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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) |  |                                                                                                 
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|           |  | For the fiscal year ended December 31,
    2002                                                 
|          
|or        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 000-31101

Applied Molecular Evolution, Inc.

(Exact name of Registrant as specified in its
charter)


|                                                                           |  |                                                   
|-------------------------------------------------------------------------- |  | --------------------------------------------------
|Delaware(State or other jurisdiction of
    incorporation or organization) |  | 33-0374014(I.R.S. Employer
    Identification No.)

3520 Dunhill Street

San Diego, CA 92121


(Address, including zip code, of principal
executive offices)


Registrants telephone number, including
area code:

(858) 597-4990


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

None


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

Common Stock, $0.001 par value


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
than the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the
past
90 days.     Yes þ          No o

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.     o

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Securities Exchange Act of
1934).     Yes þ          No o

The aggregate market value of the shares of
Common Stock held by non-affiliates of the Company, based upon
the closing price of the Common Stock on June 30, 2002, as
reported on the Nasdaq National Market, was approximately
$93,612,620. Shares of Common Stock held by each executive
officer and director and by each person who owned 10% or more of
the outstanding shares of Common Stock have been excluded in
that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a
conclusive determination for other purposes.

There were 20,589,191 shares outstanding of the
registrants Common Stock as of February 20, 2003.

DOCUMENTS INCORPORATED BY REFERENCE

Registrants Proxy Statement to be filed
with the Securities and Exchange Commission in connection with
the solicitation of proxies for the Registrants Annual
Meeting of Stockholders to be held in 2003, is incorporated by
reference in Part III, Items 10, 11, 12 and 13 on this
Form 10-K.



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TABLE OF CONTENTS



|               |                                                                                               |  |  |  |  |  |  | 
|-------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I        
|               | Item 1. Business                                                                             
|RISK FACTORS  
|MANAGEMENT    
|               | Item 2. Properties                                                                           
|               | Item 3. Legal Proceedings                                                                    
|               | Item 4. Submission of Matters to a Vote of Security Holders                                  
|PART II       
|               | Item 5. Market for Registrants Common Equity and Related Stockholder Matters                
|               | Item 6. Selected Financial Data                                                              
|               | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|               | Item 7A. Quantitative and Qualitative Disclosures About Market Risk                          
|               | Item 8. Financial Statements and Supplementary Data                                          
|               | Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 
|PART III      
|               | Item 10. Directors and Executive Officers of the Registrant                                  
|               | Item 11. Executive Compensation                                                              
|               | Item 12. Security Ownership of Certain Beneficial Owners and Management                      
|               | Item 13. Certain Relationships and Related Transactions                                      
|               | Item 14. Controls and Procedures                                                             
|PART IV       
|               | Item 15. Exhibits, Financial Statement Schedules, and Report on Form 8-K                     
|SIGNATURES    
|CERTIFICATIONS
|EXHIBIT 10.31 
|EXHIBIT 10.33 
|EXHIBIT 10.33 
|EXHIBIT 10.34 
|EXHIBIT 21.1  
|EXHIBIT 23.1  



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PART I

This Form 10-K contains, in addition to
historical information, forward-looking statements that involve
risks and uncertainties. Our actual results could differ
materially from the results discussed in any such
forward-looking statements. Factors that could cause or
contribute to such differences include those discussed in
Risk Factors as well as those discussed elsewhere in
this Form 10-K. These forward-looking statements represent
our judgment as of the date of the filing of this
Form 10-K. We disclaim, however, any intent or obligation
to update these forward-looking statements.




Item 1.     Business

Overview

Applied Molecular Evolution, Inc. (the
Company or AME), a Delaware corporation,
was incorporated on August 14, 1989. We are a leader in the
application of directed molecular evolution to the optimization
and development of human biotherapeutics. Directed molecular
evolution is a process for optimizing genes and proteins for
specific commercial purposes. Our technology has been validated
by, among other things, the ongoing clinical trials of
VitaxinTM, a humanized and optimized therapeutic
monoclonal antibody candidate, that AME licensed to MedImmune,
Inc. (MedImmune), the successful creation of
NumaxTM candidates by optimizing Synagis® for
MedImmune and the engineering of product candidates AME-527 and
AME-133, optimized versions of the FDA-approved, currently
marketed monoclonal antibodies Remicade® and Rituxan®,
respectively. We use our proprietary AMEsystemTM
technology to rapidly create improvements in proteins that would
be less efficient and more expensive to achieve through
conventional methods. Since our inception, our principal focus
has been on applying our technology to human biotherapeutics,
the largest and most profitable target market for directed
molecular evolution. We plan to use our directed molecular
evolution technology to develop improved versions of
FDA-approved, currently marketed, biopharmaceuticals as well as
novel human biotherapeutics.

Background

DNA, Codons, Genes and Proteins

(DNA, CODONS, GENES AND PROTEINS GRAPHIC)

The graphic above depicts a protein being
produced from DNA as described in the text below.

DNA is a molecule found in all living cells and
is responsible for determining the inherited characteristics of
all living organisms. The entire DNA content of an organism is
called its genome. The human genome is

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organized into 46 chromosomes, and each
chromosome contains a DNA molecule. Each DNA molecule consists
of two complementary strands comprised of four different
chemical bases called nucleotides, commonly referred to as A, C,
G and T. Each set of three adjacent nucleotides (e.g., CAG or
GAG) is referred to as a codon, and codons are organized into
discrete units called genes. Genes direct the cell to make
proteins, and the sequence of codons within a gene determines
the protein that will be made by the cell.


Scientific evidence amassed to date suggests that
the human genome contains approximately 30,000 genes, with each
gene consisting of anywhere from tens to millions of codons.
Genes are critically involved in the regulation of almost all
aspects of human biology and disease because they serve as the
blueprints for the production of proteins that control virtually
all of a cells normal biological functions. For an
organism to be healthy, genes must produce specific proteins at
the right time in the appropriate amounts in the correct cells,
a process known as gene expression. When a gene is expressed,
its DNA directs the production of a specific protein.

Human proteins are composed of combinations of
20 different subunits called amino acids which are linked
together like beads on a string. The specific sequence and types
of amino acids in a protein determine the ultimate structure and
function of the protein. Each codon in a gene specifies a
corresponding amino acid in a protein. Therefore, the specific
sequence of codons contained in the gene determines the amino
acid composition and function of the protein. Any change in any
of the three nucleotides in a codon could result in the
incorporation of a different amino acid into the protein. This
type of alteration may lead to the production of a protein with
altered biological properties. Consequently, changes in
nucleotides, e.g., if C is replaced by G within a codon, can
have a significant functional impact on the inherited biological
characteristics of an organism.

Natural Evolution and Its
Limitations

Evolution is the process by which living
organisms adapt to their environment. There are two fundamental
steps in the evolutionary process. The first step is the
creation of genetic diversity through random events. The second
step is the natural selection of organisms which possess
beneficially adaptive characteristics that will be passed to the
next generation.

The following critical limitations preclude
natural evolution from efficiently developing proteins optimized
for specific commercial purposes:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | It is extremely slow, often requiring the passage
    of thousands to millions of years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  | Natural evolution creates only a portion of the
    possible protein diversity because it introduces changes at the
    nucleotide level. Changes in individual nucleotides within a
    gene may or may not alter the amino acid sequence of the
    resulting protein. Therefore, a change that occurs at the
    nucleotide level may not alter the functional characteristics of
    the protein that is eventually produced. In contrast, by
    changing individual codons, it is possible to explore the full
    range of possible amino acid changes in a protein. Consequently,
    natural evolution is much less efficient at exploring the full
    range of protein diversity than a process which introduces
    change at the codon level.
|
| |  | Selection occurs at the level of the whole
    organism, therefore individual proteins are not necessarily
    optimized.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

These limitations create an opportunity to
improve natural proteins for commercial purposes.

Biotechnology and Its Current
Limitations

A segment of the biotechnology industry aims to
discover genes from natural sources and subsequently develop
proteins with important commercial applications from these genes.

Genomics, as it relates to healthcare, is the
study of all the genetic information of a species and its
relationship to disease. Recent technological advances in
molecular biology and in scientific instrumentation have greatly
increased the ability of researchers to identify genes and
subsequently determine their functions. These developments are
ultimately expected to lead to the identification of all the
genes in the human genome.

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To date, tens of thousands of genes have already
been identified. In spite of these recent successes, genomics
companies have been limited in their ability to develop
commercially successful protein products. As described above, a
major reason for this limitation is that naturally occurring
genes produce proteins that have not been evolved for specific
commercial purposes, and they typically yield proteins that may
be deficient with respect to characteristics including safety,
efficacy, potency, convenience (e.g. serum half-life and route
of administration), manufacturing cost and intellectual property.


Traditionally, the biotechnology industry has
attempted to modify genes for commercial purposes by employing
two different strategies: random mutagenesis and rational
design. Random mutagenesis involves inducing random mutations in
genes in an effort to produce commercially viable proteins.
Empirical evidence suggests that random mutagenesis offers a low
probability of improving a protein and usually results in
changes which are detrimental to the function of the protein.
Rational design involves deliberately modifying a gene in an
effort to change the structure of the resultant protein. This
approach is predicated on the theory that analyzing the
structure and shape of a protein will provide an understanding
of its function. Consequently, once the structure of a protein
is known, it may be possible to modify the underlying gene to
improve the function of the protein. The major drawbacks to
rational design are that it is expensive, time-consuming and,
most significantly, imprecise.

Directed Molecular Evolution and Limitations
of Competing Approaches

The goal of directed molecular evolution is to
optimize proteins for specific commercial purposes. Protein
optimization generally involves improving the functional
characteristics of a particular protein by changing its amino
acids. For example, a particular protein may have an initial
amino acid sequence that makes it susceptible to degradation at
temperatures approximating that of the human body. Consequently,
its utility as a therapeutic agent would be severely limited. By
using directed molecular evolution, the stability of this
protein could be dramatically improved by introducing changes in
the amino acid sequence of the protein, and then screening for
those changes that allow the protein to survive at higher
temperatures while retaining its other important
characteristics. Because the sequence of amino acids in a
protein determines the proteins structure and function,
and the sequence of amino acids is specified in genes, proteins
can be modified by altering the genes that produce them.

There are three fundamental steps in the process
of directed molecular evolution. In the first step, a library,
or collection, of genes is created by introducing changes in the
initial gene that produces the protein of interest. Ideally,
this library of genes should contain the optimal amount of
genetic diversity. If the process introduces too much genetic
diversity, the efficiency of directed molecular evolution may be
significantly reduced because excessive change in the genes of
interest is likely to destroy the function of most resulting
proteins. Conversely, the creation of an insufficient amount of
genetic diversity significantly reduces the probability of
producing an optimized protein. The second step involves
expressing proteins from all the different genes that were
produced in the first step to create a library of diverse
proteins. The third step in the process entails screening, or
evaluating, this library to identify those proteins with
improvements in the desired characteristics. The process is then
repeated until a sufficiently improved protein is identified.

We believe that directed molecular evolution
potentially offers several advantages over natural evolution and
traditional biotechnology approaches to improve proteins. The
entire process can be rapidly completed, efficiently and
cost-effectively accomplishing in months what it takes
traditional methods years to achieve. Because directed molecular
evolution does not require any knowledge of the structure of the
protein being optimized, it is much more rapid than conventional
approaches such as rational design, which are based on
time-consuming modeling techniques.

Directed molecular evolution represents a
significant step forward in the optimization of proteins. There
are currently a number of different competing approaches for
conducting directed molecular evolution, including gene
shuffling. We believe that these competing approaches do not
take full advantage of the potential of directed molecular
evolution to optimize proteins, particularly biotherapeutics,
our primary target market.

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Gene
Shuffling

Gene shuffling involves cleaving a collection of
genes into fragments and then recombining the fragments to
create new gene variants. Gene shuffling does not control the
extent or precise location of changes introduced into the gene
of interest nor does it explore the full range of protein
diversity. These shortcomings significantly limit the usefulness
of this approach in developing improved proteins:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Completeness of Diversity:Gene shuffling generally lacks the
    ability to substitute each of the 20 human amino acids at a
    particular location in a protein. For example, if all the
    various genes in a gene family have the same codon ATG, that
    codes for the amino acid methionine, at a certain position, they
    will each produce a protein that contains a methionine at that
    same position. If this family of genes is then shuffled in an
    effort to create genetic diversity, all the gene variants that
    are produced will still have the same codon ATG at the same
    position. Therefore, in this particular situation, shuffling
    fails to introduce any of the other 19 possible human amino
    acids at the same position in the protein. If modifying that
    particular amino acid is necessary to enhancing the
    proteins function, gene shuffling will be unable to
    produce an optimized protein.
|
| |  | Extent of Change:The very nature of gene shuffling
    requires the cleavage of a collection of genes in multiple
    locations. Consequently, the shuffling process cannot precisely
    control the number of changes introduced into the genes. The
    greater the number of changes, the more likely it is that
    harmful changes will be introduced. Furthermore, extensive
    change requires the screening of larger libraries, which is more
    time-consuming and expensive.                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | Location of Change:The gene shuffling approach lacks the
    ability to precisely control where changes are introduced into a
    gene. This limitation severely curtails the application of this
    technology to developing biotherapeutics because changing just a
    single amino acid at an inappropriate location can adversely
    impact the safety, efficacy, potency, convenience, manufacturing
    costs and intellectual property of a biotherapeutic.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

Extremophile
Isolation

Extremophile isolation attempts to identify
previously undiscovered genetic diversity in nature by
collecting unusual organisms that have adapted through natural
selection to be able to survive in extreme environments. We
believe that this approach has limited application to the
biotherapeutic market. It has taken over two decades to
transform mouse proteins, which are closely related to human
proteins, into biotherapeutics that the human immune system will
not reject. We expect it to be even more challenging to convert
proteins from organisms that are extremely different from humans
into biotherapeutics which will not be rejected by the human
immune system.

Our AMEsystem Technology

We use our proprietary AMEsystem technology to
improve the function of a target protein in order to enhance its
commercial potential. The components of our AMEsystem are
precise and efficient methods for conducting the three
fundamental steps of directed molecular evolution and address
the limitations of alternative directed molecular evolution
approaches. There are three components to our AMEsystem
technology:



| |   |                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | DirectAMETM:DirectAME is a gene synthesis process that enables the rapid
    production of a library of variant genes based on an initial
    gene.                                                               
|
| |  | ExpressAMETM:ExpressAME consists of gene expression systems that efficiently
    produce proteins from the genes generated using DirectAME.                                                                       
|
| |  | ScreenAMETM:ScreenAME is a series of tests or assays which facilitate the
    identification of proteins with the optimal, desired commercial
    properties from the protein libraries produced using ExpressAME.

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(AMESYSTEM GRAPHIC)

Step One:
DirectAME

Our patented DirectAME technology addresses the
limitations of competing directed molecular evolution approaches
by rapidly and precisely generating the appropriate amount of
genetic diversity, thereby significantly increasing the
probability of creating and identifying functionally improved
proteins. In contrast to some alternative directed molecular
evolution approaches, our DirectAME approach has the following
strengths:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Completeness of Diversity:When optimizing the function of a
    protein by applying directed molecular evolution technology, it
    is critical that all 20 possible human amino acids be evaluated
    at each position of interest in the protein. By changing codons
    as opposed to single nucleotides, our patented DirectAME
    technology ensures that all 20 possible human amino acids are
    expressed at each position of interest within the protein.
    Competing approaches which cannot achieve such complete and
    focused diversity produce enormous protein libraries that are
    not economically feasible to screen.                                                                                                                                                                                                                                                                                                                                
|
| |  | Extent of Change:The simultaneous introduction of a
    large number of amino acid changes in each protein in a library
    is undesirable because most amino acid changes are detrimental
    to the function of a protein. If multiple changes are made at
    once, the majority of the proteins produced will not possess the
    desired function, necessarily complicating the subsequent
    screening process. We can use our DirectAME technology to create
    a diverse library of proteins that differ from the initial
    target protein by a specific number of amino acids. In doing so,
    we significantly increase the probability of preserving the
    desired characteristics while keeping the number of proteins at
    a level that is efficient to express and screen. As we repeat
    the process, we introduce additional changes into the protein
    and retain only those changes that combine to produce a protein
    with improved function.
|
| |  | Location of Change:Our DirectAME technology has the
    ability to change specific, carefully targeted areas of a gene
    and ultimately a protein. This ability to precisely alter a
    specific region of a target protein greatly facilitates the
    synthesis of more focused libraries, significantly increasing
    the likelihood of identifying improved proteins. The ability to
    change specific regions of a protein in a deliberate and precise
    manner while leaving all other regions unchanged has profound
    implications for the development of new biotherapeutics as well
    as for improving FDA-approved, currently marketed
    biopharmaceuticals. Optimizing monoclonal antibodies
    demonstrates the importance of having the ability to change
    amino acids only at specific locations. While antibodies are
    relatively large proteins                                                                                           

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| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | consisting of hundreds of amino acids, the
    crucial sites on an antibody that determine its affinity or
    ability to bind to a particular target, constitute less than 5%
    of the overall protein. These sites consist of six different
    stretches of amino acids that are separated from one another.
    Therefore, antibody affinity optimization requires the ability
    to precisely confine amino acid changes to these six specific
    regions while leaving the remainder of the antibody unchanged.

Step Two:
ExpressAME

Our ExpressAME technology encompasses a number of
proprietary gene expression systems that we use to produce
protein libraries. A unique feature of our ExpressAME system is
that it enables us to apply our directed molecular evolution
technology to virtually any protein, including those that cannot
be functionally expressed in bacteria. A significant shortcoming
of certain competing technologies is that they rely primarily on
bacterial expression systems. However, many FDA-approved,
currently marketed, biopharmaceuticals cannot be expressed in
their functional, properly folded states by bacteria, and thus
require expression in mammalian cells. ExpressAME has been
developed specifically to address the technical challenges of
conducting directed molecular evolution in both bacterial and
mammalian cells.

Step Three:
ScreenAME

Our ScreenAME technology is a set of broadly
applicable proprietary tests or assays that are highly sensitive
and capable of characterizing thousands to millions of proteins
simultaneously. In selecting a screen for use in the directed
molecular evolution process, there is often a trade-off between
the speed of throughput, the rate at which proteins can be
screened, and the ability to predict the functional performance
of the protein in the human body. We believe that using the most
predictive screen available, regardless of its throughput, is
essential for identifying the most improved proteins. By using
our AMEsystem technology, we have the flexibility to create
libraries of proteins which are appropriately matched to the
throughput of the particular screen that is being used. If the
most predictive screen that is available is low throughput, we
can use DirectAME to create smaller, more focused libraries
containing proteins that have each been changed at only one or
two amino acid positions. Alternatively, when a high throughput
and highly predictive screen is available, DirectAME can be used
to generate larger protein libraries with multiple amino acid
substitutions. In contrast, certain competing technologies that
do not have the control and precision of DirectAME, and which
therefore produce larger, less focused protein libraries,
predominantly rely on high throughput screens, which are often
less predictive.

Repeating the
Process

We repeat the process starting with one or more
of the improved proteins produced by our AMEsystem to further
improve the function of the target protein. We can also combine
beneficial amino acid changes identified in the initial protein
library as a second strategy to achieve the same objective.

Market Opportunities

While virtually any product or process that
utilizes or could utilize DNA or proteins might be improved
though the application of our technology, we focus our efforts
on the biotherapeutic market, the largest and most profitable
target market for directed molecular evolution. We believe that
the level of technological sophistication and precision required
to improve FDA-approved, currently marketed, biopharmaceuticals
as well as to develop novel biotherapeutic candidates is
significantly greater than that required by other potential
target markets for directed molecular evolution technologies.
Since our inception, we have focused on developing and
optimizing our AMEsystem technology to address the
multibillion-dollar market opportunities in human
biotherapeutics.

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Biotherapeutics

Proteins are essential to all cellular processes
and have tremendous commercial value, particularly in the
pharmaceutical industry. The worldwide sales of therapeutic
proteins are projected to approach $24.0 billion by 2010.
The biotherapeutic market encompasses four major classes of
compounds, each with tremendous potential to improve human
health:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Antibodies:Antibodies currently represent the
    fastest growing biotherapeutic product category in dollar and
    percentage terms, due to the application of recently developed,
    novel approaches for generating, modifying and manufacturing
    antibodies. In 2002, worldwide sales for Synagis, a therapeutic
    antibody marketed by MedImmune, totaled more than
    $600.0 million. As demonstrated with our corporate
    collaborations and by our own internal development projects, our
    proprietary AMEsystem technology enables us to optimize
    antibodies with respect to safety, efficacy, potency,
    convenience, manufacturing cost and intellectual property.                                                                                                                                                                                                             
|
| |  | Cytokines:Cytokines
    are proteins secreted by cells that regulate the bodys
    immune system as well as its responses to inflammation.
    Cytokines have been implicated in a wide variety of diseases
    such as rheumatoid arthritis, sepsis and lupus that afflict
    millions of individuals. A well-studied cytokine is
    granulocyte-colony- stimulating factor, commonly known as G-CSF,
    which acts on the bone marrow to increase its production of
    white blood cells.                                                                                                                                                                                                                                                                                                                                                                                                            
|
| |  | Hormones:Hormones
    are proteins that are critical to the daily function and normal
    growth and development of the human body. Many of the most
    debilitating and chronic human diseases are due to hormone
    deficiencies. Human growth hormone, for example, is a naturally
    occurring human protein produced in the pituitary gland that
    regulates metabolism and is responsible for growth in children.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|
| |  | Enzymes:Enzymes
    constitute the majority of proteins in all cells. These proteins
    speed up cellular processes and are therefore critical to the
    normal function of cells. Enzymatic deficiencies are often
    fatal. Gauchers disease, for example, is a seriously
    debilitating, sometimes fatal, genetic disorder caused by a
    deficiency in an important enzyme called glucocerebrosidase.
    Administration of the synthetic form of this enzyme, called
    Cerezyme®, is currently the only treatment available to
    these patients. As demonstrated through our work on our product
    candidate AME-359, an optimized version of the human serum
    enzyme butyrylcholinesterase (BChE), that is funded
    by the National Institutes of Health, (NIH), our
    proprietary AMEsystem technology enables us to optimize enzymes
    with respect to catalytic activity.

Commercial Problems Solved Using Our AMEsystem
Technology

By applying our proprietary AMEsystem technology,
we have successfully addressed many significant challenges
involved in the biopharmaceutical development process. We
believe that our technology platform has been validated through
its successful application to critical, time-sensitive projects
for MedImmune, Eli Lilly and Company (Lilly), Chiron
Corporation (Chiron), Bristol-Myers Squibb Company
(Bristol-Myers Squibb), Seattle Genetics, Inc.
(Seattle Genetics) and CancerVax, Inc.
(CancerVax).

Increased
Potency

The use of Synagis, MedImmunes monoclonal
antibody against Respiratory Syncytial Virus (RSV),
is limited to the treatment of high-risk infants due to the
biopharmaceuticals high cost and requirement for
intramuscular administration. By using our directed molecular
evolution technology, we created several new product candidates
for MedImmune that have been demonstrated in disease models to
be at least 10 times more potent than Synagis. MedImmune is
expected to initiate clinical trials with one of these
candidates, and if successful, market it as NumaxTM.
If Numaxs significantly increased potency is confirmed in
human clinical trials, MedImmune could develop Numax for
increased efficacy, additional indications, reduce production
costs and pursue various delivery forms to broaden the
products use.

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| |                              
| | -----------------------------
| | Decreased Manufacturing Costs

A significant manufacturing problem was
encountered during the development of VitaxinTM, a
monoclonal antibody (MAb) product candidate designed
to treat diseases including cancer and arthritis by inhibiting
new blood vessel formation, a process known as
anti-angiogenesis. A particular structural feature in the
first-generation antibody made it susceptible to significant
degradation during the manufacturing process, resulting in a
loss of over 70% of the product yield. By applying our AMEsystem
technology to Vitaxin, we successfully created a
second-generation version of the antibody that is significantly
more stable than its predecessor. Our directed molecular
evolution technology decreased manufacturing costs by improving
the yield by more than 300% and also increased the affinity of
the antibody for its target by 90-fold. Second-generation
Vitaxin entered two Phase I clinical trials for cancer and
one Phase I clinical trial for rheumatoid arthritis with
MedImmune during 2001, and may enter Phase II clinical
trails in 2003.



| |                 
| | ----------------
| | Increased Safety

AME-527 is a humanized and optimized version of
Remicade, a chimeric (part-human, part-mouse) anti-Tumor
Necrosis Factor alpha (TNF alpha) antibody which the
FDA has approved for treatment of rheumatoid arthritis and
Crohns disease. AME 527 is currently in preclinical
development at AME for the treatment of rheumatoid arthritis. A
potential limitation of Remicade stems from the mouse component
of this antibody which renders it immunogenic. Certain patients
develop antibodies to the mouse portion which may not only
decrease the efficacy of Remicade, but also increase the
probability of patients experiencing an adverse effect, such as
an infusion reaction. By applying our frAMEworksTM
germline humanization and optimization technology to Remicade,
we created AME-527. Our humanized and optimized, higher-affinity
anti-TNF alpha MAb has the potential to reduce the
immunogenicity issues associated with Remicade while potentially
improving its efficacy as well.



| |                     
| | --------------------
| | Enhanced Convenience

AME-133 is a humanized and optimized anti-CD20
MAb in preclinical development for the treatment of
non-Hodgkins Lymphoma (NHL). In AMEs
head-to-head comparisons, this next-generation anti-CD20 MAb
displayed superior potency in vitro to Rituxan, an
FDA-approved, currently marketed anti-CD20 therapeutic MAb.
AME-133 exhibited higher affinity than Rituxan in in vitromodels and greater than 10-fold improved killing of human
cancer cells in comparison to Rituxan as demonstrated in ex
vivocell-based assays. This increased potency could lead to
a more convenient subcutaneous route of administration than the
time-consuming and inconvenient intravenous administration
required for Rituxan.



| |                                                             
| | ------------------------------------------------------------
| | Enabling the Commercialization of a
    Discovery Technology

Subtractive immunization is a novel approach to
discover antibodies that recognize unique therapeutic targets.
However, this approach usually results in low-affinity
antibodies that are unlikely to be commercially successful. By
applying our AMEsystem technology to this problem, we can
increase the affinity of antibodies produced by this process.
For Cell-Matrix, Inc. (Cell-Matrix), we optimized
HUI77 and HUIV26, anti-angiogenic mouse antibodies discovered
using subtractive immunization, which could enable the
commercialization of these antibodies. CancerVax acquired
Cell-Matrix in January 2002 and is in preclinical development
with these optimized antibodies.

