-in at a later stage of clinical development and by co-promotion of products resulting from the collaboration.



For the years ended December 31, 2004, 2003 and 2002, the Company recognized $20.5 million, $26.9 million and $3.4 million, respectively, of contract
revenue pursuant to this agreement, of which $6.0 million was related to non-recurring milestones earned in 2003. Such amounts, excluding the ratable portion of initial payments and milestones, approximated research and development expenses under
the collaboration agreement. Included in total Roche-related contract revenue for 2004, 2003 and 2002 was approximately $5.4 million, $3.4 million and $729,000, respectively, related to the ratable portion of the $25.0 million initial fee that is
being recognized through the second half of 2009, the current estimated clinical development period for existing product candidates in clinical trials. In December 2004, upon the commencement of a Phase I clinical trial of KOS-1584, our
second-generation Epothilone D compound, the Company determined that the estimated clinical development period extended from the second half of 2007, which was initially estimated when the Company entered into the collaboration with Roche in 2002,
to the second half of 2009. The Companys initial estimate of the clinical development period contemplated development of one product candidate, KOS-862. The change in the estimate has resulted in a further deferral of the unrecognized portion
of the initial fee. Any changes in the estimate will result in either an acceleration or further deferral of the related revenue recognition. Our research and development expenses do not reflect the costs incurred by our partners, Roche or the NCI,
associated with the clinical trials they are conducting in connection with our epothilone and Hsp90 inhibitor programs, respectively.



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Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



2. RESEARCH AND DEVELOPMENT AGREEMENTS (Continued)



Johnson & Johnson Pharmaceutical Research and Development, LLC

Effective September 1998, the Company entered into a collaborative agreement with The R.W. Johnson Pharmaceutical Research Institute, LLC and Ortho-McNeil
Pharmaceutical, Inc., both Johnson & Johnson companies. Effective December 28, 2003, the agreement expired and rights to compounds and technologies developed in the collaboration have reverted to the Company. For the years ended December 31,
2003 and 2002, the Company recognized $1.2 million and $2.9 million, respectively, of contract revenue pursuant to this agreement. Such amounts, excluding initial and milestone payments, approximated research and development expenses under the
collaboration. Included in 2003 revenue was a non-recurring milestone of $250,000.



At
December 31, 2004 and 2003, $2.6 million and $8.3 million, or 57% and 92%, respectively, of accounts and other receivables were due from Roche. For the years ended December 31, 2004 and 2003, the Company recognized $20.5 million and $26.9 million of
contract revenue pursuant to one agreement representing 90% and 86% of total revenues for fiscal years 2004 and 2003, respectively. For the year ended December 31, 2002, the Company recognized $6.3 million of contract revenue pursuant to two
agreements representing 35% and 31% of total revenues for the 2002 fiscal year.



License Agreements

The Company has collaborative and license
agreements with several academic, government and medical institutions. Included in research and development expenses were fees incurred in connection with these agreements of approximately $1.0 million, $2.5 million and $1.5 million for the years
ended December 31, 2004, 2003 and 2002, respectively.



3. INVESTMENTS



The amortized cost and fair value of securities, with gross
unrealized gains and losses, at December 31, were as follows (in thousands):



|                 |  |               |        |                 |   |   |           |   |               |   |                 |   |        |           |   |        |  |   |    |  |   |     |   |  |   |       
|---------------- |  | ------------- | ------ | --------------- | - | - | --------- | - | ------------- | - | --------------- | - | ------ | --------- | - | ------ |  | - | -- |  | - | --- | - |  | - | ------
|                 |  | 2004          |        | 2003           
|                 |  | AmortizedCost |        | GrossUnrealized |   |   | FairValue |   | AmortizedCost |   | GrossUnrealized |   |        | FairValue
|                 |  | Gains         |        | Losses          |   |   |           |   | Gains         |   | Losses          |   |       
|Debt Securities: |  |               |        |                 |   |   |           |   |               |   |                 |   |        |           |   |        |  |   |    |  |   |     |   |  |   |       
|US agency notes  |  | $             | 45,778 |                 | $ |  |           | $ | (194          | ) |                 | $ | 45,586 |           | $ | 39,591 |  | $ | 21 |  | $ | (17 | ) |  | $ | 39,595
|Corporate bonds  |  |               | 24,214 |                 |   |  |           |   | (184          | ) |                 |   | 24,030 |           |   | 34,196 |  |   | 22 |  |   | (5  | ) |  |   | 34,213
|                 |  |               |        |                 |   |   |           |   |               |   |                 |   |        |           |   |        |  |   |    |  |   |     |   |  |   |       
|                 |  | $             | 69,992 |                 | $ |  |           | $ | (378          | ) |                 | $ | 69,616 |           | $ | 73,787 |  | $ | 43 |  | $ | (22 | ) |  | $ | 73,808
|                 |  |               |        |                 |   |   |           |   |               |   |                 |   |        |           |   |        |  |   |    |  |   |     |   |  |   |       



