**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-K**

 

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

 

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

 

**or**

 

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

 

**For the transition period from                to                **

 

**Commission File Number 000-50791**

** **

**SENOMYX,INC.**

(Exact name of registrantas specified in its charter)

 

| **Delaware**                                                     | ** ** | **33-0843840**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation  or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **11099  North Torrey Pines Road  La Jolla, California**         | ** ** | **92037**                             |
| (Address of principal  executive offices)                        |       | (Zip Code)                            |

 

**(858) 646-8300**

Registrant’stelephone number, including area code

 

Securitiesregistered pursuant to Section 12(b) of the Act:

**None**

 

Securitiesregistered pursuant to Section 12(g) of the Act:

**CommonStock, par value $.001 per share**

**(Titleof class)**

 

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

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.  Yes  o  No  ý

 

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

 

As of June 30, 2004,the aggregate market value of the voting stock held by non–affiliates of theregistrant, computed by reference to the last sale price of such stock as ofsuch date on the NASDAQ National Market, was approximately $55,531,900.Excludes an aggregate of 15,853,152 shares of common stock held by officers anddirectors and by each person known by the registrant to own 5% or more of theoutstanding common stock as of June 30, 2004. Exclusion of shares held byany of these persons should not be construed to indicate that such personpossesses the power, direct or indirect, to direct or cause the direction ofthe management or policies of the registrant, or that such person is controlledby or under common control with the registrant.

 

As of February 28,2005, there were 25,435,739 shares of the registrant’s Common Stockoutstanding.

 

 

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**DOCUMENTSINCORPORATED BY REFERENCE:**

** **

Portionsof the registrant’s definitive Proxy Statement for the 2005 Annual Meeting ofStockholders to be filed with the Securities and Exchange Commission pursuantto Regulation 14A not later than 120 days after the end of the fiscal yearcovered by this Form 10-K, are incorporated by reference in Part III,Items 10-14 of this Form 10-K.

 

 

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**SENOMYX, INC.**

 

**AnnualReport on Form 10-K**

**For theFiscal Year Ended December 31, 2004**

 

**TABLE OFCONTENTS**

 
| ** **    | ** **                                                                                                             | **Page** |
|---------------|------------------------------------------------------------------------------------------------------------------------|----------|
| PART I   |                                                                                                                   |     |
| Item 1.       | Business                                                                                                               | 4        |
| Item 2.       | Properties                                                                                                             | 20       |
| Item 3.       | Legal Proceedings                                                                                                      | 20       |
| Item 4.       | Submission of Matters to a Vote of Security Holders                                                                    | 20       |
| PART II  |                                                                                                                   |     |
| Item 5.       | Market for the Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities | 21       |
| Item 6.       | Selected Financial Data                                                                                                | 22       |
| Item 7.       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                            | 23       |
| Item 7A. | Quantitative and Qualitative Disclosures About  Market Risk                                                            | 44       |
| Item 8.       | Financial Statements and Supplementary Data                                                                            | 44       |
| Item 9.       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                                  | 65       |
| Item 9A.      | Controls and Procedures                                                                                                | 65       |
| Item 9B       | Other Information                                                                                                      | 65       |
| PART III |                                                                                                                   |     |
| Item 10.      | Directors and Executive Officers of the  Registrant                                                                    | 66       |
| Item 11.      | Executive Compensation                                                                                                 | 66       |
| Item 12.      | Security Ownership of Certain Beneficial Owners  and Management and Related Stockholder Matters                        | 66       |
| Item 13.      | Certain Relationships and Related Transactions                                                                         | 66       |
| Item 14. | Principle Accountant Fees and Services                                                                                 | 66       |
| PART IV  |                                                                                                                   |     |
| Item 15.      | Exhibits and Financial Statement Schedules                                                                             | 67       |
|          |                                                                                                                   |     |
| Signatures    |                                                                                                                   | 69       |

 

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**SPECIALNOTE REGARDING FORWARD-LOOKING STATEMENTS**

** **

*This Annual Report on Form 10-K containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934. All statements included or incorporated by reference in this AnnualReport on Form 10-K other than statements of historical fact, areforward-looking statements. You can identify these and other forward-lookingstatements by the use of words such as “may,” “will,” “could,” “anticipate,” “expect,”“intend,” “believe,” “continue” or the negative of such terms, or othercomparable terminology. Forward-looking statements also include the assumptionsunderlying or relating to such statements.*

 

*Our actual results could differ materially from thoseanticipated in these forward-looking statements as a result of various factors,including those set forth below under the caption “Risk Factors” in Part IIItem 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations” in this Annual Report on Form 10-K and elsewhere inthis Annual Report on Form 10-K. Readers are cautioned not to place undue reliance on forward-lookingstatements.  The forward-lookingstatements speak only as of the date on which they are made and we undertake noobligation to update such statements to reflect events that occur orcircumstances that exist after the date on which they are made except asrequired by law.*

 

**PART I**

** **

**Item 1.****    *Business***

 

**Overview**

 

We area biotechnology company using proprietary taste receptor-based assays andscreening technologies to discover and develop novel flavors, flavor enhancersand taste modulators for the packaged food and beverage industry. We believeour flavor ingredients will enable packaged food and beverage companies toimprove the nutritional profile of their products and may generate cost ofgoods savings, while maintaining or enhancing taste. We license our flavoringredients to our collaborators on an exclusive basis, which we believe we willprovide these companies with the ability to differentiate their products. Wehave entered into product discovery and development collaborations with four ofthe world’s leading packaged food and beverage companies: Campbell SoupCompany, The Coca-Cola Company, Kraft Foods Global, Inc. and Nestlé SA. Wecurrently anticipate that we will derive all of our revenues from existing andfuture collaborations. Our existing collaboration agreements provide forresearch and development funding, milestone payments based upon our achievementof research or development goals and, in the event of commercialization,royalties on future sales of consumer products incorporating our flavors,flavor enhancers and taste modulators. Our current programs focus on thedevelopment of savory, sweet and salt flavor enhancers and bitter tastemodulators. In addition, future collaboration agreements may provide forup-front license fees.

 

Flavorsare substances that impart tastes or aromas in foods and beverages. Individualsexperience the sensation of taste when flavors in food and beverage productsinteract with taste receptors in the mouth. A taste receptor functions eitherby physically binding to a flavor ingredient in a process analogous to the waya key fits into a lock or by acting as a channel to allow ions to flow directlyinto a taste cell. As a result of these interactions, signals are sent to thebrain where a specific taste sensation is registered. There are currently fiverecognized primary senses of taste: umami, which is the savory taste ofglutamate, sweet, salt, bitter and sour.

 

We arecurrently pursuing savory, sweet and salt flavor enhancer and bitter taste modulatordiscovery and development programs. The goals of our savory program are toenhance the taste of naturally occurring glutamate and enable the reduction orelimination of added MSG. The goals of our sweet program are to enhance thetaste of natural and artificial sweeteners and enable a significant reductionin added sweeteners. The goals of our salt program are to enhance the taste ofsalt and enable a significant reduction in added salt.  The goals of our bitter taste modulationprogram are to reduce or block bitter taste and improve the overall tastecharacteristics of packaged foods, beverages, over the counter (or OTC) healthcare products and pharmaceutical products.

 

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**Industry Background**

 

***Packaged Food and Beverage Industry***

 

Packagedfood and beverage products include carbonated and non-carbonated beverages,frozen foods, snack foods, ice cream, pasta, canned soup and numerous otherproducts. According to recent data from Euromonitor International, anindependent research organization, worldwide sales of packaged food andbeverage products in 2003 were approximately $1.2 trillion, of which $260billion was generated in the United States. Based on these estimates, of theworldwide total, sales of packaged foods were approximately $958 billion andsales of non-alcoholic beverages were approximately $278 billion. Based onrecent data from Euromonitor, Information Resources, Inc. and ourcollaborators’ 2003 annual reports, we estimate that our collaborators’combined worldwide sales in 2003 of their products that fall within theirexclusive product fields were $38 billion. Our collaboration agreements providethat we will receive a royalty of 1% to 4% on our collaborators’ sales ofproducts containing our flavors, flavor enhancers or taste modulators. However,our collaborators may not incorporate our flavors, flavor enhancers and tastemodulators into all of their products within their exclusive product fields.

 

Eachof our flavors, flavor enhancers and taste modulators addresses large,potentially overlapping markets. The following table sets forth the four primarytaste areas on which we are focused and, for each taste area, provides examplesof product categories that could incorporate ingredients in those taste areas,estimated worldwide sales, growth rates in 2003 and our estimates of theworldwide sales for food and beverage products that fall within our existingcollaborators’ exclusive product fields. 

 
| **Taste Areas** | ** ** | **Example Product Categories**                                                                                                                                                         | ** ** | **2003 Estimated  Worldwide Sales(1)** | ** **  | **Estimated  Growth  Rate Over  2002(1)** | ** ** | **2003 Estimated  Revenues Of  Existing  Collaborators  In Exclusive  Product Fields(2)** | ** ** |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|-------------|-------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
|            |       |                                                                                                                                                                                   |       |                                   |        |                                      |       |                                                                                      |       |
| Savory          |       | Ready meals, sauces, spreads, frozen foods,  beverages, meal replacements, soups, pastas, dried foods, snack foods,  processed meats, processed cheeses and cracker products           |       | $                                      | 362 billion |                                      | 4.7        | %                                                                                         | $          | 7.2 billion |   |
|            |       |                                                                                                                                                                                   |       |                                   |        |                                      |       |                                                                                      |       |
| Sweet           |       | Confectionaries, cereal, ice cream, beverages,  yogurt, dessert, spreads and bakery products                                                                                           |       | $                                      | 455 billion |                                      | 4.4        | %                                                                                         | $          | 15.7 billion |   |
|            |       |                                                                                                                                                                                   |       |                                   |        |                                      |       |                                                                                      |       |
| Salt            |       | Product categories are the same as those set forth  for savory taste area plus canned foods and bakery products                                                                        |       | $                                      | 400 billion |                                      | 4.5        | %                                                                                         | $          | 10.2 billion |   |
|            |       |                                                                                                                                                                                   |       |                                   |        |                                      |       |                                                                                      |       |
| Bitter          |       | Products which contain bitter tastants, including  confectionary, beverages, ice cream, ready meals, canned foods and soups, and  products which utilize certain artificial sweeteners |       | $                                      | 428 billion |                                      | 4.6        | %                                                                                         | $          | 5.4 billion |   |

 

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(1)          Accordingto recent Euromonitor data for packaged food and beverages, excludingpharmaceutical and OTC health care applications.

 

(2)          Basedon recent data from Euromonitor, Information Resources, Inc. and ourcollaborators’ 2003 annual reports.

 

***Flavor Industry***

 

Flavors,flavor enhancers and taste modulators are used in a variety of packaged foodand beverage products throughout the world. Flavors are substances that imparttastes or aromas in foods or beverages. Flavor enhancers and taste modulators aresubstances that supplement, enhance or modify the original flavor or aroma offoods, without necessarily imparting noticeable flavors or aromas. Flavors,flavor enhancers and taste modulators can originate from either naturallyoccurring or chemically synthesized compounds.

 

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Whilesome packaged food and beverage companies have their own internal research anddevelopment programs, most have traditionally relied on purchases of flavors,flavor enhancers and taste modulators from third parties. Historically,flavors, flavor enhancers and taste modulators have been sold on a commoditybasis by independent manufacturers who make their products broadly available topackaged food and beverage companies on a non-exclusive basis. This has limitedthe ability of packaged food and beverage companies to use flavors, flavorenhancers and taste modulators to differentiate their brands from competitors.

 

Traditionally,flavor companies have discovered new flavors, flavor enhancers and tastemodulators primarily using inefficient, non-automated and labor-intensive trialand error processes involving a limited number of trained taste testers. Usingthis approach, taste testers must physically taste each potential flavor andflavor enhancer compound to assess the taste characteristics of the compound.Taste testers can assess only a limited number of potential flavors or flavorenhancers at one time due to the sensory fatigue that results from repeatedtasting. As a result, only a small fraction of the available universe ofcompounds can be tested economically.

 

In theUnited States, most flavors, flavor enhancers and taste modulators areregulated as GRAS substances under the provisions of the Federal Food, Drug andCosmetic Act, or FD&C Act. GRAS determinations for most new flavors, flavorenhancers and taste modulators are made by an independent panel of scientistsadministered by FEMA. Under the FEMA GRAS process we expect that for each ofour flavors, flavor enhancers and taste modulators it will take 12 to 18 monthsand cost less than $1 million to conduct the safety studies and complete thereview by the FEMA expert panel. Once a flavor or flavor enhancer is determinedto be FEMA GRAS, it may be immediately incorporated into products for testmarketing and commercialization in the United States and in a number of othercountries.

 

***Flavors, Flavor Enhancers and Taste Modulatorsas a Source of Competitive Advantage***

 

Thepackaged food and beverage industry is comprised of a number of large andhighly competitive market segments. Small market share gains in specific largemarket segments can translate into significant additional revenue for packagedfood and beverage companies. For example, according to recent Euromonitor data,estimated 2003 worldwide sales of soft drinks were approximately $237.0billion. Thus, an increase of a tenth of a percentage point in overallworldwide market share would result in additional revenue of approximately$237.0 million.

 

As aresult of these market opportunities, packaged food and beverage companies areconstantly seeking ways to differentiate their products, demand for which canbe greatly affected by very small actual or perceived improvements in flavor orhealth profiles. Flavors, flavor enhancers and taste modulators can potentiallyprovide an important way to differentiate a particular product through enhancedtaste, health benefits, flavor ingredient exclusivity and cost of goodssavings.

 

•                  *Taste.* Product taste is a critical competitive factor for packaged food andbeverage companies. These companies seek to use flavors, flavor enhancers andtaste modulators to improve or maintain taste while improving the nutritional profileof packaged food and beverage products or reducing ingredient costs.

 

•                  *Health Benefits.*  Packaged food and beverage companies areexploring ways to improve overall nutritional quality of their products. It iswidely accepted that poor diet contributes to adverse health conditions such ascardiovascular disease, diabetes and obesity. To address these concerns, manycompanies have introduced reduced calorie, reduced sodium and reduced fatcontent products to the market. Flavors, flavor enhancers and taste modulatorswith specific desired characteristics provide an innovative way to reduce thelevels of ingredients that may contribute to these concerns withoutcompromising desirable taste attributes.

 

•                  *Flavor Ingredient Exclusivity.*  Failure of packaged food and beveragecompanies to differentiate their brands from their competition, includingprivate label products, may result in significant loss of market share, pricepressure and erosion of profit margins. Packaged food and beverage companiesspend millions of dollars creating brands and brand images to compete withother products. Many of these competitive products contain the same or similarflavor ingredients. The limited availability of proprietary flavors, flavorenhancers and taste modulators makes it difficult for manufacturers todifferentiate their products based on flavor ingredients.

 

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•                  *Cost of Goods Savings.*  The packaged food and beverage industrypurchases enormous volumes of raw materials to produce their products.According to CMP Information Limited, an independent research organization,estimated worldwide sugar production in 2002 was over 135 million tons at atotal value exceeding $37.0 billion. Similarly, according to the 2003 ChemicalEconomics Handbook, worldwide consumption of MSG was nearly 1.6 million metrictons in 2002 at a cost of $1.4 billion. Flavors, flavor enhancers and tastemodulators can potentially facilitate a reduction in the volume of theseingredients used in packaged food and beverage products, which could result insignificant decreases in costs and associated increases in profit margins.

 

**Our Solution**

 

We useour proprietary taste receptor-based assays and screening technologies todiscover and develop novel flavors, flavor enhancers and taste modulators. Wehave developed proprietary taste receptor-based assays that incorporate humantaste receptors. We use these assays in our high-throughput screening systemsto rapidly and efficiently screen our compound libraries and identify largenumbers of novel potential flavors, flavor enhancers and taste modulators. Webelieve our approach improves the likelihood that compounds with the desiredcharacteristics can be discovered and then optimized into novel flavors, flavorenhancers or taste modulators.

 

Webelieve our approach will result in the discovery and development of flavors,flavor enhancers and taste modulators that will provide the following valuablesolutions to the following key challenges faced by the packaged food andbeverage industry:

 

•                  *Maintaining and Improving Taste.*  We are developing flavors, flavor enhancersand taste modulators to enable our collaborators to improve or maintain tastewhile improving the nutritional profile of packaged food and beverage productsor reducing ingredient costs.

 

•                  *Reducing Sugar, Salt and MSG in Packaged Food andBeverage Products. *We aredeveloping flavors, flavor enhancers and taste modulators to enable ourcollaborators to significantly reduce the levels of sugar, salt and MSG inpackaged food and beverage products while maintaining or improving taste. Webelieve reducing the levels of such ingredients will improve the nutritionalprofile of packaged food and beverage products.

 

•                  *Blocking Undesirable Tastes.*  We are discovering taste modulators that webelieve will be useful in blocking bitter and other unwanted tastes associatedwith certain packaged food, beverage, OTC health care products andpharmaceutical products.

 

•                  *Obtaining Exclusive Use of Proprietary Flavors,Flavor Enhancers and Taste Modulators. *Weare able to offer our collaborators exclusive use of our proprietary flavors,flavor enhancers and taste modulators in defined packaged food and beverageproduct categories. We believe this approach will assist our collaborators indifferentiating their products from those of their competitors.

 

•                  *Reducing Cost of Goods. *We believe our proprietary flavors,flavor enhancers and taste modulators will enable our collaborators to reduceoverall raw material ingredient costs, particularly for those productscontaining high levels of natural and artificial sweeteners and MSG.

 

**Our Strategy**

 

Ourgoal is to become the leader in discovering, developing and commercializing newand improved flavors, flavor enhancers and taste modulators. Key elements ofour strategy include:

 

•                  *Collaborating With Leading Packaged Food and BeverageCompanies. *We arecollaborating with leading packaged food and beverage companies to develop andcommercialize our product candidates. Our collaborators are responsible formarketing, selling and distributing their products incorporating our flavors,flavor enhancers and taste modulators. As a result, we expect to commercializeour flavors, flavor enhancers and taste modulators without incurring significantsales, marketing and distribution costs. We currently have collaborations withCampbell Soup, Coca-Cola, Kraft Foods and Nestlé.

 

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•                  *Developing Flavors, Flavor Enhancers and Taste Modulatorsthat are Eligible for FEMA GRAS Determination. *We are focused on continuing the development of flavors,flavor enhancers and taste modulators that will qualify for a FEMA GRASdetermination. We expect the FEMA GRAS process will take 12 to 18 months frominitiation of safety studies through the GRAS determination for each of our flavors,flavor enhancers and taste modulators. Upon the GRAS determination, ourcollaborators can begin to test market and commercialize products incorporatingour flavors, flavor enhancers or taste modulators. In the event that aparticular flavor enhancer or taste modulator is not eligible for FEMA GRASdetermination, we will dedicate our development efforts to alternativecompounds.