Business Strategy

We are a leader in applying directed molecular
evolution to the optimization and development of human
biotherapeutics. We have selected biotherapeutics as our primary
target market because it is the largest and highest margin
market for directed molecular evolution. We are using our
proprietary AMEsystem technology to significantly improve
important characteristics of established biopharmaceuticals,
acting independently or in collaboration with the initial
developer. Our business strategy includes four basic elements:



| |   |                                                                                                                                                                                                       
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Optimize Currently Marketed
    Biopharmaceuticals.We have optimized
    FDA-approved, currently marketed biopharmaceuticals to create
    improved versions of these biotherapeutics with potentially

8



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | broader patent protection, including product
    candidates AME-527 and AME-133, optimized versions of Remicade
    and Rituxan, respectively. We believe that focusing on approved
    products with known therapeutic profiles and proven markets
    represent an attractive, lower risk development strategy. We
    plan to optimize and develop product candidates that we believe
    have lower development risks and target large, highly profitable
    markets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|
| |  | Develop Novel Biotherapeutics.We plan to access and develop novel
    human biotherapeutic candidates from a wide variety of sources
    including leading academic institutions and corporate
    collaborations. We also expect genomics and the sequencing of
    the human genome to yield an expanding number of novel proteins
    to optimize and commercially develop.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|
| |  | Leverage Corporate Collaborations.We plan to continue to expand the
    number of our corporate collaborations with leading
    pharmaceutical and biotechnology companies that are facing
    technical challenges to the development and commercialization of
    their therapeutic protein candidates and to leverage these
    corporate collaborations to expand our pipeline of product
    candidates. Our goal is to combine our expertise with that of
    our collaborators. We believe that we can add the greatest value
    to a project by applying our AMEsystem technology early on in
    the development process while relying on our collaborators to
    further develop and commercialize the improved product
    candidates. Corporate collaborators provide financial support
    for research and development, potential milestone payments and
    royalties on the sale of any products resulting from the
    collaboration.
|
| |  | Enhance Our AMEsystem Technology.We plan to continue to develop our
    AMEsystem technology by investing significantly in research and
    development while simultaneously protecting and expanding our
    leading intellectual property position in directed molecular
    evolution. We plan to license and acquire from others
    technologies that complement and expand our core capabilities.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

Development Programs

Since inception, we have entered into numerous
corporate collaborations and have pursued our own internal
development projects. We expect that corporate collaborations
will continue to be an important element of our business
strategy. Unless specifically mentioned, we do not have
commercialization rights to the intellectual property of
products developed from our collaborations. The following is a
summary of our development programs and related corporate
collaborations:



| |          
| | ---------
| | MedImmune

In February 1999, we entered into a four-antibody
corporate collaboration with MedImmune. The agreement covers the
licensing of Vitaxin to MedImmune as well as the optimization of
three additional antibodies, including Synagis and an antibody
against IL-9. Licenses granted under this agreement are
exclusive and worldwide covering the right to research, develop,
sell and sublicense. The business terms of the agreement
includes research and development support, potential milestone
payments, royalties on the sales of products resulting from the
collaboration and an equity investment. The duration of the
research and development aspect of this agreement was extended
through February 2004.

Synagis, MedImmunes monoclonal antibody
against RSV, is limited to the treatment of high-risk infants
due to the biopharmaceuticals high cost and requirement
for intramuscular administration. By using our directed
molecular evolution technology, we created several new product
candidates for MedImmune that have been demonstrated in disease
models to be at least 10 times more potent than Synagis.
MedImmune is expected to initiate clinical trials with one of
these candidates, and if successful, market it as Numax. This
more potent version of Synagis could enable MedImmune to
increase efficacy, address additional indications, reduce
production costs and pursue additional methods for administering
the protein therapeutic in order to broaden the products
use.

Vitaxin is an anti-angiogenic antibody with
potential applications in cancer and arthritis. We licensed
LM609, the mouse antibody from which Vitaxin was derived, from
The Scripps Research Institute. We then optimized LM609 to
overcome a potential immune reaction in humans and licensed it
to MedImmune.

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MedImmune is now in clinical development with a
second-generation version of Vitaxin that we developed using our
AMEsystem technology. This version of the antibody has
significantly improved affinity as well as decreased
manufacturing costs. MedImmune initiated Phase I clinical
trials for cancer and rheumatoid arthritis with this antibody
during 2001, and may enter Phase II clinical trails in 2003.


Anti-IL-9 is an antibody with potential
applications in respiratory disease including asthma.



| |      
| | -----
| | Lilly

In December 2001, we entered into a corporate
collaboration covering the optimization of an antibody and a
non-antibody protein therapeutic candidate with Lilly. Under the
terms of the agreement, AME received an upfront signing fee and
may receive milestone payments and royalties on the sales of
products resulting from the collaboration. In February 2002, an
additional agreement was entered into by AME and Lilly to
include the optimization of an additional antibody therapeutic
candidate.



| |       
| | ------
| | Chiron

In December 2001, we entered in to a corporate
collaboration covering the optimization of a non-antibody
protein therapeutic candidate with Chiron. Under the terms of
the agreement, AME received an upfront signing fee and may
receive milestone payments and royalties on the sales of
products resulting from the collaboration.



| |         
| | --------
| | Centocor

In May 2002, we entered into a corporate
collaboration covering the optimization of an antibody protein
therapeutic candidate with Centocor. Under the terms of the
agreement, AME received an upfront signing fee and may receive
milestone payments and royalties on the sales of products
resulting from the collaboration.



| |          
| | ---------
| | CancerVax

In November 1999, we entered into a corporate
collaboration covering up to four novel antibody therapeutic
candidates with Cell-Matrix. During 2000, we completed the
optimization of the first two compounds, and the agreement
was not extended to include the remaining two potential
compounds. Under the terms of the agreement, AME may receive
milestone payments and royalties on the sales of products
resulting from the collaboration. CancerVax acquired Cell-Matrix
in January 2002. Research under this collaboration has been
completed.



| |           
| | ----------
| | Biosynexus

In December 2000, we entered into a corporate
collaboration covering the optimization of an antibody
therapeutic candidate, HU96-110, with Biosynexus. During 2001 we
completed the optimization of HU96-110, which is being developed
for the treatment of staphylococcal bacterial infections. Under
the terms of the agreement AME received research and development
support and may receive milestone payments and royalties on the
sale of products resulting from the collaboration. Research
under this collaboration has been completed.



| |                     
| | --------------------
| | Bristol-Myers Squibb

We have entered into two separate agreements with
Bristol-Myers Squibb. We have completed our optimization work
under these agreements and may receive milestone payments and
royalties on the sale of products resulting from the
collaboration. Under the terms of the agreement, portions of the
milestone payments may be creditable against royalties.

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In June 1993, we entered into our initial
corporate collaboration with Bristol-Myers Squibb to optimize
their BR96 anti-solid tumor antibody and to develop a discovery
technology program to treat tumors. Bristol-Myers Squibb renewed
this collaboration in 1995. As discussed below, hBR96, our
improved version of BR96, is currently in preclinical
development with Seattle Genetics, a biotechnology company
founded by former Bristol-Myers Squibb scientists. Based on the
success of our initial collaborations, Bristol-Myers Squibb
amended our agreement in 1998 to include the optimization of its
anti-CD40 antibody for treating inflammatory disease.
Bristol-Myers Squibb is in preclinical development with the
optimized anti-CD40 antibody. Research under this collaboration
has been completed.



| |                 
| | ----------------
| | Seattle Genetics

Seattle Genetics is in preclinical development
with hBR96 for the potential treatment of cancers. After we
optimized BR96 for Bristol-Myers Squibb, Seattle Genetics
licensed this product candidate from Bristol-Myers Squibb. Under
our original agreement with Bristol-Myers Squibb and an
agreement among Bristol-Myers Squibb, Seattle Genetics and AME,
we may receive milestone payments and royalties on the sale of
products resulting from the collaboration. Research under this
collaboration has been completed.

Novasite Pharmaceutical, Inc.



| |           
| | ----------
| | Background

AMEs majority-owned subsidiary, Novasite
Pharmaceuticals, Inc. (Novasite), applies directed
molecular evolution to small-molecule drug discovery and
optimization. Novasites proprietary Expanded Target Drug
DiscoveryTM (ETDD) technology works to
address a limiting factor in drug discovery by simultaneously
screening libraries of small molecules against libraries of drug
target variants created through directed molecular evolution.
Novasites ETDD technology enables the concurrent screening
of hundreds of targets. This contrasts with a conventional
method of screening compound libraries against only a single
receptor target at a time. Novasites novel approach has
the potential to screen a billion individual ligand-receptor
combinations per day.



| |                                                                                 
| | --------------------------------------------------------------------------------
| | Series B Preferred Stock Financing,
    Affiliates and Select Option Information

During 2002, Novasite raised approximately
$1.3 million, including the conversion of approximately
$550,000 of debt, from a Series B Preferred Stock
financings which occurred in September and November of 2002. In
January 2003, Novasite raised an additional $750,000 from
Series B Preferred stock financing. Following the
financings, AME held a 54% interest in Novasite, and Crabtree
Ventures LP, a venture firm and previous investor in Novasite,
held a 40% interest in Novasite. John F. Richards, one of our
directors and a director of Novasite, is the Managing Member of
Crabtree Ventures, L.L.C., the general partner of Crabtree
Ventures, L.P. An additional $750,000 is expected to be raised
in 2003 from Series B Preferred Stock financing. The funds
from the financings are expected to be used to commercialize the
ETDD technology for the discovery of highly selective
small-molecule drugs.

William D. Huse, our President, Chief Executive
Officer and one of our directors, is the President, Chief
Executive Officer and a director of Novasite. Dr. Huse has
been granted options to purchase up to 800,000 shares of
Novasite common stock with an exercise price equal to $0.05 per
share, of which he has exercised options to purchase 16,800
shares of Novasite common stock. Approximately 70% of the total
options are fully vested. Additionally, Lawrence E. Bloch, our
Chief Financial Officer and Secretary, is a director of Novasite.





| |                                         
| | ----------------------------------------
| | National Institutes of Health
    Grants

In March 2002, Novasite was awarded a
$2.4 million grant from the National Institutes of Health
(NIH) to support the discovery of anti-obesity drug
candidates with ETDD. The grant awards $2.4 million over
two years to Novasite under Phase II of the Small Business
Innovation Research Program of the National Institute of
Diabetes and Digestive and Kidney Diseases branch of the NIH.
Novasite plans to apply

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ETDD in an effort to discover novel anti-obesity
drug candidates within the chemical libraries of a corporate
collaborator.


In September 2000 Novasite received a grant from
the NIH of $3.2 million over three years for research to
develop Novasites proprietary technology platform. The
grant was awarded to Novasite under the Bioengineering Research
Partnership Program of the National Institute of Allergy and
Infectious Diseases.



| |                              
| | -----------------------------
| | Aventis Pharmaceuticals, Inc.

In July 2001, Novasite entered into an agreement
with Aventis Pharmaceuticals, Inc. (Aventis) to
conduct a pilot-screening project using Novasites
proprietary ETDD technology platform. Research under this
collaboration has not been completed.

Internal Development Programs

We are using our AMEsystem technology to develop
both improved versions of currently marketed biopharmaceuticals
and novel human protein therapeutic candidates. We are working
on improving multiple FDA-approved, currently marketed
biopharmaceuticals that are already marketed by third parties
and in their first-generation forms are expected to each have
sales in excess of $100.0 million in 2002. We have retained
full commercialization rights to these internal development
projects.



| |        
| | -------
| | AME-527

AME-527 is a humanized and optimized anti-TNF
alpha MAb, in preclinical development for the treatment of
rheumatoid arthritis. AME-527 binds to and neutralizes human TNF
alpha, which is believed to contribute to inflammatory diseases,
including rheumatoid arthritis. In AMEs head-to-head
comparisons of affinity, protection from cell killing and
potency, this next-generation MAb demonstrated superiority to
Remicade, an FDA-approved, currently marketed anti-TNF alpha
therapeutic MAb. AME-527 demonstrated greater than 15-fold
higher affinity than Remicade in in vitroassays and
provided greater than 10-fold increased protection from TNF
alpha-mediated cell killing than Remicade in cell-based assays.
Additionally, AME-527 demonstrated increased potency when
compared with Remicade in a transgenic human TNF alpha
polyarthritic murine model, as measured by the prevention of
disease progression, or joint swelling.



| |        
| | -------
| | AME-133

AME-133 is a humanized and optimized
anti-CD20 MAb in preclinical development for the treatment
of NHL. AME-133 binds to and induces death of cells
expressing the CD20 antigen. In AMEs head-to-head
comparisons of affinity and tumor cell killing potency, this
next-generation MAb displayed superiority to Rituxan, an
FDA-approved, currently marketed anti-CD20 therapeutic MAb.
AME-133 exhibited greater than 10-fold higher affinity than
Rituxan in in vitromodels and greater than 10-fold
improved killing of human cancer cells in comparison to Rituxan
as demonstrated in ex vivocell-based assays.

AME-359

In September 2001, we announced the award of a
$1.0 million grant from the NIH to support the development
of AME-359, a therapeutic enzyme BChE we licensed from the
University of Nebraska Medical Center in March 2000 and the Mayo
Clinic in January 2001, for the potential treatment of acute
cocaine toxicity and chronic cocaine addiction. BChE is a
naturally occurring human serum enzyme that inefficiently breaks
down cocaine to inactive byproducts. Using the AMEsystem, AME
has developed AME-359 demonstrating over 100-fold increased
activity compared with naturally occurring BChE and has taken
the resulting product candidate into preclinical development.
AME has conducted animal models demonstrating engineered
improvements in AME-359s catalytic rate that improve the
enzymes ability to neutralize the toxic effects of cocaine
in vivo by greater than 250-fold in comparison to the
naturally occurring enzyme.

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Intellectual Property

We hold patents and rights to patents within the
field of directed molecular evolution with an extensive
portfolio that includes 23 issued U.S. patents related
to our proprietary technology and the resultant compositions of
matter. 41 counterpart patents to these U.S. patents
are issued in other major industrialized countries. We have an
additional 45 pending U.S. patent applications and
68 pending foreign and international counterpart
applications relating to our AMEsystem technology and the
application of this technology to diverse industries including
protein pharmaceuticals and industrial enzymes.

Our intellectual property portfolio includes
trade secrets, know-how, trademarks, patents and patent
applications related to DirectAME gene synthesis, ExpressAME
protein expression and ScreenAME protein screening as well as
the exclusive license to the Kauffman patents.



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | DirectAME:The
    DirectAME gene synthesis patents are directed to methods for
    generating genetic diversity which can be used for conducting
    directed molecular evolution. They claim methods for introducing
    changes at the codon level to generate genetic diversity.                                                                                                                                                                                                                                                                                                                                                            
|
| |  | ExpressAME:ExpressAME is a system used for
    conducting directed molecular evolution in both bacterial and
    mammalian cells. This system enables the expression of many
    therapeutic proteins in their functional, properly folded
    states, a feature that cannot always be achieved by relying
    exclusively on bacterial expression systems.                                                                                                                                                                                                                                                                                    
|
| |  | ScreenAME:We have a
    number of issued patents and pending patent applications
    relating to our ScreenAME technologies for assaying protein
    libraries. The patents and patent applications describe methods
    for evaluating protein function.                                                                                                                                                                                                                                                                                                                                                                                      
|
| |  | Kauffman Patents:The Kauffman patent family comprises
    six issued U.S. patents with claims covering methods of
    randomly generating proteins, which we believe is required by
    many directed molecular evolution technologies. We were granted
    an exclusive license to the Kauffman patent family in 1994. The
    first Kauffman patent application was filed in 1985, and the
    first U.S. Kauffman patent issued in 1998 with a term
    extending into 2015. Their patent prosecution history includes a
    successful defense to an opponents challenge in Japan as
    well as being issued in Europe with no challenge.

We are fully committed to investing in the
further development, expansion and enforcement of our leading
intellectual property position in directed molecular evolution.

On June 25, 2001, we filed a complaint
against MorphoSys AG and its wholly owned subsidiary MorphoSys
USA, Inc. in the United States District Court for the District
of Massachusetts seeking injunctive relief and damages on behalf
of the Company. The complaint alleges that MorphoSys AG and
MorphoSys USA, Inc. are willfully infringing the Kauffman patent
family under which we hold an exclusive license.

On January 6, 2003, we announced a report
and recommendation from the magistrate judge in the United
States District Court for the District of Massachusetts to the
district judge in our legal action against MorphoSys AG and
its wholly owned subsidiary MorphoSys USA, Inc. that
MorphoSys motion for summary judgment of non-infringement
be allowed and that AMEs motion for partial summary
judgment of infringement be denied and all other motions be
dismissed as moot. We have filed objections to the magistrate
judges report and recommendation. The district judge may
adopt, reject or modify the magistrate judges
recommendation, or instruct the magistrate judge to reconsider
the recommendation.

Competition

We are a leader in the application of directed
molecular evolution to the optimization and development of
biotherapeutics. We are aware that companies such as Maxygen,
Inc., Diversa Corporation and Genencor International, Inc., rely
on alternative methods such as gene shuffling and extremophile
isolation for obtaining or generating genetic diversity. Some or
all of these companies will compete against us to develop novel
human biotherapeutic products and to improve FDA-approved,
currently marketed protein therapeutics. Academic institutions
such as the California Institute of Technology and the
University of Washington are also working in this field. In the
future, we expect the field to become highly competitive and
that companies

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and academic and research institutions will seek
to develop technologies that could be competitive with our
AMEsystem technology. Any products that we may develop through
our AMEsystem technology will compete in highly competitive
markets, especially our improved versions of FDA-approved,
currently marketed biopharmaceuticals.


Many of our potential competitors have
substantially greater financial, technical and personnel
resources than we do, and we cannot be certain that they will
not succeed in developing technologies and products that would
render our technology and products or those of our collaborators
obsolete or noncompetitive. In addition, many of those
competitors have significantly greater experience than we do in
their respective fields. Our ability to compete successfully
will depend, in part, on:



| |   |                                                                                                           
| | - | ----------------------------------------------------------------------------------------------------------
| |  | our ability to demonstrate the applicability of
    our technology to optimizing a broad range of proteins
|
| |  | the cost-effectiveness of our optimization
    approach                                                   
|
| |  | our ability to develop products that reach the
    market first                                           
|
| |  | our ability to develop products that are
    technologically superior to other products in the market     
|
| |  | our ability to obtain and enforce patents
    covering our technology                                     

Government Regulation

The development of new therapeutic products is a
complex, lengthy, expensive, highly regulated process, and is
subject to substantial uncertainty and risk. Any product
candidates that we or our collaborators may develop for use in
the United States will be subject to regulation by the FDA, and
may be subject to local or regional regulatory agencies in other
countries if developed for use there. Biotherapeutic products
are regulated by the Federal Food, Drug and Cosmetic Act and the
Public Health Service Act. The two statutes, and a large body of
related regulations govern, among other things, product-related
testing, manufacturing, safety, efficacy, labeling, storage,
record keeping, advertising and other promotional practices. FDA
approval is required prior to marketing a pharmaceutical product
in the United States.

New biotherapeutics typically advance from
research testing, involving laboratory and animal studies,
through preclinical pharmacology and toxicology testing, and
finally through several phases of clinical testing in humans.
Before a new product candidate may be tested in humans,
preclinical studies must be conducted in the laboratory and in
animal model systems to gain preliminary information on the
product candidates efficacy and to give indication of any
potential safety concerns. The results of these studies are
submitted as a part of an Investigational New Drug
(IND) application in the United States, or its
equivalent elsewhere in the world. The IND application must be
reviewed by the FDA and become effective pursuant to FDA
regulations before human clinical trials may commence, and the
trials may be halted by a clinical hold at any time. The IND
includes a detailed description of the product, its manufacture
and the proposed clinical investigations. A company must sponsor
and file an IND for each proposed product candidate, and usually
a separate IND for each clinical indication. The FDA may require
the modification, suspension or termination of clinical trials
at any time if an unwarranted risk is presented to patients
involved in the clinical trials.

Once the IND is active, biopharmaceutical product
candidates undergo clinical testing in several phases. Human
clinical trials typically are conducted in three phases and are
subject to detailed protocols. Each protocol regulates how the
clinical trial is to be conducted and must be submitted to the
FDA as part of the IND. In typical Phase I clinical trials,
small numbers of patients or healthy volunteers are treated to
determine a preliminary safety profile, pharmacokinetics and
sometimes preliminary evidence of efficacy of the product
candidate. In typical Phase II clinical trials, larger
groups of patients afflicted with a target disease are treated
with the investigational product at various doses in order to
determine preliminary evidence of efficacy, optimal dosages and
expanded evidence of safety. Typical Phase III clinical
trials are large scale, multicenter, controlled, comparative
trials conducted in the afflicted patient population intended
for registration. In selected cases, a given clinical trial may
contain elements of more than one typical testing phase. In some
cases, initial human testing is done in patients rather than
healthy volunteers. These studies may provide results
traditionally obtained in Phase II clinical trials and can
be referred to as Phase I/ II trials.

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Furthermore, pivotal trials, studies that provide
significant evidence of safety and efficacy in support of
registration, are usually Phase III clinical trials, but may be
Phase II clinical trials in serious, life-threatening
diseases.


Upon successful completion of clinical trials,
the pharmaceutical sponsor prepares an application requesting
approval to market the biotherapeutic for a particular patient
population. This application, a New Drug Application
(NDA) or Biologic License Application
(BLA) in the United States, contains a large amount
of information on the manufacturing and characterization of the
medicinal product candidate, its preclinical testing and all
completed phases of clinical testing, as well as any treatment
experience outside of clinical trials. Submission of a BLA does
not assure FDA approval for marketing. The FDA has recently
announced a major reorganization in which most non-vaccine,
non-gene therapy biotheropeutic candidates will be regulated by
its CDER division, and it is not clear whether either the NDA or
the BLA applications will be used in the future.

Applications submitted to the FDA are subject to
an unpredictable and potentially prolonged review process. The
FDA may require additional preclinical information,
manufacturing information or clinical information. Additional
preclinical, manufacturing or clinical studies may be required,
and the additional studies may take years to complete. External
reviews, including FDA Advisory Committees, may be required. The
FDA may and at time does ultimately decide that the application
does not satisfy its criteria for approval. Even if FDA
regulatory clearances are obtained, a marketed product is
subject to continual review. Post-approval discovery of
previously unknown problems or failure to comply with the
applicable regulatory requirements may result in restrictions
placed on the marketing of a product or may result in withdrawal
of marketing approval. In this case, the FDA or its
international counterparts may order the product to be withdrawn
from the market and recalled from distribution. Failure to
comply with the applicable regulatory requirements may also
result in fines, other civil sanctions or criminal sanctions.

Before marketing clearance is secured, the
manufacturing facility must be inspected for compliance with
current Good Manufacturing Practices (GMP) by FDA
inspectors. The manufacturing facility must satisfy current GMP
requirements prior to marketing clearance. In addition, if
marketing clearance is secured, the manufacturing facility will
be inspected periodically for GMP compliance by FDA inspectors,
and, if the facility is located in California, by inspectors
from the Food and Drug Branch of the California Department of
Health Services. In complying with the GMP regulations,
manufacturers must continue to expend time, money and effort in
production, recordkeeping and other requirements. Failure to
comply with the GMP regulations subjects the manufacturer to
possible FDA regulatory action, such as the suspension of
manufacturing, product recall or seizure, injunction, fines and
criminal prosecution.