The fair value of available-for-sale securities
by contractual maturity at December 31, were as follows (in thousands):



|                                           |  |      |       
|------------------------------------------ |  | ---- | ------
|                                           |  | 2004
|Within one year                            |  | $    | 53,783
|Greater than one year, less than two years |  |      | 15,833
|                                           |  |      |       
|                                           |  | $    | 69,616
|                                           |  |      |       



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Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



4. PROPERTY AND EQUIPMENT



Property and equipment at December 31, consisted of the following (in thousands):



|                                               |  |      |        |   |      |   |        |  
|---------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|                                               |  | 2004 |        |   | 2003 |  
|Lab equipment                                  |  | $    | 9,690  |   |      | $ | 8,239  |  
|Leasehold improvements                         |  |      | 4,752  |   |      |   | 4,398  |  
|Computer equipment and software                |  |      | 1,972  |   |      |   | 1,548  |  
|Office furniture                               |  |      | 441    |   |      |   | 388    |  
|                                               |  |      |        |   |      |   |        |  
|                                               |  |      | 16,855 |   |      |   | 14,573 |  
|Less accumulated depreciation and amortization |  |      | (9,696 | ) |      |   | (7,256 | )
|                                               |  |      |        |   |      |   |        |  
|                                               |  | $    | 7,159  |   |      | $ | 7,317  |  
|                                               |  |      |        |   |      |   |        |  



Depreciation and amortization expense was $2.5
million, $2.3 million and $1.8 million for the years ended December 31, 2004, 2003 and 2002, respectively. Property and equipment financed under capital leases amounted to $562,000 at December 31, 2004 and 2003. Accumulated amortization related to
this property and equipment amounted to $562,000 at December 31, 2004 and 2003.



5. EQUIPMENT FINANCING



The Company financed certain equipment and facility improvements under debt obligations. As of December 31, 2004, future minimum loan payments under these obligations were as
follows (in thousands):



|                                      |  |   |        |  
|------------------------------------- |  | - | ------ | -
|Year ended December 31,               |  |   |       
|2005                                  |  | $ | 2,157  |  
|2006                                  |  |   | 1,547  |  
|2007                                  |  |   | 751    |  
|2008                                  |  |   | 135    |  
|                                      |  |   |        |  
|Total minimum debt payments           |  |   | 4,590  |  
|Less amount representing interest     |  |   | (391   | )
|                                      |  |   |        |  
|Present value of net minimum payments |  |   | 4,199  |  
|Less current portion                  |  |   | (1,916 | )
|                                      |  |   |        |  
|Long-term portion                     |  | $ | 2,283  |  
|                                      |  |   |        |  



In April 2004, the Company entered into a $3.5
million equipment line of credit agreement. Each draw has an interest rate that is fixed at the time of draw down. As of December 31, 2004, the Company utilized approximately $776,000 of the line of credit. The terms of the debt obligations range
from 42 to 48 months. Some of the loans have a balloon payment at the end of the term. Interest rates are fixed at the time of the draw down, with rates ranging from 6.31% to 9.40%. Obligations under the loans are secured by the underlying assets
financed.



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Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



6. FACILITY LEASES



In June 2002, the Company expanded its facilities by entering into an assignment of a non-cancelable operating lease, which commenced in June 2002 and
expires in March 2008, with an option to renew. The Company also entered into a new lease on its existing facility lease to August 2013, with an option to renew.



