##### Table of Contents



---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



---



FORM 10-K



(Mark one)

|x |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- |  | ------------------------------------------------------------------------------------



For the Fiscal Year Ended December 31, 2002.



OR



| ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- |  | ----------------------------------------------------------------------------------------



For the Transition Period from __________ to __________.



Commission File Number: 000-31633



---



Kosan Biosciences Incorporated

(Exact name of registrant as specified in its charter)



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



3832
Bay Center Place, Hayward, California 94545

(Address of principal executive offices)



(510) 732-8400

(Registrants telephone number, including area code)



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

None



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



Common Stock, $.001 par value per share



---



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



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



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



State the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant computed by reference to the price at which the common equity was last sold, or the average bid and asked price of
such common equity, as of the last business day of the registrants most recently completed second fiscal quarter: $137,718,235(1)



The aggregate market value of the common stock of the registrant held by non-affiliates as of March 14, 2003, based upon the closing sale
price of the registrants common stock listed on the Nasdaq National Market on March 14, 2003, was $74,526,597.(2)



The number of shares of common stock of the registrant outstanding at March 14, 2003 was 25,507,249 shares.

---

|(1) |  | Based on a closing price of $8.71 per share on June 28, 2002. Excludes approximately 9,509,084 shares of the registrants common stock held by executive
officers, directors and stockholders whose ownership exceeds 5% of the common stock outstanding at June 28, 2002.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | Based on a closing price of $4.66 per share on March 14, 2003. Excludes approximately 9,514,417 shares of the registrants common stock held by executive
officers, directors and stockholders whose ownership exceeds 5% of the common stock outstanding at March 14, 2003.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



---



DOCUMENTS INCORPORATED BY REFERENCE



Certain portions of the registrants
Proxy Statement in connection with the registrants 2003 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this
report on Form 10-K, are incorporated by reference into Part II and Part III of this report.



---





---

##### Table of Contents



Kosan Biosciences Incorporated



Form 10-K



For the
Fiscal Year Ended December 31, 2002



TABLE
OF CONTENTS



|                     |  |                                                                                                |  | Page
|-------------------- |  | ---------------------------------------------------------------------------------------------- |  | ----
|PART I              
|                    
|Item 1.              |  | Business                                                                                       |  | 3   
|                    
|Item 2.              |  | Properties                                                                                     |  | 26  
|                    
|Item 3.              |  | Legal Proceedings                                                                              |  | 26  
|                    
|Item 4.              |  | Submission of Matters to a Vote of Security Holders                                            |  | 26  
|                    
|PART II             
|                    
|Item 5.              |  | Market for Registrants Common Equity and Related Stockholder Matters                          |  | 27  
|                    
|Item 6.              |  | Selected Financial Data                                                                        |  | 28  
|                    
|Item 7.              |  | Managements Discussion and Analysis of Financial Condition and Results of Operations          |  | 29  
|                    
|Item 7A.             |  | Quantitative and Qualitative Disclosures about Market Risk                                     |  | 35  
|                    
|Item 8.              |  | Financial Statements and Supplementary Data                                                    |  | 35  
|                    
|Item 9.              |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure           |  | 35  
|                    
|PART III            
|                    
|Item 10.             |  | Directors and Executive Officers of the Registrant                                             |  | 36  
|                    
|Item 11.             |  | Executive Compensation                                                                         |  | 36  
|                    
|Item 12.             |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |  | 36  
|                    
|Item 13.             |  | Certain Relationships and Related Transactions                                                 |  | 36  
|                    
|Item 14.             |  | Controls and Procedures                                                                        |  | 36  
|                    
|PART IV             
|                    
|Item 15.             |  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                               |  | 38  
|                    
|Signatures           |  | 41                                                                                            
|                    
|Certifications       |  | 42                                                                                            
|                    
|Financial Statements |  | F-1                                                                                           



2



---

##### Table of Contents



PART I



Forward-Looking Statements and Risk Factors



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



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



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



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



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



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



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



These forward-looking statements are generally identified by words such as expect, anticipate, intend,
believe, hope, assume, estimate, plan, will and other similar words and expressions. In addition, any statements that refer to expectations, projections or other
characterizations of future events or circumstances are forward-looking statements. Discussions containing these forward-looking statements may be found in Business and Managements Discussion and Analysis of Financial
Condition and Results of Operations. These forward-looking statements involve risks and uncertainties, including the risks discussed in Item 1. BusinessRisks Factors That May Affect Results of Operations and Financial
Condition, that could cause our actual results to differ materially from those in the forward-looking statements. We undertake no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances
after the date of this document. The risks discussed in Item 1. BusinessRisks Factors That May Affect Results of Operations and Financial Condition and elsewhere in this report should be considered in evaluating our prospects and
future financial performance.



Item 1.Business



Overview



We are
a biotechnology company using our proprietary technologies to develop drug candidates from an important class of natural product compounds known as polyketides. Polyketides are naturally made in very small amounts in certain microorganisms and are
difficult to make or modify chemically. Using our proprietary technologies, we are able to create, modify and produce polyketides in ways that chemists generally cannot. Because polyketides have been a rich source of marketed drugs, creating novel
polyketides should provide us with a pipeline of potential drug candidates that address existing or potential large markets.



We can make improved versions of a known polyketide pharmaceutical product and are able to change a polyketide used in one therapeutic
area to create a new polyketide to be used for another therapeutic area. We can also take the genetic instructions for making a polyketide out of one microorganism and put them into another that provides a more favorable environment to produce more
of the polyketide.



Our strategy is to use our
technologies to create new polyketides for pharmaceutical development, to make improved versions of known polyketide pharmaceuticals and to advance selected drug candidates into clinical trials. We are co-developing epothilones, a class of
polyketides, for the treatment of cancer with Hoffman-La Roche, Inc. and F. Hoffman-La Roche Ltd., collectively Roche, and have U.S. co-marketing rights to any resulting epothilones that receive regulatory approval for marketing. Our lead epothilone
candidate, KOS-862 (Epothilone D), is in Phase I human clinical trials. In collaboration with the National Cancer Institute, or NCI, a



3



---

##### Table of Contents

component of the National Institutes of Health, or NIH, we are developing derivatives of geldanamycin, a polyketide, for the treatment of
cancer. Our lead geldanamycin candidate, 17-AAG, a derivative of geldanamycin, is in Phase I human clinical trials being conducted by the NCI. We also have antibiotic product candidates that are undergoing preclinical evaluation by our collaborative
partner, Johnson & Johnson Pharmaceutical Research & Development, LLC, or J&JPRD, a subsidiary of Ortho-McNeil Pharmaceutical, Inc.



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



Overview of Polyketides



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



Selected Polyketide Products and Their Uses



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



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



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



4



---

##### Table of Contents

LOGO

The synthesis of a polyketide essentially involves the linking of a number of small
building block compounds to form the larger polyketide. A modular PKS can be functionally subdivided into units called modules, each of which is responsible for a single building block used in the synthesis. Synthesis begins at the first module,
called the loading module, located at one end of the PKS, and continues to the end through multiple extender modules, each of which adds and modifies another building block. This process creates a chain of building blocks that forms the polyketide;
in many instances, the chain is linked to itself to form a ring. Because each module codes for one building block, the number of modules in a PKS codes for the size of the polyketide. Each module contains three essential enzyme activities
responsible for connecting the polyketide building blocks. One of these activities selects which building block (there are at least four different building blocks) is used, and the other two are involved in linking the building block to the growing
chain and passing the chain to the next module. A module may also have one, two or three additional enzymes that modify the building blocks once they are incorporated into the chain.



The structure of a polyketide can therefore be viewed as being determined by the types, order and number of
modules in a modular PKS. The types of modules dictate which building blocks are used, the order of the modules dictates the sequence of building blocks and the number of modules dictates the number of building blocks in, or size of, the polyketide.
Modifying, adding or deleting the modules results in specific and predictable changes to the structure of the polyketide.



5



---

##### Table of Contents



Our Strategy



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



Maximize Value, Minimize
Risk.    Our principal programs are focused on the development of improved versions of existing pharmaceutical products and increasing the efficiency and large-scale production of polyketides. By improving the properties of
known compounds, we believe we can create novel products that take advantage of the known utility, safety, development path and market for existing drugs to reduce the risk and time required for development.



Establish Collaborative
Relationships.    We have a collaboration with Roche to co-develop and commercialize our anticancer product candidate, KOS-862 (Epothilone D), and other epothilone analogs for the treatment of cancer. We have a collaboration
with the NCI to clinically develop 17-AAG and other geldanamycin derivatives for the treatment of cancer. We have a collaboration with J&JPRD to develop ketolide antibiotics. We plan to establish additional collaborative relationships with large
pharmaceutical companies and other research and development organizations to help us obtain our drug candidates or advance them into or through clinical trials and to the market, prepare and screen our polyketide libraries, apply our technologies to
create new polyketides and develop large-scale production systems.



Acquire Complementary Technologies and Products.    We have research and license agreements with Sloan-Kettering Institute for Cancer Research, or Sloan-Kettering, and with the NCI in the area of
cancer therapeutics. We may acquire or license additional complementary technologies or product candidates from others.



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



Our Technology Platform



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



Polyketide
Gene Alteration



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



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



6



---

##### Table of Contents



Chemo-Biosynthesis



We
incorporate chemically synthesized fragments into complicated polyketide structures, permitting changes in the polyketide structures and properties in ways that have not been achieved by any other process.



First, we disable the loading and first extender modules in a
PKS by altering the gene that contains the instructions for these modules. This prevents formation of the two-building-block intermediate that feeds the second extender module, but leaves the remainder of the PKS fully functional. Then,
microorganisms containing this modified PKS are fed our chemically synthesized fragments that substitute for the natural building-block intermediate.



Heterologous Over-Expression



We can isolate a polyketide gene cluster from one organism and transfer it to another. This is important because many polyketides are
produced by microorganisms that are difficult or slow to grow, or in which recombinant DNA methods have not been developed. In addition, polyketides are often produced in small amounts in organisms that naturally produce them, which can limit their
commercial development. We have created microorganisms for efficient polyketide manipulation and production. Our proprietary technologies allow us to transfer polyketide genes to these microorganisms to enable easier manipulation and increased
production of polyketides necessary for commercialization.



Combinatorial Biosynthesis



We have developed a technology to produce large collections, called libraries, of polyketides rapidly and efficiently. Because the approximately 10,000 naturally occurring polyketides have yielded many pharmaceutical products, we
believe that libraries of new polyketides may do likewise. In addition, by changing the order, type and number of modules, we can create entirely new libraries of polyketides as sources of new compounds both for screening for new activities and for
improving a lead compound. To create these libraries we separate the large polyketide gene cluster into several fragments. Each of these fragments is then genetically manipulated to produce numerous variations. We then reassemble the gene cluster
with various combinations of the altered fragments to create large polyketide libraries. Because many different combinations of the altered fragments can be assembled simultaneously, our combinatorial biosynthesis technology can be used to produce
large polyketide libraries. For example, we believe our scientists have created the largest number of erythromycin analogs produced by genetic engineering.



Product Development Opportunities



Our primary programs are currently directed at discovery and development of polyketides for cancer, infectious disease and
gastrointestinal motility disorders. These programs were selected because they represent opportunities where our technologies could improve upon existing products or fill unmet needs, and because each addresses existing or potential large markets.
We are able to maintain a diverse portfolio of drug candidates because the fundamental aspects of our technology generally apply to all modular PKS gene clusters.



Cancer



Epothilones



A number of cancers are treated with cytotoxic drugs known as taxanes, including paclitaxel, marketed as Taxol®by Bristol-Myers Squibb Company, and docetaxel, marketed as Taxotere®by Aventis Pharmaceuticals, Inc. In 2001, sales of taxanes exceeded $2.0 billion. Some tumors are resistant to taxanes. Thus, there exists a
significant commercial opportunity for a potentially more effective and safer class of cytotoxic drugs to treat multiple forms of cancer.



7



---

##### Table of Contents



Epothilones
represent a promising class of polyketides for the treatment of cancer. KOS-862 (Epothilone D), a polyketide that has a similar mechanism of action as Taxol®, is active against taxane-resistant tumors. KOS-862 and its analogs have potent cytotoxic activity against multiple tumor cell lines and human
xenograft tumors implanted in mice. Our heterologous over-expression technology allows polyketide genes to be moved from the natural producer organism to another to produce greater quantities of polyketides than the natural producer organism. We
have internally manufactured sufficient quantities of KOS-862 to support Phase I clinical trials and are producing additional quantities in anticipation of Phase II needs.



We are conducting three Phase I human clinical trials investigating six separate dosing schedules of KOS-862
and expect to enter Phase II human clinical trials in the second half of 2003. Other epothilones, including those being developed by Bristol-Myers Squibb and Novartis AG, are reported to be in Phase II clinical trials in cancer patients. In
September 2002, we entered into a collaboration agreement with Roche to jointly conduct clinical development of KOS-862 and to research and develop back-up compounds and production improvements.



Geldanamycin



Hsp90 (heat shock protein 90) is a protein chaperone that
binds to several sets of signaling proteins, known as client proteins. These client proteins include several cancer-relevant targets such as mutated p53, Bcr-Abl, Raf-1, ErbB2 and other kinases, as well as steroid hormone receptors.
Disruption of the Hsp90-client protein complexes leads to degradation of the client proteins. The polyketide geldanamycin, and derivatives such as 17-AAG, bind to Hsp90 and cause dissociation and degradation of client proteins. Because the Hsp90
client proteins are important in signal transduction and in transcription, geldanamycin derivatives, such as 17-AAG, may serve as chemotherapeutic agents in a number of diseases. Moreover, preclinical studies suggest that these compounds are
synergistic with certain other inhibitors of the signal transduction client proteins, as well as several conventional anticancer agents.



In October 2002, we entered into two Cooperative Research and Development Agreements (CRADAs) with the NIH to collaborate with the NCI on
the clinical development of 17-AAG, currently in Phase I human clinical trials, which are being funded by the NCI, and the development of geldanamycin derivatives. We are collaborating with the NCI to complete ongoing Phase I 17-AAG clinical trials,
to initiate NCI funded Phase II clinical trials of 17-AAG as a monotherapy and to initiate Phase Ib clinical trials of 17-AAG in combination with other anticancer drugs. Under the terms of the CRADAs, we are responsible for the provision of
sufficient quantities of clinical material necessary to conduct the clinical development of 17-AAG and we have the option, at our expense, to conduct our own clinical trials of 17-AAG and geldanamycin derivatives.



Discodermolide



Discodermolide, a polyketide with potent activity against
cancer cells, originally was isolated from a Caribbean sponge in minute quantities. Discodermolide has a mechanism of action similar to KOS-862 and Taxol®. Preclinical evaluation of discodermolide indicates that it may be a potent and promising compound for the treatment of cancer. Using our proprietary polyketide technology and medicinal chemistry
techniques, we are seeking to generate novel derivatives of discodermolide for preclinical evaluation and seeking to develop methods to produce quantities sufficient for further testing.



Infectious Disease



Macrolides are clinically important antibiotics that have been used for the treatment of respiratory infections for more than 40 years.
The macrolide family is large and structurally diverse, with the most important clinical compounds belonging to the 14- and 16-membered classes. In recent years, there has been increasing resistance to macrolides in every country where macrolides
are used, driving the need to develop new and more effective drugs.



8



---

##### Table of Contents



Currently, the
leading antibiotics used in fighting infectious diseases are clarithromycin, marketed as Biaxin®by Abbott
Laboratories, and azithromycin, marketed as Zithromax®by Pfizer Inc. These are polyketide-derived antibiotics
that show high potency, a broad spectrum of activity and few side effects. In 2001, these products had combined revenues of approximately $2.0 billion. However, organisms are emerging that are resistant to these two drugs. Ketolides, derivatives of
the polyketide erythromycin, possess the potency and spectrum of activity shown by clarithromycin and azithromycin, but are effective against these resistant organisms. Aventis has received regulatory approval in Europe and major Latin American
markets and has received an approvable letter by the U.S. Food and Drug Administration, or FDA, to market a ketolide antibiotic called Ketek®.



Under our collaboration agreement with J&JPRD, we have used our chemo-biosynthesis technology to generate several proprietary ketolides that we believe have activities competitive with other ketolides. Several of these compounds
are currently undergoing preclinical evaluation by J&JPRD. We also have an internally funded program to generate new macrolide antibiotics designed to be effective against resistant organisms.



Gastrointestinal Motility



One of the actions of erythromycin is stimulation of
gastrointestinal movement, or GI motility. Erythromycin-derived compounds called motilides may be useful to treat diseases such as gastroparesis and gastroesophageal reflux disease, also known as GERD or heartburn, that are unresponsive to antacids.
Until recently, the leading product used for stimulation of GI motility was cisapride, marketed as Propulsid®by
Johnson & Johnson, which had sales of approximately $1.0 billion in 1999. However, due to reported side effects, cisapride is no longer marketed in the United States and other countries. Motilides have an entirely different mechanism of action
and should not have the same side effects as cisapride.