In both domestic and foreign markets, sales of
any approved products depends on reimbursement decisions from
governmental agencies and/or third-party payers, including
government and private insurance plans. Third-party payers are
increasingly requiring evidence from controlled clinical trials
that includes safety, efficacy, quality of life and
pharmacoeconomic endpoints. Reimbursers are also increasingly
recommending generic treatments first and challenging the prices
charged for medical products and services. If we, or our
collaborators, succeed in bringing one or more product
candidates to market, these products may not be considered
cost-effective, reimbursement may not be available, or
reimbursement policies may adversely affect our ability to sell
our products on a profitable basis.

We also are subject to various federal, state and
local laws, regulations and recommendations relating to safe
working conditions, laboratory and manufacturing practices, the
experimental use of animals and the use and disposal of
hazardous or potentially hazardous substances, including
radioactive compounds and infectious disease agents, used in
connection with our research. The extent of government
regulation which might result from any future legislation or
administrative action cannot be accurately predicted.

Second-generation Vitaxin, optimized by us,
entered Phase I clinical testing with MedImmune during
2001, and may enter Phase II clinical trails in 2003. Our
corporate collaborators control all aspects of the clinical
testing of product candidates we optimized for them. We do not
have any internal development product candidates in human
clinical trials.

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Employees

As of December 31, 2002, we had
106 full-time employees, 48 of whom hold advanced degrees.
83 of our full-time employees were engaged in research and
development, and 23 were engaged in business development,
finance and general administration. None of our employees is
represented by labor unions or covered by collective bargaining
agreements. We have not experienced any work stoppages and
consider our employee relations to be good.

Marks

Remicade® is a registered trademark of
Centocor; Rituxan® is a registered trademark of IDEC
Pharmaceuticals, Inc.; NumaxTM and
VitaxinTM are trademarks of MedImmune; and
Synagis® is a registered trademark of MedImmune.

The Companys Internet address is
www.AME.biz. The Company makes available free of charge on
www.AME.biz its annual report on Form 10-K, quarterly
reports on Form 10-Q, current reports on Form 8-K and
amendments to those reports, as soon as reasonably practical
after the Company electronically files such material with, or
furnishes it to, the SEC. The information found on the
Companys website shall not be deemed incorporated by
reference by any general statement incorporating by reference
this report into any filing under the Securities Act of 1933 or
under the Securities Exchange Act of 1934, except to the extent
the Company specifically incorporates the information found on
the Companys website by reference, and shall not otherwise
be deemed filed under such Acts.

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RISK FACTORS

We have not achieved profitability and may
never become profitable.

We are at an early stage of development. We
incurred a net loss of $17.4 million for the twelve months
ended December 31, 2002, and our revenue for the same
period was $7.9 million. Additionally, we have had net
losses each year since inception and as of December 31,
2002, had an accumulated deficit of $71.6 million. We
expect to report a net loss for fiscal year 2003, and we expect
to report increasing net losses for the foreseeable future. We
may never achieve profitability. The size of our net losses will
depend, in part, on the rate of growth, if any, in our contract
revenue and on the level of our expenses. To date, we have
derived most of our revenue from corporate collaborations and
expect to continue to do so for the foreseeable future. Revenue
from corporate collaborations is uncertain because our ability
to secure future agreements will depend upon our ability to
address the needs of our potential collaborators. We expect to
spend significant amounts to fund research and development and
enhance our AMEsystem technology. We expect that our operating
expenses will increase significantly in the near term, and
consequently, we will need to generate significant additional
revenue to achieve profitability. Even if we do achieve
profitability, we may not be able to sustain or increase
profitability on a quarterly or annual basis.

We may need additional capital in the future.
If additional capital is not available, we may have to curtail
or cease operations.

We may need to raise more capital to continue our
operations. We may seek additional funds from public and private
stock offerings, corporate collaborations, borrowings under
lease lines of credit or other sources. If we cannot raise more
capital, we may have to reduce our capital expenditures, scale
back our development of new products, reduce our workforce or
license to others product candidates or products that we
otherwise would seek to commercialize ourselves. We expect that
our current resources, together with future operating revenues,
will be sufficient to fund operations for at least the next two
years. The amount of capital we will need will depend on many
factors, including:



| |   |                                                        
| | - | -------------------------------------------------------
| |  | the success of our research and development
    efforts
|
| |  | our ability to establish collaborative agreements      
|
| |  | our costs of prosecuting and maintaining patents       
|
| |  | the market and competing technological
    developments

Additional capital may not be available on terms
acceptable to us, or at all. Any additional equity financing may
be dilutive to stockholders, and debt financing, if available,
may include restrictive covenants.

The commercial utility of our AMEsystem
technology is unproven and may never be realized.

While we have met with initial success in
applying our AMEsystem technology, to prove its commercial
value, we or our collaborators will need to commercialize
biotherapeutic candidates that we have optimized. Successful
commercialization of biotherapeutic candidates requires:
preclinical testing, clinical trials, regulatory approval, and
commercial manufacturing. It will take us or our collaborators
many years to complete these steps for any biotherapeutic
candidate. If we or our collaborators do not undertake and
successfully complete these activities, then our AMEsystem
technology will be of little commercial value, and our ability
to generate revenue will be limited. Currently, there is one
product candidate, Vitaxin, in clinical trials that has been
optimized using our technology.

We have announced the optimization of only two
types of proteins and may not be able to optimize certain
proteins, thereby limiting our market potential.

To date we have announced the optimization of
only proteins from the classes of antibodies and enzymes for
corporate collaborators and internal development projects. If,
through the application of our AMEsystem

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technology we are unable to optimize certain
proteins, the scope of our potential business will be
significantly limited.


If our collaborators are not successful or if
we are unable to find collaborators in the future, we may not be
able to commercialize product candidates.

Our strategy for developing and commercializing
product candidates may call for us to enter into contractual
arrangements with collaborators. We may be unsuccessful in
attracting collaborators to develop and commercialize our
product candidates. Some collaborators may not perform their
obligations as we expect, or we may not derive any revenue from
these arrangements. We do not know whether these collaborators
will successfully develop and market any product candidates
under their respective agreements. Moreover, some of our
collaborators may acquire or develop competing technologies and
product candidates targeted by our collaborative programs. Our
success depends in part upon the performance by these
collaborators of their responsibilities under these
arrangements. We have no control over the resources that any
collaborator may devote to the development and commercialization
of product candidates under these collaborations. Our
collaborators may terminate their agreements with us or
otherwise fail to conduct their collaborative activities
successfully and in a timely manner. Our collaborators may elect
not to develop product candidates arising out of our
collaborative arrangements or not to devote sufficient resources
to develop, manufacture, market, or sell these product
candidates.

If product candidates we optimize do not
receive regulatory approval, neither we nor our collaborators
will be able to commercialize these product
candidates.

The FDA must approve any therapeutic product
candidate before it can be marketed in the United States. The
regulatory process is expensive and time-consuming. Before we or
a collaborator can file a new drug application with the FDA, the
product candidate must undergo extensive testing, including
animal studies and human clinical trials that can take many
years and may require substantial expenditures. Data obtained
from such testing may be susceptible to varying interpretations
which could delay, limit, or prevent regulatory approval.
Changes in regulatory policy for product approval may cause
delays or rejections. Because our product candidates will be
developed in a novel way, government regulatory authorities may
subject these product candidates to greater scrutiny than those
developed using more conventional methods. Our collaborators are
in early stages of the FDA regulatory process for product
candidates we have optimized.

If we are unable to adequately protect our
proprietary technology, our competitive position could be
hurt.

The patent positions of pharmaceutical and
biotechnology companies, including our patent position, are
generally uncertain and involve complex legal and factual
questions. We may be able to protect our proprietary rights from
infringement by third parties only to the extent that our
proprietary technologies are covered by valid and enforceable
patents or are effectively maintained as trade secrets.
Furthermore, others may independently develop similar or
alternative technologies or design around our patented
technologies. Litigation or other proceedings to defend or
enforce our intellectual property rights could require us to
spend significant time and money and could disrupt and harm our
business.

We also rely upon trade secrets, technical
know-how, and continuing inventions to develop and maintain our
competitive position. Others may independently develop
substantially equivalent proprietary information and techniques
or otherwise gain access to our trade secrets or disclose our
technology, and we may not be able to meaningfully protect our
trade secrets or be capable of protecting our rights to our
trade secrets.

If we infringe third-party patents or breach
our license agreements, litigation may deplete our resources and
undermine our ability to use our AMEsystem technology.

Our commercial success depends in part on neither
infringing valid, enforceable patents or proprietary rights of
third parties, nor breaching any licenses that may relate to our
technology and product candidates. Our commercial success might
also become dependent on us not infringing valid, enforceable
patents or proprietary rights which might be developed by third
parties in the future. We are aware of third-party patents

18



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that may relate to our technology. It is possible
that we may unintentionally infringe these patents or other
patents or proprietary rights of third parties. Any legal action
taken against us or our collaborators claiming damages and
seeking to enjoin commercial activities relating to our product
candidates and processes affected by third-party rights may
require us or our collaborators to obtain licenses in order to
continue to manufacture or market the affected product
candidates and processes. In addition, these actions may subject
us to potential liability for damages. We or our collaborators
may not prevail in an action, and any license required under a
patent may not be made available on commercially acceptable
terms, or at all. Litigation could result in substantial costs
and the diversion of managements efforts, regardless of
the result of the litigation.


If we lose our key personnel or are unable to
attract and retain additional personnel, we may be unable to
successfully develop our technology.

We are highly dependent on the principal members
of our management and scientific staff, particularly our
President, Chief Executive Officer and Chairman of the Board,
William D. Huse, M.D., Ph.D. If we lose their services
we may not achieve our objectives. In addition, recruiting and
retaining qualified scientific personnel to perform future
research and development work will be critical to our success.
We do not have sufficient personnel to fully execute our
business plan, and there is currently a shortage of skilled
executives and scientists, which is likely to continue. As a
result, competition for experienced executives and scientists
from numerous companies and academic and other research
institutions may limit our ability to hire or retain personnel
on acceptable terms. If we fail to attract and retain sufficient
personnel, we may not be able to develop or implement our
technology.

Public perception of ethical and social issues
may limit the use of our technology, which could reduce our
revenue.

Our success will depend upon our ability to
develop product candidates through the application of our
directed molecular evolution technology. Governmental
authorities could, for social or other purposes, limit the use
of genetic modification or prohibit the practice of our
technology. Ethical and other concerns about the use of products
derived from modified genes could adversely affect their market
acceptance. If our technology or the product candidates we
develop cannot be marketed as a result, we would lose our core
business.

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.

We use hazardous materials, including chemicals,
and radioactive and biological materials. These materials
include o-phenylenediamine dihydrochloride, ethidium bromide,
and acrylamide. Our operations also produce hazardous waste
products. We cannot eliminate the risk of accidental
contamination or discharge and any resultant injury from these
materials. We could be subject to civil damages in the event of
an improper or unauthorized release of, or exposure of
individuals to, hazardous materials. In addition, claimants may
sue us for injury or contamination that results from the use of
these materials. Federal, state, and local laws and regulations
govern the use, manufacture, storage, handling, and disposal of
these materials. Compliance with environmental laws and
regulations may be expensive, and current or future
environmental regulations may impair our research, development,
or production efforts.

If people are harmed by protein therapeutics
developed using our AMEsystem technology, we may be sued for
product liability.

We may be sued for product liability and other
claims if our technology or products developed from our
technology are alleged to have caused harm. We may not be able
to avoid significant liability exposure. We maintain product
liability insurance, but we may not have sufficient coverage. If
we are sued for any injury caused by our product candidates and
found liable, our financial condition, reputation, and ability
to find collaborators may be harmed.

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Substantial sales of our common stock by our
existing stockholders could cause our stock price to
fall.

Future sales of our common stock by our
stockholders under Rule 144 of the Securities Act of 1933
(the Securities Act), or through the exercise of
outstanding registration rights or otherwise could have an
adverse effect on the price of our common stock. Shares of our
common stock which are not held by our affiliates are eligible
for sale in the public market in reliance on Rule 144(k) or
Rule 701 under the Securities Act, without any volume
restrictions. Additionally, we registered a total of
7,622,625 shares of common stock reserved for issuance
under our stock plans. Some of our existing stockholders have
rights to require us to register their shares for future sale.

Our financial condition could be affected by
offerings of our subsidiarys stock.

We could engage in future offerings or other
sales of the common or preferred stock of our subsidiary,
Novasite Pharmaceuticals, Inc. (Novasite), if our
board determines that it is in the best interests of the
stockholders to pursue that course of action. This could
adversely affect our business, financial condition, and results
of operations. For example, any offering or other sale of a
portion of our subsidiarys stock could reduce the
subsidiarys contribution to our gross revenues.

We are subject to influence from our executive
officers and directors who may vote in ways with which you
disagree because they have interests both as managers and
stockholders.

As of December 31, 2002, our officers and
directors and their affiliates, in the aggregate, owned
beneficially approximately 26% of our outstanding shares of
common stock. As a result, these stockholders, acting together,
would be able to effectively control most matters requiring
approval by our stockholders, including the election of a
majority of the directors. If your interests as a stockholder
are different from their interests as both managers and
stockholders, you may not agree with their decisions.

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MANAGEMENT

Executive Officers

Our executive officers and key employees, and
their ages and positions as of March 4, 2003, are:

|                                 |  |     |    |          |  |                                                                 
|-------------------------------- |  | --- | -- | -------- |  | ----------------------------------------------------------------
|Name                             |  | Age |    | Position
|                                 |  |     |    |         
|William D. Huse, M.D., Ph.D.     |  |     | 48 |          |  | Chief Executive Officer, President and Chairman
    of the Board
|Lawrence E. Bloch, M.D., J.D.    |  |     | 37 |          |  | Chief Financial Officer and Secretary                           
|James B. Breitmeyer, M.D., Ph.D. |  |     | 49 |          |  | Chief Medical Officer                                           
|Keith S. Manchester, M.D.        |  |     | 34 |          |  | Vice President of Business Development                          
|William L. Respess, J.D., Ph.D.  |  |     | 63 |          |  | Vice President, General Counsel and Director                    
|Jeffry D. Watkins, Ph.D.         |  |     | 41 |          |  | Chief Scientific Officer                                        

William D. Huse, M.D., Ph.D.,founded our Company in 1989, has been
our Chief Executive Officer since January 1999 and the Chairman
of the Board of Directors since May of 2002. Dr. Huse was
affiliated with The Scripps Research Institute from 1989 to
1990. Prior to joining Scripps, Dr. Huse was Vice
President, Research and Development at Stratagene, Inc., a
private biotechnology company, from 1986 to 1989. Dr. Huse
was an Assistant Professor at Yale University School of
Medicine, Section of Molecular Neurobiology, from 1984 to 1986.
Dr. Huse received his M.D. and Ph.D. in Neurosciences from
the Albert Einstein School of Medicine. Dr. Huse completed
his postdoctoral work at Cold Spring Harbor Laboratory.

Lawrence E. Bloch, M.D., J.D.,has been our Chief Financial Officer
since March 2000 and our Secretary since April 2000. From 1999
to 2002, he held the position of Vice President of Business
Development in our Company. From 1998 to 1999, he served as a
consultant to several private biotechnology companies, including
our Company and U.S. Genomics, Inc. In 1995, Dr. Bloch
co-founded CareCom, Inc., a developer of patient-oriented
bioinformatics applications, and served as its President from
1995 to 1999. Dr. Bloch received a J.D. from Harvard Law
School, an M.D. from Harvard Medical School and an M.B.A. from
Harvard Business School.

James B. Breitmeyer, M.D., Ph.D.,has been our Chief Medical Officer
since December 2001. From 2000 to 2001, Dr. Breitmeyer was
President and CEO of the Harvard Clinical Research Institute.
From 1991 to 2000, Dr. Breitmeyer held a variety of
positions at Serono Laboratories, Inc., including Chief Medical
Officer and Senior Vice President of Research and Development.
Prior to Serono, Dr. Breitmeyer served as a consultant to
Immunogen, Inc., and held clinical and teaching positions at the
Dana Farber Cancer Institute and Harvard Medical School.
Dr. Breitmeyer received his M.D. and Ph.D. from Washington
University School of Medicine and is board certified in Internal
Medicine and Oncology.

Keith S. Manchester, M.D.,has been our Vice President of
Business Development since January 2002. From 2000 to 2002 he
held the position of Director of Business Development in our
Company. From 1999 to 2000, Dr. Manchester was an associate
at Vestar Capital Partners, a private equity firm specializing
in management buyouts. From 1997 to 1999, Dr. Manchester
was an investment banker in the healthcare group at Goldman,
Sachs & Co. He completed his surgical internship at Parkland
Medical Hospital in Dallas, Texas. Dr. Manchester received
an A.B. from Harvard College and an M.D. from Harvard Medical
School.

William L. Respess, J.D.,
Ph.D.,has been our Vice
President and General Counsel since July 2002 and has been a
member of our Board of Directors since September 2002. From 2000
to 2002, Dr. Respess served as Senior Vice President and
General Counsel of Graviton Inc. From 1988 to 2000,
Dr. Respess served as Senior Vice President and General
Counsel of Ligand Pharmaceuticals Inc. Dr. Respess
experience also includes positions as Vice President and General
Counsel of Gen-Probe Inc., Vice President and General Counsel of
Hybritech Inc. and Partner at Lyon & Lyon. Dr. Respess
received a Ph.D. in Organic Chemistry from the Massachusetts
Institute of Technology and a J.D. from George Washington
University before serving as Law Clerk and Technical Advisor to
the Honorable J. Lindsay Almond, Jr., on the United States
Court of Customs and Patent Appeals. He is a member of the
American Intellectual Property Law Association and has been a
frequent lecturer on intellectual property and licensing law.

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Jeffry D. Watkins, Ph.D.,has been our Chief Scientific Officer
since January 2002. From 1998 to 2002, he served as our Vice
President of Research. From 1993 to 1998, Dr. Watkins held
a variety of research positions in our Company. From 1992 to
1993, he was a research scientist at Hybritech, Inc., a public
biotechnology company focused on diagnostics. Dr. Watkins
received a Ph.D. in Biochemistry from Purdue University. He
completed his postdoctoral research at The Scripps Research
Institute and at Purdue University. He is also the recipient of
a National Institutes of Health Postdoctoral Fellowship.
Dr. Watkins has authored multiple scientific peer-reviewed
articles, is named inventor on numerous directed molecular
evolution patents and has been the principal investigator on
multiple federal grants.




Item 2.     Properties

Our executive office and research facilities are
located in San Diego, California, and comprise approximately
43,000 square feet of space. The leases on these facilities
expire in December 2004 and 2008. We believe that our existing
facilities and equipment are well maintained and in good working
condition and that our current facilities will provide adequate
capacity through the term of the leases.

On August 17, 2001, the Company entered into
an Operating Agreement with Torrey View
Phase II, L.P., to establish AME Torrey View, LLC
(Torrey View), a 99% owned subsidiary of the
Company, which is consolidated in our financial statements. On
March 4, 2002, Torrey View purchased a
10.73-acre parcel of undeveloped land in San Diego County
from a third party at a cost of approximately $8.0 million.
The Company may develop this property over the next few years as
its corporate headquarters. The Company could also seek
alternative uses for the property or sell the property if
development would be inconsistent with the Companys
liquidity and cash resource needs.

In connection with the purchase, the Company
borrowed approximately $10.0 million, under a
$15.0 million credit facility, from Merrill Lynch Bank USA
to fund the purchase price and certain development costs, and as
of December 31, 2002, we had approximately
$5.0 million available for future financing needs under
this credit facility. This loan was transferred to Merrill Lynch
Business Financial Services during 2002 with substantially the
same terms as the original loan from Merrill Lynch Bank USA. As
of December 31, 2002, restricted cash of approximately
$10.5 million collateralized the outstanding loan balance.
The Company also entered into a $3.0 million loan and a
development and management agreement with a group, that is not
affiliated with the Company, but that is affiliated with the 1%
owner of Torrey View, who may assist the Company with the
development of the project. The $3.0 million loan from the
Company to the group is collateralized by a perfected security
interest in the 1% owners membership rights in Torrey View
and is due in 2004. Torrey View also entered into an engagement
letter and compensation agreement with a third party to act as a
broker and co-development manager, on behalf of Torrey View, in
connection with the purchase and development of the land.




Item 3.     Legal
Proceedings

On June 25, 2001, we filed a complaint
against MorphoSys AG and its wholly owned subsidiary MorphoSys
USA, Inc., in the United States District Court for the District
of Massachusetts seeking injunctive relief and damages on behalf
of the Company. The complaint alleges that MorphoSys AG and
MorphoSys USA, Inc., are willfully infringing the Kauffman
patent family under which we hold an exclusive license.

On January 6, 2003, we announced a report
and recommendation from the magistrate judge in the United
States District Court for the District of Massachusetts to the
district judge in our legal action against MorphoSys AG and its
wholly owned subsidiary MorphoSys USA, Inc. that MorphoSys
motion for summary judgment of non-infringement be allowed and
that AMEs motion for partial summary judgment of
infringement be denied and all other motions be dismissed as
moot. We have filed objections to the magistrate judges
report and recommendation. The district judge may adopt, reject
or modify the magistrate judges recommendation, or
instruct the magistrate judge to reconsider the recommendation.

On July 25, 2002, a petition was filed in
the Superior Court of the State of California, County of San
Diego, by the Torrey Hills Community Coalition, et al. against
the City of San Diego, et al. seeking to compel the City of San
Diego to revoke the approval which was previously issued with
respect to the development of

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our corporate headquarters. A petition was also
filed by the Del Mar Union School District on October 25,
2002, seeking a similar legal remedy. These petitions assert
that the City of San Diego failed to comply with or violated
various legal requirements in connection with its approval of
that development, but they do not seek monetary relief from the
Company. We understand that the City of San Diego believes that
it has complied with all legal requirements for this project and
therefore intends to vigorously oppose these petitions. The
Company is named as a real party in interest, and we also intend
to vigorously oppose these petitions and believe that they will
not have a material adverse effect on our business.





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

Not applicable.




PART II




Item 5.     Market
for Registrants Common Equity and Related Stockholder
Matters

(a) Our common stock has been traded on the
Nasdaq National Market since our initial public offering on
July 27, 2000, under the symbol AMEV. Prior to such time,
there was no public market for our common stock. The following
table sets forth the range of the high and low closing sale
prices for our common stock, as reported on the Nasdaq National
Market, for the two most recent fiscal years:

|                             |  |      |       |     |  |   |      | 
|---------------------------- |  | ---- | ----- | --- |  | - | ---- | 
|                             |  | High |       | Low
|                             |  |      |       |    
|Year Ended December 31, 2001 |  |      |       |     |  |   |      | 
|First Quarter                |  | $    | 18.23 |     |  | $ | 5.75 | 
|Second Quarter               |  | $    | 14.06 |     |  | $ | 6.18 | 
|Third Quarter                |  | $    | 13.80 |     |  | $ | 7.00 | 
|Fourth Quarter               |  | $    | 12.80 |     |  | $ | 7.00 | 

|                             |  |      |       |     |  |   |      | 
|---------------------------- |  | ---- | ----- | --- |  | - | ---- | 
|                             |  | High |       | Low
|                             |  |      |       |    
|Year Ended December 31, 2002 |  |      |       |     |  |   |      | 
|First Quarter                |  | $    | 13.20 |     |  | $ | 7.71 | 
|Second Quarter               |  | $    | 8.30  |     |  | $ | 5.00 | 
|Third Quarter                |  | $    | 5.55  |     |  | $ | 3.83 | 
|Fourth Quarter               |  | $    | 3.50  |     |  | $ | 1.91 | 

On February 20, 2003, there were
121 holders of record of our common stock.

We have never declared or paid any cash dividends
on our capital stock. We currently intend to retain future
earnings, if any, for development of our business and,
therefore, do not anticipate that we will declare or pay cash
dividends on our capital stock in the foreseeable future.

(b) The effective date of our first
registration statement, filed on Form S-1 under the
Securities Act of 1933 (No. 333-36830) relating to our
initial public offering of common stock, was July 26, 2000.
A total of 5,347,500 shares of our common stock were sold
at a price of $19.00 per share to an underwriting syndicate
led by CIBC World Markets, UBS PaineWebber Incorporated,
formerly known as PaineWebber Incorporated, and SG Cowen. Of
these 5,347,500 shares, 697,500 shares were issued upon exercise
of the underwriters over-allotment option. The offering
commenced on July 27, 2000, and closed on August 2, 2000.
The initial public offering resulted in gross proceeds of $101.6
million, $7.1 million of which was applied toward the
underwriting discount. Expenses related to the offering totaled
approximately $1.6 million. No direct or indirect payments
were made to any directors, officers, owners of ten percent or
more of any class of our equity securities, or other affiliates
of the Company other than for reimbursement of expenses. Net
proceeds to us, after deducting these expenses, were
approximately $92.9 million. We have used approximately
$10.9 million of the net offering proceeds for a portion of
the repurchase of approximately 3.1 million shares of our
stock for $21.7 million, $6.3 million for purchases of
property and equipment, and approximately $19.3 million to fund
our net losses. The balance of the proceeds was applied towards
the purchase of temporary investments

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consisting of U.S. government agencies
obligations, corporate bonds, asset-backed securities, and cash
and cash equivalents.