Minimum annual rental commitments at December 31, 2004 were as follows (in thousands):



|                        |  |   |       
|----------------------- |  | - | ------
|Year ended December 31, |  |  
|2005                    |  | $ | 1,609 
|2006                    |  |   | 1,624 
|2007                    |  |   | 1,679 
|2008                    |  |   | 1,163 
|2009                    |  |   | 1,088 
|Thereafter              |  |   | 3,705 
|                        |  |   |       
|Total minimum payments  |  | $ | 10,868
|                        |  |   |       



The Company holds a stand-by letter of credit
for approximately $903,000 from a commercial bank as security for the Companys obligation under one of its facility leases. The letter of credit is secured by a certificate of deposit in the amount of $949,000 held in an investment account
that the Company must maintain for the term of the letter of credit. The investment account is classified within long-term investments on the balance sheet.



Rent expense for operating leases was approximately $1.7 million, $1.8 million and $1.5 million for the years ended December 31, 2004, 2003 and 2002, respectively.



7. ACCRUED LIABILITIES



Accrued liabilities at December 31, consisted of the following (in thousands):



|                                 |  |      |       |      |   |      
|-------------------------------- |  | ---- | ----- | ---- | - | -----
|                                 |  | 2004 |       | 2003
|Research and development-related |  | $    | 2,896 |      | $ | 3,699
|Compensation-related             |  |      | 1,602 |      |   | 1,368
|Professional services            |  |      | 718   |      |   | 978  
|Facilities-related               |  |      | 948   |      |   | 670  
|Other                            |  |      | 291   |      |   | 310  
|                                 |  |      |       |      |   |      
|                                 |  | $    | 6,455 |      | $ | 7,025
|                                 |  |      |       |      |   |      



8. RELATED
PARTY TRANSACTIONS



For the years ended December 31, 2004 and 2003, the Company had
outstanding full recourse employee loans of $115,000 and $155,000, respectively, issued from March 1999 to September 2004. These loans bear interest at rates ranging from 2.34% to 6.60% and are due through October 2007. The loans are included on the
balance sheet in other assets and notes receivable from related parties. In accordance with the original terms of the loan agreement, 50% of the note to an officer totaling $150,000 was forgiven upon the third anniversary date of the officers
employment in 2003, and the remaining 50% was forgiven upon the fourth anniversary date in 2004. The Company has not issued any loans to officers or directors subsequent to the passage of Sarbanes-Oxley Act in 2002.



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Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



9. STOCKHOLDERS EQUITY



Registered Direct Offering

In
December 2003, the Company completed a registered direct offering of 3,115,000 shares of common stock at a price of $9.00 per share. The Company received approximately $26.0 million in net proceeds after placement agent fees and other offering
costs.



Common Stock and Common Stock Subject to
Repurchase

Under the terms of the 1996 Stock Option Plan (the 1996 Plan), options granted before the Companys initial public offering of common
stock are exercisable when granted, and if exercised prior to vesting, such shares are subject to repurchase upon termination of employment or consulting agreement at a price per share equal to the original exercise price. Repurchase rights lapse
over the vesting periods, which are generally four years. At December 31, 2004 and 2003, 3,000 shares and 60,428 shares, respectively, were subject to repurchase. Stock options granted after the Companys initial public offering of common stock
are exercisable only for the portion of the stock options that have vested.



1996 Stock Option Plan

In 1996, the board of directors adopted the 1996 Plan that provides for the granting of incentive stock options and
nonstatutory stock options to employees, officers, directors and consultants of the Company. The maximum number of aggregate shares that may be optioned and sold under the plan is 8,100,000, plus an annual increase to be added on January 1 of each
year that may be the lesser of 1,125,000 shares, 5% of the outstanding shares on such date or a lesser amount as determined by the board, beginning in 2001. Incentive stock options may be granted with exercise prices not less than fair value, and
nonstatutory stock options may be granted with exercise prices not less than 85% of the fair value on the date of grant. The fair value of grants before the Companys initial public offering was determined by the board of directors. The fair
value of grants after the Companys initial public offering of common stock is determined by the closing market price of the Companys common stock as listed on any established stock exchange on the date of grant. Stock options granted to
a stockholder owning more than 10% of voting stock of the Company may be granted with an exercise price of not less than 110% of the fair value on the date of grant. Options expire no later than ten years from the date of the grant. The number of
shares, terms and exercise period are determined by the board of directors. Options generally vest at 25% per year over a four-year period.



