**United States**SECURITIES AND EXCHANGE COMMISSION

**WASHINGTON, D.C. 20549**

**FORM 10-K**

**x**                               ANNUAL REPORT PURSUANT TO SECTION 13OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the fiscal year ended December 31, 2004**

**o**                                  TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACTOF 1934

**FORTHE TRANSITION PERIOD FROM                   TO                   **

**Commission File No. 0-12943**

**CYPRESS BIOSCIENCE, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                     | **22-2389839**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
| **4350 Executive Drive, Suite 325  San Diego, California**  | **92121**                             |
| (Address of  principal executive offices)                        | (Zip Code)                            |

 

Registrant’stelephone number, including area code:  **(858) 452-2323**

SECURITIESREGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:  **NONE**

SECURITIES REGISTEREDPURSUANT TO SECTION 12(g) OF THE ACT:

**CommonStock $.001 Par Value**

(Titleof Class)

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405of this chapter) is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

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

The aggregate market value ofthe voting stock held by non-affiliates of the Registrant as of June 30,2004 was approximately $296.4 million*

The number of sharesoutstanding of the Registrant’s common stock as of March 10, 2005 was30,404,415.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portions of the registrant’sDefinitive Proxy Statement to be filed subsequent to the date hereof with theCommission pursuant to Regulation 14A in connection with the Registrant’s2005 Annual Meeting of Stockholders are incorporated by reference into Part IIIof this Report. Such Definitive Proxy Statement will be filed with theSecurities and Exchange Commission not later than 120 days after theconclusion of the Registrant’s fiscal year ended December 31, 2004.

* Calculated based on 21,588,328 shares of commonstock held as of June 30, 2004 by non-affiliates and a per share marketprice of $13.73. Excludes 7,986,456 shares of common stock held by directorsand executive officers and stockholders whose ownership exceeds five percent ofthe common stock outstanding at June 30, 2004, who are deemed to beaffiliates only for purposes of this calculation. Exclusion of such sharesshould not be construed to indicate that any such person possesses the power,direct or indirect, to direct or cause the direction of the management orpolicies of the Registrant or that such person is controlled by or under commoncontrol with the Registrant.

 

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**CYPRESSBIOSCIENCE, INC.FORM 10-KINDEX**
|            | ** **                                                                                                 | ** ** | **Page**   | ** ** |
|------------|------------------------------------------------------------------------------------------------------------|------------|------------|------------|
|       | **PART I**                                                                                                 |       |       |
| Item 1     | Business                                                                                                   | 1          |       |
| 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 our Common Equity, Related Stockholder Matters and Issuer Purchases of Equity  Securities | 28         |       |
| Item 6     | Selected  Financial Data                                                                                   | 29         |       |
| Item  7    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations           | 31         |       |
| Item  7A   | Quantitative  and Qualitative Disclosures about Market Risk                                                | 40         |       |
| Item 8     | Financial  Statements                                                                                      | 40         |       |
| Item  9    | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                 | 41         |       |
| Item  9A   | Controls  and Procedures                                                                                   | 41         |       |
| Item 9B    | Other  Information                                                                                         | 43         |       |
|       | **PART III**                                                                                               |       |       |
| Item 10    | Directors and Executive  Officers                                                                          | 43         |       |
| Item 11    | Executive Compensation                                                                                     | 43         |       |
| Item 12    | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters            | 43         |       |
| Item 13    | Certain Relationships and  Related Transactions                                                            | 43         |       |
| Item 14    | Accounting Fees and  Services                                                                              | 43         |       |
|       | **PART IV**                                                                                                |       |       |
| Item  15   | Exhibits,  Financial Statement Schedules                                                                   | 44         |       |
|       | Signatures                                                                                                 | 47         |       |
|            |                                                                                                            |            |            |            |  |

 

 

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**PART I**

*Except for the historical information containedherein, the information contained herein contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended and Section 21E of the Securities Exchange Act of 1934,as amended, including, in particular, statements about our plans, strategiesand prospects. These statements, which may include words such as “may,” “will,”“expect,” “believe,” “intend,” “plan,” “anticipate,” “estimate,” or similarwords, are based on our current beliefs, expectations and assumptions and aresubject to a number of risks and uncertainties. Although we believe that ourbeliefs, expectations and assumptions reflected in these statements arereasonable, our actual results and financial performance may prove to be verydifferent from what we might have predicted on the date of this Form 10-K.Factors that could cause or contribute to differences include, but are notspecifically limited to, our ability to develop milnacipran for FibromyalgiaSyndrome, our ability to develop or acquire any compounds or products to treatany other indications we may pursue in a timely manner, or at all, as well asthe other risks detailed in this Form 10-K and in our other SEC filings.*

**ITEM 1.**                     Business

**Company Overview**

We are committed to being the innovator and leader inproviding products for the treatment of patients with Functional SomaticSyndromes and other central nervous system disorders. Functional SomaticSyndromes refer to several related syndromes characterized more by symptoms,suffering and disability than by disease-specific abnormalities that arefound upon physical examination and include many overlapping pain andpsychiatric conditions such as Fibromyalgia Syndrome, or FMS, irritable bowel syndrome,non-cardiac chest pain and interstitial cystitis, or chronic pelvic pain. Ourgoal is to be the first to commercialize a product approved in the UnitedStates for the treatment of FMS, the focus of our initial efforts in the areaof Functional Somatic Syndromes. In January 2004, we entered into acollaboration agreement with Forest Laboratories, Inc., a leading marketerof central nervous system drugs with a strong franchise in the primary care andpsychiatric markets, for the development and marketing of milnacipran. We arecurrently running the first Phase III trial for milnacipran, which wascommenced in October 2003. Enrollment in this trial was completed in December 2004,with results expected to be available in the Fall of 2005. In October 2004,Forest Laboratories initiated the second Phase III trial evaluating milnacipranfor the treatment of FMS. These two Phase III trials and any additional studiesneeded for regulatory approval could possibly be completed in 2006 and, ifsuccessful, a New Drug Application, or NDA, for FMS could possibly be submittedlater in that year at the earliest.

We completed a Phase II trial evaluating milnacipranfor the treatment of FMS in the Fall of 2002. The Phase II trial was a three-month,randomized, placebo-controlled study involving 14 sites and 125 FMSpatients who were randomized to either milnacipran treatment or placebo. Inthis clinical trial, milnacipran was shown to provide statistically significantimprovement in pain, the primary symptom of FMS. No unexpected safety concernsarose from this trial and there were no serious adverse events.

We obtained an exclusive license for milnacipran fromPierre Fabre Medicament in 2001. Milnacipran has been marketed outside of theUnited States since 1997 as an antidepressant and has been used by over3,000,000 patients worldwide. We have paid Pierre Fabre a total of$2.5 million, including upfront payments of $1.5 million inconnection with the execution of the original license agreement in 2001 and a $1.0 millionmilestone payment in September 2003, and issued Pierre Fabre 1,000,000shares of common stock and warrants to purchase 300,000 shares of common stockin connection with an amendment to the agreement with Pierre Fabre. Additionalpayments to Pierre Fabre of up to a total of $4.5 million will be due toPierre Fabre based on meeting certain clinical and regulatory milestones. Underour agreement with Forest Laboratories, we sublicensed our rights tomilnacipran to Forest Laboratories for the United States, with an option toextend the territory to include Canada. Additionally, Forest Laboratoriesassumed responsibility for funding all continuing development of milnacipran,including the funding of clinical trials and regulatory approval, as well as aspecified number of our employees. However, in light of 

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the increased expense andrisk associated with running two parallel trials, we are discussing analternative cost sharing arrangement with Forest Laboratories for the secondPhase III trial only and are currently working towards formalizing an amendmentto our agreement with Forest Laboratories. In connection with thesediscussions, the amount of funding that we receive from Forest Laboratories forcertain of our employees has been eliminated as of the fourth quarter in 2004,and we will pay for a majority of the external costs of the second Phase IIItrial only, with Forest reimbursing us under specific scenarios where thesecond Phase III trial is used as one of the two required pivotal trials in theNew Drug Application (NDA) submission to the FDA and with a premium undercertain additional circumstances. Forest Laboratories will also be responsiblefor sales and marketing activities related to any product developed under theagreement, while we have the option to co-promote using our own sales force upto 25% of the total physician details and would be reimbursed by Forest in anamount equal to Forest’s cost of providing the equivalent detailing calls.

We are continuing toevaluate various potential strategic transactions, including the acquisitionsof products, technologies and companies and other alternatives that we believemay enhance stockholder value.

**Fibromyalgia Syndrome Background**

FMS is a chronic and debilitating conditioncharacterized by widespread pain and stiffness throughout the body, accompaniedby severe fatigue, insomnia and mood symptoms. Unlike arthritis and otherdebilitating rheumatological disorders, FMS produces serious and chronic painthat is not the result of inflammation. Pain associated with FMS is of a “head-to-toe”nature, and is described as a diffuse aching or burning. Pain can vary inseverity and location from day to day and, in some people, it can be so intensethat it interferes with the performance of even simple tasks, while in othersit may cause only moderate, ongoing discomfort. By some measures, patients withFMS have at least comparable disability, more pain and lower quality of lifethan patients with rheumatoid arthritis or osteoarthritis. Although FMS hasbeen medically recognized for many years, it was only in 1990 that medicalspecialists agreed on the signs and symptoms that must be present to make thediagnosis. The American College of Rheumatology, or ACR, diagnosis criteria forFMS include a history of widespread and longstanding pain, as measured by painupon application of pressure in 11 of 18 designated tender points. Specialistsin the field of FMS have concluded that FMS is a result of a generalized andheightened perception of sensory stimuli resulting from abnormal painprocessing within the central nervous system, and in most instances, istriggered by physical trauma, emotional stress or infection.

As reported by the ACR, FMS affects an estimated 2-4%of the population worldwide, including an estimated 6-12 million patientsin the United States. A recent scientific article suggests that because the ACRcriteria were designed for clinical research purposes and therefore limit theFMS diagnosis, the 2-4% prevalence may under-represent the actual prevalence ofchronic widespread pain in the population. Most FMS patients are middle-agedwomen, although the ailment can strike children, the elderly and men. Accordingto the ACR, FMS is diagnosed four times more frequently in women than in menand once symptoms appear, most patients can expect to suffer the conditionthroughout their entire life. As a result of the diversity of symptoms, thereare numerous physician specialties involved in the treatment and management ofFMS. FMS is most often treated in the primary care setting. The leadingspecialty group treating FMS patients is rheumatologists, for whom FMS is thesecond most common diagnosis made after osteoarthritis.

Despite the highprevalence and severity of this syndrome, there are no treatments specifically approvedfor FMS in the United States or elsewhere. Current treatments consist of aregimen that includes medication to diminish pain and improve sleep, exerciseprograms that stretch muscles and improve cardiovascular fitness and physicaltherapy and relaxation techniques to ease muscle tension. Antidepressants areoften prescribed for FMS patients, as low doses of these medications appear torelieve 

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painassociated with FMS. Tricyclic antidepressants, or TCAs, a class of compoundsthat are known to be effective analgesics, or pain-reducing drugs, in multiplechronic pain conditions, including FMS, are currently viewed as the drugs ofchoice in treating FMS. TCAs act by increasing serotonin and norepinephrine.Serotonin and norepinephrine are chemicals in the brain that are thought to beinvolved in controlling “centrally mediated pain”—that is, pain that originatesat the central nervous system level, as opposed to pain that is caused by aninjury, such as a cut or an arthritic swollen joint. Some TCAs are distinguishedfrom most other antidepressants, specifically from the selective serotoninreuptake inhibitors, or SSRIs, and the serotonin norepinephrine reuptakeinhibitors, or SNRIs, because some TCAs preferentially block the reuptake ofnorepinephrine as compared to serotonin, which means that these TCAs increasethe level of norepinephrine more than they do the serotonin levels. We believethat these characteristics of TCAs make them more suited to the treatment ofthe pain associated with FMS than SSRIs and SNRIs. TCAs, however, are severelylimited in their use for the treatment of FMS because they have been linkedwith side effects such as arrhythmias, the risk of fatal overdose, as well ascontributing to weight gain and drowsiness, which is particularly problematicbecause individuals with FMS are already suffering from fatigue.

**Milnacipran for the Treatment of FMS**

***Milnacipran***

We are developingmilnacipran for the treatment of FMS. Milnacipran is the first of a new classof agents known as norepinephrine serotonin reuptake inhibitors, or NSRIs,which increase the level of norepinephrine more than they do serotonin. Whilemilnacipran is similar to TCAs with regard to the relative ratio ofnorepinephrine and serotonin activity, milnacipran appears to lack the sideeffects associated with TCAs, as it does not interact with several classes ofreceptors that are responsible for many of the adverse effects of TCAs.Therefore, we believe that milnacipran may have efficacy similar to TCAs intreating FMS and related chronic pain conditions, without causing the sideeffects that limit the prescribing of TCAs by physicians, and compliance bypatients. Milnacipran is approved for the treatment of depression in 32countries and is currently a leading antidepressant in Japan. Since itscommercial launch in 1997, milnacipran has been used by over 3,000,000 patientsworldwide, with side effects typically limited to transient and mild nausea anda slight increase in heart rate, as well as the potential for urinary retentionin older men with an enlarged prostate. Milnacipran has not been approved inthe United States for any indication, and we are the first company conductingclinical trials of milnacipran in the United States for FMS. As a result of thefavorable side effect profile of milnacipran and its ability to increase thelevel of norepinephrine more than serotonin in the brain, we believe thatmilnacipran may play a significant role in the treatment of FMS.

***Milnacipran Development Status***

*Phase II Results*

We completed a Phase IItrial evaluating milnacipran for the treatment of FMS in the Fall of 2002. ThePhase II trial was a three-month, randomized, placebo-controlledstudy involving 14 sites and 125 FMS patients who were randomized to eithermilnacipran treatment or placebo. The study evaluated the overall analgesicefficacy and safety of milnacipran in this population of FMS patients, with aprimary endpoint based on improvement in patient-reported pain.Electronic diaries were provided to all patients for the purpose of recordingdaily pain assessments in real time. We believe that performing daily painassessments using electronic diaries reduces bias involved with askingindividuals to recall symptoms over time and improves compliance by promptingand time-date stamping each patient response. The pain measures obtained fromthe electronic diaries were chosen to be the primary variable for themeasurement of pain improvement. Secondary objectives included assessment ofthe impact of dosing strategy (twice daily dosing versus once daily) and theimpact of milnacipran on other symptoms of FMS including fatigue, 

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mood,physical function and sleep disturbances. Based on tolerability, patients wereallowed to double their dose every week, up to a maximum of 200 mg of milnaciprandaily. In our Phase II trial, milnacipran was shown to provide statisticallysignificant improvement in pain, the primary symptom of FMS. Thirty-sevenpercent of milnacipran-treated patients randomized to the twice a daydosing group reported at least a 50% reduction in pain intensity, which meansthat their reported pain was half as intense as it was at the beginning of thestudy, compared to 14% of patients in the placebo group. In this analysis, 51patients received milnacipran and 28 patients received a placebo. The reductionin pain intensity was statistically significant, with a p-value of 0.0395. Ap-value is a statistical measure of probability of drawing an erroneousconclusion from an experimental result. A p-value of less than or equal to 0.05is generally considered to signify a statistically significant result, whichmeans a result is unlikely to occur by chance. Further, 75% of all milnacipran-treatedpatients reported an impression of overall improvement compared to 38% in theplacebo group. In this analysis, 68 patients received milnacipran and 21patients received a placebo. This reported impression of overall improvementwas also statistically significant, with a p-value of 0.003. Twice dailymilnacipran had significantly better analgesic properties than once dailymilnacipran, although other outcomes (e.g. fatigue, mood, patient’s globalimpression) were equally impacted by the two dosing regimens. No unexpectedsafety concerns arose from this clinical trial and there were no seriousadverse events. Milnacipran was generally well-tolerated, especially with twicedaily dosing. The most common dose-related side effect reported by patients wasnausea, particularly early in the study, as well as a slight increase in heartrate. Most adverse events were mild to moderate in intensity and only lastedfor a short time.

*Phase III Trials*

We commenced the first ofour planned Phase III trials in October 2003. We and Forest commenced thesecond of our planned Phase III trials in October 2004. To prepare for ourPhase III clinical program, and before commencing the first pivotal clinicaltrial, we completed a special protocol assessment with the FDA. In the specialprotocol assessment process, the FDA reviews the design and size of a proposedPhase III program and provides comments regarding the adequacy of the clinicaltrial design to support a claim of effectiveness in an approvable NDA. The FDA’scomments are binding on its review decision, except in limited circumstances,such as when a substantial scientific issue essential to determining the safetyor effectiveness of a drug is identified after the Phase III program commences.In response to our Phase II results, and based on modeling of the outcomemeasures used in our Phase II trial, we have mutually agreed with the FDA on aPhase III program. As generally is required by the FDA, two positive pivotaltrials are required for an NDA approval of milnacipran for the treatment ofFMS. Both of the required trials are similar in design to the Phase IItrial—they require that participants in the trial cease taking any drugs theyare taking for FMS, have virtually identical inclusion and exclusion criteria,will rely on the use of the electronic diary to assess pain and are utilizingqualitative assessment methodologies. We plan on enrolling over 1,000 patientsin total in our first two Phase III trials. Per the stipulations in the specialprotocol assessment, the first pivotal trial will include a six-monthevaluation phase once a patient has reached his or her stable treatment dose.The second trial could have an evaluation phase as short as three-monthsonce a patient has reached his or her stable dose. In these clinical trials,two milnacipran doses will be evaluated (200 mg, administered 100 mg twice daily,as well as a lower dose, also administered twice daily), and the endpoint willbe a composite responder analysis. This new endpoint is a compositeincorporating pain, the patient’s global impression of change and physicalfunction, which means the patient’s ability to perform functions of dailyliving. As part of the Phase III program, we also need to evaluate patients fora time period consistent with the minimum safety guidelines of theInternational Conference on Harmonization of Technical Requirements for theRegistration of Pharmaceuticals for Human Use, or ICH. Specifically, these ICHguidelines require that we evaluate 300 patients on the 200 mg dose ofmilnacipran for six months and 100 patients on the 200 mg dose of milnacipranfor one year. The entire Phase III program could possibly be completed in 2006and, if 

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successful,an NDA for FMS could possibly be submitted later in that year at the earliest.We do not believe that patient enrollment will be a time-limiting factor due tothe current lack of approved treatments for FMS, and our historical FMSenrollment rates have met our expectations.

**Licenses and Collaborations**

***Pierre Fabre Agreements***

In January 2004, we amended and restated ourexisting license agreement with Pierre Fabre. Our license agreement with PierreFabre provides us with an exclusive license to develop and sell any productswith the compound milnacipran as an active ingredient for any indication in theUnited States and Canada. We are obligated to pay Pierre Fabre 5% of anyupfront and milestone payments received from Forest Laboratories as asublicense fee. After a total of $7.5 million has been paid, anyadditional sublicense fees are credited against any subsequent milestone androyalty payments owed by us to Pierre Fabre. If not used, these credits arecarried forward to subsequent years. We also are obligated to pay Pierre Fabreup to $4.5 million in the aggregate upon achievement of defined clinicaland regulatory objectives. Forest Laboratories assumed our obligation to payroyalties to Pierre Fabre and the transfer price for the active ingredientsupplied by Pierre Fabre. Pierre Fabre retains the right to sell products inindications developed by us outside the United States and Canada, and will payus a royalty based on net sales for such products. The license agreement alsoprovides Pierre Fabre with certain rights to obtain a license outside theUnited States and Canada for new formulations and new salts developed by us.

The agreement is effective until the later of theexpiration of the last-to-expire of certain patents held by Pierre Fabrerelating to the development of milnacipran, or ten years after the firstcommercial sale of a licensed product, unless terminated earlier. Each partyhas the right to terminate the agreement upon 90 days’ prior writtennotice of the bankruptcy or dissolution of the other party or a breach of anymaterial provision of the agreement if such breach is not cured within90 days following such written notice. Additionally, Pierre Fabre has theright to terminate the agreement upon 90 days’ written notice if (i) weterminate all development activities, unless the termination of activities issubject to cure within 12 months and we are using commercially reasonableefforts to cure the termination of activities, (ii) we challenge thePierre Fabre patents and (iii) we effect a change in control in which athird party acquiror controls an SNRI product and certain provisions of theagreement would be breached as a result of such SNRI product, and the breach isnot cured within a specified time period.

In addition, in January 2004,we entered into a supply agreement with Pierre Fabre. If any product iscommercialized under the license agreement, Pierre Fabre will have theexclusive right to manufacture the active ingredients used in the commercialproduct, and we will pay Pierre Fabre a transfer price and royalties based onnet sales. Forest Laboratories has assumed both of these financial obligations.Our supply agreement with Pierre Fabre may be terminated for cause either by usor by Pierre Fabre upon 90 days’ prior written notice to the other partyupon a material breach of the agreement if the breach is not cured within90 days following the written notice. In addition, Pierre Fabre may electto terminate the agreement if we effect a change in control under specifiedcircumstances.

***Forest Laboratories Agreement***

In January 2004, we entered into a collaborationagreement with Forest Laboratories for the development and marketing ofmilnacipran. We selected Forest Laboratories as our development and marketingcollaborator based in part on its strong franchise in central nervous systemdrugs and in the primary care and psychiatric markets. Under our agreement withForest Laboratories, we sublicensed our exclusive rights to develop andcommercialize milnacipran to Forest Laboratories for the United States, with anoption to extend the territory to include Canada. In addition, ForestLaboratories has an option for a specified time period to acquire an exclusivelicense from us in the United States, and potentially 

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Canada, to any compoundsdeveloped under our agreement with Collegium Pharmaceutical, Inc. ForestLaboratories assumed responsibility for funding all continuing development ofmilnacipran, including the funding of clinical trials and regulatory approvals,as well as a certain number of our employees. However, in light of theincreased expense and risk associated with running two parallel trials, we arediscussing an alternative cost sharing arrangement with Forest Laboratories forthe second Phase III trial only and are currently working towards formalizingan amendment to our agreement with Forest Laboratories. In connection withthese discussions, the amount of funding that we receive from ForestLaboratories for certain of our employees has been eliminated as of the fourthquarter in 2004, and we will pay for a majority of the external costs of thesecond Phase III trial only, with Forest reimbursing us under specificscenarios where the second Phase III trial is used as one of the two requiredpivotal trials in the NDA submission to the FDA and with a premium undercertain additional circumstances. Forest Laboratories will also be responsiblefor sales and marketing activities related to any product developed under theagreement, and we will have the option to co-promote using our own sales forceup to 25% of the total physician details and would be reimbursed by Forest inan amount equal to Forest’s cost of providing the equivalent detailing calls.We share decision making authority with Forest Laboratories, through the jointdevelopment committee, with respect to the research, development and marketingof milnacipran. In the event that the joint development committee is unable toresolve any dispute, other than any marketing related issue, ForestLaboratories and we must jointly resolve such issue. With respect to anymarketing related issue, Forest Laboratories has the final decision makingauthority. Under our agreement with Forest Laboratories and our agreement withPierre Fabre, each party agreed to certain limitations on the development ofproducts for FMS and on the development of SNRI products.

Under our agreement withForest Laboratories, we received an upfront payment of $25.0 million, ofwhich $1.25 million was paid to Pierre Fabre as a sublicense fee. Thetotal upfront and milestone payments to us under the agreement could beapproximately $205.0 million related to the development of milnacipran forthe treatment of FMS, a large portion of which will depend upon achievingcertain sales of milnacipran and an additional $45.0 million in the eventthat we and Forest Laboratories develop other indications for milnacipran, aswell as potential royalty payments based on sales of licensed product underthis agreement. In addition, Forest Laboratories assumed the royalty paymentsdue to Pierre Fabre and the transfer price for the active ingredient used inmilnacipran. The agreement with Forest Laboratories extends until the later of (i) theexpiration of the last to expire of the applicable patents, (ii) 10 yearsafter the first commercial sale of a product under the agreement or (iii) thelast commercial sale of a generic product, unless terminated earlier. Eachparty has the right to terminate the agreement upon prior written notice of thebankruptcy or dissolution of the other party, or a breach of any materialprovision of the agreement if the breach has not been cured within the requiredtime period following the written notice. Forest Laboratories may alsoterminate our agreement upon an agreed notice period in the event ForestLaboratories reasonably determines that the development program indicatesissues of safety or efficacy that are likely to prevent or significantly delaythe filing or approval of an NDA or to result in labeling or indications thatwould have a significant adverse affect on the marketing of any productdeveloped under the agreement.

***Collegium Agreement***

In August 2002, weentered into a reformulation and new product agreement with Collegium pursuantto which Collegium is attempting to develop new formulations of milnacipran andnew products that are analogs of milnacipran. Collegium is led by a managementteam with significant expertise in developing novel formulations of currentlymarketed or soon-to-be marketed products for both the brand and genericindustries. In January 2004, we exercised our option to acquire anexclusive license to technology developed under this agreement. In the event wecommercialize any of the reformulations or new products developed under ouragreement with Collegium, we will be obligated to pay Collegium milestonepayments and royalty payments. The agreement with Collegium is effective untilthe expiration of the last-to-expire 

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of theissued patents, if any, unless terminated earlier. Each party has the right toterminate the agreement upon 60 days’ prior written notice of thebankruptcy or dissolution of the other party or a breach of any materialprovision of the agreement if the breach has not been cured within the 60-dayperiod following the written notice.

**Other Potential Uses of Milnacipran**

We also believe thatmilnacipran may be effective in the treatment of other Functional SomaticSyndromes, such as irritable bowel syndrome, or IBS. With our development andmarketing partner Forest Laboratories, we may in the future investigate the useof milnacipran in the treatment of IBS or other disorders. Should we and ForestLaboratories choose to pursue additional indications beyond FMS and obtain FDAapproval for such indications, we could receive up to an additional$45 million in milestone payments. Since we are entitled to royaltypayments based on sales of any licensed product under the agreement with ForestLaboratories, we would receive royalty payments for any additional indications.The decision regarding which, if any, additional indications are pursued, isone that we make together with Forest Laboratories, through the jointdevelopment committee. Such decisions relate to the research and development ofmilnacipran, so in the event the joint development committee is unable toresolve any dispute regarding potential indications, Forest Laboratories and wemust jointly resolve such issue.