Item 6.     Selected
Financial Data

The following table presents our selected
historical financial data. The selected data should be read in
conjunction with Managements Discussion and Analysis
of Financial Condition and Results of Operations and the
financial statements included elsewhere in this Form 10-K,
including the notes to the consolidated financial statements.
The selected data in this section is not intended to replace the
consolidated financial statements.

|                                                  |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |       |       | 
|------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------- | ------- | ---------- | ------ | ------- | ------- | ------- | ------ | ---- | ------- | ------ | ------ | - | ------ | ----- | ----- | - | ------ | ----- | ----- | 
|                                                  |                                                                                                                                                                                                                                 |                                      
|                                                  |                                                                                                                                                                                                                                 | Years Ended December 31,             
|                                                  |                                                                                                                                                                                                                                 |                                      
|                                                  |                                                                                                                                                                                                                                 | 2002(1)(2)                            |         | 2001(1)(2) |        | 2000(1) |         | 1999(1) |        | 1998
|                                                  |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |     
|                                                  |                                                                                                                                                                                                                                 |                                      
|                                                  |                                                                                                                                                                                                                                 | (In thousands, except per share data)
|Consolidated Statement of Operations
    Data:    |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |      
|Revenue                                           |                                                                                                                                                                                                                                 | $                                     | 7,927   |            |        | $       | 3,613   |         |        | $    | 2,693   |        |        | $ | 2,592  |       |       | $ | 2,590  |      
|Operating expenses:                               |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |      
|                                                  | Research and development                                                                                                                                                                                                        |                                       |         | 15,133     |        |         |         | 10,933  |        |      |         | 4,462  |        |   |        | 4,408 |       |   |        | 2,583 |      
|                                                  | General and administrative                                                                                                                                                                                                      |                                       |         | 9,714      |        |         |         | 4,361   |        |      |         | 2,834  |        |   |        | 1,363 |       |   |        | 1,975 |      
|                                                  | Stock-based compensation ($1,029, $2,120, $3,882
    and $78 related to research and development and $2,158, $4,687,
    $8,343 and $377 related to general and administrative for 2002,
    2001, 2000 and 1999, respectively) |                                       |         | 3,187      |        |         |         | 6,807   |        |      |         | 12,225 |        |   |        | 455   |       |   |        |      |      
|                                                  |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |      
|                                                  |                                                                                                                                                                                                                                 | Total operating expenses              |         |            | 28,034 |         |         |         | 22,101 |      |         |        | 19,521 |   |        |       | 6,226 |   |        |       | 4,558 | 
|                                                  |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |      
|Loss from operations                              |                                                                                                                                                                                                                                 |                                       | (20,107 | )          |        |         | (18,488 | )       |        |      | (16,828 | )      |        |   | (3,634 | )     |       |   | (1,968 | )    
|Minority interest                                 |                                                                                                                                                                                                                                 |                                       | 505     |            |        |         | 372     |         |        |      | 127     |        |        |   | 45     |       |       |   |       |      
|Interest income, net                              |                                                                                                                                                                                                                                 |                                       | 2,763   |            |        |         | 4,886   |         |        |      | 3,142   |        |        |   | 213    |       |       |   | 101    |      
|Other financing charges                           |                                                                                                                                                                                                                                 |                                       | (604    | )          |        |         |        |         |        |      |        |        |        |   |       |       |       |   |       |      
|                                                  |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |      
|Net loss                                          |                                                                                                                                                                                                                                 |                                       | (17,443 | )          |        |         | (13,230 | )       |        |      | (13,559 | )      |        |   | (3,376 | )     |       |   | (1,867 | )    
|Deemed dividend on Series F preferred stock       |                                                                                                                                                                                                                                 |                                       |        |            |        |         |        |         |        |      | (10,100 | )      |        |   |       |       |       |   |       |      
|                                                  |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |      
|Net loss applicable to common stockholders        |                                                                                                                                                                                                                                 | $                                     | (17,443 | )          |        | $       | (13,230 | )       |        | $    | (23,659 | )      |        | $ | (3,376 | )     |       | $ | (1,867 | )    
|                                                  |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |      
|Basic and diluted net loss per common share       |                                                                                                                                                                                                                                 | $                                     | (0.82   | )          |        | $       | (0.62   | )       |        | $    | (2.17   | )      |        | $ | (1.39  | )     |       | $ | (1.13  | )    
|                                                  |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |      
|Weighted average shares outstanding               |                                                                                                                                                                                                                                 |                                       | 21,332  |            |        |         | 21,394  |         |        |      | 10,910  |        |        |   | 2,429  |       |       |   | 1,659  |      
|                                                  |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |      
|Consolidated Balance Sheet Data:                  |                                                                                                                                                                                                                                 |                                       |         |            |        |         |         |         |        |      |         |        |        |   |        |       |       |   |        |      
|Cash, cash equivalents and short-term investments |                                                                                                                                                                                                                                 | $                                     | 51,119  |            |        | $       | 80,196  |         |        | $    | 89,550  |        |        | $ | 3,498  |       |       | $ | 824    |      
|Working capital                                   |                                                                                                                                                                                                                                 |                                       | 48,704  |            |        |         | 79,742  |         |        |      | 90,565  |        |        |   | 3,225  |       |       |   | 313    |      
|Total assets                                      |                                                                                                                                                                                                                                 |                                       | 79,971  |            |        |         | 90,682  |         |        |      | 94,874  |        |        |   | 5,938  |       |       |   | 2,752  |      
|Long-term obligations                             |                                                                                                                                                                                                                                 |                                       | 10,000  |            |        |         |        |         |        |      |        |        |        |   | 17     |       |       |   |       |      
|Minority interest                                 |                                                                                                                                                                                                                                 |                                       |        |            |        |         |        |         |        |      | 372     |        |        |   | 225    |       |       |   |       |      
|Stockholders equity                              |                                                                                                                                                                                                                                 |                                       | 65,942  |            |        |         | 85,936  |         |        |      | 91,917  |        |        |   | 3,830  |       |       |   | 725    |      



---



|    |                                                                                                                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Amounts include the results of Novasite
    Pharmaceuticals, Inc. (Novasite), our majority-owned
    subsidiary, from July 13, 1999, its date of incorporation
    (see Note 1 of Notes to Consolidated Financial Statements).

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|    |                                                                                                                                                                                                                            
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | Amounts include the results of AME Torrey View,
    LLC (Torrey View), our majority-owned subsidiary,
    from August 17, 2001, its date of incorporation (see Note 1
    of Notes to Consolidated Financial Statements).






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

The following discussion of the financial
condition and results of our operations should be read in
conjunction with the consolidated financial statements and notes
thereto included elsewhere in our Annual Report on Form 10-K.
This discussion contains forward-looking statements concerning
the Companys operating results and timing of anticipated
expenditures. Such statements involve risks and uncertainties
that could cause actual results to differ materially from those
projected. Factors that could cause or contribute to such
differences are described in the Risk Factors and
elsewhere in the Form 10-K. Readers are cautioned not to
place undue reliance on these forward-looking statements, which
reflect our analysis only as of the date hereof. We assume no
obligation to update these forward-looking statements to reflect
actual results or changes in factors or assumptions affecting
such forward-looking statements.

Overview

We are a leader in the application of directed
molecular evolution to the optimization and development of human
biotherapeutics. Directed molecular evolution is a process by
which genes and proteins are optimized for specific commercial
purposes. We focus principally on applying our technology to
human biotherapeutics, the largest and most profitable target
market for directed molecular evolution. AMEs
majority-owned subsidiary, Novasite, applies directed molecular
evolution to small-molecule drug discovery and optimization.

Since our formation, we have expended
considerable resources on the development of our
AMEsystemTM technology and the development of
VitaxinTM, a product candidate engineered from an
antibody we licensed from The Scripps Research Institute. Much
of our research and development from 1995 to 1999 was allocated
to preclinical development and initial clinical trials of
Vitaxin. In 1999, we licensed Vitaxin to MedImmune, Inc.
(MedImmune), which is responsible for future
clinical development expenses and commercialization.

To date we have generated revenue from corporate
collaborations, product candidate and technology licenses,
royalties, and government grants. We have corporate
collaborations with MedImmune, Eli Lilly and Company, Centocor,
Inc., Chiron Corporation, CancerVax, Inc., Biosynexus Inc.,
Bristol-Myers Squibb Company, Seattle Genetics, Inc., and
Aventis Pharmaceuticals, Inc., the final one through our
majority owned subsidiary, Novasite. We have licensed
intellectual property to Biosite Incorporated
(Biosite), in exchange for a nonrefundable, prepaid,
fixed royalty which is being recognized over six years, the
estimated useful lives of the related patents. Our government
grants have come from the National Institutes of Health.
Research funding from corporate collaborators and government
grants is recognized as revenue when the services are rendered.

We have incurred losses since our inception. As
of December 31, 2002, we had an accumulated deficit of
$71.6 million. These losses and this accumulated deficit
resulted from the significant costs incurred in the development
of our technology platform and the preclinical and clinical
development of Vitaxin. We expect these losses to increase as we
continue to invest in our AMEsystem technology and internal
development projects.

On August 17, 2001, the Company entered into
an Operating Agreement with Torrey View Phase II, L.P., to
establish AME Torrey View, LLC (Torrey View), a 99%
owned subsidiary of the Company, which is consolidated in our
financial statements. On March 4, 2002, Torrey View
purchased a 10.73-acre parcel of undeveloped land in San Diego
County from a third party at a cost of approximately
$8.0 million. The Company may develop this property over
the next few years as its corporate headquarters. The Company
could also seek alternative uses for the property or sell the
property if development would be inconsistent with the
Companys liquidity and cash resource needs.

In connection with the purchase, the Company
borrowed approximately $10.0 million, under a $15.0 million
credit facility, from Merrill Lynch Bank USA to fund the
purchase price and certain development costs, and as of
December 31, 2002, we had approximately $5.0 million
available for future financing needs under this credit facility.
This loan was transferred to Merrill Lynch Business Financial

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Services during 2002 with substantially the same
terms as the original loan from Merrill Lynch Bank USA. As of
December 31, 2002, restricted cash of approximately
$10.5 million collateralized the outstanding loan balance.
The Company also entered into a $3.0 million loan and a
development and management agreement with a group, that is not
affiliated with the Company, but that is affiliated with the 1%
owner of Torrey View, who may assist the Company with the
development of the project. The $3.0 million loan from the
Company to the group is collateralized by a perfected security
interest in the 1% owners membership rights in Torrey View
and is due in 2004. Torrey View also entered into an engagement
letter and compensation agreement with a third party to act as a
broker and co-development manager, on behalf of Torrey View, in
connection with the purchase and development of the land.


On July 25, 2002, a petition was filed in
the Superior Court of the State of California, County of San
Diego, by the Torrey Hills Community Coalition, et al. against
the City of San Diego, et al. seeking to compel the City of San
Diego to revoke the approval which was previously issued with
respect to the development of our corporate headquarters. A
petition was also filed by the Del Mar Union School District on
October 25, 2002, seeking a similar legal remedy. These
petitions assert that the City of San Diego failed to comply
with or violated various legal requirements in connection with
its approval of that development, but they do not seek monetary
relief from the Company. We understand that the City of San
Diego believes that it has complied with all legal requirements
for this project and therefore intends to vigorously oppose
these petitions. The Company is named as a real party in
interest, and we also intend to vigorously oppose these
petitions and believe that they will not have a material adverse
effect on our business.

On June 25, 2001, we filed a complaint
against MorphoSys AG and its wholly owned subsidiary MorphoSys
USA, Inc., in the United States District Court for the District
of Massachusetts seeking injunctive relief and damages on behalf
of the Company. The complaint alleges that MorphoSys AG and
MorphoSys USA, Inc., are willfully infringing the Kauffman
patent family under which we hold an exclusive license.

On January 6, 2003, we announced a report
and recommendation from the magistrate judge in the United
States District Court for the District of Massachusetts to the
district judge in our legal action against MorphoSys AG and its
wholly owned subsidiary MorphoSys USA, Inc. that MorphoSys
motion for summary judgment of non-infringement be allowed and
that AMEs motion for partial summary judgment of
infringement be denied and all other motions be dismissed as
moot. We have filed objections to the magistrate judges
report and recommendation. The district judge may adopt, reject
or modify the magistrate judges recommendation, or
instruct the magistrate judge to reconsider the recommendation.

Critical Accounting Policies and
Estimates

Our discussion and analysis of our financial
condition and results of operations are based upon the
Companys consolidated 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 ongoing basis, we evaluate our
estimates, including those related to revenue recognition,
patent costs and income taxes. We base our estimates on
historical experience and on various other assumptions that are
believed 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 under different assumptions or conditions.

We believe the following critical accounting
policies affect the significant judgments and estimates used in
the preparation of our consolidated financial statements (see
Note 1 to our financial statements on page F-7).

Revenue
Recognition

We recognize revenue when all four of the
following criteria are met: (i) persuasive evidence that an
arrangement exists; (ii) delivery of the products and/or
services has occurred; (iii) the selling price is fixed or

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determinable; and (iv) collectibility is
reasonably assured. In addition, we follow the provisions of the
Securities and Exchange Commissions Staff Accounting
Bulletin No. 101 (SAB101), Revenue
Recognition, which sets forth guidelines in the timing of
revenue recognition based upon factors such as passage of title,
installation, payments and customer acceptance. Amounts received
for upfront product and technology license fees under
multiple-element arrangements are deferred and recognized over
the period of such services or performance if such arrangements
require on-going services or performance. Amounts received for
milestones are recognized upon achievement of the milestone,
unless the amounts received are creditable against royalties or
we have ongoing performance obligations. Royalty revenue will be
recognized upon sale of the related products, provided the
royalty amounts are fixed and determinable and collection of the
related receivable is probable. Any amounts received prior to
satisfying our revenue recognition criteria will be recorded as
deferred revenue in the accompanying balance sheets.


Patent Costs

We capitalize the costs incurred to file patent
applications. These costs are amortized over a six-year
estimated life from the date of patent issuance. At
December 31, 2002, capitalized costs related to issued
patents total approximately $508,000 (net of accumulated
amortization) and approximately $1.5 million related to
unissued patents. Our results of operations could be materially
impacted when we begin amortizing the costs related to unissued
patents. In addition, we expense all costs related to abandoned
patent applications. If we elect to abandon any of our currently
issued or unissued patents, the related expense could be
material to our results of operations for the period of the
abandonment.

Income Taxes

We record a valuation allowance to reduce our
deferred tax assets to the amount that is more likely than not
to be realized. While we have considered future taxable income
and ongoing prudent and feasible tax planning strategies in
assessing the need for the valuation allowance, in the event we
were to determine that we would be able to realize our deferred
tax assets in the future in excess of its net recorded amount,
an adjustment to the deferred tax asset would increase income in
the period such determination was made. Likewise, should we
determine that we would not be able to realize all or part of
our net deferred tax asset in the future, an adjustment to the
deferred tax asset would be charged to income in the period such
determination was made.

Results of Operations



| |                                                                           
| | --------------------------------------------------------------------------
| | Year Ended December 31, 2002, Compared
    to Year Ended December 31, 2001

Revenue.Revenue was
$7.9 million for the year ended December 31, 2002,
compared to $3.6 million for the year ended
December 31, 2001, an increase of $4.3 million.
Revenues from corporate collaborators increased to
$5.6 million for the year ended December 31, 2002,
from $1.5 million for the year ended December 31,
2001. This increase was primarily due to contract research and
milestone revenue received under our corporate collaborations.
Other revenue, related to licenses and grants, was
$2.3 million for the year ended December 31, 2002, and
$2.1 million for the year ended December 31, 2001.

Research and development.Research and development expenses
consist primarily of compensation and other expenses related to
research and development personnel, costs associated with
preclinical development of our internal development product
candidates and facilities expenses. We generally do not track
our research and development costs by projects, therefore we
cannot accurately estimate with any degree of certainty what our
costs have been for particular research and development
projects. Research and development expenses were
$15.1 million for the year ended December 31, 2002,
compared to $10.9 million for the year ended
December 31, 2001, an increase of $4.2 million. This
increase was primarily attributable to salaries and other
personnel related expenses and additional supplies and
equipment, due to an increase in scientific staffing to support
our internal development projects, corporate collaborations and
grants.

General and administrative.General and administrative expenses
increased to $9.7 million for the year ended
December 31, 2002, from $4.4 million for the year
ended December 31, 2001, an increase of

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$5.3 million. The increase was due primarily
to the ongoing litigation with MorphoSys and expansion of our
administrative infrastructure to support our growth.


Stock-based compensation.Deferred compensation for options
granted to employees is the difference between the exercise
price and the estimated fair value of our common stock on the
date options were granted. Deferred compensation is included as
a component of stockholders equity and is being amortized
in accordance with Financial Accounting Standards Board (FASB)
Interpretation No. 28 over the vesting periods of the
related options, which is generally three or four years.
Amortization of deferred compensation, which is reported as
stock-based compensation in the statement of operations, was
approximately $3.2 million for the year ended
December 31, 2002 ($1.0 million related to research
and development and $2.2 million related to general and
administrative), and $6.8 million for the year ended
December 31, 2001 ($2.1 million related to research
and development and $4.7 million related to general and
administrative).

Interest income, net.Net interest income decreased to
$2.8 million for the year ended December 31, 2002,
from $4.9 million for the year ended December 31,
2001, a decrease of $2.1 million. The decrease was due
primarily to our lower average cash and investment balances and
lower interest earned on investment balances during 2002
compared to 2001.

Other financing charges.We incurred other financing charges of
$604,000 for the year ended December 31, 2002, compared to
no charges for the year ended December 31, 2001. The
increase is due to a non-cash finance charge related to the
issuance and conversion of convertible debt at below market
price and the issuance of warrants by our subsidiary, Novasite,
to one of its minority investors (see Note 12).



| |                                                                           
| | --------------------------------------------------------------------------
| | Year Ended December 31, 2001, Compared
    to Year Ended December 31, 2000

Revenue.Revenue was
$3.6 million for the year ended December 31, 2001,
compared to $2.7 million for the year ended
December 31, 2000, an increase of $900,000. Revenues from
corporate collaborators were $1.5 million for each of the
years ended December 31, 2001 and 2000. Other revenue
increased to $2.1 million for the year ended December 31,
2001, from $1.2 million for the year ended
December 31, 2000, an increase of approximately $900,000.
This increase was primarily due to additional grant revenue
earned in 2001.

Research and development.Research and development expenses
consist primarily of compensation and other expenses related to
research and development personnel, costs associated with
preclinical development of our internal development product
candidates and facilities expenses. We generally do not track
our research and development costs by projects, therefore we
cannot accurately estimate with any degree of certainty what our
costs have been for particular research and development
projects. Research and development expenses were
$10.9 million for the year ended December 31, 2001,
compared to $4.5 million for the year ended
December 31, 2000, an increase of $6.4 million. This
increase was primarily attributable to salaries and other
personnel related expenses, expansion of facilities and
additional supplies and equipment, due to an increase in
scientific staffing to support our internal development
projects, collaborations and grants.

General and administrative.General and administrative expenses
increased to $4.4 million for the year ended
December 31, 2001, from $2.8 million for the year
ended December 31, 2000, an increase of $1.6 million.
The increase was due primarily to the expansion of our
administrative infrastructure, including increases in salaries
and other personnel related expenses, expansion of facilities
and travel and professional fees to support our growth and
increased business development efforts.

Stock-based compensation.Deferred compensation for options
granted to employees is the difference between the exercise
price and the estimated fair value of our common stock on the
date options were granted. Deferred compensation is included as
a component of stockholders equity and is being amortized
in accordance with Financial Accounting Standards Board (FASB)
Interpretation No. 28 over the vesting periods of the
related options, which is generally three or four years.
Amortization of deferred compensation, which is reported as
stock-based compensation in the statement of operations, was
approximately $6.8 million for the year ended
December 31, 2001 ($2.1 million related to research
and development and $4.7 million related to general and
administrative), and $12.2 million for the year ended
December 31, 2000 ($3.9 million related to research
and development and $8.3 million related to general and
administrative).

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Interest income, net.Net interest income increased to
$4.9 million for the year ended December 31, 2001,
from $3.1 million for the year ended December 31,
2000, an increase of $1.8 million. The increase was due
primarily to our higher average cash and investment balances
during 2001 as a result of the cash proceeds from the initial
public offering, which closed in the third quarter of 2000.

Liquidity and Capital Resources

In July 2000, we sold approximately
5.3 million shares of common stock in an initial public
offering, resulting in net proceeds to the Company of
approximately $92.9 million. Prior to the initial public
offering, we had financed our operations primarily through
private placements of equity securities, with aggregate net
proceeds of approximately $39.6 million. In addition, we
had generated $24.8 million of cash from research
collaborations through December 31, 2002.

In December 2000, we repurchased
1.2 million shares of our common stock at a cost to us of
$14.4 million. In August 2002, we repurchased
approximately 1.9 million shares of our common stock at a
cost to us of approximately $7.3 million.

As of December 31, 2002, we had
approximately $51.1 million in unrestricted cash, cash
equivalents, and short-term investments, compared to
$80.2 million of unrestricted cash, cash equivalents, and
short-term investments as of December 31, 2001. In
addition, we had restricted cash of $10.5 million as of
December 31, 2002, which has been pledged as collateral for
the $10.0 million credit facility from Merrill Lynch.

For the year ended December 31, 2002, we
used cash of approximately $10.0 million in operating
activities primarily to fund our net losses of
$17.4 million, offset by non-cash charges for stock-based
compensation totaling $3.2 million and a decrease in
prepaid expenses and other assets of $3.5 million. We used
approximately $6.6 million of cash for operations in 2001
and $2.9 million in 2000.

For the year ended December 31, 2002, we
used cash of approximately $13.6 million in investing
activities compared to the use of cash of approximately
$4.4 million for the year ended December 31, 2001. For
the year ended December 31, 2000, we used cash of
approximately $51.8 million in investing activities. Our
investing activities consisted primarily of purchases and sales
of short-term investments, and capital expenditures for property
and equipment. We expect to continue to make investments in our
infrastructure, including purchasing property and equipment to
support our operations.

For the year ended December 31, 2002, we
generated approximately $4.0 million of cash from financing
activities, primarily from the proceeds of the Merrill Lynch
loan of $10.0 million, offset by the repurchase of
1.9 million shares of our common stock for
$7.3 million, compared to $71,000 of cash generated for the
year ended December 31, 2001. For the year ended
December 31, 2000, we generated $89.5 million of cash
from financing activities, primarily from the net proceeds of
approximately $92.9 million from the initial public
offering, $10.0 million of net proceeds from the sale of
Series F preferred stock, and $583,000 from the private
placement of equity securities in Novasite, offset by the
repurchase of 1.2 million shares of our common stock for
$14.4 million.

We expect our cash requirements to increase in
2003 as we continue our research and development efforts, hire
additional personnel, and accommodate our future facility needs.
These facility needs include leased space at our current
facilities, and may include the development of the property
purchased by Torrey View, the Companys 99% owned
subsidiary. The Company may develop this property as its
corporate headquarters over the next few years, which could
involve a substantial commitment. The Company could also seek
alternative uses for the property or sell the property if
development would be inconsistent with the Companys
liquidity and cash resource needs. We believe that our current
cash, cash equivalents and investments and interest earned
thereon, together with funding received from collaborators and
government grants will be sufficient to satisfy our anticipated
cash needs for working capital and capital expenditures for at
least the next two years. However, it is possible that we will
seek additional financing within this timeframe. We may raise
additional funds through public or private financing,
collaborative relationships or other arrangements. We cannot
guarantee that additional funding, if sought, will be available
on terms favorable to us. Further, any additional equity
financing may be dilutive to stockholders, and debt financing,
if available,

29



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may involve restrictive covenants. Our failure to
raise capital when needed may harm our business and operating
results.


On June 25, 2001, we filed a complaint
against MorphoSys AG and its wholly owned subsidiary MorphoSys
USA, Inc., in the United States District Court for the District
of Massachusetts seeking injunctive relief and damages on behalf
of the Company. The complaint alleges that MorphoSys AG and
MorphoSys USA, Inc., are willfully infringing the Kauffman
patent family under which we hold an exclusive license.

On January 6, 2003, we announced a report
and recommendation from the magistrate judge in the United
States District Court for the District of Massachusetts to the
district judge in our legal action against MorphoSys AG and its
wholly owned subsidiary MorphoSys USA, Inc. that MorphoSys
motion for summary judgment of non-infringement be allowed and
that AMEs motion for partial summary judgment of
infringement be denied and all other motions be dismissed as
moot. We have filed objections to the magistrate judges
report and recommendation. The district judge may adopt, reject
or modify the magistrate judges recommendation, or
instruct the magistrate judge to reconsider the recommendation.