 

•                  *Pursuing Additional Collaborations and Market Opportunities. *We seek to establish additionalcollaborations with leading packaged food and beverage companies to use flavors,flavor enhancers or taste modulators developed through our existing programsfor exclusive use within new packaged food and beverage product fields. Weintend to receive from future collaborators license fees, research anddevelopment funding, milestone payments and royalties on future sales ofproducts incorporating these flavors, flavor enhancers or taste modulators. Inaddition, we plan to target fields in which our collaborators can incorporatemore than one of our flavors, flavor enhancers or taste modulators into aparticular product.

 

•                  *Expanding Our Product Candidate Pipeline. *We will continue to focus on thediscovery and development of additional flavor ingredients based on additionaltaste receptors to address new taste areas. We also intend to improve thebeneficial characteristics of our current product candidates through thedevelopment of next-generation flavors, flavor enhancers and taste modulators.We will also continue to consider applications of our current products andtechnologies outside of the packaged food and beverage industry.

 

•                  *Maintaining and Expanding Technology Position. *We believe our proprietary tastereceptor-based technologies, including our receptor discovery, assaydevelopment and high-throughput screening technologies and natural andsynthetic compound libraries, provide us and our collaborators with significantcompetitive advantages. We intend to continue to develop and acquireproprietary technologies and related intellectual property rights to expand andenhance our ability to discover and develop new proprietary flavors, flavorenhancers and taste modulators.

 

**Our Discovery and Development Process**

 

Thefollowing diagram summarizes our discovery and development process.

 

 

Thekey elements of our Discovery and Development process are:

 

•                  *Proprietary Taste Receptor-Based AssayDevelopment. *The first stepin our discovery and development process is to develop proprietary assays basedon human taste receptors. Our assays are tests that measure interactionsbetween the taste receptors and potential flavors, flavor enhancers and tastemodulators. To date we have developed assays to test for compounds that affectsavory, sweet and salt taste. We are in the process of developing an assay forbitter taste receptors.

 

•                  *High-throughput Screening and Identification of LeadCompounds. *The next step inour discovery and development process is to use our proprietary tastereceptor-based assays to identify compounds that bind to human taste receptors,known as hits. We use automated high-throughput screening to rapidly evaluateour libraries of diverse synthetic and natural compounds. A panel of taste testersthen evaluates the taste effect of the most potent hits. Based on thisevaluation, we designate hits that exhibit a positive taste effect asproof-of-concept compounds. We then select the most promising of thoseproof-of-concept compounds, which we call lead compounds, for optimization.

 

•                  *Optimization of Lead Compounds and Selection ofProduct Candidates. *The nextstep in our discovery and development process is to chemically enhance, oroptimize, our lead compounds to allow lower amounts of

 

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the compound to beused in the finished product or improve the enhancement effect to meet thetaste attribute goals of our collaborators. Optimization may also be requiredto enhance the safety profile or to improve the physical properties of acompound so that it is stable under manufacturing, storage and food preparationconditions. We refer to optimized compounds that provide desirable tasteattributes in packaged food and beverage product prototypes as product candidates.

 

•                  *Safety Studies and FEMA GRAS Determination of ProductCandidates. *The next step inour discovery and development process is to select, in conjunction with ourcollaborators, one or more product candidates for commercialization. We thenevaluate the selected product candidate for safety. Following this evaluation,we submit the safety data along with the physical and chemical properties ofthe product candidate and a description of manufacturing and conditions ofintended use to the FEMA GRAS expert panel for review. Once our collaboratorselects a product candidate for commercialization, the FEMA GRAS process takesapproximately 12 to 18 months from initiation of safety studies through theGRAS determination, depending upon the timing of the FEMA Expert Panelmeetings. We intend to use the data from the FEMA GRAS review to facilitateapproval of our flavors, flavor enhancers and taste modulators for use inproducts sold outside of the United States.

 

Followinga FEMA GRAS determination, foods and beverages containing our proprietary flavors,flavor enhancers and taste modulators can be immediately commercialized in theUnited States. We anticipate, however, that our collaborators will test markettheir products containing our flavors, flavor enhancers and taste modulatorsthrough a series of consumer acceptance tests over a period of 6 to 12 monthsprior to initiating any wide-scale commercialization.

 

**Our Discovery and DevelopmentPrograms**

 

We arecurrently pursuing the discovery and development of flavors, flavor enhancersand taste modulators through programs focused on savory, sweet, salt andbitter. The following diagram indicates the principal compounds we aredeveloping in each program, and the current status of each compound.

 

 

***Savory Enhancer Program***

 

UsingSavoryScreenHT, our high-throughput savory receptor-based assay system, we haveidentified two product candidates, S336 and S807, that enhance the savory tasteof glutamate. We believe that these product candidates will enhance the tasteof naturally occurring glutamate and/or enable the reduction or elimination ofadded MSG and inosine monophosphate, or IMP, an expensive savory enhancer ofMSG taste, in a variety of foods and savory beverages, while maintaining orimproving the desired savory taste.

 

Todemonstrate the taste properties of S336 and S807, we tested each compoundagainst a reference sample consisting of MSG and IMP in amounts typically usedin foods to impart a savory taste. We tasted this reference sample against testsamples containing MSG and either S336 or S807 at concentrations of the testcompound of up to 3 parts per million, or ppm, which is typical of theconcentrations of FEMA GRAS flavors, flavor enhancers and taste modulators.

 

Inthese tests, S336 enhanced the savory taste of MSG and, at the level used, wassignificantly more potent than IMP in the reference sample. In a separate test,a solution of S336 alone, in the absence of MSG and IMP, was found

 

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to bemore savory than the reference sample. Based on these results, we believe thatthe use of S336 may allow for a significant reduction or replacement of addedMSG and IMP in savory foods. In separate tests, S807 also enhanced the savorytaste of MSG and provided for a three-fold reduction in MSG levels, yetmaintained the same savory taste of the reference sample. S336 and S807 havealso each been shown to enhance the savory taste of MSG in a product prototype.

 

Ourcollaborator has evaluated S336 and S807 for savory taste enhancement inproduct prototypes. S336 is approximately three times more potent than S807 intaste tests and exhibits greater water solubility compared to S807. Othercharacteristics, such as heat stability, are similar for the two compounds. Basedon the results of such studies, our collaborator formally selected both S336and S807 for development.

 

Wecompleted the safety assessment studies for S807 and S336 and submittedapplications for GRAS determination to the Expert Panel of the Flavor andExtract Manufacturers Association (FEMA) in December 2004.  In March 2005, we received notificationfrom FEMA that S807 and S336 have been determined to be GRAS.  In addition, two other flavor enhancers, S263and S976, which are related to S336, were also determined by FEMA to beGRAS.  A more detailed description of theFEMA GRAS process is provided in Item I, *Business – Our Discoveryand Development Process*.

 

***Sweet Enhancer Program***

 

UsingSweetScreenHT, our high-throughput sweet receptor-based assay system, weidentified S1395 and S888, proof-of-concept compounds that enhance the sweettaste of sugar. We believe that the enhancers we are developing in our sweetenhancer program will enhance the sweet taste of natural and artificialsweeteners used in a variety of packaged food and beverage products and mayprovide for a significant reduction in added sweetener in the finished productwhile maintaining or improving the desired sweet taste.

 

During2004, we identified a number of novel sweet enhancers using our optimizationchemistry process.  One compound, knownas S679, demonstrated enhanced potency in the receptor assay and in preliminarytaste tests over previous lead compounds S1395 and S888.  We have found that S679 enhances the sweettaste of fructose by approximately 1.6-fold (a 40% reduction) at aconcentration of 3 ppm in a product prototype. S679 is undergoing further testing in product prototypes by ourcollaborator.

 

Guidedby our taste receptor-based assays, we are continuing our chemistry optimizationefforts on S679 and several additional classes of compounds in order toidentify potential sweet enhancers that function at lower concentrations inproduct prototypes.  These efforts haverecently resulted in a number of new sweet enhancer compounds, including S763and S299, which have demonstrated two-fold increased potency in our in vitrosweet receptor-based assay compared to S679. These compounds are being scaled up for taste tests in productprototypes.  As we make additionalprogress in identifying potential product candidates, we will continue toprovide these enhancers to our collaborators for extensive testing in productprototypes.

 

***Salt Enhancer Program***

 

UsingSaltScreenHT, our high-throughput salt receptor-based assay, we have identifiedhundreds of compounds that enhance the activity of a taste receptor believed tobe involved in the taste of salt. The goal of our salt enhancer program is toidentify compounds that enhance the taste of salt and provide a significantreduction in sodium levels in a variety of foods while maintaining or improvingthe desired salt taste.

 

Wetested the most potent of the compounds identified by SaltScreenHT with ourelectrophysiology-based assay SaltScreenEP. This assay identifies compoundsthat specifically enhance the activity of ENaC, a taste receptor believed to beinvolved in the taste of salt. Based on the initial screening results, weselected compound S853 for further optimization.  We synthesized and tested over 1,000derivatives of S853 in the SaltScreenEP system. The most potent compounds, S112and S225, are approximately 3,000-fold more potent than the original compound,S853. We will need to synthesize additional compounds specific to human tasteENaC channels to identify a taste proof-of-concept compound.

 

***Bitter Taste Modulator Program***

 

Thebitter modulator program is currently focused on building our BitterScreenreceptor-based assays for each of the 25 human T2R bitter receptors.  The first step involves the identification ofat least one compound that

 

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activateseach bitter taste receptor.  In 2004, wepublished our work on the bitter taste receptors T2R61 and T2R64, which areactivated by saccharin and acesulfame potassium (AceK), artificial sweetenersthat are known to have a bitter off-taste. In addition, work is continuing on other T2R bitter receptors, and weare also evaluating variations of each T2R bitter receptor that are thought tobe responsible for some people to taste a food ingredient as bitter whileothers do not.  The goal of our bittertaste modulator program is to identify compounds that modulate or eliminate thebitter taste associated with certain packaged food and beverage products, OTChealth care products and pharmaceutical products.

 

**Product Discovery and DevelopmentCollaborations**

 

Wepursue collaborations with leaders in the packaged food and beverage market.Under each of our current product discovery and development collaborationagreements, we have agreed to conduct research and develop flavors, flavorenhancers or taste modulators in one or more specified taste areas, such assavory, sweet, salt or bitter. Each of these collaborations is focused on oneor more specific product fields, such as non-alcoholic beverages, wet soups, orfrozen foods. To date, we have entered into product discovery and developmentcollaborations with Campbell Soup, Coca-Cola, Kraft Foods and Nestlé.

 

All ofour current collaboration agreements provide for research and developmentfunding, milestone payments upon achievement of pre-defined research ordevelopment targets and royalty payments based upon future product sales in theevent the collaborator commercializes a product incorporating our flavors,flavor enhancers or taste modulators. The research and development fundingunder each of these agreements is paid according to a fixed payment schedule.Each of these collaborations provides us with a portion of the funding werequire to pursue the discovery and development of flavors, flavor enhancersand taste modulators for the applicable program. Under each of theseagreements, we are primarily responsible for the discovery, development andregulatory approval phases and any associated expenses, while our applicablecollaborator is responsible for selecting the consumer products that mayincorporate our flavors, flavor enhancers or taste modulators. Our collaboratoris also responsible for manufacturing, marketing, selling and distributing anyof these consumer products, and any associated expenses. We believe ourcollaborations will allow us to benefit from our collaborators’well-established brand recognition, global market presence, established salesand distribution channels and other industry-specific expertise. Each of ourcollaborations is governed by a joint steering committee, consisting of anequal number of representatives of the collaborator and us. The steeringcommittees provide strategic direction and establish performance criteria forthe research, development and commercialization of our flavors, flavorenhancers and taste modulators. All decisions of the steering committees mustbe unanimous.

 

Eachof our collaboration agreements provides that we will conduct research anddevelopment on flavors, flavor enhancers and taste modulators for use withinclearly defined packaged food and beverage product fields on an exclusive basisfor the collaborator during the collaborative period specified in each of theagreements. Our current product discovery and development collaborators are notprohibited from entering into research and development collaboration agreementswith third parties in any product field. Under the terms of each agreement, wewill retain rights to flavors, flavor enhancers and taste modulators that wediscover during the collaboration for use with the collaborator, or for our useor with other collaborators outside of the defined product field. We will alsoretain rights to any flavors, flavor enhancers and taste modulators that wediscover after the respective collaborative period. In addition, if thecollaborator terminates the agreement or, in the case of certain of ouragreements, fails after a reasonable time following regulatory approval or GRASdetermination to incorporate one or more of our flavors, flavor enhancers ortaste modulators into a product, it will no longer be entitled to use, and wewill have the right to license, the flavors, flavor enhancers or tastemodulators to other packaged food and beverage companies for use in any productfield.

 

Eachof our agreements terminates when we are no longer entitled to royalty paymentsunder the agreement. In addition, each agreement may be terminated earlier bymutual agreement or by either party in the event of a breach by the other partyof its obligations under the agreement. Our agreement with Kraft Foods and ourinitial agreement with Nestlé may each be terminated by our collaborator upon60 days written notice, provided that it pay a specified termination fee if itterminates the agreement prior to the end of the research collaborative period.Campbell Soup may only terminate its agreement without cause on or after March 28,2005 upon 60 days written notice, provided that it pay a specified terminationfee if it terminates the agreement after March 28, 2005 but prior to theend of the collaborative period. Our agreement with Coca-Cola permits Coca-Colato terminate the agreement upon specified major corporate events. Our mostrecent agreement with Nestlé gives Nestlé the right to terminate the agreement

 

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withoutcause on or after October 26, 2006 upon 90 days written notice, providedthat it pay a specified termination fee if it terminates the agreement after October 26,2006 but prior to the end of the collaborative period.

 

***Campbell Soup Company***

 

In March 2001,we entered into a collaboration agreement with Campbell Soup, a globalmanufacturer and marketer of consumer food products, to work for a three-yearcollaborative period to discover specified flavors and flavor enhancers in thepackaged food and beverage product fields of soups, including frozen soups. Welater amended the agreement to add the product field of specified savorybeverages in consideration for additional research and development payments andpotential milestone and royalty payments. We also extended the collaborativeperiod until the earlier of March 2006 or a GRAS determination, subject toearlier termination under specified circumstances.

 

Underthe terms of the collaboration, Campbell Soup has agreed to pay to us certainresearch and development funding. We are also eligible to receive a milestonepayment upon our achievement of a specific product development goal. Through December 31,2004, we have received $7.9 million in research and development funding. If allmilestones are achieved, and including the $7.9 million in research anddevelopment funding paid through December 31, 2004, we may be entitled topayments which total up to $10.1 million in research and development fundingand milestone payments. In addition, in the event of commercialization, we areentitled to receive royalties on future net sales of products containing adiscovered flavor or flavor enhancer from the date of introduction of eachproduct in each country until 17 years thereafter or until the expiration ofrelevant patents in such country, whichever is earlier. We cannot assure youthat we will receive any future milestone payments or royalties under thiscollaboration.

 

***The Coca-Cola Company***

 

In April 2002,we entered into a collaboration agreement with Coca-Cola, the world’s largestbeverage company, to work for a three-year collaborative period with Coca-Colafor the discovery and development of specified new flavors and flavor enhancersin the product field of soft drinks and other non-alcoholic beverages. Inaddition, we will work with Coca-Cola on a co-exclusive basis with Kraft Foodsfor the discovery and development of flavor enhancers in a specified food andbeverage product field. In April 2004, we amended the agreement to extendthe collaborative period until April 2008.

 

Underthe agreement, Coca-Cola has agreed to pay certain research and developmentfunding over the collaborative period. We are also eligible to receivemilestone payments upon our achievement of specific product discovery anddevelopment goals. Through December 31, 2004, we have received $5.5million in research and development funding. If all milestones are achieved,and including all research and development funding paid or payable, we may beentitled to payments which total up to $14.8 million. In addition, in the eventof commercialization, we are entitled to receive royalties on future sales ofproducts containing a discovered flavor or flavor enhancer until the expirationof relevant patents. We cannot assure you that we will receive any futuremilestone payments or royalties under this collaboration. The collaborativeperiod is subject to early conclusion by Coca-Cola upon 60 days written noticeupon payment of a specified early conclusion fee, provided that Coca-Cola mayterminate the collaborative period without payment of an early conclusion feein the event that we fail to achieve a specified research and development goalby April 22, 2006, subject to payment of research funding through July 22,2006. In the event of early conclusion, Coca-Cola will no longer be entitled touse, and we will have the right to license, any flavors or flavor enhancersdiscovered prior to such early conclusion to third parties for use in anyproduct field, provided that Coca-Cola would retain non-exclusive rights in thefield of non-alcoholic beverages with the exception of dry powdered beverages.

 

***Kraft Foods Global, Inc.***

 

In December 2000,we entered into a collaboration agreement with Kraft Foods, a global leader inbranded foods and beverages. The collaborative period for the original productdiscovery and development program expired on its own terms in December 2003.However, prior to December 2003 we amended our collaboration agreement toprovide for a new collaborative program through May 2005. Under thisprogram, we will work with Kraft Foods for the discovery and development offlavor enhancers, on a co-exclusive basis with Coca-Cola in a specified foodand beverage product field.

 

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Underthe collaboration agreement, as amended, Kraft Foods has agreed to pay uscertain research and development funding over a 4.5-year collaborative period.We are also eligible to receive milestone payments upon our achievement ofspecific product discovery and development goals. Through December 31,2004, we have received $7.2 million in research and development funding and onemilestone payment of $375,000. If all milestones are achieved, and includingall research and development funding paid or payable, we may be entitled topayments which total up to $8.6 million. In addition, in the event ofcommercialization, we are entitled to receive royalties on future net sales ofproducts containing a discovered flavor enhancer from the date of introductionof each product in each country until the earlier of 17 years thereafter oruntil the expiration of relevant patents in such country. We cannot assure youthat we will receive any further milestone payments or royalties under thiscollaboration.

 

***Nestlé SA***

 

In April 2002,we entered into a collaboration agreement with Nestlé, the world’s largest foodcompany, to work for a three-year collaborative period to discover specified flavorsand flavor enhancers in the food and beverage product fields of dehydrated andculinary food, frozen food and wet soup.

