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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



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(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, 2003.



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



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Kosan Biosciences Incorporated

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|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



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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 ̈.



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



State the aggregate market value of the voting and non-voting common equity
held by non-affiliates of the registrant computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrants most recently
completed second fiscal quarter: $95,022,879.(1)



The aggregate market value of the common stock of the registrant held by non-affiliates as of February 29, 2004, based upon
the closing sale price of the registrants common stock listed on the Nasdaq National Market on February 27, 2004, was $212,035,663.(2)



The number of shares of common stock
of the registrant outstanding at February 29, 2004 was 28,809,778 shares.



|(1) | Based on a closing price of $5.83 per share on June 30, 2003. Excludes approximately 9,248,863 shares of the registrants common stock held by executive officers, directors and
stockholders whose ownership exceeds 5% of the common stock outstanding at June 30, 2003.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Based on a closing price of $11.69 per share on February 27, 2004. Excludes approximately 10,671,569 shares of the registrants common stock held by executive officers,
directors and stockholders whose ownership exceeds 5% of the common stock outstanding at February 29, 2004.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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DOCUMENTS INCORPORATED BY REFERENCE



Certain portions of the registrants Proxy Statement in connection with
the registrants 2004 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 II and Part III of this report.



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Kosan Biosciences Incorporated

Form 10-K

For the Fiscal Year Ended December 31, 2003



TABLE OF CONTENTS



|                     |  |                                                                                                |  |     
|-------------------- |  | ---------------------------------------------------------------------------------------------- |  | ----
|                     |  |                                                                                                |  | Page
|                     |  | PART I                                                                                         |  |     
|                     |  |                                                                                               
|Item 1.              |  | Business                                                                                       |  | 3   
|                     |  |                                                                                               
|Item 2.              |  | Properties                                                                                     |  | 29  
|                     |  |                                                                                               
|Item 3.              |  | Legal Proceedings                                                                              |  | 29  
|                     |  |                                                                                               
|Item 4.              |  | Submission of Matters to a Vote of Security Holders                                            |  | 29  
|                     |  |                                                                                               
|                     |  | PART II                                                                                        |  |     
|                     |  |                                                                                               
|Item 5.              |  | Market for Registrants Common Equity and Related Stockholder Matters                          |  | 30  
|                     |  |                                                                                               
|Item 6.              |  | Selected Financial Data                                                                        |  | 31  
|                     |  |                                                                                               
|Item 7.              |  | Managements Discussion and Analysis of Financial Condition and Results of Operations          |  | 32  
|                     |  |                                                                                               
|Item 7A.             |  | Quantitative and Qualitative Disclosures about Market Risk                                     |  | 39  
|                     |  |                                                                                               
|Item 8.              |  | Financial Statements and Supplementary Data                                                    |  | 39  
|                     |  |                                                                                               
|Item 9.              |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure           |  | 39  
|                     |  |                                                                                               
|Item 9A.             |  | Controls and Procedures                                                                        |  | 39  
|                     |  |                                                                                               
|                     |  | PART III                                                                                       |  |     
|                     |  |                                                                                               
|Item 10.             |  | Directors and Executive Officers of the Registrant                                             |  | 41  
|                     |  |                                                                                               
|Item 11.             |  | Executive Compensation                                                                         |  | 41  
|                     |  |                                                                                               
|Item 12.             |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |  | 41  
|                     |  |                                                                                               
|Item 13.             |  | Certain Relationships and Related Transactions                                                 |  | 41  
|                     |  |                                                                                               
|Item 14.             |  | Principal Accounting Fees and Services                                                         |  | 41  
|                     |  |                                                                                               
|                     |  | PART IV                                                                                        |  |     
|                     |  |                                                                                               
|Item 15.             |  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                               |  | 42  
|                     | 
|Signatures           |  | 46                                                                                            
|                     | 
|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, statements about:



| |  | our strategy;
| | - | -------------



| |  | sufficiency of our cash resources;
| | - | ----------------------------------



| |  | revenues from existing and new collaborations;
| | - | ----------------------------------------------



| |  | the progress of our research programs, including clinical testing;
| | - | ------------------------------------------------------------------



| |  | product development; and
| | - | ------------------------



| |  | our research and development and other expenses.
| | - | ------------------------------------------------



These forward-looking statements are generally 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 in 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 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 document. 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 can make improved versions of a known polyketide pharmaceutical product or product candidate and are able to change a polyketide used in one
therapeutic area to create a new polyketide to be used for another therapeutic area. We can also take the genetic instructions for making a polyketide out of one microorganism and put them into another that provides a more favorable environment to
produce more of the polyketide. We can otherwise manipulate the genetic instructions for a polyketide in order to improve production.



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Our strategy is to use our technologies to create new polyketides, to make improved versions of known
polyketide pharmaceuticals, to cost-effectively produce them and to advance selected drug candidates into clinical trials. We are co-developing epothilones, a class of polyketides, for the treatment of cancer 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. Our lead epothilone candidate, KOS-862 (Epothilone D), is in Phase II and Phase Ib clinical
trials. In collaboration with the National Cancer Institute, or NCI, a component of the National Institutes of Health, or NIH, we are developing derivatives of geldanamycin, a polyketide, for the treatment of cancer. Our lead geldanamycin candidate,
17-AAG, a derivative of geldanamycin, is in Phase I and Phase Ib combination clinical trials being conducted by us and the NCI. We also have additional product candidates in the areas of cancer, infectious disease and gastrointestinal motility that
are undergoing preclinical evaluation, and several early stage product research and technology development programs.



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.



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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 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 candidate,
KOS-862, and other epothilone analogs for the treatment of cancer. We have a collaboration with the NCI to clinically develop 17-AAG and other geldanamycin derivatives for the treatment of cancer. We plan 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.



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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.



Product Development Opportunities



Our primary programs are currently directed at discovery and development of
polyketides for cancer, infectious disease and gastrointestinal motility disorders. 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.



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 2002, sales of taxanes were approximately $1.4 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.



KOS-862 is our lead epothilone. KOS-862 is being evaluated in Phase II in advanced non-small cell lung, colorectal and
breast cancers with Roche. We are conducting the lung cancer trial at multiple centers in North America, and Roche is conducting the other two multiple center trials. In addition to the Phase II monotherapy trials, Kosan and Roche are advancing
KOS-862 into Phase Ib clinical trials in which KOS-862 is being evaluated in combination with Gemzar®, Paraplatin®, Herceptin® and
Xeloda®, four standard-of-care anticancer
chemotherapeutics. We and Roche are exploring additional epothilone analogs for development, with the objective of initiating clinical trials of a novel epothilone analog during 2004. Competing epothilones in clinical development include those being
developed by Bristol-Myers Squibb (reported to be in Phase III clinical trials) and Novartis AG (reported to be in Phase II clinical trials).



In September 2002, we entered into an agreement with Roche to jointly develop KOS-862 and other epothilones.



Geldanamycin



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 derivatives may serve as chemotherapeutic agents in a number of cancers. Moreover, preclinical
studies suggest that these compounds are synergistic with certain other inhibitors of the signal transduction client proteins, as well as several conventional anticancer agents.



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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 derivatives. We are collaborating with the NCI to complete five ongoing Phase I 17-AAG clinical trials, in which over 180 patients have been
treated, and three ongoing Phase Ib trials in which patients are treated with 17-AAG in combination with Taxotere®, Gemzar®/Platinol® and
Gleevec®. In addition, we are collaborating with
the NCI to initiate Phase II clinical trials of 17-AAG as a monotherapy and to initiate additional Phase Ib clinical trials of 17-AAG in combination with other anticancer drugs. Under the terms of the CRADAs, we are responsible for the provision of
sufficient quantities of clinical materials necessary to conduct the clinical development of 17-AAG clinical trials funded by the NCI, and we have the option, at our expense, to conduct our own clinical trials of 17-AAG and geldanamycin derivatives
in addition to those funded by the NCI. We have developed a new formulation of 17-AAG (KOS-953) that addresses a limitation of the first generation formulation. In December 2003, we filed an Investigational New Drug, or IND, application for KOS-953
and plan to initiate self-funded Phase I/II and Phase Ib clinical trials of this newly formulated product candidate during 2004. We also are collaborating with the NCI on initiating clinical trials of 17-DMAG, a highly potent, water-soluble and
orally active derivative of geldanamycin.



Discodermolide



Discodermolide is a polyketide with a mechanism of action
similar to both the taxanes and the epothilones. Discodermolide has broad-spectrum activity against cancer cells and is a potent inhibitor of taxane- and epothilone-resistant tumors in cell culture and in animal models. We have generated analogs
with improved properties over the natural polyketide and are seeking to develop cost-effective production processes. Several of these compounds are undergoing preclinical evaluation.



Infectious Disease



Macrolides are clinically important antibiotics that have been used for the treatment of respiratory infections for more than 40 years.



Currently, the leading macrolides are clarithromycin, marketed as Biaxin® by Abbott Laboratories, and azithromycin, marketed as
Zithromax® by Pfizer Inc. These are
polyketide-derived antibiotics that show high potency, a broad spectrum of activity and few side effects. In 2002, these products had combined revenues of approximately $2.0 billion. In recent years, there has been increasing bacterial resistance to
macrolides, driving the need to develop new and more effective drugs. Ketolides, derivatives of the polyketide erythromycin, possess the potency and spectrum of activity shown by clarithromycin and azithromycin, but are effective against some of
these resistant organisms. Aventis has received regulatory approval in Europe and major Latin American markets and has received an approvable letter by the U.S. Food and Drug Administration, or FDA, to market a ketolide antibiotic called Ketek®.



We have generated several proprietary ketolides with in vitro activity
comparable or superior to other ketolides. Several of these compounds are currently undergoing preclinical evaluation by us.



Several compounds in this program resulted from a multi-year research collaboration between us and affiliates of Johnson & Johnson. Rights to these
compounds reverted to us without any further obligation to Johnson & Johnson and its affiliates when the agreement expired in December 2003.



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Gastrointestinal Motility



One of the actions of erythromycin is stimulation of gastrointestinal movement, or GI motility. Erythromycin-derived
compounds called motilides may be useful to treat diseases such as gastroparesis and other conditions in which GI motility is impaired or needs to be increased. We have made several series of motilides that stimulate GI motility in preclinical
models and from which the unnecessary antibiotic activity of erythromycin has been eliminated. Several of these compounds are being evaluated in preclinical studies.



Our Technology Platform



Our technology platform has four components: polyketide gene alteration, chemo-biosynthesis, heterologous over-expression 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.



First, we disable the loading and first extender modules in a PKS by altering the gene that contains the instructions for these modules. This prevents
formation of the two-building-block intermediate that feeds the second extender module, but leaves the remainder of the PKS fully functional. Then, 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 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 created microorganisms 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.



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Polyketide Chemical Synthesis



We have developed state-of-the-art capabilities to chemically synthesize polyketides and to generate chemical derivatives 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 expenses were approximately $36.8 million in
2003, $28.4 million in 2002 and $25.5 million in 2001.



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, 2003, we owned or were exclusively licensed under over 80 patents and 130 patent applications in the U.S., over 20 patents
and 50 patent applications in Europe and 2 patents and over 40 patent applications in Japan. 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.



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 eventual back-up compounds. Any such back-up candidates would be collaboratively developed by Roche and us, and would be exclusively licensed to and marketed by Roche, and could, at our option, be co-promoted
by us with Roche, all for the treatment of cancer.



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. We estimate that these types of cash payments could total up to $220 million, based upon our current expectations for program



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expenses and assuming successful development and commercialization of one product that achieves each milestone event. As
of December 31, 2003, we have received approximately $42.9 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.



Pursuant to this agreement, we recognized approximately $26.9 million and $3.4 million of contract revenue in 2003 and 2002, respectively. Such amounts, excluding the ratable portion of an initial fee and milestones,
approximated research and development expenses under this collaboration agreement. Included in 2003 revenue was the ratable portion of the $25 million initial fee that is being recognized through the second half of 2007, the estimated clinical
development period, and $6.0 million in non-recurring milestones achieved under the agreement.



Either party may terminate the agreement at any time for the other partys uncured material breach of the agreement. In addition, Roche may terminate the agreement as a whole during an initial period solely for
cause relating to the success of the program (not needing to relate to any breach by us), or after this initial period for convenience entirely or in part. Upon such a termination by Roche for cause or convenience, the licensed rights would revert
to us and Roche would provide us with other assistance to take over the previously licensed products. 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 use our technologies to produce KOS-862, work collaboratively with Sloan-Kettering to develop compounds and production methods. Under the agreement, each party licenses
the other party for activities as part of the collaborative program. In addition, Sloan-Kettering exclusively licenses us 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 will
pay annual maintenance fees as well as payments for research and development costs (including the costs of clinical trials). In addition, we 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.