Many compounds in our erythromycin library can readily be converted into motilides. In addition, our technologies enable the preparation of numerous new motilides that could not easily be made chemically. We have generated a range of
proprietary motilides and plan to conduct preclinical evaluation during 2003.



Research and Development Expenses



Our research and development expenses were approximately $28.4 million in 2002, $25.5 million in 2001 and $17.6 million in 2000.



Intellectual Property



Our intellectual property consists of patents, copyrights, trade secrets and know-how. Our ability to compete effectively depends in large
part on our ability to obtain patents for our technologies and products, maintain trade secrets and operate without infringing the rights of others and prevent others from infringing upon our proprietary rights. We will be able to protect our
technologies from unauthorized use by third parties only to the extent that they are covered by valid and enforceable patents, or are effectively maintained as trade secrets. Accordingly, patents or other proprietary rights are an essential element
of our business. As of December 31, 2002, we owned 22 U.S. and four foreign patents (which expire beginning in 2013) and had exclusive license rights to 27 U.S. and ten foreign patents (which expire beginning in 2013) owned by Stanford University
and six U.S. and 16 foreign patents (which expire beginning in 2014) owned by Sloan-Kettering. On that date, we also had 87 U.S. and 151 foreign patent applications, as well as exclusive license rights to 27 U.S. and 44 foreign patent
applications.



Our policy is to file patent
applications to protect technology and compounds commercially important to our business. We also rely on trade secrets to protect our technology where patent protection is deemed inappropriate or unobtainable. We protect our proprietary technology
and processes, in part, by confidentiality agreements with



9



---

##### Table of Contents

our employees, consultants, collaborators and certain contractors. There can be no assurance that our confidential trade secret information
will not be disclosed, that others will not independently develop substantially equivalent proprietary information and techniques or that we can meaningfully protect our proprietary information.



Collaborative Research and Development Agreements



Roche



Effective September 2002, we signed a research and
collaboration agreement with Hoffman-La Roche, Inc. and F. Hoffman-La Roche Ltd. Under the terms of the agreement, Roche has worldwide exclusive rights to market and sell KOS-862 (Epothilone D) in the field of oncology, and we will co-develop and
have the right to co-promote the product in the United States. The principal focus of the collaboration is the clinical development and marketing of KOS-862 and eventual back-up compounds. Any such back-up candidates would be collaboratively
developed by Roche and us, and would be marketed by Roche, and could, at our option, be co-promoted by us with Roche for the treatment of cancer.



Under the agreement, we are entitled to receive clinical development funding for our activities under the collaboration, process and
back-up development program funding at specified levels, and milestone payments based upon achievement of clinical, regulatory and commercial events. We estimate that these types of cash payments could total up to $220 million, based upon our
current expectations for program expenses and assuming successful development and commercialization of one product that achieves each milestone event. In addition, we are entitled to receive royalties on any sales of collaboration products. We have
the option to increase our royalties by contributing to development costs and by co-promotion of products resulting from the collaboration.



Pursuant to this agreement, we recognized approximately $3.4 million of contract revenue for the year ended December 31, 2002. Such
amount, excluding the ratable portion of an initial payment, approximated research and development expenses under this collaboration agreement. Included in 2002 contract revenue was the ratable portion of the first of two $12.5 million installments
of an initial fee, which is being recognized over a five-year estimated clinical development term of the agreement.



Either party may terminate the agreement at any time for the other partys uncured material breach of the agreement. In addition,
Roche may terminate the agreement as a whole during an initial period solely for cause relating to the success of the program (not needing to relate to any breach by us), or after this initial period for convenience entirely or in part. Upon such a
termination by Roche for cause or convenience, the licensed rights would revert to us and Roche would provide us with other assistance to take over the previously licensed products. Unless earlier terminated, the agreement will remain in effect for
the life of the relevant patents



Johnson
& Johnson



Effective September 1998, we
signed a collaborative agreement with The R.W. Johnson Pharmaceutical Research, Inc., or RWJPRI, and Ortho-McNeil Pharmaceutical, Inc., both Johnson & Johnson companies. Effective January 1, 2002, RWJPRI assigned its rights and obligations under
the agreement to Johnson & Johnson Pharmaceutical Research and Development, LLC, or J&JPRD, a subsidiary of Ortho-McNeil Pharmaceutical, Inc. Under the terms of the agreement, we use our technologies to produce specific novel antibiotics on
a reasonable efforts basis. The agreement provides for J&JPRD to fund our research and development under the program at specified levels. We have amended the agreement to extend the research program several times. Most recently, in December
2002, we amended the agreement to extend until at least December 2003, subject to early termination provisions. Under the terms of the extension, J&JPRD has the right to evaluate two selected series of compounds in preclinical studies and to
obtain exclusive commercialization rights. Rights to compounds and technologies developed in the collaboration that are not related to the compounds under study by J&JPRD or their close structural analogs have reverted to us.



10



---

##### Table of Contents



J&JPRD has
the exclusive right under the agreement to develop, market and sell those drugs resulting from this collaboration that J&JPRD selects. We are entitled to milestone payments based upon achievement of specified research and development milestones.
We are also entitled to receive royalty payments based on any product sales.



Pursuant to this agreement, we recognized approximately $2.9 million, $3.2 million and $3.8 million of contract revenue for the years ended December 31, 2002, 2001 and 2000, respectively. Such amounts,
excluding initial and milestone payments, approximated research and development expenses under this collaboration. Included in 2000 contract revenue was the ratable portion of a $1.0 million up-front fee received upon signing the agreement, which
was recognized over the initial two-year research term of the agreement. Included in 2001 contract revenue was a $250,000 non-recurring milestone payment earned under this agreement.



After the research term under this agreement ends, J&JPRD can terminate the agreement as a whole or with
respect to any pharmaceutical product upon three months written notice. Either party may terminate the agreement at any time upon the other partys uncured material breach of the agreement. Under some terminations, rights to compounds
developed under the agreement revert to us except for rights to certain compounds designated by J&JPRD. Under other terminations, all compounds included under the agreement revert to us. J&JPRD provides certain assistance to transfer
reverting compounds and rights in them to us.



Sloan-Kettering Institute for Cancer Research



Effective August 2000, we signed a research and license agreement with Sloan-Kettering relating to epothilones. Under the agreement, we will use our technologies to produce KOS-862 (Epothilone D), currently in Phase I
clinical trials, and work collaboratively with Sloan-Kettering to develop compounds and production methods and to conduct clinical trials. Under the agreement, each party licenses the other party for activities as part of the collaborative program.
In addition, Sloan-Kettering exclusively licenses us for all further development and commercialization of compounds selected by us in accordance with the agreement.



Under the agreement, we paid Sloan-Kettering an initial license fee and will pay annual maintenance fees as
well as payments for research and development costs (including the costs of clinical trials). In addition, we must pay Sloan-Kettering milestone payments if clinical development milestones are reached, royalty payments based on net sales of products
covered by the collaboration, and a share of some sublicensing revenues.



If we and Sloan-Kettering jointly determine that the objectives of the research plan cannot be met, then the agreement terminates. Upon termination, all licenses granted by one party to the other revert to the granting
party. Otherwise, so long as we are actively developing or commercializing a product under the agreement, the agreement and our license do not terminate until our royalty obligations expire, in most cases, with the last patent covering the last
product, or, if later, a specified number of years after the first commercial sale of unpatented products. Effective September 2002, we received a consent from Sloan-Kettering to enter into a sublicense agreement with Roche and amended the research
and license agreement with Sloan-Kettering to harmonize it with the collaboration agreement with Roche.



Stanford University



Effective March 1996, we entered into an exclusive license agreement with the Board of Trustees of the Leland Stanford Junior University,
or Stanford University, for certain technology and related patent rights now contained in 27 issued U.S. and ten issued foreign patents, as well as 67 U.S. and foreign patent applications, and materials for the recombinant production of novel
polyketides. Under the terms of the agreement, we paid a license issue fee to Stanford University, and we pay annual maintenance fees, make milestone payments based on achievement of specified events with licensed products, pay royalties on net
sales of products claimed in or originating from the licensed technology, and pay shares of some sublicensing fees. In March 2000, we amended the agreement to provide us an exclusive option to acquire an exclusive or non-exclusive license to future
patents



11



---

##### Table of Contents

or patent applications that are related to certain technology developed by Chaitan S. Khosla, Ph.D. related to polyketides and their
production, and chosen by Stanford University in its discretion. Effective September 2002, we received a consent from Stanford University to enter into a sublicense agreement with Roche and amended the research and license agreement to grant a
sublicense to Roche and to harmonize it with the collaboration agreement with Roche.



National Institutes of Health/NCI



Effective October 2002, we entered into two CRADAs with the NIH. Under these agreements, we will collaborate with the NCI in the clinical development of 17-AAG, and the development of geldanamycin
derivatives. We have the option to obtain exclusive licenses under patents claiming inventions made in the collaborations under standard NIH licensing terms. Under the CRADAs, we must conduct various activities, including providing quantities of the
drugs for the preclinical studies and clinical trials, and a specified number of personnel to the programs. The clinical trials of 17-AAG and other derivatives are sponsored by the NCI in collaboration with us. The term of the collaborative programs
is currently scheduled for four years, but may be adjusted as the programs proceed.



Under a November 2002 license agreement with the NIH, we obtained exclusive commercial rights under pending patent applications relating to the geldanamycin derivatives being developed under the
CRADAs. Initially, our license is limited to specified medical fields of use, including treatment of cancer, re-stenosis and neurodegenerative diseases relating to undesired cell growth, and we may include additional fields of use to the license as
we go along. We have paid the NIH an up-front fee and will owe annual minimum royalties, patent fees, royalties based on net sales of licensed products, milestone payments if clinical development milestones are reached, and a portion of our
sublicensing revenues. The agreement and our license could terminate if we are not diligent or otherwise default in performing our material obligations under the agreement, and fail to cure the deficiency. The agreement contains standard NIH
licensing terms. Unless the agreement is earlier terminated, our license will endure for the life of the licensed patents.



We made total payments under our collaboration and license agreements for the years ended December 31, 2002, 2001 and 2000 of
approximately $1.5 million, $721,000 and $373,000, respectively.



Competition



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



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



12



---

##### Table of Contents

that has published patent applications, issued patents and entered into collaborations with pharmaceutical companies relating to efforts to
modify polyketide synthase genes using recombinant DNA technology.



We expect to encounter significant competition for any of the pharmaceutical products we develop. Companies that complete clinical trials, obtain required regulatory approvals and commence commercial sales of their products
before their competitors may achieve a significant competitive advantage. We are aware that many other companies or institutions are pursuing the development of drugs and technologies directly targeted at applications for which we are developing our
drug compounds. Aventis Pharmaceuticals has received regulatory approval in Europe and major Latin American markets and has received an approvable letter from the FDA to market a ketolide antibiotic called Ketek®. Chugai Pharmaceuticals has a motilide compound in clinical trials. Two other large pharmaceutical companies, Novartis and Bristol-Myers Squibb,
have epothilone compounds in clinical trials. Because we have not yet initiated clinical trials for our own ketolide and motilide compounds, it is likely that, even if we are successful in developing a product, one or more of these compounds of our
competitors will be approved and marketed as products before our own. This could place us and our collaborators at a significant disadvantage, especially in the event our compounds do not have superior properties or cost advantages, and prevent us
from realizing significant commercial benefit from such products.



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



To compete successfully, we must develop proprietary positions and patented drugs for therapeutic markets that have not been satisfactorily addressed by conventional research strategies and, in the process, expand our technical
expertise. Our potential products, even if successfully tested and developed, may not be adopted by physicians over other products and may not offer economically feasible alternatives to other therapies.



Government Regulation



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



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



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



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



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



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



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



Prior to commencing clinical trials, which are typically conducted in three sequential phases, we must submit an IND application to the
FDA. The IND automatically becomes effective 30 days after receipt by the



13



---

##### Table of Contents

FDA, unless the FDA, within the 30-day time period, raises concerns or questions about the conduct of the trial. In such a case, the IND
sponsor and the FDA must resolve any outstanding concerns before the clinical trial can begin. Our submission of an IND may not result in FDA authorization to commence a clinical trial. Further, an independent institutional review board at the
medical center proposing to conduct the clinical trial must review and approve the plan for any clinical trial before it commences.



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



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



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



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



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



Risk Factors That May Affect Results of Operations and Financial Condition



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



14



---

##### Table of Contents

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



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



We commenced operations in 1996 and are still in an early stage of development. We have not commercialized
any products, and we have incurred significant losses to date. As of December 31, 2002, we had an accumulated deficit of approximately $69.4 million. To date, our revenues have been solely from collaborations and government grant awards. Our
expenses have consisted principally of costs incurred in research and development and from general and administrative costs associated with our operations. We have incurred net losses since our inception, including net losses of approximately $20.9
million in 2002, $21.9 million in 2001 and $26.3 million 2000. We expect our expenses to increase and to continue to incur operating losses for at least the next several years as we continue our research and development efforts for our drug
candidates. The amount of time necessary to commercialize any of our drug candidates successfully is long and uncertain, and successful commercialization may not occur at all. As a result, we may never become profitable.



If our current collaborations are unsuccessful or if conflicts develop with
these relationships or under our license agreements, our research and development efforts could be delayed and our revenues could significantly decrease.



We have collaborative arrangements with two corporate collaborators, Hoffman-La Roche, Inc. and F. Hoffman-La Roche Ltd., and Johnson
& Johnson Pharmaceutical Research and Development, LLC, a subsidiary of Ortho-McNeil Pharmaceutical, Inc., and several other research groups, including Sloan-Kettering Institute for Cancer Research and the National Cancer Institute. We may not
be able to maintain or extend these collaborations on acceptable terms, if at all. If we do not maintain, extend or replace these collaborations, our research and development efforts could be delayed and our revenues could significantly decrease.



We do not control the amount and timing of
resources that our collaborators devote to our programs or potential products. As a result, we do not know if our collaborators will dedicate sufficient resources or if the development or commercialization efforts by our corporate collaborators will
be successful. We also do not know whether our current collaborative partners or future collaborative partners, if any, might pursue alternative technologies or develop alternative products either on their own or in collaboration with others,
including our competitors, as a means for developing treatments for the diseases targeted by collaborative arrangements with us. In addition, if a business combination involving our existing corporate collaborators were to occur, the effect could
diminish, terminate or cause delays in our corporate collaborations. Should our corporate partners fail to develop or commercialize a compound or product for which they have rights from us, we may not receive any future milestone payments and will
not receive any royalties associated with such compound or product. Conflicts might also arise with collaborative partners concerning proprietary rights to particular compounds, in which case we might not obtain rights to certain compounds or
technologies. If our collaborators were to breach or terminate their agreements with us or otherwise fail to conduct the collaborative activities successfully and in a timely manner, the preclinical or clinical development or commercialization of
the affected product candidates or research program could be delayed or terminated. In addition, if we do not maintain or further extend our agreements with Roche and J&JPRD, our revenues will significantly decrease unless we enter into
additional collaborations that provide substantial revenues.



We are also a party to various license agreements that give us rights to use specified technologies in our research and development processes. The agreements, pursuant to which we have in-licensed technology, permit our licensors to
terminate the agreement under certain circumstances. If we are not able to continue to license these future technologies on commercially reasonable terms, our product development and research may be delayed and our revenues could significantly
decrease.



15



---

##### Table of Contents



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



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



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



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



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



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



We must provide the FDA and foreign regulatory authorities with clinical data that demonstrates the safety
and efficacy of our products before they can be approved for commercial sale. As a result, commercialization of our product candidates depends upon successful completion of clinical trials. Preclinical testing and clinical development are long,
expensive and uncertain processes. It may take us several years to complete our testing, and failure can occur at any stage of testing. Success in preclinical testing and early clinical trials does not ensure that later clinical trials will be
successful, and interim results of trials do not necessarily predict final results. A number of companies in the pharmaceutical industry, including biotechnology companies, have suffered significant setbacks in advanced clinical trials, even after
promising results in earlier trials. None of the product candidates that we have internally developed or licensed have advanced beyond the stage of human testing designed to determine safety, known as Phase I clinical trials.



We do not know whether planned clinical trials will begin on
time or whether any of our clinical trials will be completed on schedule, or at all. Negative or inconclusive results or adverse medical events during a clinical trial could cause a clinical trial to be repeated or a program to be terminated. We
have two product candidates in human clinical trials for the treatment of cancer. Anticancer drugs generally have a narrow therapeutic window between efficacy and toxicity. If unacceptable toxicity is observed in clinical trials, the trials may be
terminated



16



---

##### Table of Contents

at an early stage. Drug-related deaths may occur in clinical trials with anticancer drugs, because drugs for the treatment of cancer are
typically dangerous and cancer patients are critically ill.



