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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

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

For the quarterly period ended September 30, 2006

OR



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

For the transition period from  to

Commission File Number: 000-51472



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COLEY
PHARMACEUTICAL GROUP, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 06-1506689                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)

93 WORCESTER STREET, SUITE 101

WELLESLEY, MA 02481

(Address of principal executive offices, including zip
code)

(781) 431-9000

(Registrants telephone number, including area code)

Not applicable

(Former name, former address and former fiscal year, if changed since last report)



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

Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ̈Accelerated filer ̈Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x

As of November 8, 2006, there were 26,325,606 shares of the Registrants Common Stock issued and outstanding.



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##### Table of Contents

Coley Pharmaceutical Group, Inc.

Form 10-Q Index

For the Quarter Ended September 30, 2006



|                               |  |                                                                                                                                                                                                                             |  |     
|------------------------------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|                               |  |                                                                                                                                                                                                                             |  | Page
|PART I  FINANCIAL INFORMATION |  | 3                                                                                                                                                                                                                          
|                               |  |                                                                                                                                                                                                                            
|ITEM 1                         |  | FINANCIAL STATEMENTS                                                                                                                                                                                                        |  | 3   
|                               |  |                                                                                                                                                                                                                            
|                               |  | Condensed Consolidated Balance Sheets (Unaudited) as of September 30, 2006 and December 31, 2005                                                                                                                            |  | 3   
|                               |  |                                                                                                                                                                                                                            
|                               |  | Condensed Consolidated Statements of Operations and Comprehensive Loss (Unaudited) for the three months ended September 30, 2006 and September 30, 2005 and the nine months ended September 30, 2006 and September 30,
2005 |  | 4   
|                               |  |                                                                                                                                                                                                                            
|                               |  | Condensed Consolidated Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2006 and September 30, 2005                                                                                             |  | 5   
|                               |  |                                                                                                                                                                                                                            
|                               |  | Notes to Unaudited Condensed Consolidated Financial Statements                                                                                                                                                              |  | 6   
|                               |  |                                                                                                                                                                                                                            
|ITEM 2.                        |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                                                                                                                                       |  | 11  
|                               |  |                                                                                                                                                                                                                            
|ITEM 3.                        |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                                                                                                                                  |  | 22  
|                               |  |                                                                                                                                                                                                                            
|ITEM 4.                        |  | CONTROLS AND PROCEDURES                                                                                                                                                                                                     |  | 22  
|                               | 
|PART II  OTHER INFORMATION    |  | 22                                                                                                                                                                                                                         
|                               |  |                                                                                                                                                                                                                            
|ITEM 1A.                       |  | RISK FACTORS                                                                                                                                                                                                                |  | 22  
|                               |  |                                                                                                                                                                                                                            
|ITEM 2.                        |  | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                                                                                                                                                 |  | 25  
|                               |  |                                                                                                                                                                                                                            
|ITEM 6.                        |  | EXHIBITS                                                                                                                                                                                                                    |  | 25  



2



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##### Table of Contents

PART I  FINANCIAL INFORMATION

Item 1. Financial Statements

Coley Pharmaceutical Group, Inc.

Condensed Consolidated Balance Sheets

(Unaudited)



|                                                                                                                          |  |                    |          |   |                  |   |          |  
|------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | -------- | - | ---------------- | - | -------- | -
|(in thousands, except share and per share data)                                                                           |  | September 30, 2006 |          |   | December 31,2005 |  
|Assets                                                                                                                    |  |                    |          |   |                  |   |          |  
|Current assets                                                                                                            |  |                    |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                 |  | $                  | 60,337   |   |                  | $ | 85,911   |  
|Marketable securities                                                                                                     |  |                    | 49,073   |   |                  |   | 57,075   |  
|Accounts receivable                                                                                                       |  |                    | 709      |   |                  |   | 2,100    |  
|Prepaid expenses and other current assets                                                                                 |  |                    | 1,948    |   |                  |   | 1,199    |  
|Deferred royalty fees                                                                                                     |  |                    | 2,020    |   |                  |   | 2,020    |  
|                                                                                                                          |  |                    |          |   |                  |   |          |  
|Total current assets                                                                                                      |  |                    | 114,087  |   |                  |   | 148,305  |  
|Property and equipment, net                                                                                               |  |                    | 4,814    |   |                  |   | 4,532    |  
|Acquired intangible assets, net                                                                                           |  |                    | 997      |   |                  |   | 1,117    |  
|Deferred royalty fees                                                                                                     |  |                    | 4,719    |   |                  |   | 6,234    |  
|Marketable securities                                                                                                     |  |                    | 4,498    |   |                  |   |         |  
|Other noncurrent assets                                                                                                   |  |                    | 1,010    |   |                  |   | 1,036    |  
|                                                                                                                          |  |                    |          |   |                  |   |          |  
|Total assets                                                                                                              |  | $                  | 130,125  |   |                  | $ | 161,224  |  
|                                                                                                                          |  |                    |          |   |                  |   |          |  
|Liabilities and Shareholders Equity                                                                                      |  |                    |          |   |                  |   |          |  
|Current liabilities                                                                                                       |  |                    |          |   |                  |   |          |  
|Accounts payable                                                                                                          |  | $                  | 1,571    |   |                  | $ | 3,087    |  
|Accrued expenses                                                                                                          |  |                    | 5,784    |   |                  |   | 5,819    |  
|Deferred revenue                                                                                                          |  |                    | 15,590   |   |                  |   | 15,014   |  
|Other current liabilities                                                                                                 |  |                    | 195      |   |                  |   | 726      |  
|                                                                                                                          |  |                    |          |   |                  |   |          |  
|Total current liabilities                                                                                                 |  |                    | 23,140   |   |                  |   | 24,646   |  
|Deferred revenue                                                                                                          |  |                    | 29,087   |   |                  |   | 39,628   |  
|Note payable                                                                                                              |  |                    | 2,967    |   |                  |   | 2,689    |  
|Other noncurrent liabilities                                                                                              |  |                    | 709      |   |                  |   | 375      |  
|                                                                                                                          |  |                    |          |   |                  |   |          |  
|Total liabilities                                                                                                         |  |                    | 55,903   |   |                  |   | 67,338   |  
|                                                                                                                          |  |                    |          |   |                  |   |          |  
|Commitments and contingencies                                                                                             |  |                    |          |   |                  |   |          |  
|Shareholders equity                                                                                                      |  |                    |          |   |                  |   |          |  
|Common stock, $0.01 par value:                                                                                            |  |                    |          |   |                  |   |          |  
|Authorized shares50,000,000 shares at September 30, 2006 and December 31, 2005                                           |  |                    |          |   |                  |   |          |  
|Issued and outstanding shares 26,323,556 and 25,931,428 shares at September 30, 2006 and December 31, 2005,
respectively |  |                    | 263      |   |                  |   | 259      |  
|Additional paid-in capital                                                                                                |  |                    | 292,220  |   |                  |   | 291,458  |  
|Note receivable from shareholder                                                                                          |  |                    |         |   |                  |   | (391     | )
|Accumulated other comprehensive income                                                                                    |  |                    | 631      |   |                  |   | 250      |  
|Deferred compensation                                                                                                     |  |                    | (6,227   | ) |                  |   | (9,630   | )
|Accumulated deficit                                                                                                       |  |                    | (212,665 | ) |                  |   | (188,060 | )
|                                                                                                                          |  |                    |          |   |                  |   |          |  
|Total shareholders equity                                                                                                |  |                    | 74,222   |   |                  |   | 93,886   |  
|                                                                                                                          |  |                    |          |   |                  |   |          |  
|Total liabilities and shareholders equity                                                                                |  | $                  | 130,125  |   |                  | $ | 161,224  |  
|                                                                                                                          |  |                    |          |   |                  |   |          |  

The accompanying notes are an integral part of these condensed consolidated financial statements.



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##### Table of Contents

Coley Pharmaceutical Group, Inc.

Condensed Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)



|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------------------------------------------ |  | ------------------------------- | ------ | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                             |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|(in thousands, except per share amounts)                                                                     |  | 2006                            |        |   | 2005                           |   |         | 2006 |  |   | 2005    |  
|Revenue                                                                                                      |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Collaborative agreements                                                                                     |  | $                               | 4,387  |   |                                | $ | 3,932   |      |  | $ | 12,395  |   |  | $ | 6,768   |  
|Government contracts and grants                                                                              |  |                                 | 701    |   |                                |   | 1,014   |      |  |   | 2,619   |   |  |   | 3,669   |  
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Total revenue                                                                                                |  |                                 | 5,088  |   |                                |   | 4,946   |      |  |   | 15,014  |   |  |   | 10,437  |  
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Operating expenses                                                                                           |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Research and development                                                                                     |  |                                 | 10,966 |   |                                |   | 13,020  |      |  |   | 32,685  |   |  |   | 32,451  |  
|General and administrative                                                                                   |  |                                 | 3,413  |   |                                |   | 2,623   |      |  |   | 9,385   |   |  |   | 8,814   |  
|Royalty expense                                                                                              |  |                                 | 539    |   |                                |   | 504     |      |  |   | 1,599   |   |  |   | 933     |  
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Total operating expenses                                                                                     |  |                                 | 14,918 |   |                                |   | 16,147  |      |  |   | 43,669  |   |  |   | 42,198  |  
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Loss from operations                                                                                         |  |                                 | (9,830 | ) |                                |   | (11,201 | )    |  |   | (28,655 | ) |  |   | (31,761 | )
|Other income and expense                                                                                     |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Interest income                                                                                              |  |                                 | 1,453  |   |                                |   | 855     |      |  |   | 4,386   |   |  |   | 1,239   |  
|Interest expense                                                                                             |  |                                 | (67    | ) |                                |   | (120    | )    |  |   | (197    | ) |  |   | (398    | )
|Other expense, net                                                                                           |  |                                 | (18    | ) |                                |   | (8      | )    |  |   | (72     | ) |  |   | (108    | )
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Total other income and expense                                                                               |  |                                 | 1,368  |   |                                |   | 727     |      |  |   | 4,117   |   |  |   | 733     |  
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Loss before income taxes                                                                                     |  |                                 | (8,462 | ) |                                |   | (10,474 | )    |  |   | (24,538 | ) |  |   | (31,028 | )
|                                                                                                             |  |                                 |        |  
|Income tax expense                                                                                           |  |                                 | (22    | ) |                                |   |        |      |  |   | (66     | ) |  |   |        |  
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Net loss                                                                                                     |  |                                 | (8,484 | ) |                                |   | (10,474 | )    |  |   | (24,604 | ) |  |   | (31,028 | )
|Accretion of redeemable convertible preferred stock                                                          |  |                                 |       |   |                                |   | (351    | )    |  |   |        |   |  |   | (1,984  | )
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Net loss attributable to common shareholders                                                                 |  | $                               | (8,484 | ) |                                | $ | (10,825 | )    |  | $ | (24,604 | ) |  | $ | (33,012 | )
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Comprehensive loss                                                                                           |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Net loss                                                                                                     |  | $                               | (8,484 | ) |                                | $ | (10,474 | )    |  | $ | (24,604 | ) |  | $ | (31,028 | )
|Other comprehensive income (loss):                                                                           |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Foreign currency translation adjustments                                                                     |  |                                 | 58     |   |                                |   | 203     |      |  |   | 396     |   |  |   | 1,329   |  
|Unrealized gains (losses) on investments, net                                                                |  |                                 | 64     |   |                                |   |        |      |  |   | (16     | ) |  |   |        |  
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Comprehensive loss                                                                                           |  | $                               | (8,362 | ) |                                | $ | (10,271 | )    |  | $ | (24,224 | ) |  | $ | (29,699 | )
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Net loss per share attributable to common shareholders                                                       |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Basic and diluted net loss per share attributable to common shareholders                                     |  | $                               | (0.32  | ) |                                | $ | (0.71   | )    |  | $ | (0.94   | ) |  | $ | (5.68   | )
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Weighted average shares used to compute basic and diluted loss per share attributable to common shareholders |  |                                 | 26,314 |   |                                |   | 15,155  |      |  |   | 26,203  |   |  |   | 5,816   |  
|                                                                                                             |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  

The accompanying notes are an integral part of these consolidated financial statements.



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##### Table of Contents

Coley Pharmaceutical Group, Inc.