If we and Sloan-Kettering jointly determine that the objectives of the research plan cannot be met, then the agreement terminates. Upon termination, all
licenses granted by one party to the other revert to the granting party. Otherwise, so long as we are actively developing or commercializing a product under the agreement, the agreement and our license do not terminate until our royalty obligations
expire, in most cases, with the last patent covering the last product, or, if later, a specified number of years after the first commercial sale of unpatented products. 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, and 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



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that agreement (including our exclusive license to KOS-862) on the basis of any alleged breach prior to the settlement.
We are obliged under the settlement to make contingent and non-contingent payments to Sloan-Kettering, and 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, 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 and their production, and chosen by Stanford University in its discretion. 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 grant a sublicense to Roche and to harmonize it with the collaboration agreement with Roche.



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 geldanamycin derivatives. 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 programs. The clinical trials of 17-AAG and other derivatives are or will be
sponsored by the NCI in collaboration with us or by us solely. The term of the collaborative programs is currently scheduled for four years in total, but may be adjusted as the programs proceed.



Under a November 2002 license agreement with the NIH, we obtained exclusive
commercial rights under pending patent applications relating to the geldanamycin derivatives being developed under the CRADAs. Initially, our license is limited to specified medical fields of use, including treatment of cancer, restenosis and
neurodegenerative diseases relating to undesired cell growth. We may include additional fields of use to the license as we go along. 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 or otherwise default in performing our material obligations
under the agreement, and fail to cure the deficiency. The agreement contains standard NIH licensing terms. Unless the agreement is earlier terminated, our license will endure for the life of the licensed patents.



In connection with our collaboration and license agreements for the years
ended December 31, 2003, 2002 and 2001, we have expensed approximately $2.5 million, $1.5 million and $721,000, respectively.



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



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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 developing our drug compounds. Aventis
Pharmaceuticals has received regulatory approval in Europe and major Latin American markets and has received an approvable letter from the FDA to market a ketolide antibiotic called Ketek®. Chugai Pharmaceuticals has a motilide compound in clinical trials. Competing
epothilones in clinical development include those being developed by Bristol-Myers Squibb (reported to be in Phase III clinical trials) and Novartis AG (reported to be in Phase II clinical trials). Novartis has initiated clinical trials of
discodermolide. 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



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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 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



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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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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 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, 2003, we had an accumulated deficit of approximately $79.1 million. To date, our revenues have been solely 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 $9.7 million in 2003, $20.9
million in 2002 and $21.9 million in 2001. 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 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.



If our current collaborations are unsuccessful or if conflicts develop with these
relationships or under our license agreements, 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
Hoffmann-La Roche, Inc. and F. Hoffmann-La Roche Ltd. in the field of epothilones. We also have collaborations with, or have licenses to technology and compounds from, several research groups, including The Sloan-Kettering Institute for Cancer
Research in the field of epothilones, the National Cancer Institute 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 agreement
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. Loss of these rights could also result in termination of, curtailment of or a delay of research and development
efforts under our corporate collaborations, under some circumstances.



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, or if the development or commercialization efforts that our collaborators make or
authorize will be the same as those we would choose to devote ourselves 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 in the amount 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



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National Cancer Institute, we do not control the selection, conduct, timing and resources provided to clinical trials of
geldanamycin analogs sponsored by the National Cancer Institute. 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, if a business combination involving our existing collaboration
with Roche were to occur, the effect could diminish, terminate or cause delays in the epothilone program corporate collaborations. Should our corporate partners fail to develop or commercialize a compound or product for which they have rights from
us, we may not receive any future milestones and will not receive any royalties associated with such compound or product.



If our collaborators fail to conduct the collaborative activities successfully and in a timely manner or if they or our licensors were to 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. Conflicts might also arise with collaborators or licensors concerning rights
to particular compounds or technologies. If we are unable to resolve these conflicts 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 in the future. 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, then our revenues will be reduced, and our drug candidates may not be developed, manufactured or marketed.



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



Our technologies are new, and our drug candidates are in early stages of
research and development. We may not 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 U.S. Food and Drug Administration, or FDA, and international regulatory authorities for commercial use. We will need to conduct significant additional research, preclinical testing and clinical trials, before we or our
collaborators can file applications with the FDA for product approval. Clinical trials are expensive and have a high risk of failure. In addition, to compete effectively, our products must be easy to use, cost-effective and economical to manufacture
on a commercial scale. We may not achieve any of these objectives. Any of our products may not attain market acceptance. Typically, there is a high rate of attrition for products in preclinical testing and clinical trials. Also, third parties may
develop superior products or have proprietary rights that preclude us or our collaborators from marketing our products. If research and testing is not successful or we fail to obtain regulatory approval, we will be unable to market and sell our
future product candidates.



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



We must provide the FDA and foreign regulatory authorities with clinical
data that demonstrates 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 clinical trials. Preclinical testing and
clinical development are long, expensive and uncertain processes. It may take us several years to complete our testing, and failure can occur at any stage of testing. 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 industry, including biotechnology companies, have suffered significant setbacks in advanced
clinical trials, even after promising results in earlier trials. 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 planned clinical trials (including ongoing and
anticipated clinical trials of KOS-862, 17-AAG, KOS-953, 17-DMAG and other product candidates) will begin on time or whether any of our clinical trials (including ongoing and anticipated clinical trials of KOS-862, 17-AAG, KOS-953, 17-DMAG and other
product candidates) 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 repeated or a program to be terminated. We have two product
candidates in human clinical trials for the treatment of cancer. Anticancer drugs generally have a narrow therapeutic window between efficacy and toxicity. If unacceptable toxicity is observed in clinical trials, the trials may be terminated at an
early stage. Drug-related deaths may occur in clinical trials with anticancer drugs, because drugs for the treatment of cancer are typically dangerous and cancer patients are critically ill.



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, 17-AAG, KOS-953, 17-DMAG and other product
candidates) may be suspended at any time, if we or the FDA believe the patients participating in our studies are exposed to unacceptable health risks. Our commencement and rate of completion of clinical trials may be delayed 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;
| | - | --------------------------------------------------------------------------------------



| |  | failure of the FDA to approve our clinical trial protocols;
| | - | -----------------------------------------------------------



| |  | slower than expected rate of patient recruitment;
| | - | -------------------------------------------------



| |  | adverse medical events or the death of patients during a clinical trial for a variety of reasons, including the advanced status of their disease and medical problems that are not
related to our product candidates;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | inconclusive or negative results experienced during the clinical trial;
| | - | -----------------------------------------------------------------------



| |  | 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
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | government or regulatory delays.
| | - | --------------------------------



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



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the commercial prospects for our products will be harmed, and our ability to become profitable will be delayed. If any
current or future clinical trials (including ongoing and anticipated clinical trials of KOS-862, 17-AAG, KOS-953, 17-DMAG and 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 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. Failure to obtain regulatory approval for a product candidate will prevent us from commercializing the product candidate. We have not received
regulatory approval to market any of our product candidates in any jurisdiction and have only limited experience in preparing and filing the applications necessary to gain regulatory approvals. 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.



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. Even if the FDA 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. The FDA also may impose various civil or criminal sanctions for failure to comply with regulatory requirements, including withdrawal of product approval.



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 has 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. Any clinical trial may fail to produce results satisfactory to the FDA. 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 for marketing approval of a product candidate, it may not result in marketing approval from the FDA.



We do not know whether our existing or any future clinical trials (including
ongoing and anticipated clinical trials of KOS-862, 17-AAG, KOS-953, 17-DMAG and 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.



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



If third parties do not
successfully carry out their contractual duties or meet expected deadlines, we will not be able to obtain or may be delayed in obtaining regulatory approvals for our product candidates and will not be able to or may be delayed in our efforts to
successfully commercialize our product candidates for targeted diseases. 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



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and clinical investigators to perform this function. If these third parties do not perform satisfactorily, our clinical
trials may be extended or delayed. We may not be able to locate any necessary acceptable replacements or enter into favorable agreements with them, if at all.



If our manufacturing or formulation facilities encounter delays or disasters or become unavailable and our inventories are insufficient to meet our needs during the
time required to overcome a problem or establish alternative arrangements, then clinical development of our product candidates may be delayed or suspended, submissions for their regulatory approval may be delayed and we may be unable to meet demand
for any products that we may successfully develop and lose potential revenue.



We rely in some cases, and in the future may rely upon, single sources for key intermediates, active pharmaceutical ingredients and formulated drug product for our product candidates. Currently, we are the sole
manufacturer of the active pharmaceutical ingredient for KOS-862, and we use a single outside contractor to formulate drug product for KOS-862. We (or, with respect to KOS-862, Roche) currently maintain limited inventories of the active
pharmaceutical ingredient for KOS-862 at our facilities in Hayward, California and of formulated drug product for KOS-862 at a total of three locations (including our facility in Hayward). In our geldanamycin program, we currently use a single
manufacturer to make the active pharmaceutical ingredient 17-AAG and formulate drug product for KOS-953 both at our own facility and through a contract manufacturer. We currently maintain a limited inventory of KOS-953 in two locations. The NCI is
responsible for formulation of drug product for its clinical work with 17-AAG, and the NCI is not obligated to maintain an inventory of either the active pharmaceutical ingredient or formulated drug product for 17-AAG. If any of our manufacturing or
inventory facilities or relationships encounter delays, are destroyed or otherwise become unavailable, then the clinical development of our product candidates (including KOS-862, 17-AAG, KOS-953 and 17-DMAG) or submissions for their regulatory
approval could be delayed or precluded, and our ability to deliver on a timely basis any products that we may develop could be impaired or precluded. This potential delay would be particularly acute if problems arise with our sole sourcing and
inventory relationships. 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.



We currently rely upon in some cases, and in the future may rely upon, outside contractors to manufacture and supply to us
key intermediates, active pharmaceutical ingredients and formulated drug product for our product candidates. Our future contract manufacturers may not be in the United States, and some of our current manufacturers are not in the United States. Our
current dependence upon others for the manufacture of our product candidates and components thereof, and our anticipated dependence upon others for the manufacture of any products that we may develop, 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. In addition, when we use contract
manufacturers outside the United States, the certainty of our supply may be diminished due to importation and customs issues 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 adequately could harm
our 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. 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.



The patent positions of biotechnology companies, including our patent position, involve complex legal and factual questions, and, therefore, validity and
enforceability cannot be predicted with certainty. Patents may be challenged, deemed unenforceable, invalidated or circumvented. 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.



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 both 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 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 17-AAG based products. 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.



We rely upon trade secret protection for our confidential information. We have taken measures to protect our confidential
information. However, these measures may not provide adequate protection for our trade secrets. We seek to protect our confidential information by entering into confidentiality agreements with employees, collaborators and consultants. Nevertheless,
we may not be able to protect adequately our trade secrets.



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Litigation or other proceedings or third-party claims of intellectual property infringement would require us to spend
time and money and could prevent us from developing or commercializing products.



Our commercial success depends in part 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.
Others have filed patent applications and issued patents, and in the future are likely to continue to file patent applications and cause to be issued patents, claiming drug candidates that we are developing and genes, gene fragments, compounds and
technologies we use or may wish to use. If we wish to use the claimed technology in issued and unexpired patents owned by others, we may need to obtain a license from another party, enter into litigation or incur the risk of litigation.



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 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 to operate as we would like to. Others may sue us in the future to challenge our patent or other intellectual property rights or claim infringement or misappropriation of their patents or other intellectual property
rights or a breach of license agreements, or we may be required to commence legal proceedings to resolve our patent or other intellectual property rights. In particular, we recently settled litigation between us and Sloan-Kettering regarding our
August 2000 research and license agreement. Under the terms of the settlement, pending litigation has been dismissed, and we and Sloan-Kettering have agreed that rights to epothilone analogs that were in dispute are included in the exclusive license
Sloan-Kettering granted to us in the research and license agreement, and that so long as we make the payments required under the settlement, Sloan-Kettering does not have the right to terminate that agreement (including our exclusive license from
Sloan-Kettering for KOS-862) on the basis of any alleged breach prior to the settlement. An adverse determination in any other litigation or in administrative proceeding to which we may become a party could subject us to significant liabilities to
others, result in our patents being deemed invalid, unenforceable or revoked, require us to license disputed rights from others or require us 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 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 in the United States. 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 relating to erythromycin
polyketide synthase genes, methods for altering polyketide synthase genes and erythromycin analogs and derivatives. In addition, the European patent office has recently published a notice of its intent to grant a patent on an application that we
believe to be licensed to Bristol-Myers Squibb and that if issued, valid and enforceable would cover Epothilone D. We intend to and are preparing to oppose the grant of this patent. 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



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is favorable, and if the outcome is unfavorable, we could be required to license the other partys rights, at 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 commercializing products.



If we are unable to recruit and retain skilled employees, we may not be able to achieve
our objectives.



Retaining our current employees and
recruiting qualified scientific personnel to perform future research and development work will be critical to our success. Competition is intense for experienced scientists, and we may not be able to retain or recruit sufficient skilled personnel to
allow us to pursue collaborations and develop our products and core technologies to the extent otherwise possible. Additionally, we are highly dependent on the principal members of our management and scientific staff, such as our two co-founders,
the loss of whose services would adversely impact the achievement of our objectives. Although we maintain and are the beneficiary of $1.0 million key-man life insurance policies for the lives of each of our two co-founders, Daniel V. Santi, M.D.,
Ph.D., our chairman and chief executive officer, and Chaitan S. Khosla, Ph.D., a director and consultant, we do not believe the proceeds would be adequate to compensate us for their loss.