 

Underthe terms of the collaboration agreement, Nestlé has agreed to pay to uscertain research and development funding over three years. We are also eligibleto receive milestone payments upon our achievement by certain dates of specificproduct discovery and development goals. Through December 31, 2004, wehave received $7.0 million in research and development funding and threemilestone payments of $375,000 each. If all milestones are achieved, andincluding all research and development funding paid or payable, we may beentitled to payments which total up to $9.6 million. In addition, in the eventof commercialization, we are entitled to receive royalties on future net salesof products containing a discovered flavor or flavor enhancer from the date ofintroduction of each product in each country until the expiration of relevantpatents. We cannot assure you that we will receive any further milestonepayments or royalties under this collaboration.

 

In October 2004,we entered into a second product discovery and development collaborationagreement with Nestlé to work for a five-year collaborative period focusing onthe discovery and commercialization of specified novel flavor ingredients inthe coffee and coffee whiteners field. Under the terms of the agreement, Nestlé has agreed to pay us certainresearch and development funding over five years, subject to earliertermination under specified circumstances. We are also eligible to receive milestone payments upon achievement ofspecific product discovery and development goals.  Through December 31, 2004, we havereceived $450,000 in research and development funding.  If all milestones are achieved, and includingall research and development funding paid or payable, we may be entitled topayments which total up to $13.1 million. In addition, in the event of commercialization, we are entitled toreceive royalties on future net sales of products containing a discoveredflavor ingredient from the date of introduction of each product in each countryuntil the expiration of relevant patents. We cannot assure you that we willreceive any milestone payments or royalties under this collaboration.

 

**Our Technology**

 

Wehave discovered or in-licensed many of the key receptors that mediate taste inmammals. Having isolated human taste receptors, we have created proprietarytaste receptor-based assay systems that provide a biochemical or electronicreadout when a test compound affects the receptor. To enable faster compounddiscovery, we integrated our proprietary taste receptor-based screening assaysinto a robot-controlled automated system that uses plates containing an arrayof individual wells, each of which can screen a different compound. Ourreceptor-based discovery and development process has enabled us to improve ourability to find novel flavors, flavor enhancers and taste modulators over thetraditional use of simple taste tests.

 

***Receptor Discovery and Assay DevelopmentTechnology***

 

Thereare currently five recognized primary senses of taste: umami, which is thesavory taste of glutamate, sweet, salt, bitter and sour. Scientists generallybelieve that each taste sensation is recognized by a distinct taste receptor orfamily of taste receptors in the mouth or on the tongue. A taste receptorfunctions either by physically binding to a flavor ingredient in a processanalogous to the way a key fits into a lock or by acting as a channel to allowions to flow directly into a taste cell. The brain recognizes tastes bydetermining which of the numerous receptors in the mouth have been contacted bya given flavor ingredient. Savory, sweet and bitter taste compounds

 

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bind totaste receptors specific to each taste on the surface of taste bud cells. Incontrast, the taste of salt and the sour taste are thought to be recognized bytaste channels that allow the passage of particular ions into the taste budcells.

 

Thecurrent status in the development of proprietary taste receptor-based assaysystems for human taste receptors is as follows:

 

•                  *Savory Receptor. *Glutamate is a natural component of foods including tomatoes,mushrooms, parmesan cheese, and meats. It is often added to foods in the formof MSG to provide a savory flavor. The human savory receptor is composed of twoproteins called hT1R1 and hT1R3. The T1R proteins are members of the Gprotein-coupled receptor, or GPCR, family and are expressed on the surface ofcertain taste bud cells. We created SavoryScreenHT, a proprietaryhigh-throughput savory taste receptor-based assay system and demonstrated thatit responded to MSG and IMP. We have screened over 200,000 compounds inSavoryScreenHT and identified a number of savory enhancers, including S807,S336, S263 and S976, which were determined to be GRAS.

 

•                  *Sweet Receptor. *The human sweet receptor is composed of two proteins calledhT1R2 and hT1R3. The hT1R3 protein is shared in common with the savoryreceptor. Like the savory receptor, the sweet receptor is also a member of theGPCR family and is expressed on the surface of certain taste bud cells. Wecreated SweetScreenHT, a proprietary high-throughput sweet taste receptor-basedassay system, and demonstrated that it responded to many different sweet-tastingcompounds including carbohydrate sweeteners and high potency artificialsweeteners.  We have screened over200,000 compounds in SweetScreenHT and identified novel sweet flavor enhancers.

 

•                  *Bitter Receptors.* There are 25 bitterreceptors in humans.  These are alsomembers of the GPCR protein family.  Workfrom model systems showed that the 25 bitter receptors are likely presenttogether in the same taste cell.  Thebitter receptors are believed to have evolved as a defense mechanism from ingestingpoisonous substances.  It is thought thateach bitter receptor recognizes a different set of bitter-tastingcompounds.  We have characterized 10 ofthe 25 T2R receptors and we aim to create a specific receptor-based assay foreach one.

 

•                  *Salt Receptor. *In contrast to the GPCRs that mediate savory, sweet, andbitter tastes, sodium ions and to a lesser extent potassium ions, are thoughtto produce a salt taste via ion channels present on the surface of taste budcells. Ion channels are receptors that span the cell membrane and allow a flowof ions into or out of cells. Published work suggests that the EpithelialSodium Channel, or ENaC, is a mediator of salt taste. We have developed twoproprietary ENaC-based assay systems, SaltScreenHT, a high-throughput systemcapable of screening thousands of compounds per day, and SaltScreenEP, alower-throughput electrophysiology-based system. We demonstrated each of theSaltScreen systems are responsive to sodium and therefore could be used toidentify novel salt flavor enhancers.

 

***Screening Technologies and Compound Libraries***

 

Wehave developed or acquired access to expansive libraries of potential flavors,flavor enhancers and taste modulators currently comprised of over 230,000natural and synthetic compounds. We intend to continue to acquire or developadditional compounds to add to our libraries. We have designed and selected ourlibraries to comprise compounds that we believe are likely to be safe andeconomical for use in packaged food and beverage products. We are using ourSavoryScreenHT, SweetScreenHT, SaltScreenHT, SaltScreenEP and BitterScreenassay systems to screen the compounds in our libraries for their effects onspecific taste receptors. These systems use many of the same technologies thatpharmaceutical companies use to discover medicines. We also use these systemsto assist us in optimizing our lead compounds by rapidly and iterativelytesting the potency of the flavors, flavor enhancers and taste modulatorsgenerated in the optimization process as the lead compound progresses to becomea product candidate.

 

**Regulatory Process**

 

Flavoringsubstances, including flavors, flavor enhancers and taste modulators, intendedfor use in foods in the United States are regulated under provisions of theFD&C Act administered by the FDA. Flavor compounds sold in countries andregions outside of the United States are also subject to regulations imposed bynational governments or regional regulatory authorities as is the case in theEuropean Union.

 

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***Regulation of Flavors, Flavor Enhancers and TasteModulators in the United States***

 

In theUnited States, the majority of flavor compounds are regulated by the FDA asapproved food additives, or as GRAS ingredients under the FD&C Act. TheFood Additive Amendments of 1958 prompted the flavor industry to establish in1960 an Expert Panel of the Flavor and Extract Manufacturers Association, orFEMA, an organization that has administered the GRAS program for flavors on behalfof the industry for over 40 years. Another possible route to approval of aflavoring compound would be a food additive petition to the FDA; however, fewflavors are currently approved via this route. We believe that the flavorcompounds, including flavors, flavor enhancers and taste modulators, we maydiscover will be subject to the FEMA GRAS review process as described below.

 

***GRAS Review Process.***    Flavor compounds that qualify for the GRASreview process are generally intended to be consumed in small quantities andhave data supporting their safety under conditions of intended use. An expertpanel, convened to undertake a GRAS review, determines whether a compound isgenerally recognized as safe under the conditions of its intended use. Theseexperts are qualified by scientific training and experience to evaluate thesafety of chemicals used in food and may declare certain compounds as havingbeen adequately shown through scientific procedures to be generally recognizedas safe under the conditions of their intended use. Under the GRAS process,manufacturers are required to obtain safety data from the scientific literatureor through the conduct of safety studies, determine the estimated daily intakeof the flavor compound per person and submit a report to the GRAS review paneldescribing the physical, chemical, safety, and metabolic properties of theflavor compound. The entire GRAS determination process, including the safetyand metabolic studies, application preparation and GRAS panel review, can takeup to two years or longer. However, if there are prior safety data on thecompound or a compound with a related structure, then fewer safety studies maybe required for the GRAS review and the GRAS review process may be considerablyfaster than two years.

 

Themost common types of GRAS review are:

 

•                  *FEMA Expert Panel. *An independent panel of experts established by FEMA isavailable for use by members of FEMA. The FEMA expert panel meets three timesper year. The conclusions of the expert panel regarding a flavor or flavorenhancer are provided directly to the FDA and published in the journal FoodTechnology. To our knowledge, the FDA has not challenged the FEMA expert panel’sconclusion that the use of a flavoring substance is GRAS. In 2003, the FEMAexpert panel published their findings on 45 new compounds determined to be GRASfor specific flavor applications. We have been an associate member of FEMAsince 2003 and we expect to obtain a GRAS determination of our flavor compoundsvia the FEMA expert panel review.

 

•                  *Specifically Convened Independent Panel. *An independent, qualified panel ofexperts in pertinent scientific disciplines may be formed by the manufacturerto evaluate the safety of a specific compound for GRAS status. This process isknown as a “self determination of GRAS status.”

 

***Food Additive Petition Process.***    Food ingredients that are not GRAS may beconsidered food additives. Food additives require FDA approval prior to use infoods. A compound may be ineligible for FEMA GRAS determination, and may beconsidered a food additive, for a variety of reasons, including conditions ofintended use resulting in high dietary exposure, use for purposes other than aflavor or flavor enhancer and the compound’s safety profile. If the compound isconsidered a food additive, a food additive petition must be filed and approvedby the FDA. Examples of compounds that have gone through a food additivepetition include the artificial sweeteners Aspartame, Acesulfame K, andSucralose, and the fat substitute Olestra. The food additive petition approvalprocess for such food ingredients can take eight years or more. In the eventthat a particular flavor or flavor enhancer is not eligible for FEMA GRASdetermination and therefore requires FDA approval prior to use, we willdedicate our development efforts to alternative compounds that would beeligible for a GRAS determination.

 

***Benefits of the FEMA GRAS Process***

 

Thereare three key benefits of the FEMA GRAS review process:

 

•                  *Rapid Time for Commercialization. *Once a flavor compound is selectedfor development by our collaborator, we expect the time to conduct the safetystudies and complete the review by the FEMA expert panel will be 12 to 18months for the flavor compound, provided no additional studies are requested bythe panel or are necessary to explain unexpected safety study findings. This ismuch faster than the typical

 

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eight years orlonger to obtain FDA approval under the food additive petition process applicableto other food ingredients. Once the compound is determined to be FEMA GRAS, itcan be immediately commercialized in the United States and other countries thatrecognize the FEMA GRAS process. As described above, the initial phase ofcommercialization may include compound manufacturing, incorporation of theflavor enhancer into products, and the commercialization of products inconsumer test markets.

 

•                  *Low Development Costs. *The total costs for the FEMA GRASprocess, including synthesis of material for regulatory studies, contractsafety studies and preparation and submission of the FEMA GRAS application isgenerally under $1 million per compound. This amount includes synthesis ofmaterial for regulatory studies, contract metabolism and safety studies, andpreparation and submission of the FEMA GRAS application.

 

•                  *Facilitated Approval in Other Countries. *Approval of flavors for useoutside of the United States varies widely by country. According to FEMA, sevencountries, including Brazil, New Zealand and Australia, recognize compounds onthe FEMA GRAS list.  An additional set of countries recognize compounds onthe FEMA GRAS list “in principle”. These include Canada, China, Philippines,Taiwan, and Turkey. Approval in these countries typically requires specificapplications to the food safety authority of the individual countries but noadditional safety testing.

 

**License Arrangements**

 

Wehave licensed rights from several companies and academic institutions,including the following:

 

***University of California***

 

In March 2000,we entered into a license agreement with the University of California underwhich we obtained exclusive rights to certain technologies held by theUniversity of California that are involved in the biology of taste, includingspecified receptors in two taste receptor families, T1Rs and T2Rs. The licensemay be converted to a non-exclusive license, or terminated, by the Universityof California if we fail to meet specified milestones relating to the discoveryof specified products and the sale of specified products and services. Ourexclusive rights are also subject to rights granted by the University ofCalifornia to the United States Government and a private medical foundation.The agreement calls for the payment of a license issue fee, payable ininstallments through 2005, annual maintenance fees commencing in 2006 androyalties or service revenues on sales of any products developed usingtechnologies licensed under the agreement. Royalties will accrue in eachcountry for as long as there exists a valid patent claim covering a productdeveloped under the agreement. No royalty payments have accrued under theagreement to date. The agreement will remain in effect until the later of theexpiration of the last to expire patent licensed under the agreement, or tenyears from the date that the last product to be developed under the agreementis introduced to market in the United States. We may terminate the agreement atany time, without cause, upon notice to the University of California. TheUniversity of California may terminate the agreement upon a breach of ourobligations under the agreement. In addition, we are in discussions with theUniversity of California to amend the license agreement to include additionalrelated technology related to the coexpression of T1R taste receptors.

 

***Aurora Biosciences Corporation***

 

In November 2000,we entered into a technology collaboration and license agreement with Aurora todevelop certain assay technologies, which was amended April 2002. Underthe collaboration, we developed high-throughput screening assays using Aurora’sproprietary screening technologies. The agreement terminated in October 2002and Invitrogen Corporation subsequently acquired certain surviving rights andobligations under this agreement. Under the surviving terms of the agreement,we maintain exclusive rights to use certain proprietary screening technologieswith our taste receptor targets for the discovery of flavors, flavor enhancersand taste modulators. These exclusive rights are subject to rights grantedunder other current and future license agreements in connection with thepurchase of certain screening systems, as well as Invitrogen’s right to grantlicenses under its proprietary technology to academic, government and other non-profitorganizations. Our rights with respect to the screening of flavors, flavorenhancers and taste modulators are fully paid-up and will remain in effect,except in the event that we breach any remaining obligations to Invitrogenunder the agreement. In November 2000, Aurora purchased 1,000,000 sharesof our Series C preferred stock for $4.8 million.

 

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**Competition**

 

Ourgoal is to be the leader in discovering novel flavors, flavor enhancers andtaste modulators for use in a wide range of packaged food and beverageproducts. Other companies are possibly pursuing similar technologies and thecommercialization of products and services relevant to flavors, flavorenhancers and taste modulators. Although we are not aware of any othercompanies that have the scope of proprietary technologies and processes that wehave developed in our field, there are a number of competitors who possesscapabilities relevant to the flavor, flavor enhancer or taste modulation fields.

 

Inparticular, we face substantial competition from companies pursuing thecommercialization of products and services relevant to taste using moretraditional methods for the discovery of flavors, flavor enhancers and tastemodulators. These competitors include leading flavor companies, such asInternational Flavors & Fragrances Inc., Givaudan SA, Symrise, QuestInternational and Firmenich. These companies provide flavors and otherproducts, such as oils, extracts and distillates, to consumer productscompanies for use in a wide variety of products including foods, beverages,confectionaries, dairy products and pharmaceuticals. We also face indirectcompetition from other companies such as Newly Weds Foods, Inc., amanufacturer of food coatings and seasonings for restaurants, airlines and thefood services industry. We currently compete and will continue to compete inthe future with these companies in collaborating with and selling flavorproducts and technologies to manufacturers of packaged food and beverageproducts. Many of these companies have substantially greater capital resources,research and development resources and experience, manufacturing capabilities,regulatory expertise, sales and marketing resources, established relationshipswith consumer products companies and production facilities.

 

We mayin the future face competition from life sciences and other technologycompanies and other commercial enterprises. These entities engage as we do inbiotechnology, biology or chemistry and could apply this technology to thediscovery and development of flavors, flavor enhancers and taste modulators. Weare aware of another company, Linguagen Corp., a privately-held company, thatwe believe is involved in research on sweetness potentiators, salt substitutesand bitter blockers, specifically adenosine 5’ monophosphate, or AMP, and hasannounced research and development collaborations with a number of companies.While we do not believe that either of these collaborations is competitive withour product discovery and development efforts, we cannot guarantee thatproducts developed as a result of our competitors’ existing or futurecollaborations will not compete with our flavors, flavor enhancers and tastemodulators.

 

Universitiesand public and private research institutions are also potential competitors.While these organizations primarily have educational objectives, they maydevelop proprietary technologies related to the sense of taste or secure patentprotection that we may need for the development of our technologies andproducts. We may attempt to license these proprietary technologies, but theselicenses may not be available to us on acceptable terms, if at all.

 

We arenot aware of any sweet or salt enhancer that is commercially available or in developmentother than those we have discovered and are developing. Although savory flavorenhancers, such as IMP, are commercially available, they are not very potent,are expensive, are not patent protected and are sold as a commodity. Theblocking of bitter taste is typically accomplished by attempting to mask thebitter taste with a sweetener or another flavor ingredient.  Although AMP has received GRAS determination,we do not believe this compound has been widely adopted into packaged food andbeverage products.  However, ourcompetitors, either alone or with their collaborative partners, may succeed indeveloping technologies or discovering flavors, flavor enhancers or tastemodulators that are similar or preferable in the areas of, among others, effectiveness,safety, cost and ease of commercialization, and our competitors may obtainintellectual property protection or commercialize such products sooner than wedo. Developments by others may render our product candidates or ourtechnologies obsolete. In addition, our current product discovery anddevelopment collaborators are not prohibited from entering into research anddevelopment agreements with third parties in any particular field.

 

**Patents and Proprietary Rights**

 

Wewill be able to protect our proprietary rights from unauthorized use by thirdparties only to the extent that our proprietary rights are described by validand enforceable patents or are effectively maintained as trade secrets.Accordingly, we are pursuing and will continue to pursue patent protection forour proprietary technologies. As of December 31, 2004 we had one issuedUnited States patent, 40 pending United States patent applications and 69pending foreign applications covering various aspects of our proprietarytechnology. In addition, we have exclusive

 

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licenseagreements with Johns Hopkins University, The University of California, IncyteCorporation and Aurora covering an additional 38 issued United States patents,27 pending United States patent applications, 25 issued foreign patents and 51pending foreign applications.