Income Taxes

We incurred net operating losses in 2002, 2001
and 2000, and consequently did not pay any federal or state
income taxes. As of December 31, 2002, we had federal net
operating loss carryforwards of approximately
$39.8 million, which begin to expire in 2006. At
December 31, 2002, the net operating loss carryforwards for
state tax purposes were approximately $4.0 million, which
will continue to expire in 2004. We also had federal and state
research and development tax credit carryforwards at
December 31, 2002, of $1.0 million and $653,000,
respectively, which begin to expire in 2006, unless previously
utilized.

Recently Issued Accounting
Pronouncements

In October 2001, the FASB issued SFAS
No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets (SFAS No. 144), which
establishes one accounting model to be used for long-lived
assets to be disposed of by sale and broadens the presentation
of discontinued operations to include more disposal
transactions. SFAS No. 144 supercedes SFAS No. 121,
Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of, and the accounting and
reporting provisions of Accounting Principles Board
(APB) Opinion No. 30. SFAS No. 144 is
effective for fiscal years beginning after December 15,
2001. The adoption of SFAS No. 144 in January 2002 did not
have a material impact the Companys consolidated financial
position or results of operations, and we do not expect any
impact in the foreseeable future.

In June 2002, the FASB issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal
Activities (SFAS No. 146). This statement
supercedes Emerging Issues Task Force (EITF) Issue
No. 94-3 Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring (EITF
94-3). SFAS No. 146 requires that a liability for
a cost associated with an exit or disposal activity be
recognized when the liability is incurred. Under EITF 94-3,
a liability was recognized at the date an entity committed to an
exit plan. SFAS No. 146 also establishes that the liability
should initially be measured and recorded at fair value. The
provisions of SFAS No. 146 will be effective for any exit
and disposal activities initiated after December 31, 2002.

In December 2002, the FASB issued SFAS
No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure 
an amendment of FASB Statement No. 123 (SFAS
No. 148). This statement amends SFAS
No. 123, Accounting for Stock Based Compensation
(SFAS No. 123)to provide alternative
methods of voluntarily transitioning to the fair value based
method of accounting for stock-based employee compensation. SFAS
No. 148 also amends the disclosure requirements of SFAS
No. 123 to require disclosure of the method used to account
for stock-based employee compensation and the effect of the
method on reported results in both annual and interim financial
statements. The disclosure provisions will be effective for the
Company beginning with the Companys year ended
December 31, 2003. The Company has not yet completed the
final evaluation of the options presented by SFAS No. 148.
However, within this fiscal year, the

30



---



##### Table of Contents



Company expects to reach a determination of
whether and, if so, when to change the Companys existing
accounting for stock-based compensation to the fair value method
in accordance with the transition alternatives of SFAS
No. 148.


In November 2002, the EITF reached consensus on
EITF Issue 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables (EITF 00-21), which
addresses how to account for arrangements that may involve the
delivery or performance of multiple products, services, and/or
rights to use assets. The final consensus of EITF 00-21
will be applicable to agreements entered into in fiscal periods
beginning after June 15, 2003, with early adoption
permitted. Additionally, companies will be permitted to apply
the consensus guidance to all existing arrangements as the
cumulative effect of a change in accounting principle in
accordance with APB Opinion No. 20, Accounting
Changes. Management is currently evaluating the effect that
the adoption of EITF 00-21 will have on its results of
operations and financial position.




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
maximizing 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
investment to fluctuate. For example, if we hold a security that
was issued with a fixed interest rate and the then-prevailing
interest rate rises, the market value of our investment will
probably decline. To minimize this risk in the future, we intend
to maintain our portfolio of cash equivalents and short-term
investments in a variety of securities, including commercial
paper, money market funds and government and nongovernment debt
securities. The average duration of all of our investments in
2002 was approximately two years. Due to the short-term nature
of these investments, we believe that we have no material
exposure to interest rate fluctuations arising from our
investments. A hypothetical 100 basis point adverse move in
interest rates along the entire interest rate yield curve would
not materially affect the fair value of our interest sensitive
financial instruments. Declines in interest rates over time
will, however, reduce our investment income while increases in
interest rates over time will increase our interest expense.






|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

The consolidated financial statements and
supplementary data of the Company required by this item are set
forth at the pages indicated in Item 15(a)(1).






|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements With
    Accountants on Accounting and Financial Disclosure

Not applicable.




PART III






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

Information regarding directors is incorporated
by reference to the section entitled Election of
Directors in the Proxy Statement. Information regarding
executive officers is contained in Part I of this
Form 10-K. Information regarding Section 16 reporting
compliance is incorporated by reference to the Proxy Statement
under the heading Section 16 Beneficial Ownership
Reporting Compliance.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The information required by this item is
incorporated by reference to the Proxy Statement under the
heading Executive Compensation.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management

Certain of the information required by this item
is incorporated by reference to the Proxy Statement under the
heading Security Ownership of Certain Beneficial Owners
and Management.

31



---



##### Table of Contents



The following table sets forth information as of
the end of December 31, 2002, with respect to compensation
plans under which equity securities of the Company are
authorized for issuance.

|                                                                  |  |                            |           |                           |  |                         |      |  |  |  |           | 
|----------------------------------------------------------------- |  | -------------------------- | --------- | ------------------------- |  | ----------------------- | ---- |  |  |  | --------- | 
|                                                                  |  | Number of Securities to be |           | Weighted-Average Exercise |  | Number of Securities   
|                                                                  |  | Issued upon Exercise of    |           | Price of Outstanding      |  | Remaining Available for
|                                                                  |  | Outstanding Options,       |           | Options, Restricted Stock |  | Future Issuance Under  
|                                                                  |  | Restricted Stock Units and |           | Units and Performance     |  | Equity Compensation    
|                                                                  |  | Performance Units          |           | Units                     |  | Plans                  
|Plan Category(1)                                                  |  | A                          |           | B                         |  | C                      
|                                                                  |  |                            |           |                           |  |                        
|Equity compensation plans approved by security
    holders(2)     |  |                            | 3,410,309 |                           |  | $                       | 6.16 |  |  |  | 911,354   | 
|Equity compensation plans not approved by
    security holders(3) |  |                            | 0         |                           |  |                         | N/A  |  |  |  | 200,000   | 
|                                                                  |  |                            |           |                           |  |                         |      |  |  |  |           | 
|Total                                                             |  |                            | 3,410,309 |                           |  | $                       | 6.16 |  |  |  | 1,111,354 | 
|                                                                  |  |                            |           |                           |  |                         |      |  |  |  |           | 



---



|    |                                                                                                                                                                                                                                                                                                       
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The table does not include information for
    employee benefit plans of the Company and its subsidiaries
    intended to meet the qualification requirements of
    Section 401(a) of the Internal Revenue Code and foreign
    employee benefit plans which are similar to Section 401(a)
    plans.
|   
|(2) | Consists of four plans: the 1992 Stock Plan, the
    2000 Stock Plan, the 2001 Stock Incentive Plan and the 2000
    Employee Stock Purchase Plan.                                                                                                                                                    
|   
|(3) | This category consists of one plan: the 2002 New
    Employee Stock Incentive Plan.                                                                                                                                                                                                                   

The Companys 2002 New Employee Stock
Incentive Plan provides for the grant of options to purchase
shares of the Companys common stock, restricted shares of
the common stock, stock appreciation rights or awards of units
based on the value of share of the Companys common stock
to new non-officer employees of the Company as an inducement to
accept an offer of employment with the Company. Only new
non-officer employees who were not previously employed by the
Company or a parent, a subsidiary or an affiliate of the Company
may be eligible for a grant under the 2002 New Employee Stock
Incentive Plan. A maximum of 200,000 shares of common stock may
be issued under the 2002 New Employee Stock Incentive Plan,
subject to adjustment in the number of shares of common stock
that may be issued for changes in the Companys capital
structure.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

The information required by this item is
incorporated by reference to the Proxy Statement under the
heading Certain Transactions.






|         |                        
|-------- | -----------------------
|Item 14. | Controls and Procedures

Evaluation of Disclosure Controls and
Procedures

Within the 90-day period prior to the date of
this report, the Company carried out an evaluation, under the
supervision and with the participation of the Companys
management, including the Companys Chief Executive Officer
and Chief Financial Officer, of the effectiveness of the design
and operation of the Companys disclosure controls and
procedures pursuant to Rule 13a-14 of the Securities
Exchange Act of 1934 (the Exchange Act). Based
upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that the Companys disclosure
controls and procedures are effective in timely alerting them to
material information relating to the Company (including its
consolidated subsidiaries) required to be included in the
Companys Exchange Act filings.

Changes in Internal Controls

There have been no significant changes in the
Companys internal controls or in other factors that could
significantly affect internal controls subsequent to the date
the Company carried out its evaluation.

32



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##### Table of Contents






PART IV




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

(a) The following documents are filed as
part of this report:



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

The financial statements of the Company are
included herein as required under Item 8 of this Annual
Report on Form 10-K. See Index on page F-l.



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

Schedules have been omitted because information
required to be set forth therein is not applicable or is
included in the financial statements or notes thereto.



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

The exhibits listed below are required by
Item 601 of Regulation S-K. Each management contract
or compensatory plan or arrangement required to be filed as an
exhibit to the Form 10-K has been identified. See
paragraph (c).

(b) Reports on Form 8-K

On November 5, 2002, we filed a current
report on Form 8-K, with exhibits attached thereto,
reporting under Item 5 Amendment No. 1 to the Rights
Agreement dated as of May 10, 2001, between the Company and
EquiServe Trust Company, N.A.

(c) Exhibits

|        |           |                         |  |                                                                                                                                                                                                         
|------- | --------- | ----------------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |           |                        
|Number  |           | Description of Document
|        |           |                        
|        | 3(i)(1)   |                         |  | Restated Certificate of Incorporation, as filed
    with the Delaware Secretary of State on August 1, 2000.                                                                                             
|        | 3(ii)(2)  |                         |  | Amended and Restated Bylaws of the Company.                                                                                                                                                             
|        | 3(iii)(3) |                         |  | Certificate of Designations specifying the terms
    of the Series A Participating Preferred Stock of
    Registrant, as filed with the Secretary of State of the State of
    Delaware on May 11, 2001.
|        | 4.1(4)    |                         |  | Form of Common Stock Certificate.                                                                                                                                                                       
|        | 4.2(4)    |                         |  | Stock Purchase Agreement with MedImmune, Inc.
    dated as of February 24, 1999.                                                                                                                        
|        | 4.3(4)    |                         |  | Stock Purchase Agreement with each of Hilal
    Capital Management LLC and Keith Manchester dated as of
    May 3, 2000.                                                                                
|        | 4.4(5)    |                         |  | Stock Purchase Agreement with Attenuon, L.L.C.
    dated as of November 30, 2000.                                                                                                                       
|        | 4.5(6)    |                         |  | Rights Agreement dated as of May 10, 2001
    between Applied Molecular Evolution, Inc. and EquiServe Trust
    Company, N.A., as Rights Agent.                                                         
|        | 4.6(7)    |                         |  | Stock Purchase Agreement dated as of
    August 18, 2002, between Applied Molecular Evolution, Inc.
    and the Selling Stockholders listed on Annex A hereto.                                          
|        | 4.7(8)    |                         |  | Amendment No. 1 to Rights Agreement dated as
    of November 4, 2002 between Applied Molecular Evolution,
    Inc. and EquiServe Trust Company, N.A., as Rights Agent.                                  
|        | 10.1.1(4) |                         |  | 1992 Stock Plan.                                                                                                                                                                                        
|        | 10.1.2(4) |                         |  | Form of Stock Option Agreement under the 1992
    Stock Plan.                                                                                                                                           
|        | 10.2.1(4) |                         |  | 2000 Stock Plan.                                                                                                                                                                                        
|        | 10.2.2(4) |                         |  | Form of Stock Option Agreement under the 2000
    Stock Plan.                                                                                                                                           
|        | 10.3(4)   |                         |  | License Agreement with Stuart A.
    Kauffman, M.D. dated as of November 3, 1994.                                                                                                                       
|        | 10.4(4)  |                         |  | License Agreement with MedImmune, Inc. dated as
    of February 24, 1999.                                                                                                                               
|        | 10.5(4)  |                         |  | Research and Assignment and License Agreement
    with MedImmune, Inc. dated as of February 24, 1999.                                                                                                   

33



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##### Table of Contents



|        |           |                         |  |                                                                                                                                                                                                                                                                          
|------- | --------- | ----------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |           |                        
|Number  |           | Description of Document
|        |           |                        
|        | 10.6(4)  |                         |  | Selection Agreement with MedImmune, Inc. dated as
    of February 24, 1999.                                                                                                                                                                                              
|        | 10.7(4)  |                         |  | License Agreement with The Scripps Research
    Institute dated as of May 20, 1994.                                                                                                                                                                                      
|        | 10.8(4)  |                         |  | Collaboration Agreement with Cell-Matrix, dated
    as of November 29, 1999.                                                                                                                                                                                             
|        | 10.9(4)   |                         |  | Lease Agreement for 3520 Dunhill Street, San
    Diego, California dated as of June 1, 1993, as amended by
    Amendment 1, 2 and 3.                                                                                                                                     
|        | 10.10(4)  |                         |  | Form of Indemnification Agreement with executive
    officers and directors.                                                                                                                                                                                             
|        | 10.11(4)  |                         |  | Warrants issued August 30, 1996.                                                                                                                                                                                                                                         
|        | 10.12(4)  |                         |  | Warrants issued June 23, 1997.                                                                                                                                                                                                                                           
|        | 10.13(4)  |                         |  | 2000 Employee Stock Purchase Plan.                                                                                                                                                                                                                                       
|        | 10.14(4) |                         |  | License Agreement with Biosite Diagnostics
    Incorporated dated as of September 9, 1998.                                                                                                                                                                               
|        | 10.15(4)  |                         |  | Amendment dated as of July 3, 2000, to
    Collaboration Agreement with Cell-Matrix, Inc.                                                                                                                                                                                
|        | 10.16(5)  |                         |  | Lease Agreement for 11095 Flintkote Avenue, San
    Diego, California dated as of November 20, 2000.                                                                                                                                                                     
|        | 10.17(5)  |                         |  | Amendment dated as of March 8, 2001, to
    Selection Agreement with MedImmune, Inc.                                                                                                                                                                                     
|        | 10.18(9)  |                         |  | Applied Molecular Evolution, Inc. 2001 Stock
    Incentive Plan.                                                                                                                                                                                                         
|        | 10.19(10) |                         |  | Amended and Restated Operating Agreement of AME
    Torrey View, LLC, with Torrey View Phase II, L.P.,
    dated as of August 17, 2001.                                                                                                                                  
|        | 10.20(10) |                         |  | Assignment Agreement by and between Torrey View
    Phase II, L.P. and AME Torrey View, LLC, dated as of
    September 12, 2001.                                                                                                                                         
|        | 10.21(10) |                         |  | Commercial Land Purchase and Sale Agreement and
    Joint Escrow Instructions by and between Torrey View Phase II,
    L.P. and Westbrook Torrey Hills, L.P., dated as of July 10,
    2001.                                                                             
|        | 10.22(10) |                         |  | First Amendment to Commercial Land Purchase and
    Sale Agreement and Joint Escrow Instructions by and between AME
    Torrey View, LLC, as successor-in-interest to Torrey View Phase
    II, L.P., and Westbrook Torrey Hills, L.P., dated as of
    October 11, 2001.
|        | 10.23(10) |                         |  | Lease Agreement with AME Torrey View, LLC dated
    as of August 20, 2001.                                                                                                                                                                                               
|        | 10.24(10) |                         |  | Secured Promissory Note with Ocean Air
    Associates, LLC dated as of March 4, 2002.                                                                                                                                                                                    
|        | 10.25(10) |                         |  | Pledge Agreement with Torrey View Phase II,
    L.P. dated as of March 4, 2002.                                                                                                                                                                                          
|        | 10.26(10) |                         |  | Portfolio Reserve Plus Loan, Letter of Credit and
    Collateral Account Agreement with Merrill Lynch Bank USA.                                                                                                                                                          
|        | 10.27(10) |                         |  | Employment Agreement with James B.
    Breitmeyer dated as of November 20, 2001.                                                                                                                                                                                         
|        | 10.28(11) |                         |  | Engagement Letter and Compensation Agreement by
    and between AME Torrey View, LLC, and Irving Hughes, dated as of
    May 6, 2002.                                                                                                                                    
|        | 10.29(12) |                         |  | Employment Agreement with William L.
    Respess, dated as of June 7, 2002.                                                                                                                                                                                              
|        | 10.30(13) |                         |  | 2002 New Employee Stock Incentive Plan.                                                                                                                                                                                                                                  
|        | 10.31     |                         |  | First Amendment to Lease Agreement for 11095
    Flintkote Avenue, San Diego, California dated as of
    October 1, 2002.                                                                                                                                                
|        | 10.32     |                         |  | Second Amendment to Lease Agreement for 11095
    Flintkote Avenue, San Diego, California dated as of
    November 14, 2002.                                                                                                                                             

34



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##### Table of Contents



|        |       |                         |  |                                                                                                                           
|------- | ----- | ----------------------- |  | --------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |                        
|Number  |       | Description of Document
|        |       |                        
|        | 10.33 |                         |  | Fourth Amendment to Lease Agreement for 3520
    Dunhill Street, San Diego, California dated as of
    September 23, 2002.
|        | 10.34 |                         |  | Term Loan Agreement with Merrill Lynch Business
    Financial Services Inc., dated as of December 23, 2002.               
|        | 21.1  |                         |  | Subsidiaries of the Company.                                                                                              
|        | 23.1  |                         |  | Consent of Ernst & Young LLP, Independent
    Auditors.                                                                   
|        | 24.1  |                         |  | Power of Attorney (see page 36).                                                                                          



---



| |     |                                                                                                                                                                        
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Incorporated by reference to Exhibit 3(i).2
    filed with the Companys Registration Statement on
    Form S-1 (No. 333-36830) filed on May 12, 2000.                 
|
| | (2) | Incorporated by reference to Exhibit 3(ii).2
    filed with the Companys Registration Statement on
    Form S-1 (No. 333-36830) filed on May 12, 2000.                
|
| | (3) | Incorporated by reference to Exhibit 3(i).2
    filed with the Companys Registration Statement on
    Form 8-A (File No. 000-31101) filed on May 11,
    2001.        
|
| | (4) | Incorporated by reference to the exhibits of the
    same number filed with the Companys Registration Statement
    on Form S-1 (No. 333-36830) filed on May 12, 2000.
|
| | (5) | Incorporated by reference to the exhibits of the
    same number filed with the Companys Annual Report on
    Form 10-K (No. 000-31101) filed on March 19, 2001.      
|
| | (6) | Incorporated by reference to Exhibit 4.1
    filed with the Companys Registration Statement on
    Form 8-A (File No. 000-31101) filed on May 11,
    2001.           
|
| | (7) | Incorporated by reference to Exhibit 4.1
    filed with the Companys Current Report on Form 8-K
    (File No. 000-31101) filed on August 21, 2002.                    
|
| | (8) | Incorporated by reference to Exhibit 4.2
    filed with the Companys Registration Statement on
    Form 8-A (File No. 000-31101) filed on November 5,
    2002.       
|
| | (9) | Incorporated by reference to Exhibit A filed
    with the Companys Proxy Statement on Schedule 14A
    (File No. 000-31101) filed on April 23, 2001.                  



|     |                                                                                                                                                                          
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the exhibits of the
    same number filed with the Companys Annual Report on
    Form 10-K (File No. 000-31101) filed on March 5,
    2002.
|    
|(11) | Incorporated by reference to Exhibit 10.28
    filed with the Companys Quarterly Report on Form 10-Q
    (File No. 000-31101) filed on May 7, 2002.                     
|    
|(12) | Incorporated by reference to Exhibit 10.28
    filed with the Companys Quarterly Report on Form 10-Q
    (File No. 000-31101) filed on November 5, 2002.                
|    
|(13) | Incorporated by reference to Exhibit 10.1
    filed with the Companys Registration Statement on
    Form S-8 (File No. 333-102317) filed on January 2,
    2003.        
|    
|    | The Company has received confidential treatment
    of certain portions of these agreements.                                                                             

35



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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 on Form 10-K to be signed on
its behalf by the undersigned, thereunto duly authorized, in the
City of San Diego, State of California, on the fourth day of
March, 2003.



| |                                  
| | ---------------------------------
| | APPLIED MOLECULAR EVOLUTION, INC.



| |     |                    
| | --- | -------------------
| | By: | /s/ WILLIAM D. HUSE

| |                                   
| | ----------------------------------
| |                                   
| | William D. Huse, M.D., Ph.D.      
| | President, Chief Executive Officer
| | and Chairman of the Board         

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each
person whose signature appears below constitutes and appoints
William D. Huse, M.D., Ph.D., and Lawrence E.
Bloch, M.D., J.D., and each of them, his or her true
and lawful attorneys-in-fact and agents, each with full power of
substitution and resubstitution, for him and in his name, place
and stead, in any and all capacities, to sign any and all
amendments, including post-effective amendments, to this Report
on Form 10-K, and to file the same, with all exhibits
thereto and other documents in connection herewith, 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 Securities
Exchange Act of 1934, as amended, 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.

|                                                   |  |                                                                                                    |  |               |  | 
|-------------------------------------------------- |  | -------------------------------------------------------------------------------------------------- |  | ------------- |  | 
|                                                   |  |                                                                                                    |  |              
|Name                                               |  | Title                                                                                              |  | Date         
|                                                   |  |                                                                                                    |  |              
|                                                  
|/s/ WILLIAM D. HUSEWilliam D. Huse, M.D., Ph.D.    |  | President, Chief Executive Officer and Chairman
    of the Board
    (Principal Executive Officer) |  | March 4, 2003
|                                                  
|/s/ LAWRENCE E. BLOCHLawrence E. Bloch, M.D., J.D. |  | Chief Financial Officer
    (Principal Financial and
    Accounting Officer)                       |  | March 4, 2003
|                                                  
|/s/ RAYMOND V. DITTAMORERaymond V. Dittamore       |  | Director                                                                                           |  | March 4, 2003
|                                                  
|/s/ N. COLEMAN OWENN. Coleman Owen                 |  | Director                                                                                           |  | March 4, 2003

36



---



##### Table of Contents



|                                                      |  |          |  |               |  | 
|----------------------------------------------------- |  | -------- |  | ------------- |  | 
|                                                      |  |          |  |              
|Name                                                  |  | Title    |  | Date         
|                                                      |  |          |  |              
|                                                     
|/s/ WILLIAM L. RESPESSWilliam L. Respess, J.D., Ph.D. |  | Director |  | March 4, 2003
|                                                     
|/s/ JOHN F. RICHARDSJohn F. Richards                  |  | Director |  | March 4, 2003

37



---



##### Table of Contents






CERTIFICATIONS

I, William D. Huse, M.D., Ph.D., certify that:

1.     I have reviewed
this annual report on Form 10-K of Applied Molecular
Evolution, Inc.;

2.     Based on my
knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this annual
report;

3.     Based on my
knowledge, the financial statements, and other financial
information included in this annual report, fairly present in
all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this annual report;

4.     The
registrants other certifying officers and I are
responsible for establishing and maintaining disclosure controls
and procedures (as defined in Exchange Act Rules 13a-14 and
15d-14) for the registrant, and we have:



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                

5.     The
registrants other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrants auditors and the audit committee of
registrants board of directors (or persons performing the
equivalent function):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6.     The
registrants other certifying officers and I have indicated
in this annual report whether or not there were significant
changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of
our most recent evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.



| |                                           
| | ------------------------------------------
| | /s/ WILLIAM D. HUSE                       
| |                                           
| | William D. Huse, M.D., Ph.D.              
| | President, Chief Executive Officer
    and
| | Chairman of the Board                     

Date: March 4, 2003

38



---



##### Table of Contents



I, Lawrence E. Bloch, M.D., J.D., certify that:

1.     I have reviewed
this annual report on Form 10-K of Applied Molecular
Evolution, Inc.;

2.     Based on my
knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this annual
report;

3.     Based on my
knowledge, the financial statements, and other financial
information included in this annual report, fairly present in
all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this annual report;

4.     The
registrants other certifying officers and I are
responsible for establishing and maintaining disclosure controls
and procedures (as defined in Exchange Act Rules 13a-14 and
15d-14) for the registrant, and we have:



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                

5.     The
registrants other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrants auditors and the audit committee of
registrants board of directors (or persons performing the
equivalent function):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6.     The
registrants other certifying officers and I have indicated
in this annual report whether or not there were significant
changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of
our most recent evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.



| |                                          
| | -----------------------------------------
| | /s/ LAWRENCE E. BLOCH                    
| |                                          
| | Lawrence E. Bloch, M.D., J.D.            
| | Chief Financial Officer and
    Secretary

Date: March 4, 2003

39



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##### Table of Contents



INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                                                                         |  |      |     | 
|-------------------------------------------------------------------------------------------------------- |  | ---- | --- | 
|                                                                                                         |  | Page
|                                                                                                         |  |     
|Report of Ernst & Young LLP, Independent
    Auditors                                                    |  |      | F-2 | 
|Consolidated Balance Sheets as of
    December 31, 2002 and 2001.                                        |  |      | F-3 | 
|Consolidated Statements of Operations for the
    years ended December 31, 2002, 2001 and 2000.          |  |      | F-4 | 
|Consolidated Statements of Stockholders
    Equity for the years ended December 31, 2002, 2001 and 2000 |  |      | F-5 | 
|Consolidated Statements of Cash Flows for the
    years ended December 31, 2002, 2001 and 2000.          |  |      | F-6 | 
|Notes to Consolidated 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

Applied Molecular Evolution, Inc.