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 technologies



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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) and Novartis AG (reported to be in Phase II clinical trials). 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. In addition, to compete effectively, our products must be easy to use, cost-effective and economical to manufacture on a commercial scale. 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 be able to develop technologies and products more easily, which would render our technologies and products and those of our collaborators obsolete and noncompetitive.



If we face liability claims in clinical trials of a drug candidate, these claims will
divert our managements time and we will incur litigation costs.



We face an inherent business risk of clinical trial liability claims in the event that the use or misuse of our potential products results in personal injury or death. We may experience clinical trial liability claims
if our drug candidates are misused or cause harm before regulatory authorities approve them for marketing. Even though we have obtained clinical trial liability insurance, it may not be sufficient to cover claims that may be made against us.
Clinical trial 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 financial
condition, 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, 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 believe that our current operations comply in
all material respects with these laws and regulations. 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.



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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.



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 27% of our outstanding common stock as of December 31, 2003. 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 2003, our common stock traded between $4.42 and $10.30 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 us or our competitors;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | domestic and international regulatory developments;
| | - | ---------------------------------------------------



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| |  | achievement of regulatory approvals;
| | - | ------------------------------------



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



| |  | changes in financial estimates by securities analysts;
| | - | ------------------------------------------------------



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



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



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



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



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 milestones and royalties;
| | - | --------------------------------------------------------------------



| |  | 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.
| | - | -------------------------------------------------------------------------------------------------------



A large portion of our expenses is relatively fixed, including expenses for facilities, equipment and personnel.
Accordingly, if revenues decline or do not grow due to expiration or termination of research contracts 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.



If we fail to obtain the capital
necessary to fund our operations, we will be unable to successfully develop products.



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 terms favorable to
our stockholders or us. 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.



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We believe 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 2006. We have based this estimate on assumptions that may prove to be wrong. Our future capital requirements depend on many factors that affect our research, development,
collaboration and sales and marketing activities. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations.



We may raise additional financing through public or private equity offerings, debt financings or additional corporate
collaboration or licensing arrangements or any combination of the foregoing. To the extent we raise additional capital by issuing equity securities, our stockholders may experience dilution. To the extent that we raise additional funds through
collaboration and licensing arrangements, it may be necessary to relinquish some rights to our technologies or product candidates, or grant licenses on terms that are not favorable to us. If adequate funds are not available, we will not be able to
continue developing our products or financing our operations.



Employees



As of February 29, 2004, we had 134 full-time employees,
52 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, 2004, are as follows:



|                                    |  |     |  |                                                                                           
|----------------------------------- |  | --- |  | ------------------------------------------------------------------------------------------
|Name                                |  | Age |  | Title                                                                                     
|Daniel V. Santi, M.D., Ph.D.        |  | 62  |  | Chairman and Chief Executive Officer                                                      
|Michael S. Ostrach                  |  | 52  |  | President and Chief Operating Officer                                                     
|Robert G. Johnson, Jr., M.D., Ph.D. |  | 52  |  | Senior Vice President, Medical Affairs and Corporate Development and Chief Medical Officer
|Susan M. Kanaya                     |  | 41  |  | Senior Vice President, Finance, Chief Financial Officer and Secretary                     
|Dorian L. Rinella                   |  | 55  |  | Vice President, Human Resources and Facilities                                            
|Bruce A. Chabner, M.D.              |  | 63  |  | Director                                                                                  
|Peter Davis, Ph.D.                  |  | 59  |  | Director                                                                                  
|Jean Deleage, Ph.D.                 |  | 63  |  | Director                                                                                  
|Charles J. Homcy, M.D.              |  | 55  |  | Director                                                                                  
|Chaitan S. Khosla, Ph.D.            |  | 39  |  | Director                                                                                  
|Christopher T. Walsh, Ph.D.         |  | 60  |  | 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 with



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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.



Michael S. Ostrach has served as our President and Chief Operating Officer since January 2002. From October 1998 to January 2002, Mr. Ostrach served as our Chief Operating Officer. Prior to joining Kosan in October 1997 as Vice
President, Corporate Development, Mr. Ostrach worked as an independent consultant for biotechnology companies from October 1996 to October 1997. Mr. Ostrach was Executive Vice President and Chief Operating Officer of Neurobiological Technologies,
Inc., a publicly held biotechnology company, from 1994 to 1996. From 1993 to 1994, Mr. Ostrach worked as a consultant to a number of biotechnology companies. From 1981 to 1991, he was a Senior Vice President at Cetus Corporation, a biotechnology
company. In 1991, Cetus Corporation merged into Chiron Corporation, and during 1992, Mr. Ostrach was a Vice President of Chiron Corporation and a founder and the President of Chiron Technologies, a Chiron business unit. Mr. Ostrach received a B.A.
from Brown University and a J.D. from Stanford Law School.



Robert G. Johnson, Jr., M.D., Ph.D., has served as our Senior Vice President, Medical Affairs and Corporate Development and Chief Medical Officer since January 2003 and as our Senior Vice President, Medical Affairs and Corporate
Development since January 2002. From September 2000 to January 2002, Dr. Johnson served as our 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 a B.A., a Ph.D. in biophysics and an M.D. each 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 appointed Secretary in June 2001. 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.



Dorian L. Rinella has served as our Vice President, Human Resources
and Facilities since February 2004. From 1991 to 2003, Ms. Rinella was employed by SUGEN, Inc., a Pharmacia Company that merged with Pfizer Inc, serving in several management positions, most recently as Senior Vice President of Operations. Before
joining SUGEN, Ms. Rinella held positions at Doric Development, a real estate development firm, and Bio-Rad Laboratories, a manufacturer and distributor of life science research and clinical products.



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 numerous
awards, including Phi Beta



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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 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 is 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
Crucell, N.V., Rigel Pharmaceuticals, 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, a biopharmaceutical company. Dr. Homcy received an A.B. in Biology and a M.D. from Johns Hopkins University.



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 co-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 100 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. He is 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 co-chairman of our
SAB and a member of our board of directors.



Christopher T.
Walsh, Ph.D., is co-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.



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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.



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.



Available Information



We maintain a website at www.kosan.com; however, information found on 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.



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 and Related Stockholder Matters



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:



|               |  |      |       |     |   |     
|-------------- |  | ---- | ----- | --- | - | ----
|               |  | High |       | Low
|2003           |  |      |       |     |   |     
|Fourth Quarter |  | $    | 10.30 |     | $ | 8.15
|Third Quarter  |  | $    | 8.81  |     | $ | 5.90
|Second Quarter |  | $    | 7.57  |     | $ | 4.44
|First Quarter  |  | $    | 6.25  |     | $ | 4.42
|               |  |     
|2002           |  |      |       |     |   |     
|Fourth Quarter |  | $    | 6.72  |     | $ | 5.75
|Third Quarter  |  | $    | 8.01  |     | $ | 5.71
|Second Quarter |  | $    | 9.25  |     | $ | 7.03
|First Quarter  |  | $    | 9.02  |     | $ | 6.73



As of February 29,
2004, there were approximately 146 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.



Information concerning securities authorized for issuance under equity compensation plans is contained in our definitive Proxy Statement with respect to our 2004 Annual Meeting of Stockholders, to be filed with the SEC before April 30,
2004, under the caption Equity Compensation Plan Information, and is incorporated herein by reference.



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. The managing underwriters of our offering were Lehman Brothers, CIBC World Markets, SG Cowen and Fidelity Capital Markets.



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.



We intend to use the net proceeds from our initial
public offering of common stock for advancing our drug candidates through preclinical and later stage development, discovering or acquiring new drug candidates, expanding our technology platform, capital expenditures, working capital, general
corporate



30



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purposes and possible future acquisitions. Of the net proceeds, through December 31, 2003, approximately $45.3 million
had been used for general corporate purposes and approximately $6.2 million had been used to purchase property and equipment, net of proceeds from equipment financing arrangements and principal payments under those arrangements. Pending such uses,
the balance has been invested in U.S. Treasury and government agency obligations, investment-grade asset-backed securities and corporate obligations.



Item 6.Selected Financial Data



The statement of operations data for each of the years ended December 31, 2003, 2002 and 2001, and the balance sheet data as of December 31, 2003 and 2002, 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 auditors. We have derived the statement of operations data for the years ended December 31, 2000 and 1999, and the balance sheet data
as of December 31, 2001, 2000 and 1999 from our audited financial statements that we do not include 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.



|                                                                                           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|------------------------------------------------------------------------------------------ |  | ------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------ | -
|                                                                                           |  | Year Ended December 31,               |        
|                                                                                           |  | 2003                                  |         |   | 2002 |   |         | 2001 |  |   | 2000    |   |  | 1999 |        
|                                                                                           |  | (in thousands, except per share data) |        
|Statement of Operations Data:                                                              |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Contract revenue                                                                           |  | $                                     | 28,482  |   |      | $ | 7,269   |      |  | $ | 3,522   |   |  | $    | 3,784   |   |  | $ | 5,206  |  
|Grant revenue                                                                              |  |                                       | 2,907   |   |      |   | 2,334   |      |  |   | 1,654   |   |  |      | 446     |   |  |   | 140    |  
|                                                                                           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Total revenues                                                                             |  |                                       | 31,389  |   |      |   | 9,603   |      |  |   | 5,176   |   |  |      | 4,230   |   |  |   | 5,346  |  
|Operating expenses:                                                                        |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Research and development (1)                                                               |  |                                       | 36,789  |   |      |   | 28,378  |      |  |   | 25,533  |   |  |      | 17,579  |   |  |   | 8,587  |  
|General and administrative (1)                                                             |  |                                       | 5,137   |   |      |   | 4,932   |      |  |   | 5,202   |   |  |      | 4,171   |   |  |   | 1,813  |  
|                                                                                           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Total operating expenses                                                                   |  |                                       | 41,926  |   |      |   | 33,310  |      |  |   | 30,735  |   |  |      | 21,750  |   |  |   | 10,400 |  
|                                                                                           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Loss from operations                                                                       |  |                                       | (10,537 | ) |      |   | (23,707 | )    |  |   | (25,559 | ) |  |      | (17,520 | ) |  |   | (5,054 | )
|Interest and other income, net                                                             |  |                                       | 869     |   |      |   | 2,843   |      |  |   | 3,686   |   |  |      | 2,444   |   |  |   | 653    |  
|                                                                                           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Net loss                                                                                   |  |                                       | (9,668  | ) |      |   | (20,864 | )    |  |   | (21,873 | ) |  |      | (15,076 | ) |  |   | (4,401 | )
|Deemed dividend upon issuance of Series C convertible preferred stock                      |  |                                       |        |   |      |   |        |      |  |   |        |   |  |      | (11,267 | ) |  |   |       |  
|                                                                                           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Net loss attributable to common stockholders                                               |  | $                                     | (9,668  | ) |      | $ | (20,864 | )    |  | $ | (21,873 | ) |  | $    | (26,343 | ) |  | $ | (4,401 | )
|                                                                                           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Basic and diluted net loss per common share                                                |  | $                                     | (0.38   | ) |      | $ | (0.84   | )    |  | $ | (0.91   | ) |  | $    | (2.81   | ) |  | $ | (0.98  | )
|                                                                                           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Shares used in computing basic and diluted net loss per common share                       |  |                                       | 25,567  |   |      |   | 24,906  |      |  |   | 24,164  |   |  |      | 9,387   |   |  |   | 4,509  |  
|                                                                                           |  |                                       |         |   |     
|Pro forma basic and diluted net loss per common share (unaudited)                          |  |                                       |         |   |      |   |         |      |  |   |         |   |  | $    | (1.44   | ) |  | $ | (0.31  | )
|                                                                                           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Shares used in computing pro forma basic and diluted net loss per common share (unaudited) |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      | 18,259  |   |  |   | 4,318  |  
|                                                                                           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  

---

|(1) | Includes non-cash charges for stock-based compensation as follows:
|--- | ------------------------------------------------------------------



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|                                                                    |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|------------------------------------------------------------------- |  | ------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                                                                    |  | Year Ended December 31,               |        
|                                                                    |  | 2003                                  |         |   | 2002 |   |         | 2001 |  |   | 2000    |   |  | 1999 |        
|                                                                    |  | (in thousands, except per share data) |        
|Research and development                                            |  | $                                     | 695     |   |      | $ | 2,782   |      |  | $ | 5,452   |   |  | $    | 6,507   |   |  | $ | 964     |  
|General and administrative                                          |  |                                       | 232     |   |      |   | 656     |      |  |   | 1,273   |   |  |      | 1,703   |   |  |   | 181     |  
|                                                                    |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                    |  | $                                     | 927     |   |      | $ | 3,438   |      |  | $ | 6,725   |   |  | $    | 8,210   |   |  | $ | 1,145   |  
|                                                                    |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Balance Sheet Data:                                                 |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Cash, cash equivalents and short-term investments                   |  | $                                     | 81,459  |   |      | $ | 53,451  |      |  | $ | 77,441  |   |  | $    | 85,738  |   |  | $ | 2,022   |  
|Working capital                                                     |  |                                       | 75,773  |   |      |   | 48,748  |      |  |   | 72,405  |   |  |      | 82,043  |   |  |   | 750     |  
|Long-term investments                                               |  |                                       | 23,840  |   |      |   | 27,087  |      |  |   | 12,902  |   |  |      | 17,003  |   |  |   | 8,442   |  
|Total assets                                                        |  |                                       | 123,189 |   |      |   | 91,590  |      |  |   | 95,812  |   |  |      | 107,571 |   |  |   | 14,157  |  
|                                                                    |  |                                       |         |   |     
|Deferred revenue, current portion                                   |  |                                       | 5,625   |   |      |   | 2,500   |      |  |   | 999     |   |  |      | 619     |   |  |   | 409     |  
|Deferred revenue, less current portion                              |  |                                       | 15,234  |   |      |   | 9,271   |      |  |   |        |   |  |      |        |   |  |   |        |  
|Capital lease obligations and equipment loans, less current portion |  |                                       | 2,701   |   |      |   | 1,796   |      |  |   | 1,568   |   |  |      | 1,975   |   |  |   | 1,591   |  
|Accumulated deficit                                                 |  |                                       | (79,074 | ) |      |   | (69,406 | )    |  |   | (48,542 | ) |  |      | (26,669 | ) |  |   | (11,593 | )
|Stockholders equity                                                |  |                                       | 89,452  |   |      |   | 70,840  |      |  |   | 88,591  |   |  |      | 101,365 |   |  |   | 10,471  |  



New Accounting Standards



In November 2002, the FASB issued Emerging Issues Task
Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (EITF 00-21). EITF 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services
and/or rights to use assets. The provisions of EITF 00-21 applied to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have an impact upon the Companys financial statements.