Completion of clinical trials may take several years or more. The length of time generally varies substantially according to the type, complexity, novelty and intended use of the drug candidate. Our clinical trials may be suspended
at any time, if we or the FDA believe the patients participating in our studies are exposed to unacceptable health risks. Our commencement and rate of completion of clinical trials may be delayed by many factors, including:



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



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



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



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



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



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



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



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



Any clinical trial may fail to produce results satisfactory to the FDA. Preclinical and clinical data can be interpreted in different
ways, which could delay, limit or prevent regulatory approval.



Our product development costs will increase if we have delays in testing or approvals or if we need to perform more or larger clinical trials than planned. If the delays are significant, our financial results and the commercial
prospects for our products will be harmed, and our ability to become profitable will be delayed.



We do not know whether our existing or any future clinical trials will demonstrate safety and efficacy sufficient to obtain the requisite regulatory approvals or will result in marketable products. Our
failure to adequately demonstrate the safety and efficacy of our products under development will prevent receipt of FDA and foreign approvals and, ultimately, commercialization of our products. If any current or future clinical trials are not
successful, our business, financial condition and results of operations will be harmed.



Any inability to protect our proprietary technologies adequately could harm our ability to successfully commercialize product candidates.



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



The patent positions of biotechnology companies,
including our patent position, involve complex legal and factual questions, and, therefore, validity and enforceability cannot be predicted with certainty. Patents may be challenged, deemed unenforceable, invalidated or circumvented. We will be able
to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary technologies and products are covered by valid and enforceable patents or are effectively maintained as trade secrets.



17



---

##### Table of Contents



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



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



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



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



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



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



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



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



We apply for patents covering both our technologies and drug candidates, as we deem appropriate. However, we
may fail to apply for patents on important technologies or products in a timely fashion or at all. Our existing patents and any future patents we obtain may not be sufficiently broad to prevent others from practicing our technologies or from
developing competing products. In addition, we generally do not control the patent prosecution of technology that we license from others. Accordingly, we are unable to exercise the same degree of control over this intellectual property as we would
over our own.



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



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



Our commercial success depends in part on not infringing the patents and proprietary rights of other parties and not breaching any licenses that we have entered into with regard to our technologies and
products. Others have filed patent applications and issued patents, and in the future are likely to continue to file patent applications and issue patents, claiming drug candidates that we are developing and genes, gene fragments, compounds and
technologies we use or may wish to use. If we wish to use the claimed technology in issued and unexpired patents owned by others, we may need to obtain a license from another party, enter into litigation or incur the risk of litigation.



The biotechnology industry is characterized by
extensive litigation regarding patents and other intellectual property rights. We are aware of patents and published patent applications that, if valid, and if we are unsuccessful in circumventing or acquiring the rights to these patents, may block
our ability to commercialize products based on the drug candidates that we are developing. We cannot be sure that other parties have not filed for or been issued relevant patents that could affect our ability to obtain patents or to operate as we
would like to. Others may sue us in the future to challenge our patent rights or claim infringement of their patents. An adverse determination in litigation or in an administrative proceeding to which we may become a party could subject us to
significant liabilities to others, require us to license disputed rights from others or require us to cease using the disputed technology.



We are aware of a significant number of patents and patent applications relating to aspects of our technologies and compounds filed by,
and issued to, other parties. Others have filed patent applications or have been granted patents claiming inventions also claimed by us, and we may have to participate in an interference



18



---

##### Table of Contents

proceeding declared by the relevant patent agency or court to determine priority of invention and, thus, the right to a patent for these
inventions in the United States. For example, we believe one or more interferences may be declared between patents and applications we own or have exclusively licensed and patents and applications owned by Novartis relating to epothilone
biosynthetic genes and Epothilone D; patent applications believed by us to be licensed to Bristol-Myers Squibb relating to epothilones; and patents and applications owned by Abbott Laboratories and Biotica relating to erythromycin polyketide
synthase genes, methods for altering polyketide synthase genes and erythromycin analogs and derivatives. Such a proceeding or a lawsuit in which we are alleged to have infringed an issued patent could result in substantial cost to us even if the
outcome is favorable, and if the outcome is unfavorable, we could be required to license the other partys rights, at terms that may be unfavorable to us, or cease using the technology. Even if successful on priority grounds, an interference
may result in loss of claims based on patentability grounds raised in the interference. Although patent and intellectual property disputes in the biotechnology area are often settled through licensing or similar arrangements, costs associated with
these arrangements may be substantial and could include ongoing royalties. Furthermore, we cannot be certain that a license would be available to us on satisfactory terms, if at all.



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



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



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



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



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



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



Litigation or the failure to obtain licenses could prevent us from commercializing products.



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



If
third parties do not successfully carry out their contractual duties or meet expected deadlines, we will not be able to obtain regulatory approvals for our product candidates and will not be able to successfully commercialize our product candidates
for targeted diseases. We do not have the ability to independently conduct clinical trials for our products, and we rely on third parties such as contract research organizations, medical institutions and clinical investigators to perform this
function. If these third parties do not perform satisfactorily, our clinical trials may be extended or delayed. We may not be able to locate any necessary acceptable replacements or enter into favorable agreements with them, if at all.



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



Retaining
our current employees and recruiting qualified scientific personnel to perform future research and development work will be critical to our success. Competition is intense for experienced scientists, and we may not be able to retain or recruit
sufficient skilled personnel to allow us to pursue collaborations and develop our products and core technologies to the extent otherwise possible. Additionally, we are highly dependent on the



19



---

##### Table of Contents

principal members of our management and scientific staff, such as our two co-founders, the loss of whose services would adversely impact the
achievement of our objectives. Although we maintain and are the beneficiary of $1.0 million key-man life insurance policies for the lives of each of our two co-founders, Daniel V. Santi, M.D., Ph.D., our chairman and chief executive officer, and
Chaitan S. Khosla, Ph.D., a director and consultant, we do not believe the proceeds would be adequate to compensate us for their loss.



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



We face, and will continue to face, intense competition from
organizations such as large biotechnology and pharmaceutical companies, as well as academic and research institutions and government agencies, that are pursuing competing technologies and products. These organizations may develop technologies or
products that are superior alternatives to ours. For example, other epothilones, including those being developed by Bristol-Myers Squibb and Novartis AG, are reported to be in Phase II clinical trials in cancer patients. Further, our competitors in
the polyketide gene engineering field may be more effective at implementing their technologies to develop commercial products. Some of these competitors have entered into collaborations with leading companies within our target markets to produce
polyketides for commercial purposes.



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



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



We face an inherent business risk of clinical trial liability claims in the event that the use or misuse of our potential products results in personal injury or death. We may experience clinical trial
liability claims if our drug candidates are misused or cause harm before regulatory authorities approve them for marketing. Even though we have obtained clinical trial liability insurance, it may not be sufficient to cover claims that may be made
against us. Clinical trial liability insurance is expensive, difficult to obtain and may not be available in the future on acceptable terms, if at all. Any claims against us, regardless of their merit, could materially and adversely affect our
financial condition, because litigation related to these claims would strain our financial resources in addition to consuming the time and attention of our management. If we are sued for any injuries caused by our products, our liability could
exceed our total assets.



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



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



20



---

##### Table of Contents



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



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



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



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



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



Our officers, directors
and their affiliates together control approximately 32% of our outstanding common stock. As a result, these stockholders, if they act together, are able to exert a significant degree of influence over our management and affairs and over matters
requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may delay or prevent a change in control of us and might affect the market price of our common
stock, even when a change may be in the best interests of all stockholders. In addition, the interests of this concentration of ownership may not always coincide with our interests or the interests of other stockholders, and accordingly, these
stockholders could cause us to enter into transactions or agreements which we would not otherwise consider.



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



The trading price of our common stock has been, and is likely to continue to be, highly volatile. During 2002, our common stock traded
between $5.71 and $9.25 on the Nasdaq National Market. The trading price of our common stock could be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including:



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



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



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



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



21



---

##### Table of Contents



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



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



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



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



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



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



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



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



| |  |  | the success rate of our discovery efforts leading to milestones and royalties;
| | - |  | ------------------------------------------------------------------------------



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



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



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



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



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



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



We believe that our existing cash and investment securities and anticipated cash flow from existing collaborations will be sufficient to support our current operating plan into early 2005. We have based this



22



---

##### Table of Contents

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



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



Employees



As of February 28, 2003, we had 112 full-time employees, 46
of whom hold Ph.D. degrees and 90 of whom were engaged in research and development activities. None of our employees is represented by a collective bargaining agreement, nor have we experienced any work stoppage. We believe that our relations with
our employees are good.



Directors and Executive Officers of
the Registrant



Our directors and executive
officers, and their ages as of March 31, 2003, are as follows:



|Name                                |  | Age |  | Title                                                                                     
|----------------------------------- |  | --- |  | ------------------------------------------------------------------------------------------
|Daniel V. Santi, M.D., Ph.D.        |  | 61  |  | Chairman and Chief Executive Officer                                                      
|Michael S. Ostrach                  |  | 51  |  | President and Chief Operating Officer                                                     
|Robert G. Johnson, Jr., M.D., Ph.D. |  | 51  |  | Senior Vice President, Medical Affairs and Corporate Development and Chief Medical
Officer
|Susan M. Kanaya                     |  | 40  |  | Senior Vice President, Finance, Chief Financial Officer and
Secretary                     
|Bruce A. Chabner, M.D.              |  | 62  |  | Director                                                                                  
|Peter Davis, Ph.D.                  |  | 58  |  | Director                                                                                  
|Jean Deleage, Ph.D.                 |  | 62  |  | Director                                                                                  
|Chaitan S. Khosla, Ph.D.            |  | 38  |  | Director                                                                                  
|Christopher T. Walsh, Ph.D.         |  | 59  |  | Director                                                                                  



Daniel V. Santi, M.D., Ph.D., is one of our co-founders and has served as Chairman of the Board of Directors since our inception in January 1995 and as our Chief Executive Officer since November 1998. Until his retirement in
January 2001, Dr. Santi was on leave of absence from his position as Professor of Biochemistry and Biophysics, and of Pharmaceutical Chemistry at University of California, San Francisco, a position that he held since 1974. Dr. Santi was one of the
original members of the Scientific Advisory Boards of Chiron Corporation and Mitotix, Inc., and has served as a consultant to several large pharmaceutical companies. In 1988, Dr. Santi founded and served as Chairman of the Board of Directors of
Protos, Inc., a biotechnology firm and a subsidiary of Chiron Corporation, which was merged with Chiron in 1992. Dr. Santi was also founder and Chairman of Parnassus Pharmaceuticals. Dr. Santi has published over 275 scientific papers and is inventor
on many patents in combinatorial chemistry and other areas. Dr. Santi received a B.S. in pharmacy from the State University of New York, an M.D. from the University of California, San Francisco and a Ph.D. in medicinal chemistry from the State
University of New York.



Michael S.
Ostrach has served as our President and Chief Operating Officer since January 2002. From October 1998 to January 2002, Mr. Ostrach served as our Chief Operating Officer. Prior to joining Kosan in October 1997 as Vice President, Corporate
Development, Mr. Ostrach worked as an independent consultant for biotechnology companies from October 1996 to October 1997. Mr. Ostrach was Executive Vice President and



23



---

##### Table of Contents

Chief Operating Officer of Neurobiological Technologies, Inc., a publicly held biotechnology company, from 1994 to 1996. From 1993 to 1994,
Mr. Ostrach worked as a consultant to a number of biotechnology companies. From 1981 to 1991, he was a Senior Vice President at Cetus Corporation, a biotechnology company. In 1991, Cetus Corporation merged into Chiron Corporation, and during 1992,
Mr. Ostrach was a Vice President of Chiron Corporation and a founder and the President of Chiron Technologies, a Chiron business unit. Mr. Ostrach received a B.A. from Brown University and a J.D. from Stanford Law School.



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



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



Bruce A. Chabner, M.D., has served as a director since September 2001. Dr. Chabner has served as the Chief of Hematology/Oncology
at the Massachusetts General Hospital and as Professor of Medicine at Harvard Medical School since 1995. Dr. Chabner has also served as the Associate Director for Clinical Science of the Dana-Farber/Harvard Cancer Center since 1999 and has held
numerous academic appointments, including the position of Director of the Division of Cancer Treatment of the National Cancer Institute from 1982 to 1995. Dr. Chabner has received numerous awards, including Phi Beta Kappa, Alpha Omega Alpha,
the Public Health Services Distinguished Service Medal, the Karnofsky Award of the American Society for Clinical Oncology and the Bruce F. Cain Award for Drug Development of the American Association for Cancer Research. Dr. Chabner received a
B.A. from Yale College and an M.D. from Harvard Medical School.



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



Jean Deleage, Ph.D.,has served as a director since
April 1996. Dr. Deleage is a founder and managing director of Alta Partners, a venture capital firm investing in information technologies and life science companies. Alta Partners was formed in 1996. In 1979, Dr. Deleage founded, and is a managing
partner of, Burr, Egan, Deleage & Co., a major venture capital firm in San Francisco and Boston. Dr. Deleage was a member of Sofinnovas initial team, a venture capital organization in Paris, and in 1976 formed Sofinnova, Inc. (the U.S.



24



---

##### Table of Contents

subsidiary of Sofinnova). Dr. Deleage is presently a member of the board of directors of Crucell, N.V., Rigel Pharmaceuticals, Inc. and
several private companies. In 1984, Dr. Deleage was awarded the Ordre National du Merite, and in 1993, he was awarded the Legion of Honor from the French government in recognition of his career accomplishments. Dr. Deleage received a Masters
Degree in electrical engineering from Ecole Superieurie dElectricite and a Ph.D. in economics from the University of Paris, Sorbonne.



Chaitan S. Khosla, Ph.D., is one of our co-founders and has served as a director since our inception in January 1995. Dr. Khosla
has been a Professor of Chemical Engineering, Chemistry and Biochemistry at Stanford University since 2001 and has been a faculty member since 1992. Dr. Khosla is co-chairman of our Scientific Advisory Board. Dr. Khosla is the inventor of the
combinatorial biosynthesis technology that we licensed from Stanford University. He is the recipient of several awards, including the 1999 Alan T. Waterman award by the National Science Foundation, the 1999 Eli Lilly Award in biological chemistry
and the 2000 ACS Award in pure chemistry. Dr. Khosla is the author of over 100 publications and is an inventor on numerous patents. Dr. Khosla received a B.S. Tech. from the Indian Institute of Technology, Bombay, India and a Ph.D. from the
California Institute of Technology.



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



In April 1998, Mr. Ostrach consented, without admitting or denying the Securities and Exchange Commissions allegations and
conclusions, to the entry of a Commission administrative order requiring future compliance with Rule 102 of the Commissions Regulation M, a regulation that prohibits participants in a public stock offering from purchasing securities for their
own account until the public distribution is complete. The administrative order resulted from Mr. Ostrachs purchase of 600 shares of Neurobiological Technologies, Inc., or NTI, common stock during a restricted period preceding a 1996 stock
offering by NTI.



Scientific Advisory Board



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



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



Christopher T. Walsh, Ph.D., is co-chairman of our SAB and a member of our board of directors.



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



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



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



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



25



---

##### Table of Contents



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



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



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



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



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



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



Available Information



We maintain a site on the world wide web at www.kosan.com; however, information found on our website is not incorporated by reference into
this report. We make available free of charge on or through our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d)
of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.



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



Item 2.Properties



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



Item 3.Legal Proceedings



None.



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



None.



26



---

##### Table of Contents



PART II



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



Market for Registrants Common Equity



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



|               |  | High |       | Low
|-------------- |  | ---- | ----- | ---
|2002           |  |      |       |    
|Fourth Quarter |  | $    | 6.72  |    
|Third Quarter  |  | $    | 8.01  |    
|Second Quarter |  | $    | 9.25  |    
|First Quarter  |  | $    | 9.02  |    
|              
|2001           |  |      |       |    
|Fourth Quarter |  | $    | 8.35  |    
|Third Quarter  |  | $    | 9.26  |    
|Second Quarter |  | $    | 10.70 |    
|First Quarter  |  | $    | 12.56 |    



As of
March 14, 2003, there were approximately 171 record holders of our common stock. We have never declared or paid dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our
business and do not anticipate paying any cash dividends in the foreseeable future.



Information concerning securities authorized for issuance under equity compensation plans is contained in our definitive Proxy Statement with respect to our 2003 Annual Meeting of Stockholders, to be
filed with the SEC before April 30, 2003, under the caption Equity Compensation Plan Information, and is incorporated herein by reference.



Use of Proceeds From Sales of Registered Securities



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



We paid a total of approximately $5.6 million in underwriting discounts and commissions, and other costs and
expenses, other than underwriting discounts and commissions, were approximately $1.5 million. After deducting the underwriting discounts and commissions and the offering costs and expenses, we had net proceeds of approximately $73.4 million.



We intend to use the net proceeds for advancing
our drug candidates through preclinical and later stage development, discovering or acquiring new drug candidates, expanding our technology platform, capital expenditures, working capital, general corporate purposes and possible future acquisitions.
Of the net proceeds, through December 31, 2002, approximately $13.3 million had been used for general corporate purposes and approximately $3.0 million had been used to purchase property and equipment. Pending such uses, the balance has been
invested in U.S. Treasury and government agency obligations, investment-grade asset-backed securities and corporate obligations.