We have audited the accompanying consolidated
balance sheets of Applied Molecular Evolution, Inc., as of
December 31, 2002 and 2001, and the related consolidated
statements of operations, stockholders equity, and cash
flows for each of the three years in the period ended
December 31, 2002. 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 consolidated financial
statements referred to above present fairly, in all material
respects, the consolidated financial position of Applied
Molecular Evolution, Inc. at December 31, 2002 and 2001,
and the consolidated results of its operations and its cash
flows for each of the three years in the period ended
December 31, 2002, in conformity with accounting principles
generally accepted in the United States.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

San Diego, California

February 14, 2003


F-2



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.

CONSOLIDATED BALANCE SHEETS

|                                           |                                                                                                                          |                                                                                           |        |         |    |   |        |         |    | 
|------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------ | ----------------------------------------------------------------------------------------- | ------ | ------- | -- | - | ------ | ------- | -- | 
|                                           |                                                                                                                          |                                                                                          
|                                           |                                                                                                                          | December 31,                                                                             
|                                           |                                                                                                                          |                                                                                          
|                                           |                                                                                                                          | 2002                                                                                      |        | 2001   
|                                           |                                                                                                                          |                                                                                           |        |        
|                                           |                                                                                                                          |                                                                                          
|                                           |                                                                                                                          | (In thousands, except                                                                    
|                                           |                                                                                                                          | share and per share data)                                                                
|ASSETS                                    
|Current assets:                            |                                                                                                                          |                                                                                           |        |         |    |   |        |        
|                                           | Cash and cash equivalents                                                                                                |                                                                                           | $      | 6,336   |    |   | $      | 25,927  |   
|                                           | Short-term investments                                                                                                   |                                                                                           |        | 44,783  |    |   |        | 54,269  |   
|                                           | Prepaid expenses                                                                                                         |                                                                                           |        | 448     |    |   |        | 429     |   
|                                           | Other current assets                                                                                                     |                                                                                           |        | 922     |    |   |        | 3,385   |   
|                                           |                                                                                                                          |                                                                                           |        |         |    |   |        |        
|Total current assets                       |                                                                                                                          |                                                                                           | 52,489 |         |    |   | 84,010 |        
|Restricted cash                            |                                                                                                                          |                                                                                           | 10,500 |         |    |   |       |        
|Property and equipment, net                |                                                                                                                          |                                                                                           | 14,490 |         |    |   | 3,223  |        
|Patents, net                               |                                                                                                                          |                                                                                           | 1,985  |         |    |   | 1,865  |        
|Other assets                               |                                                                                                                          |                                                                                           | 507    |         |    |   | 1,584  |        
|                                           |                                                                                                                          |                                                                                           |        |         |    |   |        |        
|Total assets                               |                                                                                                                          | $                                                                                         | 79,971 |         |    | $ | 90,682 |        
|                                           |                                                                                                                          |                                                                                           |        |         |    |   |        |        
|                                          
|LIABILITIES AND STOCKHOLDERS
    EQUITY  
|Current liabilities:                       |                                                                                                                          |                                                                                           |        |         |    |   |        |        
|                                           | Accounts payables                                                                                                        |                                                                                           | $      | 958     |    |   | $      | 1,128   |   
|                                           | Accrued liabilities                                                                                                      |                                                                                           |        | 1,613   |    |   |        | 1,173   |   
|                                           | Current portion of deferred revenue                                                                                      |                                                                                           |        | 1,214   |    |   |        | 1,967   |   
|                                           |                                                                                                                          |                                                                                           |        |         |    |   |        |        
|Total current liabilities                  |                                                                                                                          |                                                                                           | 3,785  |         |    |   | 4,268  |        
|Deferred revenue                           |                                                                                                                          |                                                                                           | 158    |         |    |   | 394    |        
|Deferred rent                              |                                                                                                                          |                                                                                           | 86     |         |    |   | 84     |        
|Long-term obligation                       |                                                                                                                          |                                                                                           | 10,000 |         |    |   |       |        
|Minority interest                          |                                                                                                                          |                                                                                           |       |         |    |   |       |        
|Commitments (Note 5)                       |                                                                                                                          |                                                                                           |        |         |    |   |        |        
|Stockholders equity:                      |                                                                                                                          |                                                                                           |        |         |    |   |        |        
|                                           | Preferred stock, $0.001 par value:                                                                                       |                                                                                           |        |         |    |   |        |         |   
|                                           |                                                                                                                          | Authorized shares  5,000,000, none
    issued and outstanding                            |        |         |   |   |        |         |   | 
|                                           | Common stock, $0.001 par value:                                                                                          |                                                                                           |        |         |    |   |        |         |   
|                                           |                                                                                                                          | Authorized shares  45,000,000 at
    December 31, 2002;                                  |        |         |    |   |        |         |    | 
|                                           |                                                                                                                          | Issued shares  23,661,477 and
    23,607,058 at December 31, 2002 and 2001, respectively |        |         | 24 |   |        |         | 24 | 
|                                           | Additional paid-in capital                                                                                               |                                                                                           |        | 160,588 |    |   |        | 159,126 |   
|                                           | Deferred compensation                                                                                                    |                                                                                           |        | (1,213  | )  |   |        | (4,373  | ) 
|                                           | Notes receivable from employees                                                                                          |                                                                                           |        | (941    | )  |   |        | (880    | ) 
|                                           | Accumulated other comprehensive income                                                                                   |                                                                                           |        | 761     |    |   |        | 587     |   
|                                           | Accumulated deficit                                                                                                      |                                                                                           |        | (71,591 | )  |   |        | (54,148 | ) 
|                                           | Less: Treasury stock at cost 
    3,073,111 shares and 1,200,000 shares at
    December 31, 2002 and 2001, respectively |                                                                                           |        | (21,686 | )  |   |        | (14,400 | ) 
|                                           |                                                                                                                          |                                                                                           |        |         |    |   |        |        
|Total stockholders equity                 |                                                                                                                          |                                                                                           | 65,942 |         |    |   | 85,936 |        
|                                           |                                                                                                                          |                                                                                           |        |         |    |   |        |        
|Total liabilities and stockholders equity |                                                                                                                          | $                                                                                         | 79,971 |         |    | $ | 90,682 |        
|                                           |                                                                                                                          |                                                                                           |        |         |    |   |        |        

See accompanying notes.

F-3



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                                                  |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |        | 
|------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------- | ------- | ------ |  | ---- | ------- | ------ |  | - | ------- | ------ | 
|                                                                                                  |                                                                                                                                                                                                                |                                      
|                                                                                                  |                                                                                                                                                                                                                | Years Ended December 31,             
|                                                                                                  |                                                                                                                                                                                                                |                                      
|                                                                                                  |                                                                                                                                                                                                                | 2002                                  |         | 2001   |  | 2000
|                                                                                                  |                                                                                                                                                                                                                |                                       |         |        |  |     
|                                                                                                  |                                                                                                                                                                                                                |                                      
|                                                                                                  |                                                                                                                                                                                                                | (In thousands, except per share data)
|Revenue:                                                                                          |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |       
|                                                                                                  | Contract revenue from collaborators                                                                                                                                                                            |                                       | $       | 5,593  |  |      | $       | 1,515  |  |   | $       | 1,539  | 
|                                                                                                  | Other revenue                                                                                                                                                                                                  |                                       |         | 2,334  |  |      |         | 2,098  |  |   |         | 1,154  | 
|                                                                                                  |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |       
|Total revenue                                                                                     |                                                                                                                                                                                                                |                                       | 7,927   |        |  |      | 3,613   |        |  |   | 2,693   |       
|Operating expenses:                                                                               |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |       
|                                                                                                  | Research and development                                                                                                                                                                                       |                                       |         | 15,133 |  |      |         | 10,933 |  |   |         | 4,462  | 
|                                                                                                  | General and administrative                                                                                                                                                                                     |                                       |         | 9,714  |  |      |         | 4,361  |  |   |         | 2,834  | 
|                                                                                                  | Stock-based compensation ($1,029, $2,120 and
    $3,882 related to research and development and $2,158,
    $4,687 and $8,343 related to general and administrative for
    2002, 2001 and 2000, respectively) |                                       |         | 3,187  |  |      |         | 6,807  |  |   |         | 12,225 | 
|                                                                                                  |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |       
|Total operating expenses                                                                          |                                                                                                                                                                                                                |                                       | 28,034  |        |  |      | 22,101  |        |  |   | 19,521  |       
|                                                                                                  |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |       
|Loss from operations                                                                              |                                                                                                                                                                                                                |                                       | (20,107 | )      |  |      | (18,488 | )      |  |   | (16,828 | )     
|Minority interest                                                                                 |                                                                                                                                                                                                                |                                       | 505     |        |  |      | 372     |        |  |   | 127     |       
|Interest income, net                                                                              |                                                                                                                                                                                                                |                                       | 2,763   |        |  |      | 4,886   |        |  |   | 3,142   |       
|Other financing charges                                                                           |                                                                                                                                                                                                                |                                       | (604    | )      |  |      |        |        |  |   |        |       
|                                                                                                  |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |       
|Net loss                                                                                          |                                                                                                                                                                                                                |                                       | (17,443 | )      |  |      | (13,230 | )      |  |   | (13,559 | )     
|Deemed dividend on Series F preferred stock                                                       |                                                                                                                                                                                                                |                                       |        |        |  |      |        |        |  |   | (10,100 | )     
|                                                                                                  |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |       
|Net loss applicable to common stockholders                                                        |                                                                                                                                                                                                                | $                                     | (17,443 | )      |  | $    | (13,230 | )      |  | $ | (23,659 | )     
|                                                                                                  |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |       
|Basic and diluted net loss per common share                                                       |                                                                                                                                                                                                                | $                                     | (0.82   | )      |  | $    | (0.62   | )      |  | $ | (2.17   | )     
|                                                                                                  |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |       
|Weighted average shares outstanding used in
    computing basic and diluted loss per common share |                                                                                                                                                                                                                |                                       | 21,332  |        |  |      | 21,394  |        |  |   | 10,910  |       
|                                                                                                  |                                                                                                                                                                                                                |                                       |         |        |  |      |         |        |  |   |         |       

See accompanying notes.

F-4



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                                                            |  |                                   |             |              |  |            |     |          |  |            |            |               |  |             |    |                |  |               |         |        |  |        |         |        |  |   |      |   |  |   |     |   |  |   |         |   |  |  |            |   |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------------- |  | --------------------------------- | ----------- | ------------ |  | ---------- | --- | -------- |  | ---------- | ---------- | ------------- |  | ----------- | -- | -------------- |  | ------------- | ------- | ------ |  | ------ | ------- | ------ |  | - | ---- | - |  | - | --- | - |  | - | ------- | - |  |  | ---------- | - |  | - | ------- | - |  | - | ------- | -
|                                                                            |  |                                   |             |              |  |            |     |          |  |            |            |               |  |             |    | Accumulated    |  |               |         |        |  |       
|                                                                            |  |                                   |             |              |  |            |     |          |  | Notes      |            | Other         |  |             |    | Treasury Stock |  |              
|                                                                            |  | Preferred Stock                   |             | Common Stock |  | Additional |     |          |  | Receivable |            | Comprehensive |  |             |    | at Cost        |  | Total        
|                                                                            |  |                                   |             |              |  | Paid-in    |     | Deferred |  | from       |            | Income        |  | Accumulated |    |                |  | Stockholders
|                                                                            |  | Shares                            |             | Amount       |  | Shares     |     | Amount   |  | Capital    |            | Compensation  |  | Employees   |    | (Loss)         |  | Deficit       |         | Shares |  | Amount |         | Equity
|                                                                            |  |                                   |             |              |  |            |     |          |  |            |            |               |  |             |    |                |  |               |         |        |  |        |         |       
|                                                                            |  |                                  
|                                                                            |  | (In thousands, except share data)
|Balance at December 31, 1999                                                |  |                                   | 11,640,124  |              |  | $          | 12  |          |  |            | 2,569,846  |               |  | $           | 3  |                |  | $             | 31,831  |        |  | $      | (649    | )      |  | $ |     |   |  | $ | (8  | ) |  | $ | (27,359 | ) |  |  |           |   |  | $ |        |   |  | $ | 3,830   |  
|Exercise of stock options for cash and notes
    receivable                 |  |                                   |            |              |  |            |    |          |  |            | 1,735,335  |               |  |             | 2  |                |  |               | 1,228   |        |  |        |        |        |  |   | (799 | ) |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 431     |  
|Deferred compensation                                                       |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               | 21,220  |        |  |        | (21,220 | )      |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   |        |  
|Amortization of deferred compensation                                       |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        | 10,948  |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 10,948  |  
|Issuance of stock options to consultants                                    |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               | 4       |        |  |        | (4      | )      |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   |        |  
|Compensation related to consultant stock options                            |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               | 1,270   |        |  |        | 7       |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 1,277   |  
|Interest on notes receivable                                                |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   | (28  | ) |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | (28     | )
|Issuance of Series F preferred stock, net of
    issuance costs             |  |                                   | 2,244,444   |              |  |            | 2   |          |  |            |           |               |  |             |   |                |  |               | 10,006  |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 10,008  |  
|Issuance of common stock at IPO, net of issuance
    costs                  |  |                                   |            |              |  |            |    |          |  |            | 5,347,500  |               |  |             | 5  |                |  |               | 92,909  |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 92,914  |  
|Issuance of common stock for conversion of
    preferred stock upon IPO     |  |                                   | (13,884,568 | )            |  |            | (14 | )        |  |            | 13,884,568 |               |  |             | 14 |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   |        |  
|Issuance of common stock for exercise of warrants                           |  |                                   |            |              |  |            |    |          |  |            | 55,015     |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   |        |  
|Minority investors investment in Novasite                                  |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               | 308     |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 308     |  
|Purchase of treasury stock                                                  |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  | (1,200,000 | ) |  |   | (14,400 | ) |  |   | (14,400 | )
|Unrealized gain on short-term investments                                   |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   | 188 |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 188     |  
|Net loss                                                                    |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   | (13,559 | ) |  |  |           |   |  |   |        |   |  |   | (13,559 | )
|                                                                            |  |                                   |             |              |  |            |     |          |  |            |            |               |  |             |    |                |  |               |         |        |  |        |         |        |  |   |      |   |  |   |     |   |  |   |         |   |  |  |            |   |  |   |         |   |  |   |         |  
|Comprehensive loss                                                          |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | (13,371 | )
|                                                                            |  |                                   |             |              |  |            |     |          |  |            |            |               |  |             |    |                |  |               |         |        |  |        |         |        |  |   |      |   |  |   |     |   |  |   |         |   |  |  |            |   |  |   |         |   |  |   |         |  
|Balance at December 31, 2000                                                |  |                                   |            |              |  |            |    |          |  |            | 23,592,264 |               |  |             | 24 |                |  |               | 158,776 |        |  |        | (10,918 | )      |  |   | (827 | ) |  |   | 180 |   |  |   | (40,918 | ) |  |  | (1,200,000 | ) |  |   | (14,400 | ) |  |   | 91,917  |  
|Exercise of stock options for cash                                          |  |                                   |            |              |  |            |    |          |  |            | 9,947      |               |  |             |   |                |  |               | 14      |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 14      |  
|Issuance of common stock under employee stock
    purchase plan             |  |                                   |            |              |  |            |    |          |  |            | 7,036      |               |  |             |   |                |  |               | 75      |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 75      |  
|Repurchase of restricted stock                                              |  |                                   |            |              |  |            |    |          |  |            | (2,189     | )             |  |             |   |                |  |               | (1      | )      |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | (1      | )
|Amortization of deferred compensation                                       |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        | 6,481   |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 6,481   |  
|Elimination of deferred compensation related to
    stock options forfeited |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               | (64     | )      |  |        | 64      |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   |        |  
|Compensation related to consultant stock options                            |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               | 326     |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 326     |  
|Interest on notes receivable                                                |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   | (53  | ) |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | (53     | )
|Unrealized gain on short-term investments                                   |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   | 407 |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 407     |  
|Net loss                                                                    |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   | (13,230 | ) |  |  |           |   |  |   |        |   |  |   | (13,230 | )
|                                                                            |  |                                   |             |              |  |            |     |          |  |            |            |               |  |             |    |                |  |               |         |        |  |        |         |        |  |   |      |   |  |   |     |   |  |   |         |   |  |  |            |   |  |   |         |   |  |   |         |  
|Comprehensive loss                                                          |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | (12,823 | )
|                                                                            |  |                                   |             |              |  |            |     |          |  |            |            |               |  |             |    |                |  |               |         |        |  |        |         |        |  |   |      |   |  |   |     |   |  |   |         |   |  |  |            |   |  |   |         |   |  |   |         |  
|Balance at December 31, 2001                                                |  |                                   |            |              |  |            |    |          |  |            | 23,607,058 |               |  |             | 24 |                |  |               | 159,126 |        |  |        | (4,373  | )      |  |   | (880 | ) |  |   | 587 |   |  |   | (54,148 | ) |  |  | (1,200,000 | ) |  |   | (14,400 | ) |  |   | 85,936  |  
|Exercise of stock options for cash                                          |  |                                   |            |              |  |            |    |          |  |            | 23,706     |               |  |             |   |                |  |               | 15      |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 15      |  
|Issuance of common stock under employee stock
    purchase plan             |  |                                   |            |              |  |            |    |          |  |            | 30,713     |               |  |             |   |                |  |               | 202     |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 202     |  
|Amortization of deferred compensation                                       |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        | 3,151   |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 3,151   |  
|Elimination of deferred compensation related to
    stock options forfeited |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               | (9      | )      |  |        | 9       |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   |        |  
|Compensation related to consultant stock options                            |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               | 36      |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 36      |  
|Interest on notes receivable                                                |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   | (61  | ) |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | (61     | )
|Minority investors investment in Novasite                                  |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               | 1,218   |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 1,218   |  
|Purchase of treasury stock                                                  |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  | (1,873,111 | ) |  |   | (7,286  | ) |  |   | (7,286  | )
|Unrealized gain on short-term investments                                   |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   | 174 |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | 174     |  
|Net loss                                                                    |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   | (17,443 | ) |  |  |           |   |  |   |        |   |  |   | (17,443 | )
|                                                                            |  |                                   |             |              |  |            |     |          |  |            |            |               |  |             |    |                |  |               |         |        |  |        |         |        |  |   |      |   |  |   |     |   |  |   |         |   |  |  |            |   |  |   |         |   |  |   |         |  
|Comprehensive loss                                                          |  |                                   |            |              |  |            |    |          |  |            |           |               |  |             |   |                |  |               |        |        |  |        |        |        |  |   |     |   |  |   |    |   |  |   |        |   |  |  |           |   |  |   |        |   |  |   | (17,269 | )
|                                                                            |  |                                   |             |              |  |            |     |          |  |            |            |               |  |             |    |                |  |               |         |        |  |        |         |        |  |   |      |   |  |   |     |   |  |   |         |   |  |  |            |   |  |   |         |   |  |   |         |  
|Balance at December 31, 2002                                                |  |                                   |            |              |  | $          |    |          |  |            | 23,661,477 |               |  | $           | 24 |                |  | $             | 160,588 |        |  | $      | (1,213  | )      |  | $ | (941 | ) |  | $ | 761 |   |  | $ | (71,591 | ) |  |  | (3,073,111 | ) |  | $ | (21,686 | ) |  | $ | 65,942  |  
|                                                                            |  |                                   |             |              |  |            |     |          |  |            |            |               |  |             |    |                |  |               |         |        |  |        |         |        |  |   |      |   |  |   |     |   |  |   |         |   |  |  |            |   |  |   |         |   |  |   |         |  

See accompanying notes.

F-5



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                                |                                                         |                                       |         |       |       |      |         |       |        |   |          |        |        |  
|------------------------------------------------------------------------------- | ------------------------------------------------------- | ------------------------------------- | ------- | ----- | ----- | ---- | ------- | ----- | ------ | - | -------- | ------ | ------ | -
|                                                                                |                                                         |                                      
|                                                                                |                                                         | Years Ended December 31,             
|                                                                                |                                                         |                                      
|                                                                                |                                                         | 2002                                  |         | 2001  |       | 2000
|                                                                                |                                                         |                                       |         |       |       |     
|                                                                                |                                                         |                                      
|                                                                                |                                                         | (In thousands)                       
|Operating Activities                                                            |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Net loss                                                                        |                                                         | $                                     | (17,443 | )     |       | $    | (13,230 | )     |        | $ | (13,559  | )     
|Adjustments to reconcile net loss to net cash
    used in operating activities: |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|                                                                                | Depreciation and amortization                           |                                       |         | 1,469 |       |      |         | 930   |        |   |          | 264    |       
|                                                                                | Amortization of deferred compensation                   |                                       |         | 3,151 |       |      |         | 6,481 |        |   |          | 10,948 |       
|                                                                                | Compensation related to consultant stock options        |                                       |         | 36    |       |      |         | 326   |        |   |          | 1,277  |       
|                                                                                | Deferred revenue                                        |                                       |         | (989  | )     |      |         | 1,472 |        |   |          | (216   | )     
|                                                                                | Deferred rent                                           |                                       |         | 2     |       |      |         | (16   | )      |   |          | (14    | )     
|                                                                                | Minority interest                                       |                                       |         | (505  | )     |      |         | (372  | )      |   |          | (127   | )     
|                                                                                | Realized gain on short-term investments                 |                                       |         | (99   | )     |      |         | (408  | )      |   |          | (124   | )     
|                                                                                | Accrued interest on notes receivable from
    employees |                                       |         | (61   | )     |      |         | (53   | )      |   |          | (28    | )     
|                                                                                | Write-off of abandoned patents                          |                                       |         |      |       |      |         |      |        |   |          | 49     |       
|                                                                                | Other financing charges                                 |                                       |         | 604   |       |      |         |      |        |   |          |       |       
|                                                                                | Changes in operating assets and liabilities:            |                                       |         |       |       |      |         |       |        |   |          |        |       
|                                                                                |                                                         | Prepaid expenses and other assets     |         |       | 3,521 |      |         |       | (2,457 | ) |          |        | (2,287 | )
|                                                                                |                                                         | Accounts payable and accrued expenses |         |       | 270   |      |         |       | 722    |   |          |        | 950    |  
|                                                                                |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Net cash flows used in operations                                               |                                                         |                                       | (10,044 | )     |       |      | (6,605  | )     |        |   | (2,867   | )     
|Investing Activities                                                            |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Restricted cash                                                                 |                                                         |                                       | (10,500 | )     |       |      |        |       |        |   |         |       
|Purchase of property and equipment                                              |                                                         |                                       | (12,568 | )     |       |      | (3,180  | )     |        |   | (565     | )     
|Purchase of short-term investments                                              |                                                         |                                       | (59,100 | )     |       |      | (60,340 | )     |        |   | (109,078 | )     
|Proceeds from sale of short-term investments                                    |                                                         |                                       | 68,859  |       |       |      | 59,571  |       |        |   | 58,228   |       
|Patents                                                                         |                                                         |                                       | (288    | )     |       |      | (455    | )     |        |   | (345     | )     
|                                                                                |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Net cash flows used in investing activities                                     |                                                         |                                       | (13,597 | )     |       |      | (4,404  | )     |        |   | (51,760  | )     
|Financing Activities                                                            |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Proceeds from long-term obligations                                             |                                                         |                                       | 10,000  |       |       |      |        |       |        |   |         |       
|Payments on long-term obligations                                               |                                                         |                                       |        |       |       |      | (17     | )     |        |   | (18      | )     
|Proceeds from issuance of convertible notes                                     |                                                         |                                       | 406     |       |       |      |        |       |        |   |         |       
|Issuance of common stock, net                                                   |                                                         |                                       | 217     |       |       |      | 88      |       |        |   | 93,345   |       
|Issuance of preferred stock, net                                                |                                                         |                                       |        |       |       |      |        |       |        |   | 10,008   |       
|Purchase of treasury stock                                                      |                                                         |                                       | (7,286  | )     |       |      |        |       |        |   | (14,400  | )     
|Investment in subsidiary by minority investor, net                              |                                                         |                                       | 713     |       |       |      |        |       |        |   | 583      |       
|                                                                                |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Net cash flows provided by financing activities                                 |                                                         |                                       | 4,050   |       |       |      | 71      |       |        |   | 89,518   |       
|                                                                                |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Increase (decrease) in cash and cash
    equivalents                            |                                                         |                                       | (19,591 | )     |       |      | (10,938 | )     |        |   | 34,891   |       
|Cash and cash equivalents at the beginning of the
    year                      |                                                         |                                       | 25,927  |       |       |      | 36,865  |       |        |   | 1,974    |       
|                                                                                |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Cash and cash equivalents at the end of the year                                |                                                         | $                                     | 6,336   |       |       | $    | 25,927  |       |        | $ | 36,865   |       
|                                                                                |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Supplemental Disclosure of Cash Flow
    Information                            |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Cash paid for interest                                                          |                                                         | $                                     | 74      |       |       | $    | 1       |       |        | $ | 2        |       
|                                                                                |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Supplemental Schedule of Noncash
    Activities                                 |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Conversion of notes payable to equity in
    subsidiary                         |                                                         | $                                     | (406    | )     |       | $    |        |       |        | $ |         |       
|                                                                                |                                                         |                                       |         |       |       |      |         |       |        |   |          |       
|Exercise of stock options for notes receivable
    and interest thereon         |                                                         | $                                     | 61      |       |       | $    | 53      |       |        | $ | 827      |       
|                                                                                |                                                         |                                       |         |       |       |      |         |       |        |   |          |       

See accompanying notes.