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 have proprietary technologies for the manipulation and
production of polyketides, a rich source of pharmaceutical products. We use our 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, we are testing KOS-862 (Epothilone D), a potential anticancer agent, in Phase II and Phase Ib clinical trials. We are developing geldanamycin derivatives as anticancer agents and are collaborating with the National Cancer
Institute, or NCI, to test one of them, 17-AAG, which is in Phase I and Phase Ib clinical trials being conducted by us and the NCI. We also have additional product candidates in the areas of cancer, infectious diseases and gastrointestinal motility
that are undergoing preclinical evaluation and several early stage product and research technology development programs.



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We have incurred significant losses since our inception. As of December 31, 2003, our accumulated deficit
was $79.1 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 accounting principles generally accepted in the United States. 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, investments, intangible assets, income taxes, 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, 2003, we had $20.9 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 2007, the estimated clinical development period, which remains unchanged from the time the original estimate was determined in
the fourth quarter of 2002. 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 research and 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.



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 $619,000 in 2003, $1.4 million in 2002 and $681,000 in 2001. In addition, assuming no changes, we expect to recognize other stock-based compensation in connection with stock options
granted to non-employees of approximately $834,000 in 2004, $362,000 in 2005, $240,000 in 2006, $116,000 in 2007 and $80,000 in 2008. The measurement of stock-based compensation to non-employees



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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 our stock price would translate into a 60% increase in the related estimated expenses above. See Notes 1 and 10 of our financial
statements.



Results of Operations



Years Ended December 31, 2003 and 2002



Revenue. Our revenues increased to approximately $31.4 million in
2003 from approximately $9.6 million in 2002. This increase was primarily due to approximately $26.9 million in contract revenue recognized under our development and commercialization agreement with Roche, of which $3.4 million represented the
ratable portion of a $25.0 million initial fee that is being recognized through the second half of 2007, the estimated clinical development period, and $6.0 million in non-recurring milestones. The remaining amount consisted of reimbursement of
research and development expenses, including clinical trials conducted by us and clinical trial materials purchased by Roche from us. Total contract revenues under our collaboration agreement with Johnson & Johnson Pharmaceutical Research and
Development, LLC, or J&JPRD, were approximately $1.2 million in 2003, compared to approximately $2.9 million in 2002. Included in 2003 revenues was approximately $250,000 related to a non-recurring milestone payment received in connection with
this collaboration. This collaboration expired in December 2003 and no additional revenues will be generated under this agreement. Further, if we do not maintain or extend our agreement with Roche, our revenues will significantly decrease unless we
enter into additional collaborations that provide substantial revenues.



In addition, we recognized approximately $2.9 million in grant revenue in 2003, compared to approximately $2.3 million in 2002. This increase was primarily due to additional government grants awarded during the year.



Research and Development Expenses. Our research and development
expenses increased to approximately $36.8 million in 2003 from approximately $28.4 million in 2002. The approximately $8.4 million increase in 2003 as compared to 2002 was due in large part to an approximately $4.1 million increase in 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 of this increase was
associated with higher licensing-related expenses and the settlement of the litigation with Sloan-Kettering representing the reimbursement of research expenses related to the epothilone analog program. Also contributing to the year-to-year increase
was an approximately $2.2 million increase in research and development salaries and other personnel-related expenses due to internal growth, and an approximately $1.5 million increase in allocated facilities and expansion costs. These increases were
partly offset by an approximately $2.1 million decrease in stock-based compensation.



Research and development expenses consisted 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 allocate salary-driven and space-use-driven overhead expenses to research and development and to general and administrative expenses based on
salaries and space-use by each respective area. Our research and development employees increased to 110 in 2003 from 90 in 2002. We expect our research and development expenses will increase substantially as KOS-862 and 17-AAG advance further into
the clinic, and as we advance our research programs into later stages of development.



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



|                                    |  |                                      |  |                                                      
|----------------------------------- |  | ------------------------------------ |  | -----------------------------------------------------
|Product Candidate                   |  | Status                               |  | Commencement of Current Phase                        
|KOS-862                             |  | Phase II clinical trials             |  | Commenced in fourth quarter of 2003                  
|                                    |  |                                     
|KOS-862                             |  | Phase Ib combination clinical trials |  | Commenced in first quarter of 2004                   
|                                    |  |                                     
|17-AAG                              |  | Phase Ib combination clinical trials |  | Commenced in fourth quarter of 2003                  
|                                    |  |                                     
|KOS-953 (new formulation of 17-AAG) |  | Phase I/II clinical trials           |  | Anticipated to commence in the second quarter of 2004
|                                    |  |                                     
|17-DMAG                             |  | Phase I clinical trials              |  | Anticipated to commence in the second quarter of 2004



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 Investigational New Drug, or IND, filing varies significantly and is difficult to predict and therefore not reflected
in the table above.



Roche is responsible for the costs of the
epothilone clinical trails (currently, trials of KOS-862) conducted under our collaboration. We are responsible at our cost to supply 17-AAG for clinical trials sponsored by NCI under the CRADAs, and NCI is responsible for the remainder of the costs
of these trials through Phase II. In addition, we may sponsor other clinical trials of geldanamycin analogs at our sole expense.



General and Administrative Expenses. General and administrative expenses increased to approximately $5.1 million in 2003 from approximately $4.9
million in 2002. The increase in 2003 compared to 2002 was due to an approximately $321,000 increase in employee-related expenses to support our expanding research and development activities, an approximately $169,000 increase in professional and
outside services for corporate governance and Sarbanes-Oxley related expenses and an approximately $138,000 increase in facility-related allocations in connection with the expansion of our facilities. These increases were 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. The number of our general and administrative employees remained unchanged at 22 at
December 31, 2003 as compared to December 31, 2002. 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 income decreased to approximately $1.2
million in 2003 from approximately $2.2 million in 2002. This decrease was attributable to lower investment yields associated with a continued depressed interest rate environment and lower average investment balances during the year.



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Interest Expense. Interest expense decreased to approximately $337,000 in 2003 from approximately
$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.



Years Ended December 31, 2002 and 2001



Revenue. Our revenues increased to approximately $9.6 million in 2002 from approximately $5.2 million in 2001. This increase was primarily due to
approximately $3.4 million in contract revenue recognized under our development and commercialization agreement with Roche, of which $730,000 represented the ratable portion of the first of two $12.5 million installments of an initial fee that is
being recognized through the second half of 2007, the estimated clinical development period. In addition, we recognized approximately $2.3 million in grant revenue in 2002, compared to approximately $1.7 million in 2001. Total contract revenues
under our collaboration agreement with J&JPRD were approximately $2.9 million in 2002, compared to approximately $3.2 million in 2001. Included in 2001 revenues was a non-recurring $250,000 milestone payment received in connection with this
collaboration.



Research and Development Expenses.
Research and development expenses increased to approximately $28.4 million in 2002 from approximately $25.5 million in 2001. This increase, partially offset by the decrease in stock-based compensation in 2002, was due in large part to our expanded
research and development efforts, including three Phase I clinical trials of KOS-862, related licensing expenses and additional staffing in support of our continued investment in internally funded programs and technologies. Our research and
development employees increased to 90 in 2002 from 76 in 2001.



General and Administrative Expenses. General and administrative expenses decreased to approximately $4.9 million in 2002 from approximately $5.2 million in 2001. The decrease was due to lower stock-based
compensation expense in 2002, compared to 2001, partially offset by higher employee-related expenses to support our expanding research and development activities. Our general and administrative employees increased to 22 in 2002 from 20 in 2001.



Interest Income.Interest income decreased to
approximately $2.2 million in 2002 from approximately $5.0 million in 2001. This decrease was attributable to lower average investment balances and lower investment yields associated with the declining interest rate environment.



Interest Expense. Interest expense increased to approximately $356,000
in 2002 from approximately $349,000 in 2001. This increase resulted from additional debt financing of property and equipment during 2002.



Gain/(Loss) on the Recovery or Write-Down 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, 2003, 2002 and 2001 and consequently did not pay federal, state or foreign income taxes.
As of December 31, 2003, we had federal net operating loss carryforwards of approximately $36.0 million. We also had federal research



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and development tax credit carryforwards of approximately $3.2 million. If not utilized, the net operating losses and
credit carryforwards will expire at various dates beginning in 2010 through 2023. 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.



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, 2003, we had received
approximately $148.2 million from the sales of convertible preferred and common stock, approximately $69.3 million from contract payments received under our corporate collaboration agreements and government grant awards, approximately $12.7 million
from interest income and approximately $10.4 million from equipment financing arrangements. As of December 31, 2003, we had approximately $105.3 million in cash and investments, compared to approximately $80.5 million as of December 31, 2002. Our
funds are currently invested in U.S. Treasury and government agency obligations and corporate obligations.



Cash provided by operating activities was approximately $1.9 million in 2003, compared to cash used of approximately $6.9 million in 2002. Our net loss of
approximately $9.3 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 and 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. We
do not anticipate to generate cash from operating activities for the next several years. Our net loss of approximately $20.9 million in 2002 was partially offset by the receipt of the first of two $12.5 million installments of an initial fee from
Roche and non-cash expenses of approximately $5.8 million related to stock-based compensation and depreciation and amortization of investment premiums and discounts.



Our investing activities, excluding changes in our investments, for the year ended December 31, 2003, used cash of
approximately $4.3 million, compared to approximately $3.6 million in 2002, reflecting approximately $1.9 million related to the renovation of our facilities and approximately $2.4 million related to the purchase of additional laboratory and office
equipment. Investing activities in 2002, excluding changes in our investments, reflected approximately $1.4 million related to the renovation and expansion of our facilities and approximately $2.2 million related to the purchase of additional
laboratory and office equipment. We expect to continue our purchases of equipment and leasehold improvements in 2004 related to the enhancement and expansion of our leased facilities.



Cash provided by financing activities was approximately $28.7 million for the year ended December 31, 2003, compared to
approximately $1.3 million in 2002. 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. Financing activities in 2002 included approximately $2.2 million of equipment financing, which was offset by
scheduled payments on new and existing debt. Financing activities in 2001 included approximately $1.1 million of equipment financing, which was offset by scheduled payments on new and existing debt.



In April 2003, we entered into a $3.5 million equipment line of credit
agreement for facility improvements and capital purchases. As of December 31, 2003, we had utilized approximately $2.4 million of the line of credit leaving approximately $1.1 million available for future draws.



37



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##### Table of Contents

We believe that our existing cash, investments, and anticipated cash flow from our existing collaboration
will be sufficient to support our current operating plan into 2006. Our future capital uses and requirements depend on numerous forward-looking factors. These factors include, but are not limited to the following:



| |  | our ability to establish, and the scope of and revenues received under, any new collaborations;
| | - | -----------------------------------------------------------------------------------------------



| |  | the progress and number of research programs carried out by us;
| | - | ---------------------------------------------------------------



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



| |  | our ability to maintain our existing collaboration with Roche;
| | - | --------------------------------------------------------------



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



| |  | the costs and timing of our facilities expansion;
| | - | -------------------------------------------------



| |  | the costs and timing of regulatory approvals; 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, 2003, approximately $47.0 million remained available on the Form 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.