Condensed Consolidated Statements of Cash Flows

(Unaudited)



|                                                                                          |  |                                 |         |   |      |   |         |  
|----------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                          |  | Nine Months Ended September 30, |        
|(in thousands)                                                                            |  | 2006                            |         |   | 2005 |  
|Cash flows from operating activities                                                      |  |                                 |         |   |      |   |         |  
|Net loss                                                                                  |  | $                               | (24,604 | ) |      | $ | (31,028 | )
|Adjustments to reconcile net loss to net cash (used in) provided by operating activities: |  |                                 |         |   |      |   |         |  
|Depreciation and amortization                                                             |  |                                 | 1,021   |   |      |   | 1,149   |  
|Amortization of acquired intangible assets                                                |  |                                 | 120     |   |      |   | 120     |  
|Noncash stock compensation expense                                                        |  |                                 | 3,982   |   |      |   | 10,583  |  
|Changes in operating assets and liabilities:                                              |  |                                 |         |   |      |   |         |  
|Accounts receivable                                                                       |  |                                 | 1,414   |   |      |   | (475    | )
|Prepaid expenses and other assets                                                         |  |                                 | (249    | ) |      |   | 636     |  
|Deferred royalty fees                                                                     |  |                                 | 1,515   |   |      |   | (5,742  | )
|Accounts payable                                                                          |  |                                 | (1,608  | ) |      |   | 1,348   |  
|Accrued expenses and other liabilities                                                    |  |                                 | 39      |   |      |   | (2,443  | )
|Deferred revenue                                                                          |  |                                 | (9,965  | ) |      |   | 45,466  |  
|                                                                                          |  |                                 |         |   |      |   |         |  
|Net cash (used in) provided by operating activities                                       |  |                                 | (28,335 | ) |      |   | 19,614  |  
|                                                                                          |  |                                 |         |   |      |   |         |  
|Cash flows from investing activities                                                      |  |                                 |         |   |      |   |         |  
|Purchases of marketable securities                                                        |  |                                 | (46,762 | ) |      |   | (21,000 | )
|Maturities of marketable securities                                                       |  |                                 | 49,840  |   |      |   | 31,013  |  
|Release of restricted cash                                                                |  |                                 | 46      |   |      |   | 102     |  
|Purchases of property and equipment                                                       |  |                                 | (672    | ) |      |   | (317    | )
|                                                                                          |  |                                 |         |   |      |   |         |  
|Net cash provided by investing activities                                                 |  |                                 | 2,452   |   |      |   | 9,798   |  
|                                                                                          |  |                                 |         |   |      |   |         |  
|Cash flows from financing activities                                                      |  |                                 |         |   |      |   |         |  
|Principal payments of capital lease obligations                                           |  |                                 | (714    | ) |      |   | (1,306  | )
|Proceeds from issuance of common stock                                                    |  |                                 |        |   |      |   | 110,835 |  
|Proceeds from stock option exercises                                                      |  |                                 | 537     |   |      |   | 349     |  
|Proceeds from repayment of shareholder note                                               |  |                                 | 44      |   |      |   | 21      |  
|                                                                                          |  |                                 |         |   |      |   |         |  
|Net cash (used in) provided by financing activities                                       |  |                                 | (133    | ) |      |   | 109,899 |  
|                                                                                          |  |                                 |         |   |      |   |         |  
|Exchange rate effect on cash and cash equivalents                                         |  |                                 | 442     |   |      |   | (580    | )
|                                                                                          |  |                                 |         |   |      |   |         |  
|Net (decrease) increase in cash and cash equivalents                                      |  |                                 | (25,574 | ) |      |   | 138,731 |  
|Cash and cash equivalents, beginning of period                                            |  |                                 | 85,911  |   |      |   | 13,190  |  
|                                                                                          |  |                                 |         |   |      |   |         |  
|Cash and cash equivalents, end of period                                                  |  | $                               | 60,337  |   |      | $ | 151,921 |  
|Non-cash investing and financing activities                                               |  |                                 |         |   |      |   |         |  
|Repayment of shareholder note                                                             |  | $                               | 353     |   |      | $ |        |  
|Capital lease obligation incurred                                                         |  | $                               | 412     |   |      | $ |        |  
|                                                                                          |  |                                 |         |   |      |   |         |  

The accompanying notes are an integral part of these condensed consolidated financial statements.



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##### Table of Contents

Coley Pharmaceutical Group, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

1. Nature of the Business, Basis of Presentation and Significant Accounting Policies

Nature of the Business

Coley Pharmaceutical Group,
Inc. (the Company) is an international biopharmaceutical company focused on discovering and developing TLR Therapeutics, a new class of investigational drug candidates that direct the human immune system to fight cancers, infectious diseases, asthma and allergy. The Company has established a pipeline of four TLR Therapeutic product
candidates currently in clinical development either independently or with partners, and additional product candidates in preclinical development.

Basis
of Presentation and Principles of Consolidation

The condensed consolidated financial statements reflect the operations of the Company
and its wholly-owned subsidiaries, Coley Pharmaceutical GmbH, Coley Pharmaceutical Group, Ltd. and Coley Pharmaceutical Security Corporation. All significant intercompany balances and transactions have been eliminated.

The accompanying condensed consolidated financial statements of Coley Pharmaceutical Group, Inc. have been prepared in accordance with generally accepted
accounting principles and the rules and regulations of the Securities and Exchange Commission, or SEC, for interim financial information. Accordingly, these financial statements do not include all the information and footnotes required by generally
accepted accounting principles for complete financial statements and should be read in conjunction with the Companys consolidated financial statements included in the Companys Form 10-K for the year ended December 31, 2005. The
financial information as of September 30, 2006 and for the three and nine months ended September 30, 2006 and September 30, 2005 is unaudited, but in the opinion of management, all adjustments, consisting only of normal recurring
accruals, considered necessary for a fair statement of the results of this interim period have been included. The year-end condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by
accounting principles generally accepted in the United States.

The results of the Companys operations for any interim period are not
necessarily indicative of the results that may be expected for any other interim period or for a full fiscal year.

Cash, Cash Equivalents and
Marketable Securities

The Company considers all highly liquid investments with a maturity of three months or less when purchased to be
cash equivalents. Marketable securities are classified as available-for-sale and are carried at market value with unrealized gains and losses reported as other comprehensive income or loss, which is a separate component of
shareholders equity.

Marketable securities as of September 30, 2006 consist of the following:



|                                                |  |               |            |                 |   |                  |  |                            |        |  |   |           
|----------------------------------------------- |  | ------------- | ---------- | --------------- | - | ---------------- |  | -------------------------- | ------ |  | - | ----------
|                                                |  | Amortizedcost |            | Unrealizedgains |   | Unrealizedlosses |  | Estimated FairMarket Value
|Less than 12 months                             |  |               |            |                 |   |                  |  |                            |        |  |   |           
|Certificates of deposit                         |  | $             | 2,024,967  |                 | $ | 24               |  | $                          |       |  | $ | 2,024,991 
|U.S. government agencies                        |  |               | 22,427,007 |                 |   |                 |  |                            | 11,373 |  |   | 22,415,634
|Corporate bonds                                 |  |               | 16,770,205 |                 |   | 557              |  |                            | 14,793 |  |   | 16,755,969
|Commercial paper                                |  |               | 7,891,180  |                 |   |                 |  |                            | 14,316 |  |   | 7,876,864 
|                                                |  |               |            |                 |   |                  |  |                            |        |  |   |           
|Total marketable securities less than 12 months |  |               | 49,113,359 |                 |   | 581              |  |                            | 40,482 |  |   | 49,073,458
|                                                |  |               |            |                
|12 months or longer                             |  |               |            |                 |   |                  |  |                            |        |  |   |           
|U.S. government agencies                        |  | $             | 4,500,000  |                 | $ | 521              |  | $                          | 2,113  |  | $ | 4,498,408 
|                                                |  |               |            |                 |   |                  |  |                            |        |  |   |           
|Total marketable securities                     |  | $             | 53,613,359 |                 | $ | 1,102            |  | $                          | 42,595 |  | $ | 53,571,866
|                                                |  |               |            |                 |   |                  |  |                            |        |  |   |           

Deferred Royalty Fees

Royalty fees represent payments for in-licensed technology from third parties (licensors) where the Company generally obtains rights to develop and commercialize products covered by the licensed
technology. These licensors are primarily the University of Iowa Research Foundation (UIRF) and the Ottawa Health Research Institute (OHRI).



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##### Table of Contents

The Companys license agreements generally require royalty payments to the licensor based on the
sale of products covered by the licensed technology. The Company also has the right to sublicense the technology to third parties and is required to pay the licensor part of any sublicense fees the Company receives. Deferred royalty fees represent
payments to licensors that have been deferred and will be recognized as expense as the Company recognizes the related revenue under its collaborative research and development agreements.

Deferred royalty fees included in the condensed consolidated balance sheet totaled $6,738,548 and $8,253,198 at September 30, 2006 and
December 31, 2005, respectively.

2. Stock-Based Compensation

Upon the effectiveness of the Companys initial public offering, the 2005 Stock Plan (2005 Plan) was adopted. The 2005 Plan provides for the grant of incentive stock options, nonqualified stock
options, restricted and unrestricted stock awards and other stock-based awards. The stock options typically vest over a period of up to four years. The stock options typically expire ten years from the date granted. When an optionee ceases to be an
employee, director, or consultant of the Company, such options terminate either upon or shortly after termination of employment or the provision of services.

In 1997, the Company adopted the 1997 Stock Option Plan (1997 Plan). The terms of the 1997 Plan are similar to the 2005 Plan. Upon the completion of the Companys initial public offering, the 1997
Plan was terminated and no new options can be granted under this plan. All outstanding stock options granted under the 1997 Plan as of the date of the termination remain outstanding and subject to their terms and the terms of the 1997 Plan, unless
they have otherwise expired or been exercised in accordance with their terms. At September 30, 2006, 2,319,207 options were outstanding under the 1997 Plan.

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), Share-Based Payment (SFAS No. 123(R)), which amends SFAS No. 123, Accounting
for Stock-Based Compensation (SFAS No. 123). The Company adopted SFAS No. 123(R) on January 1, 2006 effective with the beginning of the Companys first quarter. The standard set forth in SFAS No. 123(R)
requires the Company to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award using an option pricing model. That cost is recognized over the period during which
an employee is required to provide service in exchange for the award. The Company elected to adopt the prospective transition method as provided by SFAS No. 123(R) and, accordingly, financial statement amounts for the periods prior to adoption
presented in this Form 10-Q have not been restated to reflect the fair value method of expensing prescribed by SFAS No. 123(R). The Company recognizes stock-based compensation expense using the straight-line attribution method. The net
cumulative effect of the adoption of SFAS No. 123(R) did not have a material impact on the Companys financial statements.

Prior
to January 1, 2006, the Company applied the intrinsic value method set forth in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25), in accounting for employee stock
options. Under APB No. 25, when the exercise price of options granted to employees under these plans is less than the market price of the common stock on the date of grant, compensation expense is recognized over the vesting period.

For stock options granted to non-employees, including members of the Companys Scientific Advisory Board, the Company recognizes compensation
expense in accordance with the provisions of SFAS No. 123, as amended by SFAS No. 148, and Emerging Issues Task Force, or EITF, Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services, which require such equity instruments to be recorded at their fair value on the measurement date. The measurement of stock-based compensation is subject to periodic adjustment as the
underlying equity instruments vest. The Company amortizes compensation expense related to non-employee stock options in accordance with FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or
Award Plans(FIN 28). For the three months ended September 30, 2006 and 2005, the Company recognized $37,846 and $201,594, respectively, of stock-based compensation expense related to these options. For the nine months ended
September 30, 2006 and 2005, the Company recognized $79,595 and $536,836, respectively, of stock-based compensation expense related to these options.

Under SFAS No. 123(R), entities that become public companies after June 15, 2005 and that used the minimum value method of measuring equity share options and similar instruments as a non-public company for
either recognition or pro forma disclosure purposes under SFAS No. 123 must apply the provisions of SFAS No. 123(R) prospectively to new and/or modified awards after the adoption of SFAS No. 123(R). These companies should continue to
account for any portion of awards outstanding at the date of initial application of SFAS No. 123(R) using the accounting principles originally applied to those awards  either the minimum value method under SFAS No. 123 or the
provisions of APB No. 25 and its related interpretive guidance. Accordingly, upon the adoption of SFAS No. 123(R), $775,901 of the Companys deferred stock-based compensation balance of $9,630,022 as of December 31, 2005, which
was accounted for under APB No. 25, was eliminated against additional paid-in-capital. The remaining portion of the deferred stock-based compensation balance at



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September 30, 2006 is comprised of the intrinsic value of stock options granted prior to April 20, 2005 (the date the Company filed its initial
Registration Statement on Form S-1 with the SEC) at an exercise price below fair market value which were accounted for under the minimum value method for SFAS No. 123 disclosure purposes since the Companys stock was not then publicly
traded.