 

Ourpolicy is to file patent applications and to protect technologies, inventionsand improvements to inventions that are commercially important to the developmentof our business. For example, we may seek patent protection for receptors andnucleic acid sequences encoding receptors that are involved in taste and theuse of such receptors to identify ingredients that modulate taste. We also relyon trademarks to protect our proprietary technology. Generally, United Statespatents have a term of 17 years from the date of issue or 20 years from theearliest claimed priority date, whichever is later, for patents issued fromapplications filed with the United States Patent and Trademark Office prior to June 8,1995 or 20 years from the application filing date or earlier claimed prioritydate in the case of patents issued from applications filed on or after June 8,1995. Patents in most other countries have a term of 20 years from the date offiling the patent application. Our success depends significantly upon ourability to develop ingredients and technologies that are protected by ourintellectual property and that do not infringe any competitor patents. We intendto continue to file patent applications as we discover and develop new flavorsor flavor enhancers and technologies.

 

Seekingand obtaining patents may provide some degree of protection for ourintellectual property. However, our patent positions are highly uncertain andmay involve complex legal and factual questions. No consistent standardregarding the allowability and enforceability of claims in many of the pendingpatent applications has emerged to date. As a result, we cannot predict thebreadth of claims that will ultimately be allowed in our patent applications,if any, including those we in-licensed or how we may be able to enforce ourpatent claims against our competitors. In addition, we may not have been thefirst to file patent applications for or to invent inventions relating to thetechnologies upon which we rely, which would preclude us from obtaining issuedpatents on the relevant inventions. We are aware of other companies andacademic institutions which have been performing research and have applied forpatents in the area of mammalian taste. In particular, other companies andacademic institutions have announced that they have identified taste receptors,published data on taste receptor sequence information or have filed patentapplications on receptors and their use, including the University ofCalifornia, Linguagen, Monell Chemical Senses, Mount Sinai School of Medicine,Scripps Research Institute, Warner Lambert and the German Institute of HumanNutrition. If any of these companies or academic institutions are successful inobtaining broad patent claims, such patents could potentially block our abilityto use various aspects of our discovery and development process and mightprevent us from developing or commercializing newly discovered flavors, flavorenhancers or taste modulators or otherwise conducting our business.

 

Wealso rely in part on trade secret protection for our confidential andproprietary information and process. Our policy is to execute confidentialityagreements with our employees and consultants upon the commencement of anemployment or consulting relationship. These agreements generally require thatall confidential information developed by the individual or made known to theindividual by us during the course of their employment shall be our exclusiveproperty. However, there can be no assurance that we will be able toeffectively enforce these agreements or that the subject proprietaryinformation will not be disclosed.

 

We arenot a party to any litigation, opposition, interference, or other potentiallyadverse ex parte or inter-party governmental or non-governmental proceedingwith regard to our patent and trademark positions. However, if we becomeinvolved in litigation, interference proceedings, oppositions or other intellectualproperty proceedings, for example as a result of an alleged infringement, or athird-party alleging an earlier date of invention, we may have to spendsignificant amounts of money and time and, in the event of an adverse ruling,we could be subject to liability for damages, invalidation of our intellectualproperty and injunctive relief that could prevent us from using technologies ordeveloping products, any of which could have a significant adverse effect onour business financial condition and results of operation. In addition, anyclaims relating to the infringement of third-party proprietary rights, orearlier date of invention, even if not meritorious, could result in costlylitigation, lengthy governmental proceedings, divert management’s attention andresources and require us to enter royalty or license agreements which are notadvantageous if available at all.

 

**Sales and Marketing**

 

We donot currently intend to establish internal sales and marketing capabilities.Under our current collaboration agreements, our collaborators are responsiblefor sales, marketing, and distribution of any packaged food or beverage productincorporating our flavors, flavor enhancers and taste modulators. As a result,we expect to

 

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commercializeour flavors, flavor enhancers and taste modulators without incurringsignificant sales, marketing and distribution costs. Our four currentcollaborators, Campbell Soup, Coca-Cola, Kraft Foods and Nestlé, are recognizedleaders in the sales, marketing, and distribution of packaged food and beverageproducts.

 

**Manufacturing**

 

Weintend to utilize third parties to manufacture our flavors, flavor enhancersand taste modulators. Under two of our existing product discovery and developmentcollaborations, our collaborator may, in its sole discretion, manufactureitself or through a third party manufacturer the flavors, flavor enhancers ortaste modulators it licenses from us. The remaining three agreements requirethe collaborator to identify with us a mutually agreed upon third party tomanufacture the flavors, flavor enhancers or taste modulators it licenses fromus. In some of these agreements, we maintain either the first right ofnegotiation or an option to manufacture based on provisions within theagreement.

 

Thereare a number of reliable third party contract manufacturers available toproduce our flavors, flavor enhancers and taste modulators. Our current productcandidates are relatively simple structures making them easy and inexpensive toproduce. We do not anticipate any capacity issues because of our low volumerequirements and the number of reliable and available manufacturers.

 

**Employees**

 

As of December 31,2004, we had 74 full-time employees, including 21 with Ph.D. degrees. Of ourfull-time workforce, 52 employees are engaged in research and development and22 are engaged in business development, finance and administration. We alsoretain outside consultants. None of our employees are covered by collectivebargaining arrangements, and our management considers its relationships withour employees to be good. We have entered into employment letter agreementswith Kent Snyder, Mark Zoller, Ph.D., Harry Leonhardt, Esq., and JohnPoyhonen, the terms of which are included in the prospectus we filed pursuantto Rule 424(b) of the Securities Act with the SEC on June 22,2004 under the heading “Management—Employment Agreements.”  We have entered into an employment letteragreement with Nigel R.A. Beeley, Ph.D., the terms of which are included inItem 11 of this Form 10-K.

 

**Executive Officers**

 

Thefollowing table sets forth certain information concerning our executiveofficers and their ages as of December 31, 2004:

 
| **Name**                      | ** ** | **Age** | ** ** | **Position**                                               | ** ** |
|-------------------------------|------------|---------|------------|------------------------------------------------------------|------------|
| Kent Snyder                   |       | 51      |       | President, Chief Executive  Officer and Director           |       |
| Mark J. Zoller, Ph.D.         |       | 51      |       | Chief Scientific  Officer and Sr. Vice President, Research |       |
| Harry J. Leonhardt, Esq. |       | 48      |       | Vice President, General  Counsel and Corporate Secretary   |       |
| John Poyhonen                 |       | 44      |       | Vice President and  Chief Financial and Business Officer   |       |
| Nigel R.A. Beeley, Ph.D       |       | 53      |       | Vice President,  Discovery                                 |       |

 

**Kent Snyder**, President and Chief ExecutiveOfficer, joined us in June 2003 and has served as a member of our board ofdirectors since that time. Prior to joining us, from October 2001 to June 2003,Mr. Snyder was retired. From July 1991 to October 2001, Mr. Snyderheld various marketing and sales management positions with AgouronPharmaceuticals, Inc., a Pfizer company. Mr. Snyder was President ofGlobal Commercial Operations at Agouron. Prior to holding the position ofPresident of Global Commercial operations, Mr. Snyder served as SeniorVice President of Commercial Affairs and Vice President of BusinessDevelopment. Mr. Snyder received his B.S. from the University of Kansasand his M.B.A. from Rockhurst College.

 

**Mark J. Zoller, Ph.D**., joined us in March 2000as Vice President of Research and was promoted to Senior Vice President ofResearch and Chief Scientific Officer in June 2001, which position hestill holds. From May 1992 to December 1999, Dr. Zoller held anumber of scientific management positions at ARIAD Pharmaceuticals, mostrecently as Senior Vice President, Genomics and Scientific Director of theHoechst-ARIAD Genomics Center, which in December 1999 was acquired byAventis Pharmaceuticals. Dr. Zoller received his B.A. in Chemistry fromPomona College and his Ph.D. in Chemistry from the University of California,San Diego.

 

19

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**Harry J. Leonhardt, Esq.**, Vice President,General Counsel and Corporate Secretary, joined us in September 2003. FromFebruary 2001 to February 2003, Mr. Leonhardt served asExecutive Vice President of Business Development, General Counsel and CorporateSecretary of Genoptix, Inc. From July 1996 to November 2000, Mr. Leonhardtheld senior management positions with Nanogen, Inc. and served mostrecently as Senior Vice President, General Counsel and Secretary. Mr. Leonhardtreceived his B.S. degree from the University of the Sciences in Philadelphiaand his Juris Doctorate from the University of Southern California Law Center.

 

**John Poyhonen**, Vice President and ChiefFinancial and Business Officer, joined us in October 2003 as VicePresident and Chief Business Officer and was promoted in April 2004 toVice President and Chief Financial and Business Officer. From 1996 until October 2003,Mr. Poyhonen served in various sales and marketing positions for AgouronPharmaceuticals, a Pfizer company, most recently as Vice President of NationalSales. Prior to holding this position, Mr. Poyhonen served as VicePresident of Marketing and Vice President of National Accounts. Mr. Poyhonenreceived his B.A. in Marketing from Michigan State University and his M.B.A.from the University of Kansas.

 

**Nigel R.A. Beeley, Ph.D.,**joined us in June 2004 as VicePresident, Discovery.  From March 1999through June 2004, Dr. Beeley served as Vice President, ChiefChemical Officer of Arena Pharmaceuticals, a biopharmaceutical company.  From 1994 to 1998, Dr. Beeley was SeniorDirector of Chemistry at Amylin Pharmaceuticals, Inc., a biotechnologycompany, and from 1988 to 1994, he served as Head of Oncology-Chemistry forCelltech, a biotechnology company.  From1980 to 1988, Dr. Beeley held positions of increasing seniority in thecardiovascular group at Synthelabo Research, a pharmaceutical company, and,from 1978 to 1980, he was a CNS medicinal chemist in the pharmaceuticaldivision of Reckitt and Coleman, a conglomerate.  From 1976 to 1978, Dr. Beeley held aRoyal Society Overseas Research Fellow at ETH, Zurich, Switzerland.  Dr. Beeley has a B.Sc. Honours (Class 1)degree in Chemistry from the University of Liverpool, U.K. and a Ph.D. inChemistry from the University of Manchester, U.K.

 

**Item 2.****    *Properties***

 

Wecurrently lease 86,962 square feet of laboratory and office space at 11099North Torrey Pines Road, La Jolla, California 92037. Of this leased space, asof December 31, 2004 we subleased approximately 26,207 square feet toother companies. Our lease for this facility expires on December 31, 2006,with an option to renew for an additional period of five years. Our currentmonthly lease obligations for rent are approximately $258,000, which includesspace that has been sublet to other companies. In addition, we are responsiblefor expenses associated with the use and maintenance of the building, such asutilities and common area maintenance. These costs vary each month, andhistorically have been approximately $132,000 per month. We believe that ourexisting facilities are adequate to meet our business requirements for thenear-term and that additional space will be available on commerciallyreasonable terms, if required.

 

**Item 3.****    *Legal Proceedings***

 

We arenot a party to any material legal proceedings at this time.

 

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

 

Nomatters were submitted to a vote of our security holders during the quarterended December 31, 2004.

 

20

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**PART II**

 

**Item 5.****    *Marketfor the Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchase of Equity Securities***

 

**Common Stock Market Price**

 

Ourcommon stock commenced trading on the NASDAQ National Market on June 22,2004 under the symbol “SNMX.” The following table sets forth the high and lowsales prices per share of our common stock as traded on the NASDAQ NationalMarket for the periods indicated. 

 
| **Fiscal 2004 Quarter ended** | ** ** | **March 31,  2004** | ** ** | **June 30,  2004** | ** ** | **September  30, 2004** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------|------------|--------------------------|------------|-------------------------|------------|-------------------------|------------|-----------------------------|------------|
| High                          |       | $                        | n/a        |                    | $          | 7.70                    |       | $                           | 9.95       |   | $ | 11.75 |   |
| Low                           |       | $                        | n/a        |                    | $          | 5.95                    |       | $                           | 5.20       |   | $ | 8.24 |   |

 

The lastsale price for our common stock as reported by the NASDAQ National Market on February 28,2005 was $11.03 per share.  As of February 28,2005, there were approximately 138 shareholders of record of our common stock.

 

Wehave never declared or paid any cash dividends to our shareholders. We do notpresently plan to pay cash dividends in the foreseeable future and intend toretain any future earnings for reinvestment in our business.

 

Informationabout our equity compensation plans is included in Item 12 of Part III ofthis Annual Report.

 

**Repurchases of Equity Securities**

 

There were norepurchases of equity securities in the fourth quarter of 2004.

 

**Use of Proceeds**

 

Ourinitial public offering, referred to as the Offering, of our common stock, parvalue $0.001, was effected through a Registration Statement on Form S-1(File No. 333-113998) that was declared effective by the SEC on June 21,2004.  The Registration Statement coveredthe offer and sale of up to 6,900,000 shares of our common stock for anaggregate offering price of $41.4 million. The Offering commenced on June 22, 2004.  On June 25, 2004, 6,000,000 shares ofcommon stock were sold for an aggregate offering price of $36.0 million.  On July 23, 2004, 450,000 shares of ourcommon stock were sold for an aggregate offering price of $2.7 million upon theexercise of the underwriters’ over-allotment option.  The Offering terminated following the sale ofall of the foregoing securities and the expiration of the underwriters’over-allotment option.  The Offeringresulted in aggregate proceeds to us of approximately $34.3 million, net ofunderwriting discounts and commissions of approximately $2.7 million andoffering expenses of approximately $1.7 million, through a syndicate ofunderwriters managed by Citigroup Global Markets Inc., Deutsche Bank SecuritiesInc., Needham & Company, Inc. and First Albany Capital Inc.

 

Nooffering expenses were paid directly or indirectly to any of our directors orofficers (or their associates) or person owning ten percent or more of anyclass of our equity securities or to any other affiliates.  All offering expenses were paid directly toothers.

 

As of December 31,2004, we estimate that we had used approximately $472,000 for the purchase ofequipment and approximately $5.7 million for working capital expenditures.  The remainder of the proceeds has beeninvested into short-term securities and cash equivalents.

 

Theforegoing payments were direct payments made to third parties who were not ourdirectors or officers (or their associates), persons owning ten percent or moreof any class of our equity securities or any other affiliate, except that theproceeds used for working capital included regular compensation for officersand directors.  The use of proceeds doesnot represent a material change from the use of proceeds described in theprospectus we filed pursuant to Rule 424(b) of the Securities Actwith the SEC on June 22, 2004.

 

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**Item 6****.    *SelectedFinancial Data***

 

TheStatement of Operations Data and Balance Sheet Data presented below should beread in conjunction with Item 7, Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, and Item 8, Financial Statementincluded in this Annual Report on Form 10-K.  Amounts are in thousands, except share and pershare amounts.

 
| ** **                                                       | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                       | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Statements of Operations Data:**                               |       |                              |       |   |   |   |   |   |   |   |   |
| Revenue under collaborative agreements                           |       | $                                 | 8,347      |   | $ | 9,537 |   | $ | 7,327 |   | $ | 2,275 |   | $ | 115 |   |
| Operating expenses:                                              |       |                              |       |   |   |   |   |   |   |   |   |
| Research and development                                         |       | 16,907                            |       | 16,802 |   | 17,635 |   | 16,263 |   | 6,137 |   |
| General and administrative                                       |       | 5,553                             |       | 4,096 |   | 4,154 |   | 4,952 |   | 3,196 |   |
| Stock-based compensation:                                        |       |                              |       |   |   |   |   |   |   |   |   |
| Research and development                                         |       | 1,411                             |       | 1,293 |   | 540 |   | 1,240 |   | 1,854 |   |
| General and administrative                                       |       | 4,625                             |       | 4,997 |   | 158 |   | 378 |   | 372 |   |
| Total operating expenses                                         |       | 28,496                            |       | 27,188 |   | 22,487 |   | 22,833 |   | 11,559 |   |
| Loss from operations                                             |       | (20,149                           | )          | (17,651 | ) | (15,160 | ) | (20,558 | ) | (11,444 | ) |
| Interest income, net                                             |       | 435                               |       | 198 |   | 339 |   | 329 |   | 699 |   |
| Net loss                                                         |       | $                                 | (19,714    | ) | $ | (17,453 | ) | $ | (14,821 | ) | $ | (20,229 | ) | $ | (10,745 | ) |
| Basic and diluted net loss per share(1):                         |       |                              |       |   |   |   |   |   |   |   |   |
| Historical                                                       |       | $                                 | (1.40      | ) | $ | (10.03 | ) | $ | (9.60 | ) | $ | (17.30 | ) | $ | (12.30 | ) |
| Pro Forma                                                        |       | $                                 | (0.89      | ) | $ | (0.97 | ) |   |   |   |   |   |   |
| Shares used to compute basic and diluted net loss  per share(1): |       |                              |       |   |   |   |   |   |   |   |   |
| Historical                                                       |       | 14,040,727                        |       | 1,739,380 |   | 1,544,268 |   | 1,169,134 |   | 873,241 |   |
| Pro Forma                                                        |       | 22,143,380                        |       | 17,944,686 |   |   |   |   |   |   |   |

 

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(1)          Pleasesee Note 1 to our financial statements for an explanation of the methodused to calculate the historical and pro forma net loss per share and the numberof shares used in the computation of the per share amounts.

 
| ** **                                                 | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                 | ** ** | **2004**                    | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Balance Sheet Data:**                                    |       |                        |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and investments  available-for-sale |       | $                           | 40,847     |   | $ | 17,058 |   | $ | 27,586 |   | $ | 24,726 |   | $ | 14,540 |   |
| Working capital                                            |       | 36,841                      |       | 15,160 |   | 22,667 |   | 20,862 |   | 12,345 |   |
| Total assets                                               |       | 43,802                      |       | 20,440 |   | 34,720 |   | 34,402 |   | 26,485 |   |
| Long-term obligations                                      |       | —                      |       | — |   | 906 |   | 729 |   | — |   |
| Accumulated deficit                                        |       | (84,396                     | )          | (64,682 | ) | (47,229 | ) | (32,408 | ) | (12,179 | ) |
| Total stockholders’ equity                            |       | 38,373                      |       | 17,104 |   | 28,219 |   | 29,057 |   | 23,939 |   |
|                                                            |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

A summary of our unaudited quarterly results of operations for theyears ended December 31, 2004 and 2003 is included in footnote 8 to our auditedfinancial statements, which are included in Item 8 of this Annual Report onForm 10-K.