2000 Employee Stock Purchase Plan

In March 2000, the Company
adopted the 2000 Employee Stock Purchase Plan (the Purchase Plan). The maximum number of shares available for issuance is 450,000, plus an annual increase on January 1 of each year, beginning in 2001, equal to the lesser of 150,000
shares, 0.75% of the outstanding shares on such date or such amount as determined by the board. The Purchase Plan permits eligible employees to purchase common stock at a discount through payroll deductions during defined offering periods. The price
at which the stock is purchased is equal to the lower of 85% of the fair market value of the common stock on the first day of the offering or 85% of the fair market value of the Companys common stock on the purchase date. Each offering period
is for approximately six months, with the initial offering period commencing on October 5, 2000. As of December 31, 2004, 403,458 shares were granted under the Purchase Plan.



2000 Non-Employee Directors Plan

In March 2000, the Company adopted the 2000 Non-Employee Directors Stock Option Plan (the Directors Plan) and reserved 300,000 shares of common stock for issuance thereunder. The Directors Plan provides for an
annual increase on January 1 of each year, beginning in 2001, equal to the lesser of 150,000 shares, 0.75% of the outstanding shares on such date or a lesser amount as determined by the board. In May 2002, stockholders approved an



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



9. STOCKHOLDERS EQUITY (Continued)



amendment to the Directors Plan to increase the number of options that may be granted to each
non-employee director and adjust the date of grant and the term over which shares vest. Under the Directors Plan, as amended, each non-employee director who becomes a director of the Company will be automatically granted a non-statutory stock
option to purchase 20,000 shares of common stock on the date on which such person first becomes a director, and such option will vest over four years. Beginning with the 2002 Annual Stockholders Meeting and each year thereafter, each non-employee
director will automatically be granted, one day following each years annual meeting of stockholders, a non-statutory option to purchase 5,000 shares of common stock, which will vest one day before the annual meeting of stockholders subsequent
to the date of grant. The exercise price of options under the Directors Plan will be equal to the fair market value of the common stock on the date of grant.



The maximum term of the options granted under the Directors Plan is ten years. The Directors Plan will terminate in March 2010, unless
terminated in accordance with the provisions of the Directors Plan. As of December 31, 2004, 194,000 shares were granted under the Directors Plan.



A summary of stock option activity is as follows:



|                              |  |                          |                 |  |                     |               |  |                |              |  |                               |            |   |  |   |     
|----------------------------- |  | ------------------------ | --------------- |  | ------------------- | ------------- |  | -------------- | ------------ |  | ----------------------------- | ---------- | - |  | - | ----
|                              |  | SharesAvailableFor Grant |                 |  | Options Outstanding
|                              |  |                          | Numberof Shares |  |                     | ExercisePrice |  | AggregatePrice |              |  | Weighted-AverageExercisePrice
|Balances at December 31, 2001 |  | 635,989                  |                 |  | 2,355,874           |               |  |                |              |  | $                             | 15,636,777 |   |  | $ | 6.64
|Additional reserved           |  | 1,125,000                |                 |  |                    |               |  |                |             |  |                               |           |   |  |   |    
|Granted                       |  | (1,134,100               | )               |  | 1,134,100           |               |  | $              | 6.25-$  8.85 |  |                               | 8,149,229  |   |  | $ | 7.15
|Canceled                      |  | 319,167                  |                 |  | (319,167            | )             |  | $              | 0.33-$10.50  |  |                               | (1,891,887 | ) |  | $ | 5.93
|Exercised                     |  |                         |                 |  | (90,462             | )             |  | $              | 0.33-$4.00   |  |                               | (85,486    | ) |  | $ | 0.94
|                              |  |                          |                 |  |                     |               |  |                |              |  |                               |            |   |  |   |     
|Balances at December 31, 2002 |  | 946,056                  |                 |  | 3,080,345           |               |  |                |              |  | $                             | 21,808,633 |   |  | $ | 7.08
|Additional reserved           |  | 500,000                  |                 |  |                    |               |  |                |             |  |                               |           |   |  |   |    
|Granted                       |  | (1,186,195               | )               |  | 1,186,195           |               |  | $              | 5.62-$11.22  |  |                               | 10,657,920 |   |  | $ | 8.98
|Canceled                      |  | 174,708                  |                 |  | (174,708            | )             |  | $              | 0.33-$10.50  |  |                               | (1,294,456 | ) |  | $ | 7.42
|Exercised                     |  |                         |                 |  | (186,778            | )             |  | $              | 0.33-$7.75   |  |                               | (325,883   | ) |  | $ | 1.74
|                              |  |                          |                 |  |                     |               |  |                |              |  |                               |            |   |  |   |     
|Balances at December 31, 2003 |  | 434,569                  |                 |  | 3,905,054           |               |  |                |              |  | $                             | 30,846,214 |   |  | $ | 7.90
|Additional reserved           |  | 1,000,000                |                 |  |                    |               |  |                |             |  |                               |           |   |  |   |    
|Granted                       |  | (1,423,275               | )               |  | 1,423,275           |               |  | $              | 5.93-$14.44  |  |                               | 10,661,163 |   |  | $ | 7.49
|Canceled                      |  | 212,697                  |                 |  | (212,697            | )             |  | $              | 2.00-$14.44  |  |                               | (1,605,108 | ) |  | $ | 7.55
|Exercised                     |  |                         |                 |  | (239,768            | )             |  | $              | 0.33-$12.75  |  |                               | (907,026   | ) |  | $ | 3.78
|                              |  |                          |                 |  |                     |               |  |                |              |  |                               |            |   |  |   |     
|Balances at December 31, 2004 |  | 223,991                  |                 |  | 4,875,864           |               |  |                |              |  | $                             | 38,995,243 |   |  | $ | 8.00
|                              |  |                          |                 |  |                     |               |  |                |              |  |                               |            |   |  |   |     



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



9. STOCKHOLDERS EQUITY (Continued)



The following table summarizes information with respect to stock options outstanding at December 31,
2004:



|                        |  |                 |  |                                                     |  |                               |       |                 |           |                               |   |      
|----------------------- |  | --------------- |  | --------------------------------------------------- |  | ----------------------------- | ----- | --------------- | --------- | ----------------------------- | - | -----
|Options Outstanding     |  | Options Vested 
|Range of Exercise Price |  | Numberof Shares |  | Weighted-AverageRemainingContractualLife (In Years) |  | Weighted-AverageExercisePrice |       | Numberof Shares |           | Weighted-AverageExercisePrice
|$ 0.15  - $ 6.25        |  | 732,784         |  | 7.44                                                |  | $                             | 4.64  |                 | 396,569   |                               | $ | 3.76 
|$ 6.30  - $ 6.50        |  | 1,116,847       |  | 9.03                                                |  | $                             | 6.39  |                 | 242,707   |                               | $ | 6.50 
|$ 6.65  - $ 7.75        |  | 767,650         |  | 8.23                                                |  | $                             | 7.34  |                 | 296,512   |                               | $ | 7.34 
|$ 8.00  - $ 9.70        |  | 974,948         |  | 6.68                                                |  | $                             | 9.27  |                 | 792,713   |                               | $ | 9.31 
|$10.20 - $10.50         |  | 593,135         |  | 8.85                                                |  | $                             | 10.21 |                 | 159,599   |                               | $ | 10.24
|$10.67 - $14.44         |  | 690,500         |  | 8.03                                                |  | $                             | 11.19 |                 | 277,791   |                               | $ | 11.14
|                        |  |                 |  |                                                     |  |                               |       |                 |           |                               |   |      
|                        |  | 4,875,864       |  | 8.03                                                |  | $                             | 8.00  |                 | 2,165,891 |                               | $ | 8.33 
|                        |  |                 |  |                                                     |  |                               |       |                 |           |                               |   |      



Of the 4,875,864 options outstanding, 2,165,891
options were exercisable as of December 31, 2004. The weighted-average fair value of options granted and outstanding was $8.00, $7.90 and $7.08 as of the years ended December 31, 2004, 2003 and 2002, respectively.