27



---

##### Table of Contents



Item 6.Selected Financial Data



The statement of operations data for each of the years ended December 31, 2002, 2001 and 2000, and the balance sheet data as of December
31, 2002 and 2001, have been derived from our audited financial statements included elsewhere in this Annual Report on Form 10-K that have been audited by Ernst & Young LLP, independent auditors. We have derived the statement of operations data
for the years ended December 31, 1999 and 1998, and the balance sheet data as of December 31, 2000, 1999 and 1998 from our audited financial statements that we do not include in this Annual Report on Form 10-K. Our historical results are not
necessarily indicative of results to be expected for any future period. The data presented below have been derived from financial statements that have been prepared in accordance with accounting principles generally accepted in the United States and
should be read with our financial statements, including the notes, and with Item 7.Managements Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Annual Report on Form
10-K.



|                                                                               |  | Year Ended December 31,               |        
|------------------------------------------------------------------------------ |  | ------------------------------------- | -------
|                                                                               |  | 2002                                  |        
|                                                                               |  | (in thousands, except per share data) |        
|Statement of Operations Data:                                                  |  |                                       |        
|Contract revenue                                                               |  | $                                     | 7,269  
|Grant revenue                                                                  |  |                                       | 2,334  
|                                                                               |  |                                       |        
|Total revenues                                                                 |  |                                       | 9,603  
|Operating expenses:                                                            |  |                                       |        
|Research and development(1)                                                    |  |                                       | 28,378 
|General and administrative(1)                                                  |  |                                       | 4,932  
|                                                                               |  |                                       |        
|Total operating expenses                                                       |  |                                       | 33,310 
|                                                                               |  |                                       |        
|Loss from operations                                                           |  |                                       | (23,707
|Interest and other income, net                                                 |  |                                       | 2,843  
|                                                                               |  |                                       |        
|Net loss                                                                       |  |                                       | (20,864
|Deemed dividend upon issuance of Series C convertible preferred stock          |  |                                       |       
|                                                                               |  |                                       |        
|Net loss attributable to common stockholders                                   |  | $                                     | (20,864
|                                                                               |  |                                       |        
|Basic and diluted net loss per common share                                    |  | $                                     | (0.84  
|                                                                               |  |                                       |        
|Shares used in computing basic and diluted net loss per common share           |  |                                       | 24,906 
|Pro forma basic and diluted net loss per common share (unaudited)              |  |                                       |        
|                                                                               |  |                                       |        
|Shares used in computing pro forma basic and diluted net loss per common
share |  |                                       |        
|                                                                               |  |                                       |        
|(1)    Includes non-cash charges for stock-based compensation as follows:     
|                                                                              
|                                                                               |  | Year Ended December 31,               |        
|                                                                               |  | 2002                                  |        
|                                                                               |  | (in thousands, except per share data) |        
|Research and development                                                       |  | $                                     | 2,782  
|General and administrative                                                     |  |                                       | 656    
|                                                                               |  | $                                     | 3,438  



28



---

##### Table of Contents



|                                                                    |  | As of December 31, |        
|------------------------------------------------------------------- |  | ------------------ | -------
|                                                                    |  | 2002               |        
|                                                                    |  | (in thousands)     |        
|Balance Sheet Data:                                                 |  |                    |        
|Cash, cash equivalents and short-term investments                   |  | $                  | 53,451 
|Working capital                                                     |  |                    | 48,748 
|Long-term investments                                               |  |                    | 27,087 
|Total assets                                                        |  |                    | 91,590 
|Deferred revenue, current portion                                   |  |                    | 2,500  
|Deferred revenue, less current portion                              |  |                    | 9,271  
|Capital lease obligations and equipment loans, less current portion |  |                    | 1,796  
|Accumulated deficit                                                 |  |                    | (69,406
|Stockholders equity                                                |  |                    | 70,840 



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



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



We have proprietary gene-engineering technologies for the manipulation and production of polyketides, a rich source of pharmaceutical products. We use our platform technologies to develop product candidates that target large
pharmaceutical markets. In collaboration with Hoffman-La Roche, Inc. and F. Hoffman-La Roche Ltd., collectively Roche, we are testing KOS-862 (Epothilone D), a potential anticancer agent, in Phase I human clinical trials. We are developing
geldanamycin derivatives as anticancer agents and are collaborating with the National Cancer Institute, or NCI, to test one of them, 17-AAG, which is in Phase I human clinical trials. In infectious disease, we have a collaboration with Johnson &
Johnson Pharmaceutical Research & Development, LLC, or J&JPRD, a subsidiary of Ortho-McNeil Pharmaceutical, Inc., focusing on the development of antibiotics. We have additional product development and research programs.



We have incurred significant losses since our inception. As of
December 31, 2002, our accumulated deficit was $69.4 million. We expect to incur additional operating losses over the next several years as we continue to develop our technologies and fund internal product research and development.



Critical Accounting Policies



Our discussion and analysis of our financial condition and
results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to our research and
development collaborations, investments, intangible assets, income taxes, financing operations and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.





29



---

##### Table of Contents

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



Revenue Recognition



We recognize license and other up-front fees over the estimated research and development term of the respective agreement. If the
agreement does not have a specified research and development term, we must apply judgment in determining the appropriate level of recognition. Any changes in our estimates will result in either an acceleration or further deferral of related revenue
recognition. Milestone payments are recognized upon successful completion of a specified scientific or regulatory milestone event. Contract revenues related to collaborative research and development agreements are recognized as revenues as the
related services are performed. Such payments are generally made based on the number of full-time equivalent researchers assigned to the collaboration project and as the related research and development expenses are incurred. Revenues related to
government grant awards are recognized at the time a grant is awarded and as related research expenses are incurred. Any amounts received in advance of performance are recorded as deferred revenue until earned.



Stock-Based Compensation



We continue to account for common stock options granted to
employees using the intrinsic value method and, thus, recognize compensation expense for options granted with exercise prices less than the fair value of our common stock on the date of the grant. We disclose the fair value of such grants in the
notes to the financial statements as currently permitted under Statement of Financial Accounting Standards No. 123 Accounting for Stock-based Compensation. We recorded total deferred stock-based compensation of approximately
$15.6 million in 2000 and $2.9 million in 1999, which is being amortized to expense using the graded vesting method over the vesting periods of the underlying options, generally four years. Subsequently, if employees terminate during the
vesting period, adjustments of previous charges are recognized in the period of termination. We expect to record amortization of deferred stock-based compensation approximately as follows: $930,000 in 2003 and $204,000 in 2004.



Stock-based compensation expense for options granted to
non-employees has been determined as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. We recognized other stock-based compensation for non-employees of
approximately $1.4 million in 2002, $681,000 in 2001 and $1.4 million in 2000. In addition, assuming no changes, we expect to recognize other stock-based compensation in connection with stock options granted to non-employees of approximately
$597,000 in 2003, $366,000 in 2004, $234,000 in 2005 and $45,000 in 2006. The measurement of stock-based compensation to non-employees is subject to periodic adjustment as the underlying securities vest. As such, changes to these measurements could
be substantial should we experience significant changes in our stock price. See Notes 1 and 10 of our financial statements.



Investments



We invest in debt and equity securities. The price of these securities is subject to significant volatility. We record an impairment
charge when we believe that an investment has experienced a decline in value that is other than temporary. Generally, we review an investment for impairment if its market value has been below its carrying value for each trading day in a six-month
period.



Clinical Trial Accruals



Over the next year our clinical trials of KOS-862 will
significantly increase our research and development expenditures. Research and development expenditures are charged to operations as incurred. Our expenses related to clinical trials are based on estimates of the services received and efforts
expended pursuant to contracts with multiple research institutions and clinical research organizations that conduct and manage clinical trials on



30



---

##### Table of Contents

our behalf. The financial terms of these agreements are subject to negotiation and variation from contract to contract and may result in
uneven payment flows. Payments under the contracts depend on factors such as the achievement of certain events or the successful enrollment of patients or the completion of portions of the clinical trial or similar conditions. Expenses related to
clinical trials generally are accrued based on the level of patient enrollment and activity according to the protocol. We monitor patient enrollment levels and related activity to the extent possible and adjust our estimates accordingly.



Results of Operations



Years Ended December 31, 2002 and 2001



Revenue.    Our revenues increased
to approximately $9.6 million in 2002 from approximately $5.2 million in 2001. This increase was primarily due to approximately $3.4 million in contract revenue recognized under our development and commercialization agreement with Roche, of which
$730,000 represented the ratable portion of the first of two $12.5 million installments of an initial fee that is being recognized over an estimated five-year clinical development period. In addition, we recognized approximately $2.3 million in
grant revenue in 2002, compared to approximately $1.7 million in 2001. Total contract revenues under our collaboration agreement with J&JPRD were approximately $2.9 million in 2002, compared to approximately $3.2 million in 2001. Included in
2001 revenues was a non-recurring $250,000 milestone payment received in connection with this collaboration. In December 2002, we amended our collaboration agreement with J&JPRD to extend the research program through at least December 2003,
subject to early termination provisions. If we do not maintain or further extend our agreements with Roche and J&JPRD, our revenues will significantly decrease unless we enter into additional collaborations that provide substantial revenues.



Research and Development
Expenses.    Our research and development expenses consisted primarily of salaries and other personnel-related expenses, stock-based compensation, facility-related expenses, licensing-related expenses, depreciation of
facilities and equipment, lab consumables, clinical trial-related services performed by clinical research organizations and research institutions and other outside service providers. Research and development expenses increased to approximately $28.4
million in 2002 from approximately $25.5 million in 2001. This increase, partially offset by the decrease in stock-based compensation in 2002, was due in large part to our expanded research and development efforts, including three Phase I studies of
KOS-862 (Epothilone D), related licensing expenses and additional staffing in support of our continued investment in internally funded programs and technologies. Our research and development employees increased to 90 in 2002 from 76 in 2001. We
expect our research and development expenses will increase substantially as KOS-862 advances further into the clinic and as we support our collaborative research and development programs and advance our in-house research programs into later stages
of development.



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



|Product Candidate |  | Status                  |  | Commencement of Current Phase                       
|----------------- |  | ----------------------- |  | ----------------------------------------------------
|KOS-862           |  | Phase I clinical trials |  | Commenced clinical trials in the second half of 2001
|                 
|17-AAG            |  | Phase I clinical trials |  | NCI commenced clinical trials in 1999               



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



31



---

##### Table of Contents



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



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



Interest Expense.    Interest expense increased to approximately $356,000 in 2002
from approximately $349,000 in 2001. This increase resulted from additional debt financing of property and equipment during 2002. We expect our interest expense will increase in the future resulting from additional property and equipment-related
debt financings.



Gain/(Loss) on the Recovery
or Write-Down of Investment.    At June 30, 2001, we determined that an other-than-temporary decline in the fair value of our investment in short-term commercial paper of Southern California Edison, or So Cal Ed, a utility
company, had occurred. At the time of purchase, the security was a high investment-grade security, but was subsequently downgraded due to the financial uncertainty that resulted from the California energy crisis. The security matured on April 18,
2001, and So Cal Ed defaulted on payment. The amortized cost of the security was $3.0 million, and the security was valued at approximately 67% of cost at June 30, 2001. Accordingly, for the quarter ended June 30, 2001, we recorded a write-down on
the carrying value of the investment of $990,000. In March 2002, the security was fully repaid. Thus, we recorded a realized gain on the investment of $990,000 in 2002.



Years Ended December 31, 2001 and 2000



Revenue.    Our revenues increased to approximately $5.2 million in 2001 from
approximately $4.2 million in 2000. This increase was due to approximately $1.7 million of grant revenue in 2001, compared to approximately $446,000 in 2000. During the year ended December 31, 2001, we recognized a non-recurring $250,000 milestone
payment received in connection with our research collaboration with J&JPRD. Total contract revenues under this collaboration were approximately $3.2 million in 2001 and approximately $3.8 million in 2000. Included in 2000 revenues was $375,000
in remaining amortization of the up-front fee received in connection with this collaboration.



Research and Development Expenses.    Our research and development expenses consisted primarily of salaries and other personnel-related expenses, stock-based compensation,
fees paid to outside service providers, facility-related expenses, depreciation of facilities and equipment and lab consumables. Research and development expenses increased to approximately $25.5 million in 2001 from approximately $17.6 million in
2000. This increase was due in large part to our expanded research and development efforts, including advancing KOS-862 into the clinic, and continued investment in internally funded programs and technologies. In addition, increased payroll and
personnel-related expenses contributed to the increase as the number of research and development employees increased to 76 in 2001 from 56 in 2000.



General and Administrative Expenses.    General and administrative expenses increased to approximately $5.2
million in 2001 from approximately $4.2 million in 2000. This increase was primarily due to higher employee-related costs to support our expanding research and development activities and a full year of public company-related expenses. Our general
and administrative employees increased to 20 in 2001 from 13 in 2000.



Interest Income.    Interest income increased to approximately $5.0 million in 2001 from approximately $2.8 million in 2000. This increase was due to higher average investment balances due to
aggregate net proceeds



32



---

##### Table of Contents

of approximately $98.0 million received in connection with our October 2000 initial public offering of common stock and the issuance of
Series C convertible preferred stock in March 2000.



Interest Expense.    Interest expense decreased to approximately $349,000 in 2001 from approximately $359,000 in 2000. The decrease resulted from normal amortization of existing debt and a lower cost of
capital on additional debt financing due to declining interest rates in 2001.



Beneficial Conversion Feature.    In March 2000, we sold 804,196 shares of Series C convertible preferred stock (that converted into 2,412,588 shares of common stock at the
closing of our initial public offering) for net proceeds of approximately $24.6 million. After evaluating the fair value of our common stock in contemplation of our initial public offering, we determined that the issuance of the Series C convertible
preferred stock resulted in a beneficial conversion feature calculated in accordance with Emerging Issues Task Force Consensus No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features. The beneficial
conversion feature was reflected as a deemed dividend of $11.3 million in our financial statements in 2000.



Provision for Income Taxes



We incurred net operating losses in the years ended December 31, 2002, 2001 and 2000 and consequently did not pay federal, state or foreign income taxes. As of December 31, 2002, we had federal net
operating loss carryforwards of approximately $35.0 million. We also had federal research and development tax credit carryforwards of approximately $1.6 million. If not utilized, the net operating losses and credit carryforwards will expire at
various dates beginning in 2011 through 2022. Use of the net operating losses and credits may be subject to a substantial annual limitation due to the change in ownership provisions of the Internal Revenue Code of 1986, as amended, and similar state
provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization. See Note 11 of our financial statements.



Liquidity and Capital Resources



We have financed our operations from inception primarily through sales of convertible preferred stock and common stock, totaling
approximately $120.1 million in net proceeds, contract payments under our collaboration agreements, equipment financing arrangements and government grant awards. As of December 31, 2002, we had approximately $80.5 million in cash and investments,
compared to approximately $90.3 million as of December 31, 2001. Our funds are currently invested in U.S. Treasury and government agency obligations and corporate obligations.



Our operating activities used cash of approximately $6.9 million in 2002, compared to approximately
$13.0 million in 2001. Our net loss of approximately $20.9 million in 2002 was partially offset by the unrecognized portion of the first of two $12.5 million installments of an initial fee from Roche and non-cash expenses of approximately $5.8
million related to stock-based compensation and depreciation and amortization expenses. Our net loss of approximately $21.9 million in 2001 was partially offset by non-cash charges of $7.0 million related to stock-based compensation and
depreciation and amortization expenses. Our net loss of approximately $15.1 million in 2000 was partially offset by non-cash charges of approximately $8.8 million related to stock-based compensation and depreciation and amortization expenses.



Our investing activities, excluding changes in
our investments, for the year ended December 31, 2002, used cash of approximately $3.6 million, compared to approximately $1.7 million in 2001, reflecting facility improvements and capital expenditures as we continued to enhance our laboratory
capabilities. Investing activities in 2000, excluding changes in our investments, used cash of approximately $1.5 million to fund capital purchases and leasehold improvements.



Cash provided by financing activities was approximately $1.3 million for the year ended December 31, 2002,
compared to approximately $723,000 in 2001. Financing activities in 2002 included approximately



33



---

##### Table of Contents

$2.2 million of equipment financing, which was partially offset by scheduled payments on new and existing debt. Financing activities in
2001 included approximately $1.1 million of equipment financing, which was offset by scheduled payments on new and existing debt. Financing activities in 2000 included approximately $73.4 million in net proceeds raised from our October 2000 initial
public offering of common stock and approximately $24.6 million in net proceeds from the issuance of our Series C convertible preferred stock in March 2000.



In April 2002, we entered into a $3.0 million equipment line of credit agreement for facility improvements
and capital purchases. As of December 31, 2002, we had utilized approximately $2.2 million of the line of credit leaving approximately $800,000 available for future draws.