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



|                                   |  |                        |        |                  |   |           |  |           |       |              |   |       |  |   |      
|---------------------------------- |  | ---------------------- | ------ | ---------------- | - | --------- |  | --------- | ----- | ------------ | - | ----- |  | - | -----
|                                   |  | Payments Due by Period
|                                   |  | Total                  |        | Less than 1 Year |   | 1-3 Years |  | 4-5 Years |       | After 5Years
|                                   |  | (in thousands)        
|Equipment financing obligations    |  | $                      | 5,034  |                  | $ | 2,129     |  | $         | 2,589 |              | $ | 316   |  | $ |     
|Operating leases                   |  |                        | 12,455 |                  |   | 1,588     |  |           | 3,233 |              |   | 2,841 |  |   | 4,793
|                                   |  |                        |        |                  |   |           |  |           |       |              |   |       |  |   |      
|Total contractual cash obligations |  | $                      | 17,489 |                  | $ | 3,717     |  | $         | 5,822 |              | $ | 3,157 |  | $ | 4,793
|                                   |  |                        |        |                  |   |           |  |           |       |              |   |       |  |   |      



38



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##### Table of Contents

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, 2003 rates, the fair value of our portfolio would decline by approximately $566,000 on that date.



At June 30, 2001, we determined that an other-than-temporary decline in fair value of our investment in short-term commercial paper of Southern California
Edison, a utility company, had occurred. Accordingly, we recorded a $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 of $990,000 for the
year ended December 31, 2002.



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, 2003:



|                      |  |                                                  |        |   |      |   |        |      |  |   |      |   |  |      |      |       |  |   |            |  |   |        |   |  |   |       
|--------------------- |  | ------------------------------------------------ | ------ | - | ---- | - | ------ | ---- |  | - | ---- | - |  | ---- | ---- | ----- |  | - | ---------- |  | - | ------ | - |  | - | ------
|                      |  | 2004                                             |        |   | 2005 |   |        | 2006 |  |   | 2007 |   |  | 2008 |      | Total |  |   | Fair Value
|                      |  | (in thousands, except interest rate information)
|Debt securities:      |  |                                                  |        |   |      |   |        |      |  |   |      |   |  |      |      |       |  |   |            |  |   |        |   |  |   |       
|U.S. agency notes     |  | $                                                | 26,491 |   |      | $ | 13,100 |      |  | $ |     |   |  | $    |     |       |  | $ |           |  | $ | 39,592 |   |  | $ | 39,595
|Corporate bonds       |  |                                                  | 23,467 |   |      |   | 10,729 |      |  |   |     |   |  |      |     |       |  |   |           |  |   | 34,197 |   |  |   | 34,213
|Average interest rate |  |                                                  | 1.55   | % |      |   | 1.65   | %    |  |   |     |   |  |      |     |       |  |   |           |  |   | 1.58   | % |  |   |      
|                      |  |                                                  |        |   |      |   |       
|Equipment financing   |  |                                                  | 1,854  |   |      |   | 1,455  |      |  |   | 938  |   |  |      | 308  |       |  |   |           |  |   | 4,555  |   |  |   | 4,555 
|Average interest rate |  |                                                  | 8.05   | % |      |   | 7.46   | %    |  |   | 7.17 | % |  |      | 6.96 | %     |  |   |           |  |   | 7.60   | % |  |   |      



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.



Item 9A.Controls and Procedures



Evaluation of Disclosure Controls and Procedures. Based on their evaluation, 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)) were sufficiently effective as of December 31, 2003 to ensure that information required to be disclosed by us in this
Annual Report on Form 10-K was recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commissions rule and Form 10-K.



39



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##### Table of Contents

Changes in Internal Controls over Financial Reporting. There were no changes in our internal
controls over financial reporting during the twelve months ended December 31, 2003 that have materially affected, or are reasonably likely to 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 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. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some
persons, by collusion of two or more people or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any
design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because
of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Accordingly, our disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that
the objectives of our disclosure control system are met and, as set forth above, our chief executive officer and chief financial officer have concluded, based on their evaluation, that our disclosure controls and procedures were sufficiently
effective as of December 31, 2003 to provide reasonable assurance that the objectives of our disclosure control system were met.



40



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##### Table of Contents

Part III



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 2004 Annual Meeting of Stockholders to be
filed with the Securities and Exchange Commission not later than April 30, 2004 (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 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. Information concerning securities authorized for issuance under equity compensation plans will be contained in our Proxy Statement
under the caption Equity Compensation Plan Information, and is incorporated herein by reference.



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 will be 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.



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.



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##### Table of Contents

PART IV



Item 15.Exhibits, Financial Statement Schedules and Reports on Form 8-K



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



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



Report of Ernst & Young LLP, Independent Auditors

Balance Sheets - December 31, 2003 and 2002

Statements of Operations - Years Ended December 31, 2003, 2002, and 2001

Statement of Changes in Stockholders Equity - Years Ended December 31, 2003, 2002 and 2001

Statements of Cash Flows - Years Ended December 31, 2003, 2002 and 2001

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         |  | Bylaws of Registrant. (8)                                                                                                          
|            | 
|4.1         |  | Form of Registrants Common Stock Certificate. (2)                                                                                 
|            | 
|4.2         |  | Third Amended and Restated Registration Rights Agreement, dated March 30, 2000, between Registrant and certain stockholders. (2)   
|            | 
|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. (2)                
|            | 
|10.2        |  | 1996 Stock Option Plan, as amended. (2)*                                                                                           
|            | 
|10.3        |  | 2000 Employee Stock Purchase Plan and related agreements. (2)*                                                                     
|            | 
|10.4        |  | 2000 Non-Employee Director Stock Option Plan and related agreements, as amended. (6)*                                              
|            | 
|10.5        |  | Amended and Restated Consulting Agreement between Registrant and Chaitan Khosla, Ph.D., dated December 7, 1998. (2)*               
|            | 
|10.6        |  | Consulting Agreement between Registrant and Christopher Walsh, Ph.D., dated December 14, 1995. (2)*                                
|            | 
|10.7       |  | Research and License Agreement between Registrant and The Sloan-Kettering Institute for Cancer Research, dated August 25, 2000. (2)



42



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##### Table of Contents

|            |  |                                                                                                                                                                                                                                                                                                                                                           
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                               
|10.8       |  | License Agreement between Registrant and The Board of Trustees of The Leland Stanford Junior University, dated March 11, 1996. (2)                                                                                                                                                                                                                        
|            | 
|10.9       |  | 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. (2)
|            | 
|10.10      |  | License Agreement between Registrant and President and Fellows of Harvard College, dated December 2, 1998. (2)                                                                                                                                                                                                                                            
|            | 
|10.11      |  | Research and License Agreement between Registrant and Ortho-McNeil Pharmaceutical Corporation and The R.W. Johnson Pharmaceutical Research Institute, dated September 28, 1998.
(9)                                                                                                                                                                       
|            | 
|10.12      |  | Amendment No.1 to the Research and License Agreement between Registrant and Ortho-McNeil Pharmaceutical Corporation and The R.W. Johnson Pharmaceutical Research Institute, dated March 17,
2000. (2)                                                                                                                                                     
|            | 
|10.13       |  | Sublease Agreement between Registrant and Lynx Therapeutics, Inc., dated January 6, 1999. (2)                                                                                                                                                                                                                                                             
|            | 
|10.14       |  | Consent to Sublease Agreement between Spieker Properties L.P. and Lynx Therapeutics, Inc., dated September 17, 1999. (2)                                                                                                                                                                                                                                  
|            | 
|10.16       |  | Master Loan and Security Agreement between Registrant and Finova Technology Finance, Inc., dated August 25, 1998. (2)                                                                                                                                                                                                                                     
|            | 
|10.17       |  | Commitment Letter between Registrant and Finova Technology Finance, Inc., dated August 24, 1998. (2)                                                                                                                                                                                                                                                      
|            | 
|10.18       |  | Commitment Letter between Registrant and Finova Capital Corporation, dated January 6, 2000. (2)                                                                                                                                                                                                                                                           
|            | 
|10.24       |  | Employment Agreement between Registrant and Daniel V. Santi, M.D., Ph.D., dated November 1, 1998. (2)*                                                                                                                                                                                                                                                    
|            | 
|10.26       |  | Employment Agreement between Registrant and Susan M. Kanaya, dated October 11, 1999. (2)*                                                                                                                                                                                                                                                                 
|            | 
|10.28       |  | Form of Series C Stock Purchase Agreement between the Registrant and certain investors, dated March 30, 2000. (2)                                                                                                                                                                                                                                         
|            | 
|10.33¶     |  | Amendment No.2 to the Research and License Agreement between Registrant and The R.W. Johnson Pharmaceutical Research Institute and Ortho-McNeil Pharmaceutical, Inc., dated August 31, 2000.
(2)                                                                                                                                                          
|            | 
|10.34¶     |  | Employment Agreement between Registrant and Robert G. Johnson, Jr., dated September 5, 2000. (2)*                                                                                                                                                                                                                                                         
|            | 
|10.36      |  | Amendment No.3 to Research and License Agreement between Registrant and The R.W. Johnson Pharmaceutical Research Institute and Ortho-McNeil Pharmaceutical, Inc., dated September 28, 2001.
(3)                                                                                                                                                           
|            | 
|10.37       |  | 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. (3)                                                                                                                                                                               



43



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##### Table of Contents

|            |  |                                                                                                                                                                                                                                                                                                                                                                       
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                                           
|10.38       |  | Rights Agreement, dated as of October 5, 2001, between Registrant and Mellon Investor Services, LLC. (4)                                                                                                                                                                                                                                                              
|            | 
|10.40       |  | Amendment to Restated Promissory Note from Stockholder by and between Registrant and Daniel V. Santi, M.D., Ph.D., dated December 23, 2001. (5)*                                                                                                                                                                                                                      
|            | 
|10.41       |  | Lease Agreement, dated as of June 7, 2002, by and between EOP-Industrial Portfolio, L.L.C. and Registrant. (6)                                                                                                                                                                                                                                                        
|            | 
|10.42       |  | 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.
(6)                                                                                                                                                                                   
|            | 
|10.43      |  | Collaborative Research, Development and Commercialization Agreement, dated as of September 19, 2002, by and between Registrant and Hoffmann-La Roche, Inc. (7)                                                                                                                                                                                                        
|            | 
|10.44      |  | Consent to the License Agreement, effective as of September 16, 2002, by and between Registrant and Stanford University. (7)                                                                                                                                                                                                                                          
|            | 
|10.45      |  | Consent to the License Agreement, effective as of September 16, 2002, by and between Registrant and The Sloan-Kettering Institute for Cancer Research. (7)                                                                                                                                                                                                            
|            | 
|10.46      |  | Amendment No. 4 to Research and License Agreement between Registrant and The R.W. Johnson Pharmaceutical Research Institute and Ortho-McNeil Pharmaceutical, Inc., dated December 12, 2002.
(10)                                                                                                                                                                      
|            | 
|10.47      |  | Settlement Agreement, entered into September 19, 2003, by and between Registrant and The Sloan-Kettering Institute for Cancer Research. (11)                                                                                                                                                                                                                          
|            | 
|23.1        |  | Consent of Ernst & Young LLP, Independent Auditors.                                                                                                                                                                                                                                                                                                                   
|            | 
|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)                                                                                                                    
|            | 
|(b)         |  | Reports on Form 8-K                                                                                                                                                                                                                                                                                                                                                   
|            | 
|            |  | On October 24, 2003, we filed a Current Report on Form 8-K, in connection with the announcement of the Companys financial results for the quarter ended September 30,
2003.                                                                                                                                                                                          
|            | 
|            |  | On December 8, 2003, we filed a Current Report on Form 8-K, in connection with the announcement that the Company had initiated Phase II clinical trials of KOS-862 (Epothilone
D).                                                                                                                                                                                    
|            | 
|            |  | On December 10, 2003, we filed a Current Report on Form 8-K, in connection with the announcement that the Company entered into a Placement Agent Agreement with SG Cowen Securities
Corporation, CIBC World Markets Corp. and Adams, Harkness & Hill, Inc. relating to the solicitation of offers to purchase of up to 3,115,000 shares of the Companys common stock.