F-6



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

December 31, 2002


1.     Organization
and Significant Accounting Policies

Organization

Applied Molecular Evolution, Inc. (the
Company or AME), a Delaware corporation,
was incorporated on August 14, 1989. The Company has a
broad technology platform termed AMEsystem, which the
Companys management believes will provide AME with a
valuable and efficient solution to optimizing proteins with
commercial potential. To date, the Company has announced that it
has successfully utilized its proprietary technology to optimize
proteins from all major classes of therapeutic proteins for
corporate collaborators and the Companys internal
development projects. AMEs majority owned subsidiary,
Novasite applies directed molecular evolution to small-molecule
drug discovery and optimization.

Principles of
Consolidation

The consolidated financial statements include the
accounts of the Company and its majority owned subsidiaries,
Novasite Pharmaceuticals, Inc. (Novasite), and AME
Torrey View, LLC (Torrey View). All significant
intercompany accounts and transactions have been eliminated.

At December 31, 2002, 2001 and 2000,
AMEs ownership interest in Novasite was 59%, 72% and 72%,
respectively. Prior to December 2000, AME had a 78% ownership
interest in Novasite. The net loss of Novasite ($2,566,000,
$1,522,000 and $567,000 in 2002, 2001 and 2000, respectively) is
allocated to the minority interests based on their ownership
percentage of Novasite. The amounts ($1,218,000, $0 and $308,000
in 2002, 2001 and 2000, respectively) by which AMEs
ownership interest in Novasites equity exceeded AMEs
cost basis in its investment has been recorded as additional
paid-in capital of AME.

On August 17, 2001, the Company entered into
an Operating Agreement with Torrey View Phase II, L.P., to
establish AME Torrey View, LLC (Torrey View). In
March 2002, Torrey View purchased a parcel of undeveloped
land that the Company may develop over the next few years as its
corporate headquarters. Torrey View is a 99% owned subsidiary
and is consolidated in the Companys financial statements.

Cash, Cash
Equivalents and Short-Term Investments

Cash and cash equivalents consist primarily of
highly liquid investments with original maturities of
90 days or less when purchased. Short-term investments
consist of debt securities with maturities in excess of
90 days when purchased.

In accordance with Financial Accounting Standards
Board (FASB) Statement of Financial Accounting
Standards (SFAS) No. 115, Accounting for
Certain Investments in Debt and Equity Securities,management determines the appropriate classification of
short-term investment securities at the time of purchase and
reevaluates such designation as of each balance sheet date. All
securities have been classified as available-for-sale and are
carried at fair value, with unrealized gains and losses, if any,
reported in comprehensive income (loss). Realized gains and
losses on available-for-sale securities are included in interest
income. The cost of securities sold is based on the specific
identification method.

Fair Value of
Financial Instruments

Cash and cash equivalents, accounts payable and
accrued liabilities, are carried at cost, which management
believes approximates fair value due to the short-term maturity
of these instruments. Short-term investments are carried at fair
value.

F-7



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Concentration
of Credit Risk

Financial instruments which potentially subject
the Company to concentrations of credit risk consist primarily
of cash and cash equivalents. The Company limits its exposure to
credit loss by placing its cash with high credit quality
financial institutions.

Property and
Equipment

Property and equipment are stated at cost and
depreciated over the estimated useful lives of the assets (3 to
10 years) using the straight-line method. Leasehold
improvements and assets under capital leases are stated at cost
and amortized over the shorter of the estimated useful lives of
the assets or the lease term. The Company capitalized the
acquisition costs in connection with a land purchase and is
capitalizing costs incurred in the development of the land.

Long-Lived
Assets

In accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived
Assets,if indicators of impairment exist, the Company
assesses the recoverability of the affected long-lived assets by
determining whether the carrying value of such assets can be
recovered through the undiscounted future operating cash flows.
If impairment is indicated, the Company measures the amount of
such impairment by comparing the carrying value of the asset to
the fair value of the asset and records the impairment as a
reduction in the carrying value of the related asset and a
charge to operating results. While the Companys current
and historical operating and cash flow losses are indicators of
impairment, the Company believes the future cash flows to be
received from the long-lived assets will exceed the assets
carrying value, and accordingly the Company has not recognized
any impairment losses through December 31, 2002.

Patent
Costs

Legal costs incurred in filing patent
applications have been capitalized and, upon patent issuance,
are amortized over the six-year estimated useful lives of the
patents. Costs related to abandoned patent applications are
expensed at the time of abandonment.

Income
Taxes

In accordance with SFAS No. 109,
Accounting for Income Taxes,a deferred tax asset or
liability is determined based on the difference between the
financial statement and tax basis of assets and liabilities as
measured by the enacted tax rates which will be in effect when
these differences reverse. The Company has provided a full
valuation allowance against any deferred tax assets.

Deferred
Rent

Rent expense is recorded on a straight-line basis
over the term of the lease. The difference between rent expense
and amounts paid under the lease agreements is recorded as
deferred rent in the accompanying consolidated balance sheets.

Comprehensive
Income (Loss)

In accordance with SFAS No. 130,
Reporting Comprehensive Income,all components of
comprehensive income or loss, including net income or loss, are
reported in the financial statements in the period in which they
are recognized. Comprehensive income or loss is defined as the
change in equity during a period from transactions and other
events and circumstances from non-owner sources. Net income or
loss and other comprehensive income or loss, including foreign
currency translation adjustments and unrealized gains and losses
on investments, shall be reported, net of their related tax
effect, to arrive at comprehensive income or loss.

F-8



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Net Loss Per
Share

Basic and diluted net loss per common share are
presented in conformity with SFAS No. 128, Earnings per
Share. In accordance with SFAS No. 128, basic and
diluted net loss per share have been computed using the weighted
average number of shares of common stock outstanding during the
period, less shares subject to repurchase.

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

|                                                                                    |  |                          |         |      |  |      |         |   |  |   |         |  
|----------------------------------------------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                                                                    |  |                         
|                                                                                    |  | Years Ended December 31,
|                                                                                    |  |                         
|                                                                                    |  | 2002                     |         | 2001 |  | 2000
|                                                                                    |  |                          |         |      |  |     
|Net loss applicable to common stockholders                                          |  | $                        | (17,443 | )    |  | $    | (13,230 | ) |  | $ | (23,659 | )
|                                                                                    |  |                          |         |      |  |      |         |   |  |   |         |  
|Weighted average shares used in computing net
    loss per share, basic and diluted |  |                          | 21,332  |      |  |      | 21,394  |   |  |   | 10,910  |  
|                                                                                    |  |                          |         |      |  |      |         |   |  |   |         |  
|Net loss per common share, basic and diluted                                        |  | $                        | (0.82   | )    |  | $    | (0.62   | ) |  | $ | (2.17   | )
|                                                                                    |  |                          |         |      |  |      |         |   |  |   |         |  

The Company has excluded all preferred stock,
outstanding stock options and warrants, and shares subject to
repurchase from the calculation of diluted loss per common share
because all such securities are antidilutive for all periods
presented. The total number of shares excluded from the
calculation of diluted net loss per share, prior to the
application of the treasury stock method for options and
warrants, was 3,598,788, 3,097,273 and 2,509,716 for the years
ended December 31, 2002, 2001 and 2000, respectively.

Revenue
Recognition

Contract revenue is recognized either
(i) ratably over the term of the agreement, which
approximates the performance of services, for contracts
specifying payment for services over a given period, or
(ii) as services are performed under the agreement, for
contracts specifying payment on a per full-time employee basis.
Contract revenue in 2002 includes amounts received under
collaborative agreements with Eli Lilly and Company
(Lilly), MedImmune, Inc. (MedImmune),
Chiron Corporation (Chiron), Centocor Inc.
(Centocor), CancerVax, Inc. (CancerVax)
and Aventis Pharmaceuticals, Inc. (Aventis)
(Note 7). Contract revenue in 2001 includes amounts
received under collaborative agreements with Lilly, MedImmune,
Biosynexus Incorporated (Biosynexus) and Aventis
(Note 7). Contract revenue in 2000 includes amounts
received under collaborative agreements with MedImmune and
CancerVax (Note 7).

Other revenue consists principally of research
grants from the National Institutes of Health (NIH),
and a nonrefundable, prepaid royalty fee received from Biosite
Incorporated (Biosite), which is being recognized
ratably over the estimated useful lives of the related patents
(Note 8). Grant revenue is recognized as the research
expenses related to the grants are incurred. All amounts
received under the collaborative research agreements or research
grants are not refundable, regardless of the success of the
underlying research.

Revenue earned related to up-front product and
technology license fees is recognized in accordance with Staff
Accounting Bulletin 101 issued by the Securities and
Exchange Commission. Accordingly, amounts received under
multiple-element arrangements requiring ongoing services or
performance by the Company are recognized over the period of
such services or performance.

Revenue from milestones are recognized when
earned, as evidenced by written acknowledgement from the
collaborator, provided that (i) the milestone event is
substantive and its achievability was not reasonably assured at
the inception of the agreement, and (ii) the Companys
performance obligations after the milestone achievement will
continue to be funded by the collaborator at a comparable level
to before the milestone achievement. If both of these criteria
are not met, the milestone payment would be recognized over the
remaining minimum period of the Companys performance
obligations under the arrangement. Royalties, if any, will be
recognized as earned. Under the Companys research
agreement with MedImmune (Note 7),

F-9



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

MedImmune may make milestone payments in the form
of either cash payment or a purchase of equity at a specified
premium to the then-current fair value of the Companys
stock, and a portion of such milestones are creditable against
future royalties. Upon receipt of a cash milestone payment, the
amount creditable against future royalties will be recorded as
deferred royalty revenue and recognized as royalties would
otherwise be due to the Company. Upon receipt of an equity
milestone payment, the specified premium will be recorded as
deferred royalty revenue and recognized as royalties would
otherwise be due to the Company. In the event the Company is
notified by MedImmune that MedImmune is terminating the
development of all products for which royalties could be due to
the Company, any amount then recorded as deferred royalty
revenue will be recognized in full.

Amounts received in excess of revenue recognized
are recorded as deferred revenue.

Research and
Development Costs

Research and development costs are expensed as
incurred. Such costs include: personnel expenses, contractor
fees, laboratory supplies, facilities and allocation of
corporate costs. These expenses are incurred during research and
development activities for our internal development projects,
corporate collaborations and grants.

Stock-Based
Compensation

The Company has elected to follow Accounting
Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees(APB 25) and related
Interpretations, in accounting for its employee and director
stock options. Under APB 25, when the purchase price of
restricted stock or the exercise price of the Companys
employee stock options equals or exceeds the fair value of the
underlying stock on the date of issuance or grant, no
compensation expense is recognized.

In March 2000, the FASB issued Interpretation
No. 44, (FIN 44), Accounting for
Certain Transactions Involving Stock Compensation  An
Interpretation of APB 25.This interpretation clarifies
the definition of employee for purpose of applying APB 25,
the criteria for determining whether a plan qualifies as a
non-compensatory plan, the accounting consequence of various
modifications to the terms of a previously fixed stock option or
award, and the accounting for an exchange of stock compensation
awards in a business combination. FIN 44 was effective, and the
Company adopted the interpretation on July 1, 2000. The
adoption did not have a material impact on the Companys
consolidated results of operations.

Options or stock awards issued to non-employees
are recorded at their fair value as determined in accordance
with SFAS No. 123, Accounting for Stock-Based
Compensation,and the Emerging Issues Task Forces
(EITF) Issue 96-18, Accounting for Equity
Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services,and recognized over the related service period.

As required under SFAS No. 123 and newly
issued SFAS No. 148, Accounting for Stock-Based
Compensation Transition and Disclosure, the pro forma
effects of stock-based compensation on net income
(loss) and net earnings per common share are estimated at
the date of grant using the Black-Scholes option-pricing model
and are disclosed herein.

Segment
Reporting

SFAS No. 131, Disclosures About Segments
of an Enterprise and Related Information,requires the use
of a management approach in identifying segments of an
enterprise. Management has determined that the Company operates
in one business segment, which is scientific research and
development activities.

F-10



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Use of
Estimates

The preparation of financial statements in
conformity with generally accepted accounting principles
requires management to make estimates and assumptions that
affect the amounts of recorded assets and liabilities and
disclosure of contingent assets and liabilities at the date of
the financial statements and the recorded amounts of revenues
and expenses during the reporting period. Actual results could
differ from the estimates.

Recently
Issued Accounting Standards

In October 2001, the FASB issued SFAS
No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, which establishes one accounting model to
be used for long-lived assets to be disposed of by sale and
broadens the presentation of discontinued operations to include
more disposal transactions. SFAS No. 144 supercedes SFAS
No. 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of, and the
accounting and reporting provisions of Accounting Principle
Board (APB) Opinion No. 30. SFAS No. 144
is effective for fiscal years beginning after December 15,
2001. The adoption of SFAS No. 144 in January 2002 did not
have a material impact on the Companys consolidated
financial position or results of operations, and we do not
expect any impact in the foreseeable future.

In June 2002, the FASB issued SFAS
No. 146, Accounting for Costs Associated with Exit or
Disposal Activities. This statement supercedes EITF Issue
No. 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)
(EITF 94-3). SFAS No. 146 requires that a
liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred. Under
EITF 94-3, a liability was recognized at the date an entity
committed to an exit plan. SFAS No. 146 also establishes
that the liability should initially be measured and recorded at
fair value. The provisions of SFAS No. 146 will be
effective for any exit and disposal activities initiated after
December 31, 2002.

In December 2002, the FASB issued SFAS
No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure 
an amendment of FASB Statement No. 123. This statement
amends SFAS No. 123, Accounting for Stock Based
Compensationto provide alternative methods of voluntarily
transitioning to the fair value based method of accounting for
stock-based employee compensation. SFAS No. 148 also amends
the disclosure requirements of SFAS No. 123 to require
disclosure of the method used to account for stock-based
employee compensation and the effect of the method on reported
results in both annual and interim financial statements. The
disclosure provisions will be effective for the Company
beginning with the Companys year ended December 31,
2003. The Company has not yet completed the final evaluation of
the options presented by SFAS No. 148. However, within this
fiscal year, the Company expects to reach a determination of
whether and, if so, when to change the Companys existing
accounting for stock-based compensation to the fair value method
in accordance with the transition alternatives of SFAS
No. 148.

In November 2002, the EITF reached consensus on
EITF Issue 00-21, Accounting for Revenue Arrangements
with Multiple Deliverables (EITF 00-21), which
addresses how to account for arrangements that may involve the
delivery or performance of multiple products, services, and/or
rights to use assets. The final consensus of EITF 00-21 will be
applicable to agreements entered into in fiscal periods
beginning after June 15, 2003, with early adoption
permitted. Additionally, companies will be permitted to apply
the consensus guidance to all existing arrangements as the
cumulative effect of a change in accounting principle in
accordance with APB Opinion No. 20, Accounting
Changes. Management is currently evaluating the effect that
the adoption of EITF Issue 00-21 will have on its results
of operations and financial position.

F-11



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

2.     Balance Sheet
Details

Short-Term
Investments

At December 31, 2002, short-term investments
consisted of the following (in thousands):

|                                        |  |           |        |        |  |             |        |  |  |   |     | 
|--------------------------------------- |  | --------- | ------ | ------ |  | ----------- | ------ |  |  | - | --- | 
|                                        |  | Amortized |        | Market |  | Unrealized 
|                                        |  | Cost      |        | Value  |  | Gain (Loss)
|                                        |  |           |        |        |  |            
|Obligations of U.S. government agencies |  | $         | 13,887 |        |  | $           | 14,222 |  |  | $ | 335 | 
|Corporate debt securities               |  |           | 22,917 |        |  |             | 23,292 |  |  |   | 375 | 
|Asset-backed securities                 |  |           | 7,218  |        |  |             | 7,269  |  |  |   | 51  | 
|                                        |  |           |        |        |  |             |        |  |  |   |     | 
|                                        |  | $         | 44,022 |        |  | $           | 44,783 |  |  | $ | 761 | 
|                                        |  |           |        |        |  |             |        |  |  |   |     | 

At December 31, 2001, short-term investments
consisted of the following (in thousands):

|                                        |  |           |        |        |  |             |        |  |  |   |     | 
|--------------------------------------- |  | --------- | ------ | ------ |  | ----------- | ------ |  |  | - | --- | 
|                                        |  | Amortized |        | Market |  | Unrealized 
|                                        |  | Cost      |        | Value  |  | Gain (Loss)
|                                        |  |           |        |        |  |            
|Obligations of U.S. government agencies |  | $         | 3,707  |        |  | $           | 3,808  |  |  | $ | 101 | 
|Corporate debt securities               |  |           | 42,211 |        |  |             | 42,614 |  |  |   | 403 | 
|Asset-backed securities                 |  |           | 7,764  |        |  |             | 7,847  |  |  |   | 83  | 
|                                        |  |           |        |        |  |             |        |  |  |   |     | 
|                                        |  | $         | 53,682 |        |  | $           | 54,269 |  |  | $ | 587 | 
|                                        |  |           |        |        |  |             |        |  |  |   |     | 

Short-term investments by contractual maturity at
December 31, 2002, are as follows (in thousands):

|                                     |  |   |        | 
|------------------------------------ |  | - | ------ | 
|Due in one year or less              |  | $ | 15,051 | 
|Due after one year through two years |  |   | 20,378 | 
|Due after two years                  |  |   | 9,354  | 
|                                     |  |   |        | 
|                                     |  | $ | 44,783 | 
|                                     |  |   |        | 

Other Current
Assets

Other current assets consist of the following (in
thousands):

|                                       |  |              |     |      |  |   |       | 
|-------------------------------------- |  | ------------ | --- | ---- |  | - | ----- | 
|                                       |  |             
|                                       |  | December 31,
|                                       |  |             
|                                       |  | 2002         |     | 2001
|                                       |  |              |     |     
|Interest income receivable             |  | $            | 651 |      |  | $ | 1,143 | 
|Contract and grant research receivable |  |              | 58  |      |  |   | 2,094 | 
|Other                                  |  |              | 213 |      |  |   | 148   | 
|                                       |  |              |     |      |  |   |       | 
|                                       |  | $            | 922 |      |  | $ | 3,385 | 
|                                       |  |              |     |      |  |   |       | 

F-12



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Property and
Equipment

Property and equipment consist of the following
(in thousands):

|                                          |  |              |        |      |  |   |        |  
|----------------------------------------- |  | ------------ | ------ | ---- |  | - | ------ | -
|                                          |  |             
|                                          |  | December 31,
|                                          |  |             
|                                          |  | 2002         |        | 2001
|                                          |  |              |        |     
|Land and related pre-development costs    |  | $            | 11,048 |      |  | $ |       |  
|Laboratory equipment                      |  |              | 3,909  |      |  |   | 2,825  |  
|Computers, office furniture and equipment |  |              | 1,764  |      |  |   | 1,527  |  
|Leasehold improvements                    |  |              | 2,319  |      |  |   | 2,120  |  
|                                          |  |              |        |      |  |   |        |  
|                                          |  |              | 19,040 |      |  |   | 6,472  |  
|Accumulated depreciation                  |  |              | (4,550 | )    |  |   | (3,249 | )
|                                          |  |              |        |      |  |   |        |  
|                                          |  | $            | 14,490 |      |  | $ | 3,223  |  
|                                          |  |              |        |      |  |   |        |  

Patent
Costs

Patent costs consist of the following (in
thousands):

|                         |  |              |       |      |  |   |       |  
|------------------------ |  | ------------ | ----- | ---- |  | - | ----- | -
|                         |  |             
|                         |  | December 31,
|                         |  |             
|                         |  | 2002         |       | 2001
|                         |  |              |       |     
|Issued patents           |  | $            | 1,103 |      |  | $ | 954   |  
|Accumulated amortization |  |              | (595  | )    |  |   | (427  | )
|                         |  |              |       |      |  |   |       |  
|                         |  |              | 508   |      |  |   | 527   |  
|Unissued patents         |  |              | 1,477 |      |  |   | 1,338 |  
|                         |  |              |       |      |  |   |       |  
|                         |  | $            | 1,985 |      |  | $ | 1,865 |  
|                         |  |              |       |      |  |   |       |  

3.     Stockholders
Equity

Preferred
Stock

Prior to the completion of the Companys
initial public offering, the Series F preferred stock was
sold primarily to the affiliates of an independent accredited
investor at $4.50 per share; however, the price was
substantially below the Companys initial public offering
price. Accordingly, pursuant to EITF 98-5, Accounting
for Convertible Securities with Beneficial Conversion Features,the Company recognized a deemed dividend on the
Series F preferred stock of $10.1 million.

In July 2000, the Company completed its initial
public offering of common stock under the Securities Act of
1933, resulting in gross proceeds of $101.6 million and net
proceeds (less the underwriters discount and offering
expenses) of $92.9 million. Upon completion of the initial
public offering, all of the Companys convertible preferred
stock and series A, B, C, D, E and F preferred stock outstanding
converted into 13,884,568 shares of common stock.

Common
Stock

In December 2000, the Company repurchased
1.2 million shares of its common stock at a price of $12.00
per share. In August 2002, the Company repurchased approximately
1.9 million shares of its common stock at a price of $3.89
per share.

F-13



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Warrants

During 1996 and 1997, in connection with a
short-term loan and security agreements, the Company issued
warrants to purchase 26,667 shares and 40,000 shares,
respectively, of Series E preferred stock at an exercise
price of $5.625 per share. In September 2000, these warrants
were converted, in accordance with the warrant agreements, into
55,015 shares of the Companys common stock.

Stock Option
Plans

The Company has in effect several stock-based
plans under which nonqualified and incentive stock options have
been granted to employees, consultants and directors. At
December 31, 2002, approximately 3.4 million stock
options were outstanding and approximately 399,000 shares
were available for future grant under these plans.

The Board of Directors has designated committees
that determine eligibility, vesting schedules and exercise
prices for options granted under these plans. Options and other
stock awards expire not more than ten years from the date of
grant and are either exercisable immediately after the date of
grant and subject to certain repurchase rights by the Company
until such ownership rights have vested or are exercisable upon
vesting. Vesting generally occurs over three or four years. At
December 31, 2002, 2001 and 2000, 188,479, 616,812 and
1,273,844 shares of common stock, respectively, were
subject to repurchase at a weighted-average price of $0.75,
$0.79 and $0.79, respectively. Options are generally granted at
fair market value of the Companys common stock on the date
of grant.

Pro forma net loss information is required to be
disclosed by SFAS No. 123 and has been determined as if the
Company has accounted for its employee stock options under the
fair value method prescribed in that statement.

The fair value for the 2002 options was estimated
at the date of grant, using the Black-Scholes option pricing
model with the following assumptions: risk-free interest rate of
4.5%; dividend yield of 0%; a weighted-average expected life of
the option of five years; and a volatility factor of 106%. The
fair value for the 2001 options was estimated at the date of
grant, using the Black-Scholes option pricing model with the
following assumptions: risk-free interest rate of 5%; dividend
yield of 0%; a weighted-average expected life of the option of
five years; and a volatility factor of 115%. The fair value for
the 2000 options granted after the Company filed its initial
registration statement relating to the IPO was estimated at the
date of grant, using the Black-Scholes option pricing model with
the following assumptions: risk-free interest rate of 5.5%;
dividend yield of 0%; a weighted-average expected life of the
option of two years; and a volatility factor of 136%. The fair
value for the 2000 options granted before the Company filed its
initial registration statement relating to the IPO was estimated
at the date of grant, using the minimum value pricing model with
the following weighted average assumptions: risk-free interest
rate of 6%; dividend yield of 0%; and a weighted-average
expected life of the option of two years.

The weighted average fair values of options
granted in 2002, 2001 and 2000 were $6.07, $8.35 and $0.67,
respectively.