**Patents,Trademarks and Proprietary Technology**

We believe that patents, trademarks, copyrights andother proprietary rights are important to our business. We also rely on tradesecrets, know-how, continuing technological innovations and licensingopportunities to develop and maintain our competitive position. We seek toprotect our intellectual property rights by a variety of means, includingpatents, maintaining trade secrets and proprietary know-how, and technologicalinnovation to develop and maintain our competitive position. We actively seekpatent protection both in the United States and internationally and have filed10 patent applications related to FMS and milnacipran. It is possible that apatent application will not issue from any of our patent applications and thebreadth or scope of protection allowed under any issued patents may not provideadequate protection to protect any of our future products. We intend to enforceour patents, trademarks and brand names. We have also obtained a license fromPierre Fabre to certain patents and patent applications related to milnacipran,our only product candidate. Under the license, which we have sublicensed toForest Laboratories, we have rights to a method of synthesis patent formilnacipran in the United States and Canada. Both the United States patent (U.S.Patent 5,034,541) and the Canadian patent (No. 2,006,464) terminate in December 2009.The composition of matter patent for milnacipran expired in June 2002.Pursuant to the terms of the license agreement, Pierre Fabre is responsible forthe prosecution and maintenance of the patents and patent applications licensedthereunder at its sole expense. In addition, Pierre Fabre has the first rightto take actions with respect to the infringement or potential infringement ofsuch patents and patent applications, except for any action in connection withan abbreviated NDA filed by a third party, and provided that we may takeappropriate actions with respect to the infringement of such patents and patentapplications in the United States and Canada if Pierre Fabre fails to do sowithin a specified period of time. We or Forest Laboratories has the firstright to take any action with respect to any proceeding in connection with anabbreviated NDA filed by a third party. Although we have filed use patents onmilnacipran, two of which have issued (U.S. Patent 6,602,911 and U.S. Patent6,635,675, both expiring in 2021), we may not be able to secure any additionalpatent protection and the existing patents may not ensure exclusivity throughthe patent term. As a new chemical entity in the United States, milnacipranalso qualifies under the terms of the Hatch-Waxman Amendments to theFederal Food, Drug and Cosmetic Act, or Hatch-Waxman Amendments, underwhich it would receive five years of marketing exclusivity upon marketingapproval, during which time a generic milnacipran may not be approved. Even so,recent amendments to the Hatch-Waxman Amendments have been proposed andit, therefore, may not apply to us in the future.

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Although patents are enforceable from the date ofissuance and presumed to be valid, future litigation or reexaminationproceedings regarding the enforcement or validity of our existing patents orfuture patents, if issued, could result in a ruling adverse to us that couldinvalidate such patents or substantially reduce the scope of protectionafforded by such patents. Our patents may not afford commercially significantprotection of our proprietary technology or have commercial application. Therehas been no judicial determination of the validity or scope of our proprietaryrights. Moreover, the patent laws in foreign countries may differ from those ofthe United States, and the degree of protection afforded by foreign patents maybe different.

Others have filedapplications for, or have been issued, patents and may obtain additionalpatents and other proprietary rights relating to products or processescompetitive with us. The scope and validity of such patents is presentlyunknown. If existing or future patents are upheld as valid by courts, we may berequired to obtain licenses to use technology covered by such patents.

**Government Regulation**

Our research, preclinical testing, clinical trials,manufacturing and marketing activities are subject to extensive regulation bynumerous governmental authorities in the United States and other countries. Inthe United States, pharmaceutical drugs are subject to rigorous FDA regulationunder the Federal Food, Drug and Cosmetic Act and other federal and statestatutes and regulations. These laws and regulations govern, among otherthings, the preclinical and clinical testing, manufacture, quality control,safety, efficacy, labeling, storage, record keeping, approval, marketing,advertising and promotion of our drug products and drug product candidates. Theproduct development and regulatory approval process requires the commitment ofsubstantial time, effort and financial resources.

The steps requiredbefore a pharmaceutical agent may be marketed in the United States generallyinclude:

·       completionof preclinical laboratory tests, animal pharmacology and toxicology studies andformulation studies performed in compliance with the FDA’s Good LaboratoryPractice, or GLP regulations;

·       thesubmission of an investigational new drug application, or IND, to the FDA forhuman clinical testing that must be accepted by the FDA before human clinicaltrials may commence;

·       performanceof adequate and well-controlled human clinical trials to establish the safetyand efficacy of the product candidate for the proposed indication of use;

·       thesubmission of an NDA to the FDA; and

·       FDAapproval of the NDA prior to any commercial sale or shipment of the drug.

Preclinical studies include the laboratory evaluationof in vitro pharmacology, product chemistry and formulation, as well as animalstudies to assess the potential safety and efficacy of a product. Compoundsmust be formulated according to the FDA’s current good manufacturing practices,or cGMP, requirements and preclinical safety tests must be conducted bylaboratories that comply with GLP requirements. The results of the preclinicaltests, together with manufacturing information and analytical data, aresubmitted to the FDA as part of an IND application and are reviewed by the FDAbefore human clinical trials may begin. The IND must also contain protocols forany clinical trials that will be carried out. The IND automatically becomeseffective 30 days after receipt by the FDA unless the FDA raises concernsor questions regarding the conduct of the proposed clinical trial during the 30-daywaiting period. If the FDA objects to an IND application during this 30-daywaiting period or at any time thereafter, the FDA may halt proposed or ongoingclinical trials or may authorize trials only under specified terms. Such ahalt, called a clinical hold, continues in effect until and unless the FDA’sconcerns are adequately addressed. In 

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some cases, clinical holdsare never lifted. Imposition by the FDA of a clinical hold can delay orpreclude further product development. The IND process may be extremely costlyand may substantially delay product development.

Clinical trialsmust be sponsored and conducted in accordance with good clinical practice, orGCP, requirements and under protocols and methodologies that, among otherthings:

·       ensurereceipt from participants of signed consents that inform them of risks;

·       detailthe protocol and objectives of the study;

·       detailthe parameters to be used to monitor safety; and

·       detailthe efficacy criteria to be evaluated.

Furthermore, each clinical study must be conductedunder the supervision of a principal investigator operating under the auspicesof an institutional review board, or IRB, at the institution where the study isconducted. The IRB must review and approve the plan for any clinical trialbefore it commences at that institution and it must monitor the study until itis completed. The IRB will consider, among other things, ethical factors, thesafety of human subjects and the possible liability of the institution.Sponsors, investigators and IRB members are obligated to avoid conflicts ofinterests and ensure compliance with all legal requirements. The FDA, the IRBor the sponsor may suspend or discontinue a clinical trial at any time onvarious grounds, including potential health risks to study subjects.

Clinical trials are conducted in accordance withprotocols that detail the objectives of the study, the parameters to be used tomonitor safety and the efficacy criteria to be evaluated. Each protocol issubmitted to the FDA as part of the IND, and the FDA must grant permissionbefore each clinical trial may begin. Clinical trials typically are conductedin three sequential phases that may overlap. In Phase I, the initialintroduction of the drug into a small number of healthy volunteers, the drug isevaluated for safety by assessing the adverse effects, dosage tolerance,metabolism, distribution, excretion and clinical pharmacology. The Phase Itrial must provide pharmacological data that is sufficient to devise the PhaseII trials.

Phase II trialsinvolve a limited patient population in order to:

·       obtaininitial indications of the efficacy of the drug for specific, targetedindications;

·       determinedosage tolerance and optimal dosage; and

·       identifypossible adverse affects and safety risks.

When a compound is determined preliminarily to beeffective and to have an acceptable safety profile in Phase II evaluation,Phase III trials—commonly referred to as pivotal studies—can be undertaken toevaluate safety and efficacy endpoints further in expanded and diverse patientpopulations at geographically dispersed clinical trial sites. Positive resultsin Phase I or II are not necessarily predictive of positive results in PhaseIII. In our case, our positive results from the Phase II clinical trial ofmilnacipran are no guarantee of positive results in our current or future PhaseIII trials. To prepare for our Phase III clinical program and before commencingthe first pivotal clinical trial, we completed a special protocol assessment,or SPA, with the FDA. During the SPA process, the FDA requested that we provideadditional information, including information regarding our statisticalanalysis plan. We have responded to the FDA’s request. In the SPA process, theFDA reviews the proposed Phase III program and provides comments regarding theadequacy of the design and size of a proposed clinical trial to support claimsof effectiveness in an approvable NDA. These FDA comments are binding on thereview decision of the FDA, except in limited circumstances, such as when asubstantial scientific issue essential to determining the safety oreffectiveness of a drug is identified after the Phase III program subject tothe SPA commences.

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The results of the pharmaceutical development,preclinical studies and clinical trials, together with detailed information onthe manufacture and composition of the product, are submitted to the FDA in theform of an NDA, which must be complete, accurate and in compliance with FDAregulations. Once the submission has been accepted for filing by the FDA, aprocess that may take up to 60 days after submission, by law the FDA has180 days to review the application and respond to the applicant. Thereview process is often significantly extended by FDA requests for additionalinformation or clarification. The FDA may deny an NDA filed by us or ourcollaborators if the applicable scientific and regulatory criteria are notsatisfied, or it may require additional clinical data and/or an additional pivotaltrial. Moreover, data obtained from clinical trials are not always conclusiveand may be susceptible to varying interpretations that could delay, limit orprevent regulatory approval. The approval of an NDA permits commercial-scalemanufacturing, marketing, distribution and sale of the drug in the UnitedStates and, with some limitations, export from the United States. Uponapproval, a drug may only be marketed in those dosage forms, for thoseindications and subject to those limitations approved in the NDA. Moreover,after approval, the FDA may require additional post-approval testing,surveillance and reporting to monitor the products. Thus, even if approval fora drug is granted, it can be limited or revoked if evidence subsequentlyemerges casting doubt on the safety or efficacy of a product or if themanufacturing facility, processes or controls do not comply with regulatoryrequirements. Finally, an approval may entail limitations on the uses,labeling, dosage forms, distribution and packaging of the product.

Among the conditions for new drug approval is therequirement that the prospective manufacturer’s quality control, recordkeeping, notifications and reporting and manufacturing systems conform to theFDA’s cGMP regulations. To obtain approval, the drug manufacturing facilitymust be registered with the FDA and must pass a pre-approval inspectiondemonstrating compliance with cGMP requirements. If milnacipran iscommercialized in the United States, Pierre Fabre’s facility will need to beinspected by the FDA for compliance with cGMP requirements. Manufacturingestablishments also are subject to periodic, ongoing compliance inspections. Incomplying with the standards contained in these regulations, manufacturers mustcontinue to expend time, money, resources and effort in order to ensurecompliance. Failure to comply with these requirements can result in legal orregulatory action, including warning letters, suspension of manufacture,product seizure or recalls, injunctive action or civil or criminal penalties.

The FDA closely regulates the post-approval marketingand promotion of drugs, including standards and regulations fordirect-to-consumer advertising, off-label promotion, industry sponsoredscientific and educational activities and promotional activities involving theInternet. Failure to comply with these requirements can result in adversepublicity, warning letters, corrective advertising and potential civil andcriminal penalties.

Outside the United States, our ability to market aproduct is contingent upon receiving a marketing authorization from theappropriate regulatory authority. This foreign regulatory approval processincludes many of the same steps associated with FDA approval described above.

In addition to regulations enforced by the FDA, we areand will be subject to regulation under the Occupational Safety and Health Act,the Environmental Protection Act, the Toxic Substances Control Act, theResource Conservation and Recovery Act and other present and future federal,state or local regulations. Our research and development activities involve thecontrolled use of hazardous materials, chemicals and various radioactivecompounds. Although we believe that the safety procedures used by third partiesfor handling and disposing of these materials comply with the standardsprescribed by state and federal regulations, the risk of accidentalcontamination or injury from these materials cannot be completely eliminated.In the event of an accident, we could be liable for any damages that result.

Theapproval process for milnacipran or any of our future products is expensive,time consuming and uncertain, and any applicable regulatory agency may notgrant marketing approval. We may not have 

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sufficient resources to complete the required testingand regulatory review processes. Furthermore, we are unable to predict theextent of adverse governmental regulation, which might arise from future UnitedStates or foreign legislative or administrative action.

**Competition**

We are currently focusing on developing milnacipran totreat patients with FMS. Currently, there are no approved treatmentsspecifically for FMS in the United States or elsewhere. As a result, the firstoption for treatment of FMS is physical therapy, followed by analgesics toattempt to alleviate the pain. If the analgesics do not alleviate the pain,then muscle relaxants and antidepressants are often prescribed. TCAs, which areavailable in inexpensive generic formulations, are currently viewed as thedrugs of choice in treating FMS. We are also focusing on the development ofproducts for the treatment of patients with Functional Somatic Syndromes.

Preliminary clinical trials have been conducted byother pharmaceutical companies for the treatment of FMS. In particular,Pfizer Inc. has publicly disclosed that it has conducted a Phase IIclinical trial evaluating the efficacy and safety of its compound, pregabalin,as a treatment for FMS. In addition, Eli Lilly and Company has publiclydisclosed that it has conducted two Phase II clinical trials evaluating theefficacy and safety of its compound, duloxetine, as a treatment for FMS. Themarket potential for Functional Somatic Syndromes, including FMS, isconsiderable and a number of pharmaceutical companies focused on therapies foralleviating pain or antidepressant therapies could decide to evaluate theircurrent product candidates for the treatment of Functional Somatic Syndromes,including FMS, at any time. Due to the high incidence of Functional SomaticSyndromes, including FMS, we anticipate that most, if not all, of the majorpharmaceutical companies will have significant research and product developmentprograms in these areas. We expect to encounter significant competition both inthe United States and in foreign markets for each of the drugs we seek todevelop.

Our competitors include fully-integratedpharmaceutical and biotechnology companies both in the United States and inforeign markets which have expertise in research and development, manufacturingprocesses, testing, obtaining regulatory clearances and marketing, and may havefinancial and other resources significantly greater than we do. Smallercompanies may also prove to be significant competitors. Academic institutions,United States and foreign government agencies and other public and privateresearch organizations conduct research relating to Functional SomaticSyndromes, including FMS, and may develop products for the treatment of thesediseases that compete directly with any products we develop. Our competitorsmay compete with us for collaborations. These companies and institutions alsocompete with us in recruiting and retaining highly qualified scientificpersonnel.

Our competition will bepartially determined by the potential indications that are ultimately clearedfor marketing by regulatory authorities, the timing of any clearances andmarket introductions and whether any currently available drugs, or drugs underdevelopment by others, are effective in the same indications. Accordingly, therelative speed with which we can develop milnacipran or any of our futureproduct candidates, complete the clinical trials, receive regulatory clearanceand supply commercial quantities of the products to the market is expected tobe an important competitive factor. We expect that competition among productsapproved for sale will be based, among other things, on product efficacy,safety, reliability, availability and patent protection.

**Manufacturing and Supply**

Pursuant to the terms ofour purchase and supply agreement with Pierre Fabre, Pierre Fabre is theexclusive supplier to us and Forest Laboratories of the active pharmaceuticalingredient for milnacipran in exchange for a transfer price. ForestLaboratories has assumed the obligation to pay the transfer price directly toPierre Fabre. Currently, Pierre Fabre manufactures the active pharmaceuticalingredient for 

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milnacipranin its facility located in Gaillac, France. This facility will need to beinspected by the FDA. Due to the projected commercial quantities of milnacipranthat we may require and to provide a second manufacturing site, Pierre Fabrehas agreed that within a certain time period after commercial launch ofmilnacipran, it will qualify an additional manufacturing facility. In addition,because Pierre Fabre is our sole supplier of the active pharmaceuticalingredient for milnacipran and is currently the only supplier of the activepharmaceutical ingredient for milnacipran in the world, we have the right, butnot the obligation, to qualify us or Forest Laboratories as an additionalmanufacturing facility to manufacture the active pharmaceutical ingredient formilnacipran. We do not currently have this capability. In addition, we have theright to manufacture milnacipran if Pierre Fabre does not have the requiredbuffer stock or in the event that we terminate our license agreement withPierre Fabre under certain circumstances. Currently, we have contracted withPatheon Inc. to complete the manufacture process by encapsulating andpackaging milnacipran for our clinical trials. Forest Laboratories will beresponsible for future encapsulating and packaging at their Forest Irelandfacility.

**Employees**

As of February 28,2005, we employed 14 full-time employees. None of our employees are covered bya collective bargaining agreement. We believe that our relationship with ouremployees is good.

**The PROSORBA Column**

Prior to December 31,2000, we were engaged in the product development and marketing of the PROSORBAcolumn, a medical device, which was marketed for the treatment of rheumatoidarthritis and idiopathic thrombocytopenia purpura. In January 2001,Fresenius HemoCare, or Fresenius, purchased most of our assets related to thePROSORBA column. In February 2002, we amended certain provisions of ourlicense and distribution agreement with Fresenius. Under the terms of theamendment, the initial $8 million payment we received in January 2001was made non-refundable under any circumstances. The amendment also eliminatedthe payment from Fresenius to us of royalties on column sales in excess of10,000 units in any of the first five years of the agreement and eliminated allroyalties on sales beyond five years. A contingent payment is due to us on January 30,2008 in the amount of $1 million if sales during the first seven yearsexceed 35,000 units, $2 million if they exceed 50,000 units and none ifthe sales are less than 35,000 units. We are responsible for prosecuting andmaintaining the patents and trademarks related to the PROSORBA column. Inaddition, we agreed to indemnify Fresenius for any losses related to patent ortrademark infringement claims.

**Available Information**

Our website address is *www.cypressbio.com**.* We makeavailable free of charge through our website our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-Kand all amendments to those reports as soon as reasonably practicable aftersuch material is electronically filed with the Securities and ExchangeCommission.

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**RiskFactors**

***There are limited data regarding milnacipran as atreatment of FMS and it may not work for FMS or there may be safety issues withits use in this patient population.***

There are limited datasupporting the use of milnacipran, our only product candidate, for thetreatment of FMS. Although milnacipran is currently being sold by Pierre Fabreoutside North America as an antidepressant, it has only been tested as atreatment for FMS in our Phase II trial, during which milnacipran wasadministered to only 97 individuals with FMS. We must conduct and obtainfavorable results in at least two pivotal Phase III trials to support anapplication for FDA approval of the product candidate. We cannot predictwhether the results of our Phase II trial will be repeated in our Phase IIIclinical trials which have larger patient populations and are being conductedfor longer time periods. The FDA has never approved a drug for the treatment ofFMS. In addition, our future clinical trials may reveal that milnacipran is notsafe or that it is not effective for the treatment of FMS. If milnacipran isnot demonstrated to be a safe and effective treatment for FMS to thesatisfaction of the FDA or other regulatory agencies, we will not receiveregulatory approval and our business would be materially harmed.

***We are dependent on our collaboration with ForestLaboratories to develop and commercialize milnacipran, our only productcandidate, and to obtain regulatory approval. Events or circumstances may occurthat delay or prevent the development and commercialization of milnacipran.***

Pursuant to the terms of our collaboration agreementwith Forest Laboratories, we granted Forest Laboratories an exclusivesublicense for the development and marketing of milnacipran, our only product candidate,for all indications in the United States, with an option to extend theterritory to include Canada. In addition, Forest Laboratories has the option toacquire an exclusive license from us in the United States, and potentiallyCanada, to any compounds developed under our agreement with CollegiumPharmaceutical. Forest Laboratories is responsible for funding the developmentof milnacipran, including clinical trials and regulatory approval. In light ofthe increased expense and risk associated with running two parallel trials, weare discussing an alternative cost sharing arrangement with Forest Laboratoriesfor the second Phase III trial only and are currently working towardsformalizing an amendment to our agreement with Forest Laboratories. If the FDAapproves this product candidate, Forest Laboratories will also have primaryresponsibility for the marketing and sale of the approved product and willshare responsibility for compliance with regulatory requirements. We havelimited control over the amount and timing of resources that ForestLaboratories will dedicate to the development, approval and marketing ofmilnacipran. Our ability to generate milestone and royalty payments from ForestLaboratories depends on Forest Laboratories’ ability to establish the safetyand efficacy of milnacipran, obtain regulatory approvals and achieve marketacceptance of milnacipran for the treatment of FMS.

We are subject to anumber of additional risks associated with our dependence on our collaborationwith Forest Laboratories, including:

·       ForestLaboratories could delay the commencement of any additional clinical trials formilnacipran for the treatment of FMS, extend the timeframe of any clinicaltrials, including the second Phase III clinical trial for milnacipran,underfund such clinical trials, stop either phase III trial or any otherclinical trials for milnacipran or abandon development of milnacipran, repeator conduct additional clinical trials or require a new formulation ofmilnacipran for clinical testing;

·       Weand Forest Laboratories could disagree as to development plans, including thenumber and timing of clinical trials or regulatory approval strategy, or as towhich additional indications for milnacipran should be pursued, if any andtherefore, milnacipran may never be developed for any indications other thanFMS;

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·       ForestLaboratories could independently develop, develop with third parties or acquireproducts that could compete with milnacipran, including drugs approved forother indications used by physicians off-label for the treatment of FMS;

·       ForestLaboratories could fail to devote sufficient resources to the development,approval, commercialization, or marketing and distribution of any productsdeveloped under our collaboration agreement, including by failing to developspecialty sales forces if such sales forces are necessary for the mosteffective distribution of any approved product; and

·       Disputesregarding the collaboration agreement that delay or terminate the development,commercialization or receipt of regulatory approvals of milnacipran, delay orprevent the achievement of clinical or regulatory objectives that would resultin the payment of milestone payments or result in significant litigation orarbitration.

Furthermore, ForestLaboratories may terminate our collaboration agreement upon our material breachor our bankruptcy and may also terminate our agreement upon 120 days’notice in the event Forest Laboratories reasonably determines that thedevelopment program indicates issues of safety or efficacy that are likely toprevent or significantly delay the filing or approval of a new drug applicationor to result in labeling or indications that would significantly adverselyaffect the marketing of any product developed under the agreement. If any ofthese events occur, we may not be able to find another collaborator fordevelopment or commercialization, and if we elected to pursue furtherdevelopment and commercialization of milnacipran, we would experiencesubstantially increased capital requirements that we might not be able to fund.

***We rely upon an exclusive license from Pierre Fabre inorder to develop and sell our milnacipran product candidate, and our ability topursue the development and commercialization of milnacipran for the treatmentof FMS depends upon the continuation of our license from Pierre Fabre.***

Our license agreement withPierre Fabre provides us with an exclusive license to develop and sell anyproducts with the compound milnacipran as an active ingredient for any indicationin the United States and Canada, with a right to sublicense certain rights toForest Laboratories under our collaboration with Forest Laboratories. Either weor Pierre Fabre may terminate the license agreement for cause upon 90 days’prior written notice to the other party upon the bankruptcy or dissolution ofthe other party, or upon a breach of any material provision of the agreement ifthe breach is not cured within 90 days following the written notice.Furthermore, Pierre Fabre has the right to terminate the agreement upon90 days’ prior notice to us if we and our sub-licensees terminate ourdevelopment and marketing activities with respect to milnacipran, if wechallenge certain patent rights of Pierre Fabre and under specified othercircumstances. If our license agreement with Pierre Fabre were terminated, wewould lose our rights to develop and commercialize products using the compoundmilnacipran as an active ingredient, as the compound is manufactured underPierre Fabre patents and using Pierre Fabre know-how and trade secrets, and itwould be unlikely that we could obtain the active ingredient in milnacipranfrom any other source.

***We rely upon Pierre Fabre as our exclusive supplier ofthe compound used as the active ingredient in our milnacipran product candidateand if Pierre Fabre fails to supply us sufficient quantities of the activeingredient it may delay or prevent us from developing and commercializing ouronly product candidate.***

Pursuant to our purchase and supply agreement withPierre Fabre, Pierre Fabre is the exclusive supplier to us and ForestLaboratories of the compound used as the active pharmaceutical ingredient inour milnacipran product candidate. Neither we nor Forest Laboratories havefacilities for the manufacture of the product candidate. Currently, PierreFabre manufactures the active ingredient of milnacipran in its facility inGaillac, France and Pierre Fabre is the only worldwide supplier of the activeingredient of 

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milnacipran that iscurrently approved for sale as an antidepressant and sold in 32 countries, butis not approved for sale in the United States. If any product is commercializedunder the agreement, Pierre Fabre will have the exclusive right to manufacturethe active ingredient used in our commercial product. If milnacipran iscommercialized in the United States, Pierre Fabre’s facility will need to beinspected by the FDA for compliance with current good manufacturing practices,or cGMP, requirements. Due to the projected commercial quantities ofmilnacipran that we may require and to provide a second manufacturing site,Pierre Fabre has agreed that within a certain time period after commerciallaunch of milnacipran, it will qualify an additional manufacturing facility. Wedo not have control over Pierre Fabre’s compliance with cGMP requirements orPierre Fabre’s compliance with its obligation to qualify a second manufacturingfacility. If Pierre Fabre fails or is unable to provide, in a timely andeconomic manner, required quantities of the active ingredient that ForestLaboratories or we request for clinical purposes, our development program couldbe delayed. In addition, if Pierre Fabre fails to timely and economicallysupply us sufficient quantities for commercial sale, our product sales andmarket acceptance of the product could be adversely affected.

Furthermore, our purchaseand supply agreement may be terminated for cause either by us or by PierreFabre upon 90 days’ prior written notice to the other party upon amaterial breach of the agreement if the breach is not cured within 90 daysfollowing the written notice. We have the right to manufacture milnacipran ifPierre Fabre does not have a required buffer stock or in the event that weterminate our license agreement with Pierre Fabre under certain circumstances.If our purchase and supply agreement with Pierre Fabre is terminated, we areunlikely to be able to qualify another supplier of the active ingredient withina reasonable time period, and our ability to develop and commercializemilnacipran will be significantly impaired.

***Our agreements with Pierre Fabre and ForestLaboratories restrict our ability to develop specified compounds, which limitshow we can expand our product candidates.***

Under our agreements withPierre Fabre and Forest Laboratories, Forest Laboratories has agreed to payPierre Fabre and us a royalty, in the event that Forest Laboratories sells aproduct other than milnacipran for FMS for a specified period of time, whichshall not be less than three years. We are, in turn, obligated to pay a portionof the royalty we receive from Forest Laboratories to Pierre Fabre. Inaddition, each of us is subject to limitations related to each party’sdevelopment of any serotonin norephinephrine reuptake inhibitors, or SNRI,products other than milnacipran. These limitations include: (i) aprohibition on developing an SNRI product for specified indications for whichmilnacipran is being developed; and (ii) a prohibition on developing anSNRI product for any indication for a specified time period, and after suchspecified time period, a requirement that if one of the parties launches andsells an SNRI product that is prescribed off-label for any indication forwhich milnacipran is being developed, the selling party must reimburse theother parties for lost sales due to the off-label use.

***Provisions in our collaboration agreement with ForestLaboratories and our license agreement with Pierre Fabre may prevent or delay achange in control.***

Our collaboration agreement with Forest Laboratoriesprovides that Forest Laboratories may elect to terminate our co-promotionrights for milnacipran or any other product developed under the collaborationagreement and we may lose our decision making authority with respect to thedevelopment and marketing of milnacipran if we engage in a merger,consolidation or sale of all or substantially all of our assets, or if anotherperson or entity acquires at least 50% of our voting capital stock. Our licenseagreement with Pierre Fabre provides that Pierre Fabre may elect to terminatethe agreement upon a change in control transaction in which a third partyacquiror of us controls an SNRI product, and the acquiror does not take certainactions (e.g., divestiture of such SNRI product) within a specified time periodto cure the breach of certain restrictions in the agreement that results fromsuch SNRI product.