The fair value of options at the date of grant, based upon certain assumptions, was calculated using the Black-Scholes option
pricing model. Given its limited history as a public company, the Companys expected stock price volatility was based upon the expected stock price volatility of companies whose stock prices are publicly available and are similar in size and
development stage to the Company. The expected term assumption is based upon the simplified method provided under Staff Accounting Bulletin No. 107 which averages the contractual term of the Companys options (10 years) with the vesting
term (4 years) taking into consideration multiple vesting tranches. The dividend yield of zero is based upon the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends on its securities. The risk-free
interest rate used for each grant is equal to the United States Treasury yield curve in effect at the time of the grant for instruments with a similar expected life.

The table below illustrates the Black-Scholes option pricing model with the following assumptions used for grants issued during the three and nine months ended September 30, 2006 and 2005:



|                                |  |                                  |   |  |                                 |   |  |             |  |      |  
|------------------------------- |  | -------------------------------- | - |  | ------------------------------- | - |  | ----------- |  | ---- | -
|                                |  | Three Months Ended September 30, |   |  | Nine Months Ended September 30, |  
|                                |  | 2006                             |   |  | 2005                            |   |  | 2006        |  | 2005 |  
|Risk-free interest rate         |  | 5.0                              | % |  | 4.14                            | % |  | 4.8% - 5.1% |  | 4.13 | %
|Expected dividend yield         |  | 0                                | % |  | 0                               | % |  | 0%          |  | 0    | %
|Expected option life            |  | 6.25                             |   |  | 5                               |   |  | 6.25        |  | 5    |  
|Expected stock price volatility |  | 75                               | % |  | 80                              | % |  | 75%         |  | 80   | %

SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised in
subsequent periods, if necessary, if actual forfeiture rates differ from those estimates. The Company will record additional expense if the actual forfeitures are less than those estimated and will record a recovery of expense if actual forfeitures
are greater than those estimated. No amounts related to stock-based compensation have been capitalized.

The adoption of SFAS
No. 123(R) increased the Companys stock-based compensation expense by approximately $566,000 (representing a $0.02 impact to basic and diluted net loss per share) in the three months ended September 30, 2006 and $1,458,000
(representing a $0.06 impact to basic and diluted net loss per share) for the nine months ended September 30, 2006. The following table shows stock-based compensation expense included in the condensed consolidated statements of operations for
the three and nine months ended September 30, 2006 and 2005.



|                                       |  |                                  |           |                                 |   |           |  |      |           |  |   |           
|-------------------------------------- |  | -------------------------------- | --------- | ------------------------------- | - | --------- |  | ---- | --------- |  | - | ----------
|                                       |  | Three Months Ended September 30, |           | Nine Months Ended September 30,
|                                       |  | 2006                             |           | 2005                            |   | 2006      |  | 2005
|Research and development               |  | $                                | 626,564   |                                 | $ | 3,264,417 |  | $    | 1,879,780 |  | $ | 6,688,397 
|General and administrative             |  |                                  | 730,803   |                                 |   | 695,370   |  |      | 2,101,788 |  |   | 3,895,071 
|                                       |  |                                  |           |                                 |   |           |  |      |           |  |   |           
|Total stock-based compensation expense |  | $                                | 1,357,367 |                                 | $ | 3,959,787 |  | $    | 3,981,568 |  | $ | 10,583,468
|                                       |  |                                  |           |                                 |   |           |  |      |           |  |   |           

As of September 30, 2006, there remained approximately $13,079,278 of compensation costs, net
of estimated forfeitures, related to unvested stock options to be recognized as expense over a weighted average period of approximately 2.69 years.

A summary of stock option activity under the Companys 1997 and 2005 Stock Option Plans for the period ended September 30, 2006 is as follows:



|                                                           |  |                 |   |  |                                         |       |                                           |     |                          |   |           
|---------------------------------------------------------- |  | --------------- | - |  | --------------------------------------- | ----- | ----------------------------------------- | --- | ------------------------ | - | ----------
|                                                           |  | Number ofShares |   |  | WeightedAverage ExercisePrice per Share |       | Weighted AverageRemainingContractual Life |     | Aggregate IntrinsicValue
|Options outstanding at December 31, 2005                   |  | 3,385,384       |   |  | $                                       | 4.86  |                                           |     |                          |   |           
|Granted                                                    |  | 290,036         |   |  | $                                       | 11.74 |                                           |     |                          |   |           
|Cancelled                                                  |  | (48,364         | ) |  | $                                       | 7.52  |                                           |     |                          |   |           
|Exercised                                                  |  | (401,903        | ) |  | $                                       | 1.34  |                                           |     |                          | $ | 5,159,649 
|                                                           |  |                 |   |  |                                         |       |                                           |     |                          |   |           
|Options outstanding at September 30, 2006                  |  | 3,225,153       |   |  | $                                       | 5.88  |                                           | 7.9 |                          | $ | 20,274,773
|Options vested at September 30, 2006                       |  | 1,672,061       |   |  | $                                       | 4.41  |                                           | 7.3 |                          | $ | 12,537,169
|Options vested and expected to vest at September 30, 2006  |  | 3,139,514       |   |  | $                                       | 5.80  |                                           | 7.8 |                          | $ | 19,956,603
|Weighted average fair value of options granted during 2006 |  |                 |   |  | $                                       | 8.45  |                                           |     |                          |   |           
|Weighted average fair value of options granted during 2005 |  |                 |   |  | $                                       | 11.42 |                                           |     |                          |   |           



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3. Net Loss Per Common Share

The Company accounts for and discloses net loss per common share in accordance with SFAS No. 128, Earnings Per Share (SFAS No. 128). Under the provisions of SFAS No. 128, basic net
loss per common share is computed by dividing net loss by the weighted-average number of common shares outstanding. Diluted net loss per share is computed by dividing net loss by the weighted-average number of common shares and other potential
common shares then outstanding. Other potential common shares consist of the incremental common shares issuable upon the conversion of preferred stock, shares issuable upon the exercise of stock options and the conversion of preferred stock upon the
exercise of warrants. Diluted net loss per share is identical to basic net loss per share for all periods presented since other potential common shares are excluded from the calculation as their effect is anti-dilutive.

The following table shows the number of potentially dilutive common shares outstanding which are not included in the historical calculations of net loss
per common share as the effect of their inclusion is anti-dilutive during each period:



|         |  |                                  |  |                                 |  |           |  |          
|-------- |  | -------------------------------- |  | ------------------------------- |  | --------- |  | ---------
|         |  | Three Months Ended September 30, |  | Nine Months Ended September 30,
|         |  | 2006                             |  | 2005                            |  | 2006      |  | 2005     
|Options  |  | 2,394,144                        |  | 3,289,672                       |  | 2,394,144 |  | 3,289,672
|Warrants |  | 2,038,205                        |  | 2,061,271                       |  | 2,038,205 |  | 2,061,271
|         |  |                                  |  |                                 |  |           |  |          
|         |  | 4,432,349                        |  | 5,350,943                       |  | 4,432,349 |  | 5,350,943
|         |  |                                  |  |                                 |  |           |  |          

The Company became a public company on August 9, 2005. At that time all preferred stock
outstanding converted into an aggregate of 17,003,547 shares of common stock, including shares of common stock issuable in connection with a guaranteed paid-in-kind dividend on the Companys Series F Preferred Stock.

4. Significant Research and Development and Licensing Agreements

Pfizer Inc.

In March 2005, the Company entered into a series of agreements with Pfizer Inc. under which it has granted
Pfizer development and worldwide marketing rights to ProMune(also known as CPG 7909 and now referred to as
PF-3512676 by Pfizer). Under the license agreement, the Company received a $50,000,000 upfront license fee and may receive up to $455,000,000 in milestone payments, a significant majority of which relates to potential development and regulatory
approval milestones, as well as royalties on any future product sales. The Company also entered into a stock purchase agreement with Pfizer pursuant to which Pfizer purchased $10,000,000 of the Companys common stock in a private placement
concurrent with the Companys initial public offering.

A primary focus of the agreements with Pfizer is the development and
commercialization of PF-3512676 for the treatment, control and prevention of multiple cancers, including the treatment of advanced non-small cell lung cancer, or NSCLC. Pfizer will fund all future development of PF-3512676 including Phase III
clinical trials for the treatment of NSCLC, breast cancer and other cancer indications. Pfizer has initiated two pivotal international Phase III clinical trials of PF-3512676 in the first-line treatment of advanced NSCLC patients.

Pursuant to a separate screening agreement, Pfizer is providing the Company with funding for the discovery and development of next-generation TLR9
agonists for cancer, which, if successful, would be licensed to Pfizer and could result in additional milestone payments and additional royalties to the Company.

Under the terms of the license agreement, the license extends until the later to occur of the expiration of the last of the licensed patents which covers the sale of PF-3512676 or any next generation TLR9 agonist
licensed by the Company to Pfizer and the emergence of generic competition for such products, in each case, as determined on a country-by-country basis. Currently, the latest to expire of the Companys patents covering PF-3512676 is scheduled
to expire in 2014. The Company has patent applications pending which, if issued, may provide patent protection for PF-3512676 through 2017.

Pfizer may terminate the collaboration relationship without cause upon not less than 120 days prior written notice. Either Pfizer or the Company may terminate the collaboration relationship upon the bankruptcy of the other party or the
commitment by the other party of an uncured material default, as defined in the license agreement.

Upon a change of control of the
Company, as defined in the license agreement, the agreement would remain in effect, although Pfizer would have the right to terminate certain provisions.



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In connection with the $50,000,000 upfront license payment from Pfizer, the Company will recognize this
initial fee over 44 months, the expected period of the Companys performance obligations. Accordingly, for the three months ended September 30, 2006 and 2005, the Company recognized license, sponsored research revenue and expense
reimbursements of $4,058,977 and $3,576,920, respectively. For the nine months ended September 30, 2006 and 2005, the Company recognized $11,498,316 and $5,901,520, respectively. To date, the Company has received or invoiced $54,337,137 for
upfront license, sponsored research and expense reimbursement under the Pfizer agreement.

During 2005, the Company paid UIRF $6,500,000
and OHRI $150,000 for royalties related to the $50,000,000 upfront license payment received from Pfizer. These amounts were included in deferred royalty fees and are being recognized as expense over 44 months to match the recognition of revenue of
the $50,000,000 upfront payment described above.

Avant Immunotherapeutics, Inc.

In the second quarter of 2006, the Company entered into a license agreement with Avant Immunotherapeutics, Inc. (Avant). The license agreement
is for the use of VaxImmunein combination with Avants CETP vaccine candidate for cholesterol
management. The Company received an upfront payment and will receive payments upon Avants achievement of development and regulatory milestones as well as royalties from sales of vaccine products developed that contain VaxImmune. Under this
agreement, Avant is solely responsible for the development of products containing VaxImmune.

Either party may terminate the agreement upon
customary terms included in the agreement including upon an uncured material default by the other party, as defined in the license agreement. This license extends through the later to occur of (i) the expiration or termination of the last valid
patent claim in the territory or (ii) twelve (12) years from the first commercial sale of a licensed product in the territory.

Government
Contracts and Grants

U.S. National Institute of Allergy and Infectious Diseases (NIAID), part of the National Institutes
of Health

The Company has a $6,250,000 grant with the NIAID to perform research and preclinical development in the area of pulmonary
innate immune activation for bio-terror defense. This grant extends through February 2007. The Company has recognized revenues under this grant of $73,047 and $611,917 for the three months ended September 30, 2006 and 2005, respectively. For
the nine months ended September 30, 2006 and 2005, the Company has recognized revenue under this grant of $648,358 and $1,532,228, respectively.

In 2004, the Company was awarded a $16,902,000 five-year contract from the NIAID to perform research in the area of innate immune receptors and vaccine adjuvant discovery for defense against bio-terror agents. The
Company recognized revenues under this contract of $627,475 and $418,553 for the three months ended September 30, 2006 and 2005, respectively. For the nine months ended September 30, 2006 and 2005, the Company recognized revenue under this
contract of $1,970,512 and $1,607,933, respectively.

Funding of the above mentioned government contracts and grants beyond the United
States governments current fiscal year are subject to Congressional appropriations. Overhead billed to the United States government under these contracts is considered provisional until audited by the United States government.