44



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##### Table of Contents

---

|(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 Registration Statement on Form S-1, Registration No. 333-33732.
|--- | ---------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended September 30, 2001.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|(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 annual report on Form 10-K for the year ended December 31, 2001.
|--- | ----------------------------------------------------------------------------------------------------------------------

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

|(7) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended September 30, 2002.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|(8) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended June 30, 2003.
|--- | -----------------------------------------------------------------------------------------------------------------------

|(9) | Incorporated herein by reference to an exhibit of our quarterly report on Form 10-Q for the period ended September 30, 2003.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|(10) | Incorporated herein by reference to an exhibit of our annual report on Form 10-K for the year ended December 31, 2002.
|---- | ----------------------------------------------------------------------------------------------------------------------

|(11) | Originally filed as exhibit 10.46 of our quarterly report on Form 10-Q for the period ended September 30, 2003 and incorporated herein by reference.
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------

|(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.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Confidential treatment has been requested 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.
|- | ------------------------------------------------------

|¶ | Exhibits 10.33 and 10.34 were originally filed as exhibits 10.34 and 10.35 of our Registration Statement on Form S-1, Registration No. 333-33732, and are incorporated herein by
reference.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



45



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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 12, 2004 |  | 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. |  | Chairman and Chief Executive Officer (Principal Executive Officer)                                                 |  | March 12, 2004
|Daniel V. Santi, M.D., Ph.D.     |  |                                                                                                                    |  |               
|                                 |  |                                                                                                                   
|/s/ Susan M. Kanaya              |  | Senior Vice President, Finance, Chief Financial
Officer and Secretary (Principal Financial and Accounting Officer) |  | March 12, 2004
|Susan M. Kanaya                  |  |                                                                                                                    |  |               



46



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|                                |  |          |  |               
|------------------------------- |  | -------- |  | --------------
|/s/ Bruce A. Chabner, M.D.      |  | Director |  | March 12, 2004
|Bruce A. Chabner, M.D.          |  |          |  |               
|                                |  |         
|/s/ Peter Davis, Ph.D           |  | Director |  | March 12, 2004
|Peter Davis, Ph.D.              |  |          |  |               
|                                |  |         
|/s/ Jean Deleage, Ph.D.         |  | Director |  | March 12, 2004
|Jean Deleage, Ph.D.             |  |          |  |               
|                                |  |         
|/s/ Charles J. Homcy, Ph.D.     |  | Director |  | March 12, 2004
|Charles J. Homcy, Ph.D.         |  |          |  |               
|                                |  |         
|/s/ Chaitan S. Khosla, Ph.D.    |  | Director |  | March 12, 2004
|Chaitan S. Khosla, Ph.D.        |  |          |  |               
|                                |  |         
|/s/ Christopher T. Walsh, Ph.D. |  | Director |  | March 12, 2004
|Christopher T. Walsh, Ph.D.     |  |          |  |               



47



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Kosan Biosciences Incorporated



INDEX TO FINANCIAL STATEMENTS



|                                                                                  |  |    
|--------------------------------------------------------------------------------- |  | ---
|Report of Ernst & Young LLP, Independent Auditors                                 |  | F-2
|                                                                                  | 
|Balance Sheets - December 31, 2003 and 2002                                       |  | F-3
|                                                                                  | 
|Statements of Operations - Years ended December 31, 2003, 2002 and 2001           |  | F-4
|                                                                                  | 
|Statements of Stockholders Equity - Years ended December 31, 2003, 2002 and 2001 |  | F-5
|                                                                                  | 
|Statements of Cash Flows - Years ended December 31, 2003, 2002 and 2001           |  | F-6
|                                                                                  | 
|Notes to Financial Statements                                                     |  | F-7



F-1



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##### Table of Contents

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS



The Board of Directors and Stockholders

Kosan Biosciences Incorporated



We have audited the accompanying balance sheets of Kosan Biosciences Incorporated as of December 31, 2003 and 2002, and the related statements of operations, stockholders equity, and cash flows for each of the three years in the
period ended December 31, 2003. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.



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



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



/s/ ERNST & YOUNG LLP



Palo Alto, California

February 10, 2004



F-2



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##### Table of Contents

Kosan Biosciences Incorporated



BALANCE SHEETS

(in thousands, except share and per share data)



|                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                                                                                                                                                                                                            |  | December 31, |        
|                                                                                                                                                                                                            |  | 2003         |         |   | 2002 |  
|Assets                                                                                                                                                                                                      |  |              |         |   |      |   |         |  
|Current assets:                                                                                                                                                                                             |  |              |         |   |      |   |         |  
|Cash and cash equivalents                                                                                                                                                                                   |  | $            | 31,491  |   |      | $ | 22,191  |  
|Short-term investments                                                                                                                                                                                      |  |              | 49,968  |   |      |   | 31,260  |  
|Accounts receivable                                                                                                                                                                                         |  |              | 9,022   |   |      |   | 3,874   |  
|Prepaid and other current assets                                                                                                                                                                            |  |              | 1,094   |   |      |   | 1,106   |  
|                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|Total current assets                                                                                                                                                                                        |  |              | 91,575  |   |      |   | 58,431  |  
|                                                                                                                                                                                                            |  |             
|Property and equipment, net                                                                                                                                                                                 |  |              | 7,317   |   |      |   | 5,368   |  
|Long-term investments                                                                                                                                                                                       |  |              | 23,840  |   |      |   | 27,087  |  
|Other assets and notes receivable from related parties                                                                                                                                                      |  |              | 457     |   |      |   | 704     |  
|                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|Total assets                                                                                                                                                                                                |  | $            | 123,189 |   |      | $ | 91,590  |  
|                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|Liabilities and Stockholders Equity                                                                                                                                                                        |  |              |         |   |      |   |         |  
|Current liabilities:                                                                                                                                                                                        |  |              |         |   |      |   |         |  
|Accounts payable                                                                                                                                                                                            |  | $            | 1,298   |   |      | $ | 1,790   |  
|Accrued liabilities                                                                                                                                                                                         |  |              | 7,025   |   |      |   | 3,681   |  
|Current portion of deferred revenue                                                                                                                                                                         |  |              | 5,625   |   |      |   | 2,500   |  
|Current portion of equipment loans                                                                                                                                                                          |  |              | 1,854   |   |      |   | 1,712   |  
|                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|Total current liabilities                                                                                                                                                                                   |  |              | 15,802  |   |      |   | 9,683   |  
|                                                                                                                                                                                                            |  |             
|Deferred revenue, less current portion                                                                                                                                                                      |  |              | 15,234  |   |      |   | 9,271   |  
|Equipment loans, less current portion                                                                                                                                                                       |  |              | 2,701   |   |      |   | 1,796   |  
|                                                                                                                                                                                                            |  |             
|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, 2003 and 2002 |  |              |        |   |      |   |        |  
|Common stock, $0.001 par value, 100,000,000 shares authorized, 28,752,535 and 25,392,309 shares issued and outstanding at December 31, 2003
and 2002, respectively                                          |  |              | 29      |   |      |   | 25      |  
|Additional paid-in capital                                                                                                                                                                                  |  |              | 168,668 |   |      |   | 142,424 |  
|Notes receivable from stockholders                                                                                                                                                                          |  |              |        |   |      |   | (1,221  | )
|Deferred stock-based compensation                                                                                                                                                                           |  |              | (192    | ) |      |   | (1,134  | )
|Accumulated other comprehensive income                                                                                                                                                                      |  |              | 21      |   |      |   | 152     |  
|Accumulated deficit                                                                                                                                                                                         |  |              | (79,074 | ) |      |   | (69,406 | )
|                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|Total stockholders equity                                                                                                                                                                                  |  |              | 89,452  |   |      |   | 70,840  |  
|                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|Total liabilities and stockholders equity                                                                                                                                                                  |  | $            | 123,189 |   |      | $ | 91,590  |  
|                                                                                                                                                                                                            |  |              |         |   |      |   |         |  



See accompanying notes.



F-3



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##### Table of Contents

Kosan Biosciences Incorporated



STATEMENTS OF OPERATIONS

(in thousands, except per share data)



|                                                                                                                   |  |                         |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------------------------------------ |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                   |  | Year Ended December 31, |        
|                                                                                                                   |  | 2003                    |         |   | 2002 |   |         | 2001 | 
|Revenues:                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|Contract revenue                                                                                                   |  | $                       | 28,482  |   |      | $ | 7,269   |      |  | $ | 3,522   |  
|Grant revenue                                                                                                      |  |                         | 2,907   |   |      |   | 2,334   |      |  |   | 1,654   |  
|                                                                                                                   |  |                         |         |   |      |   |         |      |  |   |         |  
|Total revenues                                                                                                     |  |                         | 31,389  |   |      |   | 9,603   |      |  |   | 5,176   |  
|                                                                                                                   |  |                         |        
|Operating expenses:                                                                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Research and development (including charges for stock-based compensation of $695, $2,782 and $5,452, respectively) |  |                         | 36,789  |   |      |   | 28,378  |      |  |   | 25,533  |  
|General and administrative (including charges for stock-based compensation of $232, $656 and $1,273, respectively) |  |                         | 5,137   |   |      |   | 4,932   |      |  |   | 5,202   |  
|                                                                                                                   |  |                         |         |   |      |   |         |      |  |   |         |  
|Total operating expenses                                                                                           |  |                         | 41,926  |   |      |   | 33,310  |      |  |   | 30,735  |  
|                                                                                                                   |  |                         |         |   |      |   |         |      |  |   |         |  
|Loss from operations                                                                                               |  |                         | (10,537 | ) |      |   | (23,707 | )    |  |   | (25,559 | )
|Interest income                                                                                                    |  |                         | 1,206   |   |      |   | 2,209   |      |  |   | 5,025   |  
|Interest expense                                                                                                   |  |                         | (337    | ) |      |   | (356    | )    |  |   | (349    | )
|Gain/(loss) on the recovery or write-down of investment                                                            |  |                         |        |   |      |   | 990     |      |  |   | (990    | )
|                                                                                                                   |  |                         |         |   |      |   |         |      |  |   |         |  
|Net loss                                                                                                           |  | $                       | (9,668  | ) |      | $ | (20,864 | )    |  | $ | (21,873 | )
|                                                                                                                   |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic and diluted net loss per common share                                                                        |  | $                       | (0.38   | ) |      | $ | (0.84   | )    |  | $ | (0.91   | )
|                                                                                                                   |  |                         |         |   |      |   |         |      |  |   |         |  
|Shares used in computing basic and diluted net loss per common share                                               |  |                         | 25,567  |   |      |   | 24,906  |      |  |   | 24,164  |  



See accompanying notes.



F-4



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##### Table of Contents

Kosan Biosciences Incorporated



STATEMENT OF STOCKHOLDERS EQUITY

(in thousands, except shares)



|                                                                                                    |  |                             |  |              |   |                            |            |   |                                    |   |    |                                   |   |         |                                               |  |   |                           |   |  |                      |         |   |  |   |        |   |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------------------------------------- |  | --------------------------- |  | ------------ | - | -------------------------- | ---------- | - | ---------------------------------- | - | -- | --------------------------------- | - | ------- | --------------------------------------------- |  | - | ------------------------- | - |  | -------------------- | ------- | - |  | - | ------ | - |  | - | ------- | - |  | - | ------- | -
|                                                                                                    |  | Convertible Preferred Stock |  | Common Stock |   | Additional Paid-In Capital |            |   | Notes Receivable From Stockholders |   |    | Deferred Stock-Based Compensation |   |         | Accumulated Other Comprehensive Loss/(Income) |  |   | Total Accumulated Deficit |   |  | Stockholders Equity |        
|                                                                                                    |  | Shares                      |  | Amount       |   | Shares                     |            |   | Amount                             |   |    |                                   |   |         |                                              
|Balances at December 31, 2000                                                                       |  |                            |  | $            |  |                            | 25,146,653 |   |                                    | $ | 25 |                                   | $ | 141,590 |                                               |  | $ | (2,079                    | ) |  | $                    | (11,122 | ) |  | $ | (380   | ) |  | $ | (26,669 | ) |  | $ | 101,365 |  
|Issuance of common stock upon exercise of options for cash and promissory notes, net of repurchases |  |                            |  |              |  |                            | 33,130     |   |                                    |   |   |                                   |   | 60      |                                               |  |   | 80                        |   |  |                      |        |   |  |   |       |   |  |   |        |   |  |   | 140     |  
|Issuance of common stock under employee stock purchase plan                                         |  |                            |  |              |  |                            | 63,074     |   |                                    |   |   |                                   |   | 315     |                                               |  |   |                          |   |  |                      |        |   |  |   |       |   |  |   |        |   |  |   | 315     |  
|Repayment of stockholder notes, net of repurchase of unvested shares                                |  |                            |  |              |  |                            | (16,344    | ) |                                    |   |   |                                   |   | (135    | )                                             |  |   | 458                       |   |  |                      |        |   |  |   |       |   |  |   |        |   |  |   | 323     |  
|Reversal of deferred stock-based compensation from employee terminations                            |  |                            |  |              |  |                            |           |   |                                    |   |   |                                   |   | (648    | )                                             |  |   |                          |   |  |                      | 648     |   |  |   |       |   |  |   |        |   |  |   |        |  
|Amortization of deferred stock-based compensation                                                   |  |                            |  |              |  |                            |           |   |                                    |   |   |                                   |   |        |                                               |  |   |                          |   |  |                      | 6,044   |   |  |   |       |   |  |   |        |   |  |   | 6,044   |  
|Other stock-based compensation                                                                      |  |                            |  |              |  |                            |           |   |                                    |   |   |                                   |   | 681     |                                               |  |   |                          |   |  |                      |        |   |  |   |       |   |  |   |        |   |  |   | 681     |  
|Comprehensive income (loss):                                                                        |  |                             |  |              |   |                            |            |   |                                    |   |    |                                   |   |         |                                               |  |   |                           |   |  |                      |         |   |  |   |        |   |  |   |         |   |  |   |         |  
|Net loss                                                                                            |  |                            |  |              |  |                            |           |   |                                    |   |   |                                   |   |        |                                               |  |   |                          |   |  |                      |        |   |  |   |       |   |  |   | (21,873 | ) |  |   | (21,873 | )
|Unrealized gain on available-for-sale securities, net                                               |  |                            |  |              |  |                            |           |   |                                    |   |   |                                   |   |        |                                               |  |   |                          |   |  |                      |        |   |  |   | 1,596  |   |  |   |        |   |  |   | 1,596   |  
|                                                                                                    |  |                             |  |              |   |                            |            |   |                                    |   |    |                                   |   |         |                                               |  |   |                           |   |  |                      |         |   |  |   |        |   |  |   |         |   |  |   |         |  
|Comprehensive loss                                                                                  |  |                            |  |              |  |                            |           |   |                                    |   |   |                                   |   |        |                                               |  |   |                          |   |  |                      |        |   |  |   |       |   |  |   |        |   |  |   | (20,277 | )
|                                                                                                    |  |                             |  |              |   |                            |            |   |                                    |   |    |                                   |   |         |                                               |  |   |                           |   |  |                      |         |   |  |   |        |   |  |   |         |   |  |   |         |  
|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 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  |  
|                                                                                                    |  |                             |  |              |   |                            |            |   |                                    |   |    |                                   |   |         |                                               |  |   |                           |   |  |                      |         |   |  |   |        |   |  |   |         |   |  |   |         |  



See accompanying
notes.