 

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

 

*The following discussion of our financial condition andresults of operations should be read in conjunction with our FinancialStatements and the related Notes to Financial Statements in Item 8, “FinancialStatements and Supplementary Data” in this Annual Report on Form 10-K.*

 

*Certain statements contained in this annual reporton Form 10-K, including statements regarding the development, growth andexpansion of our business, our intent, belief or current expectations,primarily with respect to our future operating performance, and the products weexpect to offer and other statements regarding matters that are not historicalfacts, are “forward-looking statements” within the meaning of Section 27Aof the Securities Act and Section 21E of the Securities Exchange Act of1934, as amended, or Exchange Act, and are subject to the “safe harbor” createdby these sections. Future filings with the SEC, future press releases andfuture oral or written statements made by us or with our approval, which arenot statements of historical fact, may also contain forward-looking statements.Because such statements include risks and uncertainties, many of which arebeyond our control, actual results may differ materially from those expressedor implied by such forward-looking statements. Some of the factors that couldcause actual results to differ materially from those expressed or implied bysuch forward-looking statements can be found under the caption “Risk Factors,”and elsewhere in this annual report on Form 10-K.  Readers are cautioned not to place unduereliance on forward-looking statements. The forward-looking statements speakonly as of the date on which they are made, and we undertake no obligation toupdate such statements to reflect events that occur or circumstances that existafter the date on which they are made.*

 

**Overview and Recent Developments**

** **

We area biotechnology company using proprietary taste receptor-based assays,screening technologies and optimization chemistry to discover and develop novelflavors, flavor enhancers and taste modulators for the packaged food andbeverage industry.  We believe our flavoringredients will enable packaged food and beverage companies to improve thenutritional profile of their products and generate cost of goods savings, whilemaintaining or enhancing taste.  Welicense our flavor ingredients to our collaborators on an exclusive basis,which we believe will provide these companies with the ability to differentiatetheir products.  We have entered intoproduct discovery and development collaborations with four of the world’s leadingpackaged food and beverage companies: Campbell Soup Company, The Coca-ColaCompany, Kraft Foods Global, Inc. and Nestlé SA.  We currently anticipate that we will deriveall of our revenues from existing and future collaborations.  Our existing collaboration agreements providefor research and development funding, milestone payments based upon ourachievement of research or development goals and, in the event ofcommercialization, royalties on future sales of consumer products incorporatingour flavors, flavor enhancers and taste modulators.  Our current programs focus on the developmentof savory, sweet and salt flavor enhancers and bitter taste modulators.  In addition, future collaboration agreementsmay provide for up-front license fees.

 

Wehave incurred significant losses since our inception in 1998 and, as of December 31,2004 our accumulated deficit was $84.4 million. We expect to incur additional losses over at least the next two years aswe continue to develop flavors, flavor enhancers and taste modulators.  Our results of operations have fluctuatedfrom period to period and likely will continue to fluctuate substantially inthe future based upon:

 

•                  terminationof any of our product discovery and development collaboration agreements;

 

•                  ourability to discover and develop new flavors, flavor enhancers and tastemodulators or the ability of our product discovery and developmentcollaborators to incorporate them into their products;

 

•                  ourability to enter into new, or extend existing, product discovery anddevelopment collaborations and technology collaborations;

 

•                  thedemand for our collaborators’ products containing our flavors, flavor enhancersand taste modulators; and

 

•                  variabilityof our stock-based compensation expense in conjunction with fluctuations of ourstock price.

 

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On June 7,2004 we effected a 4-for-7 reverse stock split of our outstanding commonstock.  On June 16, 2004 we effected a 1-for-1.4005989 reverse stocksplit of our outstanding common stock.  On June 25, 2004 we completedan initial public offering of 6,000,000 shares of common stock for proceeds tous of $31.9 million, net of underwriting discounts, commissions, and offeringcosts.  In connection with the closing of our initial public offering alloutstanding shares of our convertible preferred Series A, B, C, D and Estock were automatically converted into common stock.  On July 23,2004 pursuant to the exercise by the underwriters of an over-allotment option,we closed the sale of an additional 450,000 shares of our common stock whichresulted in proceeds to us of $2.4 million, net of underwriting discounts,commissions and offering costs.

 

In October 2004,we entered into a second product discovery and development collaborationagreement with Nestlé to work for a five-year collaborative period focusing onthe discovery and commercialization of specified novel flavor ingredients inthe coffee and coffee whiteners field.  Under the terms of the agreement,Nestlé has agreed to pay us certain research and development funding totaling$11.7 million over five years, subject to earlier termination under specifiedcircumstances.  We are also eligible to receive milestone payments uponachievement of specific product discovery and development goals and, in theevent of commercialization, we are entitled to receive royalties on future netsales of products containing a discovered novel flavor ingredient.

 

In March 2005,we were notified by the Flavor and Extract Manufacturers Association (FEMA)that our savory enhancers S807 and S336 have been determined to be GenerallyRecognized as Safe (GRAS) under the provisions of the Federal Food, Drug andCosmetic Act, administered by the United States Food and DrugAdministration,  In addition, two of ourother savory enhancers, S263 and S976, which are related to S336, were alsodetermined to be GRAS.

 

**Revenue**

** **

Wederive revenue from our product discovery and development collaborations. Todate, our revenue has come solely from research and development funding andmilestone payments under our product discovery and development collaborationagreements with Campbell Soup, Coca-Cola, Kraft Foods and Nestlé. As of December 31,2004, we have recognized cumulative revenue under our collaborations of $27.6million. If any of these collaborative agreements were to be terminated, thiscould have a significant effect on future revenues.

 

Fromthe company’s inception date to the present, research and development paymentsrepresented the primary source of our revenue. Based on current collaborations,we anticipate that substantially all of our revenues in the near future will bederived from research and development payments, and we may receive additionalmilestone payments in the future upon the achievement of certain goals setforth in our collaboration agreements.

 

Inaddition, in the event our collaborators launch products incorporating ourflavors, flavor enhancers and taste modulators, we will receive royaltypayments based upon the future sales of those products, which, if received,could be significantly larger than research and development funding ormilestone payments. In order for us to generate royalty revenue and becomeprofitable, we must retain our existing or establish new product discovery anddevelopment collaborations and our collaborators must commercialize productsincorporating one or more of our flavors, flavor enhancers or taste modulators.Our ability to generate royalty revenue is uncertain and will depend upon ourability to meet particular research, development and commercializationobjectives.

 

**Research and Development**

** **

Ourresearch and development expenses consist primarily of costs associated withour discovery and development efforts in connection with our four primaryprograms: savory, sweet, salt and bitter. We track research and developmentcosts by the type of cost incurred rather than by project. Research anddevelopment costs are comprised of salaries and other personnel relatedexpenses, facilities and depreciation, research and development supplies,patent and licensing, and outside services. We charge research and developmentexpenses to operations as incurred.

 

Theresearch and development payments we have received from our collaborationagreements with Campbell Soup, Coca-Cola, Kraft Foods and Nestlé historicallyhave not covered all of our research and development expenses. We expect thatour research and development expenses are likely to increase in the future as aresult of our existing product discovery and development collaborations,internal product discovery and development activities and technologydevelopment and any expansion of these activities.

 

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Atthis time, due to the risks inherent in the discovery of flavors, flavorenhancers and taste modulators, we are unable to estimate with any certaintythe costs we will incur in the continued development of our flavors, flavorenhancers and taste modulators for commercialization. In March 2005, wereceived FEMA GRAS determination on S807, S336, S263 and S976 from our savoryprogram.  We anticipate that we willreceive FEMA GRAS determination on lead compounds in our sweet and saltprograms within an estimated 18 to 24 months and 24 to 30 months, respectivelyfrom December 31, 2004.  We have notdetermined an estimate for the timing of FEMA GRAS determination for tastemodulators in our bitter program as of this time.

 

Weanticipate that we will make determinations regarding the research anddevelopment projects to pursue and the funding of each project on an ongoingbasis in response to the progress of each discovery and development program, aswell as an ongoing assessment of its market potential. We cannot be certainwhen any net cash inflow from the commercialization of our flavors, flavorenhancers and taste modulators will commence.

 

In2000, we paid $2.5 million to acquire a perpetual license from Aurora for therights to the use of certain assays and paid Incyte $6.5 million for access toIncyte’s database for a three year period. The use of these assays and thereceptors identified from the database have been utilized in our efforts withits collaborative partners. The license and database were determined to havealternative future uses and therefore, capitalized and amortized to researchand development expense over the estimated useful life of the license and overthe three years of the access to the database.

 

Ourability to complete the development of our current product candidates issubject to many risks and uncertainties. These risks include the risks, amongothers, that:

 

•                  weare substantially dependent upon our collaborators for research and developmentfunding;

 

•                  ourcollaborators may terminate their respective collaboration programs early;

 

•                  wemay not be able to discover flavors, flavor enhancers or taste modulators withthe desired taste attributes;

 

•                  wemay not be successful in developing flavors, flavor enhancers or tastemodulators with attributes required for use in commercial products;

 

•                  wemay be unable to maintain FEMA GRAS determination for our savory productcandidates; and

 

•                  wemay be unable to obtain FEMA GRAS determination for candidates in our otherprograms.

 

If wedo not complete the development of our flavors, flavor enhancers and tastemodulators on a timely basis, our collaborators may terminate or not renew ourcollaboration agreements, we may begin receiving revenue from thecommercialization of products incorporating our flavors, flavor enhancers andtaste modulators later than anticipated, or not at all, and it may be moredifficult to enter into new collaboration agreements. In any of these cases, wemay require substantial additional funding in order to continue development ofour flavors, flavor enhancers and taste modulators.

 

**General and Administrative**

** **

Generaland administrative expenses consist primarily of salaries and other personnelrelated expenses related to business development, legal, financial and otheradministrative functions. We expect that our general and administrativeexpenses will continue to increase in 2005 as a result of becoming a publiccompany due to the additional reporting requirements imposed on publiccompanies, particularly in light of recently enacted legislation such as theSarbanes-Oxley Act of 2002 and related governmental and securities industry rules andregulations.

 

**Stock-Based Compensation**

** **

Wehave recorded deferred compensation for stock options and stock awards grantedequal to the difference between the exercise price and the fair value of ourcommon stock on the date of grant as determined for the purpose of recordingour IPO cheap stock calculation. We record options or awards issued tonon-employees at their fair value in accordance with the Statement of FinancialAccounting Standards (“SFAS”) No. 123, *Accounting for Stock-BasedCompensation*, and periodically remeasure them in accordance withEmerging Issues Task Force No.

 

25

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(“EITF”)96-18, *Accounting for Equity Instruments That Are Issuedto Other Than Employees for Acquiring or in Conjunction with Selling Goods orServices*, and recognize them over the service period. In connectionwith the grant of stock options to employees, we recorded deferred stock-basedcompensation of $442,000 and $13.3 million for the years ended December 31,2004 and 2003, respectively. We recorded these amounts as a component ofstockholders’ equity and amortize them, on an accelerated basis, as a non-cashcharge to operations over the vesting period of the options. We recordedemployee and non-employee stock-based compensation expense of $6.0 million,$6.3 million and $698,000 for the years ended December 31, 2004, 2003 and2002, respectively. We expect that the charges to be recognized in futureperiods from amortization of deferred compensation related to employee stockoption grants will be $2.3 million, $1.0 million and $143,000 for the yearsending December 31, 2005, 2006 and 2007, respectively.

 

In December 2004,the Financial Accounting Standards Board (FASB) issued revised statement No. 123(SFAS No. 123R),*Share-Based Payment,*which requires companies to expense the estimated fair value of employee stockoptions and similar awards. The accounting provisions of SFAS No. 123Rwill be effective for the third quarter of fiscal 2005. SFAS No. 123Rpermits public companies to choose between the following two adoption methods:

 

1. A “modifiedprospective” method in which compensation cost is recognized beginning with theeffective date (a) based on the requirements of SFAS No. 123R for allshare-based payments granted after the effective date and (b) based on therequirements of SFAS No. 123 for all awards granted to employees prior tothe effective date of SFAS No. 123R that remain unvested on the effectivedate, or

 

2. A “modifiedretrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS No. 123 for purposes ofpro forma disclosures for either (a) all prior periods presented or (b) priorinterim periods of the year of adoption.

 

SFAS No. 123R,which provides certain changes to the method for valuing stock-basedcompensation among other changes, will apply to new awards and to awards thatare outstanding on the effective date and are subsequently modified orcancelled. Compensation expense for outstanding awards for which the requisiteservice had not been rendered as of the effective date will be recognized overthe remaining service period using the compensation cost calculated for proforma disclosure purposes under SFAS No. 123. For such pro formadisclosures, please see the discussion under the heading “Stock-BasedCompensation” in Note 1 to our Financial Statements.  We are in the process of determining how thenew method of valuing stock-based compensation as prescribed in SFAS No. 123Rwill be applied to valuing stock-based awards granted after the effective dateand the impact the recognition of compensation expense related to such awardswill have on our financial statements.

 

**Results of Operations**

 

**Years Ended December 31,2004, 2003 and 2002**

 

***Revenue Under Collaboration Agreements***

 

Werecorded revenue of $8.3 million, $9.5 million and $7.3 million during theyears ended December 31, 2004, 2003 and 2002, respectively.  Researchand development payments and milestone payments under collaborations withCampbell Soup, Coca-Cola, Kraft Foods, and Nestlé accounted for 100% of totalrevenue for the years ended December 31, 2004, 2003 and 2002.

 

***Research and Development Expenses***

 

Ourresearch and development expenses (excluding stock-based compensation expensescharged to research and development) were $16.9 million, $16.8 million and$17.6 million for the years ended December 31, 2004, 2003 and 2002. Stock-based compensation expenses charged to research and development for theyears ended December 31, 2004, 2003 and 2002 were $1.4 million, $1.3million and $540,000, respectively.  A comparison of research anddevelopment expenses exclusive of stock-based compensation expenses by categoryis as follows (in thousands):

 

26

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| ** **                              | ** ** | **Year Ended  December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|
| ** **                              | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| Salaries and personnel                  |       | $                                 | 7,211      |   | $ | 5,466 |   | $ | 4,951 |   |
| Facilities and depreciation             |       | 4,449                             |       | 4,498 |   | 3,083 |   |
| Research and development supplies       |       | 1,989                             |       | 2,299 |   | 3,260 |   |
| Patent and licensing                    |       | 1,588                             |       | 3,741 |   | 4,103 |   |
| Outside services                        |       | 1,357                             |       | 479 |   | 1,950 |   |
| Miscellaneous                           |       | 313                               |       | 317 |   | 289 |   |
| Total research and development expenses |       | $                                 | 16,907     |   | $ | 16,802 |   | $ | 17,635 |   |

 

***Salaries and Personnel.*** Our expenses for research and development personnel, including consultants,were $7.2 million, $5.5 million and $5.0 million for the years ended December 31,2004, 2003 and 2002, respectively.  The increase of $1.7 million from 2003to 2004 was primarily due to increases in payroll expenses, recruiting expensesand employee benefits expenses of approximately $1.4 million, $158,000 and$125,000, respectively.  Our research and development staff increased froman average of 50 for the year ended December 31, 2003 to an average of 56for the year ended December 31, 2004.  The increase in staff wasprimarily to support continuing optimization of product candidates from ourresearch programs.  The increase of$515,000 from 2002 to 2003 was primarily due to increased salaries andrecruiting expenses.  Our research and development staff increased from anaverage of 45 for the year ended December 31, 2002 to an average of 50 forthe year ended December 31, 2003.  The increase in staff wasprimarily to support continuing optimization of product candidates from ourresearch programs.

 

***Facilities and Depreciation.***    Ourfacilities and depreciation expenses were $4.4 million, $4.5 million and$3.1 million for the years ended December 31, 2004, 2003 and 2002,respectively. The decrease of $49,000 from 2003 to 2004 was primarilyattributable to a reduction of depreciation expense of approximately $506,000,offset by an increase in rent expense and other related costs of approximately$436,000 incurred as a result of occupying additional space within our facilityfor the full year, as opposed to part of the year in 2003. The increase of $1.4million from 2002 to 2003 was primarily attributable to expanding intoadditional space within our facility to accommodate additional research anddevelopment personnel hired for optimization of product candidates.

 

***Research and Development Supplies.*** Our expenses for supplies used in research and development were $2.0 million,$2.3 million and $3.3 million for the years ended December 31, 2004, 2003and 2002, respectively.  The decrease of $310,000 from 2003 to 2004 wasprimarily attributable to reduced screening activities as our research anddevelopment activities have advanced into certain less expensive optimizationactivities.  The decrease of $961,000from 2002 to 2003 was primarily attributable to reduced chemical librarypurchases and related screening activity as our research and developmentactivities advanced into certain less expensive compound optimizationactivities.

 

***Patent and Licensing.*** Our patent and licensing expenses were $1.6 million, $3.7 million and $4.1million for the years ended December 31, 2004, 2003 and 2002,respectively.  The decrease of $2.2 million from 2003 to 2004 wasprimarily attributable to reduced licensing fees in 2004 compared to2003.  Included in licensing fees was the amortization of certain licensestotaling $2.9 million for the year ended December 31, 2003.  Therelated licenses were fully amortized at December 31, 2003, thus we didnot have any costs relating to the amortization of these licenses for the yearended December 31, 2004.  This decrease was partially offset by anincrease of approximately $656,000 incurred for outside patent legal feesassociated with developing our intellectual property portfolio.  The decrease of $362,000 from 2002 to 2003was primarily attributable to reduced outside patent legal fees.  Included in these costs was amortization oflicenses totaling $2.9 million in 2003 and $3.0 million in 2002.

 

***Outside Services.*** Our outside services expenses were $1.4 million, $479,000 and $2.0 million forthe years ended December 31, 2004, 2003 and 2002, respectively.  Theincrease of $878,000 from 2003 to 2004 was primarily attributable to costsincurred for outsourced development activities, including regulatory studiesand product candidate synthesis scale-up. The decrease of $1.5 million from 2002 to 2003 was primarilyattributable to the full year impact of the conclusion in 2002 of research anddevelopment support performed by Aurora, which totaled $2.0 million, partiallyoffset by outsourced chemical synthesis and analysis of product candidates in2003.

 

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***General and Administrative Expenses***

 

Ourgeneral and administrative expenses (excluding stock-based compensationexpenses charged to general and administrative) were $5.6 million, $4.1 millionand $4.2 million for the years ended December 31, 2004, 2003 and 2002,respectively.  Stock-based compensation expenses charged to general andadministrative for the years ended December 31, 2004, 2003 and 2002 were$4.6 million, $5.0 million and $158,000, respectively.  The $1.5 millionincrease in expenses (other than stock-based compensation expense) from 2003 to2004 was primarily attributable to an increase in expenses for personnel andrelated expenses of approximately $849,000, an increase in facilities expenseof approximately $319,000, and an increase in public relations and marketingcosts of approximately $263,000.  The$57,000 decrease in expenses from 2002 to 2003 was primarily attributable to adecrease of $492,000 in personnel and related expenses attributable to reducedbusiness development activities and financing activities, offset by an increaseof $280,000 in facility costs and $155,000 in legal and miscellaneous costs.