Non-Employee Stock-Based Compensation

As of December 31, 2004, the Company had issued consultant stock options totaling approximately 1,034,000 shares with exercise prices ranging from $0.15 to $14.40 and terms up to
ten years. Compensation related to the grants of stock options is recorded in accordance with SFAS 123 and EITF 96-18 using the Black-Scholes Model. The Company recognized other stock-based compensation for grants to non-employees of approximately
$605,000, $619,000, and $1.4 million for the years ended December 31, 2004, 2003 and 2002, respectively. The measurement of stock-based compensation to non-employees is subject to periodic adjustment as the underlying awards vest.



Reserved Shares

As of December 31, 2004, the Company had reserved shares of common stock for future issuance as follows:



|                             |  |               
|---------------------------- |  | --------------
|                             |  | SharesReserved
|Stock option plans           |  | 5,099,855     
|Employee Stock Purchase Plan |  | 46,452        
|                             |  |               
|                             |  | 5,146,307     
|                             |  |               



Stockholder
Rights Plan

In October 2001, the board of directors of the Company adopted a Stockholder Rights Plan (the Rights Plan) under which all stockholders
received rights (the Rights) to purchase shares of a new series of Preferred Stock. 1,000,000 shares of Junior A Preferred Stock were authorized in conjunction with the Series A Junior Participating Preferred Stock under certain
circumstances at an exercise price of $70.00 per adoption of the Rights Plan. Each Right entitles the holder to purchase one one-hundredth of a share of a Series A Junior Participating Preferred Stock under certain circumstances at an exercise price
of $70.00 per one-one hundredth of a share. The Rights were distributed as a non-taxable dividend and expire on October 29, 2011. At the time of the adoption, the Rights were neither exercisable nor traded separately from the common stock. However,
subject to certain exceptions, the Rights will become exercisable at such time that a person (or group of affiliated persons) acquires beneficial ownership of 20% or more of



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



9. STOCKHOLDERS EQUITY (Continued)



the outstanding Company common stock (an Acquiring Person) or on the tenth business day
after a person or entity commences, or expresses an intention to commence, a tender or exchange offer that would result in such person acquiring 20% or more of the outstanding Company common stock.



In the event a person becomes an Acquiring Person, each Right held by all persons other than the
Acquiring Person will become the right to acquire one share of Company common stock at a price equal to 50% of the then-current market value of the Company common stock. Furthermore, in the event an Acquiring Person effects a merger of the Company,
each Right will entitle the holder thereof to purchase one share of common stock of the Acquiring Person or the Acquiring Persons ultimate parent at a price equal to 50% of the then-current market value of the Acquiring Persons or the
Acquiring Persons ultimate parents common stock.



The board of directors can
redeem the Rights at any time prior to a person becoming an Acquiring Person at a redemption price of $0.001 per Right. In addition, the board of directors may, after any time a person becomes an Acquiring Person, exchange each Right for one share
of common stock of the Company. As of December 31, 2004, no shares had been issued under the Rights Plan.



10. COMPREHENSIVE INCOME



Comprehensive loss was as follows (in thousands):



|                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------ | ---- |  | - | ------- | -
|                                                  |  | Year Ended December 31, |        
|                                                  |  | 2004                    |         |   | 2003 |   |        | 2002 | 
|Net loss                                          |  | $                       | (22,126 | ) |      | $ | (9,668 | )    |  | $ | (20,864 | )
|Unrealized loss on available-for-sale securities  |  |                         | (399    | ) |      |   | (131   | )    |  |   | (74     | )
|Gain on recovery of available-for-sale securities |  |                         |        |   |      |   |       |      |  |   | (990    | )
|                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|Comprehensive loss                                |  | $                       | (22,525 | ) |      | $ | (9,799 | )    |  | $ | (21,928 | )
|                                                  |  |                         |         |   |      |   |        |      |  |   |         |  



11. INCOME
TAXES



As of December 31, 2004, the Company had federal net operating loss carryforwards
and federal research and development tax credit carryforwards of approximately $65.3 million and $2.6 million, respectively. The federal net operating loss and research and development credit carryforwards will expire at various dates beginning in
the year 2010 through 2024, if not utilized. As of December 31, 2004, the Company had state net operating loss carryforwards and state research and development tax credit carryforwards of approximately $36.8 million and $2.7 million,
respectively. The state net operating loss carryforwards will expire at various dates beginning in the year 2005 through 2014, if not utilized. The state research and development carryforwards do not expire.