We believe that our existing cash, investments, and anticipated cash flow from existing collaborations will
be sufficient to support our current operating plan into early 2005. Our future capital uses and requirements depend on numerous forward-looking factors. These factors include, but are not limited to the following:



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



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



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



| |  |  | our ability to maintain and extend our existing collaborations with Roche and J&JPRD;
| | - |  | -------------------------------------------------------------------------------------



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



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



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



| |  |  | expenses associated with unforeseen litigation.
| | - |  | -----------------------------------------------



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



We expect that additional financing will be required in the future to fund operations. We expect to finance future cash needs through the
sale of equity securities, strategic collaborations, government grant awards and debt financing. Additional financing or collaboration and licensing arrangements may not be available when needed or, if available, may not be on terms favorable to us
or our stockholders. Insufficient funds may require us to delay, scale back or eliminate some or all of our research or development programs, to lose rights under existing licenses or to relinquish greater or all rights to product candidates at an
earlier stage of development or on less favorable terms than we would otherwise choose or may adversely affect our ability to operate as a going concern. If additional funds are obtained by issuing equity securities, substantial dilution to existing
stockholders may result. In addition, see Item 1. BusinessRisk Factors That May Affect Results of Operations and Financial Condition.



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



|                                   |  | Payments Due by Period
|---------------------------------- |  | ----------------------
|                                   |  | Total                 
|                                   |  | (in thousands)        
|Equipment financing obligations    |  | $                     
|Operating leases                   |  |                       
|Contingent commitments             |  |                       
|                                   |  |                       
|Total contractual cash obligations |  | $                     
|                                   |  |                       





34



---

##### Table of Contents

Item 7A.Quantitative and Qualitative Disclosures About Market Risk



The primary objective of our investment activities is to preserve principal while at the same time maximize the income we receive from our
investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investments to fluctuate. To minimize this
risk in the future, we intend to maintain our portfolio of cash equivalents and investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and investment-grade corporate
obligations.



At December 31, 2001, we had
approximately $3.0 million invested in short-term commercial paper of Southern California Edison, or So Cal Ed, a utility company. At the time of purchase, the security was a high investment-grade security, but was subsequently downgraded due to the
financial uncertainty that resulted from the California energy crisis. The security matured on April 18, 2001, and So Cal Ed defaulted on payment. The amortized cost of the security was $3.0 million, and the security was valued at approximately 67%
of cost at June 30, 2001. Accordingly, we recorded a $990,000 loss on the related write-down in the carrying value of the investment. In March 2002, the security was fully repaid. Thus, we recorded a realized gain of $990,000 in 2002.



The table below presents the principal amounts of our
investments and equipment loans by expected maturity and related weighted average interest rates at December 31, 2002:



|                      |  | 2003           |        |   | 2004 |   |        | 2005 |  |   | 2006 |   |  | Total |      |   | Fair Value
|--------------------- |  | -------------- | ------ | - | ---- | - | ------ | ---- |  | - | ---- | - |  | ----- | ---- | - | ----------
|                      |  | (in thousands)
|Debt securities:      |  |                |        |   |      |   |        |      |  |   |      |   |  |       |      |   |           
|U.S. agency notes     |  | $              | 11,512 |   |      | $ | 18,000 |      |  | $ |     |   |  | $     |     |   |           
|Corporate bonds       |  |                | 20,576 |   |      |   | 8,108  |      |  |   |     |   |  |       |     |   |           
|Average interest rate |  |                | 2.69   | % |      |   | 2.24   | %    |  |   |     |   |  |       |     |   |           
|                     
|Equipment financing   |  |                | 1,712  |   |      |   | 1,027  |      |  |   | 570  |   |  |       | 199  |   |           
|Average interest rate |  |                | 10.62  | % |      |   | 9.03   | %    |  |   | 8.42 | % |  |       | 8.26 | % |           



Item 8.Financial Statements and Supplementary Data



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



Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure



None.



35



---

##### Table of Contents



PART III



Item 10.Directors and Executive Officers of the Registrant



Information concerning our directors is contained in our definitive Proxy Statement with respect to our 2003 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission not later than April 30, 2003 (the Proxy Statement), under the caption Proposal 1Election of Directors and is incorporated by reference herein.
See also Item I. BusinessDirectors and Executive Officers of the Registrant. Information concerning compliance with Section 16(a) of the Exchange Act is contained in our Proxy Statement under the caption Section 16(a)
Beneficial Ownership Reporting Compliance and is incorporated by reference herein.



Item 11.Executive Compensation



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



Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters



Information concerning the security ownership of certain beneficial owners and management is contained in our
Proxy Statement under the caption Security Ownership of Certain Beneficial Owners and Management and is incorporated by reference herein. Information concerning securities authorized for issuance under equity compensation plans is
contained in our Proxy Statement under the caption Equity Compensation Plan Information, and is incorporated herein by reference.



Item 13.Certain Relationships and Related Transactions



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



Item 14.Controls and Procedures



Evaluation of Disclosure Controls and Procedures.    Based on their evaluation as of a date within 90 days of
the filing date of this report, our principal executive officer and principal financial officer have concluded that Kosans disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of
1934, as amended (the Exchange Act)) are sufficiently effective to ensure that the information required to be disclosed by Kosan in the reports that we file under the Exchange Act is gathered, analyzed and disclosed with adequate
timeliness, accuracy and completeness.



Changes in Internal Controls.    There have been no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation
referred to above, nor were there any significant deficiencies or material weaknesses in Kosans internal controls. Accordingly, no corrective actions were required or undertaken.



Limitations on the Effectiveness of Controls.    Kosans management,
including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and
operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be
considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company



36



---

##### Table of Contents

have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can
occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the control. The design of any system of controls also is
based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate
because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.



37



---

##### Table of Contents



PART IV



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



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



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



Report of Ernst & Young LLP, Independent Auditors

Balance SheetsDecember 31, 2002 and 2001

Statements of OperationsYears Ended December 31, 2002, 2001 and 2000

Statement of Changes in Stockholders EquityYears Ended December 31, 2002, 2001 and 2000

Statements of Cash FlowsYears Ended December 31, 2002, 2001 and 2000

Notes to Financial Statements



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



None



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



|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                               
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1         |  | Amended and Restated Certificate of Incorporation of
Registrant.(1)                                                                                                                                                                                                                                                                                       
|           
|3.2         |  | Bylaws of Registrant.(2)                                                                                                                                                                                                                                                                                                                                  
|           
|4.1         |  | Form of Registrants Common Stock Certificate.(2)                                                                                                                                                                                                                                                                                                         
|           
|4.2         |  | Third Amended and Restated Registration Rights Agreement, dated March 30, 2000,
between Registrant and certain stockholders.(2)                                                                                                                                                                                                                           
|           
|4.3         |  | Registrants Certificate of Designation of Series A Junior Preferred
Stock.(4)                                                                                                                                                                                                                                                                            
|           
|10.1        |  | Form of Indemnification Agreement entered into by Registrant with each of its
directors and executive officers.(2)                                                                                                                                                                                                                                        
|           
|10.2        |  | 1996 Stock Option Plan, as amended.(2)*                                                                                                                                                                                                                                                                                                                   
|           
|10.3        |  | 2000 Employee Stock Purchase Plan and related agreements.(2)*                                                                                                                                                                                                                                                                                             
|           
|10.4        |  | 2000 Non-Employee Director Stock Option Plan and related agreements, as
amended.(6)*                                                                                                                                                                                                                                                                      
|           
|10.5        |  | Amended and Restated Consulting Agreement between Registrant and Chaitan Khosla,
Ph.D., dated December 7, 1998.(2)*                                                                                                                                                                                                                                       
|           
|10.6        |  | Consulting Agreement between Registrant and Christopher Walsh, Ph.D., dated December
14, 1995.(2)*                                                                                                                                                                                                                                                        
|           
|10.7        |  | Research and License Agreement between Registrant and The Sloan-Kettering Institute
for Cancer Research, dated August 25, 2000.(2)                                                                                                                                                                                                                       
|           
|10.8        |  | License Agreement between Registrant and The Board of Trustees of The Leland Stanford
Junior University, dated March 11, 1996.(2)                                                                                                                                                                                                                        
|           
|10.9        |  | Amendment No.1 to License Agreement with the Board of Trustees of The Leland Stanford
Junior University, dated March 1996; Letter to Mona Wan to confirm the agreement between Registrant and the Board of Trustees of The Leland Stanford Junior University, dated September 21, 1998; and Amendment No.3 to License Agreement, dated March
10, 2000.(2)
|           
|10.10       |  | License Agreement between Registrant and President and Fellows of Harvard College,
dated December 2, 1998.(2)                                                                                                                                                                                                                                            
|           
|10.11       |  | Research and License Agreement between Registrant and Ortho-McNeil Pharmaceutical
Corporation and The R.W. Johnson Pharmaceutical Research Institute, dated September 28, 1998.(2)                                                                                                                                                                       



38



---

##### Table of Contents

|Exhibit No. |  | Description                                                                                                                                                                                          
|----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.12       |  | Amendment No.1 to the Research and License Agreement between Registrant and
Ortho-McNeil Pharmaceutical Corporation and The R.W. Johnson Pharmaceutical Research Institute, dated March 17, 2000.(2)
|           
|10.13       |  | Sublease Agreement between Registrant and Lynx Therapeutics, Inc., dated January 6,
1999. (2)                                                                                                        
|           
|10.14       |  | Consent to Sublease Agreement between Spieker Properties L.P. and Lynx Therapeutics,
Inc., dated September 17, 1999.(2)                                                                              
|           
|10.15       |  | Master Equipment Lease between Registrant and Phoenix Leasing Incorporated, dated
September 3, 1996.(2)                                                                                              
|           
|10.16       |  | Master Loan and Security Agreement between Registrant and Finova Technology Finance,
Inc., dated August 25, 1998.(2)                                                                                 
|           
|10.17       |  | Commitment Letter between Registrant and Finova Technology Finance, Inc., dated
August 24, 1998.(2)                                                                                                  
|           
|10.18       |  | Commitment Letter between Registrant and Finova Capital Corporation, dated January 6,
2000.(2)                                                                                                       
|           
|10.19       |  | Restated Promissory Note from Stockholder by and between Registrant and Daniel V.
Santi, M.D., Ph.D., dated December 23, 1998.(2)*                                                                   
|           
|10.20       |  | Promissory Note from Stockholder by and between Registrant and Chaitan S. Khosla,
Ph.D., dated September 22, 1999.(2)*                                                                               
|           
|10.21       |  | Promissory Note from Stockholder by and between Registrant and Michael S. Ostrach,
dated February 21, 2000.(2)*                                                                                      
|           
|10.22       |  | Promissory Note from Stockholder by and between Registrant and Susan M. Kanaya, dated
February 21, 2000.(2)*                                                                                         
|           
|10.23       |  | Promissory Note from Stockholder by and between Registrant and Kevin R. Kaster, dated
February 21, 2000.(2)*                                                                                         
|           
|10.24       |  | Employment Agreement between Registrant and Daniel V. Santi, M.D., Ph.D., dated
November 1, 1998.(2)*                                                                                                
|           
|10.25       |  | Employment Agreement between Registrant and Kevin R. Kaster, dated July 20,
1998.(2)*                                                                                                                
|           
|10.26       |  | Employment Agreement between Registrant and Susan M. Kanaya, dated October 11,
1999.(2)*                                                                                                             
|           
|10.27       |  | Employment Agreement between Registrant and Brian W. Metcalf, Ph.D., dated March 15,
2000.(2)*                                                                                                       
|           
|10.28       |  | Form of Series C Stock Purchase Agreement between the Registrant and certain
investors, dated March 30, 2000.(2)                                                                                     
|           
|10.30       |  | Promissory Note from Stockholder by and between Registrant and Susan M. Kanaya, dated
April 25, 2000.(2)*                                                                                            
|           
|10.31       |  | Loan Agreement and Promissory Note from Stockholder by and between Registrant and
Susan M. Kanaya, dated March 3, 2000 and March 31, 2000, respectively.(2)*                                         
|           
|10.32       |  | Loan Agreement and Promissory Note from Stockholder by and between Registrant and
Brian W. Metcalf, Ph.D., dated May 30, 2000.(2)*                                                                   
|           
|10.33       |  | Amendment No.2 to the Research and License Agreement between Registrant and The R.W.
Johnson Pharmaceutical Research Institute and Ortho-McNeil Pharmaceutical, Inc., dated August 31, 2000.(2)     
|           
|10.34       |  | Employment Agreement between Registrant and Robert G. Johnson, Jr., dated September
5, 2000.(2)*                                                                                                     
|           
|10.36       |  | Amendment No.3 to Research and License Agreement between Registrant and The R.W.
Johnson Pharmaceutical Research Institute and Ortho-McNeil Pharmaceutical, Inc., dated September 28, 2001.(3)      



39



---

##### Table of Contents

|Exhibit No. |  | Description                                                                                                                                                                                
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.37       |  | Master Loan and Security Agreement No.84325 and associated Prepayment Agreement, by
and between Registrant and Wells Fargo Equipment Finance, Inc., dated July 9, 2001. (3)                
|           
|10.38       |  | Rights Agreement, dated as of October 5, 2001, between Registrant and Mellon Investor
Services, LLC.(4)                                                                                    
|           
|10.39       |  | Separation Agreement between Registrant and Brian W. Metcalf, Ph.D., dated January
28, 2002.(5)*                                                                                           
|           
|10.40       |  | Amendment to Restated Promissory Note from Stockholder by and between Registrant and
Daniel V. Santi, M.D., Ph.D., dated December 23, 2001.(5)*                                            
|           
|10.41       |  | Lease Agreement, dated as of June 7, 2002, by and between EOP-Industrial Portfolio,
L.L.C. and Registrant.(6)                                                                              
|           
|10.42       |  | Landlord Consent to Assignment and Assumption of Lease, dated as of June 20, 2002, by
and among EOP-Industrial Portfolio, L.L.C., Aventis Pharmaceuticals, Inc. and Registrant.(6)         
|           
|10.43       |  | Collaborative Research, Development and Commercialization Agreement, dated as of
September 19, 2002, by and between Registrant and Hoffman-La Roche, Inc.(7)                              
|           
|10.44       |  | Consent to the License Agreement, effective as of September 16, 2002, by and between
Registrant and Stanford University.(7)                                                               
|           
|10.45       |  | Consent to the License Agreement, effective as of September 16, 2002, by and between
Registrant and The Sloan-Kettering Institute for Cancer Research.(7)                                 
|           
|10.46       |  | Amendment No.4 to Research and License Agreement between Registrant and The R.W.
Johnson Pharmaceutical Research Institute and Ortho-McNeil Pharmaceutical, Inc., dated December 12, 2002.
|           
|23.1        |  | Consent of Ernst &Young LLP, Independent Auditors.                                                                                                                                         
|           
|24.1        |  | Power of Attorney (included in signature page hereto).                                                                                                                                     
|           
|99.1        |  | Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.(8)                                                                                                                

---

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

|(2) |  | Incorporated by reference to an exhibit of our Registration Statement on Form S-1, Registration No. 333-33732.
|--- |  | --------------------------------------------------------------------------------------------------------------

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

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

|(5) |  | Incorporated by reference to an exhibit of our annual report on Form 10-K for the year ended December 31, 2001.
|--- |  | ---------------------------------------------------------------------------------------------------------------

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

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

|(8) |  | This certification accompanies this annual report on Form 10-K and shall not be deemed filed by Registrant for purposes of Section 18 of the Exchange
Act.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------

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

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

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



|(b) |  | Reports on Form 8-K
|--- |  | -------------------



None.



40



---

##### Table of Contents

SIGNATURES



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



KOSAN BIOSCIENCES INCORPORATEDMarch 27, 2003

By:

/s/    DANIEL V. SANTI, M.D.,
PH.D.Daniel V. Santi, M.D., Ph.D. Chairman and Chief Executive Officer




POWER OF ATTORNEY



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



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



|Signature                                                       |  | Title                                                                                                              |  | Date          
|--------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------ |  | --------------
|                                                               
|/s/    DANIEL V. SANTI, M.D.,
PH.D.Daniel V. Santi, M.D., Ph.D. |  | Chairman and Chief Executive Officer (Principal Executive Officer)                                                 |  | March 27, 2003
|                                                               
|/s/    SUSAN M.
KANAYASusan M. Kanaya                           |  | Senior Vice President, Finance, Chief Financial Officer and Secretary (Principal
Financial and Accounting Officer) |  | March 27, 2003
|                                                               
|/s/    BRUCE A. CHABNER,
M.D.Bruce A. Chabner,
M.D.             |  | Director                                                                                                           |  | March 27, 2003
|                                                               
|/s/    PETER DAVIS,
PH.DPeter Davis, Ph.D.                      |  | Director                                                                                                           |  | March 27, 2003
|                                                               
|/s/    JEAN DELEAGE,
PH.D.Jean Deleage, Ph.D.                   |  | Director                                                                                                           |  | March 27, 2003
|                                                               
|/s/    CHAITAN S. KHOSLA,
PH.D.Chaitan S. Khosla, Ph.D.         |  | Director                                                                                                           |  | March 27, 2003
|                                                               
|/s/    CHRISTOPHER T. WALSH,
PH.D.Christopher T. Walsh, Ph.D.   |  | Director                                                                                                           |  | March 27, 2003



41



---

##### Table of Contents



CERTIFICATION



I,
Daniel V. Santi, M.D., Ph.D., Chairman and Chief Executive Officer of Kosan Biosciences Incorporated, certify that:



1.  I have reviewed this annual report on Form 10-K of Kosan Biosciences Incorporated;



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 functions):



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 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.