5. Related Party Transactions

In 2001, the Company
loaned its co-founder and Chief Scientific Officer, Dr. Arthur Krieg, $500,000 evidenced by a promissory note bearing interest of 7% and payable in full on May 8, 2006. The loan was made in connection with Dr. Kriegs purchase of
a home in Massachusetts.

In 2005, Dr. Krieg remitted $310,000 to the Company as a partial pre-payment of his loan. In the second
quarter of 2006, Dr. Krieg settled the remaining balance, including interest, of approximately $353,000 by tendering 24,579 shares of Coley common stock to the Company.

6. Recent Accounting Pronouncements

In July 2006, the FASB issued FASB Interpretation No. 48,
Accounting for Uncertainty in Income Taxes  an interpretation of FASB Statement No. 109. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in
accordance with FASB Statement No. 109, Accounting for Income Taxes. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective
for fiscal years beginning after December 15, 2006. At the present time, the Company is evaluating the impact the adoption may have on the Companys financial statements.



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In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement. This standard
addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles (GAAP). This standard is effective for all
financial statements issued for fiscal years beginning after November 15, 2007. The Company is in the process of evaluating whether this standard will have a material effect on its financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement
Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)(SFAS No. 158).SFAS No. 158 requires recognition of a net liability or asset for the funded status of defined benefit pension and other
postretirement plans and recognition of changes in the funded status through comprehensive income. SFAS No. 158 also requires the measurement of defined benefit plan assets and obligations as of a companys fiscal year-end. SFAS
No. 158 shall be effective as of the end of the first fiscal year ending after December 15, 2006. The Company does not expect the provisions of SFAS No. 158 will have a material impact on its financial position or results of
operations.

Staff Accounting Bulletin No. 108 (SAB No. 108), released in September 2006, provides guidance on
evaluating the effects of misstatements on all periods disclosed in the financial statements and related financial statement disclosures. In order to quantify the impact of misstatements both the carryover and reversing effects of prior year
misstatements should be considered in the current year financial statements. An adjustment would be required if the misstatement is material to the financial statements, after all relevant quantitative and qualitative factors are considered. SAB
No. 108 shall be effective for the first fiscal year ending after November 15, 2006. The Company does not expect the provisions of SAB No. 108 will have a material impact on its financial position or results of operations.

Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations

You
should read the following discussion and analysis of financial condition and results of operations together with our condensed consolidated financial statements and related notes included elsewhere in this report.

Overview

We are a biopharmaceutical company focused
on discovering and developing TLR Therapeutics, a novel class of drug candidates for cancers, infectious diseases, asthma and allergy. We began operations in 1998. Independently and with our collaborators, we currently have four drug candidates in
clinical trials, including our lead product candidate, PF-3512676 for cancers, which is currently in pivotal international Phase III clinical trials (being conducted by Pfizer), ACTILONfor Hepatitis C virus, or HCV, which is currently in Phase Ib and Phase II clinical trials, and two product candidates being developed by our
collaborators. Since our inception, we have generated significant losses while we, or our collaborators, have advanced our products into clinical trials. As of September 30, 2006, we had accumulated a deficit of $212.7 million.

Our most advanced product candidate, PF-3512676, was licensed to Pfizer Inc. in March 2005 and is currently in Phase III clinical trials which are being
conducted by Pfizer. Development, regulatory and commercialization costs for PF-3512676 are being funded by Pfizer. We expect to continue to spend significant amounts on the discovery and development of TLR Therapeutics for HCV and research and
development programs for new TLR Therapeutics for additional disease indications.

Ongoing Clinical Programs

Cancer

At September 30, 2006,
substantially all PF-3512676 clinical trials initiated by us prior to entering the Pfizer license agreement have been completed. We have been reimbursed $1.7 million by Pfizer for the external costs associated with the conduct of PF-3512676 trials
from the inception of the Pfizer agreement through September 30, 2006.

Hepatitis C Virus

Our lead product candidate for the treatment of Hepatitis C virus is ACTILON. The status of ACTILON clinical trials as of September 30, 2006 is as
follows:



|                               |  |             |  |                  
|------------------------------ |  | ----------- |  | -----------------
|Trial                          |  | Indication  |  | Enrollment Status
|Phase Ib combination therapies |  | Hepatitis C |  | Fully enrolled   
|Phase II combination therapies |  | Hepatitis C |  | Enrolling        



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Consistent with our PF-3512676 clinical development strategy, we plan to use the results of our Phase Ib
and Phase II clinical trials to determine our ACTILON clinical development strategy in HCV before proceeding into large scale efficacy clinical trials. Initial results from the Phase II trial were disclosed in the fourth quarter of 2006. The trial
was expanded in the fourth quarter of 2006 to include an additional sub-population of refractory patients with initial results expected in the first half of 2007.

We have incurred $1.7 million in external costs to date on the Phase Ib study, including $0.1 million of external costs in the quarter ended September 30, 2006. We expect to incur an additional $0.2 million in
external costs for this study through its conclusion. For the Phase II study, we have incurred $1.5 million in external costs to date, including $0.6 million of external costs in the quarter ended September 30, 2006. We expect to incur an
additional $0.8 million in external costs for this study through its conclusion.

We are independently developing and funding
ACTILONs clinical development, with Schering-Plough Corporation supplying pegylated interferon and ribavirin at no cost for the above clinical trials.

United States Government Contracts and Grants

As of September 30, 2006, gross proceeds of $11.7 million remained to be
received under our various government contracts and grants, which include amounts for reimbursement to our subcontractors, as well as reimbursement for our employees time and benefits and other expenses related to performance under the various
contracts. Funding of these government contracts and grants beyond the United States governments current fiscal year is subject to annual Congressional appropriations. Overhead billed to the United States government under these contracts is
considered provisional until audited by the United States government.

The status of our United States government contracts and grants, in
millions, as of September 30, 2006, is as follows:



|                                                          |  |        |     |  |              |      |                                          |   |                                                        |  |                          |      |  |     
|--------------------------------------------------------- |  | ------ | --- |  | ------------ | ---- | ---------------------------------------- | - | ------------------------------------------------------ |  | ------------------------ | ---- |  | ----
|Program Title                                             |  | Agency |     |  | ProgramTotal |      | Total Received ThroughSeptember 30, 2006 |   | RemainingAmounts tobe Received as ofSeptember 30, 2006 |  | Contract/GrantExpiration
|Pulmonary Innate Immune Activation for Bio-terror Defense |  | NIAID  | (1) |  | $            | 6.3  |                                          | $ | 5.7                                                    |  | $                        | 0.6  |  | 2007
|Innate Immune Receptors and Adjuvant Discovery            |  | NIAID  |     |  |              | 16.9 |                                          |   | 5.8                                                    |  |                          | 11.1 |  | 2009
|                                                          |  |        |     |  |              |      |                                          |   |                                                        |  |                          |      |  |     
|Total                                                     |  |        |     |  | $            | 23.2 |                                          | $ | 11.5                                                   |  | $                        | 11.7 |  |     
|                                                          |  |        |     |  |              |      |                                          |   |                                                        |  |                          |      |  |     

---

|(1) | National Institute of Allergy and Infectious Diseases, part of the U.S. National Institutes of Health
|--- | -----------------------------------------------------------------------------------------------------

Research and Development

Risks and Uncertainties Associated with Research and Development Activities

Most of our product development programs are at an early stage; therefore, the successful development of our product candidates is
highly uncertain and may not result in approved products. Completion dates and completion costs can vary significantly for each product candidate and are difficult to predict. Product candidates that may appear promising at early stages of
development may not reach the market for a number of reasons. Product candidates may be found ineffective, may cause harmful side effects during clinical trials, may take longer to progress through clinical trials than anticipated, including as a
result of the clinical trial being placed on clinical hold or for other reasons, may fail to receive necessary regulatory approvals and may prove impracticable to manufacture in commercial quantities at reasonable cost and with acceptable quality.
The lengthy process of seeking United States Food and Drug Administration, or FDA, approvals requires the expenditure of substantial resources. Any failure by us to obtain, or any delay in obtaining, regulatory approvals could materially adversely
affect our product development efforts. Because of these risks and uncertainties, we cannot predict when or whether we will successfully complete the development of our product candidates or the ultimate cost of such product development, or whether
we will obtain any approval required by the FDA on a timely basis, if at all.

Critical Accounting Policies and Estimates

The preparation of our condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent assets and liabilities at the date of our



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financial statements as well as the reported revenues and expenses during the reported periods. We base our estimates on historical experience and on various
other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not apparent from other sources. Actual results may differ
from these estimates under different assumptions or conditions.

Our significant accounting policies are described in the notes to our
consolidated financial statements included in our Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2005. However, we believe that there has been one significant change to our critical accounting
policies and estimates regarding stock-based compensation expense that is important in understanding and evaluating our reported financial results.

Stock-Based Compensation Expense

Stock-based compensation expense, which is a non-cash charge, results from estimating the
fair value of stock options on the date they were granted and recognizing the related expense over the expected vesting period.

We adopted
SFAS No. 123(R) on January 1, 2006 effective with the beginning of our first quarter of 2006. The standard set forth in SFAS No. 123(R) requires us to measure the cost of employee services received in exchange for an award of equity
instruments based on the fair value of the award on the grant date using an option pricing model. That cost is recognized over the period during which an employee is required to provide service in exchange for the award. We elected to adopt the
prospective transition method as provided by SFAS No. 123(R) and, accordingly, financial statement amounts for the periods prior to adoption presented in this Form 10-Q have not been restated to reflect the fair value method of expensing
prescribed by SFAS No. 123(R). The net cumulative effect of the adoption of SFAS No. 123(R) did not have a material impact on the financial statements.

Prior to January 1, 2006, we applied the intrinsic value method set forth in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25), in
accounting for employee stock options. Under APB No. 25, when the exercise price of options granted to employees under these plans is less than the market price of the common stock on the date of grant, compensation expense is recognized over
the vesting period.

Under SFAS No. 123(R), entities that become public companies after June 15, 2005 and that used the minimum
value method of measuring equity share options and similar instruments as a non-public company for either recognition or pro forma disclosure purposes under SFAS No. 123 must apply the provisions of SFAS No. 123(R) prospectively to new
and/or modified awards after the adoption of SFAS No. 123(R). These companies should continue to account for any portion of awards outstanding at the date of initial application of SFAS No. 123(R) using the accounting principles originally
applied to those awards  either the minimum value method under SFAS No. 123 or the provisions of APB No. 25 and its related interpretive guidance. Accordingly, upon the adoption of SFAS No. 123(R), $0.8 million of our deferred
stock-based compensation balance of $9.6 million as of December 31, 2005, which was accounted for under APB No. 25, was eliminated against additional paid-in-capital. The remaining portion of the deferred stock-based compensation balance
at September 30, 2006 is comprised of the intrinsic value of stock options granted prior to April 20, 2005 (the date we filed our initial Registration Statement on Form S-1 with the SEC) at an exercise price below fair market value which
were accounted for under the minimum value method for SFAS No. 123 disclosure purposes since our stock was not then publicly traded.

In order to determine the amount of stock-based compensation to be recorded under SFAS No. 123(R), we are required to develop estimates to be used in calculating the grant date fair value of stock options. We calculated the grant date
fair value of the awards using the Black-Scholes option pricing model. Given our limited history as a public company, we calculated our expected stock price volatility assumption based upon the expected volatility of companies that are of a similar
size and development stage as our Company and whose stock prices are publicly available. For stock options granted during the three and nine months ended September 30, 2006 we used an average stock price volatility of 75%. The expected term
assumption is based upon the simplified method provided under SAB 107 which averages the contractual term of our options (10 years) with the vesting term (4 years) taking into consideration multiple vesting tranches. For the three and nine months
ended September 30, 2006, the expected term was calculated to be 6.25 years. The dividend yield of zero is based upon the fact that we have never paid cash dividends and have no present intention to pay cash dividends. The risk-free interest
rate used for each grant is equal to the United States Treasury yield curve in effect at the time of the grant for instruments with a similar expected life.

As of September 30, 2006, the estimated cost of unvested employee awards was $13.1 million net of estimated forfeitures. The weighted average remaining vesting period for these awards is 2.7 years.