 

***Stock-based Compensation***

 

Ouraggregate stock-based compensation expenses charged to both research anddevelopment and general and administrative expenses decreased to $6.0 millionfor the year ended December 31, 2004 from $6.3 million for the year ended December 31,2003.  The decrease in overall stock-based compensation expense isprimarily due to a decrease in compensation expense in 2004 compared to 2003for stock options granted to employees, partially offset by an increase incompensation expense in 2004 compared to 2003 for stock options granted tonon-employees, as the fair value of these options at December 31, 2004 wasrevalued in accordance with EITF Issue No. 96-18.  Our aggregate stock-based compensationexpenses charged to both research and development and general andadministrative expenses increased to $6.3 million for the year ended December 31,2003 from $698,000 for the year ended December 31, 2002.  Theincrease in overall stock-based compensation expense is primarily due to anincrease in compensation expense in 2003 compared to 2002 for stock optionsgranted to employees and the increase in fair values of options granted in 2003as a result of our initial public offering in June 2004.  In connection with the grant of stock optionsto employees, we recorded deferred stock-based compensation of $442,000 and$13.3 million for the years ended December 31, 2004 and 2003,respectively. We recorded these amounts as a component of stockholders’ equityand amortize them, on an accelerated basis, as a non-cash charge to operationsover the vesting period of the options.

 

***Interest Income, net***

 

Interestincome was $435,000, $268,000 and $496,000 for the years ended December 31,2004, 2003 and 2002, respectively.  The increase of $167,000 from 2003 to2004 was primarily attributable to our higher average cash balances for theyear ended December 31, 2004 as a result of our initial public offering inJune 2004, which generated higher interest earnings on thosebalances.  Conversely, the decrease of $228,000from 2002 to 2003 was primarily attributable to our lower average cash balancesfrom the year ended December 31, 2003 as compared to the year ended December 31,2002, which generated lower interest earnings on those balances.  Interestexpense was $0, $70,000 and $157,000 for the years ended December 31,2004, 2003 and 2002, respectively.  Interest expense decreased $70,000 from2004 to 2003 and $87,000 from 2003 to 2002 due to the payment in full ofequipment financing debt in July 2003.

 

***Liquidity and Capital Resources***

 

Sinceour inception, we have financed our business primarily through private andpublic placements of stock, research and development payments under our productdiscovery and development collaborations with Campbell Soup, Coca-Cola, KraftFoods, and Nestlé, and interest income.  As of December 31, 2004 wehad received in excess of $106.2 million in proceeds from the sales of commonand preferred stock.  In addition, we had received $29.5 million innon-refundable research and development payments and non-refundable milestonepayments from our collaboration agreements, and $2.3 million in interestincome.  Over the remaining life of our current collaboration agreements,we expect to receive an additional $19.2 million in non-refundable research anddevelopment payments from our collaborators.  In addition, we may receivepayments in the event we achieve research or development milestones and royaltypayments in the event our collaborators commercialize products incorporatingour flavors, flavor enhancers and taste modulators.

 

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At December 31,2004, we had $40.8 million in cash, cash equivalents and investmentsavailable-for-sale as compared to $17.1 million at December 31, 2003, anincrease of $23.7 million.  This overall increase resulted primarily fromthe sale of common stock for net proceeds of $35.0 million.

 

***Operating Activities***

 

Operatingactivities used cash of $10.1 million for the year ended December 31, 2004compared to $8.3 million for the year ended December 31, 2003. Operating cash flow in 2004 compared to the prior year period reflects anincrease in our net loss of $2.3 million.  Non-cash expenses for the yearended December 31, 2004 decreased $3.7 million to $7.5 million for theyear ended December 31, 2004 from $11.2 million for the year ended December 31,2003.  This decrease was primarily due to relative decreases indepreciation and license amortization expense of approximately $3.6 million,specifically the amortization of certain licenses totaling $2.9 million for theyear ended December 31, 2003.  The related licenses were fullyamortized at December 31, 2003, thus we did not have any non-cashamortization expense relating to the amortization of these licenses for theyear ended December 31, 2004.  Additionally, net increases inoperating assets and liabilities over the year ended December 31, 2004provided cash of $2.1 million, while net decreases in operating assets andliabilities over the year ended December 31, 2003 used cash of $2.0million.

 

Operatingactivities used cash of $8.3 million for the year ended December 31, 2003compared to $8.7 million for the year ended December 31, 2002. Operating cash flow in 2003 compared to the prior year period reflects anincrease in our net loss of $2.6 million.  Non-cash expenses for the yearended December 31, 2003 increased $5.6 million to $11.2 million for theyear ended December 31, 2003 from $5.5 million for the year ended December 31,2002.  This increase was primarily due to the increase in amortization ofdeferred compensation of $4.4 million from $635,000 in 2002 to $5.0 million in2003.  Additionally, stock-basedcompensation for non-employees increased $1.2 million from $63,000 in 2002 to$1.3 million in 2003.  Additionally, netdecreases in operating liabilities over the year ended December 31, 2003used cash of $1.4 million, while net increases in operating liabilities overthe year ended December 31, 2002 provided cash of $474,000.

 

***Investing Activities***

 

Investingactivities used cash of $21.3 million for the year ended December 31,2004, and provided cash of $1.7 million for the year ended December 31,2003.  Cash used in 2004 reflects the purchases of available-for-salesecurities with the proceeds from our initial public offering in June 2004to obtain higher rates of interest income.    Cash provided in2003 reflects the maturities of available-for-sale securities, partially offsetby purchases of available-for-sale securities.

 

 Investing activities provided cash of $1.7million for the year ended December 31, 2003, and used cash of $8.1million for the year ended December 31, 2002.  Cash provided in 2003reflects the maturities of available-for-sale securities, partially offset bypurchases of available-for-sale securities. Cash used in 2002 reflects thepurchases of available-for-sale securities to obtain higher rates of interestincome, partially offset by the maturities of available-for-sale securities.

 

***Financing Activities***

 

Financingactivities provided cash of $35.0 million for the year ended December 31,2004, used cash of $1.7 million for the year ended December 31, 2003, andprovided cash of $14.0 million for the year ended December 31, 2002. Cash provided by financing activities in 2004 reflects the net proceeds fromthe sale of common stock of $35.0 million, primarily from the sale of commonstock during our initial public offering.  Cash used by financingactivities in 2003 reflects the repayment of equipment financing arrangementsof $1.8 million, offset by the net proceeds of $53,000 from the issuance ofcommon stock.  Cash provided by financingactivities in 2002 reflects the net proceeds from the issuance of preferredstock of $13.0 million and proceeds from equipment financing loans of $1.6million, partially offset by the repayment of equipment financing loans of$905,000.

 

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As of December 31,2004 future minimum payments due under our contractual obligations are asfollows (in thousands):

 
| ** **       | ** ** | **Payments Due by Period** | ** ** |
|------------------|------------|----------------------------|------------|
| ** **       | ** ** | **Total**                  | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **After 5 years** | ** ** |
| Operating leases |       | $                          | 8,228      |   | $ | 4,054 |   | $ | 4,174 |   | $ | — |   | $ | — |   |
| License payments |       | 332                        |       | 120 |   | 89 |   | 51 |   | 72 |   |
| Total            |       | $                          | 8,560      |   | $ | 4,174 |   | $ | 4,263 |   | $ | 51 |   | $ | 72 |   |

 

As of December 31,2004, we had no long-term debt obligations.

 

As of December 31,2004, we have net open purchase orders (defined as total open purchase ordersat year end less any accruals or invoices charged to or amounts paid againstsuch purchase orders) totaling approximately $213,000.  In the next twelve months, we also plan tospend approximately $1.5 to $2.5 million on capital expenditures.

 

Ourfuture capital uses and requirements depend on numerous forward-lookingfactors.  These factors may include, but are not limited to, thefollowing:

 

•                  therate of progress and cost of research and development activities;

•                  thenumber and scope of our research activities;

•                  thecosts of filing, prosecuting, defending and enforcing any patent claims andother intellectual property rights;

•                  ourability to establish and maintain product discovery and developmentcollaborations;

•                  theeffect of competing technological and market developments;

•                  theterms and timing of any collaborative, licensing and other arrangements that wemay establish; and

•                  theextent to which we acquire or in-license new products, technologies orbusinesses.

 

Webelieve our available cash, cash equivalents, investments and existing sourcesof funding will be sufficient to satisfy our anticipated operating and capitalrequirements through at least the next 12 months.

 

Untilwe can generate significant cash from our operations, we expect to continue tofund our operations with existing cash resources that were primarily generatedfrom the proceeds of offerings of our equity securities and research anddevelopment payments and milestone payments under our product discovery and developmentcollaborations.  Under our existing collaboration agreements, assuming allmilestones are achieved and we receive all research and development funding, wemay be entitled to payments which total up to $26.6 million.  In 2005, weanticipate receiving $5.2 million in non-refundable research and development fundingand $375,000 in milestone payments.  Thisdoes not include any additional payments we may receive related to theachievement of additional milestones, or to new collaborations or extensions ofexisting collaborations.  We may notreceive the payments if the collaborations are terminated or not renewed, or ifwe do not achieve the milestones set forth in the collaborationagreements.  In addition, the timing of the receipt of milestone paymentsin particular is uncertain, as we may achieve milestones significantly earlieror later than we currently expect.  We continue to pursue additionalcollaborations, which could result in additional revenue.  We may notrecognize revenues for research and development funding or milestones if thecollaborations are terminated, or if we do not achieve the milestones set forthin the collaboration agreements.  Our expenses will vary based upon (butnot limited to) the forward-looking factors listed above.  Our non-cashstock-based compensation expense will vary upon the volatility of our stockprice, the risk-free interest rate, the expected life of our stock options, theclosing price of our stock, the strike price at which stock options are grantedand the number of options granted.  Ournon-cash stock-based compensation expense will vary upon the implementation of SFASNo. 123R or other similar accounting changes.

 

As of December 31,2004 and 2003, we did not have any relationships with unconsolidated entitiesor financial partnerships, such as entities often referred to as specialpurpose or structured finance entities, which would have been established forthe purposes of facilitating off-balance sheet arrangements or othercontractually narrow or limited purposes.  As such, we are not materiallyexposed to any financing, liquidity, market or credit risk that could arise ifwe had engaged in these relationships.

 

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**Critical Accounting Policies**

 

Ourdiscussion and analysis of our financial condition and results of operationsare based on our financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States, orGAAP.  The preparation of these financial statements requires managementto make estimates and judgments that affect the reported amounts of assets,liabilities and expenses and related disclosure of contingent assets andliabilities.  On an ongoing basis, we evaluate these estimates, includingthose related to revenue recognition, long-lived assets, accrued liabilities,and income taxes.  These estimates are based on historical experience andvarious other assumptions that we believe to be reasonable under thecircumstances, the results of which form the basis for judgments about thecarrying values of assets and liabilities.  Actual results may differ fromthese estimates under different assumptions or conditions.  While oursignificant accounting policies are described in more detail in Note 1 to ourfinancial statements, we believe the following accounting policies to becritical to the judgments and estimates used in the preparation of ourfinancial statements:

 

***Revenue Recognition.***

 

Ourrevenue recognition policies are in compliance with the Staff AccountingBulletin (“SAB”) No. 101 (as amended by SAB No. 104), *Revenue Recognition in Financial Statements*and EITF Issue No. 00-21, *RevenueArrangements with Multiple Deliverables*.  Revenue is deferredfor fees received before earned.  Some of our agreements contain multipleelements, including research funding, milestones, and royalties.

 

Revenuefrom milestones is recognized when earned, as evidence by writtenacknowledgement from the collaborator or other persuasive evidence that themilestone has been achieved, provided that (i) the milestone event issubstantive and its achievability was not reasonably assured at the inceptionof the agreement, and (ii) our performance obligations after the milestoneachievement will continue to be funded by the collaborator at a levelcomparable to before the milestone achievement.  If both of these criteriaare not met, the milestone payment is recognized over the remaining minimumperiod of our performance obligations under the agreement.  Non-refundableupfront fees, if any, not associated with our future performance, will berecognized when received.  Amounts received for research funding arerecognized as revenues as the services are performed.  Royalties to bereceived based on product sales made by our collaborators incorporating ourproduct, if any, will be recognized as earned.  To date, we have notearned any royalties.

 

***Stock-based Compensation.***

 

Aspermitted by SFAS No. 123, *Accounting for Stock-BasedCompensation*, we account for stock options granted to employeesusing the intrinsic value method in accordance with Accounting PrinciplesBoard, or APB, Opinion No. 25, *Accounting for StockIssued to Employees*, and the Financial Accounting Standards Board,or FASB, Interpretation No. 44, *Accounting for CertainTransactions Involving Stock Compensation – An Interpretation of APB 25*.  Pursuant to these guidelines, we measure theintrinsic value of the option or restricted stock award on its grant date asthe difference between the purchase price of the restricted stock or theexercise price of employee stock options and the fair market value of our stockon the date of issuance or grant, and expense the difference, if any, over thevesting period of the option or restricted stock award.

 

SFAS No. 123required stock-based compensation to be accounted for under the fair valuemethod.  If we adopted SFAS No. 123to account for options granted to employees under our stock-based compensationplans, our loss would have been materially impacted.  The impact of this method is disclosed in thenotes to the financial statements.

 

Optionsor stock awards are issued to non-employees are recorded at their fair value inaccordance with SFAS No. 123, and periodically remeasured in accordancewith EITF No. 96-18, *Accounting for EquityInstruments That Are Issued to Other Than Employees for Acquiring or inConjunction with Selling Goods or Services*, and recognized over therelated service period.

 

**New Accounting Pronouncements**

 

In March 2004,the EITF reached a final consensus on Issue 03-1, *The Meaning of Other-Than-Temporary Impairment and Its Application toCertain Investments*. EITF Issue No. 03-1 requires that when thefair value of an investment security is less than its carrying value, animpairment exists for which the determination must be made as

 

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towhether the impairment is other-than-temporary. The EITF Issue No. 03-1impairment model applies to all investment securities accounted for under SFAS No. 115,*Accounting for Certain Investments in Debtand Equity Securities* and to investment securities accounted forunder the cost method to the extent an impairment indicator exists. Under theguidance, the determination of whether an impairment is other-than-temporaryand therefore would result in a recognized loss depends on market conditionsand management’s intent and ability to hold the securities with unrealizedlosses. In September 2004, the FASB approved FASB Staff Position, or FSP,EITF 03-1-1, which defers the effective date for recognition and measurementguidance contained in EITF 03-1 until certain issues are resolved.  As of December 31,2004, these issues have not yet been resolved. We do not expect the adoption ofEITF 03-1 to have a material effect on our results of operations and financialcondition.

 

In December 2004,the FASB issued SFAS No. 123R,*Share-Based Payment,*which requires companies to expense the estimated fair value of employee stockoptions and similar awards. This statement is a revision to SFAS No. 123and supersedes APB Opinion No. 25, *Accounting for StockIssued to Employees,* and amends FASB Statement No. 95, *Statement of Cash Flows.* The accounting provisions of SFAS No. 123Rwill be effective for the third quarter of fiscal 2005.

 

SFAS No. 123Rpermits public companies to choose between the following two adoption methods:

 

1. A “modifiedprospective” method in which compensation cost is recognized beginning with theeffective date (a) based on the requirements of SFAS No. 123R for allshare-based payments granted after the effective date and (b) based on therequirements of SFAS No. 123 for all awards granted to employees prior tothe effective date of SFAS No. 123R that remain unvested on the effectivedate, or

 

2. A “modifiedretrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS No. 123 for purposes ofpro forma disclosures for either (a) all prior periods presented or (b) priorinterim periods of the year of adoption.

 

Aspermitted by SFAS No. 123, we currently account for share-based paymentsto employees using APB Opinion No. 25’s intrinsic value method. The impactof the adoption of SFAS No. 123R cannot be predicted at this time becauseit will be depend on levels of share-based payments granted in the future.However, valuation of employee stock options under SFAS No. 123R issimilar to SFAS No. 123, with minor exceptions. For information about whatour reported results of operations and earnings per share would have been hadwe adopted SFAS No. 123, please see the discussion under the heading “Stock-basedCompensation” in Note 1 to our Financial Statements. Accordingly, the adoptionof SFAS No. 123R’s fair value method will have a significant impact on ourresults of operations, although it will have no impact on our overall financialposition. SFAS No. 123R also requires the benefits of tax deductions inexcess of recognized compensation cost to be reported as a financing cash flow,rather than as an operating cash flow as required under current literature.This requirement will reduce net operating cash flows and increase netfinancing cash flows in periods after adoption. Due to timing of the release ofSFAS No. 123R, we have not yet completed the analysis of the ultimateimpact that this new pronouncement will have on the results of operations, northe method of adoption for this new standard.

 

**Risk Factors**

 

*You should consider carefully the following informationabout the risks described below, together with the other information containedin this annual report on Form 10-K and in our other public filings, inevaluating our business. If any of the following risks actually occurs, ourbusiness, financial condition, results of operations and future growthprospects would likely be materially and adversely affected.  In thesecircumstances, the market price of our common stock would likely decline.*

 

**Risks Related To Our Business**

 

***We are dependent on our product discovery and developmentcollaborators for all of our revenue and we are dependent on our current andany future product discovery and development collaborators to develop andcommercialize any flavors, flavor enhancers or taste modulators we maydiscover.***

 

A keyelement of our strategy is to commercialize our flavors, flavor enhancers andtaste modulators through product discovery and development collaborations. Todate, all of our revenue has been derived solely from research

 

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anddevelopment payments and milestone payments received under collaborationagreements with Campbell Soup, Coca-Cola, Kraft Foods and Nestlé. Substantiallyall of our revenue in the foreseeable future will result from these types ofpayments from these collaborations, unless we successfully commercialize aproduct candidate through these or other collaborators and earn royalties onfuture sales of consumer products incorporating our flavors, flavor enhancersor taste modulators.