March 27, 2003

By:

/s/    DANIEL V. SANTI, M.D.,
PH.D.Daniel V. Santi, M.D., Ph.D. Chairman and Chief Executive Officer




42



---

##### Table of Contents



CERTIFICATION



I, Susan M.
Kanaya, Senior Vice President, Finance, Chief Financial Officer and Secretary of Kosan Biosciences Incorporated, certify that:



1.  I have reviewed this annual report on Form 10-K of Kosan Biosciences Incorporated;



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 functions):



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 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.



March 27, 2003

By:

/s/    SUSAN M.
KANAYASusan M. Kanaya Senior Vice President, Finance, Chief
Financial Officer and Secretary






43



---

##### Table of Contents



KOSAN BIOSCIENCES INCORPORATED



INDEX TO FINANCIAL STATEMENTS



|Report of Ernst & Young LLP, Independent Auditors                              |  | F-2
|------------------------------------------------------------------------------ |  | ---
|                                                                              
|Balance SheetsDecember 31, 2002 and 2001                                      |  | F-3
|                                                                              
|Statements of OperationsYears ended December 31, 2002, 2001 and
2000          |  | F-4
|                                                                              
|Statement of Stockholders EquityYears ended December 31, 2002, 2001 and
2000 |  | F-5
|                                                                              
|Statements of Cash FlowsYears ended December 31, 2002, 2001 and
2000          |  | F-6
|                                                                              
|Notes to Financial Statements                                                  |  | F-7



F-1



---

##### Table of Contents



REPORT OF
ERNST & YOUNG LLP, INDEPENDENT AUDITORS



The Board of
Directors and Stockholders

Kosan Biosciences Incorporated



We have audited the accompanying balance sheets of Kosan Biosciences Incorporated as of December 31, 2002 and
2001, and the related 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 financial statements referred to above
present fairly, in all material respects, the financial position of Kosan Biosciences Incorporated at December 31, 2002 and 2001, and the 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



Palo Alto, California

February 7, 2003



F-2



---

##### Table of Contents



KOSAN
BIOSCIENCES INCORPORATED



BALANCE SHEETS

(in thousands, except share and per share data)



|                                                                                                                                                                                                            |  | December 31, |        
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | -------
|                                                                                                                                                                                                            |  | 2002         |        
|Assets                                                                                                                                                                                                      |  |              |        
|Current assets:                                                                                                                                                                                             |  |              |        
|Cash and cash equivalents                                                                                                                                                                                   |  | $            | 22,191 
|Short-term investments                                                                                                                                                                                      |  |              | 31,260 
|Accounts receivable                                                                                                                                                                                         |  |              | 3,874  
|Prepaid and other current assets                                                                                                                                                                            |  |              | 1,106  
|                                                                                                                                                                                                            |  |              |        
|Total current assets                                                                                                                                                                                        |  |              | 58,431 
|                                                                                                                                                                                                           
|Property and equipment, net                                                                                                                                                                                 |  |              | 5,368  
|Long-term investments                                                                                                                                                                                       |  |              | 27,087 
|Notes receivable from related parties                                                                                                                                                                       |  |              | 445    
|Other assets                                                                                                                                                                                                |  |              | 259    
|                                                                                                                                                                                                            |  |              |        
|Total assets                                                                                                                                                                                                |  | $            | 91,590 
|                                                                                                                                                                                                            |  |              |        
|Liabilities and Stockholders Equity                                                                                                                                                                        |  |              |        
|Current liabilities:                                                                                                                                                                                        |  |              |        
|Accounts payable                                                                                                                                                                                            |  | $            | 1,790  
|Accrued liabilities                                                                                                                                                                                         |  |              | 3,681  
|Current portion of deferred revenue                                                                                                                                                                         |  |              | 2,500  
|Current portion of capital lease obligation & equipment loans                                                                                                                                               |  |              | 1,712  
|                                                                                                                                                                                                            |  |              |        
|Total current liabilities                                                                                                                                                                                   |  |              | 9,683  
|                                                                                                                                                                                                           
|Deferred revenue, less current portion                                                                                                                                                                      |  |              | 9,271  
|Capital lease obligation & equipment loans, less current portion                                                                                                                                            |  |              | 1,796  
|                                                                                                                                                                                                           
|Commitments                                                                                                                                                                                                 |  |              |        
|                                                                                                                                                                                                           
|Stockholders equity:                                                                                                                                                                                       |  |              |        
|Convertible preferred stock, $0.001 par value, 10,000,000 shares authorized, 1,000,000
shares designated as Series A junior preferred stock, no shares issued and outstanding at December 31, 2002 and 2001 |  |              |       
|Common stock, $0.001 par value, 100,000,000 shares authorized, 25,392,309 and 25,226,513
shares issued and outstanding at December 31, 2002 and 2001, respectively                                          |  |              | 25     
|Additional paid-in capital                                                                                                                                                                                  |  |              | 142,424
|Notes receivable from stockholders                                                                                                                                                                          |  |              | (1,221 
|Deferred stock-based compensation                                                                                                                                                                           |  |              | (1,134 
|Accumulated other comprehensive income                                                                                                                                                                      |  |              | 152    
|Accumulated deficit                                                                                                                                                                                         |  |              | (69,406
|                                                                                                                                                                                                            |  |              |        
|Total stockholders equity                                                                                                                                                                                  |  |              | 70,840 
|                                                                                                                                                                                                            |  |              |        
|Total liabilities and stockholders equity                                                                                                                                                                  |  | $            | 91,590 
|                                                                                                                                                                                                            |  |              |        



See
accompanying notes.



F-3



---

##### Table of Contents



KOSAN
BIOSCIENCES INCORPORATED



STATEMENTS OF
OPERATIONS

(in thousands, except per share data)



|                                                                                                                     |  | Year Ended December 31, |        
|-------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | -------
|                                                                                                                     |  | 2002                    |        
|Revenues:                                                                                                            |  |                         |        
|Contract revenue                                                                                                     |  | $                       | 7,269  
|Grant revenue                                                                                                        |  |                         | 2,334  
|                                                                                                                     |  |                         |        
|Total revenues                                                                                                       |  |                         | 9,603  
|                                                                                                                    
|Operating expenses:                                                                                                  |  |                         |        
|Research and development (including charges for stock-based compensation of $2,782,
$5,452 and $6,507, respectively) |  |                         | 28,378 
|General and administrative (including charges for stock-based compensation of $656,
$1,273 and $1,703, respectively) |  |                         | 4,932  
|                                                                                                                     |  |                         |        
|Total operating expenses                                                                                             |  |                         | 33,310 
|                                                                                                                     |  |                         |        
|Loss from operations                                                                                                 |  |                         | (23,707
|Interest income                                                                                                      |  |                         | 2,209  
|Interest expense                                                                                                     |  |                         | (356   
|Gain/(loss) on the recovery or write-down of investment                                                              |  |                         | 990    
|                                                                                                                     |  |                         |        
|Net loss                                                                                                             |  |                         | (20,864
|Deemed dividend upon issuance of Series C convertible preferred stock                                                |  |                         |       
|                                                                                                                     |  |                         |        
|Net loss attributable to common stockholders                                                                         |  | $                       | (20,864
|                                                                                                                     |  |                         |        
|Basic and diluted net loss per common share                                                                          |  | $                       | (0.84  
|                                                                                                                     |  |                         |        
|Shares used in computing basic and diluted net loss per common share                                                 |  |                         | 24,906 







See accompanying notes.



F-4



---

##### Table of Contents



KOSAN
BIOSCIENCES INCORPORATED



STATEMENT OF
STOCKHOLDERS EQUITY

(in thousands, except shares)



|                                                                                                            |  | Convertible Preferred Stock |   |  | Common Stock |    | Additional Paid-In Capital |        |            | Notes Receivable From Stockholders |        |   | Deferred Stock-Based Compensation |  |   | Accumulated Other Comprehensive Loss/(Income) |   |  | Total Accumulated Deficit |        |   | Stockholders Equity |  
|----------------------------------------------------------------------------------------------------------- |  | --------------------------- | - |  | ------------ | -- | -------------------------- | ------ | ---------- | ---------------------------------- | ------ | - | --------------------------------- |  | - | --------------------------------------------- | - |  | ------------------------- | ------ | - | -------------------- | -
|                                                                                                            |  | Shares                      |   |  | Amount       |    |                            | Shares |            |                                    | Amount |   |                                   |  |   |                                               |  
|Balances at December 31, 1999                                                                               |  | 3,269,377                   |   |  | $            | 3  |                            |        | 5,480,544  |                                    |        | $ | 5                                 |  | $ | 24,848                                        |   |  | $                         | (349   | ) |                      | $
|Issuance of Series C convertible preferred stock, net of issuance costs
of $300                             |  | 804,196                     |   |  |              | 1  |                            |        |           |                                    |        |   |                                  |  |   | 24,629                                        |   |  |                           |       |   |                      |  
|Issuance of shares of common stock in the initial public offering, net of offering costs
of $7,135          |  |                            |   |  |              |   |                            |        | 5,750,000  |                                    |        |   | 6                                 |  |   | 73,359                                        |   |  |                           |       |   |                      |  
|Conversion of convertible preferred stock into common stock, in connection with the
initial public offering |  | (4,073,573                  | ) |  |              | (4 | )                          |        | 12,220,719 |                                    |        |   | 12                                |  |   | (8                                            | ) |  |                           |       |   |                      |  
|Issuance of common stock upon exercise of options for cash and promissory
notes                             |  |                            |   |  |              |   |                            |        | 1,695,390  |                                    |        |   | 2                                 |  |   | 1,807                                         |   |  |                           | (1,734 | ) |                      |  
|Repayment of stockholder notes                                                                              |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           | 4      |   |                      |  
|Beneficial conversion feature associated with the issuance of Series C convertible
preferred stock          |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   | 11,267                                        |   |  |                           |       |   |                      |  
|Deemed dividend to preferred stockholders                                                                   |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   | (11,267                                       | ) |  |                           |       |   |                      |  
|Deferred stock-based compensation                                                                           |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   | 15,602                                        |   |  |                           |       |   |                      |  
|Amortization of deferred stock-based compensation                                                           |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|Other stock-based compensation                                                                              |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   | 1,353                                         |   |  |                           |       |   |                      |  
|Comprehensive income (loss):                                                                                |  |                             |   |  |              |    |                            |        |            |                                    |        |   |                                   |  |   |                                               |   |  |                           |        |   |                      |  
|Net loss                                                                                                    |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|Unrealized loss on available-for-sale securities, net                                                       |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|                                                                                                            |  |                             |   |  |              |    |                            |        |            |                                    |        |   |                                   |  |   |                                               |   |  |                           |        |   |                      |  
|Comprehensive loss                                                                                          |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|                                                                                                            |  |                             |   |  |              |    |                            |        |            |                                    |        |   |                                   |  |   |                                               |   |  |                           |        |   |                      |  
|Balances at December 31, 2000                                                                               |  |                            |   |  |              |   |                            |        | 25,146,653 |                                    |        | $ | 25                                |  | $ | 141,590                                       |   |  | $                         | (2,079 | ) |                      | $
|Issuance of common stock upon exercise of options for cash and promissory notes, net of
repurchases         |  |                            |   |  |              |   |                            |        | 33,130     |                                    |        |   |                                  |  |   | 60                                            |   |  |                           | 80     |   |                      |  
|Issuance of common stock under employee stock purchase plan                                                 |  |                            |   |  |              |   |                            |        | 63,074     |                                    |        |   |                                  |  |   | 315                                           |   |  |                           |       |   |                      |  
|Repayment of stockholder notes, net of repurchase of unvested shares                                        |  |                            |   |  |              |   |                            |        | (16,344    | )                                  |        |   |                                  |  |   | (135                                          | ) |  |                           | 458    |   |                      |  
|Reversal of deferred stock-based compensation from employee terminations                                    |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   | (648                                          | ) |  |                           |       |   |                      |  
|Amortization of deferred stock-based compensation                                                           |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|Other stock-based compensation                                                                              |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   | 681                                           |   |  |                           |       |   |                      |  
|Comprehensive income (loss):                                                                                |  |                             |   |  |              |    |                            |        |            |                                    |        |   |                                   |  |   |                                               |   |  |                           |        |   |                      |  
|Net loss                                                                                                    |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|Unrealized gain on available-for-sale securities, net                                                       |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|                                                                                                            |  |                             |   |  |              |    |                            |        |            |                                    |        |   |                                   |  |   |                                               |   |  |                           |        |   |                      |  
|Comprehensive loss                                                                                          |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|                                                                                                            |  |                             |   |  |              |    |                            |        |            |                                    |        |   |                                   |  |   |                                               |   |  |                           |        |   |                      |  
|Balances at December 31, 2001                                                                               |  |                            |   |  |              |   |                            |        | 25,226,513 |                                    |        | $ | 25                                |  | $ | 141,863                                       |   |  | $                         | (1,541 | ) |                      | $
|Issuance of common stock upon exercise of options for cash, net of
repurchases                              |  |                            |   |  |              |   |                            |        | 86,574     |                                    |        |   |                                  |  |   | 57                                            |   |  |                           |       |   |                      |  
|Issuance of common stock under employee stock purchase plan                                                 |  |                            |   |  |              |   |                            |        | 98,349     |                                    |        |   |                                  |  |   | 484                                           |   |  |                           |       |   |                      |  
|Repayment of stockholder notes, net of repurchase of unvested shares                                        |  |                            |   |  |              |   |                            |        | (19,127    | )                                  |        |   |                                  |  |   | (122                                          | ) |  |                           | 320    |   |                      |  
|Reversal of deferred stock-based compensation from employee terminations                                    |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   | (1,246                                        | ) |  |                           |       |   |                      |  
|Amortization of deferred stock-based compensation                                                           |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|Other stock-based compensation                                                                              |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   | 1,388                                         |   |  |                           |       |   |                      |  
|Comprehensive income (loss):                                                                                |  |                             |   |  |              |    |                            |        |            |                                    |        |   |                                   |  |   |                                               |   |  |                           |        |   |                      |  
|Net loss                                                                                                    |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|Unrealized loss on available-for-sale securities, net                                                       |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|                                                                                                            |  |                             |   |  |              |    |                            |        |            |                                    |        |   |                                   |  |   |                                               |   |  |                           |        |   |                      |  
|Comprehensive loss                                                                                          |  |                            |   |  |              |   |                            |        |           |                                    |        |   |                                  |  |   |                                              |   |  |                           |       |   |                      |  
|                                                                                                            |  |                             |   |  |              |    |                            |        |            |                                    |        |   |                                   |  |   |                                               |   |  |                           |        |   |                      |  
|Balances at December 31, 2002                                                                               |  |                            |   |  | $            |   |                            |        | 25,392,309 |                                    |        | $ | 25                                |  | $ | 142,424                                       |   |  | $                         | (1,221 | ) |                      | $
|                                                                                                            |  |                             |   |  |              |    |                            |        |            |                                    |        |   |                                   |  |   |                                               |   |  |                           |        |   |                      |  



See
accompanying notes.