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If Forest Laboratoriesand/or Pierre Fabre elected to exercise these termination rights, we or oursuccessor could lose the ability to develop, commercialize and market milnacipran.These provisions may have the effect of delaying or preventing a change incontrol or a sale of all or substantially all of our assets, or may reduce thenumber of companies interested in acquiring us.

***We are at an early stage of development and we do nothave and may never develop any commercial drugs or other products that generaterevenues.***

We are at an early stageof development as a biotechnology company and do not have any commercialproducts. We have only one product candidate, milnacipran, which we sublicensedto Forest Laboratories in January 2004. Milnacipran, or any future productcandidates we may acquire or develop, will require significant additionaldevelopment, clinical trials, regulatory approvals and additional investmentbefore they can be commercialized. Our product development and productacquisition efforts may not lead to commercial drugs, either because theproduct candidates are not shown to be safe and effective in clinical trials,because we have inadequate financial or other resources to pursue clinicaldevelopment of the product candidate, or because the FDA does not grantregulatory approval. We do not expect milnacipran to be marketed for a numberof years, if at all. If we and Forest Laboratories are unable to develop milnacipranas a commercial drug in the United States and Canada, or if such development isdelayed, we will be unable to generate revenues, may be unsuccessful in raisingadditional capital, and may cease our operations.

***The FDA approval of milnacipran or any future productcandidate is uncertain and will involve the commitment of substantial time andresources.***

Even if our Phase III trials or any future clinicaltrials are successful, we may not receive required regulatory approval from theFDA or any other regulatory body required for the commercial sale ofmilnacipran in the United States. In addition, even if we do obtain approval tomarket milnacipran, the approval process by the FDA may take longer than weanticipate. The regulatory approval of a new drug typically takes many yearsand the outcome is uncertain. Despite the time and resources expended,regulatory approval is never guaranteed. If we fail to obtain regulatoryapproval for milnacipran or any future product candidates, we will be unable tomarket and sell any products and therefore may never generate any revenues fromproduct sales or become profitable. In addition, our collaborators, or ourthird party manufacturers’ failure to comply with the FDA and other applicableUnited States or foreign regulations may subject us to administrative orjudicially imposed sanctions, including warning letters, civil and criminalpenalties, injunctions, product seizure or detention, product recalls, total orpartial suspension of production and refusal to approve new drug approvalapplications.

As part of theregulatory approval process, we must conduct, at our own expense, preclinicalresearch and clinical trials for each product candidate sufficient todemonstrate its safety and efficacy to the satisfaction of the FDA and otherregulatory agencies in the United States and other countries where the productcandidate will be marketed if approved. The number of preclinical studies andclinical trials that will be required varies depending on the product, thedisease or condition that the product is in development for and the regulationsapplicable to any particular product. The regulatory process typically alsoincludes a review of the manufacturing process to ensure compliance withapplicable regulations and standards, including the cGMP requirements. The FDAcan delay, limit or decline to grant approval for many reasons, including:

·       aproduct candidate may not be safe or effective;

·       wemay not achieve statistical significance for the primary endpoint;

·       FDAofficials may interpret data from preclinical testing and clinical trials indifferent ways than we interpret such data;

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·       theFDA might not approve our manufacturing processes or facilities, or theprocesses or facilities of any future collaborators or contract manufacturers,including Pierre Fabre’s facility for the manufacture of the active ingredientin milnacipran; and

·       the FDA may change itsapproval policies or adopt new regulations.

***We have agreed to pay certain external expensesassociated with our second Phase III clinical trial evaluating milnacipran forFMS, currently being run by Forest Laboratories, and we may never be reimbursedfor these amounts.***

The amounts we are fundingfor external expenses for the second Phase III clinical trial evaluating milnacipranare only reimbursed to us by Forest Laboratories under specific scenarios wherethe second Phase III trial is used as one of the two required pivotal trials inthe New Drug Application (NDA) submission to the FDA. It is possible that thesecond Phase III trial may not be utilized as one of the pivotal trials in theNDA submission, and, in such event, we will not be reimbursed by ForestLaboratories for certain costs incurred in connection with the second Phase IIIclinical trial.

***If we receive regulatory approval for milnacipran orany other future product candidate, we will be subject to ongoing FDAobligations and continuing regulatory review.***

Any regulatory approvalsthat we or our collaborators receive for milnacipran or any future product candidateswill be limited to the indications, dosages and restrictions on the productlabel. We currently intend to seek approval for milnacipran in the treatment ofFMS. The FDA may not approve milnacipran for this indication at all, mayapprove milnacipran for a more limited indication, or may impose additionallimitations on the indicated uses or contain requirements for post-marketingsurveillance or the performance of potentially costly post-marketing studies.Even if we receive FDA and other regulatory approvals, milnacipran or any ofour other future product candidates may later exhibit adverse effects thatlimit or prevent their widespread use or that force us to withdraw thoseproduct candidates from the market. In our Phase II trial evaluating milnacipranfor the treatment of FMS, the most common dose-related side effects reported bypatients were nausea, particularly early in the study, as well as a slightincrease in heart rate. Any marketed product and its manufacturer continue tobe subject to strict FDA regulation after approval, including regulation ofproduct labeling and packaging, adverse event reporting, manufacture, storage,advertising, promotion and recordkeeping. Any unforeseen problems with anapproved product or any violation of regulations could result in restrictionson the product, including its withdrawal from the market.

***We rely on third parties to conduct all of ourclinical trials. If these third parties do not successfully carry out theircontractual duties or meet expected deadlines, we may not be able to obtainregulatory approval for or commercialize milnacipran or any of our other futureproduct candidates.***

As of February 28,2005, we have only 14 full-time employees. We have in the past and expect tocontinue to rely on third parties to conduct all of our clinical trials. We andForest Laboratories are using the services of Scirex, a contract researchorganization, to conduct the first Phase III trial with respect to milnacipran,and to assist in the conduct of the second Phase III trial with respect tomilnacipran. Because we do not conduct our own clinical trials, we must rely onthe efforts of others and cannot always control or predict accurately thetiming of such trials, the costs associated with such trials or the proceduresthat are followed for such trials. We do not anticipate significantlyincreasing our personnel in the foreseeable future and therefore, expect tocontinue to rely on third parties to conduct all of our future clinical trials.If these third parties do not successfully carry out their contractual dutiesor obligations or meet expected deadlines, or if the quality or accuracy of theclinical data they obtain is compromised due to their failure to adhere to ourclinical protocols or for other reasons, or if they fail to maintain compliancewith applicable government regulations and standards, our clinical trials maybe extended, delayed or 

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terminated,and we may not be able to obtain regulatory approval for or successfullycommercialize milnacipran or any of our other future product candidates.

***Even if our productcandidates are approved, the market may not accept these products.***

Evenif our product development efforts are successful and even if the requisiteregulatory approvals are obtained, milnacipran or any future product candidatesthat we may develop may not gain market acceptance among physicians, patients,healthcare payors and the medical community. The FDA has never approved a drugfor the treatment of FMS and we cannot predict whether milnacipran, if approvedfor this indication, will gain market acceptance. A number of additionalfactors may limit the market acceptance of products including the following:

·       timingof market entry relative to competitive products;

·       extentof marketing efforts by us and third-party distributors or agentsretained by us;

·       rateof adoption by healthcare practitioners;

·       rateof a product’s acceptance by the target community;

·       availabilityof alternative therapies;

·       priceof our product relative to alternative therapies;

·       availabilityof third-party reimbursement; and

·       theprevalence or severity of side effects or unfavorable publicity concerning ourproducts or similar products.

If milnacipran or anyfuture product candidates that we may develop do not achieve market acceptance,we may lose our investment in that product candidate, which may cause our stockprice to decline.

***Our competitors maydevelop and market products that are less expensive, more effective or safer,which may diminish or eliminate the commercial success of any products we maycommercialize.***

The biotechnology marketis highly competitive. Large pharmaceutical and biotechnology companies havedeveloped or are attempting to develop products that will compete with anyproducts we may develop to target Functional Somatic Syndromes***,*** such as FMS, or other centralnervous system disorders. In particular, Pfizer, Inc. has publiclydisclosed that it has conducted a Phase II clinical trial evaluating theefficacy and safety of its compound, pregabalin, as a treatment for FMS. Inaddition, Eli Lilly and Company has publicly disclosed that it has conductedtwo Phase II clinical trials evaluating the efficacy and safety of itscompound, duloxetine, as a treatment for FMS. Duloxetine is a serotoninnorepinephrine reuptake inhibitor, and as a dual reuptake inhibitor istherefore similar in pharmacology to milnacipran, which is a norepinephrineserotonin reuptake inhibitor. Based on the similar pharmacology, it isanticipated that duloxetine, which is currently approved but not yet availablefor the treatment of depression, will receive some off-label use for thetreatment of FMS. TCAs, which are inexpensive generic formulations, arecurrently viewed as the drugs of choice in treating FMS.

It is possible that our competitorswill develop and market products for FMS prior to us and that are lessexpensive and more effective than milnacipran or any of our future products orthat will render milnacipran or any other of our products obsolete. We alsoexpect that, in the treatment of Functional Somatic Syndromes and other centralnervous system disorders, competition from other biopharmaceutical companies,pharmaceutical companies, universities and public and private researchinstitutions will increase. Many of these competitors have substantiallygreater financial resources, technical expertise, research capabilities andother resources than we do. We may not have the financial resources, technicalexpertise or marketing, distribution or support capabilities to compete successfully.

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***We have the right to co-promote milnacipran, but we donot have the marketing, sales or distribution experience or capabilities.***

Our ability to co-promoteany product developed under our agreement with Forest Laboratories is subjectto our building our own marketing and sales capabilities, and we currently donot have the ability to directly sell, market or distribute any product. Inaddition, in the event our agreement with Forest Laboratories is terminated orwith respect to any other product we may develop that is not covered by ourcollaboration with Forest Laboratories, we would have to obtain the assistanceof a pharmaceutical company or other entity with a large distribution systemand a large direct sales force or build a substantial marketing and sales forcewith appropriate technical expertise and supporting distribution capabilities.We may not be able to enter into such arrangements with third parties in atimely manner or on acceptable terms or establish sales, marketing and distributioncapabilities of our own. To the extent that we enter into co-promotion or otherlicensing arrangements, our product revenues are likely to be lower than if wedirectly marketed and sold our products, and any revenues we receive willdepend upon the efforts of third parties, which efforts may not be successful.

***We are subject to uncertainty relating to health carereform measures and reimbursement policies which, if not favorable to ourproduct candidates, could hinder or prevent our product candidate’s commercializationsuccess.***

The continuingefforts of the government, insurance and management care organizations andother health care payors to contain or reduce prescription drug costs mayadversely affect:

·       ourability to set a price we believe is fair for our products;

·       ourability to generate revenues and achieve or maintain profitability;

·       thefuture revenues and profitability of our potential customers, suppliers andcollaborators; and

·       theavailability of capital.

Successfulcommercialization of milnacipran in the United States will depend in part onthe extent to which government, insurance and management care organizations andother health care payors establish appropriate coverage and reimbursementlevels for the cost of our products and related treatments. Third-partypayors are increasingly challenging the prices charged for prescription drugs.Third-party payors are also encouraging the use of generic drugs. Thesetrends could influence health care purchases, as well as legislative proposalsto reform health care or reduce government insurance programs and result in theexclusion of our product candidates from coverage and reimbursement programs orlower the prices of our product candidates. Our revenues from the sale of anyapproved products could be significantly reduced as a result of these costcontainment measures and reforms.

***We rely on our employees and consultants for theirscientific and technical expertise in connection with our business operations.***

We rely significantly on the scientific and technicalexpertise of our employees and consultants to conduct our business. As of February 28,2005, we have only 14 full time employees and therefore, we rely heavily on ouremployees. In addition, because we have a small number of employees, we relymore on consultants than do other companies. If any of our relationships withour employees or consultants are terminated, we may lose access to scientificknowledge and expertise necessary for the research, development andcommercialization of milnacipran or any further products. We do not anticipatesignificantly increasing our personnel in the foreseeable future and therefore,we expect to continue to rely on consultants and our current employees forscientific and technical knowledge and expertise essential to our business.

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Our employment agreementwith our chief executive officer provides for “at will” employment, which meansthat he may terminate his services to us at any time. In addition, ourscientific advisors may terminate their services to us at any time.

***We have limited experience in identifying, completingand integrating acquisitions, including acquisitions of product candidates, andother targets, and we may incur unexpected costs and disruptions to ourbusinesses if we make mistakes in our selection of future acquisitions or failto integrate any future acquisitions.***

As part of ourstrategy, we are continuing to evaluate potential strategic transactions,including potential acquisitions of products, technologies and companies, inorder to expand our product pipeline. As we did with our in-licensing ofmilnacipran, we may seek to in-license compounds or acquire products orbusinesses. We have no agreements or understandings with respect to anyacquisitions. Future acquisitions, however, may expose us to operational andfinancial risks, including:

·       higherdevelopment costs than we anticipate;

·       higherthan expected acquisition and integration costs;

·       exposureto unknown liabilities of acquired intellectual property, compounds or products;

·       disruptionof our business and diversion of our management’s time and attention todeveloping acquired compounds or products;

·       incurrenceof dilutive issuances of securities or substantial debt to pay foracquisitions; and

·       impairmentof relationships with key collaborators, suppliers or customers of any acquiredbusinesses due to changes in management or ownership.

We also may devoteresources to potential strategic transactions that we never complete or mayfail to realize the anticipated benefit of any strategic transaction we docomplete. Finally, we may incur unexpected costs in connection with thedisposition of products or businesses, including our disposition of ourPROSORBA column for which we indemnified Fresenius HemoCare for any losses relatedto patent or trademark infringement claims.

***We may be subject to product liability claims thatcould cause us to incur liabilities beyond our insurance coverage.***

We plan to continueconducting clinical trials on humans using milnacipran, and the use ofmilnacipran may result in adverse effects. We cannot predict all possible harmor side effects that may result from the treatment of patients with milnacipranor any of our future products, and the amount of insurance coverage wecurrently hold may not be adequate to protect us from any liabilities. Wecurrently maintain $10,000,000 in insurance for product liability claims. Wemay not have sufficient resources to pay any liability resulting from such aclaim beyond our insurance coverage.

***We have a history of operating losses and we may neverbe profitable.***

We have incurredsubstantial losses during our history. For the years ended December 31,2004, 2003 and 2002, we incurred net losses of $11.2 million,$21.7 million and $1.0 million, respectively. As of December 31,2004, we had an accumulated deficit of $137.5 million. Our ability to becomeprofitable will depend upon our and Forest Laboratories’ ability to develop,market and commercialize milnacipran with sufficient sales volumes, and ourability to develop, market and commercialize any other products. We do notexpect to generate revenue from the sale of products for the next several yearsor become profitable in the foreseeable future and may never achieveprofitability.

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***We will need substantial additional funding and may beunable to raise capital when needed, which could force us to scale back ordiscontinue the completion of any proposed acquisitions or adversely affect ourability to realize the expected benefits of any completed acquisitions.***

We agreed to pay certainexpenses in connection with the second Phase III clinical trial for milnacipranin FMS. In addition, we will incur certain non-reimbursable expenses inconnection with the development of milnacipran. We will incur expenses inconnection with the evaluation of potential acquisitions or other strategictransactions and additional expenses in the event we close any suchtransactions. We do not have any committed external sources of funding and wewill likely need to raise additional capital through the sale of equity ordebt. The amount of capital we will require will depend upon many factors,including but not limited to, the evaluation and potential closing of anystrategic transactions and the development strategy for milnacipran. If we areunable to raise capital when we need it, we may have to scale back ordiscontinue the evaluation or completion of any proposed acquisitions orstrategic transaction(s).

***Raising additional funds by issuing securities or throughcollaboration and licensing arrangements may cause dilution to existingstockholders, restrict our operations or require us to relinquish proprietyrights.***

We will likely raiseadditional funds through public or private equity offerings, debt financings orcorporate collaborations and licensing arrangements. To the extent that weraise additional capital by issuing equity securities, our existingstockholders’ ownership percentage will be diluted. In addition, if we raiseadditional funds through collaborations and licensing arrangements, it may benecessary to relinquish potential valuable rights to our potential products onterms that are not favorable to us.

***We may lose our net operating loss carryforwards,which could prevent us from offsetting future taxable income.***

We have incurredsubstantial losses during our history and do not expect to become profitable inthe foreseeable future and may never achieve profitability. To the extent thatwe continue to generate taxable losses, unused losses will carry forward tooffset future taxable income, if any, until such unused losses expire. Allunused federal net operating losses will expire 15 or 20 years after anyyear in which they were generated. The carryforward period is 15 years forlosses incurred prior to 1998 and 20 years for losses incurred subsequentto 1997. Approximately $1.2 million in federal net operating losses expired in2004. Our California tax loss carryforwards will begin to expire in 2006.

***Our stock price will likely be volatile.***

The market pricesof the stock of technology companies, particularly biotechnology companies,have been highly volatile. For the period from January 1, 2002 through December 31,2004, the high and low closing sales prices for our common stock ranged from$1.00 to $16.05. Our stock price has been and will likely continue to beaffected by this type of market volatility, as well as by our own performance.The following factors, among other risk factors, may have a significant effecton the market price of our common stock:

·       theresults and timing of clinical trials for milnacipran;

·       developmentsin our relationship with Forest Laboratories;

·       developmentsin our relationship with Pierre Fabre;

·       ourentering into, or failing to enter into, an agreement for the acquisition ofany products or companies, or an agreement with any corporate collaborator;

·       ouravailable cash;

·       announcementsof technological innovations or new products by us or our competitors;

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·       developmentsin patent or other proprietary rights;

·       fluctuationsin our operating results;

·       litigationinitiated by or against us;

·       developmentsin domestic and international governmental policy or regulation; and

·       economic and other externalfactors or other disaster or crisis.

***The concentration of ownership among our existingofficers, directors and principal stockholders may result in the entrenchmentof management, prevent other stockholders from influencing significantcorporate decisions and depress our stock price.***

As of February 28,2005, our executive officers, directors and stockholders who hold at least 5%of our stock beneficially owned and controlled approximately 35% of ouroutstanding common stock. If these officers, directors and principalstockholders act together, they will be able to help entrench management and toinfluence significantly and possibly control matters requiring approval by ourstockholders, including a financing in which we sell more than 20% of ourvoting stock at a discount to the market price, the removal of any directors upfor election, the election of the members of our board of directors, mergers, asale of all or substantially all of our assets, going private transactions andother fundamental transactions. This concentration of ownership could alsodepress our stock price.

***We expect to continue incurring increased costs as aresult of recently enacted and proposed changes in laws and regulationsrelating to corporate governance matters.***

Recently enacted changesin the laws and regulations affecting public companies, including theprovisions of the Sarbanes-Oxley Act of 2002 and rules adopted bythe Securities and Exchange Commission and by the Nasdaq National Market, haveand we expect will continue to result in increased costs to us as we evaluatethe implications of these laws and regulations and respond to theirrequirements. In particular, our efforts to comply with Section 404 of theSarbanes-Oxley Act of 2002 and the related regulations regarding our requiredassessment of our internal controls over financial reporting and our externalauditors’ audit of that assessment has required the commitment of significantfinancial and managerial resources. We expect these efforts to require thecontinued commitment of significant financial resources and management time relatedto compliance activities. Additionally, these laws and regulations could makeit more difficult or costly for us to obtain certain types of insurance,including director and officer liability insurance, and we may be forced toaccept reduced policy limits and coverage or incur substantially higher coststo obtain the same or similar coverage. The impact of these events could alsomake it more difficult for us to attract and retain qualified persons to serveon our board of directors, our board committees or as executive officers.

**RisksRelated to Our Intellectual Property**

***We rely primarily on a method patent to protect ourproprietary technology for the development of milnacipran, and our ability tocompete may decrease or be eliminated if we are not able to protect ourproprietary technology.***

Our ability to compete may decrease or be eliminatedif we are not able to protect our proprietary technology. The composition ofmatter patent for milnacipran (U.S. Patent 4,478,836) expired in June 2002.Accordingly, we rely on the patent for the method of synthesis of milnacipran(U.S. Patent 5,034,541), which expires on December 27, 2009 and wasassigned to Pierre Fabre and licensed to us and on patents on the method of useof milnacipran to treat symptoms of FMS (U.S. Patent 6,602,911) and the methodof use of milnacipran to treat symptoms of chronic fatigue syndrome (U.S.Patent 6,635,675) issued to us, to protect our proprietary technology withrespect to the development of milnacipran. We 

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have also filed additionalpatent applications related to milnacipran and to the use of milnacipran forFMS (and other related pain syndromes and disorders), although no patents haveissued on these patent applications. Because there is limited patent protectionfor the composition of matter of milnacipran, other companies may be able tosell milnacipran in competition with us and Forest Laboratories unless we andForest Laboratories are able to obtain additional protection throughmilnacipran-related patents or additional use patents that may issue fromour pending patent applications or other regulatory exclusivity. It may be moredifficult to establish infringement of methods of synthesis, formulation or usepatents as compared to a patent on a compound. If we or Forest Laboratories arenot able to obtain and enforce these patents, a competitor could usemilnacipran for a treatment or use not covered by any of our patents.

We also expect to rely on the United States Drug PriceCompetition and Patent Term Restoration Act, commonly known as the Hatch-WaxmanAmendments, for protection of milnacipran or our other future products. TheHatch-Waxman Amendments provide data exclusivity for new molecularentities, such as that in milnacipran. Once a drug containing a new molecule isapproved by the FDA, the FDA cannot accept an abbreviated NDA for a genericdrug containing that molecule for five years, although the FDA may accept andapprove a drug containing the molecule pursuant to an NDA supported byindependent clinical data. Recent amendments have been proposed that wouldnarrow the scope of Hatch-Waxman exclusivity and permit generic drugs tocompete with our drug. After the Hatch-Waxman exclusivity period expires,assuming our patents are valid, we still expect to rely on our method of usepatents to protect our proprietary technology with respect to the developmentof milnacipran. The patent positions of pharmaceutical companies are uncertainand may involve complex legal and factual questions. We may incur significantexpense in protecting our intellectual property and defending or assessingclaims with respect to intellectual property owned by others. Any patent orother infringement litigation by or against us could result in significantexpense to us, including diversion of the resources of management.

Others may file patent applications or obtain patentson similar technology or compounds that compete with milnacipran for thetreatment of FMS. We cannot predict the breadth of claims that will be allowedand issued in patent applications. Once patents have issued, we cannot predicthow the claims will be construed or enforced. We may infringe on intellectualproperty rights of others without being aware of the infringement. If anotherparty claims we are infringing their technology, we could have to defend anexpensive and time consuming lawsuit, pay a large sum if we are found to beinfringing, or be prohibited from selling or licensing our products unless weobtain a license or redesign our product, which may not be possible.

We also rely on tradesecrets and proprietary know-how to develop and maintain our competitiveposition. Some of our current or former employees, consultants or scientificadvisors, or current or prospective corporate collaborators, mayunintentionally or willfully disclose our confidential information tocompetitors or use our proprietary technology for their own benefit.Furthermore, enforcing a claim alleging the infringement of our trade secretswould be expensive and difficult to prove, making the outcome uncertain. Ourcompetitors may also independently develop similar knowledge, methods andknow-how or gain access to our proprietary information through some othermeans.

***Our ability to compete may decline if we do notadequately protect our proprietary rights.***

Our commercial success depends on obtaining andmaintaining proprietary rights to our product candidates and technologies andtheir uses as well as successfully defending these rights against third partychallenges. We will only be able to protect our product candidates, proprietarytechnologies and their uses from unauthorized use by third parties to theextent that valid and enforceable patents or effectively-protected tradesecrets cover them.

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Our ability toobtain patent protection for our products and technologies is uncertain due toa number of factors, including:

·       wemay not have been the first to make the inventions covered by our pendingpatent applications or issued patents;

·       wemay not have been the first to file patent applications for our productcandidates or the technologies we rely upon;

·       othersmay independently develop similar or alternative technologies or duplicate anyof our technologies;

·       ourdisclosures in patent applications may not be sufficient to meet the statutoryrequirements for patentability;

·       anyor all of our pending patent applications may not result in issued patents;

·       wemay not seek or obtain patent protection in all countries that will eventuallyprovide a significant business opportunity;

·       anypatents issued to us or our collaborators may not provide a basis forcommercially viable products, may not provide us with any competitiveadvantages or may be challenged by third parties;

·       someof our proprietary technologies may not be patentable;

·       othersmay design around our patent claims to produce competitive products which falloutside of the scope of our patents; or

·       othersmay identify prior art which could invalidate our patents.

Even if we obtain patents covering our productcandidates or technologies, we may still be barred from making, using andselling our product candidates or technologies because of the patent rights ofothers. Others may have filed and in the future are likely to file patentapplications covering compounds, assays, genes, gene products or therapeuticproducts that are similar or identical to ours. Numerous U.S. and foreignissued patents and pending patent applications owned by others exist in thearea of central nervous system disorders and the other fields in which we aredeveloping products. These could materially affect our ability to develop ourproduct candidates or sell our products. Because patent applications can takemany years to issue, there may be currently pending applications, unknown tous, which may later result in issued patents that our product candidates ortechnologies may infringe. These patent applications may have priority overpatent applications filed by us. Disputes may arise regarding the ownership orinventorship of our inventions. It is difficult to determine how such disputeswill be resolved. Others may challenge the validity of our patents. If ourpatents are found to be invalid we will lose the ability to exclude others frommaking, using or selling the inventions claimed therein.

Some of our research collaboratorsand scientific advisors have rights to publish data and information to which wehave rights. If we cannot maintain the confidentiality of our technology andother confidential information in connection with our collaborations, then ourability to receive patent protection or protect our proprietary informationwill be impaired. In addition, in-licensed technology is important to ourbusiness. We generally will not control the patent prosecution, maintenance orenforcement of in-licensed technology.

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***A dispute concerning the infringement ormisappropriation of our proprietary rights or the proprietary rights of otherscould be time consuming and costly and an unfavorable outcome could harm ourbusiness.***

There issignificant litigation in the industry regarding patent and other intellectualproperty rights. We may be exposed to future litigation by third parties basedon claims that our product candidates, technologies or activities infringe theintellectual property rights of others. If our drug development activities arefound to infringe any such patents, we may have to pay significant damages.There are many patents relating to chemical compounds and the uses thereof. Ifour compounds are found to infringe any such patents, we may have to pay significantdamages. A patentee could prevent us from making, using or selling the patentedcompounds. We may need to resort to litigation to enforce a patent issued tous, protect our trade secrets or determine the scope and validity of thirdparty proprietary rights. From time to time, we may hire scientific personnelformerly employed by other companies involved in one or more areas similar tothe activities conducted by us. Either we or these individuals may be subjectto allegations of trade secret misappropriation or other similar claims as aresult of their prior affiliations. If we become involved in litigation, itcould consume a substantial portion of our managerial and financial resources,whether we win or lose. We may not be able to afford the costs of litigation.Any legal action against our company or our collaborators could lead to:

·       paymentof damages, potentially treble damages, if we are found to have willfullyinfringed such parties’ patent rights;

·       injunctiveor other equitable relief that may effectively block our ability to furtherdevelop, commercialize and sell products; or

·       weor our collaborators having to enter into license arrangements that may not beavailable on commercially acceptable terms, if at all.