Utilization of the federal net operating loss and credit carryforwards may be subject to a substantial
annual limitation due to the change in ownership provisions of the Internal Revenue Code of 1986. The annual limitation may result in the expiration of net operating losses and credits before utilization.



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



11. INCOME TAXES (Continued)



Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets for financial reporting and the
amount used for income tax purposes. Significant components of the Companys deferred tax assets for federal income taxes as of December 31 were as follows (in thousands):



|                                              |  |      |         |   |      |   |         |  
|--------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                              |  | 2004 |         |   | 2003 |  
|Deferred tax assets:                          |  |      |         |   |      |   |         |  
|Net operating loss carryforwards              |  | $    | 24,410  |   |      | $ | 12,390  |  
|Deferred revenue                              |  |      | 6,170   |   |      |   | 8,340   |  
|Research and development credits              |  |      | 2,190   |   |      |   | 2,640   |  
|Capitalized research and development expenses |  |      | 1,620   |   |      |   | 1,930   |  
|Other                                         |  |      | 990     |   |      |   | 760     |  
|                                              |  |      |         |   |      |   |         |  
|Total deferred tax assets                     |  |      | 35,380  |   |      |   | 26,060  |  
|                                              |  |      |         |   |      |   |         |  
|Valuation allowance                           |  |      | (35,380 | ) |      |   | (26,060 | )
|                                              |  |      |         |   |      |   |         |  
|Net deferred taxes                            |  | $    |        |   |      | $ |        |  
|                                              |  |      |         |   |      |   |         |  



Due to the Companys lack of earnings
history, the total deferred tax assets have been fully offset by a valuation allowance. The valuation allowance increased by $9.3 million and $3.0 million during the years ended December 31, 2004 and 2003, respectively.



12. QUARTERLY INFORMATION (Unaudited)



The Companys quarterly results were as follows (in thousands, except per share amounts):



|                                            |  |               |        |   |          |   |        |               |  |   |              |   |  |       |        |   |  |   |         |  
|------------------------------------------- |  | ------------- | ------ | - | -------- | - | ------ | ------------- |  | - | ------------ | - |  | ----- | ------ | - |  | - | ------- | -
|                                            |  | Quarter Ended |        |   |          |  
|                                            |  | March 31,     |        |   | June 30, |   |        | September 30, |  |   | December 31, |   |  | Total |       
|2004                                        |  |               |        |   |          |   |        |               |  |   |              |   |  |       |        |   |  |   |         |  
|Revenue                                     |  | $             | 6,361  |   |          | $ | 5,940  |               |  | $ | 6,757        |   |  | $     | 3,834  |   |  | $ | 22,892  |  
|Loss from operations                        |  |               | (4,383 | ) |          |   | (5,448 | )             |  |   | (6,150       | ) |  |       | (7,236 | ) |  |   | (23,217 | )
|Net loss                                    |  |               | (4,125 | ) |          |   | (5,180 | )             |  |   | (5,872       | ) |  |       | (6,949 | ) |  |   | (22,126 | )
|Basic and diluted earnings per common share |  | $             | (0.14  | ) |          | $ | (0.18  | )             |  | $ | (0.20        | ) |  | $     | (0.24  | ) |  | $ | (0.77   | )
|2003                                        |  |               |        |   |          |   |        |               |  |   |              |   |  |       |        |   |  |   |         |  
|Revenue                                     |  | $             | 5,258  |   |          | $ | 9,259  |               |  | $ | 6,274        |   |  | $     | 10,598 |   |  | $ | 31,389  |  
|Loss from operations                        |  |               | (2,871 | ) |          |   | (734   | )             |  |   | (6,211       | ) |  |       | (721   | ) |  |   | (10,537 | )
|Net loss                                    |  |               | (2,582 | ) |          |   | (521   | )             |  |   | (6,040       | ) |  |       | (525   | ) |  |   | (9,668  | )
|Basic and diluted earnings per common share |  | $             | (0.10  | ) |          | $ | (0.02  | )             |  | $ | (0.24        | ) |  | $     | (0.02  | ) |  | $ | (0.38   | )



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