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

F-14



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

For purposes of pro forma disclosures, the
estimated fair value of the options is amortized to expense over
the options vesting period. The Companys pro forma
net loss information is as follows (in thousands, except per
share amounts):

|                                                              |  |                          |         |      |  |      |         |   |  |   |         |  
|------------------------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                                              |  |                         
|                                                              |  | Years Ended December 31,
|                                                              |  |                         
|                                                              |  | 2002                     |         | 2001 |  | 2000
|                                                              |  |                          |         |      |  |     
|Net loss attributable to common stockholders, as
    reported |  | $                        | (17,443 | )    |  | $    | (13,230 | ) |  | $ | (23,659 | )
|Net loss attributable to common stockholders, pro
    forma   |  | $                        | (21,690 | )    |  | $    | (14,831 | ) |  | $ | (23,802 | )
|Basic and diluted net loss per share, as reported             |  | $                        | (0.82   | )    |  | $    | (0.62   | ) |  | $ | (2.17   | )
|Basic and diluted net loss per share, pro forma               |  | $                        | (1.02   | )    |  | $    | (0.69   | ) |  | $ | (2.18   | )

The following table summarizes stock option
activity (shares in thousands):

|                             |           |           |       |                |   |   |      |       | 
|---------------------------- | --------- | --------- | ----- | -------------- | - | - | ---- | ----- | 
|                             |           |           |       | Weighted      
|                             |           | Number of |       | Average       
|                             |           | Shares    |       | Exercise Price
|                             |           |           |       |               
|Balance at December 31, 1999 |           |           | 1,302 |                |   | $ | 0.41 |      
|                             | Granted   |           |       | 1,772          |   |   | $    | 1.69  | 
|                             | Exercised |           |       | (1,735         | ) |   | $    | 0.71  | 
|                             | Canceled  |           |       | (103           | ) |   | $    | 0.45  | 
|                             |           |           |       |                |   |   |      |      
|Balance at December 31, 2000 |           |           | 1,236 |                |   | $ | 1.82 |      
|                             | Granted   |           |       | 1,315          |   |   | $    | 9.71  | 
|                             | Exercised |           |       | (10            | ) |   | $    | 1.45  | 
|                             | Canceled  |           |       | (60            | ) |   | $    | 11.77 | 
|                             |           |           |       |                |   |   |      |      
|Balance at December 31, 2001 |           |           | 2,481 |                |   | $ | 5.76 |      
|                             | Granted   |           |       | 1,056          |   |   | $    | 7.52  | 
|                             | Exercised |           |       | (24            | ) |   | $    | 0.64  | 
|                             | Canceled  |           |       | (103           | ) |   | $    | 11.91 | 
|                             |           |           |       |                |   |   |      |      
|Balance at December 31, 2002 |           |           | 3,410 |                |   | $ | 6.16 |      
|                             |           |           |       |                |   |   |      |      

Exercise prices and the weighted average
remaining contractual life for options outstanding as of
December 31, 2002, are as follows (shares in thousands):

|                         |  |             |       |                  |  |          |      |             |  |          |       |  |  |  |       |  |  |   |       | 
|------------------------ |  | ----------- | ----- | ---------------- |  | -------- | ---- | ----------- |  | -------- | ----- |  |  |  | ----- |  |  | - | ----- | 
|                         |  |             |       | Weighted         |  | Weighted |      |             |  | Weighted
|                         |  |             |       | Average          |  | Average  |      |             |  | Average 
|                         |  | Number      |       | Remaining        |  | Exercise |      | Number      |  | Exercise
|Range of Exercise Prices |  | Outstanding |       | Contractual Life |  | Price    |      | Exercisable |  | Price   
|                         |  |             |       |                  |  |          |      |             |  |         
|$ 0.25-$ 0.45            |  |             | 794   |                  |  |          | 4.26 |             |  | $        | 0.40  |  |  |  | 794   |  |  | $ | 0.40  | 
|$ 0.75-$ 2.49            |  |             | 370   |                  |  |          | 7.45 |             |  | $        | 0.93  |  |  |  | 330   |  |  | $ | 0.79  | 
|$ 2.50-$ 6.99            |  |             | 526   |                  |  |          | 9.54 |             |  | $        | 5.17  |  |  |  | 33    |  |  | $ | 5.22  | 
|$ 7.00-$12.90            |  |             | 1,536 |                  |  |          | 8.94 |             |  | $        | 9.40  |  |  |  | 884   |  |  | $ | 9.14  | 
|$12.91-$29.13            |  |             | 184   |                  |  |          | 8.00 |             |  | $        | 17.38 |  |  |  | 98    |  |  | $ | 17.38 | 
|                         |  |             |       |                  |  |          |      |             |  |          |       |  |  |  |       |  |  |   |       | 
|$ 0.25-$29.13            |  |             | 3,410 |                  |  |          | 7.73 |             |  | $        | 6.16  |  |  |  | 2,139 |  |  | $ | 4.93  | 
|                         |  |             |       |                  |  |          |      |             |  |          |       |  |  |  |       |  |  |   |       | 

During the years ended December 31, 2000 and
1999, in connection with the grant of certain stock options to
employees, the Company recorded deferred stock compensation
totaling approximately $21.2 million and $1.1 million,
respectively, representing the difference between the exercise
price and the estimated fair value of the Companys common
stock on the date such stock options were granted. Deferred

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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

compensation is included as a reduction of
stockholders equity and is being amortized to expense over
the vesting period of the options in accordance with FASB
Interpretation No. 28, which permits an accelerated
amortization methodology. During the years ended
December 31, 2002, 2001 and 2000, the Company recorded
amortization of deferred stock compensation expense of
approximately $3.2 million, $6.5 million and
$10.9 million, respectively.



| |                           
| | --------------------------
| | Novasite Stock Option Plan

In addition to the stock option plans of the
Company as disclosed above, the Companys majority-owned
subsidiary, Novasite, also has a stock option plan under which
nonqualified and incentive stock option have been granted to
employees, consultants and directors. Under the plan, Novasite
is authorized to issue approximately 1.8 million stock
options. At December 31, 2002, approximately
1.6 million stock options were outstanding and
approximately 213,000 stock options were available for future
grants under the plan. The options have been granted with the
exercise price equal to the fair market value of Novasites
common stock of $0.05 per share as determined by Novasites
Board of Directors and generally vest over four years. The
effect on the consolidated financial statements of options
granted to non-employees through December 31, 2002, is not
material.

Employee
Stock Purchase Plan

The Companys 2000 Employee Stock Purchase
Plan (ESPP) was adopted by the board of directors on
June 20, 2000, and was subsequently approved by the
stockholders. The ESPP permits eligible employees to purchase
common stock through payroll deductions at 85% of fair market
value. The initial offering period commenced on January 1,
2001. The Company has reserved 750,000 shares of common stock
for issuance under the ESPP. The number of shares reserved for
issuance under the ESPP may be increased on the first day of
each fiscal year. At December 31, 2002, 37,749 shares had
been issued under the ESPP, and 712,251 shares were available
for future issuance.

Common Stock
Sold to MedImmune

In conjunction with a collaborative research and
development agreement entered into with MedImmune in February
1999 (Note 7), MedImmune paid the Company an aggregate of
$6,350,000, before expenses of $40,000, for (i) 907,143
shares of common stock, (ii) a specified quantity of
Vitaxin, and (iii) an exclusive license to Vitaxin. At
MedImmunes request the agreement did not allocate the
total proceeds among the three elements of the agreement. Of the
aggregate proceeds of $6,350,000, $1,200,000 was refundable if
the Company did not deliver the specified quantity of Vitaxin.
This amount approximates the Companys actual cost to
acquire the specified quantity of Vitaxin from a third-party
manufacturer and provide it to MedImmune. Accordingly, the
Company allocated such amount to the specified quantity of
Vitaxin and recognized it as revenue in August 1999 when the
Vitaxin was delivered to and accepted by MedImmune. While the
Company believes a significant portion of the proceeds relate to
the value of the license to Vitaxin, the Company concluded that
the available objective evidence was not persuasive enough to
support an allocation of the remaining proceeds ($5,110,000)
between the license and equity elements of the agreement, and
accordingly the entire remaining proceeds were allocated to
common stock.

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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Common Shares
Reserved for Future Issuance

At December 31, 2002, the following shares
of common stock were reserved for issuance upon the exercise of
equity instruments (in thousands):

|                    |                              |  |       |       | 
|------------------- | ---------------------------- |  | ----- | ----- | 
|Stock options:      |                              |  |       |      
|                    | Issued and outstanding       |  |       | 3,410 | 
|                    | Authorized for future grants |  |       | 399   | 
|Stock purchase plan |                              |  | 712   |      
|                    |                              |  |       |      
|                    |                              |  | 4,521 |      
|                    |                              |  |       |      

4.     Long-Term
Obligations

During 2002, the Company borrowed approximately
$10.0 million, under a $15.0 million credit facility,
from Merrill Lynch Bank USA to fund the purchase price and
certain development costs in connection with a land purchase.
The loan bears interest at a floating rate equal to LIBOR plus
one percent, payable monthly, and the principal is due on
June 23, 2004. This loan was transferred to Merrill Lynch
Business Financial Services during 2002, with substantially the
same terms as the original loan from Merrill Lynch Bank USA. As
of December 31, 2002, restricted cash of approximately
$10.5 million collateralized the outstanding loan balance.
The Company capitalized all interest paid on this loan in 2002,
and as of December 31, 2002, total capitalized interest was
approximately $173,000.

5.     Lease
Commitments

The Company leases its facilities under operating
leases, which expire in 2004 and 2008. The leases provide for
escalating rent payments during the term. For financial
reporting purposes, rent expense is recognized on a
straight-line basis over the terms of the leases. Accordingly,
rent expense recognized in excess of rent paid is reflected as
deferred rent. Under the lease agreements, the Company is
required to pay a percentage of operating expenses relating to
the building. Rent expense was approximately $510,000, $519,000
and $415,000 for the three years ended December 31, 2002,
2001 and 2000, respectively.

The Company also leases certain office equipment
under operating leases, which expire in 2005.

Annual future minimum lease payments as of
December 31, 2002, are as follows (in thousands):

|                             |  |   |       | 
|---------------------------- |  | - | ----- | 
|2003                         |  | $ | 606   | 
|2004                         |  |   | 837   | 
|2005                         |  |   | 475   | 
|2006                         |  |   | 485   | 
|2007                         |  |   | 505   | 
|                             |  |   |       | 
|Total minimum lease payments |  | $ | 2,908 | 
|                             |  |   |       | 

The Company subleased a portion of its facilities
under a sublease that expired in December 2002. Sublease income
was approximately $114,000, $78,000 and $86,000 for the years
ended December 31, 2002, 2001 and 2000, respectively.

6.     Income
Taxes

At December 31, 2002, the Company had
federal and California tax net operating loss carryforwards of
approximately $39.8 million and $4.0 million,
respectively. The difference between the tax loss carryforwards
for federal and California purposes is primarily attributable to
the capitalization of research and development

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APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

expenses for California and the 50-60% limitation
of California loss carryforwards. The federal tax loss
carryforwards will begin expiring in 2006, unless previously
utilized. The California tax loss carryforwards will continue to
expire in 2004, unless previously utilized. The Company also has
federal and California research and development tax credit
carryforwards totaling $1.0 million and $653,000,
respectively, which will expire beginning in 2006, unless
previously utilized.

Pursuant to Internal Revenue Code
Section 382 and 383, use of the Companys net
operating loss and tax credit carryforwards will be limited as a
result of certain cumulative changes in the Companys stock
ownership that occurred during 1993. However, the Company
believes that the limitation will not have a material impact on
the utilization of the carryforwards.

Significant components of the Companys
deferred tax assets as of December 31, 2002 and 2001, are
shown below. A valuation allowance of $25.0 million has
been recognized to offset the deferred tax assets as realization
of such assets is uncertain.

|                          |                                             |                |        |         |   |   |        |         |  
|------------------------- | ------------------------------------------- | -------------- | ------ | ------- | - | - | ------ | ------- | -
|                          |                                             |               
|                          |                                             | December 31,  
|                          |                                             |               
|                          |                                             | 2002           |        | 2001   
|                          |                                             |                |        |        
|                          |                                             |               
|                          |                                             | (In thousands)
|Deferred tax assets:      |                                             |                |        |         |   |   |        |        
|                          | Net operating loss carryforwards            |                | $      | 14,155  |   |   | $      | 9,489   |  
|                          | Research and development credits            |                |        | 1,458   |   |   |        | 1,142   |  
|                          | Capitalized research expense                |                |        | 1,444   |   |   |        | 636     |  
|                          | Deferred compensation                       |                |        | 8,000   |   |   |        | 7,223   |  
|                          | Deferred revenue                            |                |        | 539     |   |   |        | 938     |  
|                          | Other                                       |                |        | 646     |   |   |        | 400     |  
|                          |                                             |                |        |         |   |   |        |        
|Total deferred tax assets |                                             |                | 26,242 |         |   |   | 19,828 |        
|                          | Valuation allowance for deferred tax assets |                |        | (25,511 | ) |   |        | (19,416 | )
|                          |                                             |                |        |         |   |   |        |        
|Net deferred tax assets   |                                             |                | 731    |         |   |   | 412    |        
|Deferred tax liabilities: |                                             |                |        |         |   |   |        |        
|                          | Patent expenses                             |                |        | (731    | ) |   |        | (412    | )
|                          |                                             |                |        |         |   |   |        |        
|Net deferred taxes        |                                             | $              |       |         |   | $ |       |        
|                          |                                             |                |        |         |   |   |        |        

7.     Collaborative
Research and Development Agreements

As of December 31, 2002, the Companys
collaborative research and development agreements included
14 projects with eight different corporate collaborators.
Generally these agreements include research funding and
milestones, as well as additional payments upon the achievement
of certain clinical milestones and royalties on net sales of
products developed. During the years ended December 31,
2002, 2001 and 2000, the Company recorded revenue of
approximately $5.6 million, $1.5 million and
$1.5 million, respectively, related to research activities
performed and research milestones achieved under these
agreements.

MedImmune

In February 1999, the Company entered into a
collaboration agreement with MedImmune to produce optimized
antibodies. In addition, Vitaxin, the Companys
angiogenesis inhibitor, was exclusively licensed to MedImmune in
return for an equity investment, milestone payments and
royalties related to the development and commercialization of
resulting products. Pursuant to the terms of the research
program under the collaboration agreement, MedImmune agreed to
fund three research programs, each for a period of six months,
extendable up to 24 months. In addition to program funding,
MedImmune will pay royalties to AME

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APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

on net sales of products developed. The agreement
also provides that MedImmune will make additional payments,
either through cash payments or equity purchases at a specified
premium to then-current fair value, to the Company upon the
achievement of certain milestones. Under the terms of the
agreement, MedImmune has the option to credit up to 65% of cash
payments and 20% of equity purchases against future royalty
payments. At the time of a cash payment, 35% of the payment will
be recognized as milestone revenue, and the remaining 65% will
be recorded as deferred royalty revenue. Additionally, if
MedImmune makes the milestone payment through an equity
purchase, 20% of the amount will be recorded as deferred royalty
revenue.

Lilly

In December 2001, the Company entered into a
collaboration agreement with Lilly to create optimized versions
of an antibody as well as a non-antibody protein therapeutic
candidate. Pursuant to the terms of the research program under
the collaboration agreement, Lilly agreed to fund two research
programs, one for a period of up to one year and the other for a
period of six months, extendable by mutual consent. In February
2002, an additional agreement was entered into by AME and Lilly
for the optimization of an additional antibody. In addition to
program funding, these agreements also provides that Lilly will
make additional payments to the Company upon the achievement of
certain milestones and pay royalties on its net sales of
products developed.

Centocor

In May 2002, the Company entered into a research
agreement with Centocor to optimize a therapeutic antibody
candidate. The research program of this agreement is for six
months, extendable upon mutual written consent. In addition to
program funding, the agreement also provides that Centocor will
make additional payments to the Company upon the achievement of
certain milestones and pay royalties on its net sales of
products developed.

Chiron

In December 2001, the Company entered into a
research agreement with Chiron to optimize a non-antibody
protein therapeutic candidate. The research program of this
agreement is for six months, extendable upon mutual written
consent. In addition to program funding, the agreement also
provides that Chiron will make additional payments to the
Company upon the achievement of certain milestones and pay
royalties on its net sales of products developed.

CancerVax

In November 1999, the Company entered into a
collaboration agreement with Cell-Matrix, Inc., which was
acquired by CancerVax in January 2002, to optimize candidate
molecules and to perform some preclinical development. Pursuant
to the terms of the agreement, Cell-Matrix paid the Company for
the optimization of each of the two candidate molecules, which
was completed in 2000. In addition, Cell-Matrix made milestone
payments to AME for each enhanced antibody in 2000. The
agreement also provides that CancerVax will make additional
payments to the Company upon the achievement of certain
milestones and pay royalties on its net sales of products
developed. Research under this collaboration has been completed.

Biosynexus

In December 2000, the Company entered into a
collaboration agreement with Biosynexus to optimize a candidate
molecule and perform certain preclinical development. The
research and development aspect of this collaboration was for
six months. In addition to research and development funding, the
agreement also provides that Biosynexus will make additional
payments to the Company upon the achievement of certain

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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

milestones and pay royalties on its net sales of
products developed. Research under this collaboration has been
completed.

Aventis

In July 2001, Novasite entered into an agreement
with Aventis to conduct a pilot-screening project using
Novasites proprietary ETDD technology platform.

8.     License
Agreements

TSRI

During 1994, the Company entered into a license
agreement with The Scripps Research Institute of California
(TSRI). TSRI granted the Company exclusive rights to
certain technology relating to a murine monoclonal antibody and
the use of the antibody as an inhibitor of angiogenesis. In
exchange, the Company paid TSRI $100,000 and issued TSRI 20,000
shares of AME common stock. The Company also agreed to provide
TSRI additional payments based on the completion of certain
clinical and approval milestones. In addition, the Company has
agreed to reimburse TSRI for a portion of its past and future
patent costs related to the licensed technology and pay
royalties to TSRI on net sales of each licensed product. The
exclusive license will expire 10 years after the date of
the first commercial sale of such licensed product.

Biosite

During 1998, the Company entered into a license
agreement with Biosite. The Company granted Biosite
non-exclusive rights to certain AME patent technology in
exchange for an up-front, nonrefundable royalty fee of
approximately $1.5 million. The Company is recognizing the
royalty fee as revenue over the estimated lives of the related
patents. As of December 31, 2002, 2001 and 2000,
approximately $394,000, $631,000 and $868,000, respectively, of
the amount originally received are included in deferred revenue.

9.     NIH
Grants

The Company and Novasite are currently performing
research and preclinical development under three grants from the
NIH. Other revenue includes approximately $1.9 million,
$1.9 million and $748,000 related to these grants for the
years ended December 31, 2002, 2001 and 2000, respectively.

In September 2001, the NIH awarded a grant to AME
that provides $1.0 million over two years for the
preclinical development of a therapeutic enzyme optimized by
AMEs proprietary directed molecular evolution technology.

In March 2002, the NIH awarded a grant to
Novasite that provides $2.4 million over two years for
research to develop Novasites proprietary technology
platform.

In September 2000, the NIH awarded a grant to
Novasite that provides $3.2 million over three years for
research to develop Novasites proprietary technology
platform.

10.     401(k)
Plan

The Company maintains a 401(k) plan which allows
substantially all employees to contribute up to 15% of their
salary, subject to annual limitations and requirements set by
the Company. The board of directors may, at its sole discretion,
approve Company contributions. The Company contributed
approximately $144,000, $73,000 and $0 under the plan for the
years ended December 31, 2002, 2001 and 2000, respectively.

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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

11.     Quarterly
Results of Operations (Unaudited)

The following is a summary of the unaudited
quarterly results of operations for the years ended
December 31, 2002 and 2001 (in thousands, except per share
data):

|                                                           |  |                              |        |                              |  |    |        |    |  |    |        |    |  |    |        |    |  |   |        |   |  |   |        |   |  |   |        |   |  |   |        |  
|---------------------------------------------------------- |  | ---------------------------- | ------ | ---------------------------- |  | -- | ------ | -- |  | -- | ------ | -- |  | -- | ------ | -- |  | - | ------ | - |  | - | ------ | - |  | - | ------ | - |  | - | ------ | -
|                                                           |  |                              |        |                             
|                                                           |  | Year Ended December 31, 2002 |        | Year Ended December 31, 2001
|                                                           |  |                              |        |                             
|                                                           |  | Q1                           |        | Q2                           |  | Q3 |        | Q4 |  | Q1 |        | Q2 |  | Q3 |        | Q4
|                                                           |  |                              |        |                              |  |    |        |    |  |    |        |    |  |    |        |   
|Revenue                                                    |  | $                            | 2,615  |                              |  | $  | 1,580  |    |  | $  | 1,457  |    |  | $  | 2,275  |    |  | $ | 852    |   |  | $ | 764    |   |  | $ | 872    |   |  | $ | 1,125  |  
|Operating expenses                                         |  |                              | 7,209  |                              |  |    | 6,987  |    |  |    | 6,998  |    |  |    | 6,840  |    |  |   | 5,657  |   |  |   | 5,507  |   |  |   | 5,452  |   |  |   | 5,485  |  
|                                                           |  |                              |        |                              |  |    |        |    |  |    |        |    |  |    |        |    |  |   |        |   |  |   |        |   |  |   |        |   |  |   |        |  
|Loss from operations                                       |  |                              | (4,594 | )                            |  |    | (5,407 | )  |  |    | (5,541 | )  |  |    | (4,565 | )  |  |   | (4,805 | ) |  |   | (4,743 | ) |  |   | (4,580 | ) |  |   | (4,360 | )
|Minority interest                                          |  |                              |       |                              |  |    |       |    |  |    | 402    |    |  |    | 103    |    |  |   | (13    | ) |  |   | 147    |   |  |   | 180    |   |  |   | 58     |  
|Interest income, net                                       |  |                              | 924    |                              |  |    | 719    |    |  |    | 638    |    |  |    | 482    |    |  |   | 1,516  |   |  |   | 1,239  |   |  |   | 1,263  |   |  |   | 868    |  
|Other financing charges                                    |  |                              |       |                              |  |    |       |    |  |    | (604   | )  |  |    |       |    |  |   |       |   |  |   |       |   |  |   |       |   |  |   |       |  
|                                                           |  |                              |        |                              |  |    |        |    |  |    |        |    |  |    |        |    |  |   |        |   |  |   |        |   |  |   |        |   |  |   |        |  
|Net loss                                                   |  |                              | (3,670 | )                            |  |    | (4,688 | )  |  |    | (5,105 | )  |  |    | (3,980 | )  |  |   | (3,302 | ) |  |   | (3,357 | ) |  |   | (3,137 | ) |  |   | (3,434 | )
|Basic and diluted net loss per common share                |  | $                            | (0.17  | )                            |  | $  | (0.21  | )  |  | $  | (0.24  | )  |  | $  | (0.20  | )  |  | $ | (0.16  | ) |  | $ | (0.16  | ) |  | $ | (0.15  | ) |  | $ | (0.16  | )
|                                                           |  |                              |        |                              |  |    |        |    |  |    |        |    |  |    |        |    |  |   |        |   |  |   |        |   |  |   |        |   |  |   |        |  
|Weighted average shares outstanding, basic and
    diluted |  |                              | 21,842 |                              |  |    | 21,954 |    |  |    | 21,227 |    |  |    | 20,321 |    |  |   | 21,125 |   |  |   | 21,355 |   |  |   | 21,440 |   |  |   | 21,652 |  
|                                                           |  |                              |        |                              |  |    |        |    |  |    |        |    |  |    |        |    |  |   |        |   |  |   |        |   |  |   |        |   |  |   |        |  

12.     Novasite
Financing

In January 2002, the Companys subsidiary,
Novasite, received $200,000 from a private placement of 10%
convertible notes with AME and a minority investor of Novasite.
These notes, which did not have a material beneficial conversion
feature and did not include warrants, were converted into
preferred stock of Novasite in connection with the financing
which closed on September 30, 2002.

In addition, in August 2002, Novasite received
$350,000 from a private placement of 10% convertible notes with
a minority investor of Novasite. The notes plus accrued interest
were converted at a discounted price into preferred stock of
Novasite in connection with the financing which closed on
September 30, 2002. Novasite recorded a debt discount of
$477,000 related to the beneficial conversion feature of the
notes, and the full amount of the debt discount was expensed as
other financing charges as of September 30, 2002. John F.
Richards, one of our directors, is the President of Crabtree
Ventures, L.L.C., the general partner of Crabtree Ventures,
L.P., which as a minority investor, provided the funding for the
private placement.

In connection with the issuance of the August
2002 convertible notes, Novasite issued warrants to purchase
350,000 shares of preferred stock. The warrants are fully vested
and expire in August 2006. Novasite recorded a debt discount
related to the warrants of $127,000 based upon a Black-Scholes
valuation, which was expensed as other financing charges as of
September 30, 2002, when the notes were converted.

In addition to the conversion of notes held by
Crabtree Ventures, L.P. and AME and related accrued interest on
September 30, 2002, which totaled $554,041, Novasite
received cash from Crabtree Ventures, L.P. of $500,000 and
issued 1,430,304 shares of preferred stock to AME and Crabtree
Ventures, L.P.

In November 2002, Novasite received an additional
$250,000 and issued 250,000 shares of preferred stock to
Crabtree Ventures, L.P. In January 2003 Novasite received
an additional $750,000 and issued 750,000 shares of
preferred stock to Crabtree Ventures, L.P.

F-21