As a result, we could beprevented from commercializing current or future products.

***The patent applications of pharmaceutical andbiotechnology companies involve highly complex legal and factual questions,which could negatively impact our patent position.***

The patent positions of pharmaceutical andbiotechnology companies can be highly uncertain and involve complex legal andfactual questions. The United States Patent and Trademark Office’s standardsare uncertain and could change in the future. Consequently, the issuance andscope of patents cannot be predicted with certainty. Patents, if issued, may bechallenged, invalidated or circumvented. United States patents and patentapplications may also be subject to interference proceedings and United Statespatents may be subject to reexamination proceedings in the United States Patentand Trademark Office (and foreign patents may be subject to opposition orcomparable proceedings in the corresponding foreign patent office), whichproceedings could result in either loss of the patent or denial of the patentapplication or loss or reduction in the scope of one or more of the claims ofthe patent or patent application. In addition, such interference, reexaminationand opposition proceedings may be costly. Accordingly, rights under any issued patentsmay not provide us with sufficient protection against competitive products orprocesses.

In addition, changes in or different interpretationsof patent laws in the United States and foreign countries may permit others touse our discoveries or to develop and commercialize our technology and productswithout providing any compensation to us. The laws of some countries do notprotect intellectual property rights to the same extent as United States lawsand those countries may lack adequate rules and procedures for defendingour intellectual property rights. For example, some countries, including manyin Europe, do not grant patent claims directed to methods of treating humans,and in these countries patent protection may not be available at all to protectour product candidates.

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If we fail to obtain andmaintain patent protection and trade secret protection of our productcandidates, proprietary technologies and their uses, we could lose ourcompetitive advantage and competition we face would increase, reducing ourpotential revenues and adversely affecting our ability to attain or maintainprofitability.

**ITEM 2.**                     Properties

We currently occupyapproximately 5,200 square feet of leased office space in San Diego, California.The San Diego facility houses our executive and administrative offices. Thelease for this facility expires in July 2007 and contains monthly rentalpayments ranging from $13,465 to $15,753 over the lease term.

**ITEM 3.**                     LegalProceedings

From time to time, in thenormal course of business, we are involved in litigation arising out of ouroperations. We are not currently engaged in any legal proceedings that weexpect would materially harm our business or financial condition.

**ITEM 4.**                     Submissionof Matters to a Vote of Security Holders

No matter was submitted to a vote of security holdersduring the fourth quarter of the fiscal year ended December 31, 2004.

Ourexecutive officers are as follows:
| **NAME**                          | ** ** | ** ** | ** ** | ** **                                                        | **AGE** | ** ** | ** ** | **POSITION** |
|-----------------------------------|------------|------------|------------|-------------------------------------------------------------------|---------|------------|------------|--------------|
| Jay D. Kranzler, M.D.,  Ph.D.(1)  |       | 47         |       | Chief Executive Officer  and Chairman of the Board of Directors   |
| Sabrina Martucci Johnson          |       | 38         |       | Chief Financial Officer and Vice President                        |
| R. Michael Gendreau,  M.D., Ph.D. |       | 49         |       | Vice President of  Clinical Development and Chief Medical Officer |
| Denise L. Woolard                 |       | 35         |       | Vice President of  Business and Legal Affairs                     |

 

***JAY D. KRANZLER,M.D., Ph.D.,*** was appointed as our Chief Executive Officerand Vice-Chairman in December 1995. In April 1998, Dr. Kranzlerwas appointed as Chairman of the Board. From January 1989 until August 1995,Dr. Kranzler served as President, Chief Executive Officer and a directorof Cytel Corporation, a publicly held biotechnology company. Dr. Kranzlerhas been an adjunct member of the Research Institute of Scripps Clinic since January 1989.Before joining Cytel, from 1985 to January 1989, Dr. Kranzler wasemployed by McKinsey & Company, a management-consulting firm, asa consultant specializing in the pharmaceutical industry. Dr. Kranzler hasan M.D. with a concentration in psychiatry and a Ph.D. in pharmacology fromYale University. He graduated summa cum laude from Yeshiva University.

***SABRINA MARTUCCI JOHNSON***was appointed as our interim Chief Financial Officer in February 2002and in April 2002, she was appointed as our Vice President and ChiefFinancial Officer. Ms. Johnson served as our Vice President of Marketingfrom March 2001 to April 2002. Ms. Johnson joined us in August of1998 and held various positions from 1998 through 2000, including ProductDirector, Executive Director of Marketing and Sales, and Vice President ofMarketing and Sales. From 1993 to 1998, Ms. Johnson held marketing andsales positions with Advanced Tissue Sciences and Clonetics. Ms. Johnsonbegan her career in the biotechnology industry in 1990 as a research scientistwith Baxter Healthcare, Hyland Division. Ms. Johnson has an MBA from theAmerican Graduate School of International Management (Thunderbird), a MSc. inBiochemical Engineering from the University of London and a BSc. in biomedicalengineering from Tulane University.

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***R. MICHAEL GENDREAU,M.D., Ph.D.,*** was appointed as our Vice President ofResearch and Development and Chief Medical Officer in December 1996 and iscurrently serving as the Vice President of Clinical Development and ChiefMedical Officer. Dr. Gendreau joined us in 1994 and held various positionsfrom 1994 through 1996, including Executive Director of Scientific Affairs.From 1991 to 1994, Dr. Gendreau was Vice President of Research andDevelopment and Chief Medical Officer for MicroProbe Corporation, a developerand manufacturer of DNA probe-based diagnostic equipment. Dr. Gendreauhas a B.S. in chemistry from Ohio University and an M.D./Ph.D. in medicine andpharmacology from the Ohio State University.

***DENISE L. WOOLARD***was appointed as our Vice President of Business and Legal Affairs and CorporateSecretary in February 2004. Prior to joining us, from September 1997until January 2004, Ms. Woolard worked as a corporate attorney at thelaw firm of Cooley Godward LLP. Ms. Woolard has a B.A. from Old DominionUniversity and a J.D. from the University of San Diego, School of Law.

 

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**PART II**

**ITEM 5.**                     Marketfor our Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities

Ourcommon stock is traded on the Nasdaq National Market under the symbol “CYPB”.Prior to March 1, 2004, our stock was traded on the Nasdaq SmallCapMarket. Set forth below are the high and low closing sales prices for ourcommon stock for the periods indicated as reported on the Nasdaq NationalMarket and the Nasdaq SmallCap Market, as applicable.
| ** **                              | ** ** | **Price Range of  Common Stock** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **High**                                        | ** ** | **Low** | ** ** |
| **Year  Ended December 31, 2004:** |       |                                            |       |   |   |
| First Quarter                           |       | $                                               | 15.71      |   | $ | 10.94 |   |
| Second Quarter                          |       | 16.05                                           |       | 11.92 |   |
| Third Quarter                           |       | 13.67                                           |       | 8.94 |   |
| Fourth Quarter                          |       | 14.06                                           |       | 9.28 |   |
| **Year Ended December 31, 2003:**  |       |                                            |       |   |   |
| First Quarter                           |       | $                                               | 3.25       |   | $ | 2.30 |   |
| Second Quarter                          |       | 5.57                                            |       | 2.20 |   |
| Third Quarter                           |       | 8.66                                            |       | 4.27 |   |
| Fourth Quarter                          |       | 15.19                                           |       | 8.02 |   |

 

As of March 1, 2005,there were approximately 750 holders of record of our common stock. On March 10,2005, the last reported sale price of our common stock on the Nasdaq NationalMarket was $10.10 per share. We have never paid any cash dividends on ourcommon stock, and we do not anticipate paying any cash dividends in theforeseeable future as we intend to retain any earnings for use in our business.

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**ITEM 6.**                     SelectedFinancial Data

The followingtable presents our selected financial data, which is derived from our auditedfinancial statements. The information set forth below is not indicative of theresults of future operations, particularly because we changed our businessfocus in 2001, and should be read in conjunction with “Management’s Discussionand Analysis of Financial Condition and Results of Operations” in Item 7 ofthis report and the financial statements and the related notes thereto includedin this Form 10-K.
| ** **                                                          | ** ** | **YEARS ENDED DECEMBER 31,** | ** **  |
|---------------------------------------------------------------------|------------|-----------------------------------|-------------|
| ** **                                                          | ** ** | **2004**                          | ** **  | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Statement  of Operations Data:**                                  |       |                              |        |   |   |   |   |   |   |   |   |
| Revenues:                                                           |       |                              |        |   |   |   |   |   |   |   |   |
| Revenues under collaborative agreement                              |       | $                                 | 14,414,619  |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Revenue from Fresenius agreement                                    |       | —                            |        | — |   | 6,400,000 |   | 1,600,000 |   | 2,975,208 |   |
|                                                                |       | 14,414,619                        |        | — |   | 6,400,000 |   | 1,600,000 |   | 2,975,208 |   |
| Costs and  expenses:                                                |       |                              |        |   |   |   |   |   |   |   |   |
| Production costs                                                    |       | —                            |        | — |   | — |   | — |   | 426,971 |   |
| Sales and marketing                                                 |       | —                            |        | — |   | — |   | — |   | 5,922,706 |   |
| Research and development                                            |       | 15,201,192                        |        | 11,443,693 |   | 5,094,079 |   | 3,677,544 |   | 1,880,086 |   |
| General and administrative                                          |       | 5,732,641                         |        | 4,120,156 |   | 2,985,862 |   | 4,281,283 |   | 3,082,877 |   |
| Non-cash compensation charges                                       |       | 6,479,308                         |        | 416,659 |   | 222,377 |   | 194,493 |   | 248,992 |   |
| Compensation expense (benefit)—variable stock  options         |       | (699,033                          | )           | 5,879,277 |   | (688,376 | ) | 784,874 |   | — |   |
|                                                                |       | 26,714,108                        |        | 21,859,785 |   | 7,613,942 |   | 8,938,194 |   | 11,561,632 |   |
| Other income  (expense):                                            |       |                              |        |   |   |   |   |   |   |   |   |
| Interest income                                                     |       | 1,092,404                         |        | 121,679 |   | 199,678 |   | 434,363 |   | 633,523 |   |
| Interest expense                                                    |       | (5,826                            | )           | (9,097 | ) | (33,529 | ) | (273,083 | ) | (549,125 | ) |
| Gain (loss) on disposal of assets                                   |       | (2,095                            | )           | 4,931 |   | (1,090 | ) | (16,714 | ) | — |   |
|                                                                |       | 1,084,483                         |        | 117,513 |   | 165,059 |   | 144,566 |   | 84,398 |   |
| Net loss                                                            |       | $                                 | (11,215,006 | ) | $ | (21,742,272 | ) | $ | (1,048,883 | ) | $ | (7,193,628 | ) | $ | (8,502,026 | ) |
| Net loss per share—basic and diluted                           |       | $                                 | (0.40       | ) | $ | (1.21 | ) | $ | (0.09 | ) | $ | (1.15 | ) | $ | (1.40 | ) |
| Shares used in computing net loss per share—basic  and diluted |       | 27,764,975                        |        | 17,924,353 |   | 11,572,101 |   | 6,249,917 |   | 6,052,905 |   |

 

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| ** **                                         | ** ** | **DECEMBER 31,** | ** **  |
|----------------------------------------------------|------------|-----------------------|-------------|
| ** **                                         | ** ** | **2004**              | ** **  | **          2003          ** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Balance Sheet Data:**                            |       |                  |        |   |   |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term investments |       | $                     | 112,023,998 |   |   | $ | 23,524,646 |   |   | $ | 12,209,383 |   | $ | 5,867,083 |   | $ | 7,102,317 |   |
| Total assets                                       |       | 118,389,524           |        |   | 23,806,681 |   |   | 12,477,519 |   | 6,685,108 |   | 7,891,271 |   |
| Long-term debt  (net of current portion)           |       | 20,848                |        |   | 36,870 |   |   | 51,344 |   | — |   | 563,688 |   |
| Deferred revenue  (net of current portion)         |       | 18,750,000            |        |   | — |   |   | — |   | 6,400,000 |   | — |   |
| Total  stockholders’ equity (deficit)         |       | 94,173,809            |        |   | 22,129,122 |   |   | 11,785,137 |   | (1,968,943 | ) | 4,099,228 |   |
| Working capital  (deficit)                         |       | 112,858,381           |        |   | 22,049,874 |   |   | 11,680,864 |   | (2,113,492 | ) | 4,520,806 |   |
|                                                    |            |                       |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM 7.**                     Management’sDiscussion and Analysis of Financial Condition and Results of Operations

**OVERVIEW**

We are committed to being the innovator and leader inproviding products for the treatment of patients with Functional SomaticSyndromes and other central nervous system disorders. Functional SomaticSyndromes refer to several related syndromes characterized more by symptoms,suffering and disability than by disease-specific abnormalities that arefound upon physical examination and include many overlapping pain andpsychiatric conditions such as Fibromyalgia Syndrome, or FMS, irritable bowelsyndrome, non-cardiac chest pain and interstitial cystitis, or chronic pelvicpain. Our goal is to be the first to commercialize a product approved in theUnited States for the treatment of FMS, the focus of our initial efforts in thearea of Functional Somatic Syndromes. In January 2004, we entered into acollaboration agreement with Forest Laboratories, Inc., a leading marketerof central nervous system drugs with a strong franchise in the primary care andpsychiatric markets, for the development and marketing of milnacipran. We arecurrently running the first Phase III trial for milnacipran, which wascommenced in October 2003. Enrollment in this trial was completed in December 2004,with results expected to be available in the Fall of 2005. In October 2004,Forest Laboratories initiated the second Phase III trial evaluating milnacipranfor the treatment of FMS. These two Phase III trials and any additional studiesneeded for regulatory approval could possibly be completed in 2006 and, ifsuccessful, a New Drug Application, or NDA, for FMS could possibly be submittedlater in that year at the earliest.

We completed a Phase II trial evaluating milnacipranfor the treatment of FMS in the Fall of 2002. The Phase II trial was a three-month,randomized, placebo-controlled study involving 14 sites and 125 FMSpatients who were randomized to either milnacipran treatment or placebo. Inthis clinical trial, milnacipran was shown to provide statistically significantimprovement in pain, the primary symptom of FMS. No unexpected safety concernsarose from this trial and there were no serious adverse events.

We obtained an exclusive license for milnacipran fromPierre Fabre Medicament in 2001. Milnacipran has been marketed outside of theUnited States since 1997 as an antidepressant and has been used by over3,000,000 patients worldwide. We have paid Pierre Fabre a total of$2.5 million, including upfront payments of $1.5 million in connectionwith the execution of the original license agreement in 2001 and a$1.0 million milestone payment in September 2003, and issued PierreFabre 1,000,000 shares of common stock and warrants to purchase 300,000 sharesof common stock in connection with an amendment to the agreement with PierreFabre. Additional payments to Pierre Fabre of up to a total of$4.5 million will be due to Pierre Fabre based on meeting certain clinicaland regulatory milestones. Under our agreement with Forest Laboratories, wesublicensed our rights to milnacipran to Forest Laboratories for the UnitedStates, with an option to extend the territory to include Canada. Additionally,Forest Laboratories assumed responsibility for funding all continuingdevelopment of milnacipran, including the funding of clinical trials andregulatory approval, as well as a specified number of our employees. However,in light of the increased expense and risk associated with running two paralleltrials, we are discussing an alternative cost sharing arrangement with ForestLaboratories for the second Phase III trial only and are currently workingtowards formalizing an amendment to our agreement with Forest Laboratories. Inconnection with these discussions, the amount of funding that we receive fromForest Laboratories for certain of our employees has been eliminated as of thefourth quarter in 2004, and we will pay for a majority of the external costs ofthe second Phase III trial only, with Forest reimbursing us under specificscenarios where the second Phase III trial is used as one of the two requiredpivotal trials in the NDA submission to the FDA and with a premium undercertain additional circumstances. Forest Laboratories will also be responsiblefor sales and marketing activities related to any product developed under theagreement, while we have the option to co-promote using our own sales force upto 25% of the total physician details and would be reimbursed by Forest in anamount equal to Forest’s cost of providing the equivalent detailing calls.

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In August 2002, we entered into a reformulationand new product agreement with Collegium Pharmaceutical, Inc. pursuant towhich Collegium is attempting to develop new formulations of milnacipran andnew products that are analogs of milnacipran. In January 2004, weexercised our option to acquire an exclusive license to technology developedunder this agreement. In the event we commercialize any of the reformulationsor new products developed under our agreement with Collegium, we will beobligated to pay Collegium milestone payments of up to $5.4 million in theaggregate upon achievement of defined clinical and regulatory objectives, aswell as potential royalty payments based on the net sales of reformulated ornew products. In October 2002, we also entered into a common stockissuance agreement with Collegium, pursuant to which Collegium may elect to beissued shares of our common stock, subject to certain conditions, in lieu ofcash, for milestone payments.

We are continuing to evaluate other various potentialstrategic transactions, including the potential acquisitions of products,technologies and companies, and other alternatives that we believe may enhancestockholder value.

As of December 31,2004, we had working capital of approximately $112.9 million and anaccumulated deficit of approximately $137.5 million. Our future successdepends on our ability to develop and market new products for the treatment ofFunctional Somatic Syndromes, such as FMS, and other central nervous system disorders.

**Results of Operations**

***Comparison of Years Ended December 31, 2004 and2003***

***Revenues***

We recognized revenues under our collaborativeagreement of $14.4 million for the year ended December 31, 2004 comparedto no revenue for the year ended December 31, 2003. The revenues recordedduring 2004 consist solely of amounts earned pursuant to our collaborationagreement with Forest Laboratories for the development and marketing ofmilnacipran, entered into in January 2004. Such revenues include therecognition of the upfront payment of $25.0 million from Forest Laboratories ona straight-line basis over a period of 8 years, funding received from ForestLaboratories for certain of our employees devoted to the development ofmilnacipran and sponsored development reimbursements.

We currently are notgenerating any revenues from product sales and we do not expect to generaterevenues from product sales for at least the next several years, if at all. Untilwe generate revenues from product sales, we expect our revenues to consist ofthe continued recognition on a straight-line basis of the upfront payment of$25.0 million, sponsored development reimbursements and possible futuremilestone payments under our agreement with Forest Laboratories, which arecontingent upon the achievement of agreed upon objectives. In connection withdiscussions with Forest Laboratories regarding cost sharing arrangements forthe second Phase III trial only, the amount of funding that we receive fromForest Laboratories for certain of our employees has been eliminated as of thefourth quarter in 2004. Additionally, the amount of sponsored developmentreimbursements from Forest Laboratories may change periodically based on thelevel of development activity. Our collaboration agreement is subject to earlytermination by Forest Laboratories upon specified events, including breach ofthe agreement.

***Research and Development***

Research and development expenses for the year ended December 31,2004 were $15.2 million compared to $11.4 million for the year ended December 31,2003. The increase in research and development expenses is primarilyattributable to increased costs in connection with our first Phase III clinicaltrial for milnacipran due to a full year of activity during 2004 and costsincurred during 2004 in connection with the extension trial and our secondPhase III trial for milnacipran. During 2004, we 

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incurred total costs of$12.9 million in connection with our Phase III programs compared to a total of$3.3 million during 2003. Research and development expenses during 2003included a non-cash charge in the amount of $5.0 million recognized during thesecond quarter of 2003 in connection with the issuance of 1,000,000 shares ofour common stock and warrants to purchase 300,000 shares of our common stock toPierre Fabre under the Restated Pierre Fabre Agreement and costs incurredduring the first quarter of 2003 related to the Phase II clinical trial formilnacipran, which was in its final completion stage during the first quarterof 2003. The costs for the first Phase III clinical trial and extension trialincurred during 2004 are being reimbursed by Forest Laboratories as notedbelow.

Effective January 9, 2004, pursuant to ourcollaboration agreement with Forest Laboratories, Forest Laboratories assumedresponsibility for funding all continuing development of milnacipran, includingthe funding of clinical trials and regulatory approvals. This funding receivedfrom Forest Laboratories for sponsored development reimbursements is includedas a component of our revenue under collaborative agreement on the statement ofoperations. However, inlight of the increased expense and risk associated with running two paralleltrials, we are discussing an alternative cost sharing arrangement with ForestLaboratories for the second Phase III trial only and are currently workingtowards formalizing an amendment to our agreement with Forest Laboratories. Inconnection with these discussions, we will pay for a majority of the externalcosts of the second Phase III trial only, with Forest reimbursing us underspecific scenarios where the second Phase III trial is used as one of the tworequired pivotal trials in the NDA submission to the FDA and with a premiumunder certain additional circumstances.

In addition, as discussedbelow in “Non-Cash Compensation Charges,” we recognized non-cash compensationexpense of $449,000 and $201,000 related to research and development expensesfor the years ended December 31, 2004 and 2003, respectively, and asdiscussed below in “Compensation Expense (Benefit)—Variable Stock Options,” werecognized a compensation (benefit) for variable stock options of $(180,000)and compensation expense for variable stock options of $646,000 related toresearch and development expenses for the years ended December 31, 2004and 2003, respectively.

***General and Administrative***

General and administrative expenses for the year endedDecember 31, 2004 were $5.7 million compared to $4.1 million for the yearended December 31, 2003. The increase in general and administrativeexpenses is primarily due to a success-based fee paid to our investment bankersin connection with the closing of our collaboration agreement with ForestLaboratories, a one-time fee associated with our being listed during the firstquarter of 2004 on the Nasdaq National Market, increased wages and benefitsexpense associated with an increase in headcount, increased consulting costsand travel expenses in connection with business development activitiessurrounding potential strategic transactions and increased business insurancecosts.

In addition, as discussedbelow in “Non-Cash Compensation Charges,” we recognized non-cash compensationexpense of $6.0 million and $216,000 related to general and administrativeexpenses for the years ended December 31, 2004 and 2003, respectively, andas discussed below in “Compensation Expense (Benefit)—Variable Stock Options,”we recognized a compensation (benefit) for variable stock options of $(519,000)and compensation expense for variable stock options of $5.2 million related togeneral and administrative expenses for the years ended December 31, 2004and 2003, respectively.

***Non-Cash Compensation Charges***

Non-cash compensationcharges for the year ended December 31, 2004 were $6.5 million, consisting ofapproximately $449,000 related to research and development expenses and $6.0million related to general and administrative expenses, compared to $417,000,consisting of approximately $201,000 related to research and developmentexpenses and $216,000 related to general and administrative expenses, for 

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the yearended December 31, 2003. The increase in non-cash compensation charges isprimarily due to: (i) non-recurring, non-cash compensation chargesrecognized during the first quarter of 2004, consisting of $2.4 million relatedto stock options previously granted to consultants and two former board membersfor services that vested upon the execution of the collaboration agreement withForest Laboratories and $2.8 million related to the accounting treatment forstock options in connection with the resignation of certain board members toroles as consultants during the first quarter of 2004; (ii) a non-recurring,non-cash compensation charge in the amount of $385,000 recognized during thesecond quarter of 2004 related to the issuance of warrants to purchase 50,000shares of our common stock to an outside consultant as compensation forservices provided; and (iii) an increase in the Black-Scholes valuation forstock options previously granted to consultants due to the overall averageincrease in our stock price. These options are being expensed over theirrelated vesting period.

***Compensation Expense (Benefit)—Variable Stock Options***

In June 2001, weimplemented an option cancel and re-grant program, which resulted in variableaccounting for the newly issued options under Financial Accounting StandardsBoard Interpretation No. 44 (“FIN 44”), *Accountingfor Certain Transaction Involving Stock Compensation—An Interpretation of APB 25*.During the year ended December 31, 2004, as the intrinsic value of the commonstock underlying the options declined due to a decrease in our stock priceduring the period, we recognized a compensation (benefit) of $(699,000),consisting of $(180,000) related to research and development expenses and $(519,000)related to general and administrative expenses. In contrast, due to an increasein our stock price during the year ended December 31, 2003, we recognizedcompensation expense of $5.9 million, consisting of $646,000 related toresearch and development expenses and $5.2 million related to general andadministrative expenses. In the event our stock price is above $14.06 (closingprice on December 31, 2004) on March 31, 2005, we will record additionalcompensation charges (however, we cannot predict what our stock price will bein the future and it may be substantially lower than $14.06).

***Interest Income***

Interest income for theyear ended December 31, 2004 was $1.1 million compared to $122,000 for the yearended December 31, 2003. The increase in interest income for the year endedDecember 31, 2004 compared to the corresponding period in 2003 is due to highercash and investment balances during 2004 achieved primarily through the upfrontpayment received from Forest Laboratories in January 2004 and the proceeds fromour secondary offering completed in April 2004, and a general increase ininterest rates and related yields experienced during 2004.

***Comparison of Years Ended December 31, 2003 and2002***

***Revenues***

We had no revenue for the year ended December 31, 2003compared to revenue of $6.4 million for the year ended December 31, 2002.Pursuant to the Second Restructured Agreement with Fresenius, the agreement wasmodified to clarify that the $8.0 million upfront fee received under the FirstRestructured Agreement was not refundable under any circumstances andtherefore, the entire $6.4 million of remaining deferred revenue as of December31, 2001 was recognized as revenue in the first quarter of 2002.

As a result of themodification to our agreement with Fresenius reflected in the SecondRestructured Agreement, the 2003 and 2002 revenues are not comparable. Inaddition, as a result of this modification, we will not recognize additionalrevenue, if any, under our agreement with Fresenius until at the earliest,January 30, 2008, when we may receive a one-time payment of $1.0 million, $2.0million or no payment at all.

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***Research and Development***

Research and development expenses were$11.4 million for the year ended December 31, 2003 compared to $5.1 millionfor the year ended December 31, 2002. The increase in research anddevelopment expenses is primarily attributable to the non-cash charge in theamount of $5.0 million recognized during the second quarter of 2003 inconnection with the issuance of 1,000,000 shares of our common stock andwarrants to purchase 300,000 shares of our common stock to Pierre Fabre underthe Restated Pierre Fabre Agreement, costs incurred during 2003 ofapproximately $3.3 million in connection with our Phase III clinicaltrials for milnacipran, including expenses for clinical research organizationand trial consultants, and higher bonuses for research and developmentexecutives accrued in the fourth quarter of 2003 following commencement of thePhase III clinical trial of milnacipran. During the year ended December 31,2002, we incurred costs of approximately $2.9 million related to the PhaseII clinical trial for milnacipran compared to corresponding costs of$0.4 million during 2003, as all costs associated with the Phase II trialwere substantially completed by the first quarter of 2003.