13



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##### Table of Contents

The following table shows stock-based compensation expense included in the condensed consolidated
statements of operations for the three and nine months ended September 30, 2006 and 2005:



|                                       |  |                                  |       |                                 |   |       |  |      |       |  |   |       
|-------------------------------------- |  | -------------------------------- | ----- | ------------------------------- | - | ----- |  | ---- | ----- |  | - | ------
|                                       |  | Three Months Ended September 30, |       | Nine Months Ended September 30,
|                                       |  | 2006                             |       | 2005                            |   | 2006  |  | 2005
|                                       |  | (in thousands)                  
|Research and development               |  | $                                | 627   |                                 | $ | 3,264 |  | $    | 1,880 |  | $ | 6,688 
|General and administrative             |  |                                  | 731   |                                 |   | 695   |  |      | 2,102 |  |   | 3,895 
|                                       |  |                                  |       |                                 |   |       |  |      |       |  |   |       
|Total stock-based compensation expense |  | $                                | 1,358 |                                 | $ | 3,959 |  | $    | 3,982 |  | $ | 10,583
|                                       |  |                                  |       |                                 |   |       |  |      |       |  |   |       

The amount of stock-based compensation expense to be recognized in future periods cannot be
predicted at this time because it will depend on the number of options granted in the future as well as the portion of awards that will actually vest. Under SFAS No. 123(R), we are required to estimate forfeitures at the time of grant and
revise this estimate in subsequent periods, if necessary, if actual forfeiture rates differ from those estimates. This estimate will be re-evaluated quarterly and the forfeiture rate adjusted accordingly.

Results of Operations

Presented below is a
comparison of our results of operations for the three and nine month periods ended September 30, 2006 and 2005. On August 9, 2005, we completed our initial public offering so the results of operations for the nine months ended
September 30, 2005 reflect our status as a private company for most of that period. As a public company, we have incurred increases in general and administrative expenses for directors and officers insurance, investor relations and professional
fees associated with operating as a publicly traded company.

Three Months Ended September 30, 2006 and 2005

Revenue: Revenue increased by $0.1 million to $5.1 million in the three months ended September 30, 2006 from $5.0 million in the same period
in 2005, an increase of 2.9%.



|                                                                |  |                                 |       |                     |   |       |  |   |      |  
|--------------------------------------------------------------- |  | ------------------------------- | ----- | ------------------- | - | ----- |  | - | ---- | -
|                                                                |  | Three months endedSeptember 30, |       | Increase/(Decrease) |  
|Revenue                                                         |  | 2006                            |       | 2005                |  
|                                                                |  | (in thousands)                  |      
|Collaborator:                                                   |  |                                 |       |                     |   |       |  |   |      |  
|Fees recognized over performance period                         |  | $                               | 3,601 |                     | $ | 3,598 |  | $ | 3    |  
|Cost reimbursement and other recognized over performance period |  |                                 | 786   |                     |   | 334   |  |   | 452  |  
|                                                                |  |                                 |       |                     |   |       |  |   |      |  
|Total collaborator revenue                                      |  |                                 | 4,387 |                     |   | 3,932 |  |   | 455  |  
|Government                                                      |  |                                 | 701   |                     |   | 1,014 |  |   | (313 | )
|                                                                |  |                                 |       |                     |   |       |  |   |      |  
|Total revenue                                                   |  | $                               | 5,088 |                     | $ | 4,946 |  | $ | 142  |  
|                                                                |  |                                 |       |                     |   |       |  |   |      |  

Collaborator revenue increased by $0.5 million in the three months ended September 30, 2006
compared to the same period in 2005. This increase was primarily due to the recognition of revenue under our screening and cost reimbursement agreements with Pfizer.

Government revenue decreased by $0.3 million in the three months ended September 30, 2006 compared to the same period in 2005. This decrease is primarily due to the wind down of one of our NIAID programs, which
is expected to be completed in early 2007.

Research and development expenses:Research and development expenses decreased by $2.0
million to $11.0 million in the three months ended September 30, 2006 from $13.0 million in the same period in 2005, a decrease of 15.8%.



|                                             |  |                                 |        |                     |   |        |  |   |        |  
|-------------------------------------------- |  | ------------------------------- | ------ | ------------------- | - | ------ |  | - | ------ | -
|                                             |  | Three months endedSeptember 30, |        | Increase/(Decrease) |  
|Research and Development Expenses            |  | 2006                            |        | 2005                |  
|                                             |  | (in thousands)                  |       
|Basic research and preclinical expense       |  | $                               | 2,982  |                     | $ | 3,510  |  | $ | (528   | )
|Clinical trials and drug development expense |  |                                 | 6,439  |                     |   | 5,011  |  |   | 1,428  |  
|Government program expense                   |  |                                 | 554    |                     |   | 849    |  |   | (295   | )
|Stock-based compensation expense             |  |                                 | 627    |                     |   | 3,264  |  |   | (2,637 | )
|Depreciation and amortization expense        |  |                                 | 364    |                     |   | 386    |  |   | (22    | )
|                                             |  |                                 |        |                     |   |        |  |   |        |  
|Total research and development expenses      |  | $                               | 10,966 |                     | $ | 13,020 |  | $ | (2,054 | )
|                                             |  |                                 |        |                     |   |        |  |   |        |  



14



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##### Table of Contents

Basic research and preclinical expense decreased by $0.5 million in the three months ended
September 30, 2006 as compared to the same period in 2005. The decrease was primarily due to lower patent related costs.

Clinical
trials and drug development expense increased by $1.4 million in the three months ended September 30, 2006 as compared to the same period in 2005. This increase was comprised of a $0.4 million increase in internal expenses and a $1.0 million
increase in external expenses. The increase in internal expenses was primarily due to higher compensation, consulting and laboratory expenses in the three months ended September 30, 2006 as compared to the same period in 2005.

Our internal resources, employees and infrastructure are not directly tied to any individual project with the exception of our government research
programs. Only external costs are tracked by product candidate. External expenses by product candidate are as follows:



|                                                  |  |                                 |       |                     |   |       |  |   |       |  
|------------------------------------------------- |  | ------------------------------- | ----- | ------------------- | - | ----- |  | - | ----- | -
|                                                  |  | Three months endedSeptember 30, |       | Increase/(Decrease) |  
|                                                  |  | 2006                            |       | 2005                |  
|                                                  |  | (in thousands)                  |      
|Internal expenses (non-program specific)          |  | $                               | 2,960 |                     | $ | 2,505 |  | $ | 455   |  
|External expenses:                                |  |                                 |       |                     |   |       |  |   |       |  
|PF-3512676                                        |  |                                 | 127   |                     |   | 586   |  |   | (459  | )
|ACTILON                                           |  |                                 | 2,066 |                     |   | 1,920 |  |   | 146   |  
|Other TLR Therapeutics                            |  |                                 | 1,286 |                     |   |      |  |   | 1,286 |  
|                                                  |  |                                 |       |                     |   |       |  |   |       |  
|Total external expenses                           |  |                                 | 3,479 |                     |   | 2,506 |  |   | 973   |  
|                                                  |  |                                 |       |                     |   |       |  |   |       |  
|Total clinical trial and drug development expense |  | $                               | 6,439 |                     | $ | 5,011 |  | $ | 1,428 |  
|                                                  |  |                                 |       |                     |   |       |  |   |       |  

External expenses for our PF-3512676 program were $0.1 million in the three months ended
September 30, 2006, a decrease of $0.5 million over the same period in 2005. This decrease was due primarily to lower clinical trial expenses, as our Phase II clinical trials in NSCLC and advanced melanoma were completed during 2005.

External expenses for our ACTILON program of $2.1 million for the three months ended September 30, 2006 were substantially unchanged
as compared to the same period in 2005. These expenses were related to our ongoing ACTILON clinical trials.

External expenses for our
other TLR Therapeutics programs were $1.3 million for the three months ended September 30, 2006, an increase of $1.3 million over the same period in 2005. This increase was due primarily to drug supply, pharmacology, and toxicology study
expenses in developing additional TLR Therapeutics.

Clinical trials and drug development expense includes external costs of manufacturing
TLR Therapeutics and toxicology study expenses and of conducting clinical trials, as well as internal costs for clinical development, regulatory compliance, quality assurance, pharmaceutical development and operating our clinical immunology
laboratory.

Government program expense decreased by $0.3 million to $0.6 million in the three months ended September 30, 2006
compared to the same period in 2005 due to the wind down of one of our NIAID programs, which is expected to be completed in early 2007. Government program expense includes amounts incurred for our labor, external consulting and manufacturing costs,
as well as sub-contractor costs attributable to our government contracts and grants.

Stock-based compensation expense for research and
development employees and consultants, which is a non-cash expense, is allocated on an employee and consultant specific basis. Stock-based compensation expense decreased by $2.6 million to $0.6 million for the three months ended September 30,
2006 from $3.2 million in the same period in 2005. This decrease is primarily due to the remeasurement of stock options and related expense for employees who left employment with us in the third quarter of 2005.

Depreciation and amortization expense for laboratory equipment and leasehold improvements at our research facilities of $0.4 million in the three months
ended September 30, 2006 was substantially unchanged as compared to the same period in 2005.

General and administrative
expenses: General and administrative expenses increased by $0.8 million to $3.4 million in the three months ended September 30, 2006 from $2.6 million in the same period in 2005, an increase of 30.1%.



15



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##### Table of Contents

|                                           |  |                                 |       |                     |   |       |  |   |      |  
|------------------------------------------ |  | ------------------------------- | ----- | ------------------- | - | ----- |  | - | ---- | -
|                                           |  | Three months endedSeptember 30, |       | Increase/(Decrease) |  
|General and Administrative Expenses        |  | 2006                            |       | 2005                |  
|                                           |  | (in thousands)                  |      
|Compensation and personnel related expense |  | $                               | 1,260 |                     | $ | 1,404 |  | $ | (144 | )
|Professional services                      |  |                                 | 1,136 |                     |   | 304   |  |   | 832  |  
|Insurance                                  |  |                                 | 190   |                     |   | 138   |  |   | 52   |  
|Facility costs                             |  |                                 | 75    |                     |   | 58    |  |   | 17   |  
|Stock-based compensation expense           |  |                                 | 731   |                     |   | 695   |  |   | 36   |  
|Depreciation and amortization expense      |  |                                 | 21    |                     |   | 24    |  |   | (3   | )
|                                           |  |                                 |       |                     |   |       |  |   |      |  
|Total general and administrative expenses  |  | $                               | 3,413 |                     | $ | 2,623 |  | $ | 790  |  
|                                           |  |                                 |       |                     |   |       |  |   |      |  

The $0.8 million increase in general and administrative expenses in the three months ended
September 30, 2006 as compared to the same period in 2005 was primarily attributable to a $0.3 million increase in public company expenses and $0.5 million of market research study expenses.

Royalty expense: Royalty expense results from the amortization of royalties paid to the UIRF and the OHRI related to revenues from collaboration
agreements. Royalty expense of $0.5 million was substantially unchanged as compared to the same period in 2005.

Other income and
expense: Interest income increased by $0.6 million in the three months ended September 30, 2006 as compared to the same period in 2005 reflecting higher average cash and investment balances due to proceeds from our 2005 initial public
offering, the Pfizer private placement and receipt of an upfront license fee from Pfizer. Interest expense decreased by $0.1 million in the three months ended September 30, 2006 as compared to the same period in 2005 as a result of lower
interest payments on our declining debt balance under our capital lease facility which will terminate in the fourth quarter of 2006.

Net loss: For the foregoing reasons, net loss decreased by $2.0 million to $8.5 million in the three months ended September 30, 2006 from a net loss of $10.5 million in the same period in 2005.

Nine Months Ended September 30, 2006 and 2005

Revenue: Revenue increased by $4.6 million to $15.0 million in the nine months ended September 30, 2006 from $10.4 million in the same period in 2005, an increase of 43.9%.



|                                                                |  |                                |        |                     |   |        |  |   |        |  
|--------------------------------------------------------------- |  | ------------------------------ | ------ | ------------------- | - | ------ |  | - | ------ | -
|                                                                |  | Nine months endedSeptember 30, |        | Increase/(Decrease) |  
|Revenue                                                         |  | 2006                           |        | 2005                |  
|                                                                |  | (in thousands)                 |       
|Collaborator:                                                   |  |                                |        |                     |   |        |  |   |        |  
|Fees recognized over performance period                         |  | $                              | 10,905 |                     | $ | 6,323  |  | $ | 4,582  |  
|Cost reimbursement and other recognized over performance period |  |                                | 1,490  |                     |   | 445    |  |   | 1,045  |  
|                                                                |  |                                |        |                     |   |        |  |   |        |  
|Total collaborator revenue                                      |  |                                | 12,395 |                     |   | 6,768  |  |   | 5,627  |  
|Government                                                      |  |                                | 2,619  |                     |   | 3,669  |  |   | (1,050 | )
|                                                                |  |                                |        |                     |   |        |  |   |        |  
|Total revenue                                                   |  | $                              | 15,014 |                     | $ | 10,437 |  | $ | 4,577  |  
|                                                                |  |                                |        |                     |   |        |  |   |        |  

Collaborator revenue increased by $5.6 million in the nine months ended September 30, 2006
compared to the same period in 2005. This increase was primarily due to the recognition of nine months of revenue under the Pfizer license agreement in 2006 as compared to five months of revenue recognized under the agreement in the same period in
2005.