F-5



---

##### Table of Contents



KOSAN
BIOSCIENCES INCORPORATED



STATEMENTS OF
CASH FLOWS

(in thousands)



|                                                                                                         |  | Year Ended December 31, |        
|-------------------------------------------------------------------------------------------------------- |  | ----------------------- | -------
|                                                                                                         |  | 2002                    |        
|Operating Activities                                                                                     |  |                         |        
|Net loss                                                                                                 |  | $                       | (20,864
|Adjustment to reconcile net loss to net cash used in operating
activities:                               |  |                         |        
|Depreciation and amortization                                                                            |  |                         | 1,755  
|Amortization of investment premiums and discounts, net                                                   |  |                         | 559    
|Amortization of stock-based compensation                                                                 |  |                         | 2,050  
|Other stock-based compensation                                                                           |  |                         | 1,388  
|Issuance of convertible preferred stock for license fee                                                  |  |                         |       
|(Gain)/loss on the recovery or write-down of investment                                                  |  |                         | (990   
|Changes in assets and liabilities:                                                                       |  |                         |        
|Accounts receivable                                                                                      |  |                         | (3,874 
|Prepaid expenses and other current assets                                                                |  |                         | (489   
|Other assets and notes receivable from related parties                                                   |  |                         | 581    
|Accounts payable and accrued liabilities                                                                 |  |                         | 2,204  
|Deferred revenue                                                                                         |  |                         | 10,772 
|                                                                                                         |  |                         |        
|Net cash used in operating activities                                                                    |  |                         | (6,908 
|                                                                                                         |  |                         |        
|Investing activities                                                                                     |  |                         |        
|Acquisition of property and equipment                                                                    |  |                         | (3,556 
|Purchase of investments                                                                                  |  |                         | (70,930
|Proceeds from maturity of investments                                                                    |  |                         | 83,732 
|                                                                                                         |  |                         |        
|Net cash provided by (used in) investing activities                                                      |  |                         | 9,246  
|                                                                                                         |  |                         |        
|Financing activities                                                                                     |  |                         |        
|Proceeds from issuance of common stock, net of repurchases and issuance
costs                            |  |                         | 541    
|Proceeds from the repayment of notes receivable from stockholders, net of repurchases of
unvested shares |  |                         | 198    
|Proceeds from issuance of convertible preferred stock, net of issuance
costs                             |  |                         |       
|Proceeds from equipment loans                                                                            |  |                         | 2,215  
|Principal payments under capital lease obligations and equipment loans                                   |  |                         | (1,662 
|                                                                                                         |  |                         |        
|Net cash provided by financing activities                                                                |  |                         | 1,292  
|                                                                                                         |  |                         |        
|Net increase (decrease) in cash and cash equivalents                                                     |  |                         | 3,630  
|Cash and cash equivalents at beginning of period                                                         |  |                         | 18,561 
|                                                                                                         |  |                         |        
|Cash and cash equivalents at end of period                                                               |  | $                       | 22,191 
|                                                                                                         |  |                         |        
|Supplemental disclosures                                                                                 |  |                         |        
|Interest expense paid in cash                                                                            |  | $                       | 356    
|                                                                                                         |  |                         |        
|Non-cash investing and financing activities                                                              |  |                         |        
|Issuance of common stock under notes receivable                                                          |  | $                       |       
|                                                                                                         |  |                         |        
|Unrealized (loss)/gain on investments, net                                                               |  | $                       | (74    
|                                                                                                         |  |                         |        
|Deferred stock-based compensation                                                                        |  | $                       | (1,246 
|                                                                                                         |  |                         |        



See
accompanying notes.



F-6



---

##### Table of Contents



KOSAN
BIOSCIENCES INCORPORATED



NOTES TO
FINANCIAL STATEMENTS



1.    ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Overview



Kosan Biosciences Incorporated (the Company) was incorporated under the laws of the state of California on January 6, 1995 and commenced operations in 1996. In July 2000, the Company was reincorporated under the laws of
the state of Delaware. The Company uses its proprietary genetic engineering technologies to develop drug candidates from polyketides, a rich source of pharmaceutical products.



The Company has funded its operations primarily through sales of common stock and convertible preferred
stock, contract payments under its collaboration agreements, equipment financing arrangements and government grants. Prior to achieving profitable operations, the Company intends to fund operations through the additional sale of equity securities,
strategic collaborations, government grant awards and debt financing.



Use of Estimates



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



Recent Accounting Pronouncements



In December 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 148, Accounting for Stock-Based CompensationTransition and
Disclosure. SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation.
In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the
method used on reported results. The additional disclosure requirements of SFAS 148 are effective for fiscal years ending after December 15, 2002. The Company has elected to continue to follow the intrinsic value method of accounting as prescribed
by Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, to account for employee stock options.



In November 2002, the FASB issued Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables
(EITF 00-21). EITF 00-21 addresses certain aspects of the accounting by a company for arrangements under which it will perform multiple revenue-generating activities. EITF 00-21 addresses when and how an arrangement involving multiple
deliverables should be divided into separate units of accounting. EITF 00-21 provides guidance with respect to the effect of certain customer rights due to company nonperformance on the recognition of revenue allocated to delivered units of
accounting. EITF 00-21 also addresses the impact on the measurement and/or allocation of arrangement consideration of customer cancellation provisions and consideration that varies as a result of future actions of the customer or the company.
Finally, EITF 00-21 provides guidance with respect to the recognition of the cost of certain deliverables that are excluded from the revenue accounting for an arrangement. The provisions of EITF 00-21 will apply to revenue arrangements entered into
in fiscal periods beginning after June 15, 2003. The Company is currently evaluating the effect that the adoption of EITF 00-21 will have on its financial statements.



Effective January 1, 2002, the Company adopted SFAS No. 144 Accounting for the Impairment or Disposal
of Long-Lived Assets. SFAS 144 addresses the financial accounting and reporting for the impairment or disposal of long-lived assets and supercedes SFAS No. 121 Accounting for the Impairment of Long-Lived



F-7



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)



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



Assets and Long-Lived Assets to Be Disposed Of. The primary objectives of SFAS 144 are to develop one accounting model based on the
framework established in FSAS 121 for long-lived assets to be disposed of by sale, and to address significant implementation issues. The adoption of SFAS 144 did not have an impact on the Companys financial statements.



Cash Equivalents and Investments



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



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



Property and Equipment



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



Revenue Recognition



The Company recognizes license and other up-front and initial fees pursuant to research and development collaboration agreements over the estimated research and development term of the respective
agreement. Payments related to substantive performance milestones that are at risk at the initiation of an agreement are recognized upon successful completion of a performance milestone event. Contract revenues related to collaborative research and
development efforts are recognized as revenue as the related services are performed. Such payments generally are made based on the number of full-time equivalent researchers assigned to the collaboration project and the related research and
development expenses incurred. Revenues related to government grants are recognized at the time a grant is awarded and as related research expenses are incurred. Any amounts received in advance of performance are recorded as deferred revenue until
earned.



Research and Development



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



F-8



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)



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





The
continuation of KOS-862 clinical trials have had, and will continue to have, a significant effect on the Companys research and development expenses. Expenses related to clinical trials generally are accrued based on the level of patient
enrollment and activity according to the protocol. The Company monitors patient enrollment level and related activity to the extent possible and adjusts estimates accordingly.



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



Net Loss Per Share



Basic and diluted net loss per common share have been computed using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase. Diluted net
loss is not presented separately as the Company is in a net loss position and including potentially dilutive securities in the loss per share computation would be antidilutive. Pro forma net loss per common share has been computed to give effect to
the automatic conversion of preferred stock into common stock immediately prior to the completion of the Companys initial public offering (using the if-converted method) from the original date of issuance.



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



|                                                                                                         |  | Year Ended December 31, |        
|-------------------------------------------------------------------------------------------------------- |  | ----------------------- | -------
|                                                                                                         |  | 2002                    |        
|Net loss attributable to common stockholders                                                             |  | $                       | (20,864
|                                                                                                         |  |                         |        
|Weighted-average shares of common stock outstanding                                                      |  |                         | 25,307 
|Less: weighted-average shares subject to repurchase                                                      |  |                         | (401   
|                                                                                                         |  |                         |        
|Weighted-average shares used in computing basic and diluted net loss per common
share                    |  |                         | 24,906 
|                                                                                                         |  |                         |        
|Basic and diluted net loss per common share                                                              |  | $                       | (0.84  
|                                                                                                         |  |                         |        
|Pro forma:                                                                                               |  |                         |        
|Shares used above                                                                                        |  |                         |        
|Pro forma adjustment to reflect weighted effect of conversion of convertible preferred
stock (unaudited) |  |                         |        
|                                                                                                         |  |                         |        
|Shares used in computing pro forma basic and diluted net loss per common share
(unaudited)               |  |                         |        
|                                                                                                         |  |                         |        
|Pro forma basic and diluted net loss per common share (unaudited)                                        |  |                         |        
|                                                                                                         |  |                         |        



The
Company has excluded all convertible preferred stock, outstanding stock options and shares subject to repurchase from the calculation of diluted net loss per common share because all such securities are antidilutive for all applicable periods
presented. The total number of outstanding stock options excluded from the calculations of diluted net loss per share, prior to application of the treasury stock method for options, was 3,080,345, 2,355,874 and 1,080,141 for the years ended December
31, 2002, 2001 and 2000, respectively. Such securities, had they been dilutive, would have been included in the computations of diluted net loss per share. See Note 9 for further information on these securities.



F-9



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)



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





Stock-Based
Compensation



The Company accounts for
common stock options granted to employees using the intrinsic value method as prescribed by APB 25, and related interpretations, and thus recognizes compensation expense for options granted with exercise prices less than the fair value of the
Companys common stock on the date of the grant. The Company elected to follow APB 25 because the alternative fair value accounting provided for under SFAS 123 requires use of option valuation models that were not developed for use in valuing
employee stock-based awards. Deferred stock compensation calculated for options granted with exercise prices less than the deemed fair value is included as a reduction of stockholders equity and is amortized over the vesting period of the
individual options, generally four years, using the graded vesting method. For the year ended December 31, 2000, in connection with the grant of stock options to employees, the Company recorded deferred stock-based compensation totaling $15.6
million, representing the difference between the deemed fair value of the common stock on the date such options were granted and the applicable exercise prices.



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



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



|                                                                                                          |  | Year Ended December 31, |        
|--------------------------------------------------------------------------------------------------------- |  | ----------------------- | -------
|                                                                                                          |  | 2002                    |        
|Risk free interest rate                                                                                   |  |                         | 3.7    
|Dividend yield                                                                                            |  |                         |       
|Weighted-average expected life                                                                            |  |                         | 4 years
|Volatility                                                                                                |  |                         | 70     
|Net loss attributable common stockholders, as reported                                                    |  | $                       | (20,864
|Add: Stock-based employee compensation expense included in reported net
loss                              |  |                         | 2,050  
|Deduct: Stock-based employee compensation expense determined under fair value based
method for all awards |  |                         | (4,707 
|                                                                                                          |  |                         |        
|Pro forma net loss                                                                                        |  | $                       | (23,521
|                                                                                                          |  |                         |        
|Basic and diluted net loss per common share:                                                              |  |                         |        
|As reported                                                                                               |  | $                       | (0.84  
|Pro forma                                                                                                 |  | $                       | (0.94  



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



F-10



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)



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





Comprehensive
Income/(Loss)



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



Income Taxes



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



Segment Reporting



The Company has determined that it operates in only one
segment. Accordingly, no segment disclosures have been included in the accompanying notes to the financial statements.



Reclassifications



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



2.    RESEARCH AND DEVELOPMENT AGREEMENTS



Hoffman-La Roche, Inc.



Effective September 2002, the Company signed a research and development collaboration agreement with Hoffman-La Roche, Inc. and F.
Hoffman-La Roche Ltd. (collectively Roche). Under the terms of the agreement, Roche has worldwide exclusive rights to market and sell KOS-862 (Epothilone D) in the field of oncology, and the Company will co-develop and has the right to
co-promote the product in the United States. The Company is entitled to receive payments for the reimbursement of research and development expenditures, funding of a back-up program, achievement of clinical, regulatory and commercial milestones,
development activities and royalties on sales of collaboration products, subject to potential offsets and credits. In addition, the Company has the opportunity to increase its royalties and profit participation through a buy-in at a later stage of
clinical development and by co-promotion of products resulting from the collaboration.



For the year ended December 31, 2002, the Company recognized $3.4 million of contract revenue pursuant to this agreement. Such amount, excluding the ratable portion of an initial payment, approximated
research and development expenses under the collaboration agreement. Included in 2002 contract revenue was the ratable portion of the first of two $12.5 million installments of an initial fee, which was deferred and is being amortized on a ratable
basis over a five-year estimated clinical development term of the agreement.



Johnson & Johnson Pharmaceutical Research and Development, LLC



Effective September 1998, the Company signed a collaborative agreement with The R.W. Johnson Pharmaceutical Research Institute, LLC and Ortho-McNeil Pharmaceutical, Inc., both Johnson & Johnson
companies. Effective January 1, 2002, the rights and obligations under the agreement were assigned to Johnson



F-11



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)



2.    RESEARCH AND DEVELOPMENT
AGREEMENTS(Continued)



& Johnson Pharmaceutical Research and Development, LLC (J&JPRD), a subsidiary of Ortho-McNeil Pharmaceutical, Inc. Under
the terms of the agreement, the Company will use its technologies to produce specific novel antibiotics on a reasonable efforts basis.

J&JPRD has the right to receive exclusive worldwide rights to specified antibiotic compounds. The development, marketing and sale of drugs resulting from the collaborative agreement will be undertaken by J&JPRD, and
should the development efforts result in a marketable product, the Company will receive milestone payments and royalty payments based on product sales. Upon the execution of the collaborative agreement, the Company received an initial up-front fee
of $1.0 million, which was deferred and recognized on a ratable basis over the term of the agreement. In December 2002, the Company amended the collaboration research and development agreement. Under the terms of the amended agreement, subject to
early termination provisions, the research program and funding have been extended until December 28, 2003. J&JPRD will take two selected series of compounds forward into preclinical studies. Rights to compounds and technologies developed in the
collaboration that are not related to the compounds under study by J&JPRD, or their structural analogs, have reverted to the Company.



For the years ended December 31, 2002, 2001 and 2000, the Company recognized $2.9 million, $3.2 million and $3.8 million, respectively, of
contract revenue pursuant to this agreement. Such amounts, excluding initial and milestone payments, approximated research and development expenses under the collaboration. Included in 2000 revenue is the ratable portion of a $1.0 million up-front
fee received upon signing the agreement with J&JPRD, which was recognized over the initial two-year term of the agreement. A milestone payment earned under the J&JPRD agreement of $250,000 was included in the year ended December 31, 2001.



At December 31, 2002, $3.6 million or 93% of
accounts receivable were due from two sources. For the years ended December 31, 2002, 2001 and 2000, the Company recognized $6.3 million, $3.2 million and $3.8 million, respectively, of contract revenue pursuant to two agreements in 2002 and one
agreement in 2001 and 2000, which represented 66%, 61% and 90% of total revenues for fiscal years 2002, 2001 and 2000, respectively.



License Agreements



The Company has collaborative and license agreements with several academic, government and medical institutions. Included in research and
development expenses were total payments made under these agreements of approximately $1.5 million, $721,000 and $373,000 for the years ended December 31, 2002, 2001 and 2000, respectively.



3.    INVESTMENTS



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



|                        |  | 2002           |        | 2001            
|----------------------- |  | -------------- | ------ | ----------------
|                        |  | Amortized Cost |        | Gross Unrealized
|                        |  |                | Gains  |                 
|Debt Securities:        |  |                |        |                 
|US agency notes         |  | $              | 29,512 |                 
|Corporate bonds         |  |                | 28,684 |                 
|Asset-backed securities |  |                |       |                 
|                        |  |                |        |                 
|                        |  | $              | 58,196 |                 
|                        |  |                |        |                 



F-12



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)



3.    INVESTMENTS (Continued)







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



|                                           |  | 2002
|------------------------------------------ |  | ----
|Within one year                            |  | $   
|Greater than one year, less than two years |  |     
|                                           |  |     
|                                           |  | $   
|                                           |  |     



At June
30, 2001, the Company determined that an other-than-temporary decline in fair value of its investment in short-term commercial paper of Southern California Edison (So Cal Ed), a utility company had occurred. At the time of purchase, the
security was a high investment-grade security, but was subsequently downgraded due to the financial uncertainty that resulted from the California energy crisis. The security matured on April 18, 2001, and So Cal Ed defaulted on payment. The
amortized cost of the security was $3.0 million, and the security was valued at approximately 67% of cost at June 30, 2001. Accordingly, the Company recorded a $990,000 loss on the related write-down in the carrying value of the investment. At
December 31, 2001, the security remained outstanding and was valued at approximately 94% of amortized cost. The unrealized gain of $810,000 was included in accumulated other comprehensive income/(loss). In March 2002, the security was fully repaid.
Thus, the Company recorded a realized gain of $990,000 for the year ended December 31, 2002.



4.    PROPERTY AND EQUIPMENT



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



|                                               |  | 2002 |        |   | 2001 |  
|---------------------------------------------- |  | ---- | ------ | - | ---- | -
|Computer equipment and software                |  | $    | 1,353  |   |      | $
|Office furniture                               |  |      | 321    |   |      |  
|Lab equipment                                  |  |      | 6,120  |   |      |  
|Leasehold improvements                         |  |      | 2,522  |   |      |  
|                                               |  |      |        |   |      |  
|                                               |  |      | 10,316 |   |      |  
|Less accumulated depreciation and amortization |  |      | (4,948 | ) |      |  
|                                               |  |      |        |   |      |  
|                                               |  | $    | 5,368  |   |      | $
|                                               |  |      |        |   |      |  



Depreciation and amortization expense was $1.8 million, $1.3 million and $932,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Property and equipment financed under capital leases amounted to $562,000 at
December 31, 2002 and 2001. Accumulated amortization related to this property and equipment amounted to $562,000 and $556,000 at December 31, 2002 and 2001, respectively.