In addition, as discussedbelow in “Non-Cash Compensation Charges,” we recognized non-cash compensationexpense of $201,000 and $85,000 related to research and development expensesfor the years ended December 31, 2003 and 2002, respectively, and as discussedbelow in "Compensation Expense (Benefit)—Variable Stock Options," we recognized compensationexpense for variable stock options of $646,000 and a compensation (benefit) forvariable stock options of $(74,000) related to research and developmentexpenses for the years ended December 31, 2003 and 2002, respectively.

***General and Administrative***

General and administrative expenses were$4.1 million for the year ended December 31, 2003 compared to$3.0 million for the year ended December 31, 2002. The increase ingeneral and administrative expenses is primarily due to executive bonusesaccrued in the fourth quarter of 2003 and increased legal, consulting andtravel costs related to business development activities in 2003, includingcosts incurred in connection with our collaboration agreement with ForestLaboratories. During 2002, we incurred initial set-up costs related to theimplementation of a database for our physician and patient registries focusedon patients with FMS and physicians that treat patients with FMS that were notincurred during 2003.

In addition, as discussedbelow in “Non-Cash Compensation Charges,” we recognized non-cash compensationexpense of $216,000 and $138,000 related to general and administrative expensesfor the years ended December 31, 2003 and 2002, respectively, and as discussedbelow in "Compensation Expense (Benefit)—Variable Stock Options," we recognized compensationexpense for variable stock options of $5.2 million and a compensation (benefit)for variable stock options of $(614,000) related to general and administrativeexpenses for the years ended December 31, 2003 and 2002, respectively.

***Non-Cash Compensation Charges***

Non-cash compensationcharges for the year ended December 31, 2003 were $417,000, consisting ofapproximately $201,000 related to research and development expenses and$216,000 related to general and administrative expenses, compared to $222,000,consisting of approximately $85,000 related to research and developmentexpenses and $138,000 related to general and administrative expenses, for theyear ended December 31, 2002. The increase in non-cash compensationcharges is primarily due to an increase in the Black-Scholes value for stockoptions granted to consultants due to the increase experienced in our stockprice during 2003 and an increase in the number of consultant options thatvested during 2003. These options are being expensed over their related vestingperiod.

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***Compensation Expense (Benefit)—Variable Stock Options***

In connection with theoption cancel and re-grant program implemented in June 2001, whichresulted in variable accounting for the newly issued options under FIN 44, werecognized compensation expense of $5.9 million for the year ended December 31,2003 compared to a compensation (benefit) of $(688,000) for the year ended December 31,2002. During the year ended December 31, 2003, as the intrinsic value ofthe common stock underlying the options increased due to an increase in ourstock price during the period, we recognized compensation expense of $5.9million, consisting of $646,000 related to research and development expensesand $5.2 million related to general and administrative expenses. In contrast, asour stock price decreased during the year ended December 31, 2002, werecognized a compensation (benefit) of $(688,000), consisting of $(74,000)related to research and development expenses and $(614,000) related to generaland administrative expenses.

***Interest Income***

Interest income for theyear ended December 31, 2003 was $122,000 compared to $200,000 for theyear ended December 31, 2002. The decrease in interest income during 2003is primarily due to a change in the composition of our cash and cash equivalentsbalance and lower rates offered for our cash investments. During the year endedDecember 31, 2003, a majority of our cash balance was invested inshort-term investments classified as “available-for-sale” whereby unrealizedgains or losses are recorded as a component of stockholders’ equity, comparedto the corresponding period in 2002, during which our cash balance was investedin money market accounts.

**Liquidity and Capital Resources**

At December 31, 2004, we had cash, cashequivalents and short-term investments of $112.0 million compared to cash,cash equivalents and short-term investments of $23.5 million at December 31,2003. Working capital at December 31, 2004 totaled $112.9 million comparedto $22.0 million at December 31, 2003. We have invested a substantialportion of our available cash in high quality marketable debt instruments ofgovernmental agencies and certificates of deposit, which are within federallyinsured limits. We have established guidelines relating to our investments topreserve principal and maintain liquidity.

Net cash provided by operating activities totaled$11.1 million for the year ended December 31, 2004 compared to netcash used in operating activities of $9.4 million for the year ended December 31,2003. The primary source of cash from operations during 2004 was the upfrontpayment of $25.0 million received from Forest Laboratories, offset by cash usedin operations of approximately $13.9 million. The primary use of cash during2003 was to fund our operating activities during the period.

Net cash used in investing activities was$81.0 million for the year ended December 31, 2004 compared to$17.7 million for the year ended December 31, 2003. The increase innet cash used in investing activities during 2004 compared to 2003 wasprimarily a result of the increase in the level of activity related to thepurchase of short-term investments, net of the proceeds from the sale ofshort-term investments.

Net cash provided by financing activities was $77.4million for the year ended December 31, 2004 compared to $20.7 million forthe year ended December 31, 2003. The increase in net cash provided byfinancing activities during 2004 compared 2003 was primarily the result ofproceeds of approximately $74.2 million from the completion of our publicoffering of common stock during April 2004 and proceeds of approximately$3.0 million from the exercise of stock options and warrants during 2004,compared to net proceeds of approximately $9.5 million from the privateplacement of our common stock and warrants to purchase our common stockcompleted in April 2003 and proceeds of approximately $11.2 million fromthe exercise of stock options and warrants during 2003.

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Thefollowing table summarizes our long-term contractual obligations at December 31,2004:
| ** **                                    | ** ** | **Total** | ** ** | **Less than  1 year  (2005)** | ** ** | **1 – 3 years  (2006 – 2008)** | ** ** | **After 4 years  (2009 +)** | ** ** |
|-----------------------------------------------|------------|-----------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|--------------------------------------------|------------|
| Capital leases,  including interest  payments |       | $         | 41,210     |                                    | $          | 19,020                                                            |       |                                       | $          | 22,190 |   |   |   | $ | — |   |   |
| Operating leases                              |       | 472,778   |       | 177,704                                 |       |                                                              | 295,074    |                                       |       |   | — |   |   |
| Purchase  obligations(1)                      |       | 541,240   |       | 432,770                                 |       |                                                              | 108,470    |                                       |       |   | — |   |   |
| Total                                         |       | $         | 1,055,228  |                                    | $          | 629,494                                                           |       |                                       | $          | 425,734 |   |   |   | $ | — |   |   |

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(1)          Purchase obligationsinclude agreements to purchase goods or services, including consultingservices, that are enforceable and legally binding on us and that specify allsignificant terms. This includes contracts that are cancelable with notice andthe payment of an early termination penalty. Purchase obligations excludeagreements that are cancelable without penalty and also exclude liabilities tothe extent presented on the balance sheet as of December 31, 2004.

Other commercial commitments include certain potentialmilestone, sublicense and royalty payments to Pierre Fabre and Collegiumdiscussed in the “Overview” section. Contractual obligations for which we willbe reimbursed by Forest Laboratories are not included in the table above. Inlight of the increased expense and risk associated with running two paralleltrials, we are discussing an alternative cost sharing arrangement with ForestLaboratories for the second Phase III trial only and are currently workingtowards formalizing an amendment to our agreement with Forest Laboratories. Inconnection with these discussions, we will pay for a majority of the externalcosts of the second Phase III trial only, with Forest reimbursing us under specificscenarios where the second Phase III trial is used as one of the two requiredpivotal trials in the NDA submission to the FDA with a premium undercertain additional circumstances.

Until we can consistently generate significant cashfrom our operations, we expect to continue to fund our operations with existingcash resources that were primarily generated from the proceeds of offerings ofour equity securities and from revenue from our collaboration agreement. Ourcurrent expected primary cash needs on both a short term and long-term basisare for the identification, acquisition or license, and development ofpotential future products, development of current products, working capital andother general corporate purposes. In addition to the amounts required to payany amounts payable under our agreements with Pierre Fabre and Collegium, costsof in-licensing or acquiring additional compounds or companies, fundingexternal research and funding clinical development for any product that we mayin-license or acquire, we estimate that based on our current business plan, wewill require approximately $12 million to fund our operations for the year2005. One of our goals for 2005 is to identify and in-license a new product. Inthe event we acquire, license or develop any new products, the amount to fundour operations for 2005 would increase, possibly materially. We expect thecurrent trend of net losses to continue for at least the next several years aswe seek to acquire, license or develop additional products for the treatment ofFunctional Somatic Syndromes and other central nervous system disorders. Suchlosses may fluctuate, and the fluctuations may be substantial.

Based on ourcurrent business plan, we believe our cash and cash equivalents and short-terminvestments balances at December 31, 2004 are sufficient to fundoperations for the next several years. We are actively continuing to evaluatevarious potential strategic transactions, including the potential acquisitionsof products and companies, and other alternatives that we believe may enhancestockholder value. In order to acquire or develop additional products, we willrequire additional capital. The amount of capital we require is dependent uponmany forward-looking factors that could significantly increase ourcapital requirements, including the following:

·       theextent to which we acquire or invest in other products and businesses;

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·       thecosts of in-licensing drug candidates;

·       theability of Forest Laboratories and us to reach milestones, and other events ordevelopments under our collaboration agreement;

·       thecosts and timing of development and regulatory approvals for milnacipran; and

·       thecosts of commercialization of any future products.

Because we are unable to predict the outcome of theforegoing factors, some of which are beyond our control, we are unable toestimate with certainty our mid to long-term capital needs. Until we cangenerate a sufficient amount of product revenue, if ever, we expect to financefuture capital needs through public or private debt or equity offerings orcollaboration and licensing arrangements, as well as interest income earned oncash balances. We do not currently have any commitments for future externalfunding. We may not be able to raise additional capital through such sourcesand the funds we raise, if any, may not allow us to maintain our current andplanned operations. If we are unable to obtain additional capital, we may berequired to delay, scale back or eliminate some or all of our development offuture additional product candidates.

To date, we have not hadany relationships with unconsolidated entities or financial partnerships, suchas entities referred to as structured finance or special purpose entities,which are established for the purpose of facilitating off-balance sheetarrangements or other contractually narrow or limited purposes.

**CriticalAccounting Policies and Estimates**

Our discussion andanalysis of our financial condition and results of operations are based uponour financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof these financial statements requires us to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenues and expenses, andrelated disclosure of contingent assets and liabilities. On an ongoing basis,we evaluate our estimates, including those related to revenue recognition,research and development expenses and stock-based compensation. We baseour estimates on historical experience and on various other assumptions thatare believed to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions. Webelieve the following are some of the more critical accounting policies thataffect the significant judgments and estimates used in the preparation of ourfinancial statements (see also the notes to our financial statements).

***Revenue Recognition***

In accordance with StaffAccounting Bulletin (“SAB”) No. 101, *RevenueRecognition in Financial Statements* (as amended by SAB 104), revenues are recognized whenpersuasive evidence of an arrangement exists, delivery has occurred or serviceshave been rendered, the price is fixed and determinable and collectibility isreasonably assured. Amounts received for upfront license fees undermultiple-element arrangements are deferred and recognized over the period ofsuch services or performance if such arrangements require on-going services orperformance. Accordingly, the upfront payment of $25.0 million from ForestLaboratories is being recognized over a period of 8 years, which represents theestimated period of significant on-going services and performance, includingthe development period, under our agreement with Forest Laboratories. Amountsreceived for sponsored development activities, including funding received forcertain of our employees, are recognized as research costs are incurred overthe period specified in the related agreement or as the services are performed.Amounts received for milestones are recognized upon achievement of themilestone, which requires 

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substantiveeffort and was not readily assured at the inception of the agreement. Anyamounts received prior to satisfying revenue recognition criteria will berecorded as deferred revenue.

***Research and Development Expenses***

We expense research anddevelopment costs as they are incurred pursuant to Statement of FinancialAccounting Standards (“SFAS”) No. 2, *Accountingfor Research and Development Costs*, as the ultimatecommercialization of the related products is uncertain and the technology hasno alternative uses. In connection with our agreement with Pierre Fabre, wehave paid certain upfront and milestone payments and are also obligated to makeadditional payments based on meeting certain clinical and regulatorymilestones. Such upfront and milestone payments are expensed as incurredpursuant to SFAS 2. We also issued Pierre Fabre 1,000,000 shares of our commonstock and warrants to purchase 300,000 shares of our common stock in the secondquarter of 2003 in connection with the Restated Pierre Fabre Agreement.Pursuant to SFAS 2, the additional license consideration in the form of theseequity instruments has been expensed as the ultimate commercialization of therelated product is uncertain and the technology has no alternative uses.

***Stock Based Compensation***

We grant stock options for a fixed number of shares toemployees in accordance with Accounting Principles Board Opinion No. 25 (“APB25”), *Accounting for Stock Issued toEmployees*, as amended by SFAS No. 123, *Accounting for Stock Based Compensation*.Accordingly, we ordinarily recognize no compensation expense for stock optiongrants to employees provided that the option exercise price is not less thanthe fair market value of the underlying stock on the date of grant. The valueof options or stock awards issued to non-employees has been determined inaccordance with SFAS 123 and Emerging Issues Task Force No. 96-18,*Accounting for Equity Instruments that areIssued to Other than Employees for Acquiring or in Conjunction with sellingGoods and Services*, and is periodically re-measured as the optionsvest. For the years ended December 31, 2004 and 2003, we recordedcompensation expense of $3.1 million (including $2.4 million related to stockoptions that vested upon the execution of the collaboration agreement withForest Laboratories) and $351,000, respectively, related to options issued toconsultants. Additionally, during the year ended December 31, 2004, werecorded compensation expense of $2.8 million in connection with the accountingtreatment for stock options related to the resignation of certain board membersduring the first quarter of 2004 and compensation expense of $385,000 inconnection with the issuance of warrants to purchase 50,000 shares of ourcommon stock to an outside consultant as compensation for services provided.

In June 2001, weimplemented an option cancel and re-grant program, which resulted in variableaccounting for the newly issued options under Financial Accounting StandardsBoard Interpretation No. 44 (“FIN 44”), *Accountingfor Certain Transaction Involving Stock Compensation—An Interpretation of APB25*. Pursuant to FIN 44, the intrinsic value of the options topurchase common stock will be re-measured at the end of each period for theterm of the option and amortized over the vesting period. During the year endedDecember 31, 2004, as the intrinsic value of the common stock underlyingthe options declined due to a decrease in our stock price during the period, werecognized a compensation benefit of $699,000. During the year ended December 31,2003, as the intrinsic value of the common stock underlying the options increaseddue to an increase in our stock price during the period, we recognizedcompensation expense of $5.9 million. In the event our stock price is above$14.06 (closing price on December 31, 2004) on March 31, 2005, wewill record additional compensation charges (however, we cannot predict whatour stock price will be in the future and it may be substantially lower than$14.06). Pursuant to the option cancel and re-grant program, options withcertain exercise prices held by certain of our employees, including executiveofficers, and directors were exchanged for options with an exercise 

39

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price of$2.50, the fair market value of our common stock on June 27, 2001, thedate the program was effected.

***Recent Accounting Pronouncements***

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (revised 2004), *Share Based Payment*(“SFAS 123R”), whichis a revision of SFAS 123, *Accounting forStock-Based Compensation*. This statement supercedes APB Opinion 25, *Accounting for Stock Issued to Employees*(“APB25”), and amends SFAS 95, *Statement of CashFlows*. Generally, the approach in SFAS 123R is similar to theapproach described in SFAS 123, however, SFAS 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair values. Pro formadisclosure is no longer an alternative.

SFAS 123R permits companies to adopt its requirementsusing either a “modified prospective” method or a “modified retrospective” method.Under the “modified prospective” method, compensation cost is recognized in thefinancial statements beginning with the effective date, based on therequirements of SFAS 123R for all share-based payments granted after that date,and based on the requirements for SFAS 123 for all unvested awards grantedprior to the effective date of SFAS 123R. Under the “modified retrospective”method, the requirements are the same as under the “modified prospective”method, but also permits companies to restate financial statements of previousperiods based on proforma disclosures made in accordance with SFAS 123. Wecurrently utilize the Black-Scholes model to measure the fair value of stockoptions granted to employees. While SFAS 123R permits companies to continue touse such model, it also permits the use of a “lattice” model. We have not yetdetermined which model we will use to measure the fair value of employee stockoptions under the adoption for SFAS 123R. The new standard is effective forperiods beginning after June 15, 2005 and we expect to adopt SFAS 123R on July 1,2005.

We currently account forshare-based payments to employees using APB 25’s intrinsic value method and, assuch, recognize no compensation cost for employee stock options granted withexercise prices equal to or greater than the fair value of our common stock onthe date of the grant. Accordingly, the adoption of SFAS 123R’s fair valuemethod will have a significant impact on our results of operations, although itwill have no impact on our overall financial position. The impact of adoptionof SFAS 123R cannot be predicted at this time because it will depend on thelevel of share-based payments granted in the future. However, had we adoptedSFAS 123R in prior periods, the impact of that standard would have approximatedthe impact of SFAS 123 as described in the disclosure of pro forma net loss andnet loss per share in the notes to the financial statements.

**ITEM 7A.**             Quantitativeand Qualitative Disclosure about Market Risk

We have invested our excesscash in United States government securities, certificates of deposit and moneymarket funds with strong credit ratings. As a result, our interest income ismost sensitive to changes in the general level of United States interest rates.We do not use derivative financial instruments, derivative commodityinstruments or other market risk sensitive instruments, positions ortransactions in any material fashion. Accordingly, we believe that, while theinvestment-grade securities we hold are subject to changes in thefinancial standing of the issuer of such securities, we are not subject to anymaterial risks arising from changes in interest rates, foreign currencyexchange rates, commodity prices, equity prices or other market changes thataffect market risk sensitive instruments. A hypothetical 1% adverse move ininterest rates along the entire interest rate yield curve would not materiallyaffect the fair value of our financial instruments that are exposed to changesin interest rates.

**ITEM 8.**                     Financial Statements

Refer to the Index on Page F-1of the Financial Report included herein.

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**ITEM 9.**                     Changesin and Disagreements with Accountants on Accounting and Financial Disclosure

None.

**ITEM 9A.**             Controls and Procedures

**ConclusionsRegarding the Effectiveness of Disclosure Controls and Procedures**

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported within thetimelines specified in the Securities and Exchange Commission’s rules andforms, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognized that any controls and procedures, no matter how well designed andoperated, can only provide reasonable assurance of achieving the desired controlobjectives, and in reaching a reasonable level of assurance, managementnecessarily was required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

As required by SEC Rule 13a-15(b),the Company carried out an evaluation, under the supervision and with theparticipation of the Company’s management, including the Company’s ChiefExecutive Officer and the Company’s Chief Financial Officer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures as of the end of the year covered by this report. Based on theforegoing, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures were effective at the reasonable assurancelevel. There has been no change in our internal controls over financialreporting during our most recent fiscal quarter that has materially affected,or is reasonably likely to materially affect, our internal controls overfinancial reporting.

**Management’sReport on Internal Control Over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rules 13a-15(f). Under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer, we conducted an evaluation of the effectiveness ofour internal control over financial reporting based on the framework in *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission. Basedon our evaluation under the framework in *InternalControl—Integrated Framework*, our management concluded that ourinternal control over financial reporting was effective as of December 31,2004.

Our management’s assessment of the effectiveness ofour internal control over financial reporting as of December 31, 2004 hasbeen audited by Ernst & Young LLP, an independent registered publicaccounting firm, as stated in their report which is included herein.

41

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**Report of Independent Registered Public AccountingFirm on Internal Control Over Financial Reporting**

The Board of Directors andStockholdersCypress Bioscience, Inc.

We have audited management’sassessment, included in the accompanying “Management’s Report on InternalControl Over Financial Reporting” that Cypress Bioscience, Inc. maintainedeffective internal control over financial reporting as of December 31,2004, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(the COSO criteria). Cypress Bioscience, Inc.’s management is responsiblefor maintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design andoperating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinion.

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

In our opinion, management’sassessment that Cypress Bioscience, Inc. maintained effective internalcontrol over financial reporting as of December 31, 2004, is fairlystated, in all material respects, based on the COSO criteria. Also, in ouropinion, Cypress Bioscience, Inc. maintained, in all material respects,effective internal control over financial reporting as of December 31,2004, based on the COSO criteria.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the balance sheets of Cypress Bioscience, Inc. as of December 31,2004 and 2003, and the related statements of operations, stockholders’ equityand cash flows for each of the three years in the period ended December 31,2004 of Cypress Bioscience, Inc. and our report dated February 25,2005 expressed an unqualified opinion thereon.
|                        | /s/ ERNST &  YOUNG LLP |
|------------------------|----------------------------|
| San Diego, California  |                       |
| February 25, 2005 |                       |

 

42

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**Item 9B.**               Other Information

None.

**PART III**

**ITEM 10**.     Directorsand Executive Officers

Information required by this item will be contained inour Definitive Proxy Statement for our 2005 Annual Meeting of Stockholders, tobe filed pursuant to Regulation 14A with the Securities and ExchangeCommission within 120 days of December 31, 2004 (except thatinformation pertaining to executive officers of the Registrant is contained in Part Iof this report). Such information is incorporated herein by reference.

We have adopted a Code ofBusiness Conduct and Ethics, which covers all employees, including ourprincipal executive, financial and accounting officers. A copy of our Code ofBusiness Conduct and Ethics is posted on our website, *www.cypressbio.com*. We also will post onour website any waiver or amendment (other than technical, administrative andother non-substantive amendments) to our Code of Business Conduct and Ethicsthat is granted to or affects the duties of any of our directors or ourprincipal executive, financial and accounting officers. Such posting will bemade within five business days after the date of the waiver or amendment andwill remain on the website for at least twelve months.

**ITEM 11**.     ExecutiveCompensation

Information required bythis item will be contained in our Definitive Proxy Statement for our 2005Annual Meeting of Stockholders, to be filed pursuant to Regulation 14Awith the Securities and Exchange Commission within 120 days of December 31,2004. Such information is incorporated herein by reference.

**ITEM 12**.     SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

Information required bythis item will be contained in our Definitive Proxy Statement for our 2005Annual Meeting of Stockholders, to be filed pursuant to Regulation 14Awith the Securities and Exchange Commission within 120 days of December 31,2004. Such information is incorporated herein by reference.

**ITEM 13**.     CertainRelationships and Related Transactions

Information required bythis item will be contained in our Definitive Proxy Statement for our 2005Annual Meeting of Stockholders, to be filed pursuant to Regulation 14Awith the Securities and Exchange Commission within 120 days of December 31,2004. Such information is incorporated herein by reference.

**ITEM 14**.     AccountingFees and Services

Information required by this item will be contained inour Definitive Proxy Statement for our 2005 Annual Meeting of Stockholders, tobe filed pursuant to Regulation 14A with the Securities and ExchangeCommission within 120 days of December 31, 2004. Such information isincorporated herein by reference.

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**PART IV**

**ITEM  15.   Exhibits, Financial StatementSchedules**

(a)   FinancialStatements

Our financial statements are included herein asrequired under Item 8 of this Annual Report on Form 10-K. See Indexon page F-1.

Financial statementschedules have been omitted since they are either not required, not applicableor the information is otherwise included.

(b)   Exhibits
| Exhibit | ** **   | ** **                                                                                                                                                                                                                                             | ** ** | ** **                                                                                                          | ** ** | ** **                       |
|---------|--------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|
| No.     | ** **   | ** **                                                                                                                                                                                                                                             | ** ** | **Description**                                                                                                     | ** ** | **Incorporated by Reference to** |
| 3.1     |         | Second Amended and Restated Certificate of  Incorporation                                                                                                                                                                                              |       | Appendix C to Definitive Proxy Statement filed with  the Securities and Exchange Commission on August 11, 2003 |
| 3.2     |         | Second Amended and Restated By-Laws                                                                                                                                                                                                                    |       | Appendix D to Definitive Proxy Statement filed with  the Securities and Exchange Commission on August 11, 2003 |
| 4.1     |         | Form of Stock Certificate                                                                                                                                                                                                                         |       | Exhibit 4.1 to Form S-1 Registration  Statement No. 33-41225                                         |
| 10.1    | *** *** | 1996 Equity Incentive Plan (the “***1996 Plan***”)(†)                                                                                                                                                                                   |       | Exhibit 99.2 to Form 10-Q for the  quarter ended March 31, 1996 (File No. 0-12943)              |
| 10.2    |         | Form of Incentive Stock Option Agreement under  the 1996 Plan(†)                                                                                                                                                                             |       | Exhibit 99.3 to Form 10-Q for the  quarter ended March 31, 1996 (File No. 0-12943)              |
| 10.3    |         | Form of Non-Statutory Stock Option  Agreement under 1996 Equity Incentive Plan(†)                                                                                                                                                            |       | Exhibit 99.4 to Form 10-Q for the  quarter ended March 31, 1996 (File No. 0-12943)              |
| 10.4    |         | Incentive Stock Option and Appreciation Plan, as  amended June 29, 1992(†)                                                                                                                                                                   |       | Exhibit 99.4 to Form S-8  Registration Statement No. 333-06771                                       |
| 10.5    |         | Form of Stock Option Agreement for issuances of  all non-plan options(†)                                                                                                                                                                     |       | Exhibit 99.8 to Form S-8  Registration Statement No. 333-06771                                       |
| 10.7    |         | Sublease dated February 1, 1999 between the  Registrant and Cardia Pacemakers, Inc. and related lease dated  August 1991 between Michael R. Mastro and Redmond East Associates and  Incontrol, Inc. and Amendments One through Ten |       | Exhibit 10.41 to Form 10-K for the  year ended December 31, 1998                                     |
| 10.8    |         | Amended and Restated License and Distribution  Agreement dated January 19, 2001 among the Registrant, Fresenius  HemoCare, Inc. and Fresenius HemoCare GmbH(*)                                                                               |       | Exhibit 2.2 to Form 8-K filed on  January 23, 2001                                                   |
| 10.9    |         | 2000 Equity Incentive Plan(†)                                                                                                                                                                                                                     |       | Exhibit 10.25 to Form 10-K for the  year ended December 31, 2000                                     |
| 10.10   |         | Form of Stock Option Agreement for use with the  2000 Equity Incentive Plan(†)                                                                                                                                                               |       | Exhibit 10.26 to Form 10-K for the  year ended December 31, 2000                                     |
|         |              |                                                                                                                                                                                                                                                        |            |                                                                                                                     |            |                                  |  |

44

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| 10.11 |   | Letter Amendment dated February 1, 2002 to the  Amended and Restated License Agreement dated January 19, 2001 among the  Registrant, Fresenius HemoCare, Inc. and Fresenius HemoCare GmbH |   | Exhibit 10.24 to Form 10-K for the  year ended December 31, 2001      |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------|
| 10.12 |   | Reformulation and New Product Agreement dated  August 22, 2002 between the Registrant and Collegium  Pharmaceuticals, Inc.(*)                                                                  |   | Exhibit 10.2 to Form 10-Q for the  quarter ended September 30, 2002   |
| 10.13 |   | Common Stock Issuance Agreement dated  October 31, 2002 between the Registrant and Collegium  Pharmaceuticals, Inc.(*)                                                                         |   | Exhibit 10.3 to Form 10-Q for the  quarter ended September 30, 2002   |
| 10.14 |   | Equity Investment Agreement dated June 6, 2003  between the Registrant and Pierre Fabre Medicament                                                                                                  |   | Exhibit 10.2 to Form 10-Q for the  quarter ended June 30, 2003        |
| 10.15 |   | Warrant to purchase Common Stock of the Registrant  issued to Pierre Fabre Medicament on June 6, 2003                                                                                               |   | Exhibit 10.3 to Form 10-Q for the  quarter ended June 30, 2003        |
| 10.16 |   | Amended and Restated Employment Agreement dated  August 11, 2003 between the Registrant and Jay D. Kranzler, M.D.,  Ph.D(†)                                                                    |   | Exhibit 10.4 to Form 10-Q for the  quarter ended June 30, 2003        |
| 10.17 |   | Employment Agreement dated February 4, 2004  between the Registrant and Denise Woolard(†)                                                                                                      |   | Exhibit 10.22 to the Form 10-K for the  year ended December 31, 2003. |
| 10.18 |   | Third Restated License Agreement dated  January 9, 2004 between the Registrant and Pierre Fabre Medicament(*)                                                                                       |   | Exhibit 10.23 to the Form 10-K for the  year ended December 31, 2003. |
| 10.19 |   | First Restated Trademark Agreement dated  January 9, 2004 between the Registrant and Pierre Fabre Medicament(*)                                                                                     |   | Exhibit 10.24 to the Form 10-K for the  year ended December 31, 2003. |
| 10.20 |   | Purchase and Supply Agreement dated January 9,  2004 between the Registrant and Pierre Fabre Medicament(*)                                                                                          |   | Exhibit 10.25 to the Form 10-K for the  year ended December 31, 2003. |
| 10.21 |   | License and Collaboration Agreement dated  January 9, 2004 between the Registrant and Forest Laboratories(*)                                                                                        |   | Exhibit 10.26 to the Form 10-K for the  year ended December 31, 2003. |
| 10.22 |   | Side Letter dated January 9, 2004 among the  Registrant, Forest Laboratories and Pierre Fabre Medicament(*)                                                                                         |   | Exhibit 10.27 to the Form 10-K for the  year ended December 31, 2003. |
| 10.23 |   | Letter Agreement dated January 9, 2004 among  the Registrant, Forest Laboratories and Pierre Fabre Medicament(*)                                                                                    |   | Exhibit 10.28 to the Form 10-K for the  year ended December 31, 2003. |
| 10.24 |   | 2005 Bonus Plan                                                                                                                                                                                          |   |                                                                                 |
| 21.1  |   | Subsidiaries of the registrant                                                                                                                                                                           |   | The registrant has no subsidiaries                                                   |
| 23.1  |   | Consent of Independent Registered Public Accounting  Firm                                                                                                                                                |   |                                                                                 |
| 24.1  |   | Power of Attorney                                                                                                                                                                                        |   | Reference is made to page 47                                                    |

45

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| 31.1 |   | Certification of Chief Executive Officer pursuant to  Section 302 of the Public Company Accounting Reform and Investor  Protection Act of 2002 (18 U.S.C. §1350, as adopted)                              |   |   |
|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| 31.2 |   | Certification of Chief Financial Officer pursuant to  Section 302 of the Public Company Accounting Reform and Investor  Protection Act of 2002 (18 U.S.C. §1350, as adopted)                              |   |   |
| 32.1 |   | Certification of Chief Executive Officer and Chief  Financial Officer pursuant to Section 906 of the Public Company  Accounting Reform and Investor Protection Act of 2002 (18 U.S.C. §1350, as  adopted) |   |   |

----

*                    ConfidentialTreatment has been granted to certain portions of this agreement.