Government revenue decreased by $1.1 million in the nine months ended September 30, 2006 compared to the same period in 2005.
This decrease is primarily due to the completion of our cost reimbursement contract with the Defense Advance Research Projects Agency, or DARPA, in 2005 and the decrease in activity in 2006 related to one of our NIAID programs, which is expected to
be completed in early 2007.

Research and development expenses:Research and development expenses increased by $0.2 million to $32.7
million in the nine months ended September 30, 2006 from $32.5 million in the same period in 2005, an increase of 1.0%.



16



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##### Table of Contents

|                                             |  |                                |        |                     |   |        |  |   |        |  
|-------------------------------------------- |  | ------------------------------ | ------ | ------------------- | - | ------ |  | - | ------ | -
|                                             |  | Nine months endedSeptember 30, |        | Increase/(Decrease) |  
|Research and Development Expenses            |  | 2006                           |        | 2005                |  
|                                             |  | (in thousands)                 |       
|Basic research and preclinical expense       |  | $                              | 9,212  |                     | $ | 8,798  |  | $ | 414    |  
|Clinical trials and drug development expense |  |                                | 18,292 |                     |   | 12,761 |  |   | 5,531  |  
|Government program expense                   |  |                                | 2,223  |                     |   | 2,999  |  |   | (776   | )
|Stock-based compensation expense             |  |                                | 1,880  |                     |   | 6,688  |  |   | (4,808 | )
|Depreciation and amortization expense        |  |                                | 1,078  |                     |   | 1,205  |  |   | (127   | )
|                                             |  |                                |        |                     |   |        |  |   |        |  
|Total research and development expenses      |  | $                              | 32,685 |                     | $ | 32,451 |  | $ | 234    |  
|                                             |  |                                |        |                     |   |        |  |   |        |  

Basic research and preclinical expense increased by $0.4 million in the nine months ended
September 30, 2006 as compared to the same period in 2005 due primarily to $0.2 million in higher compensation costs and $0.2 million in higher laboratory supply costs. Basic research and preclinical expense includes discovery research,
chemical development, pharmacology, product development and patent costs related to our internal research programs.

Clinical trials and
drug development expense increased by $5.5 million in the nine months ended September 30, 2006 as compared to the same period in 2005. This increase was comprised of a $2.1 million increase in internal expenses and a $3.4 million increase in
external expenses.

The $2.1 million increase in internal expenses for the nine months ended September 30, 2006 as compared to the
same period in 2005 is primarily due to a $0.7 million increase in compensation and personnel related expenses, a $0.6 million increase in consulting expense and a $0.8 million increase in laboratory expenses to support our ongoing clinical
activity. Our internal resources, employees and infrastructure are not directly tied to any individual project with the exception of our government research programs. Only external costs are tracked by product candidate. External expenses by product
candidate are as follows:



|                                                  |  |                                |        |                     |   |        |  |   |        |  
|------------------------------------------------- |  | ------------------------------ | ------ | ------------------- | - | ------ |  | - | ------ | -
|                                                  |  | Nine months endedSeptember 30, |        | Increase/(Decrease) |  
|                                                  |  | 2006                           |        | 2005                |  
|                                                  |  | (in thousands)                 |       
|Internal expenses (non-program specific)          |  | $                              | 8,562  |                     | $ | 6,500  |  | $ | 2,062  |  
|External expenses:                                |  |                                |        |                     |   |        |  |   |        |  
|PF-3512676                                        |  |                                | 290    |                     |   | 2,678  |  |   | (2,388 | )
|ACTILON                                           |  |                                | 5,727  |                     |   | 3,583  |  |   | 2,144  |  
|Other TLR Therapeutics                            |  |                                | 3,713  |                     |   |       |  |   | 3,713  |  
|                                                  |  |                                |        |                     |   |        |  |   |        |  
|Total external expenses                           |  |                                | 9,730  |                     |   | 6,261  |  |   | 3,469  |  
|                                                  |  |                                |        |                     |   |        |  |   |        |  
|Total clinical trial and drug development expense |  | $                              | 18,292 |                     | $ | 12,761 |  | $ | 5,531  |  
|                                                  |  |                                |        |                     |   |        |  |   |        |  

External expenses for our PF-3512676 program were $0.3 million in the nine months ended
September 30, 2006, a decrease of $2.4 million over the same period in 2005. This decrease was due primarily to lower clinical trial expenses, as our Phase II clinical trials in NSCLC and advanced melanoma were completed during 2005.

External expenses for our ACTILON program were $5.7 million for the nine months ended September 30, 2006, an increase of $2.1 million
over the same period in 2005. This increase was due primarily to higher drug supply and clinical trial expenses associated with ACTILON Phase II clinical trials initiated earlier in 2006.

External expenses for our other TLR Therapeutics programs were $3.7 million for the nine months ended September 30, 2006, an increase of $3.7
million over the same period in 2005. This increase was due primarily to drug supply, pharmacology, and toxicology study expenses in developing additional TLR Therapeutics.

Clinical trials and drug development expense includes external costs of manufacturing TLR Therapeutics and toxicology expenses and of conducting clinical
trials, as well as internal costs for clinical development, regulatory compliance, quality assurance, pharmaceutical development and operating our clinical immunology laboratory.

Government program expense decreased by $0.8 million to $2.2 million in the nine months ended September 30, 2006 compared to the same period in
2005, due to the completion of our DARPA contract in 2005 and a decrease in activity related to one of our NIAID programs, which is expected to be completed in early 2007. Government program expense includes amounts incurred for our labor, external
consulting and manufacturing costs, as well as sub-contractor costs attributable to our government contracts and grants.



17



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##### Table of Contents

Stock-based compensation expense for research and development employees and consultants, which is a
non-cash expense, is allocated on an employee and consultant specific basis. Stock-based compensation expense decreased by $4.8 million to $1.9 million for the nine months ended September 30, 2006 from $6.7 million in the same period 2005. This
decrease is primarily due to the remeasurement of stock options and related expense for employees who left employment with us during the third quarter of 2005. Also included in the nine months ended September 30, 2005 is stock-based
compensation expense that was immediately recognized for fully vested stock options granted to employees in 2005 prior to our initial public offering.

Depreciation and amortization expense for laboratory equipment and leasehold improvements at our research facilities of $1.1 million in the nine months ended September 30, 2006 was substantially unchanged as
compared to the same period in 2005.

General and administrative expenses: General and administrative expenses increased by $0.6
million to $9.4 million in the nine months ended September 30, 2006 from $8.8 million in the same period in 2005, an increase of 6.5%.



|                                           |  |                                |       |                     |   |       |  |   |        |  
|------------------------------------------ |  | ------------------------------ | ----- | ------------------- | - | ----- |  | - | ------ | -
|                                           |  | Nine months endedSeptember 30, |       | Increase/(Decrease) |  
|General and Administrative Expenses        |  | 2006                           |       | 2005                |  
|                                           |  | (in thousands)                 |      
|Compensation and personnel related expense |  | $                              | 3,942 |                     | $ | 3,434 |  | $ | 508    |  
|Professional services                      |  |                                | 2,466 |                     |   | 993   |  |   | 1,473  |  
|Insurance                                  |  |                                | 586   |                     |   | 228   |  |   | 358    |  
|Facility costs                             |  |                                | 225   |                     |   | 182   |  |   | 43     |  
|Stock-based compensation expense           |  |                                | 2,102 |                     |   | 3,895 |  |   | (1,793 | )
|Depreciation and amortization expense      |  |                                | 64    |                     |   | 82    |  |   | (18    | )
|                                           |  |                                |       |                     |   |       |  |   |        |  
|Total general and administrative expenses  |  | $                              | 9,385 |                     | $ | 8,814 |  | $ | 571    |  
|                                           |  |                                |       |                     |   |       |  |   |        |  

The $0.6 million increase in general and administrative expenses in the nine months ended
September 30, 2006 as compared to the same period in 2005 was primarily attributed to a $0.5 million increase in compensation expense, a $1.5 million increase in professional services, and $0.4 million increase in insurance expense all related
to being a public company offset by a $1.8 million decrease in stock-based compensation expense. The decrease in stock-based compensation expense in the nine months ended September 30, 2006 was primarily due to expense that was immediately
recognized for fully vested stock options granted in 2005 prior to our initial public offering.

Royalty expense: Royalty expense
results from the amortization of royalties paid to the UIRF and the OHRI related to revenues from collaboration agreements. Royalty expense increased by $0.7 million to $1.6 million in the nine months ended September 30, 2006 from $0.9 million
in the same period in 2005. This increase results primarily from the amortization of royalties paid to the UIRF that were related to the $50.0 million upfront payment received from Pfizer in 2005.

Other income and expense: Interest income increased by $3.1 million in the nine months ended September 30, 2006 reflecting higher average
cash and investment balances due to proceeds from our 2005 initial public offering, the Pfizer private placement and receipt of the upfront license fee from Pfizer. Interest expense decreased by $0.2 million in the nine months ended
September 30, 2006 as a result of lower interest payments on our declining debt balance under our capital lease facility.

Net
loss: For the foregoing reasons, net loss decreased by $6.4 million to $24.6 million in the nine months ended September 30, 2006 from a net loss of $31.0 million in the same period in 2005.

Liquidity and Capital Resources

Sources of Liquidity

Since our inception in 1998, we have funded our operations primarily through:



| |  |  | proceeds of $145.6 million from private placements of preferred stock and warrants;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | proceeds of $110.8 million from our initial public offering and concurrent private placement of common stock to Pfizer;
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| |  |  | cash receipts of $89.2 million from our commercial collaborations;
| | - |  | ------------------------------------------------------------------



18



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##### Table of Contents

| |  |  | cash receipts of $23.2 million from United States government contracts and grants;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | $7.2 million borrowed for leasehold improvements and equipment financing under capital lease facilities; and
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | $2.1 million in debt to fund our initial research and development activities.
| | - |  | -----------------------------------------------------------------------------

Included in the amounts above is $64.2 million from Pfizer that we have received in upfront license fees, sales of common stock, sponsored research fees and expense reimbursements.

At September 30, 2006, we had unrestricted cash, cash equivalents and marketable securities of $113.9 million, compared to $143.0 million as of
December 31, 2005.

We invest in cash, cash equivalents, United States government agencies, high-grade municipal and corporate notes
and commercial paper. Our investment objectives are primarily, to assure liquidity and preservation of capital and, secondarily, to obtain investment income.

Nine months ended September 30, 2006 and 2005



|                                                                 |  |                                 |         |   |        |   |         |               |  |   |          |  
|---------------------------------------------------------------- |  | ------------------------------- | ------- | - | ------ | - | ------- | ------------- |  | - | -------- | -
|                                                                 |  | Nine Months Ended September 30, |         |   | Change |  
|Summary Cash Flow Information                                    |  | 2006                            |         |   | 2005   |   |         | 2006 vs. 2005 | 
|                                                                 |  | (in thousands)                  |        
|Net cash (used in) provided by:                                  |  |                                 |         |   |        |   |         |               |  |   |          |  
|Operating activities                                             |  | $                               | (28,335 | ) |        | $ | 19,614  |               |  | $ | (47,949  | )
|Investing activities                                             |  |                                 | 2,452   |   |        |   | 9,798   |               |  |   | (7,346   | )
|Financing activities                                             |  |                                 | (133    | ) |        |   | 109,899 |               |  |   | (110,032 | )
|Exchange rate effect on cash and cash equivalents                |  |                                 | 442     |   |        |   | (580    | )             |  |   | 1,022    |  
|                                                                 |  |                                 |         |   |        |   |         |               |  |   |          |  
|Net (decrease) increase in cash and cash equivalents             |  |                                 | (25,574 | ) |        |   | 138,731 |               |  |   | (164,305 | )
|                                                                 |  |                                 |         |   |        |   |         |               |  |   |          |  
|Cash and cash equivalents at September 30                        |  |                                 | 60,337  |   |        | $ | 151,921 |               |  |   | (91,584  | )
|Marketable securities at September 30 (current and long-term)    |  |                                 | 53,571  |   |        |   |        |               |  |   | 53,571   |  
|                                                                 |  |                                 |         |   |        |   |         |               |  |   |          |  
|Cash, cash equivalents and marketable securities at September 30 |  | $                               | 113,908 |   |        | $ | 151,921 |               |  | $ | (38,013  | )
|                                                                 |  |                                 |         |   |        |   |         |               |  |   |          |  

For the nine months ended September 30, 2006 we had negative operating cash flow of $28.3
million compared to positive operating cash flow of $19.6 million for the nine months ended September 30, 2005. The increase in net cash used in operating activities for the nine months ended September 30, 2006 as compared to the same
period in 2005 is primarily due to the $50.0 million upfront payment received from Pfizer in 2005 as well as higher operating and public company expenses in 2006.