F-13



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)





5.    EQUIPMENT FINANCING



The Company financed certain equipment and facility improvements under debt obligations. As of December 31, 2002, future minimum loan payments under these obligations were as follows (in thousands):



|Year ended December 31,               |  |   |        |  
|------------------------------------- |  | - | ------ | -
|2003                                  |  | $ | 1,954  |  
|2004                                  |  |   | 1,138  |  
|2005                                  |  |   | 609    |  
|2006                                  |  |   | 204    |  
|                                      |  |   |        |  
|Total minimum debt payments           |  |   | 3,905  |  
|Less amount representing interest     |  |   | (397   | )
|                                      |  |   |        |  
|Present value of net minimum payments |  |   | 3,508  |  
|Less current portion                  |  |   | (1,712 | )
|                                      |  |   |        |  
|Long-term portion                     |  | $ | 1,796  |  
|                                      |  |   |        |  



In April
2002, the Company entered into a $3.0 million equipment line of credit agreement. Each draw has an interest rate that is fixed at the time of draw down. As of December 31, 2002, the Company utilized approximately $2.2 million of the line of credit.



The terms of the debt obligations range from 42
to 49 months. Some of the loans have a balloon payment at the end of the term. Interest rates are fixed at the time of the draw down, with rates ranging from 7.19% to 13.86%. Obligations under the loans are secured by the assets financed under the
loans.



6.    FACILITY LEASES



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



Minimum annual rental
commitments at December 31, 2002 were as follows (in thousands):



|Year ended December 31, |  |   |       
|----------------------- |  | - | ------
|2003                    |  | $ | 1,708 
|2004                    |  |   | 1,588 
|2005                    |  |   | 1,609 
|2006                    |  |   | 1,624 
|2007                    |  |   | 1,679 
|Thereafter              |  |   | 5,956 
|                        |  |   |       
|Total minimum payments  |  | $ | 14,164
|                        |  |   |       



In June
2002, the Company obtained a stand-by letter of credit for approximately $903,000 from a commercial bank as security for the Companys obligation under one of its facility leases. The letter of credit is secured by a certificate of deposit in
the amount of $904,000 held in an investment account that the Company must maintain for the term of the lease. The investment account is classified within long-term investments on the balance sheet.



Rent expense for operating leases was approximately $1.5
million, $1.1 million and $1.3 million for the years ended December 31, 2002, 2001 and 2000, respectively.



F-14



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)





7.    ACCRUED LIABILITIES



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



|                               |  | 2002 |       | 2001
|------------------------------ |  | ---- | ----- | ----
|Facilities-related             |  | $    | 510   |     
|Compensation-related           |  |      | 1,176 |     
|Professional services          |  |      | 858   |     
|Research & development-related |  |      | 847   |     
|Other                          |  |      | 290   |     
|                               |  |      |       |     
|                               |  | $    | 3,681 |     
|                               |  |      |       |     



8.    RELATED PARTY TRANSACTIONS



For the years ended December 31, 2002 and 2001, the Company had outstanding promissory notes issued to officers and employees of $1.2 million and $1.5 million, respectively. These promissory notes were
issued for the exercise of stock options. These notes bear interest at rates ranging from 6.00% to 6.69% per annum, with principal and interest due from February 2003 through October 2003. All of these are full recourse notes, secured in part by a
pledge of the Companys common stock owned, and are classified in stockholders equity.



For the years ended December 31, 2002 and 2001, the Company had outstanding full recourse employee loans of $445,000 and $1.0 million,
respectively. These loans bear interest at rates ranging from 4.47% to 6.60% and are due from March 2004 through March 2006. The loans are secured by deeds of trust to residential property and are classified on the balance sheet as notes receivable
from related parties. One of the notes to an officer totaling $150,000 will be forgiven by the fourth anniversary date of the officers employment in accordance with the original terms of the loan agreement.



9.    STOCKHOLDERS EQUITY



Common Stock Split and Shares Authorized



In September 2000, the Company split its common stock 3-for-1
and increased the authorized shares of common stock to 36,000,000 shares. In October 2000, in conjunction with the closing of the Companys initial public offering of common stock, the Company increased the authorized shares of common stock to
200,000,000. All common stock, options to purchase common stock and per share amounts in the accompanying financial statements have been adjusted retroactively to reflect the stock split. The conversion ratios of the respective series of convertible
preferred stock were automatically adjusted to reflect the stock split. In July 2001, the Company decreased the authorized shares of common stock to 100,000,000.



Initial Public Offering



In October 2000, the Company completed its initial public offering of 5,750,000 shares of common stock, inclusive of the
underwriters over-allotment option, at a price of $14.00 per share. The Company received approximately $73.4 million in net proceeds after underwriting discounts and other offering costs. Upon closing of the initial public offering, the
4,073,573 shares of convertible preferred stock outstanding were automatically converted into 12,220,719 shares of common stock.



F-15



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)



9.    STOCKHOLDERS
EQUITY(Continued)





Preferred Stock



On March 30, 2000, the Company completed a
private placement for the sale of 804,196 shares of Series C convertible preferred stock, resulting in gross proceeds of $24.9 million. The issuance of the Series C convertible preferred stock resulted in a beneficial conversion feature that was
reflected as a deemed dividend of $11.3 million in the statement of operations for the year ended December 31, 2000.



Common Stock and Common Stock Subject to Repurchase



Under the terms of the 1996 Stock Option Plan (the 1996 Plan), options granted before the Companys initial public
offering of common stock are exercisable when granted, and if exercised prior to vesting, such shares are subject to repurchase upon termination of employment or consulting agreement at a price per share equal to the original exercise price.
Repurchase rights lapse over the vesting periods, which are generally four years. At December 31, 2002 and 2001, 208,436 shares and 689,483 shares, respectively, were subject to repurchase. Stock options granted after the Companys initial
public offering of common stock are exercisable only for the portion of the stock options that have vested.



1996 Stock Option Plan



In 1996, the board of directors adopted the 1996 Plan that provides for the granting of incentive stock options and nonstatutory stock options to employees, officers, directors and consultants of the
Company. The maximum number of aggregate shares that may be optioned and sold under the plan is 6,600,000, plus an annual increase to be added on January 1 of each year that may be the lesser of 1,125,000 shares, 5% of the outstanding shares on such
date or a lesser amount as determined by the board, beginning in 2001. Incentive stock options may be granted with exercise prices not less than fair value, and nonstatutory stock options may be granted with exercise prices not less than 85% of the
fair value on the date of grant. The fair value of grants before the Companys initial public offering was determined by the board of directors. The fair value of grants after the Companys initial public offering of common stock is
determined by the closing market price of the Companys common stock as listed on any established stock exchange on the date of grant. Stock options granted to a stockholder owning more than 10% of voting stock of the Company may be granted
with an exercise price of not less than 110% of the fair value on the date of grant. Options expire no later than ten years from the date of the grant. The number of shares, terms and exercise period are determined by the board of directors. Options
generally vest at 25% per year over a four-year period.



2000
Employee Stock Purchase Plan



In March 2000,
the Company adopted the 2000 Employee Stock Purchase Plan (the Purchase Plan) and reserved 300,000 shares of common stock for issuance thereunder. In addition, the Purchase Plan provides for annual increases in the number of shares
available for issuance under the Purchase Plan on January 1 of each year, beginning in 2001, equal to the lesser of 150,000 shares, 0.75% of the outstanding shares on such date or such amount as determined by the board. The Purchase Plan permits
eligible employees to purchase common stock at a discount through payroll deductions during defined offering periods. The price at which the stock is purchased is equal to the lower of 85% of the fair market value of the common stock on the first
day of the offering or 85% of the fair market value of the Companys common stock on the purchase date. Each offering period is for approximately six months, with the initial offering period commencing on October 5, 2000. As of December 31,
2002, 161,423 shares were granted under the Purchase Plan.



F-16



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)



9.    STOCKHOLDERS
EQUITY(Continued)





2000 Employee Stock
Purchase Plan



In March 2000, the Company
adopted the 2000 Employee Stock Purchase Plan (the Purchase Plan) and reserved 300,000 shares of common stock for issuance thereunder. In addition, the Purchase Plan provides for annual increases in the number of shares available for
issuance under the Purchase Plan on January 1 of each year, beginning in 2001, equal to the lesser of 150,000 shares, 0.75% of the outstanding shares on such date or such amount as determined by the board. The Purchase Plan permits eligible
employees to purchase common stock at a discount through payroll deductions during defined offering periods. The price at which the stock is purchased is equal to the lower of 85% of the fair market value of the common stock on the first day of the
offering or 85% of the fair market value of the Companys common stock on the purchase date. Each offering period is for approximately six months, with the initial offering period commencing on October 5, 2000. As of December 31, 2002, 161,423
shares were granted under the Purchase Plan.



2000
Non-Employee Directors Plan



In March
2000, the Company adopted the 2000 Non-Employee Directors Stock Option Plan (the Directors Plan) and reserved 300,000 shares of common stock for issuance thereunder. The Directors Plan provides for an annual increase on
January 1 of each year, beginning in 2001, equal to the lesser of 150,000 shares, 0.75% of the outstanding shares on such date or a lesser amount as determined by the board. In May 2002, stockholders approved an amendment to the Directors
Plan to increase the number of options that may be granted to each non-employee director and adjust the date of grant and the term over which shares vest. Under the Directors Plan, as amended, each non-employee director who becomes a director
of the Company will be automatically granted a non-statutory stock option to purchase 20,000 shares of common stock on the date on which such person first becomes a director, and such option will vest over four years. Beginning with the 2002 Annual
Stockholders Meeting and each year thereafter, each non-employee director will automatically be granted, one day following each years annual meeting of stockholders, a non-statutory option to purchase 5,000 shares of common stock, which
will vest one day before the annual meeting of stockholders subsequent to the date of grant. The exercise price of options under the Directors Plan will be equal to the fair market value of the common stock on the date of grant.



The maximum term of the options granted under the
Directors Plan is ten years. The Directors Plan will terminate in March 2010, unless terminated in accordance with the provisions of the Directors Plan. As of December 31, 2002, 93,000 shares were granted under the Directors
Plan.



F-17



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)



9.    STOCKHOLDERS
EQUITY(Continued)





A summary
of stock option activity is as follows:



|                              |  | Shares Available For Grant |                  |  | Options Outstanding
|----------------------------- |  | -------------------------- | ---------------- |  | -------------------
|                              |  |                            | Number of Shares |  |                    
|Balances at December 31, 1999 |  | 277,683                    |                  |  | 1,367,700          
|Additional reserved           |  | 2,700,000                  |                  |  |                   
|Granted                       |  | (1,489,350                 | )                |  | 1,489,350          
|Canceled                      |  | 81,519                     |                  |  | (81,519            
|Exercised                     |  |                           |                  |  | (1,695,390         
|                              |  |                            |                  |  |                    
|Balances at December 31, 2000 |  | 1,569,852                  |                  |  | 1,080,141          
|Additional reserved           |  | 375,000                    |                  |  |                   
|Granted                       |  | (1,501,775                 | )                |  | 1,501,775          
|Canceled                      |  | 192,912                    |                  |  | (192,912           
|Exercised                     |  |                           |                  |  | (33,130            
|                              |  |                            |                  |  |                    
|Balances at December 31, 2001 |  | 635,989                    |                  |  | 2,355,874          
|Additional reserved           |  | 1,125,000                  |                  |  |                   
|Granted                       |  | (1,134,100                 | )                |  | 1,134,100          
|Canceled                      |  | 319,167                    |                  |  | (319,167           
|Exercised                     |  |                           |                  |  | (90,462            
|                              |  |                            |                  |  |                    
|Balances at December 31, 2002 |  | 946,056                    |                  |  | 3,080,345          
|                              |  |                            |                  |  |                    



The
following table summarizes information with respect to stock options outstanding at December 31, 2002:



|Options Outstanding     |  | Options Vested  
|----------------------- |  | ----------------
|Range of Exercise Price |  | Number of Shares
|$  0.15$  2.00         |  | 432,004         
|$  4.00$  6.50         |  | 808,925         
|$  6.65$  7.75         |  | 492,500         
|$  8.00$  8.87         |  | 435,450         
|$  9.70$  9.70         |  | 615,266         
|$10.50$14.00           |  | 296,200         
|                        |  |                 
|                        |  | 3,080,345       
|                        |  |                 



Of the
3,080,345 options outstanding, 1,201,014 options were exercisable as of December 31, 2002, including 238,438 that, if exercised, would be subject to the Companys lapsing right to repurchase over the remaining vesting term. The weighted-average
fair value of options granted at their date of grant was $7.08, $6.05 and $0.66 for the years ending December 31, 2002, 2001 and 2000, respectively.



F-18



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)



9.    STOCKHOLDERS
EQUITY(Continued)





Non-Employee
Stock-Based Compensation



As of December 31,
2002, the Company had issued consultant stock options totaling approximately 884,000 shares with exercise prices ranging from $0.15 to $9.70 and terms up to five years. Compensation related to the grants of stock options is recorded in
accordance with SFAS 123 and EITF 96-18 using the Black-Scholes Model. The Company recognized other stock-based compensation for grants to non-employees of $1.4 million, $681,000 and $1.4 million for the years ended December 31, 2002, 2001 and
2000, respectively. The measurement of stock-based compensation to non-employees is subject to periodic adjustment as the underlying awards vest.



Reserved Shares



As of December 31, 2002, the Company had reserved shares of common stock for future issuance as follows:



|                             |  | Shares Reserved
|---------------------------- |  | ---------------
|Stock option plans           |  | 4,026,401      
|Employee Stock Purchase Plan |  | 138,577        
|                             |  |                
|                             |  | 4,164,978      
|                             |  |                



Stockholder Rights
Plan



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



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



The board of directors can redeem the Rights at any time prior to a person becoming an Acquiring Person at a redemption price of $0.001
per Right. In addition, the board of directors may, after any time a person becomes an Acquiring Person, exchange each Right for one share of common stock of the Company. As of December 31, 2002, no shares had been issued under the Rights Plan.





F-19



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)





10.    COMPREHENSIVE INCOME



Comprehensive loss was as follows (in thousands):



|                                                                 |  | Year Ended December 31, |        
|---------------------------------------------------------------- |  | ----------------------- | -------
|                                                                 |  | 2002                    |        
|Net loss                                                         |  | $                       | (20,864
|Unrealized (loss)/gain on available-for-sale securities          |  |                         | (74    
|Reclassification of (gain)/loss on available-for-sale securities |  |                         | (990   
|                                                                 |  |                         |        
|Comprehensive loss                                               |  | $                       | (21,928
|                                                                 |  |                         |        



11.    INCOME TAXES



As of December 31, 2002, the Company had federal net operating loss carryforwards and federal research and development tax credit carryforwards of approximately $35.0 million and $1.6 million, respectively. The federal net operating
loss and credit carryforwards will expire at various dates beginning in the year 2011 through 2022, if not utilized.



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



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



|                                              |  | 2002 |         |   | 2001 |  
|--------------------------------------------- |  | ---- | ------- | - | ---- | -
|Deferred tax assets:                          |  |      |         |   |      |  
|Net operating loss carryforwards              |  | $    | 12,360  |   |      | $
|Deferred revenue                              |  |      | 4,700   |   |      |  
|Research and development credits              |  |      | 2,710   |   |      |  
|Capitalized research and development expenses |  |      | 1,850   |   |      |  
|Other                                         |  |      | 1,470   |   |      |  
|                                              |  |      |         |   |      |  
|Total deferred tax assets                     |  |      | 23,090  |   |      |  
|                                              |  |      |         |   |      |  
|Valuation allowance                           |  |      | (23,090 | ) |      |  
|                                              |  |      |         |   |      |  
|Net deferred taxes                            |  | $    |        |   |      | $
|                                              |  |      |         |   |      |  



Due to
the Companys lack of earnings history, the total deferred tax assets have been fully offset by a valuation allowance. The valuation allowance increased by $8.5 million and $5.4 million during the years ended December 31, 2002 and 2001,
respectively.



F-20



---

##### Table of Contents

KOSAN BIOSCIENCES INCORPORATED



NOTES TO FINANCIAL STATEMENTS(Continued)





12.    QUARTERLY INFORMATION (Unaudited)



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



|                                            |  | Quarter Ended |        |   | Total    |  
|------------------------------------------- |  | ------------- | ------ | - | -------- | -
|                                            |  | March 31,     |        |   | June 30, |  
|2002                                        |  |               |        |   |          |  
|Revenue (1)                                 |  | $             | 1,662  |   |          | $
|Loss from operations                        |  |               | (5,545 | ) |          |  
|Net loss                                    |  |               | (3,934 | ) |          |  
|Basic and diluted earnings per common share |  | $             | (0.16  | ) |          | $
|                                           
|2001                                        |  |               |        |   |          |  
|Revenue                                     |  | $             | 1,229  |   |          | $
|Loss from operations                        |  |               | (5,428 | ) |          |  
|Net loss                                    |  |               | (3,923 | ) |          |  
|Basic and diluted earnings per common share |  | $             | (0.16  | ) |          | $

---

|(1) |  | Revenue for the quarter ended December 31, 2002 included $3.4 million of contract revenue recognized pursuant to the research and development collaboration agreement
with Roche.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------





F-21