**             ConfidentialTreatment has been requested for certain portions of this agreement.

†                    Indicatesmanagement contract or compensatory plan or arrangement.

46

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, as amended, the Registrant has duly caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.
|                            | CYPRESS  BIOSCIENCE, INC. |
|----------------------------|--------------------------------|
| Date: March 16,  2005 | By:                            | /s/ JAY D. KRANZLER |
|                       |                           | *Chief Executive Officer and Chairman of the Board* |
| Date: March 16,  2005 | By:                            | /s/ SABRINA MARTUCCI JOHNSON |
|                       |                           | *Chief Financial Officer and Vice President* |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints Jay D. Kranzler, M.D.,Ph.D. and Sabrina Martucci Johnson, and each of them, as his or her true andlawful attorneys-in-fact and agents, with full power of substitution andresubstitution, for him or her and in his or her name, place and stead, in anyand all capacities, to sign any and all amendments to this Form 10-K, andto file the same with all exhibits thereto, and other documents in connectiontherewith, with the Securities and Exchange Commission, granting unto saidattorneys-in-fact and agents, and full power and authority to do andperformance each and every act and thing requisite and necessary to be done inconnection therewith, as fully to intents and purposes as he or she might orcould do in person, hereby ratifying and confirming that all saidattorneys-in-fact and agents, or any of them or their substitute orresubstitute, may lawfully do or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, thisreport has been signed below by the following person on behalf of theRegistrant and in the capacities and on the dates indicated.
|                               | **Signature** | ** **                                         | ** **           | ** ** | **Title** | ** ** | ** ** | **Date** | ** ** |
|-------------------------------|---------------|----------------------------------------------------|----------------------|------------|-----------|------------|------------|----------|------------|
| /s/  JAY D. KRANZLER          |          | Chief Executive Officer  and Chairman of the Board | March 16,  2005 |
| Jay D. Kranzler,  M.D., Ph.D. | * *      | *(Principal Executive Officer)*                    |                 |
| /s/  SABRINA MARTUCCI JOHNSON |          | Chief Financial Officer  and Vice President        | March 16,  2005 |
| Sabrina Martucci  Johnson     | * *      | *(Principal Financial and Accounting Officer)*     |                 |
| /s/  SAMUEL D. ANDERSON       |          | Director                                           | March 16,  2005 |
| Samuel D.  Anderson           |          |                                               |                 |
| /s/  JON W. MCGARITY          |          | Director                                           | March 16,  2005 |
| Jon W. McGarity               |          |                                               |                 |
| /s/  JEAN-PIERRE MILLON       |          | Director                                           | March 16,  2005 |
| Jean-Pierre  Millon           |          |                                               |                 |

47

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| /s/ PERRY  B. MOLINOFF |   | Director | March 16, 2005  |
|------------------------|--------|----------|----------------------|
| Perry  B. Molinoff     |   |     |                 |
| /s/  DANIEL H. PETREE  |   | Director | March 16,  2005 |
| Daniel H. Petree       |   |     |                 |
| /s/  GARY D. TOLLEFSON |   | Director | March 16,  2005 |
| Gary D. Tollefson      |   |     |                 |
| /s/  JACK H. VAUGHN    |   | Director | March 16,  2005 |
| Jack H. Vaughn         |   |     |                 |

 

 

48

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**CYPRESS BIOSCIENCE,INC.INDEX TO FINANCIAL STATEMENTS**
| Report of Independent  Registered Public Accounting Firm                                           | F-2 |
|----------------------------------------------------------------------------------------------------|-----|
| Balance Sheets as of  December 31, 2004 and 2003                                              | F-3 |
| Statements of  Operations for the years ended December 31, 2004, 2003 and 2002                | F-4 |
| Statements of Stockholders’ Equity  for the years ended December 31, 2004, 2003 and 2002 | F-5 |
| Statements of Cash Flows for  the years ended December 31, 2004, 2003 and 2002                | F-6 |
| Notes  to Financial Statements                                                                     | F-7 |

 

F-1

----

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

The Board of Directors and StockholdersCypress Bioscience, Inc.

We have audited the accompanying balance sheets ofCypress Bioscience, Inc. as of December 31, 2004 and 2003, and therelated statements of operations, stockholders’ equity and cash flows for eachof the three years in the period ended December 31, 2004. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements basedupon our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, 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 toabove present fairly, in all material respects, the financial position ofCypress Bioscience, Inc. as of December 31, 2004 and 2003, and theresults of its operations and its cash flows for each of the three years in theperiod ended December 31, 2004, in conformity with U.S. generally acceptedaccounting principles.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of CypressBioscience’s internal control over financial reporting as of December 31,2004, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commissionand our report dated February 25, 2005 expressed an unqualified opinionthereon.
|                        | /s/ Ernst & Young LLP |
|------------------------|--------------------------------|
| San Diego, California  |                           |
| February 25, 2005 |                           |

 

F-2

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**CYPRESSBIOSCIENCE, INC.**BALANCE SHEETS
| ** **                                                                                                                                                                                                                                                                  | ** ** | **December 31,** | ** **  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|
| ** **                                                                                                                                                                                                                                                                  | ** ** | **2004**              | ** **  | **2003** | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                  |       |                  |        |   |   |
| Current assets:                                                                                                                                                                                                                                                             |       |                  |        |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                                                   |       | $                     | 8,303,388   |   | $ | 859,820 |   |
| Short-term investments                                                                                                                                                                                                                                                      |       | 103,720,610           |        | 22,664,826 |   |
| Receivable from Forest Laboratories                                                                                                                                                                                                                                         |       | 5,656,964             |        | — |   |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                   |       | 601,721               |        | 149,538 |   |
| Total current assets                                                                                                                                                                                                                                                        |       | 118,282,683           |        | 23,674,184 |   |
| Property and equipment, net                                                                                                                                                                                                                                                 |       | 75,379                |        | 101,035 |   |
| Other assets                                                                                                                                                                                                                                                                |       | 31,462                |        | 31,462 |   |
| Total assets                                                                                                                                                                                                                                                                |       | $                     | 118,389,524 |   | $ | 23,806,681 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                              |       |                  |        |   |   |
| Current liabilities:                                                                                                                                                                                                                                                        |       |                  |        |   |   |
| Accounts payable                                                                                                                                                                                                                                                            |       | $                     | 712,843     |   | $ | 415,166 |   |
| Accrued compensation                                                                                                                                                                                                                                                        |       | 308,855               |        | 891,714 |   |
| Accrued liabilities                                                                                                                                                                                                                                                         |       | 461,582               |        | 302,956 |   |
| Payable to Forest Laboratories                                                                                                                                                                                                                                              |       | 800,000               |        | — |   |
| Current portion of long-term obligations                                                                                                                                                                                                                                    |       | 16,022                |        | 14,474 |   |
| Current portion of deferred revenue                                                                                                                                                                                                                                         |       | 3,125,000             |        | — |   |
| Total current liabilities                                                                                                                                                                                                                                                   |       | 5,424,302             |        | 1,624,310 |   |
| Deferred rent                                                                                                                                                                                                                                                               |       | 20,565                |        | 16,379 |   |
| Long-term  obligations, net of current portion                                                                                                                                                                                                                              |       | 20,848                |        | 36,870 |   |
| Deferred revenue,  net of current portion                                                                                                                                                                                                                                   |       | 18,750,000            |        | — |   |
| Commitments and  contingencies                                                                                                                                                                                                                                              |       |                  |        |   |   |
| Stockholders’  equity:                                                                                                                                                                                                                                                 |       |                  |        |   |   |
| Common stock, $.001 par value; 60,000,000 shares of  common stock authorized; 30,363,994 and 22,184,952 shares issued and  outstanding at December 31, 2004 and 2003, respectively; 15,000,000  shares of preferred stock authorized; no shares issued and outstanding |       | 30,364                |        | 22,185 |   |
| Additional paid-in capital                                                                                                                                                                                                                                                  |       | 231,474,500           |        | 148,509,080 |   |
| Shareholder receivable                                                                                                                                                                                                                                                      |       | —                |        | (189,973 | ) |
| Accumulated other comprehensive income                                                                                                                                                                                                                                      |       | 161,327               |        | 65,206 |   |
| Accumulated deficit                                                                                                                                                                                                                                                         |       | (137,492,382          | )           | (126,277,376 | ) |
| Total stockholders’ equity                                                                                                                                                                                                                                             |       | 94,173,809            |        | 22,129,122 |   |
|                                                                                                                                                                                                                                                                        |       | $                     | 118,389,524 |   | $ | 23,806,681 |   |

 

See accompanying notes to the financial statements.

F-3

----

**CYPRESS BIOSCIENCE, INC.**STATEMENTS OF OPERATIONS
| ** **                                                                                                        | ** ** | **Years Ended December 31,** | ** **  |
|-------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|-------------|
| ** **                                                                                                        | ** ** | **2004**                                    | ** **  | **2003** | ** ** | **2002** | ** ** |
| Revenues:                                                                                                         |       |                                        |        |   |   |   |   |
| Revenues under collaborative agreement                                                                            |       | $                                           | 14,414,619  |   | $ | — |   | $ | — |   |
| Revenue from Fresenius agreement                                                                                  |       | —                                      |        | — |   | 6,400,000 |   |
|                                                                                                              |       | 14,414,619                                  |        | — |   | 6,400,000 |   |
| Costs and  expenses:                                                                                              |       |                                        |        |   |   |   |   |
| Research and development                                                                                          |       | 15,201,192                                  |        | 11,443,693 |   | 5,094,079 |   |
| General and administrative                                                                                        |       | 5,732,641                                   |        | 4,120,156 |   | 2,985,862 |   |
| Non-cash compensation charges**(A)**                                                                              |       | 6,479,308                                   |        | 416,659 |   | 222,377 |   |
| Compensation expense (benefit)—variable stock  options**(B)**                                                |       | (699,033                                    | )           | 5,879,277 |   | (688,376 | ) |
|                                                                                                              |       | 26,714,108                                  |        | 21,859,785 |   | 7,613,942 |   |
| Other income  (expense):                                                                                          |       |                                        |        |   |   |   |   |
| Interest income                                                                                                   |       | 1,092,404                                   |        | 121,679 |   | 199,678 |   |
| Interest expense                                                                                                  |       | (5,826                                      | )           | (9,097 | ) | (33,529 | ) |
| Gain (loss) on disposal of assets                                                                                 |       | (2,095                                      | )           | 4,931 |   | (1,090 | ) |
|                                                                                                              |       | 1,084,483                                   |        | 117,513 |   | 165,059 |   |
| Net loss                                                                                                          |       | $                                           | (11,215,006 | ) | $ | (21,742,272 | ) | $ | (1,048,883 | ) |
| Net loss per share—basic and diluted                                                                         |       | $                                           | (0.40       | ) | $ | (1.21 | ) | $ | (0.09 | ) |
| Shares used in computing net loss per share—basic  and diluted                                               |       | 27,764,975                                  |        | 17,924,353 |   | 11,572,101 |   |
| **(A)** Non-cash compensation  charges include the following related expenses:                               |       |                                        |        |   |   |   |   |
| Research and development                                                                                          |       | $                                           | 449,136     |   | $ | 200,801 |   | $ | 84,774 |   |
| General and administrative                                                                                        |       | 6,030,172                                   |        | 215,858 |   | 137,603 |   |
|                                                                                                              |       | $                                           | 6,479,308   |   | $ | 416,659 |   | $ | 222,377 |   |
| **(B)** Compensation expense  (benefit)—variable stock options includes the following related expenses: |       |                                        |        |   |   |   |   |
| Research and development                                                                                          |       | $                                           | (179,928    | ) | $ | 646,302 |   | $ | (74,432 | ) |
| General and administrative                                                                                        |       | (519,105                                    | )           | 5,232,975 |   | (613,944 | ) |
|                                                                                                              |       | $                                           | (699,033    | ) | $ | 5,879,277 |   | $ | (688,376 | ) |

 

See accompanying notes to the financial statements.

F-4

----

**CYPRESSBIOSCIENCE, INC.**STATEMENTS OF STOCKHOLDERS’ EQUITY YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 
| ** **                                                                             | ** ** | ** **            | ** ** | ** **         | ** ** | ** **               | ** **  | ** **        | ** **  | **Accumulated** | ** ** | ** **  | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------|------------|--------------------------|-------------|-------------------|-------------|-----------------|------------|-------------|------------|------------|------------|
| ** **                                                                             | ** ** | ** **            | ** ** | ** **         | ** ** | ** **               | ** **  | ** **        | ** **  | **Other**       | ** ** | ** **  | ** ** | ** ** | ** ** |
| ** **                                                                             | ** ** | **Common Stock** | ** ** | **Additional**     | ** ** | **Shareholder**          | ** **  | **Comprehensive** | ** **  | **Accumulated** | ** ** | ** **  | ** ** |
| ** **                                                                             | ** ** | **Shares**            | ** ** | **Par Value** | ** ** | **Paid-in Capital** | ** **  | **Receivable**    | ** **  | **Income**      | ** ** | **Deficit** | ** ** | **Total**  | ** ** |
| Balance at  December 31, 2001                                                     |       | 6,349,221             |       | $                  | 126,984    |                     |        | $                 | 101,580,267 |            |       |        | $          | (189,973   | )          |   |   | $ | — |   |   | $ | (103,486,221 | ) | $ | (1,968,943 | ) |
| Issuance of stock  and warrants in private placement, net of placement fees            |       | 6,871,467             |       | 137,429            |       |                     | 15,194,973  |              |        |            | —     |        |       |       | —     |   |   | — |   | 15,332,402 |   |
| Compensation  related to stock options issued to consultants for services              |       | —                |       | —             |       |                     | 143,363     |              |        |            | —     |        |       |       | —     |   |   | — |   | 143,363 |   |
| Issuance of stock  to match 401(k) contributions                                  |       | 39,040                |       | 781                |       |                     | 78,233      |              |        |            | —     |        |       |       | —     |   |   | — |   | 79,014 |   |
| Stock compensation  (benefit) on variable employee stock options                       |       | —                |       | —             |       |                     | (688,376    | )                 |        |            | —     |        |       |       | —     |   |   | — |   | (688,376 | ) |
| Repurchase and  retirement of common stock                                             |       | (62,502               | )          | (1,250             | )          |                     | (70,377     | )                 |        |            | —     |        |       |       | —     |   |   | — |   | (71,627 | ) |
| Comprehensive loss:                                                                    |       |                  |       |               |       |                     |        |              |        |            |       |        |       |       |       |   |   |   |   |   |   |
| Net loss                                                                               |       | —                |       | —             |       |                     | —      |              |        |            | —     |        |       |       | —     |   |   | (1,048,883 | ) | (1,048,883 | ) |
| Unrealized gain on  short-term investments                                             |       | —                |       | —             |       |                     | —      |              |        |            | —     |        |       |       | 8,187      |   |   | — |   | 8,187 |   |
| Comprehensive loss                                                                     |       | —                |       | —             |       |                     | —      |              |        |            | —     |        |       |       | —     |   |   | — |   | (1,040,696 | ) |
| Balance at  December 31, 2002                                                     |       | 13,197,226            |       | 263,944            |       |                     | 116,238,083 |              |        |            | (189,973   | )           |       |       | 8,187      |   |   | (104,535,104 | ) | 11,785,137 |   |
| Issuance of stock  and warrants in private placement, net of placement fees            |       | 4,029,342             |       | 80,587             |       |                     | 9,427,716   |              |        |            | —     |        |       |       | —     |   |   | — |   | 9,508,303 |   |
| Issuance of stock  and warrants in connection with restated license agreement          |       | 1,000,000             |       | 20,000             |       |                     | 5,001,000   |              |        |            | —     |        |       |       | —     |   |   | — |   | 5,021,000 |   |
| Issuance of stock  upon options exercised                                              |       | 148,708               |       | 2,670              |       |                     | 301,235     |              |        |            | —     |        |       |       | —     |   |   | — |   | 303,905 |   |
| Issuance of stock  upon warrants exercised                                             |       | 3,800,045             |       | 30,714             |       |                     | 10,869,380  |              |        |            | —     |        |       |       | —     |   |   | — |   | 10,900,094 |   |
| Compensation  related to stock options issued to consultants for services              |       | —                |       | —             |       |                     | 351,159     |              |        |            | —     |        |       |       | —     |   |   | — |   | 351,159 |   |
| Issuance of stock  to match 401(k) contributions                                  |       | 9,631                 |       | 148                |       |                     | 65,352      |              |        |            | —     |        |       |       | —     |   |   | — |   | 65,500 |   |
| Stock compensation  on variable employee stock options                                 |       | —                |       | —             |       |                     | 5,879,277   |              |        |            | —     |        |       |       | —     |   |   | — |   | 5,879,277 |   |
| Change in par  value from $0.02 to $0.001                                              |       | —                |       | (375,878           | )          |                     | 375,878     |              |        |            | —     |        |       |       |       |   |   |   |   | — |   |
| Comprehensive loss:                                                                    |       |                  |       |               |       |                     |        |              |        |            |       |        |       |       |       |   |   |   |   |   |   |
| Net loss                                                                               |       | —                |       | —             |       |                     | —      |              |        |            | —     |        |       |       | —     |   |   | (21,742,272 | ) | (21,742,272 | ) |
| Unrealized gain on  short-term investments                                             |       | —                |       | —             |       |                     | —      |              |        |            | —     |        |       |       | 57,019     |   |   | — |   | 57,019 |   |
| Comprehensive loss                                                                     |       | —                |       | —             |       |                     | —      |              |        |            | —     |        |       |       | —     |   |   | — |   | (21,685,253 | ) |
| Balance at  December 31, 2003                                                     |       | 22,184,952            |       | 22,185             |       |                     | 148,509,080 |              |        |            | (189,973   | )           |       |       | 65,206     |   |   | (126,277,376 | ) | 22,129,122 |   |
| Issuance of stock  in secondary offering, net of placement fees                        |       | 6,900,000             |       | 6,900              |       |                     | 74,211,997  |              |        |            | —     |        |       |       | —     |   |   | — |   | 74,218,897 |   |
| Issuance of stock  upon options exercised                                              |       | 885,135               |       | 885                |       |                     | 1,780,285   |              |        |            | —     |        |       |       | —     |   |   | — |   | 1,781,170 |   |
| Issuance of stock  upon warrants exercised                                             |       | 384,939               |       | 385                |       |                     | 1,192,872   |              |        |            | —     |        |       |       | —     |   |   | — |   | 1,193,257 |   |
| Compensation  related to stock options and warrants issued to consultants for services |       | —                |       | —             |       |                     | 6,355,545   |              |        |            | —     |        |       |       | —     |   |   | — |   | 6,355,545 |   |
| Issuance of stock  to match 401(k) contributions                                  |       | 8,968                 |       | 9                  |       |                     | 123,754     |              |        |            | —     |        |       |       | —     |   |   | — |   | 123,763 |   |
| Stock compensation  (benefit) on variable employee stock options                       |       | —                |       | —             |       |                     | (699,033    | )                 |        |            | —     |        |       |       | —     |   |   | — |   | (699,033 | ) |
| Payment of  shareholder receivable                                                     |       | —                |       | —             |       |                     | —      |              |        |            | 189,973    |        |       |       | —     |   |   | — |   | 189,973 |   |
| Comprehensive loss:                                                                    |       |                  |       |               |       |                     |        |              |        |            |       |        |       |       |       |   |   |   |   |   |   |
| Net loss                                                                               |       | —                |       | —             |       |                     | —      |              |        |            | —     |        |       |       | —     |   |   | (11,215,006 | ) | (11,215,006 | ) |
| Unrealized gain on  short-term investments                                             |       | —                |       | —             |       |                     | —      |              |        |            | —     |        |       |       | 96,121     |   |   | — |   | 96,121 |   |
| Comprehensive loss                                                                     |       | —                |       | —             |       |                     | —      |              |        |            | —     |        |       |       | —     |   |   | — |   | (11,118,885 | ) |
| Balance at  December 31, 2004                                                     |       | 30,363,994            |       | $                  | 30,364     |                     |        | $                 | 231,474,500 |            |       |        | $          | —     |       |   |   | $ | 161,327 |   |   | $ | (137,492,382 | ) | $ | 94,173,809 |   |

 

See accompanyingnotes to the financial statements.

F-5

 

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**CYPRESSBIOSCIENCE, INC.**STATEMENTS OF CASH FLOWS
| ** **                                                                                 | ** ** | **Years Ended December 31,** | ** **  |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------|-------------|
| ** **                                                                                 | ** ** | **2004**                                    | ** **  | **2003** | ** ** | **2002** | ** ** |
| **Operating Activities**                                                                   | ** ** | ** **                                  | ** **  | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                                   |       | $                                           | (11,215,006 | ) | $ | (21,742,272 | ) | $ | (1,048,883 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                                        |        |   |   |   |   |
| Depreciation and  amortization                                                             |       | 45,653                                      |        | 56,793 |   | 87,848 |   |
| Stock and warrants issue  in connection with restated license agreement                    |       | —                                      |        | 5,021,000 |   | — |   |
| Stock compensation on  variable employee options                                           |       | (699,033                                    | )           | 5,879,277 |   | (688,376 | ) |
| Stock and options issued  for services                                                     |       | 6,479,308                                   |        | 416,659 |   | 151,375 |   |
| (Gain) loss on disposal  of property and equipment                                         |       | 2,095                                       |        | (4,931 | ) | 3,352 |   |
| Changes in operating assets and liabilities:                                               |       |                                        |        |   |   |   |   |
| Prepaid expenses and  other current assets                                                 |       | (452,183                                    | )           | (42,630 | ) | (45,664 | ) |
| Receivable from Forest  Laboratories                                                       |       | (5,656,964                                  | )           | — |   | — |   |
| Other assets                                                                               |       | —                                      |        | 4,694 |   | (18,587 | ) |
| Accounts payable and  other accrued liabilities                                            |       | (126,556                                    | )           | 987,510 |   | (1,076,095 | ) |
| Payable to Forest  Laboratories                                                            |       | 800,000                                     |        | — |   | — |   |
| Deferred rent                                                                              |       | 4,186                                       |        | 10,768 |   | 5,611 |   |
| Deferred revenue                                                                           |       | 21,875,000                                  |        | — |   | (6,400,000 | ) |
| Net cash provided  by (used in) operating activities                                       |       | 11,056,500                                  |        | (9,413,132 | ) | (9,029,419 | ) |
| **Investing Activities**                                                                   |       |                                        |        |   |   |   |   |
| Purchases of short-term  investments                                                       |       | (540,338,663                                | )           | (44,633,827 | ) | (4,965,793 | ) |
| Proceeds from sale of  short-term investments                                              |       | 459,379,000                                 |        | 27,000,000 |   | — |   |
| Purchase of property and  equipment                                                        |       | (22,092                                     | )           | (33,325 | ) | (7,300 | ) |
| Proceeds from sale of  property and equipment                                              |       | —                                      |        | 5,500 |   | — |   |
| Release of restricted cash                                                                 |       | —                                      |        | — |   | 605,240 |   |
| Net cash used in  investing activities                                                     |       | (80,981,755                                 | )           | (17,661,652 | ) | (4,367,853 | ) |
| **Financing Activities**                                                                   |       |                                        |        |   |   |   |   |
| Proceeds from exercise of  stock options and warrants                                      |       | 2,974,427                                   |        | 11,203,999 |   | — |   |
| Proceeds from secondary  offering of common stock, net                                |       | 74,218,897                                  |        | — |   | — |   |
| Proceeds from private  placement of common stock and warrants, net                         |       | —                                      |        | 9,508,303 |   | 15,332,402 |   |
| Proceeds from payment of  shareholder receivable                                           |       | 189,973                                     |        | — |   | — |   |
| Payments on capital lease  obligation                                                      |       | (14,474                                     | )           | (13,101 | ) | (10,555 | ) |
| Payments on notes payable                                                                  |       | —                                      |        | — |   | (555,630 | ) |
| Cash used to repurchase  common stock                                                      |       | —                                      |        | — |   | (625 | ) |
| Net cash provided  by financing activities                                                 |       | 77,368,823                                  |        | 20,699,201 |   | 14,765,592 |   |
| **Increase  (decrease) in cash and cash equivalents**                                      |       | 7,443,568                                   |        | (6,375,583 | ) | 1,368,320 |   |
| Cash and cash equivalents  at beginning of the year                                        |       | 859,820                                     |        | 7,235,403 |   | 5,867,083 |   |
| Cash and cash equivalents  at end of the year                                              |       | $                                           | 8,303,388   |   | $ | 859,820 |   | $ | 7,235,403 |   |
| **Supplemental disclosure of cash flow information**                                       |       |                                        |        |   |   |   |   |
| Interest paid                                                                              |       | $                                           | 5,826       |   | $ | 9,097 |   | $ | 26,537 |   |
| Equipment acquired under capital leases                                                    |       | $                                           | —      |   | $ | — |   | $ | 75,000 |   |

 

See accompanying notes to the financial statements.