 

Ouragreement with Campbell Soup provides for research and development fundinguntil March 2006 and gives Campbell Soup the right to terminate theagreement earlier without cause on or after March 28, 2005, provided thatit pay a specified termination fee if it terminates the agreement after March 28,2005 but prior to March 28, 2006. Our agreements with Coca-Cola and KraftFoods and our initial agreement with Nestlé provide for research anddevelopment funding until April 2008, May 2005 and April 2005,respectively, and give each party the right to conclude the respectivecollaborative program earlier for any reason upon payment to us of atermination fee, provided that Coca-Cola may terminate the collaborative periodwithout payment of an early conclusion fee in the event that we fail to achievea specified research and development goal by April 22, 2006, subject topayment of research funding through July 22, 2006. Our most recentagreement with Nestlé provides for research and development funding through October 2009and gives Nestlé the right to terminate the agreement earlier without cause onor after October 26, 2006, provided that it pay additional specifiedresearch funding if it terminates the agreement after October 26, 2006 butprior to October 26, 2009.  If any or all of our agreements withCampbell Soup, Coca-Cola, Kraft Foods and Nestlé expire or are terminated, ourrevenue would significantly decline and if all of our agreements expire or areterminated, our revenue would be substantially eliminated, which would have amaterial adverse effect on our business, financial condition and results ofoperations. Our collaborators may not renew their agreements with us or, ifthey do, they may not be on terms that are as favorable to us as our currentagreements.

 

We donot currently have a commercialized product and cannot assure you we will havea commercialized product in the foreseeable future, or at all. We will bedependent on our current and any other possible future collaborators to commercializeany flavors, flavor enhancers or taste modulators that we successfully developand to provide the sales, marketing and distribution capabilities required forthe success of our business. We have limited or no control over the amount andtiming of resources that our current or any future collaborators may devote toour programs or potential products. Our collaborators may decide not to devotethe necessary resources to the commercialization of our flavors, flavorenhancers or taste modulators, or may pursue a competitor’s product if our flavors,flavor enhancers or taste modulators do not have the characteristics desired bythe collaborator. These characteristics include, among other things,enhancement properties, temperature stability, solubility, taste and cost. Ifthese collaborators fail to conduct their commercialization, sales andmarketing or distribution activities successfully and in a timely manner, wewill earn little or no royalty revenues from our flavors, flavor enhancers andtaste modulators and we will not be able to achieve our objectives or build asustainable or profitable business.

 

Ourpresent and any future product discovery and development collaborationopportunities could be harmed if:

 

•                  our existing or any futurecollaborators terminate their collaboration agreements with us prior to theexpiration of the agreements;

•                  we do not achieve our research anddevelopment objectives under our collaboration agreements prior to thetermination of the collaboration periods;

•                  we disagree with our collaborators asto the parties’ respective licensing rights to our flavors, flavor enhancersand taste modulators, methods or other intellectual property we develop;

•                  we are unable to manage multiplesimultaneous collaborations;

•                  potential collaborators fail to spendtheir resources on research and development due to general market conditions orfor any other reason; or

•                  consolidation in our target marketslimits the number of potential collaborators.

 

***We may not be able to negotiate additional collaborationagreements having terms satisfactory to us or at all.***

 

We maynot be able to enter into additional product discovery and developmentcollaborations due to the exclusive nature of our current product discovery anddevelopment collaborations. Each of our current collaboration agreementsprovides that we will conduct research and development on flavors, flavorenhancers and taste modulators for use within one or more defined packaged foodand beverage product fields on an exclusive basis for the respectivecollaborator during the collaborative period specified in the agreement.Because each of these agreements is exclusive or co-exclusive, we will not beable to enter into a collaboration agreement with any other

 

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foodand beverage company covering the same product field during the applicablecollaborative period. In addition, our collaborators’ competitors may not wishto do business with us at all due to our relationship with our collaborators.If we are unable to enter into additional product discovery and developmentcollaborations, our ability to sustain or expand our business will besignificantly diminished.

 

***We may not be successful in developing flavors, flavorenhancers or taste modulators useful for formulation into products.***

 

We maynot succeed in developing flavors, flavor enhancers or taste modulators withthe appropriate attributes required for use in successful commercial products.Successful flavors, flavor enhancers and taste modulators require, among otherthings, appropriate biological activity, including the correct flavor or flavorenhancer property for the product application, an acceptable safety profile,including lack of toxicity or allergenicity, and appropriate physical orchemical properties, including relative levels of stability, volatility andresistance to heat. Successful flavors, flavor enhancers and taste modulatorsmust also be cost-efficient for our collaborators. We may not be able todevelop flavors, flavor enhancers or taste modulators that meet these criteria.

 

***If we or our collaborators are unable to obtain and maintainthe GRAS determination or regulatory approval required before any flavors,flavor enhancers or taste modulators can be incorporated into products that aresold, we would be unable to commercialize our flavors, flavor enhancers andtaste modulators and our business would be adversely affected.***

 

In March 2005,we obtained a Generally Recognized as Safe, or GRAS, determination for S807,S336, S263 and S976.  Apart from these compounds,we do not have GRAS determination or regulatory approval for any other productcandidate at this time. In the United States, the development, sale andincorporation of our flavors, flavor enhancers or taste modulators intoproducts are subject to regulation by the Food and Drug Administration, or FDA,and in some instances other government bodies. Obtaining and maintaining a GRASdetermination or regulatory approval is typically costly and can take manyyears.

 

Dependingon the amount or intended use of a particular flavor enhancer or tastemodulator added to a product and the number of product categories in which theflavor enhancer or taste modulator will be incorporated, specific safetyassessment protocols and regulatory processes must be satisfied before we orour collaborators can commercially market and sell products containing any flavors,flavor enhancers or taste modulators that we may discover. A key element of ourstrategy is to develop flavors, flavor enhancers and taste modulators that willbe subject to review under the Flavor and Extract Manufacturers Association, orFEMA, GRAS process, which we expect will take 12 to 18 months and is lessexpensive than the alternative of filing a food additive petition with the FDA,approval of which can take eight years or more. The FEMA GRAS review processmay take longer than 18 months and cost more than $1 million if additionalsafety studies are requested by the FEMA expert panel or are necessary toexplain unexpected safety study findings. There is a risk that one or more ofour product candidates may not qualify for a FEMA GRAS determination. This mayoccur for a variety of reasons, including the flavor enhancer or tastemodulator’s intended use, the amount of the flavor enhancer or taste modulatorintended to be added to packaged foods and beverages, the number of productcategories in which the flavor enhancer or taste modulator will beincorporated, whether the flavor enhancer or taste modulator imparts sweetness,the safety profile of the flavor enhancer or taste modulator and the FEMAexpert panel’s interpretation of the safety data. Even if we obtain a GRASdetermination with respect to a flavor enhancer or taste modulator, the FDA hasthe ability to challenge such determination, which could materially adverselyaffect our ability to market products on schedule or at all. In the eventthat a particular flavor enhancer or taste modulator does not qualify for FEMAGRAS determination, we will be required to pursue a lengthy FDA approvalprocess or dedicate our development efforts to alternative compounds, whichwould further delay commercialization. In addition, laws, regulations or FDApractice governing the regulatory approval process, the availability of the GRASdetermination process or the manufacture or labeling of such products, maychange in a manner that could adversely affect our ability to commercializeproducts on schedule or at all.

 

Salesof our flavors, flavor enhancers or taste modulators outside of the UnitedStates will be subject to foreign regulatory requirements. In most cases,whether or not a GRAS determination or FDA approval has been obtained, approvalof a product by the comparable regulatory authorities of foreign countries muststill be obtained prior to manufacturing or marketing the product in thosecountries. A GRAS determination or FDA approval in the United States or in anyother jurisdiction does not ensure approval in other jurisdictions because therequirements from jurisdiction to jurisdiction may vary widely. Obtainingforeign approvals could result in significant delays,

 

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difficultiesand costs for us and require additional safety studies and additional expenses.If we fail to comply with these regulatory requirements or to obtain andmaintain required approvals, our ability to generate revenue will bediminished.

 

We andour collaborators may not be successful in overcoming these regulatory hurdles,which could result in product launch delays, unanticipated expenses,termination of collaborations, and flavors, flavor enhancers and tastemodulators not being approved for incorporation into consumer products. Theseconsequences would have a material adverse effect on our business financialcondition and results of operations.

 

***Even if we or our collaborators receive a GRAS determinationor regulatory approval and incorporate our flavors, flavor enhancers or tastemodulators into products, those products may never be commercially successful.***

 

Evenif we discover and develop flavors, flavor enhancers and taste modulators thatobtain the necessary GRAS determination or regulatory approval, our successdepends to a significant degree upon the commercial success of packaged foodand beverage products incorporating those flavors, flavor enhancers or tastemodulators. If these products fail to achieve or subsequently maintain marketacceptance or commercial viability, our business would be significantly harmedbecause our royalty revenue is dependent upon consumer sales of these products.In addition, we could be unable to maintain our existing collaborations orattract new product discovery and development collaborators. Many factors mayaffect the market acceptance and commercial success of any potential productsincorporating flavors, flavor enhancers or taste modulators that we maydiscover, including:

 

•                  health concerns, whether actual orperceived, or unfavorable publicity regarding our flavors, flavor enhancers andtaste modulators or those of our competitors;

•                  the timing of market entry ascompared to competitive products;

•                  the rate of adoption of products byour collaborators and other companies in the flavor industry; and

•                  any product labeling that may berequired by the FDA or other United States or foreign regulatory agencies forproducts incorporating our flavors, flavor enhancers and taste modulators.

 

***We have a history of operating losses and we may not achieveor maintain profitability.***

 

Wehave not been profitable and have generated substantial operating losses sincewe were incorporated in September 1998. We incurred net losses ofapproximately $19.7 million for the year ended December 31, 2004. Asof December 31, 2004, we had an accumulated deficit of approximately$84.4 million. We expect to incur additional losses for at least the nexttwo years. The extent of our future losses will depend, in part, on the rate ofincrease in our operating expenses and the rate of growth, if any, in ourrevenue from our four existing and any future product discovery and developmentcollaborations as well as from other sources that may become available to us inthe future and on the level of our expenses. To date, our revenue has comesolely from research and development funding and milestone payments under ourproduct discovery and development collaboration agreements with Campbell Soup,Coca-Cola, Kraft Foods and Nestlé. In order for us to generate royalty revenueand become profitable, we must retain our existing product discovery and developmentcollaborations and our collaborators must commercialize products incorporatingone or more of our flavors, flavor enhancers or taste modulators, from which wecan derive royalty revenues. Our ability to generate royalty revenue isuncertain and will depend upon our ability to meet particular research,development and commercialization objectives.

 

***We expect that our results of operations will fluctuate fromperiod to period, and this fluctuation could cause our stock price to decline,causing investor losses.***

 

Ouroperating results have fluctuated in the past and are likely to varysignificantly in the future based upon a number of factors, many of which wehave little or no control over. We operate in a highly dynamic industry andfuture results could be subject to significant fluctuations. These fluctuationscould cause us to fail to meet or exceed financial expectations of securitiesanalysts or investors, which could cause our stock price to decline rapidly andsignificantly. Revenue and expenses in future periods may be greater or lessthan revenue and expenses in the immediately preceding period or in thecomparable period of the prior year. Therefore, period-to-period comparisons ofour operating results are not necessarily a good indication of our futureperformance. Some of the factors that could cause our operating results tofluctuate include:

 

•                  termination of any of our productdiscovery and development collaboration agreements;

 

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•                  our ability to discover and develop flavors,flavor enhancers and taste modulators or the ability of our product discoveryand development collaborators to incorporate them into packaged food andbeverage products;

•                  our receipt of milestone payments inany particular period;

•                  the ability and willingness ofcollaborators to commercialize products incorporating our flavors, flavorenhancers and taste modulators on expected timelines, or at all;

•                  our ability to enter into new productdiscovery and development collaborations and technology collaborations or toextend the terms of our existing collaboration agreements and our paymentobligations, expected revenue and other terms of any other agreements of thistype;

•                  our ability, or our collaborators’ability, to successfully satisfy all pertinent regulatory requirements;

•                  the demand for our collaborators’products containing our flavors, flavor enhancers and taste modulators; and

•                  general and industry specificeconomic conditions, which may affect our collaborators’ research anddevelopment expenditures.

 

***The price of our common stock is volatile.***

 

The market prices for securities of biotechnology companieshistorically have been highly volatile, and the market has from time to timeexperienced significant price and volume fluctuations that are unrelated to theoperating performance of particular companies. Since our initial publicoffering in June 2004, the price of our common stock has ranged fromapproximately $6 per share to approximately $13 per share in March 2005.The market price of our common stock may fluctuate in response to many factors,including:

 

•                  developments related to the FEMA GRASdetermination and international regulatory approval of our products;

•                  developments concerning ourcollaborative agreements;

•                  announcements of technologicalinnovations by us or others;

•                  developments in patent or otherproprietary rights;

•                  results of safety evaluation of ourflavors, flavor enhancers and taste modulators;

•                  results of consumer acceptancetesting of our flavors, flavor enhancers and taste modulators by ourcollaborators;

•                  future sales of our common stock byexisting stockholders;

•                  comments by securities analysts;

•                  general market conditions;

•                  fluctuations in our operatingresults;

•                  government regulation;

•                  failure of any of our flavors, flavorenhancers or taste modulators, if approved, to achieve commercial success; and

•                  public concern as to the safety ofour flavors, flavor enhancers, and taste modulators.

 

***Changes in financial accounting standards related to stockoption expenses are expected to have a significant effect on our reportedresults.***

 

TheFASB recently issued a revised standard that requires that we recordcompensation expense in the statement of operations for employee stock optionsusing the fair value method. The adoption of the new standard is expected tohave a significant effect on our reported earnings, although it will not affectour cash flows, and could adversely impact our ability to provide accurateguidance on our projected future financial results due to the variability ofthe factors used to establish the value of stock options. As a result, theadoption of the new standard in the third quarter of fiscal 2005 couldnegatively affect our stock price and our stock price volatility.

 

***We may need to obtain additional capital to fund ouroperations.***

 

If weare unable to successfully commercialize our flavors, flavor enhancers andtaste modulators, we may need to obtain additional capital or change ourstrategy to continue our operations. In addition, our business and

 

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operationsmay change in a manner that would consume available resources at a greater ratethan anticipated. In such event, we may need to raise substantial additionalcapital to, among other things:

 

•                  fund new research, discovery ordevelopment programs;

•                  advance additional product candidatesinto and through the regulatory approval process; and

•                  acquire rights to products or productcandidates, technologies or businesses.

 

If werequire additional capital to continue our operations, we cannot assure youthat additional financing will be available on terms acceptable to us, or atall. If adequate funds are not available or are not available on acceptableterms, our ability to fund our operations, take advantage of opportunities,identify and develop flavors, flavor enhancers and taste modulators, developtechnologies or otherwise respond to competitive pressures could besignificantly limited. In addition, if financing is not available, we may needto alter our strategy or cease operations. In addition, issuances of debt oradditional equity could impact the rights of the holders of our common stock,may dilute our stockholders’ ownership and may impose restrictions on ouroperations. These restrictions could include limitations on additionalborrowing, specific restrictions on the use of our assets as well asprohibitions on our ability to create liens, pay dividends, redeem our stock ormake investments.

 

***If we lose our key personnel or are unable to attract andretain qualified personnel, it could adversely affect our business.***

 

Oursuccess depends to a significant degree upon the continued contributions of ourexecutive officers, management and scientific staff. If we lose the services ofone or more of these people and, in particular, Kent Snyder, our President andChief Executive Officer, or Mark Zoller, Ph.D., our Chief Scientific Officerand Sr. Vice President, Research, the relationships we have with our collaboratorswould likely be negatively impacted and we may be delayed or unable to developnew product candidates, commercialize our existing product candidates orachieve our other business objectives, any of which could cause our stock priceto decline. We have entered into employment letter agreements with thefollowing executive officers: Kent Snyder, Mark Zoller, Ph.D., Harry Leonhardt, Esq.,our Vice President, General Counsel and Corporate Secretary and John Poyhonen,our Vice President and Chief Financial and Business Officer.  The terms ofthese agreements are described under the heading “Management—EmploymentAgreements” in our prospectus filed pursuant to Rule 424(b) of theSecurities Act with the SEC on June 22, 2004.  We have entered into an employment letteragreement with Nigel R.A. Beeley, Ph.D., our Vice President, Discovery, theterms of which are included in Item 11 of this Form 10-K. All of ouremployees are at-will employees, which means that either we or the employee mayterminate their employment at any time. We currently have no key personinsurance.

 

Inaddition, our discovery and development programs depend on our ability toattract and retain highly skilled scientists, including molecular biologists,biochemists, chemists and engineers. We may not be able to attract or retainqualified employees in the future due to the intense competition for qualifiedpersonnel among technology-based businesses, particularly in the San Diegoarea. We also face competition from universities and public and privateresearch institutions in recruiting and retaining highly qualified scientificand management personnel. If we are not able to attract and retain thenecessary personnel to accomplish our business objectives, we may experienceconstraints that will adversely affect our ability to meet the demands of ourcurrent or any future product discovery and development collaborators in atimely fashion or to support our independent discovery and developmentprograms.

 

***We may encounter difficulties managing our growth, whichcould adversely affect our business.***

 

Ourstrategy includes entering into and working on simultaneous flavor and flavorenhancer discovery and development programs across multiple markets. Weincreased the number of our full-time employees from seven on December 31,1999 to 74 on December 31, 2004 and we expect to continue to grow to meetour strategic objectives. If our growth continues, it will continue to place astrain on us, our management and our resources. Our ability to effectively manageour operations, growth and various projects requires us to continue to improveour operational, financial and management controls, reporting systems andprocedures and to attract and retain sufficient numbers of talented employees.We may not be able to successfully implement these tasks on a larger scale and,accordingly, we may not achieve our research, development and commercializationgoals. If we fail to improve our operational, financial and managementinformation systems, or fail to effectively monitor or manage our new andfuture employees or our growth, our business would suffer significantly. Inaddition, no assurance can be made that we will be able to secure adequatefacilities to house our staff, conduct our research or achieve our businessobjectives.

 

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***We will rely on third parties to manufacture our flavors,flavor enhancers and taste modulators on a commercial scale.***

 

We donot have experience in manufacturing, nor do we have the resources orfacilities to manufacture, flavors, flavor enhancers and taste modulators on acommercial scale. Therefore, the commercialization of our flavors, flavorenhancers and taste modulators will depend in part on our or our collaborators’ability to contract with third-party manufacturers of our flavors, flavorenhancers and taste modulators on a large scale, at a competitive cost, withthe specified quality and in accordance with relevant food and beverageregulatory requirements. Any such third-party manufacturers may encountermanufacturing difficulties at any time that could result in delays in thecommercialization of potential flavors, flavor enhancers and taste modulators.Our inability to find capable third-party manufacturers or to enter into agreementson acceptable terms with third-party manufacturers could delaycommercialization of any products we may develop and may harm our relationshipswith our existing and any future product discovery and developmentcollaborators and our customers. Moreover, if we are required to change fromone third-party manufacturer to another for any reason, the commercializationof our products may be delayed further. In addition, if third-partymanufacturers fail to comply with the FDA’s good manufacturing practice regulations,then we may be subject to adverse regulatory action including product recalls,warning letters and withdrawal of our products, or our collaborators’ orcustomers’ products, from the market.