F-5



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##### Table of Contents

Kosan Biosciences Incorporated



STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|-------------------------------------------------------------------------------------------------------- |  | ----------------------- | -------- | - | ---- | - | ------- | ---- |  | - | -------- | -
|                                                                                                         |  | Year Ended December 31, |         
|                                                                                                         |  | 2003                    |          |   | 2002 |   |         | 2001 | 
|Operating activities                                                                                     |  |                         |          |   |      |   |         |      |  |   |          |  
|Net loss                                                                                                 |  | $                       | (9,668   | ) |      | $ | (20,864 | )    |  | $ | (21,873  | )
|Adjustment to reconcile net loss to net cash provided by (used in) operating activities:                 |  |                         |          |   |      |   |         |      |  |   |          |  
|Depreciation and amortization                                                                            |  |                         | 2,308    |   |      |   | 1,755   |      |  |   | 1,291    |  
|Amortization of investment premiums and discounts                                                        |  |                         | 1,351    |   |      |   | 559     |      |  |   | (979     | )
|Amortization of stock-based compensation                                                                 |  |                         | 308      |   |      |   | 2,050   |      |  |   | 6,044    |  
|Other stock-based compensation                                                                           |  |                         | 619      |   |      |   | 1,388   |      |  |   | 681      |  
|(Gain)/loss on the recovery or write-down of investment                                                  |  |                         |         |   |      |   | (990    | )    |  |   | 990      |  
|Changes in assets and liabilities:                                                                       |  |                         |          |   |      |   |         |      |  |   |          |  
|Accounts receivable                                                                                      |  |                         | (5,148   | ) |      |   | (3,874  | )    |  |   |         |  
|Prepaid expenses and other current assets                                                                |  |                         | 12       |   |      |   | (489    | )    |  |   | (81      | )
|Other assets and notes receivable from related parties                                                   |  |                         | 162      |   |      |   | 581     |      |  |   | (124     | )
|Accounts payable and accrued liabilities                                                                 |  |                         | 2,852    |   |      |   | 2,204   |      |  |   | 690      |  
|Deferred revenue                                                                                         |  |                         | 9,088    |   |      |   | 10,772  |      |  |   | 380      |  
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Net cash provided by (used in) operating activities                                                      |  |                         | 1,884    |   |      |   | (6,908  | )    |  |   | (12,981  | )
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Investing activities                                                                                     |  |                         |          |   |      |   |         |      |  |   |          |  
|Acquisition of property and equipment                                                                    |  |                         | (4,257   | ) |      |   | (3,556  | )    |  |   | (1,725   | )
|Purchase of investments                                                                                  |  |                         | (116,034 | ) |      |   | (70,930 | )    |  |   | (100,676 | )
|Proceeds from maturity or sale of investments                                                            |  |                         | 99,091   |   |      |   | 83,732  |      |  |   | 96,795   |  
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Net cash (used in) provided by investing activities                                                      |  |                         | (21,200  | ) |      |   | 9,246   |      |  |   | (5,606   | )
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Financing activities                                                                                     |  |                         |          |   |      |   |         |      |  |   |          |  
|Proceeds from issuance of common stock, net of repurchases and issuance costs                            |  |                         | 26,793   |   |      |   | 541     |      |  |   | 455      |  
|Proceeds from the repayment of notes receivable from stockholders, net of repurchases of unvested shares |  |                         | 776      |   |      |   | 198     |      |  |   | 323      |  
|Proceeds from equipment loans                                                                            |  |                         | 3,140    |   |      |   | 2,215   |      |  |   | 1,092    |  
|Principal payments under capital lease obligations and equipment loans                                   |  |                         | (2,093   | ) |      |   | (1,662  | )    |  |   | (1,147   | )
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Net cash provided by financing activities                                                                |  |                         | 28,616   |   |      |   | 1,292   |      |  |   | 723      |  
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Net increase (decrease) in cash and cash equivalents                                                     |  |                         | 9,300    |   |      |   | 3,630   |      |  |   | (17,864  | )
|Cash and cash equivalents at beginning of period                                                         |  |                         | 22,191   |   |      |   | 18,561  |      |  |   | 36,425   |  
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Cash and cash equivalents at end of period                                                               |  | $                       | 31,491   |   |      | $ | 22,191  |      |  | $ | 18,561   |  
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Supplemental disclosures                                                                                 |  |                         |          |   |      |   |         |      |  |   |          |  
|Interest expense paid in cash                                                                            |  | $                       | 337      |   |      | $ | 356     |      |  | $ | 349      |  
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Non-cash investing and financing activities                                                              |  |                         |          |   |      |   |         |      |  |   |          |  
|Unrealized (loss)/gain on investments, net                                                               |  | $                       | (131     | ) |      | $ | (74     | )    |  | $ | 606      |  
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Deferred stock-based compensation                                                                        |  | $                       | (634     | ) |      | $ | (1,246  | )    |  | $ | (648     | )
|                                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  



See accompanying notes.



F-6



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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 uses its proprietary technologies to develop drug
candidates from polyketides, a rich source of pharmaceutical products. The Company has two product candidates in clinical trials and three programs with product candidates in preclinical studies.



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. Prior to achieving profitable operations, the Company intends to fund operations through the additional
sale of equity securities, strategic collaborations, government grant awards and debt financing.



Use of Estimates



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



Recent Accounting Pronouncements



In November
2002, the FASB issued Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (EITF 00-21). EITF 00-21 provides guidance on how to account for arrangements that involve the delivery or
performance of multiple products, services and/or rights to use assets. The provisions of EITF 00-21 applied to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have an impact upon
the Companys financial statements.



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. 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.



F-7



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



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



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 recognizes license and other up-front and initial fees pursuant to research and development collaboration
agreements over the estimated research and development term of the respective agreement. 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.



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.



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)



Net Loss per Share (Continued)



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



|                                                                                      |  |                         |        |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                      |  | Year Ended December 31, |       
|                                                                                      |  | 2003                    |        |   | 2002 |   |         | 2001 | 
|Net loss                                                                              |  | $                       | (9,668 | ) |      | $ | (20,864 | )    |  | $ | (21,873 | )
|                                                                                      |  |                         |        |   |      |   |         |      |  |   |         |  
|Weighted-average shares of common stock outstanding                                   |  |                         | 25,692 |   |      |   | 25,307  |      |  |   | 25,199  |  
|Less: weighted-average shares subject to repurchase                                   |  |                         | (125   | ) |      |   | (401    | )    |  |   | (1,035  | )
|                                                                                      |  |                         |        |   |      |   |         |      |  |   |         |  
|Weighted-average shares used in computing basic and diluted net loss per common share |  |                         | 25,567 |   |      |   | 24,906  |      |  |   | 24,164  |  
|                                                                                      |  |                         |        |   |      |   |         |      |  |   |         |  
|Basic and diluted net loss per common share                                           |  | $                       | (0.38  | ) |      | $ | (0.84   | )    |  | $ | (0.91   | )
|                                                                                      |  |                         |        |   |      |   |         |      |  |   |         |  



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 3,905,054, 3,080,345, and 2,355,874 for the years ended December 31, 2003,
2002 and 2001, 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 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.



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)



Stock-Based Compensation (Continued)



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



|                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                          |  | Year Ended December 31, |        
|                                                                                                          |  | 2003                    |         |   | 2002 |   |         | 2001 | 
|Risk free interest rate                                                                                   |  |                         | 2.5     | % |      |   | 3.7     | %    |  |   | 4.4     | %
|Dividend yield                                                                                            |  |                         |        |   |      |   |        |      |  |   |        |  
|Weighted-average expected life                                                                            |  |                         | 4 years |   |      |   | 4 years |      |  |   | 4 years |  
|Volatility                                                                                                |  |                         | 70      | % |      |   | 70      | %    |  |   | 70      | %
|                                                                                                          |  |                         |        
|Net loss attributable to common stockholders, as reported                                                 |  | $                       | (9,668  | ) |      | $ | (20,864 | )    |  | $ | (21,873 | )
|Add: Stock-based employee compensation expense included in reported net loss                              |  |                         | 308     |   |      |   | 2,050   |      |  |   | 6,044   |  
|Deduct: Stock-based employee compensation expense determined under fair value based method for all awards |  |                         | (2,631  | ) |      |   | (4,707  | )    |  |   | (7,630  | )
|                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|Pro forma net loss                                                                                        |  | $                       | (11,991 | ) |      | $ | (23,521 | )    |  | $ | (23,459 | )
|                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic and diluted net loss per common share:                                                              |  |                         |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                               |  | $                       | (0.38   | ) |      | $ | (0.84   | )    |  | $ | (0.91   | )
|Pro forma                                                                                                 |  | $                       | (0.47   | ) |      | $ | (0.94   | )    |  | $ | (0.97   | )



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).



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.



F-10



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



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



Segment Reporting



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.



Reclassifications



Certain reclassifications of prior years balances
have been made to conform to the current year presentation. These reclassifications had no effect on prior years net loss or stockholders equity.



2. RESEARCH AND DEVELOPMENT AGREEMENTS



Roche



Effective September 2002, the Company entered into a research and development collaboration 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 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 Company
is entitled 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. 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, 2003 and 2002, the Company recognized $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 2003 and 2002 was approximately $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 2007, the estimated clinical development period.



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 January 1, 2002, the agreement was assigned to Johnson & Johnson Pharmaceutical Research and Development, LLC, a subsidiary of Ortho-McNeil Pharmaceutical, Inc. 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, 2002 and 2001, the Company recognized $1.2 million, $2.9 million, and $3.2 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 and 2001 revenue were non-recurring milestones of $250,000 in each
period.



F-11



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



2. RESEARCH AND DEVELOPMENT AGREEMENTS (Continued)



At December 31, 2003, $8.3 million or 92% of accounts receivable was due from one source. For the years ended December 31,
2003 and 2001, the Company recognized $26.9 million and $3.2 million of contract revenue pursuant to one agreement representing 86% and 61% of total revenues for fiscal years 2003 and 2001. 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 $2.5 million, $1.5 million and $721,000 for the years ended December 31, 2003, 2002 and 2001, 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):



|                 |  |                |        |                 |        |    |           |   |               |       |                 |        |           |  |   |        |  |   |     |  |   |   |  |   |       
|---------------- |  | -------------- | ------ | --------------- | ------ | -- | --------- | - | ------------- | ----- | --------------- | ------ | --------- |  | - | ------ |  | - | --- |  | - | - |  | - | ------
|                 |  | 2003           |        | 2002           
|                 |  | Amortized Cost |        | GrossUnrealized |        |    | FairValue |   | AmortizedCost |       | GrossUnrealized |        | FairValue
|                 |  |                | Gains  |                 | Losses |    |           |   |               | Gains |                 | Losses |          
|Debt Securities: |  |                |        |                 |        |    |           |   |               |       |                 |        |           |  |   |        |  |   |     |  |   |   |  |   |       
|US agency notes  |  | $              | 39,591 |                 | $      | 21 |           | $ | (17           | )     |                 | $      | 39,595    |  | $ | 29,511 |  | $ | 67  |  | $ |  |  | $ | 29,578
|Corporate bonds  |  |                | 34,196 |                 |        | 22 |           |   | (5            | )     |                 |        | 34,213    |  |   | 28,684 |  |   | 85  |  |   |   |  |   | 28,769
|                 |  |                |        |                 |        |    |           |   |               |       |                 |        |           |  |   |        |  |   |     |  |   |   |  |   |       
|                 |  | $              | 73,787 |                 | $      | 43 |           | $ | (22           | )     |                 | $      | 73,808    |  | $ | 58,195 |  | $ | 152 |  | $ |  |  | $ | 58,347
|                 |  |                |        |                 |        |    |           |   |               |       |                 |        |           |  |   |        |  |   |     |  |   |   |  |   |       



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



|                                           |  |      |       
|------------------------------------------ |  | ---- | ------
|                                           |  | 2003
|Within one year                            |  | $    | 49,968
|Greater than one year, less than two years |  |      | 23,840
|                                           |  |      |       
|                                           |  | $    | 73,808
|                                           |  |      |       



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



F-12



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



4. PROPERTY AND EQUIPMENT



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



|                                               |  |      |        |   |      |   |        |  
|---------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|                                               |  | 2003 |        |   | 2002 |  
|Computer equipment and software                |  | $    | 1,548  |   |      | $ | 1,353  |  
|Office furniture                               |  |      | 388    |   |      |   | 321    |  
|Lab equipment                                  |  |      | 8,239  |   |      |   | 6,120  |  
|Leasehold improvements                         |  |      | 4,398  |   |      |   | 2,522  |  
|                                               |  |      |        |   |      |   |        |  
|                                               |  |      | 14,573 |   |      |   | 10,316 |  
|Less accumulated depreciation and amortization |  |      | (7,256 | ) |      |   | (4,948 | )
|                                               |  |      |        |   |      |   |        |  
|                                               |  | $    | 7,317  |   |      | $ | 5,368  |  
|                                               |  |      |        |   |      |   |        |  



Depreciation and
amortization expense was $2.3 million, $1.8 million and $1.3 million for the years ended December 31, 2003, 2002 and 2001, respectively. Property and equipment financed under capital leases amounted to $562,000 at December 31, 2003 and 2002.
Accumulated amortization related to this property and equipment amounted to $562,000 at December 31, 2003 and 2002.