F-6

----

**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS**

**1.**   THECOMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES

*The Company*

Cypress Bioscience, Inc. (the “Company”) iscommitted to being the innovator and leader in providing products for thetreatment of patients with Functional Somatic Syndromes, such as FibromyalgiaSyndrome, or FMS, and other central nervous system disorders. The Companyin-licensed its first clinical candidate for clinical development, milnacipran,in August of 2001 from Pierre Fabre Médicament, or Pierre Fabre. TheCompany completed its Phase II trial to evaluate milnacipran in the potentialtreatment of FMS in the fall of 2002, and the final results were announced inthe first quarter of 2003. The Company initiated its first Phase III clinicaltrial evaluating the use of milnacipran as a potential treatment for FMS in thefourth quarter of 2003. In January 2004, the Company entered into anagreement with Forest Laboratories, Inc. (“Forest Laboratories”) for thedevelopment and marketing of milnacipran (Note 5). In October 2004, theCompany and Forest Laboratories initiated the second Phase III clinical trialevaluating milnacipran for the treatment of FMS.

Prior to December 31,2000, the Company was engaged in the product development and marketing of thePROSORBA® column, a medical device, which was marketed for the treatment ofrheumatoid arthritis and idiopathic thrombocytopenia purpura.

*Basis ofPresentation*

Effective October 2002,the Company merged its wholly-owned subsidiary, PRP, Inc. (“PRP”), withand into the Company. Upon the effectiveness of the merger, each outstandingshare of capital stock of PRP ceased to be outstanding, without any paymentbeing made, and the Company remained as the surviving corporation. As PRP wasan inactive subsidiary, the merger of PRP into the Company had no financialstatement impact.

*AccountingEstimates in the Preparation of Financial Statements*

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from those estimates.

*Cash and CashEquivalents*

The Company considers cashequivalents to be those investments which are highly liquid, readilyconvertible into cash and which mature within three months from the date ofpurchase.

*Short-TermInvestments*

The Company’s short-term investments consist ofsecurities of the U.S. government or its agencies and certificates of depositwith maturities ranging from one to twelve months. The Company has classifiedits short-term investments as “available-for-sale” and carries them at fairvalue with unrealized gains and losses, if any, reported as a separatecomponent of stockholders’ equity and included in comprehensive loss. Realizedgains and losses are calculated on the specific identification method andrecorded as interest income. Realized gains on the sale of available for salesecurities during the years ended December 31, 

F-7

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**1.**   THE COMPANY ANDITS SIGNIFICANT ACCOUNTING POLICIES (Continued)

2004 and 2003 were$615,872 and $79,837, respectively. There were no realized gains or lossesduring the year ended December 31, 2002.

At December 31, 2004and 2003, short-term investments consisted of the following:
| ** **                       | ** ** | ** **              | ** **  | **December 31, 2004** | ** ** | ** **                 | ** ** |
|----------------------------------|------------|-------------------------|-------------|---------------------------------|------------|----------------------------|------------|
| ** **                       | ** ** | **Amortized Cost** | ** **  | **Unrealized Gains**       | ** ** | **Unrealized Losses** | ** ** | **Fair Value** | ** ** |
| U.S. government  and agency debt |       | $                       | 95,058,608  |                            |       | $                          | 175,347    |   |   |   | $ | — |   |   | $ | 95,233,955 |   |
| Certificates of  deposit         |       | 8,500,675               |        |                            | —     |                       |       |   | (14,020 | ) |   | 8,486,655 |   |
|                             |       | $                       | 103,559,283 |                            |       | $                          | 175,347    |   |   |   | $ | (14,020 | ) |   | $ | 103,720,610 |   |

 
| ** **                       | ** ** | ** **                          | ** ** | **December 31, 2003** | ** ** | ** **                 | ** ** |
|----------------------------------|------------|-------------------------------------|------------|---------------------------------|------------|----------------------------|------------|
| ** **                       | ** ** | ** Amortized Cost ** | ** ** | **Unrealized Gains**       | ** ** | **Unrealized Losses** | ** ** | **Fair Value** | ** ** |
| U.S. government  and agency debt |       |                                | $          | 19,899,324                      |       |                       |       | $ | 68,525 |   |   |   | $ | — |   |   | $ | 19,967,849 |   |
| Certificates of  deposit         |       |                                | 2,700,296  |                            |       |                       | —     |   |   |   | (3,319 | ) |   | 2,696,977 |   |
|                             |       |                                | $          | 22,599,620                      |       |                       |       | $ | 68,525 |   |   |   | $ | (3,319 | ) |   | $ | 22,664,826 |   |

 

*Concentrations ofCredit Risk*

Financial instruments thatpotentially subject the Company to concentrations of credit risk consist primarilyof cash, cash equivalents and short-term investments. The Company hasestablished guidelines to limit its exposure to credit risk by placinginvestments with high credit quality financial institutions, diversifying itsinvestment portfolio and placing investments with maturities that maintainsafety and liquidity.

*Property andEquipment*

Property and equipment,including assets acquired under capital leases, are recorded at cost anddepreciated or amortized over the estimated useful lives of the assets (threeto five years) or the lease term using the straight-line method.

*Long-Lived Assets*

The Company evaluates thecarrying value of its long-lived assets when events or changes in circumstancesindicate that an asset’s carrying value may not be recoverable. An impairmentloss is recognized when the sum of the expected future undiscounted net cashflows is less than the carrying value of the asset. To date, the Company hasnot identified any indicators of impairment or recorded any impairment oflong-lived assets.

*Accrued ClinicalTrial Costs*

The Company enrollspatients in various clinical trial sites, which are located in the UnitedStates. The Company records the cost of such studies as the clinical work isperformed by the respective research entities. The Company accrues costsrelated to clinical trials in the period incurred.

F-8

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**1.**   THE COMPANY ANDITS SIGNIFICANT ACCOUNTING POLICIES (Continued)

*Fair Value ofFinancial Instruments*

Thecarrying amounts of financial instruments, including cash and cash equivalents,prepaid expenses, receivables, accounts payable, accrued compensation andaccrued liabilities, approximate fair value due to the nature of theirshort-term maturities. The Company believes the carrying amount of its capitallease obligations approximates fair value because the interest rate on theseinstruments are at market rates.

*Revenue Recognition*

In accordance with Staff Accounting Bulletin (“SAB”) No. 101,*Revenue Recognition in Financial Statements*(as amended by SAB 104), revenues are recognized when persuasive evidence of anarrangement exists, delivery has occurred or services have been rendered, theprice is fixed and determinable and collectibility is reasonably assured. Amountsreceived for upfront license fees under multiple-element arrangements aredeferred and recognized over the period of such services or performance if sucharrangements require on-going services or performance. Amounts received forsponsored development activities, including funding received for certain of theCompany’s employees, are recognized as research costs are incurred over theperiod specified in the related agreement or as the services are performed. Amountsreceived for milestones are recognized upon achievement of the milestone, whichrequires substantive effort and was not readily assured at the inception of theagreement. Any amounts received prior to satisfying revenue recognitioncriteria will be recorded as deferred revenue.

Revenue from the Freseniusagreement (Note 6) for the year ended December 31, 2002 related to an$8.0 million upfront payment that the Company received in January 2001,which was originally recognized ratably over 5 years. The agreement withFresenius was restructured in February 2002, whereby the Company andFresenius agreed that the $8.0 million payment would cover all sales ofthe PROSORBA column in the seven-year period commencing January 2001 andthat it was non-refundable. As of a result of this modification and the factthat the Company had no further performance obligations, the Company recognizedthe remaining deferred revenue, which amounted to $6.4 million at December 31,2001, as revenue in the first quarter of 2002.

*Research andDevelopment*

Research and developmentexpenses are expensed as incurred and consist primarily of salaries and relatedpersonnel expenses for the Company’s research and development personnel, feespaid to external service providers, patient enrollment costs, fees andmilestone payments under the Company’s license and development agreements andcosts for facilities, supplies, materials and equipment. All such costs arecharged to research and development expenses as incurred. Such costs alsoinclude research and development expenses incurred in connection with the firstPhase III clinical trial for milnacipran which are reimbursed by ForestLaboratories pursuant to the collaboration agreement, as well as expensesincurred in connection with the second Phase III trial for milnacipran whichcommenced in October 2004. The Company is discussing with ForestLaboratories an arrangement whereby the costs of the second Phase III trialwill be reimbursed in the future at a premium under certain circumstances.

F-9

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**1.**   THE COMPANY ANDITS SIGNIFICANT ACCOUNTING POLICIES (Continued)

*Stock-BasedCompensation*

The Company measures compensation costs related tostock option plans using the intrinsic value method and provides pro formadisclosures of net loss per common share as if the fair value based method hadbeen applied in measuring compensation costs. Accordingly, no compensationexpense is recognized if the exercise price of stock options equals the fairvalue of the underlying stock at the date of grant.

Compensation expensefor options granted to non-employees has been determined at the grant date inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 123,*Accounting for Stock-Based Compensation,*and Emerging Issues Task Force (“EITF”) No. 96-18, *Accounting for Equity Instruments That are Issued toOther Than Employees for Acquiring or in Conjunction with Selling Goods orServices,* and has been recorded at the fair value of theconsideration received or the fair value of the equity instruments issued, whicheveris more reliably measured. Such compensation is recognized over the relatedvesting period of the underlying option.

Hadcompensation cost for the Company’s stock-based compensation plans beendetermined based on the fair value at the grant dates for awards under thoseplans, the Company’s net loss and net loss per share would have been adjustedto the pro forma amounts presented below:
| ** **                                                                                  | ** ** | **2004**   | ** **  | **2003**   | ** ** | **2002**    | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| Net loss, as  reported                                                                      |       | $          | (11,215,006 | )          | $          | (21,742,272 | )          | $ | (1,048,883 | ) |
| Add: Stock-based  employee compensation expense (benefit) included in reported net loss     |       | (699,033   | )           | 5,879,277  |       | (688,376    | )          |
| Deduct: Total  stock-based employee compensation determined under fair value based  methods |       | (2,725,218 | )           | (1,421,697 | )          | (1,741,740  | )          |
| Pro forma net  loss                                                                         |       | $          | (14,639,257 | )          | $          | (17,284,692 | )          | $ | (3,478,999 | ) |
| Net loss per  share—basic and diluted, as reported                                     |       | $          | (0.40       | )          | $          | (1.21       | )          | $ | (0.09 | ) |
| Pro forma net loss per  share—basic and diluted                                        |       | $          | (0.53       | )          | $          | (0.96       | )          | $ | (0.30 | ) |

 

The fair value of eachoption grant was estimated as of the date of grant using the Black-Scholesoption pricing model with the following weighted-average assumptions used forgrants during the years ended December 31, 2004, 2003 and 2002: nodividend yield; a risk-free interest rate of 2.6%, 2.9% and 4%, respectively;an expected term of 4.0 years for all years presented; and an expectedvolatility of 112.0%, 116.6% and 115.8%, respectively. The weighted averagefair value of options granted during the years ended December 31, 2004,2003 and 2002 was $9.45, $2.68 and $2.52, respectively.

*Earnings (Loss) PerShare*

Earnings (loss) per shareis computed using the weighted average number of shares of common stockoutstanding and is presented for basic and diluted earnings (loss) per share. Basicearnings (loss) per share is computed by dividing net income (loss) by theweighted average number of common shares outstanding during the period. Dilutedearnings (loss) per share is computed by dividing net income (loss) by theweighted average number of common shares outstanding during the periodincreased to include, if dilutive, the number of additional common shares thatwould have been outstanding if the potential common shares had been issued. Thedilutive effect of outstanding stock options and warrants is reflected indiluted earnings (loss) per share by application of the treasury stock method.The Company has excluded all 

F-10

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**1.**   THE COMPANY ANDITS SIGNIFICANT ACCOUNTING POLICIES (Continued)

outstandingstock options and warrants from the calculation of diluted loss per share forthe years ended December 31, 2004, 2003 and 2002 because such securitiesare antidilutive for these periods. The total number of potential common sharesexcluded from the calculation of diluted loss per common share for the yearsended December 31, 2004, 2003 and 2002 was 3,444,888, 2,718,175 and120,106, respectively.

*ComprehensiveIncome (Loss)*

Comprehensive income(loss) is calculated in accordance with SFAS No. 130, *ComprehensiveIncome*. SFAS No. 130 requires the disclosure of all componentsof comprehensive income (loss), including net income (loss) and changes inequity during a period from transactions and other events and circumstancesgenerated from non-owner sources. The Company’s other comprehensive income(loss) consisted of gains and losses on short-term investments and is reportedin the statements of stockholders’ equity.

*Recent Accounting Pronouncements*

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (revised 2004), *Share Based Payment*(SFAS 123R), which isa revision of SFAS 123, *Accounting forStock-Based Compensation*. This statement supercedes APB Opinion 25, *Accounting for Stock Issued to Employees*(APB25), and amends SFAS 95, *Statement of CashFlows*. Generally, the approach in SFAS 123R is similar to theapproach described in SFAS 123, however, SFAS 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair values. Pro formadisclosure is no longer an alternative.

SFAS 123R permits companies to adopt its requirementsusing either a “modified prospective” method or a “modified retrospective”method. Under the “modified prospective” method, compensation cost isrecognized in the financial statements beginning with the effective date, basedon the requirements of SFAS 123R for all share-based payments granted afterthat date, and based on the requirements for SFAS 123 for all unvested awardsgranted prior to the effective date of SFAS 123R. Under the “modifiedretrospective” method, the requirements are the same as under the “modifiedprospective” method, but also permits companies to restate financial statementsof previous periods based on proforma disclosures made in accordance with SFAS123. The Company currently utilizes the Black-Scholes model to measure the fairvalue of stock options granted to employees. While SFAS 123R permits companiesto continue to use such model, it also permits the use of a “lattice” model. TheCompany has not yet determined which model it will use to measure the fairvalue of employee stock options under the adoption for SFAS 123R. The newstandard is effective for periods beginning after June 15, 2005 and theCompany expects to adopt SFAS 123R on July 1, 2005.

The Company currentlyaccounts for share-based payments to employees using APB 25’s intrinsic valuemethod and, as such, recognizes no compensation cost for employee stock optionsgranted with exercise prices equal to or greater than the fair value of theCompany’s common stock on the date of the grant. Accordingly, the adoption ofSFAS 123R’s fair value method will have a significant impact on the Company’sresults of operations, although it will have no impact on its overall financialposition. The impact of adoption of SFAS 123R cannot be predicted at this timebecause it will depend on the level of share-based payments granted in thefuture. However, had the Company adopted SFAS 123R in prior periods, the impactof that standard would have approximated the impact of SFAS 123 as described inthe disclosure of pro forma net loss and net loss per share above.

F-11

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**2.**   COMPOSITIONOF CERTAIN FINANCIAL STATEMENT CAPTIONS

*Property andEquipment*

Propertyand equipment are comprised of the following as of December 31:
| ** **                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Laboratory and  production equipment       |       | $        | 121,321    |     | $          | 121,321 |   |
| Office equipment                           |       | 534,776  |       | 515,378  |       |
| Leasehold  improvements                    |       | 20,261   |       | 20,261   |       |
|                                       |       | 676,358  |       | 656,960  |       |
| Accumulated  depreciation and amortization |       | (600,979 | )          | (555,925 | )          |
|                                       |       | $        | 75,379     |     | $          | 101,035 |   |

 

Depreciation andamortization expense for the years ended December 31, 2004, 2003 and 2002was $45,653, $56,793 and $80,856, respectively, including assets under capitalleases. The cost for assets acquired under capital leases totaled $75,000 at December 31,2004 and 2003 with accumulation amortization of $41,250 and $26,250 at December 31,2004 and 2003, respectively.

*Accrued Liabilities*

Accruedliabilities are comprised of the following as of December 31:
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Accrued clinical  trial costs |       | $        | 232,962    |     | $          | 28,227 |   |
| Professional  services        |       | 170,152  |       | 238,653  |       |
| Other                         |       | 58,468   |       | 36,076   |       |
|                          |       | $        | 461,582    |     | $          | 302,956 |   |

 

**3.**   STOCKHOLDERS’EQUITY

*Authorized Shares*

The Company is authorizedto issue up to 60,000,000 shares of common stock and 15,000,000 shares ofpreferred stock.

*Public Offering ofShares of Common Stock*

On April 7, 2004, theCompany completed a public offering of 6,900,000 shares of common stock,including the underwriters’ purchase of an additional 900,000 shares to coverover-allotments, at $11.50 per share resulting in proceeds of approximately$74.2 million, net of placement costs.

*Shelf Registration*

On October 31, 2003,the Company filed a Form S-3 with the Securities and ExchangeCommission (“SEC”) to issue and sell up to a total dollar amount of$60 million of the Company’s common stock to the public in a registeredoffering or offerings. The Form S-3 was subsequently amended on January 13,2004 to increase the total dollar amount of the offering or offerings to$100 million of the Company’s common 

F-12

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**3.**   STOCKHOLDERS’EQUITY (Continued)

stock, comprised of up to $88 million that theCompany may sell and up to $12 million that selling stockholders may sell,and was declared effective by the SEC on January 16, 2004. During April 2004,the Company issued $79.4 million of common stock pursuant to this shelfregistration.

*Warrants*

On May 21, 2004, theCompany issued an outside consultant warrants to purchase 50,000 shares ofcommon stock as compensation for services provided. These warrants, which havean exercise price of $13.23 per share and expire in May 2007, were valuedat $385,000 using the Black-Scholes valuation model and recorded as a non-cashcompensation charge during the second quarter of 2004.

*Private Placementof Common Stock and Warrants to Purchase Common Stock*

During April 2003, the Company completed a privateplacement of 4,029,342 shares of common stock and warrants to purchase1,007,333 shares of common stock for proceeds of approximately$9.5 million, net of placement costs and fees of approximately$0.8 million. The purchase price of each security, which is thecombination of one share of common stock and a warrant to purchase 25% of oneshare of the Company’s common stock, was priced at the market value of $2.56.Each warrant has an exercise price equal to $3.84 and expires in April 2008.In addition, in connection with the private placement, the Company issuedwarrants to purchase 380,908 shares of common stock to various placementagents. These warrants have an exercise price of $2.82 and expire in April 2008.One of the placement agents in the financing, who received warrants to purchase283,301 shares of common stock and cash commission of $508,000, is affiliatedwith a stockholder of the Company.

During March 2002,the Company completed a private placement of 6,871,467 shares of common stockand warrants to purchase 3,435,726 shares of common stock. For each two sharesof common stock bought, the purchaser received a warrant to acquire one shareof common stock at $3.09 per share, a premium to the then-current market price.Such warrants expire in March 2007. The purchase price for the combinedsecurity was $2.47. The Company received proceeds of approximately$15.3 million, net of placement costs and fees of approximately$1.6 million. In addition, in March 2002, in connection with theprivate placement, the Company issued warrants to purchase 889,575 shares ofcommon stock to various placement agents. These warrants have exercise pricesranging from $2.72 to $2.96 and expire in March and April of 2007.

*Call for Redemptionof Outstanding Warrants*

During October 2003,the Company called for redemption of the outstanding warrants to purchasecommon stock of the Company issued in connection with the Company’s privateplacement in March 2002. As of October 1, 2003, there were warrantsto purchase 2,167,962 shares of common stock outstanding at an exercise priceof $3.09 out of 3,435,726 warrants originally issued. Pursuant to the terms ofthe warrant agreements, the Company had the right to call for redemption of thewarrants if the closing price of the Company’s common stock exceeded 200% ofthe warrant purchase price for 20 consecutive trading days, or $6.18, whichoccurred on September 26, 2003. All outstanding warrants from the privateplacement in March 2002 were exercised prior to the redemption date of October 20,2003 resulting in gross proceeds to the Company of $6.7 million.

F-13

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**4.**   BENEFITPLANS

*401(k) Plan*

The Company has a savingsplan under Section 401(k) of the Internal Revenue Code under whichall employees over the age of twenty-one are eligible to participate on thefirst entry date (January 1, April 1, July 1 and October 1)following their hire date. The plan allows for a matching contribution in theCompany’s common stock (valued as of the contribution date) equal to 100% ofthe amount of the salary contributed for the preceding six- month period.Employees vest in the matching contribution made on the last day of June ofthe plan year provided they are employed on the last day of December ofthe plan year and vest in the matching contribution made on the last day of December ofthe plan year provided that they are employed on the last day of June ofthe following plan year. After five years of vesting service, the matchingcontribution is 100% vested immediately. During the years ended December 31,2004, 2003 and 2002, the charge to operations for the matching contribution was$123,763, $65,500 and $79,014, respectively.

*Stock Options*

*2000 EQUITY INCENTIVE PLAN*  In May 2000, the Company adopted the2000 Equity Incentive Plan (the “2000 Plan”) providing for the grant toemployees, directors and consultants of the Company of incentive andnon-qualified stock options to purchase the Company’s common stock, as well asthe granting of stock bonuses and rights to purchase restricted stock. Theexercise price of all incentive stock options granted under the 2000 Plan shallnot be less than the fair market value of the Company’s common stock on thedate of grant. The exercise price of non-qualified stock options granted underthe 2000 Plan shall not be less than 85% of the fair market value of theCompany’s common stock on the date of grant. Options granted under the 2000Plan have a term of up to ten years and generally vest over four years. In February 2001,the shareholders of the Company approved a provision to amend the 2000 Plan,whereby the total number of shares reserved for issuance under the 2000 Planand the 1996 Equity Incentive Plan, in the aggregate, may be increasedquarterly such that the number equals 21.1% of the number of shares of theCompany’s common stock issued and outstanding as of the end of that day.Additionally, in September 2003, the shareholders of the Company approvedan amendment to the 2000 Plan to increase the number of shares of common stockavailable for issuance as incentive stock options from 875,000 shares to5,600,000 shares. This amendment does not alter the total number of sharesavailable for issuance under the 2000 Plan; it only increases the total numberof shares that may be issued under the 2000 Plan as incentive stock options. Asof December 31, 2004, 3,538,907 shares of the Company’s common stock areavailable for future grant under the 2000 Plan.

*1996 EQUITY INCENTIVE PLAN*  In January 1996, the Company adopted the1996 Equity Incentive Plan (the “1996 Plan”) providing for the grant toemployees, directors and consultants of the Company of incentive andnon-qualified stock options to purchase the Company’s common stock, as well asthe granting of stock bonuses and rights to purchase restricted stock. Theexercise price of all incentive stock options granted under the 1996 Plan shallnot be less than the fair market value of the Company’s common stock on thedate of grant. The exercise price of non-qualified stock options granted underthe 1996 Plan shall not be less than 85% of the fair market value of theCompany’s common stock on the date of grant. Options granted under the 1996Plan have a term of up to ten years and vest as determined by the Board but inno event less than twenty percent per year. As of December 31, 2004,16,873 shares of the Company’s common stock are available for future grantunder the 1996 Plan.

F-14

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**4.**   BENEFIT PLANS(Continued)

*STOCK OPTION CANCEL AND RE-GRANTPROGRAM*  In June 2001,the Company implemented an option cancel and re-grant program. Pursuant to theprogram, the exercise price of certain options held by certain of the Company’sexecutive officers and directors were exchanged for options with an exerciseprice of $2.50, the fair market value of the Company’s common stock on June 27,2001, the date the option cancel and re-grant program was effected. As acondition to participating in the option cancel and re-grant program, optioneeswho elected to surrender their old options for the replacement options had toexercise at least twenty percent of the replacement options on June 27,2001. In addition, the replacement options expire no later than the earlier ofthe expiration date of the original option grant or June 27, 2006. TheCompany’s chief executive officer exercised his options to purchase 101,319shares of common stock pursuant to a promissory note that was issued by theCompany and was secured by his stock. The outstanding principal amount of thepromissory note was due on June 27, 2006, with interest payable annually.The principal amount of the loan was $189,973 and the interest rate wasvariable, adjusted monthly and was two points above the federal funds rate. In January 2004,the principal amount of the loan and related interest was paid in full.

As a result of the program, the Company grantedoptions to purchase 618,738 shares of its common stock. In accordance with FASBInterpretation No. 44, *Accounting forCertain Transactions Involving Stock Compensation—An Interpretation of APBOpinion No. 25*, the shares underlying the options are accountedfor as variable, and the intrinsic value of the options to purchase commonstock are re-measured at the end of each period for the term of the option andamortized over the vesting period. During the years ended December 31,2004 and 2002, the Company recorded a compensation benefit of $699,033 and$688,376, respectively, as the intrinsic value of the common stock underlyingthe options declined due to a decline in the Company’s stock price. Incontrast, the Company recorded stock compensation expense of $5,879,277 for theyear ended December 31, 2003 to reflect in an increase in the intrinsicvalue of the common stock underlying the options due to an increase in theCompany’s stock price during this period.