Net cash provided by investing activities decreased by $7.3 million in the nine months ended September 30, 2006 as compared to the same period in 2005. The decrease is primarily due to a greater allocation of
proceeds from maturing securities to marketable securities in 2006.

Net cash provided by financing activities decreased by $110.0 million
in the nine months ended September 30, 2006 as compared to the same period in 2005. This decrease is primarily attributed to the $110.8 million in cash received from our initial public offering in 2005 offset by lower capital lease payments in
2006 as compared to the same period in 2005.

Our foreign currency cash balances at our subsidiary in Germany expose us to fluctuations in
currency exchange rates. During the nine months ended September 30, 2006, the U.S. Dollar depreciated approximately 6.6% against the Euro, which resulted in a $0.4 million favorable translation adjustment when converting our Euro cash
balances to U.S. Dollars for financial reporting purposes.



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Contractual Obligations and Commitments

The following summarizes our long-term contractual cash obligations as of September 30, 2006:



|                       |  |                             |        |        |   |           |  |           |       |               |   |       |  |   |    
|---------------------- |  | --------------------------- | ------ | ------ | - | --------- |  | --------- | ----- | ------------- | - | ----- |  | - | ---
|                       |  | Cash Payments Due by Period
|                       |  | Total                       |        | 1 year |   | 2-3 years |  | 4-5 years |       | After 5 years
|                       |  | (in thousands)             
|Operating leases       |  | $                           | 6,182  |        | $ | 1,604     |  | $         | 2,547 |               | $ | 1,436 |  | $ | 595
|Capital leases         |  |                             | 501    |        |   | 195       |  |           | 306   |               |   |      |  |   |   
|Long-term debt         |  |                             | 3,113  |        |   |          |  |           | 3,113 |               |   |      |  |   |   
|In-licensed technology |  |                             | 750    |        |   | 150       |  |           | 300   |               |   | 300   |  |   | *  
|Other liabilities      |  |                             | 519    |        |   | 116       |  |           |      |               |   |      |  |   | 403
|                       |  |                             |        |        |   |           |  |           |       |               |   |       |  |   |    
|                       |  | $                           | 11,065 |        | $ | 2,065     |  | $         | 6,266 |               | $ | 1,736 |  |   | 998
|                       |  |                             |        |        |   |           |  |           |       |               |   |       |  |   |    

---

|* | Minimum annual license fees of $0.2 million are required through the date of the last patent expiration. As a result of pending patent applications, we are currently unable to
determine the length of this period.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Operating Leases

Our commitments under operating leases shown above consist of payments relating to our real estate lease in Wellesley, Massachusetts, U.S.A. expiring in 2008, our lease in Ottawa, Canada, expiring in 2012, and our two
leases in Langenfeld, Germany, expiring in 2007 and 2010.

Capital Leases

We have entered into a capital lease facility agreement with General Electric Capital Corporation, primarily for new laboratory and computer equipment.
Based on the terms of the agreement and the type of underlying equipment, each lease extends for a period of 36 or 48 equal monthly payments at a weighed average interest rate of 8.25%. As of September 30, 2006, we have principal and interest
obligations of $0.1 million remaining.

In August 2006, we entered into a 0.3 million ($0.4 million at September 30, 2006)
capital lease agreement for the purchase of a piece of laboratory equipment. The lease extends for a period of 36 months with an annual interest rate of 7%. As of September 30, 2006, we have principal and interest obligations of
0.3 million ($0.4 million at September 30, 2006) remaining.

Long-term Debt

In 1998, our foreign subsidiary Coley Pharmaceutical GmbH (Coley GmbH) obtained a research and development loan from
Technologie-Beteiligungs-Gesellschaft (Tbg). The loan of 1.5 million ($1.9 million at September 30, 2006) was to fund the early research and development of our product candidates. The loan bears interest at 6% annually, with
principal payable December 31, 2007 and interest payable semi-annually on March 31 and September 30. An additional contingent fee of 6% annually of the loan principal is payable when the loan is due or earlier if the loan is
terminated before its due date by either Coley GmbH or Tbg. We have accrued this contingent fee under the loan as Tbg may, at its sole discretion, request payment of the fee. The minimum contingent fee is 30% of the loan principal. As of
September 30, 2006, we have accrued $1.0 million for this potential contingent fee.

In-Licensed Technology

We have also entered into technology in-license agreements with the UIRF and the OHRI that require us to pay annual license maintenance fees and royalty
payments based on license fees, milestones and product royalties received by us from third parties, as well as on products that are sold by us. In 2005, we paid the UIRF $6.5 million and the OHRI $0.2 million related to the $50.0 million received
from Pfizer as an upfront license fee payment.

Funding Requirements

We expect to devote substantial resources to continue our research and development efforts. Our funding requirements will depend on a number of forward-looking factors. These factors include, but are not limited to,
the following:



| |  |  | the success of our collaborative arrangement with Pfizer for the development and commercialization of PF-3512676;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | the scope of our HCV program and results of our clinical trials of ACTILON;
| | - |  | ---------------------------------------------------------------------------



| |  |  | the advancement of additional product candidates into clinical development;
| | - |  | ---------------------------------------------------------------------------



| |  |  | the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and other patent-related costs, including litigation or interference costs and the
results of such litigation or interference; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

| |  |  | our ability to maintain collaborative arrangements and obtain milestone, royalties and other payments from our collaborators, other than Pfizer.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------

All of our drug candidates are currently in preclinical or clinical development. To commercialize our drug candidates, we will be required to
successfully complete preclinical studies and clinical trials to obtain required regulatory approvals.

Based on our current operating
plan, we believe that our cash and cash equivalent balance at September 30, 2006 will be sufficient to finance our working capital and capital requirements for approximately 3 years. Changes in our research and development plans or other
changes affecting our operating expenses may affect our cash burn and existing cash resources. We expect our sources of funding for the next several years to include potential milestone payments relating to PF-3512676 and VaxImmune, proceeds from
our government programs and sanofi-aventis drug candidates and other collaborative license agreements we may enter into.

Although we
have no specific plans to raise additional capital in the next two years, we will continue to review our financing options, and if opportunities arise to raise capital on favorable terms, we may avail ourselves of these opportunities. If we need to
raise funds in the future, we may be required to raise those funds through public or private financings, strategic relationships or other arrangements. We cannot assure you that the funding, if needed, will be available on terms attractive to us, or
at all. Furthermore, any additional equity financing may be dilutive to stockholders and debt financing, if available, may involve restrictive covenants. Our failure to raise capital as and when needed could have a negative impact on our financial
condition and our ability to pursue our business strategy.

Recent Accounting Pronouncements

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes  an interpretation of FASB Statement
No. 10. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with FASB Statement No. 109, Accounting for Income
Taxes. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation
also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. At the present
time, we are evaluating the impact the adoption may have on our financial statements.

In September 2006, the FASB issued SFAS
No. 157, Fair Value Measurement. This standard addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting
principles (GAAP). This standard is effective for all financial statements issued for fiscal years beginning after November 15, 2007. We are in the process of evaluating whether this standard will have a material effect on our
financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 158, Employers
Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)(SFAS No. 158).SFAS No. 158 requires recognition of a net liability or
asset for the funded status of defined benefit pension and other postretirement plans and recognition of changes in the funded status through comprehensive income. SFAS No. 158 also requires the measurement of defined benefit plan assets and
obligations as of the companys fiscal year-end. SFAS No. 158 shall be effective as of the end of any fiscal year ending after December 15, 2006. We do not expect the provisions of SFAS No. 158 will have a material impact on our
financial position or results of operations.

Staff Accounting Bulletin No. 108 (SAB No. 108), released in September
2006, provides guidance on evaluating the effects of misstatements on all periods disclosed in the financial statements and related financial statement disclosures. In order to quantify the impact of misstatements both the carryover and reversing
effects of prior year misstatements should be considered in the current year financial statements. An adjustment would be required if the misstatement is material to the financial statements, after all relevant quantitative and qualitative factors
are considered. SAB No. 108 shall be effective for the first fiscal year ending after November 15, 2006. We do not expect the provisions of SAB No. 108 will have a material impact on our financial position or results of operations.

Off-Balance Sheet Arrangements

Since
inception, we have not engaged in any material off-balance sheet activities, including the use of structured finance, special purpose entities or variable interest entities.



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Related Party Transactions

In 2001, we loaned our scientific co-founder and Chief Scientific Officer, Dr. Arthur Krieg, $0.5 million evidenced by a promissory note bearing interest of 7% and payable in full on May 8, 2006. The loan
was made in connection with Dr. Kriegs purchase of a home in Massachusetts.

In 2005, Dr. Krieg remitted $0.3 million to us
as a partial pre-payment of his loan. In the second quarter of 2006, Dr. Krieg settled the remaining balance, including interest, of approximately $0.3 million by tendering 24,579 shares of Coley common stock to us.

Forward-Looking Statements

Various statements in
this Quarterly Report on Form 10-Q are forward-looking statements concerning our future products, revenues, expenses, liquidity and cash needs, as well as our plans and strategies. Forward-looking statements give managements current
expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historic or current events. They use words such as anticipate, estimate, expect,
project, intend, plan, believe, should, may, will, and other words and terms of similar meaning. These forward-looking statements are based upon current expectations
and we assume no obligation to update this information. Any or all of our forward-looking statements in this Quarterly Report on Form 10-Q may turn out to be wrong. They can be affected by inaccurate assumptions we might make or by known or unknown
risks or uncertainties. Consequently, no forward-looking statement can be guaranteed. Actual results may vary materially from those set forth in the forward-looking statements. Forward-looking statements, therefore, should be considered in light of
all of the information included or referred to in this Quarterly Report on Form 10-Q, including the cautionary information set forth under Part II, Item 1A., Risk Factors.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market Risks

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our marketable
securities without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the marketable securities to fluctuate. To
minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and marketable securities in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and
corporate obligations. Because of the short-term maturities of our cash equivalents and marketable securities, we do not believe that an increase in market rates would have any significant impact on the realized value of our marketable securities.

The costs and expenses of our international subsidiaries are denominated in the Canadian dollar and the Euro. If exchange rates change
10%, the impact on our 2006 net loss and cash burn would be $0.7 million.

Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

As required by Rule 13a-15 under the Exchange Act, our management, under the supervision and with the participation of our Chief
Executive Officer and Chief Financial Officer, performed an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, these
officers have concluded that, as of September 30, 2006, our disclosure controls and procedures were effective.

(b) Changes in
Internal Controls

There have been no changes in our internal controls over financial reporting, identified in connection with the
evaluation of such internal controls, that have occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II  OTHER INFORMATION

Item 1A. Risk Factors

The following risk factors represent those in which updates or changes to the
information set forth in our prior risk factors descriptions have been made.



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Risks Related to Our Business and Strategy

We depend heavily on the success of our lead product candidate, PF-3512676, which is still under development.

We have invested a significant portion of our time and financial resources since our inception in the development of TLR Therapeutics, including PF-3512676 for the potential treatment of cancer. We anticipate that in the near term our
ability to generate revenues will depend primarily on the successful development and commercialization of PF-3512676 for cancers by Pfizer pursuant to our collaboration. The commercial success of PF-3512676 will depend on several factors, including
the following:



| |  |  | our ability to work effectively with Pfizer under our collaboration during their development of PF-3512676 for cancer;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | commencement and successful completion of Phase III clinical trials in NSCLC and Phase II clinical trials in other cancer indications;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------



| |  |  | receipt of marketing approvals from the FDA and similar foreign regulatory authorities;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | if approved, the successful commercial launch of PF-3512676 by Pfizer;
| | - |  | ----------------------------------------------------------------------



| |  |  | producing batches of the active pharmaceutical ingredient used in PF-3512676 in commercial quantities through a validated process; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------



| |  |  | acceptance of PF-3512676 or competitive products in the medical community and with third-party payors.
| | - |  | ------------------------------------------------------------------------------------------------------

If Pfizer is not successful in developing or commercializing PF-3512676, or is significantly delayed in doing so, our business will be materially harmed
and we may need to curtail or cease operations.