5. EQUIPMENT FINANCING



The Company financed certain equipment and facility improvements under debt obligations. As of December 31, 2003, future minimum loan payments under these
obligations were as follows (in thousands):



|                                      |  |   |        |  
|------------------------------------- |  | - | ------ | -
|Year ended December 31,               |  |   |       
|2004                                  |  | $ | 2,129  |  
|2005                                  |  |   | 1,599  |  
|2006                                  |  |   | 990    |  
|2007                                  |  |   | 316    |  
|                                      |  |   |        |  
|Total minimum debt payments           |  |   | 5,034  |  
|Less amount representing interest     |  |   | (479   | )
|                                      |  |   |        |  
|Present value of net minimum payments |  |   | 4,555  |  
|Less current portion                  |  |   | (1,854 | )
|                                      |  |   |        |  
|Long-term portion                     |  | $ | 2,701  |  
|                                      |  |   |        |  



In May 2003, 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, 2003, the Company utilized approximately $2.4 million 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 13.36%. Obligations under the loans are secured by the assets financed under the loans.



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##### Table of Contents

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, 2003 were as follows (in thousands):



|                        |  |   |       
|----------------------- |  | - | ------
|Year ended December 31, |  |  
|2004                    |  | $ | 1,588 
|2005                    |  |   | 1,609 
|2006                    |  |   | 1,624 
|2007                    |  |   | 1,679 
|2008                    |  |   | 1,163 
|Thereafter              |  |   | 4,793 
|                        |  |   |       
|Total minimum payments  |  | $ | 12,456
|                        |  |   |       



In June 2002, the
Company obtained 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 $904,000 held in an investment account that the Company must maintain for the term of the lease. The investment account is classified within long-term investments on the balance sheet.



Rent expense for operating leases was approximately $1.8 million, $1.5 million and $1.1 million for the years ended December
31, 2003, 2002 and 2001, respectively.



7. ACCRUED LIABILITIES



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



|                               |  |      |       |      |   |      
|------------------------------ |  | ---- | ----- | ---- | - | -----
|                               |  | 2003 |       | 2002
|Research & development-related |  | $    | 3,699 |      | $ | 847  
|Compensation-related           |  |      | 1,368 |      |   | 1,176
|Professional services          |  |      | 978   |      |   | 858  
|Facilities-related             |  |      | 670   |      |   | 510  
|Other                          |  |      | 310   |      |   | 290  
|                               |  |      |       |      |   |      
|                               |  | $    | 7,025 |      | $ | 3,681
|                               |  |      |       |      |   |      



8. RELATED PARTY TRANSACTIONS



For the year ended December 31, 2002, the Company had
outstanding promissory notes issued to officers and employees of $1.2 million. These promissory notes were issued for the exercise of stock options and were paid in full in 2003.



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



8. RELATED PARTY TRANSACTIONS (Continued)



For the years ended December 31, 2003 and 2002, the Company had outstanding full recourse employee loans of $155,000 and $445,000, respectively, issued
from March 1999 to January 2003. These loans bear interest at rates ranging from 4.47% to 6.60% and are due from March 2004 through March 2006. The loans are secured by deeds of trust to residential property and 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% will be forgiven by 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.



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, 2003 and 2002, 60,428 shares and 208,436 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 7,100,000, 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.



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



9. STOCKHOLDERS EQUITY (continued)



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,
2003, 294,072 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 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, 2003, 151,000 shares were granted under the Directors Plan.



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



9. STOCKHOLDERS EQUITY (Continued)



A summary of stock option activity is as follows:



|                              |  |                            |                  |  |                     |                |  |                 |              |  |                                  |            |   |  |   |     
|----------------------------- |  | -------------------------- | ---------------- |  | ------------------- | -------------- |  | --------------- | ------------ |  | -------------------------------- | ---------- | - |  | - | ----
|                              |  | Shares Available For Grant |                  |  | Options Outstanding
|                              |  |                            | Number of Shares |  |                     | Exercise Price |  | Aggregate Price |              |  | Weighted- Average Exercise Price
|Balances at December 31, 2000 |  | 1,569,852                  |                  |  | 1,080,141           |                |  |                 |              |  | $                                | 2,904,003  |   |  | $ | 2.69
|Additional reserved           |  | 375,000                    |                  |  |                    |                |  |                 |             |  |                                  |           |   |  |   |    
|Granted                       |  | (1,501,775                 | )                |  | 1,501,775           |                |  | $               | 5.28-$10.67  |  |                                  | 13,640,396 |   |  | $ | 9.19
|Canceled                      |  | 192,912                    |                  |  | (192,912            | )              |  | $               | 0.33-$14.00  |  |                                  | (847,479   | ) |  | $ | 4.39
|Exercised                     |  |                           |                  |  | (33,130             | )              |  | $               | 0.15-$  4.00 |  |                                  | (60,143    | ) |  | $ | 1.82
|                              |  |                            |                  |  |                     |                |  |                 |              |  |                                  |            |   |  |   |     
|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
|                              |  |                            |                  |  |                     |                |  |                 |              |  |                                  |            |   |  |   |     



The following table
summarizes information with respect to stock options outstanding at December 31, 2003:





|                        |  |                  |  |                                                         |  |                                  |       |                  |           |                                  |   |      
|----------------------- |  | ---------------- |  | ------------------------------------------------------- |  | -------------------------------- | ----- | ---------------- | --------- | -------------------------------- | - | -----
|Options Outstanding     |  | Options Vested  
|Range of Exercise Price |  | Number of Shares |  | Weighted- Average Remaining Contractual Life (In Years) |  | Weighted- Average Exercise Price |       | Number of Shares |           | Weighted- Average Exercise Price
|$ 0.15 - $ 6.04         |  | 679,184          |  | 7.26                                                    |  | $                                | 3.46  |                  | 407,611   |                                  | $ | 2.86 
|$ 6.19 - $ 6.99         |  | 798,650          |  | 8.92                                                    |  | $                                | 6.59  |                  | 182,624   |                                  | $ | 6.57 
|$ 7.10 - $ 8.87         |  | 783,650          |  | 8.05                                                    |  | $                                | 8.14  |                  | 374,482   |                                  | $ | 8.19 
|$  9.70                 |  | 587,375          |  | 7.42                                                    |  | $                                | 9.70  |                  | 376,125   |                                  | $ | 9.70 
|$10.20                  |  | 619,495          |  | 9.95                                                    |  | $                                | 10.20 |                  |          |                                  |   |     
|$10.50 - $14.00         |  | 436,700          |  | 8.19                                                    |  | $                                | 11.08 |                  | 188,295   |                                  | $ | 11.07
|                        |  |                  |  |                                                         |  |                                  |       |                  |           |                                  |   |      
|                        |  | 3,905,054        |  | 8.31                                                    |  | $                                | 7.90  |                  | 1,529,137 |                                  | $ | 8.03 
|                        |  |                  |  |                                                         |  |                                  |       |                  |           |                                  |   |      



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



9. STOCKHOLDERS EQUITY (Continued)



Of the 3,905,054 options outstanding, 1,641,688 options were exercisable as of December 31, 2003, including 112,551 that, if exercised, would be subject
to the Companys lapsing right to repurchase over the remaining vesting term. The weighted-average fair value of options granted and outstanding was $7.90, $7.08 and $6.05 as of the years ended December 31, 2003, 2002 and 2001, respectively.



Non-Employee Stock-Based Compensation



As of December 31, 2003, the Company had issued consultant stock options
totaling approximately 914,000 shares with exercise prices ranging from $0.15 to $10.20 and terms up to five 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 $619,000, $1.4 million, and $681,000 for the years ended December 31, 2003, 2002 and 2001, 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, 2003, the Company had reserved shares of common stock for future issuance as follows:



|                             |  |                
|---------------------------- |  | ---------------
|                             |  | Shares Reserved
|Stock option plans           |  | 4,339,623      
|Employee Stock Purchase Plan |  | 155,928        
|                             |  |                
|                             |  | 4,495,551      
|                             |  |                



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 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.



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



9. STOCKHOLDERS EQUITY (Continued)



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, 2003, no shares had been issued under the Rights Plan.



10. COMPREHENSIVE INCOME



Comprehensive loss was as follows (in thousands):



|                                                                 |  |                         |        |   |      |   |         |      |  |   |         |  
|---------------------------------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                 |  | Year Ended December 31, |       
|                                                                 |  | 2003                    |        |   | 2002 |   |         | 2001 | 
|Net loss                                                         |  | $                       | (9,668 | ) |      | $ | (20,864 | )    |  | $ | (21,873 | )
|Unrealized (loss)/gain on available-for-sale securities          |  |                         | (131   | ) |      |   | (74     | )    |  |   | 606     |  
|Reclassification of (gain)/loss on available-for-sale securities |  |                         |       |   |      |   | (990    | )    |  |   | 990     |  
|                                                                 |  |                         |        |   |      |   |         |      |  |   |         |  
|Comprehensive loss                                               |  | $                       | (9,799 | ) |      | $ | (21,928 | )    |  | $ | (20,277 | )
|                                                                 |  |                         |        |   |      |   |         |      |  |   |         |  



11. INCOME TAXES



As of December 31, 2003, the Company had federal net operating loss
carryforwards and federal research and development tax credit carryforwards of approximately $36.0 million and $3.2 million, respectively. The federal net operating loss and credit carryforwards will expire at various dates beginning in the year
2010 through 2023, if not utilized.



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.



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):



|                                              |  |      |         |   |      |   |         |  
|--------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                              |  | 2003 |         |   | 2002 |  
|Deferred tax assets:                          |  |      |         |   |      |   |         |  
|Net operating loss carryforwards              |  | $    | 12,390  |   |      | $ | 12,360  |  
|Deferred revenue                              |  |      | 8,340   |   |      |   | 4,700   |  
|Research and development credits              |  |      | 2,640   |   |      |   | 2,710   |  
|Capitalized research and development expenses |  |      | 1,930   |   |      |   | 1,850   |  
|Other                                         |  |      | 760     |   |      |   | 1,470   |  
|                                              |  |      |         |   |      |   |         |  
|Total deferred tax assets                     |  |      | 26,060  |   |      |   | 23,090  |  
|                                              |  |      |         |   |      |   |         |  
|Valuation allowance                           |  |      | (26,060 | ) |      |   | (23,090 | )
|                                              |  |      |         |   |      |   |         |  
|Net deferred taxes                            |  | $    |        |   |      | $ |        |  
|                                              |  |      |         |   |      |   |         |  



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##### Table of Contents

Kosan Biosciences Incorporated



NOTES TO FINANCIAL STATEMENTS (Continued)



11. INCOME TAXES (Continued)



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 $3.0 million and $8.5 million during the years ended December 31, 2003 and 2002, 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 |       
|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   | )
|2002                                        |  |               |        |   |          |   |        |               |  |   |              |   |  |       |        |   |  |   |         |  
|Revenue                                     |  | $             | 1,662  |   |          | $ | 1,515  |               |  | $ | 883          |   |  | $     | 5,543  |   |  | $ | 9,603   |  
|Loss from operations                        |  |               | (5,545 | ) |          |   | (6,886 | )             |  |   | (7,745       | ) |  |       | (3,531 | ) |  |   | (23,707 | )
|Net loss                                    |  |               | (3,934 | ) |          |   | (6,390 | )             |  |   | (7,366       | ) |  |       | (3,174 | ) |  |   | (20,864 | )
|Basic and diluted earnings per common share |  | $             | (0.16  | ) |          | $ | (0.26  | )             |  | $ | (0.29        | ) |  | $     | (0.13  | ) |  | $ | (0.84   | )



F-20