F-15

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**4.**   BENEFIT PLANS(Continued)

The following tablesummarizes the activity of the Company’s stock options and warrants for theperiods presented:
| ** **                      | ** ** | **NUMBER OF WARRANTS/OPTIONS** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|
| ** **                      | ** ** | ** **                               | ** ** | **2000** | ** ** | **1996** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **                               | ** ** | **Equity  Incentive** | ** ** | **Equity  Incentive** | ** ** | **Non-Qualified** | ** ** | ** Other ** | ** ** |
| ** **                      | ** ** | **Warrants**                             | ** ** | **Plan Options** | ** ** | **Plan Options** | ** ** | **Stock Options** | ** ** | ** Options ** | ** ** |
| Balance  December 31, 2001 |       | 82,640                                   |       |   | 328,300 |   |   |   | 733,840 |   |   |   | 10,000 |   |   |   | 3,125 |   |   |
| Granted                         |       | 4,325,301                                |       |   | 813,891 |   |   |   | 36,000 |   |   |   | — |   |   |   | — |   |   |
| Exercised                       |       | —                                   |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Canceled                        |       | —                                   |       |   | (179,842 | ) |   |   | (4,125 | ) |   |   | — |   |   |   | — |   |   |
| Expired                         |       | (49,059                                  | )          |   | (40,135 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Balance  December 31, 2002 |       | 4,358,882                                |       |   | 922,214 |   |   |   | 765,715 |   |   |   | 10,000 |   |   |   | 3,125 |   |   |
| Granted                         |       | 1,688,241                                |       |   | 1,783,345 |   |   |   | 19,397 |   |   |   | — |   |   |   | — |   |   |
| Exercised                       |       | (4,008,811                               | )          |   | (136,553 | ) |   |   | (12,155 | ) |   |   | — |   |   |   | — |   |   |
| Canceled                        |       | (12,500                                  | )          |   | (12,500 | ) |   |   | (16,873 | ) |   |   | — |   |   |   | — |   |   |
| Expired                         |       | —                                   |       |   | — |   |   |   | (10,205 | ) |   |   | (10,000 | ) |   |   | — |   |   |
| Balance  December 31, 2003 |       | 2,025,812                                |       |   | 2,556,506 |   |   |   | 745,879 |   |   |   | — |   |   |   | 3,125 |   |   |
| Granted                         |       | 50,000                                   |       |   | 459,863 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Exercised                       |       | (403,681                                 | )          |   | (536,502 | ) |   |   | (374,723 | ) |   |   | — |   |   |   | — |   |   |
| Canceled                        |       | —                                   |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Expired                         |       | (21,081                                  | )          |   | — |   |   |   | — |   |   |   | — |   |   |   | (3,125 | ) |   |
| Balance  December 31, 2004 |       | 1,651,050                                |       |   | 2,479,867 |   |   |   | 371,156 |   |   |   | — |   |   |   | — |   |   |

 

Thefollowing table summarizes information regarding stock options outstanding at December 31,2004:
| **Range of  Exercise Prices** | ** ** | ** ** | ** ** | **Options   Outstanding ** | ** ** | **Weighted  Average  Remaining  Contractual Life  in Years** | ** ** | **Weighted**

**Average  Exercise Price** | ** ** | **Options  Exercisable** | ** ** | **Weighted  Average  Exercise Price of  Options  Exercisable** | ** ** |
|-----------------------------------------|------------|------------|------------|--------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------|------------|--------------------------|------------|--------------------------------------------------------------------------|------------|
| $  0.00  - $2.00              |       |       | 23,082     |                                 |       |                                                                   | 6.6        |                                           |       |                     | $          | 1.30                                                                     |       |   | 16,823 |   |   | $ | 1.32 |   |   |
| $  2.01  - $2.50              |       |       | 291,238    |                                 |       |                                                                   | 1.3        |                                           |       |                     | $          | 2.50                                                                     |       |   | 291,238 |   |   | $ | 2.50 |   |   |
| $  2.51  - $3.00              |       |       | 773,899    |                                 |       |                                                                   | 8.1        |                                           |       |                     | $          | 2.52                                                                     |       |   | 426,952 |   |   | $ | 2.52 |   |   |
| $  3.01  - $3.50              |       |       | 522,761    |                                 |       |                                                                   | 7.3        |                                           |       |                     | $          | 3.24                                                                     |       |   | 327,163 |   |   | $ | 3.24 |   |   |
| $  3.51  - $5.00              |       |       | 639,986    |                                 |       |                                                                   | 8.4        |                                           |       |                     | $          | 4.41                                                                     |       |   | 261,773 |   |   | $ | 4.34 |   |   |
| $  5.01  - $11.00             |       |       | 168,174    |                                 |       |                                                                   | 8.9        |                                           |       |                     | $          | 7.30                                                                     |       |   | 46,921 |   |   | $ | 6.70 |   |   |
| $11.01 - $15.00                         |       |       | 322,996    |                                 |       |                                                                   | 9.1        |                                           |       |                     | $          | 12.33                                                                    |       |   | 126,302 |   |   | $ | 12.34 |   |   |
| $15.01 - $20.00                         |       |       | 108,575    |                                 |       |                                                                   | 9.0        |                                           |       |                     | $          | 15.03                                                                    |       |   | 78,134 |   |   | $ | 15.04 |   |   |
| $20.01 - $25.00                         |       |       | 312        |                                 |       |                                                                   | 3.5        |                                           |       |                     | $          | 22.25                                                                    |       |   | 312 |   |   | $ | 22.25 |   |   |
|                                    |       |       | 2,851,023  |                                 |       |                                                                   | 7.5        |                                           |       |                     | $          | 4.93                                                                     |       |   | 1,575,618 |   |   | $ | 4.49 |   |   |

 

F-16

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**4.**   BENEFIT PLANS(Continued)

The weighted averageexercise prices for stock option activity are as follows:
| ** **                      | ** ** | **Number of Stock  Options Under  All Plans** | ** ** | **Weighted Average  Exercise Prices** | ** ** |
|---------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Balance  December 31, 2001 |       |                                                              | 1,075,265  |                                            |       |   | $ | 2.86 |   |   |
| Granted                         |       |                                                              | 849,891    |                                            |       |   | $ | 3.24 |   |   |
| Exercised                       |       |                                                              | —     |                                            |       |   | $ | — |   |   |
| Cancelled                       |       |                                                              | (183,967   | )                                               |       |   | $ | 2.96 |   |   |
| Expired                         |       |                                                              | (40,135    | )                                               |       |   | $ | 3.36 |   |   |
| Balance  December 31, 2002 |       |                                                              | 1,701,054  |                                            |       |   | $ | 3.03 |   |   |
| Granted                         |       |                                                              | 1,802,742  |                                            |       |   | $ | 3.48 |   |   |
| Exercised                       |       |                                                              | (148,708   | )                                               |       |   | $ | 2.04 |   |   |
| Cancelled                       |       |                                                              | (29,373    | )                                               |       |   | $ | 9.06 |   |   |
| Expired                         |       |                                                              | (20,205    | )                                               |       |   | $ | 16.50 |   |   |
| Balance  December 31, 2003 |       |                                                              | 3,305,510  |                                            |       |   | $ | 3.18 |   |   |
| Granted                         |       |                                                              | 459,863    |                                            |       |   | $ | 12.61 |   |   |
| Exercised                       |       |                                                              | (911,225   | )                                               |       |   | $ | 2.40 |   |   |
| Cancelled                       |       |                                                              | —     |                                            |       |   | $ | — |   |   |
| Expired                         |       |                                                              | (3,125     | )                                               |       |   | $ | 18.00 |   |   |
| Balance  December 31, 2004 |       |                                                              | 2,851,023  |                                            |       |   | $ | 4.93 |   |   |

 

**5.**   SIGNIFICANTLICENSING AND COLLABORATION AGREEMENTS

*License andCollaboration Agreement with Forest Laboratories*

In January 2004, the Company entered into acollaboration agreement with Forest Laboratories for the development andmarketing of milnacipran. Under the agreement with Forest Laboratories, theCompany sublicensed its exclusive rights to develop and commercializemilnacipran to Forest Laboratories for the United States, with an option toextend the territory to include Canada. In addition, Forest Laboratories has anoption to acquire an exclusive license from the Company in the United States,and potentially Canada, to any compounds developed under the Company’sagreement with Collegium Pharmaceutical, Inc. Forest Laboratories assumedresponsibility for funding all continuing development of milnacipran, includingthe funding of clinical trials and regulatory approvals, as well as a certainnumber of the Company’s employees. However, in light of the increased expenseand risk associated with running two parallel trials, the Company is discussingan alternative cost sharing arrangement with Forest Laboratories for the secondPhase III trial only and are currently working towards formalizing an amendmentto the agreement with Forest Laboratories. In connection with thesediscussions, the amount of funding that the Company receives from ForestLaboratories for certain of its employees has been eliminated as of the fourthquarter in 2004, and the Company will pay for a majority of the external costsof the second Phase III trial only, with Forest reimbursing the Company under specificscenarios where the second Phase III trial is used as one of the two requiredpivotal trials in the New Drug Application (NDA) submission to the FDAand with a premium under certain additional circumstances. Forest Laboratorieswill also be responsible for sales and marketing activities related to anyproduct developed under the agreement, and the Company will have the option toco-promote using its own sales force up to 25% of the total physician 

F-17

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**5.**   SIGNIFICANTLICENSING AND COLLABORATION AGREEMENTS (Continued)

details and would bereimbursed by Forest in an amount equal to Forest’s cost of providing theequivalent detailing calls.

Under the agreement with Forest Laboratories, theCompany received an upfront, non-refundable payment of $25.0 million, ofwhich $1.25 million, classified as research and development expenses, waspaid to Pierre Fabre as a sublicense fee. The total upfront and milestonepayments to the Company under the agreement could total approximately$205.0 million related to the development of milnacipran for the treatmentof FMS, a large portion of which will depend upon achieving certain sales ofmilnacipran and an additional $45.0 million in the event that the Companyand Forest Laboratories develop other indications for milnacipran. In addition,the Company has the potential to receive royalty payments based on sales oflicensed product under this agreement. Forest Laboratories also assumed thefuture royalty payments due to Pierre Fabre and the transfer price for theactive ingredient used in milnacipran. The agreement with Forest Laboratoriesextends until the later of (i) the expiration of the last to expire of theapplicable patents, (ii) 10 years after the first commercial sale ofa product under the agreement or (iii) the last commercial sale of ageneric product, unless terminated earlier. Each party has the right toterminate the agreement upon prior written notice of the bankruptcy ordissolution of the other party, or a breach of any material provision of theagreement if such breach has not been cured within the required time periodfollowing such written notice. Forest Laboratories may also terminate theagreement upon an agreed notice period in the event Forest Laboratoriesreasonably determines that the development program indicates issues of safetyor efficacy that are likely to prevent or significantly delay the filing orapproval of a new drug application or to result in labeling or indications thatwould have a significant adverse affect on the marketing of any productdeveloped under the agreement.

For the year ended December 31,2004, the Company recognized revenue of $14.4 million under its collaborationagreement with Forest Laboratories, consisting of the recognition of theupfront payment of $25.0 million from Forest Laboratories on a straight-linebasis over a period of 8 years, funding received from Forest Laboratories forcertain of the Company’s employees devoted to the development of milnacipranand sponsored development reimbursements.

*Licensing Agreementwith Pierre Fabre*

In August 2001, the Company entered into alicense agreement and a trademark agreement with Pierre Fabre. Pursuant to theterms of the license agreement, the Company paid Pierre Fabre $1.5 millionupon execution of the agreement and a $1.0 million milestone payment in September 2003.The upfront payment of $1.5 million and $1.0 million milestonepayment have been expensed pursuant to SFAS No. 2, *Accountingfor Research and Development Costs*, as the ultimatecommercialization of the related products is uncertain and the technology hasno alternative uses. Additional payments of up to $4.5 million will be dueto Pierre Fabre based on meeting certain clinical and regulatory milestones.

The license agreement was amended and restated in November 2001and subsequently in May 2003. In connection with the second amended andrestated agreement in May 2003, the Company issued Pierre Fabre 1,000,000shares of common stock and warrants to purchase 300,000 shares of common stock.These warrants have an exercise price of $4.91 per share and expire in June 2008.Pursuant to SFAS No. 2, the additional license consideration in the formof the equity instruments has been expensed as the ultimate commercializationof the related product is uncertain and the technology has no alternative uses.Accordingly, during the second quarter of 2003, the Company recognized anon-cash charge of $5.0 million 

F-18

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**5.**   SIGNIFICANT LICENSINGAND COLLABORATION AGREEMENTS (Continued)

classified as research anddevelopment expense based on the fair value of the stock and warrants issued toPierre Fabre.

In January 2004, inconnection with the Company’s transaction with Forest Laboratories, the Company’slicense agreement and trademark agreement with Pierre Fabre were furtheramended. The third amended and restated license agreement with Pierre Fabreprovides the Company with an exclusive license to develop and sell any productswith the compound milnacipran as an active ingredient for any indication in theUnited States and Canada. Simultaneous to the third amended and restatedlicense agreement, the Company also entered into a purchase and supplyagreement with Pierre Fabre for the active pharmaceutical ingredient inmilnacipran. If any product is commercialized, Pierre Fabre will have theexclusive right to manufacture the active ingredients used in the commercialproduct for a specified time period (subject to compliance with certain provisionsin the agreement), and Pierre Fabre will be paid a transfer price for eachproduct manufactured and royalties based on net sales, both obligations whichhave been assumed by Forest Laboratories. Additionally, the Company isobligated to pay Pierre Fabre a 5% sublicense fee on upfront and milestonepayments received from Forest Laboratories. Once a total of $7.5 millionhas been paid to Pierre Fabre, such additional sublicense payments due toPierre Fabre shall be credited against any royalties or milestones owed by theCompany to Pierre Fabre, which shall be carried forward to any subsequent yearsas applicable. Pierre Fabre also retains the right to sell products inindications developed by the Company outside the United States and Canada andwill pay the Company a royalty based on net sales for such products. Thelicense agreement also provides Pierre Fabre with certain rights to obtain alicense outside the United States and Canada for new formulations and new saltsdeveloped by the Company. The agreement is effective until the later of theexpiration of the last-to-expire of certain patents held by Pierre Fabrerelating to the development of milnacipran or ten years after the firstcommercial sale of a licensed product, unless terminated earlier. Each partyhas the right to terminate the agreement upon 90 days’ prior writtennotice of the bankruptcy or dissolution of the other party or a breach of anymaterial provision of the agreement if the breach is not cured within90 days following the written notice. Additionally, Pierre Fabre has theright to terminate the agreement upon 90 days’ prior notice to the Companyif the Company takes certain actions.

*Reformulation andNew Product Agreement*

In August 2002, theCompany entered into a Reformulation and New Product Agreement (“Agreement”)with Collegium Pharmaceutical, Inc., or Collegium, pursuant to whichCollegium is attempting to develop new formulations of milnacipran and newproducts that are analogs of milnacipran. In January 2004, the Company exercisedits option to acquire an exclusive license to technology developed under thisagreement. In the event the Company commercializes any of the reformulations ornew products developed under the agreement with Collegium, the Company will beobligated to pay Collegium milestone payments, which amount to $5.4 million inthe aggregate, as well as potential royalty payments based on the net sales ofreformulated or new products. Additionally, in October 2002, the Companyentered into a Common Stock Issuance Agreement with Collegium, pursuant towhich Collegium may elect to be issued shares of the Company’s common stock,subject to certain conditions, in lieu of cash, for milestone payments. TheCompany has authorized the issuance of up to 1,800,000 shares of common stockas milestone payments. The agreement with Collegium is effective until theexpiration of the last-to-expire of the issued patents, if any, unlessterminated earlier. Each party has the right to terminate the agreement upon60 days’ prior written notice of the bankruptcy or dissolution of theother party or a breach of any 

F-19

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**5.**   SIGNIFICANTLICENSING AND COLLABORATION AGREEMENTS(Continued)

materialprovision of the agreement if the breach has not been cured within the 60-dayperiod following the written notice.

**6.**   FRESENIUSAGREEMENT

In March 1999, the Company entered into anagreement with Fresenius HemoCare, or Fresenius, providing Fresenius with anexclusive license to distribute the PROSORBA column in the United States,Europe and Latin America and, subject to certain conditions, Japan and selectAsian countries, referred to as the Original Fresenius Agreement. The OriginalFresenius Agreement contemplated joint efforts to introduce and market thePROSORBA column in the United States, with us bearing the responsibility forsales, marketing and clinical research associated with the product in theUnited States. The Original Fresenius Agreement included a 50/50 profit splitin countries other than the United States, and a 50/50 profit split in theUnited States until the revenue from sales of the PROSORBA column reached apre-determined sales threshold, after which time the Company would receive 60%of the profits.

On January 19, 2001, the Company restructured itsagreement with Fresenius, referred to as the First Restructured Agreement.Pursuant to the terms of the First Restructured Agreement, Fresenius assumedall of the sales, marketing and clinical efforts associated with the PROSORBAcolumn worldwide. The Company received an upfront payment of $8.0 million,a portion of which reflected prepaid royalties on the sales of 10,000 PROSORBAcolumns in any year during the initial five years of the agreement. The FirstRestructured Agreement eliminated certain profit sharing and expense sharingprovisions, and the Company was entitled to receive additional royalties forany sales in excess of the 10,000 PROSORBA columns. Pursuant to the FirstRestructured Agreement, the Company also transferred to Fresenius certainassets associated with the PROSORBA column, including the Food and DrugAdministration Pre-Market Approval. In addition, Fresenius assumed theliability under a lease for a facility in Redmond, Washington and obligationsunder contracts relating to the PROSORBA column, including royalty obligationsunder assigned patent licenses. The Company also assigned a distributionagreement for the territory of Canada to Fresenius, but retained ownership ofthe patents and trademarks for the PROSORBA column.

In light of lower salesthan the Company and Fresenius anticipated, the Company and Freseniusdetermined to implement a different set of economic terms. As a result, theagreement was further restructured on February 1, 2002, referred to as theSecond Restructured Agreement. Under the Second Restructured Agreement, theCompany agreed that the $8.0 million upfront fee would cover all sales ofthe PROSORBA column in the initial seven-year period commencing January 2001and that it was non-refundable under any circumstances. The Company is notentitled to any additional royalty payments during the initial seven-yearperiod of the agreement. In addition, whereas under the First RestructuredAgreement, the Company was entitled to certain royalty payments on sales of thePROSORBA column after January 2006, pursuant to the terms of the SecondRestructured Agreement, a contingent payment is due to us in the amount of$1 million if sales during the first seven years exceed 35,000 units,$2 million if they exceed 50,000 units and none if the sales are less than35,000 units. Such payment, if any, will be due on January 30, 2008 and isnon-refundable. Prior to these modifications, the Company had accounted for theinitial $8.0 million payment as deferred revenue, and had amortized thisamount on a straight-line basis over five years, at the rate of $400,000 perquarter. As a result of these modifications, the Company 

F-20

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**6.**   FRESENIUSAGREEMENT (Continued)

recognizedthe remaining deferred revenue, which amounted to $6.4 million at December 31,2001, as revenue in the first quarter of 2002.

**7.**   INCOMETAXES

Significantcomponents of the Company’s net deferred income tax assets as of December 31,2004 and 2003 are shown below. A valuation allowance has been established tooffset the net deferred tax asset as of December 31, 2004 and 2003,respectively, as the realization of such assets is uncertain.
| ** **                            | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|---------------------------------------|------------|-------------|------------|-------------|------------|
| Net operating  loss carryforwards     |       | $           | 31,965,000 |        | $          | 34,127,000 |   |
| Capitalized  research and development |       | 5,925,000   |       | 1,083,000   |       |
| Capitalized  intangibles              |       | 3,165,000   |       | 1,035,000   |       |
| Tax credits                           |       | 2,301,000   |       | 2,304,000   |       |
| Other                                 |       | 195,000     |       | 48,000      |       |
|                                  |       | 43,551,000  |       | 38,597,000  |       |
| Valuation  allowance                  |       | (43,551,000 | )          | (38,597,000 | )          |
|                                  |       | $           | —     |        | $          | — |   |

                                                                                                

As of December 31, 2004, the Company hasaccumulated federal and California net operating loss carryforwards ofapproximately $87,100,000 and $26,000,000, respectively. Approximately $1,200,000of the federal net operating loss expired in 2004. The federal tax losscarryforwards will continue to expire in 2005. The California tax losscarryforwards will begin to expire in 2006. Additionally, the Company hasfederal and California research and development tax credit carryforwards ofapproximately $1,927,000 and $549,000, respectively, which will begin expiringin 2006 unless previously utilized.

The Company has determinedthat “ownership changes” within the meaning of Internal Revenue Code Section 382have occurred in prior years. However, the Company has determined based on ananalysis completed in 2004 that those limitations on the future utilization ofnet operating loss carryforwards will not have a material impact on suchutilization. Future financings may cause additional changes in ownership andcause further limitation on the use of net operating loss carryforwards.

**8.**   RELATEDPARTY TRANSACTIONS

In conjunction with the signing of the collaborationagreement with Forest Laboratories, options to purchase 200,000 shares ofcommon stock at $2.51 per share became fully vested. Such options werepreviously granted to outside consultants and two former board members forservices provided in connection with corporate partner negotiations and were tobecome fully vested upon the execution of a significant strategic collaborationwithin two years of the date of grant. The Company recorded a non-cash compensationcharge of $2.4 million, determined using the Black-Scholes valuation model, inthe first quarter of 2004 in connection with this transaction.

During March 2004,the Company entered into consulting agreements with certain board members inconnection with their resignation from the Company’s board of directors toroles as consultants. Pursuant to such consulting agreements, the Company iscommitted to pay each consultant a fee of $50,000 per year for servicesprovided over a two-year term. Additionally, eachconsultant will vest in all unvested shares 

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**8.**   RELATED PARTYTRANSACTIONS (Continued)

under outstanding option grants in equal monthlyinstallments over a period of two years from the effective date of theagreements. In connection with the consulting agreements, the Company recordeda non-cash compensation charge of $2.8 million during the first quarter of 2004related to the accounting for the stock options previously granted to suchformer board members.

**9.**   COMMITMENTS AND CONTINGENCIES

The Company currently occupies approximately 5,200square feet of leased office space in San Diego, California. The San Diegofacility houses the Company’s executive and administrative offices. The leasefor this facility expires in July 2007.

Futureannual minimum lease payments due under noncancelable capital and operatingleases consists of the following at December 31, 2004:
| **Years Ending December 31,** | ** ** | ** ** | ** ** | **Capital  Leases** | ** ** | **Operating  Leases** | ** ** |
|----------------------------------------------|------------|------------|------------|---------------------|------------|-----------------------|------------|
| 2005                                         |       | $          | 19,020     |                | $          | 177,704               |       |
| 2006                                         |       | 19,020     |       | 184,804             |       |
| 2007                                         |       | 3,170      |       | 110,270             |       |
| Total minimum lease payments                 |       | 41,210     |       | $                   | 472,778    |                  |
| Amount  representing interest                |       | 4,340      |       |                |       |
| Obligation under  capital leases             |       | 36,870     |       |                |       |
| Less current  portion                        |       | 16,022     |       |                |       |
| Long-term capital lease  obligation          |       | $          | 20,848     |                |       |                  |

 

Total rent expense wasapproximately $191,000, $171,000 and $189,000 for the years ended December 31,2004, 2003 and 2002, respectively.

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**CYPRESS BIOSCIENCE, INC. NOTES TO FINANCIAL STATEMENTS (Continued)**

**10.**   QUARTERLY INFORMATION (UNAUDITED)

Thefollowing quarterly information includes all adjustments which managementconsiders necessary for a fair statement of such information.
| ** **                                                 | ** ** | **2004**                 | ** ** |
|------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                 | ** ** | **First  Quarter(1)(2)** | ** ** | **Second  Quarter(1)** | ** ** | **Third  Quarter(1)** | ** ** | **Fourth  Quarter(1)** | ** ** |
| Revenues                                                   |       | $                        | 3,392,618  |   | $ | 3,465,823 |   | $ | 4,259,010 |   | $ | 3,297,168 |   |
| Total costs and  expenses                                  |       | $                        | 10,745,200 |   | $ | 5,422,385 |   | $ | 4,315,142 |   | $ | 6,231,381 |   |
| Other income                                               |       | $                        | 69,735     |   | $ | 196,670 |   | $ | 432,557 |   | $ | 385,521 |   |
| Net income (loss)                                          |       | $                        | (7,282,847 | ) | $ | (1,759,892 | ) | $ | 376,425 |   | $ | (2,548,692 | ) |
| Net income (loss)  per share—basic                    |       | $                        | (0.33      | ) | $ | (0.06 | ) | $ | 0.01 |   | $ | (0.08 | ) |
| Net income (loss)  per share—diluted                  |       | $                        | (0.33      | ) | $ | (0.06 | ) | $ | 0.01 |   | $ | (0.08 | ) |
| Shares used in  calculating per share amounts—basic   |       | 22,361,079               |       | 28,989,249 |   | 29,624,813 |   | 30,039,328 |   |
| Shares used in  calculating per share amounts—diluted |       | 22,361,079               |       | 28,989,249 |   | 32,890,482 |   | 30,039,328 |   |

----

(1)          Duringthe first, second, third and fourth quarters, the Company recognized non-cashcompensation expense (benefit) for variable stock options of $(1,442,933),$847,025, $(782,454) and $679,329, respectively, related to the variableaccounting treatment for options issued pursuant to the cancel and re-grantprogram in June 2001.

(2)          Duringthe first quarter, the Company recognized non-cash charges of $2.4 millionrelated to stock options that vested upon the execution of the collaborationagreement with Forest Laboratories and $2.8 million in connection with theaccounting treatment for stock options related to the resignation of certainboard members during the first quarter of 2004.
| ** **                                                                      | ** ** | **2003**              | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                      | ** ** | **First  Quarter(1)** | ** ** | **Second  Quarter(1)(2)** | ** ** | **Third  Quarter(1)** | ** ** | **Fourth  Quarter(1)** | ** ** |
| Revenues                                                                        |       | $                     | —     |   | $ | — |   | $ | — |   | $ | — |   |
| Total costs and  expenses                                                       |       | $                     | 1,771,866  |   | $ | 7,568,070 |   | $ | 5,265,752 |   | $ | 7,254,097 |   |
| Other income                                                                    |       | $                     | 21,243     |   | $ | 25,381 |   | $ | 31,694 |   | $ | 39,195 |   |
| Net loss                                                                        |       | $                     | (1,750,623 | ) | $ | (7,542,689 | ) | $ | (5,234,058 | ) | $ | (7,214,902 | ) |
| Net loss per  share—basic and diluted                                      |       | $                     | (0.13      | ) | $ | (0.43 | ) | $ | (0.28 | ) | $ | (0.33 | ) |
| Shares used in  calculating per share amounts––basic and diluted |       | 13,197,497            |       | 17,492,844 |   | 18,946,581 |   | 21,953,044 |   |

----

(1)          Duringthe first, second, third and fourth quarters, the Company recognized non-cashcompensation expense (benefit) for variable stock options of $(96,498),$882,956, $1,616,342 and $3,476,477, respectively, related to the variableaccounting treatment for options issued pursuant to the cancel and re-grantprogram in June 2001.

(2)          During the second quarter,the Company recognized a non-cash charge of $5.0 million related to commonstock and warrants issued to Pierre Fabre in connection with the second amendedand restated agreement.

F-23

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