We also depend on the success of ACTILON, which is at an early stage of clinical development.

Most of our work to date with ACTILON has been limited to preclinical studies and early stage clinical trials in a small number of
healthy volunteers and patients infected with the Hepatitis C virus or HCV. We have only recently begun clinical trials of ACTILON in patients infected with HCV. We will be required to spend considerable additional time, money and effort on
development activities before seeking regulatory approval to market ACTILON. There can be no assurance that we will receive regulatory approval or that, if we do, such regulatory approval will be timely enough to assure the commercial viability of
ACTILON. Our business prospects depend on our ability to successfully complete clinical trials, obtain required regulatory approvals and successfully commercialize ACTILON. If we do not achieve clinical success with ACTILON or if we ultimately fail
to commercialize ACTILON, we may be unable to generate sufficient revenues to maintain our business, and our reputation in the industry and in the investment community would likely be significantly damaged, each of which could cause our stock price
to decline.

Positive results from preclinical studies or early clinical trials do not assure that later or larger-scale clinical trials
will succeed. The initial trials of ACTILON have been conducted only in small numbers of patients who may not fully represent the diversity of larger populations infected with HCV and may not predict the ability of ACTILON to achieve a sustained
virological response or its ability to provide a long-term therapeutic benefit. We will be required to demonstrate through larger-scale clinical trials that ACTILON is safe and effective for use in a diverse patient population before we can seek
regulatory approval for its commercial sale. If ACTILON fails to demonstrate sufficient safety and efficacy in any clinical trial, we would likely experience significant delays or be required to abandon development of ACTILON.

If our competitors develop treatments for HCV that are approved faster, marketed more successfully or demonstrated to be more effective than ACTILON, our commercial
opportunity will be reduced or eliminated.

If approved by the necessary regulatory authorities, ACTILON will be subject to competition
in the treatment of HCV from a significant number of additional drugs that are currently under development and may become available in the future for the treatment of HCV. These treatments may be more effective or less costly than ACTILON. A partial
list of potential new products for the treatment of HCV includes Zadaxin®, which is being developed by SciClone Pharmaceuticals; VX 950, which is being developed by Vertex Pharmaceuticals; NM283, which is being developed by Idenix Pharmaceuticals and Novartis; and Albuferon, which is being developed by Human Genome Sciences. Additionally, less expensive generic forms of currently marketed drugs
could lead to additional competition upon the expiration or invalidation of patents underlying such currently marketed drugs.



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Our TLR Therapeutic product candidates are at an early stage of product development, and our success depends on the
further development and clinical trials of our product candidates. Failure to prove our products safe and effective in clinical trials could require us to discontinue operations.

Our TLR Therapeutic product candidates are in the early stages of development, and significant additional research and development, financial resources
and additional personnel will be required to develop any of our TLR Therapeutic product candidates into commercially viable products and to obtain regulatory approval. Currently, only one of our product candidates, PF-3512676, has completed Phase II
clinical trials.

In order for PF-3512676 to be approved by the FDA, Pfizer will be required to demonstrate in a much larger scale Phase
III clinical trial and to a statistically significant degree that PF-3512676 prolongs survival of patients with NSCLC when used as a first-line treatment in conjunction with the current standard of care. We cannot assure you that such results will
be achieved.

We may fail to successfully develop and commercialize our other TLR Therapeutic product candidates because they:



| |  |  | are found to be unsafe or ineffective in clinical trials;
| | - |  | ---------------------------------------------------------



| |  |  | do not receive necessary approval from the FDA or foreign regulatory agencies;
| | - |  | ------------------------------------------------------------------------------



| |  |  | fail to conform to a changing standard of care for the diseases they seek to treat; or
| | - |  | --------------------------------------------------------------------------------------



| |  |  | are less effective or more expensive than current or alternative treatment methods.
| | - |  | -----------------------------------------------------------------------------------

Although to date the side effects observed in clinical trial participants receiving TLR Therapeutics have been as expected, we cannot assure you that additional or more severe adverse side effects with respect to our
product candidates will not develop in future clinical trials, which could delay or preclude regulatory approval of our product candidates or limit their commercial use.

Regulatory agencies may delay the start of clinical trials and delay or preclude regulatory approval by requiring us or our collaborators to obtain additional preclinical data including safety and toxicology data.
Regulatory agencies may delay or preclude regulatory approval by requiring us or our collaborators to obtain additional safety or efficacy data which require additional clinical trials. Regulatory agencies may employ a range of methods to delay or
preclude their approval, including placing trials on clinical hold. For example, on June 17, 2005, the IND for our product candidate AVE0675 was placed on a clinical hold by the FDA prior to commencing enrollment pending the submission by our
collaborator, sanofi-aventis, of additional preclinical data relating to the IND for this product candidate. Sanofi-aventis is working to provide the information requested by the FDA in order to resolve the clinical hold.

We cannot assure you that this clinical hold will be resolved in a timely manner, or at all.

Product development failure can occur at any stage of clinical trials, and as a result of many factors there can be no assurance that we or our
collaborators will reach our anticipated clinical targets. Even if we or our collaborators complete our clinical trials, we do not know what the long-term effects of exposure to our TLR Therapeutic product candidates will be. Such long-term effects
may include the incurrence or aggravation of autoimmune disease, as has occurred with some other immunomodulatory drug therapies. Furthermore, our products will be used in combination with other treatments and there can be no assurance that such use
will not lead to unique safety issues. Failure to complete clinical trials or to prove that our products are safe and effective would have a material adverse effect on our ability to generate revenue and could require us to reduce the scope of or
discontinue our operations.

A key part of our business strategy is to establish collaborative relationships to commercialize and fund development of
our TLR Therapeutic product candidates. If any collaborator terminates or fails to perform its obligations under agreements with us, the development and commercialization of our drug candidates could be delayed or terminated.

A key aspect of our business strategy is to develop and commercialize products for the treatment of diseases through collaborative arrangements with
pharmaceutical companies, research institutions, the United States government and universities. Currently, we have established collaborative relationships with several pharmaceutical companies and government agencies. We also intend to establish
collaborative relationships to obtain domestic and international sales, marketing and distribution capabilities for our TLR Therapeutic product candidates.

Funding of government contracts and grants beyond the U.S. governments current fiscal year is subject to Congressional appropriations. In addition, the overhead rates used in these contracts are considered
provisional and are subject to an annual review and audit.

The process of establishing collaborative relationships is difficult,
time-consuming and involves significant uncertainty. Moreover, even if we do establish collaborative relationships, our collaborators may seek to renegotiate or terminate their relationships with us due to unsatisfactory clinical results, a change
in business strategy, a change of control or other reasons. If any collaborator fails to fulfill its responsibilities in a timely manner, or at all, our research, clinical development or commercialization efforts related to that collaboration could
be delayed or terminated, or it may be necessary for us to



24



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assume responsibility for activities that would otherwise have been the responsibility of our collaborator. If we are unable to establish and maintain
collaborative relationships on acceptable terms, we may have to delay or discontinue further development of one or more of our product candidates, undertake development and commercialization activities at our own expense or find alternative sources
of funding.

Risks Related to our Intellectual Property

If the combination of patents, trade secrets and contractual provisions that we rely on to protect our intellectual property is inadequate, our ability to successfully commercialize our product candidates will be harmed and we may not be
able to operate our business profitably.

Our success depends on our ability to obtain, maintain and enforce our intellectual property
rights domestically and abroad. The patent position of biotechnology companies is generally highly uncertain, involves complex legal and factual questions and has recently been the subject of much litigation. Neither the United States Patent and
Trademark Office, or PTO, nor the courts have a consistent policy regarding the breadth of claims allowed or the degree of protection afforded under many biotechnology patents. The validity, enforceability and commercial value of these rights,
therefore, is highly uncertain.

Our patent estate includes, on a worldwide basis, 16 patents issued in the United States, 127 patents
issued in the rest of the world and more than 438 pending patent applications. However, our patents may not protect us against our competitors. The issuance of a patent is not conclusive as to its scope, validity or enforceability. The scope,
validity or enforceability of our patents can be challenged in litigation. Such litigation can involve substantial costs and distraction. If the outcome of such litigation is adverse to us, third parties may be able to use our patented inventions
and compete directly with us, without payment to us. Third parties may also be able to circumvent our patents by design innovations. We may not receive any additional patents based on the applications currently pending.

On July 17, 2006, the United States Court of Appeals for the Federal Circuit affirmed the dismissal of an interference action initiated by Dynavax
Technologies Corporation (Dynavax) in December 2003. The United States Patent and Trademark Offices Board of Patent Appeals and Interferences dismissed the interference in March 2005. The interference challenged a claim issued to
Coley in 2001 which covers the use of immunomodulatory CpG sequences in combination with allergens to treat allergies. Dynavax filed an appeal requesting a rehearing en bancby the United States Court of Appeals for the Federal Circuit in
September 2006. The United States Court of Appeals for the Federal Circuit denied the appeal on October 16, 2006. Dynavaxs final route of appeal would be to request the United States Supreme Court to hear the case.

Because patent applications in the United States and many foreign jurisdictions are typically not published until 18 months after filing or, in some
cases, not at all, and because publications of discoveries in the scientific literature often lag behind actual discoveries, neither we nor our licensors or collaborators can be certain that we or they were the first to make the inventions claimed
in patents or pending patent applications, or that we or they were the first to file for protection of the inventions set forth in these patent applications.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Use of Proceeds from Registered Securities

We registered shares of our common stock in connection with our initial public offering under the Securities Act of 1933, as amended. Our Registration
Statement on Form S-1 (Reg. No. 333-124176) in connection with our initial public offering was declared effective by the SEC on August 9, 2005.

From the effective date of our Registration Statement on Form S-1, April 20, 2005 through September 30, 2006, we have utilized approximately $3.5 million of the net proceeds of our initial public offering to fund our
operations. The net unused offering proceeds have been invested in short and long-term marketable securities.

None of the proceeds have been used to pay
expenses that were directly or indirectly made to (i) any of our directors, officers or associates, (ii) any person(s) owning 10% or more of any class of our equity, securities or (iii) any of our affiliates.

Item 6. Exhibits



|     |  |                                                                                                                                                                                   
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|31.1 |  | Certification of the Principal Executive Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002.                                                                   
|     | 
|31.2 |  | Certification of the Principal Financial Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002.                                                                   
|     | 
|32   |  | Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.

---

|* | The certification attached as Exhibit 32 that accompanies this Quarterly Report on Form 10-Q is not deemed filed with the Securities and Exchange Commission and is not to be
incorporated by reference into any filing of Coley Pharmaceutical Group, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form
10-Q, irrespective of any general incorporation language contained in such filing.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                 |  |                                                                                              
|---------------- |  | ---------------------------------------------------------------------------------------------
|                 |  | COLEY PHARMACEUTICAL GROUP, INC.                                                             
|                 | 
|November 8, 2006 |  | /s/ ROBERT L. BRATZLER, PH.D.                                                                
|                 |  | Robert L. Bratzler, Ph.D. President and Chief Executive Officer (Principal Executive Officer)
|                 | 
|November 8, 2006 |  | /s/ CHARLES H. ABDALIAN, JR.                                                                 
|                 |  | Charles H. Abdalian, Jr. Chief Financial Officer (Principal Financial and Accounting Officer)



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COLEY PHARMACEUTICAL GROUP, INC.

EXHIBIT INDEX



|            |  |                                                                                                                                                                                   
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                       
|31.1        |  | Certification of the Principal Executive Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002.                                                                   
|            | 
|31.2        |  | Certification of the Principal Financial Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002.                                                                   
|            | 
|32          |  | Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.

---

|* | The certification attached as Exhibit 32 that accompanies this Quarterly Report on Form 10-Q is not deemed filed with the Securities and Exchange Commission and is not to be
incorporated by reference into any filing of Coley Pharmaceutical Group, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form
10-Q, irrespective of any general incorporation language contained in such filing.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



27