 

Further,because our flavors, flavor enhancers and taste modulators are regulated asfood products under the Federal Food, Drug and Cosmetic Act, we and the thirdparties with which we collaborate or contract to manufacture, process, pack,import or otherwise handle our products or our product ingredients, may berequired to comply with certain registration, prior notice submission,recordkeeping and other regulatory requirements. Failure of any party in thechain of distribution to comply with any applicable requirements under theFederal Food, Drug and Cosmetic Act or the FDA’s implementing regulations mayadversely affect the manufacture and/or distribution of our products incommerce.

 

***If we acquire products, technologies or other businesses, wewill incur a variety of costs, may have integration difficulties and mayexperience numerous other risks that could adversely affect our business.***

 

Ifappropriate opportunities become available, we may consider acquiringbusinesses, technologies or products that we believe are a strategic fit withour business. We currently have no commitments or agreements with respect to,and are not actively seeking, any material acquisitions. We have limitedexperience in identifying acquisition targets, successfully acquiring them andintegrating them into our current infrastructure. We may not be able tosuccessfully integrate any businesses, products, technologies or personnel thatwe might acquire in the future without a significant expenditure of operating,financial and management resources, if at all. In addition, future acquisitionsmight be funded by issuances of additional debt or equity, which could impactyour rights as a holder of our common stock and may dilute your ownershippercentage. Any of the foregoing could have a significant adverse effect on ourbusiness, financial condition and results of operations.

 

**Risks Related To Our Industry**

 

***Our ability to compete in the flavor and flavor enhancermarket may decline if we do not adequately protect our proprietarytechnologies.***

 

Oursuccess depends in part on our ability to obtain and maintain intellectualproperty that protects our technologies and flavors, flavor enhancers and tastemodulators. Patent positions may be highly uncertain and may involve complexlegal and factual questions, including the ability to establish patentabilityof sequences relating to taste receptors, proteins, chemical synthesistechniques, compounds and methods for using them to modulate taste for which weseek patent protection. No consistent standard regarding the allowability orenforceability of claims in many of our pending patent applications has emergedto date. As a result, we cannot predict the breadth of claims that willultimately be allowed in our patent applications, if any, including those wehave in-licensed or the extent to which we may enforce these claims against ourcompetitors. The degree of future protection for our proprietary rights istherefore highly uncertain and we cannot assure you that:

 

•                  we were the first to file patentapplications or to invent the subject matter claimed in patent applicationsrelating to the technologies upon which we rely;

•                  others will not independently developsimilar or alternative technologies or duplicate any of our technologies;

 

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•                  others did not publicly disclose ourclaimed technology before we conceived the subject matter included in any ofour patent applications;

•                  any of our patent applications willresult in issued patents;

•                  any of our patent applications willnot result in interferences or disputes with third parties regarding priorityof invention;

•                  any patents that may be issued to us,our collaborators or our licensors will provide a basis for commercially viableproducts or will provide us with any competitive advantages or will not bechallenged by third parties;

•                  we will develop additionalproprietary technologies that are patentable;

•                  the patents of others will not havean adverse effect on our ability to do business; or

•                  new proprietary technologies fromthird parties, including existing licensors, will be available for licensing tous on reasonable commercial terms, if at all.

 

Inaddition, patent law outside the United States is uncertain and in manycountries intellectual property laws are undergoing review and revision. Thelaws of some countries do not protect intellectual property rights to the sameextent as domestic laws. It may be necessary or useful for us to participate inopposition proceedings to determine the validity of our competitors’ patents orto defend the validity of any of our or our licensor’s future patents, whichcould result in substantial costs and would divert our efforts and attentionfrom other aspects of our business.

 

Technologieslicensed to us by others, or in-licensed technologies, are important to ourbusiness. In particular, we depend on high-throughput screening technologiesthat we licensed from Aurora Biosciences, technology related to certain tastereceptor sequences that we license from the University of California and othersand technology related to compound libraries that we license from thirdparties. In addition, we may in the future acquire rights to additionaltechnologies by licensing such rights from existing licensors or from thirdparties. Such in-licenses may be costly. Also, we generally do not control thepatent prosecution, maintenance or enforcement of in-licensed technologies.Accordingly, we are unable to exercise the same degree of control over thisintellectual property as we do over our internally developed technologies.Moreover, some of our academic institution licensors, collaborators andscientific advisors have rights to publish data and information to which wehave rights. If we cannot maintain the confidentiality of our technologies andother confidential information in connection with our collaborations, ourability to protect our proprietary information or obtain patent protection inthe future may be impaired, which could have a significant adverse effect onour business, financial condition and results of operations.

 

***Many of the patent applications we and our licensors havefiled have not yet been substantively examined and may not result in patentsbeing issued.***

 

Manyof the patent applications filed by us and our licensors were filed recentlywith the United States Patent and Trademark Office and most have not beensubstantively examined and may not result in patents being issued. Some ofthese patent applications claim sequences that were identified from differentpublicly available sequence information sources such as the High-ThroughputGenomic Sequences division of GenBank. It is difficult to predict whether anyof our or our licensors’ applications will ultimately be found to be patentableor, if so, to predict the scope of any allowed claims. In addition, thedisclosure in our or our licensors’ patent applications, particularly inrespect of the utility of our claimed inventions, may not be sufficient to meetthe statutory requirements for patentability in all cases. As a result, it isdifficult to predict whether any of our or our licensors’ applications will beallowed, or, if so, to predict the scope of any allowed claims or theenforceability of the patents. Even if enforceable, others may be able todesign around any patents or develop similar technologies that are not withinthe scope of such patents. Our and our licensors’ patent applications may notissue as patents that will provide us with any protection or competitiveadvantage.

 

***Disputes concerning the infringement or misappropriation ofour proprietary rights or the proprietary rights of others could be timeconsuming and extremely costly and could delay our research and developmentefforts.***

 

Ourcommercial success, if any, will be significantly harmed if we infringe thepatent rights of third parties or if we breach any license or other agreementsthat we have entered into with regard to our technology or business.

 

We areaware of other companies and academic institutions that have been performingresearch in the areas of taste modulation and flavors, flavor enhancers andtaste modulators. In particular, other companies and academic institutions haveannounced that they have conducted taste-receptor research and have publisheddata on taste

 

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receptorsequence information and taste receptors or filed patent applications orobtained patent protection on taste modulation or taste receptors and theiruses, including Linguagen Corp., Mount Sinai School of Medicine, The ScrippsResearch Institute, the University of California, Monell Chemical Senses Corp.,the Warner-Lambert Company, Virginia Commonwealth University and the GermanInstitute of Human Nutrition. To the extent any of these companies or academicinstitutions currently have, or obtain in the future, broad patent claims, suchpatents could block our ability to use various aspects of our discovery anddevelopment process and might prevent us from developing or commercializingnewly discovered flavors, flavor enhancers and taste modulators or otherwiseconducting our business. The University of California, for example, claimscertain patent rights relating to the coexpression of T1R receptors that maynot have been licensed to us. While our technology is focused on the use ofhuman T1R receptors, we cannot assure you that it does not infringe such patentrights.  In such event, if we are not able to amend our license with theUniversity of California to include such patent rights and our technology isfound to interfere with or infringe such patent rights, our business, financialcondition and results of operations could suffer a significant adverse effect.In addition, it is possible that some of the flavors, flavor enhancers or tastemodulators that are discovered using our technology may not be patentable ormay be covered by intellectual property of third parties.

 

We arenot currently a party to any litigation, interference, opposition, protest,reexamination, reissue or any other potentially adverse governmental, ex parteor inter-party proceeding with regard to our patent or trademarkpositions.  However, the life sciences and other technology industries arecharacterized by extensive litigation regarding patents and other intellectualproperty rights. Many life sciences and other technology companies haveemployed intellectual property litigation as a way to gain a competitiveadvantage. If we become involved in litigation, interference proceedings,oppositions, reexamination, protest or other potentially adverse intellectualproperty proceedings as a result of alleged infringement by us of the rights ofothers or as a result of priority of invention disputes with third parties, wemight have to spend significant amounts of money, time and effort defending ourposition and we may not be successful. In addition, any claims relating to theinfringement of third-party proprietary rights or proprietary determinations,even if not meritorious, could result in costly litigation, lengthygovernmental proceedings, divert management’s attention and resources, orrequire us to enter into royalty or license agreements that are notadvantageous to us.

 

Shouldany person have filed patent applications or obtained patents that claiminventions also claimed by us, we may have to participate in an interferenceproceeding declared by the relevant patent regulatory agency to determinepriority of invention and, thus, the right to a patent for these inventions inthe United States. Such a proceeding could result in substantial cost to useven if the outcome is favorable. Even if successful on priority grounds, aninterference action may result in loss of claims based on patentability groundsraised in the interference action. Litigation, interference proceedings orother proceedings could divert management’s time and efforts. Even unsuccessfulclaims could result in significant legal fees and other expenses, diversion ofmanagement’s time and disruption in our business. Uncertainties resulting frominitiation and continuation of any patent proceeding or related litigationcould harm our ability to compete and could have a significant adverse effecton our business, financial condition and results of operations.

 

Anadverse ruling arising out of any intellectual property dispute, including anadverse decision as to the priority of our inventions, could undercut orinvalidate our intellectual property position. An adverse ruling could alsosubject us to significant liability for damages, including possible trebledamages, prevent us from using technologies or developing products, or requireus to negotiate licenses to disputed rights from third parties. Although patentand intellectual property disputes in the technology area are often settledthrough licensing or similar arrangements, costs associated with these arrangementsmay be substantial and could include license fees and ongoing royalties.Furthermore, necessary licenses may not be available to us on satisfactoryterms, if at all. Failure to obtain a license in such a case could have asignificant adverse effect on our business, financial condition and results ofoperations.

 

***If we are unable to protect our trade secrets and otherproprietary information, we could lose any competitive advantage we may have,which could adversely affect our business.***

 

Werely in part on trade secret protection for our confidential and proprietaryinformation, know how and processes. Our policy is to execute proprietaryinformation and invention agreements with our employees and consultants uponthe commencement of an employment or consulting relationship. These agreementsgenerally require that all confidential information developed by the individualor made known to the individual by us during the course of the individual’srelationship with us be kept confidential and not be disclosed to thirdparties. These

 

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agreementsalso generally provide that inventions conceived by the individual in thecourse of their employment shall be our exclusive property. There can be noassurance that we will be able to effectively enforce these agreements or thatproprietary information is our exclusive property. There can be no assurancethat the subject proprietary information will not be disclosed, that otherswill not independently develop substantially equivalent proprietary informationand techniques or otherwise gain access to our trade secrets or that we canmeaningfully protect our trade secrets. Costly and time-consuming litigationcould be necessary to enforce and determine the scope of our proprietaryrights, and failure to obtain or maintain trade secret protection couldadversely affect our competitive business position.

 

***Many potential competitors, including those who have greaterresources and experience than we do, may develop products or technologies thatmake ours obsolete or noncompetitive.***

 

Thelife sciences and other technology industries are characterized by rapidtechnological change, and the area of sensory or taste receptor research is arapidly evolving field. Our future success will depend on our ability tomaintain a competitive position with respect to technological advances.Technological developments by others may result in our flavors, flavorenhancers or taste modulators and technologies becoming obsolete.

 

Inparticular, we face substantial competition from companies pursuing thecommercialization of products and services relevant to taste using moretraditional methods for the discovery of flavors, flavor enhancers and tastemodulators. These competitors include leading flavor companies, such asInternational Flavors & Fragrances Inc., Givaudan SA, Symrise,Quest International and Firmenich. We currently compete and will continue tocompete in the future with these companies in collaborating with and sellingflavor products and technologies to manufacturers of packaged food and beverageproducts. Many of these companies have substantially greater capital resources,research and development resources and experience, manufacturing capabilities,regulatory expertise, sales and marketing resources, established relationshipswith consumer products companies and production facilities.

 

We arenot aware of any products currently available or under development that wouldcompete with the flavors, flavor enhancers and taste modulators that we aredeveloping under our sweet and salt programs. Savory flavor enhancers,particularly inosine monophosphate, or IMP, are commercially available, and wewill compete with the companies that produce these flavors. IMP is widelyavailable and is a generally accepted food additive by the packaged food andbeverage industry. As a result, our existing and future collaborators maychoose to incorporate IMP or similar savory flavor enhancers into theirpackaged food and beverage products instead of our savory flavors, flavorenhancers and taste modulators.  In addition, we may compete with bittermasking or bitter blocking compounds, such as adenosine 5’ monophosphate, orAMP.

 

We mayin the future face competition from life sciences and other technologycompanies and other commercial enterprises. These entities engage as we do in biotechnology,biology or chemistry and could apply this technology to the discovery anddevelopment of flavors, flavor enhancers and taste modulators. We are aware ofone other company, Linguagen Corp., a privately-held company that we believe isinvolved in research on sweetness potentiators, salt substitutes and bitterblockers, specifically AMP, and has announced research and developmentcollaborations with several companies. We cannot guarantee that productsdeveloped as a result of our competitors’ existing or future collaborationswill not compete with our flavors, flavor enhancers and taste modulators.

 

Universitiesand public and private research institutions are also potential competitors.While these organizations primarily have educational objectives, they maydevelop proprietary technologies related to the sense of taste or secure patentprotection that we may need for the development of our technologies andproducts. We may attempt to license these proprietary technologies, but theselicenses may not be available to us on acceptable terms, if at all.

 

Ourcompetitors, either alone or with their collaborative partners, may succeed indeveloping technologies or discovering flavors, flavor enhancers or tastemodulators that are more effective, safer, more affordable or more easilycommercialized than ours, and our competitors may obtain intellectual propertyprotection or commercialize products sooner than we do. Developments by othersmay render our product candidates or our technologies obsolete. In addition,our current product discovery and development collaborators are not prohibitedfrom entering into research and development collaboration agreements with thirdparties in any product field. Our failure to compete effectively would have asignificant adverse effect on our business, financial condition and results ofoperations.

 

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***We may be sued for product liability, which could adverselyaffect our business.***

 

Becauseour business strategy involves the development and sale by our collaborators ofcommercial products incorporating our flavors, flavor enhancers and tastemodulators, we may be sued for product liability. We may be held liable if anyproduct we develop and commercialize, or any product our collaboratorscommercialize that incorporates any of our flavors, flavor enhancers or tastemodulators, causes injury or is found otherwise unsuitable during producttesting, manufacturing, marketing, sale or consumer use. In addition, thesafety studies we must perform and the FEMA GRAS determination we must obtainprior to incorporating our flavors, flavor enhancers and taste modulators intoa commercial product will not protect us from any such liability.

 

If weand our collaborators commence sale of commercial products we will need toobtain product liability insurance, and this insurance may be prohibitivelyexpensive, or may not fully cover our potential liabilities. Inability toobtain sufficient insurance coverage at an acceptable cost or otherwise toprotect against potential product liability claims could prevent or inhibit thecommercialization of products developed by us or our product discovery anddevelopment collaborators. We may be obligated to indemnify our productdiscovery and development collaborators for product liability or other lossesthey incur as a result of our flavors, flavor enhancers and taste modulators.Any indemnification we receive from such collaborators for product liabilitythat does not arise from our flavors, flavor enhancers and taste modulators maynot be sufficient to satisfy our liability to injured parties. If we are suedfor any injury caused by our flavors, flavor enhancers and taste modulators orproducts incorporating our flavors, flavor enhancers and taste modulators, ourliability could exceed our total assets.

 

***We use hazardous materials. Any claims relating to improperhandling, storage or disposal of these materials could be time consuming andcostly.***

 

Ourdiscovery and development process requires our employees to routinely handlehazardous chemical, radioactive and biological materials. Our operations alsoproduce hazardous waste products. Federal, state and local laws and regulationsgovern the use, manufacture, storage, handling and disposal of these materials.As a result of the increase in size of our operations, we were recentlyre-classified from a small quantity to a large quantity generator of hazardouswaste. This reclassification may result in increased scrutiny of our operationsby the Environmental Protection Agency. Compliance with applicableenvironmental laws and regulations may be expensive, and current or futureenvironmental regulations may impair our discovery and development efforts.

 

Inaddition, we cannot entirely eliminate the risk of accidental contamination ordischarge and any resultant injury from these materials. Our property andcasualty policy has very limited coverage for damages or cleanup costs relatedto radioactive contamination and pollutants and our general liability insurancepolicy excludes coverage for damages and fines arising from biological orhazardous waste disposal or contamination. We do not carry specific biologicalor hazardous waste insurance. We may be forced to curtail operations or be suedfor any injury or contamination that results from our use or the use by othersof these materials, and our liability may exceed our total assets.

 

**RisksRelated To Our Common Stock**

 

***Anti-takeover provisions in our charter documents and underDelaware law may make an acquisition of us more complicated and the removal andreplacement of our directors and management more difficult.***

 

Provisionsof our amended and restated certificate of incorporation and bylaws, as well asprovisions of Delaware law, could make it more difficult for a third party toacquire us, even if doing so would benefit our stockholders. These provisionsmay also make it difficult for stockholders to remove and replace our board ofdirectors and management. These provisions:

 

•                  authorize the issuance of “blankcheck” preferred stock by our board of directors, without stockholder approval,which could increase the number of outstanding shares and prevent or delay atakeover attempt;

•                  limit who may call a special meetingof stockholders;

•                  prohibit stockholder action bywritten consent, thereby requiring all stockholder actions to be taken at ameeting of our stockholders; and

•                  establish advance notice requirementsfor nominations for election to the board of directors or for proposing mattersthat can be acted upon at stockholder meetings.

 

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Inaddition, the requirements of Section 203 of the Delaware GeneralCorporation Law may discourage, delay or prevent a third party from acquiringus. These requirements are described under the heading “Description of CapitalStock—Delaware Anti-Takeover Law and Certain Charter Provisions” in ourprospectus filed pursuant to Rule 424(b) of the Securities Act withthe SEC on June 22, 2004.

 

***Our shareholder rights plan may hinder or prevent change ofcontrol transactions.***

 

Ourshareholder rights plans may discourage transactions involving an actual orpotential change in our ownership.  Inaddition, our board of directors may issue shares of preferred stock withoutany further action by you.  Suchissuances may have the effect of delaying or preventing a change in ourownership.  If changes in our ownershipare discouraged, delayed or prevented, it would be more difficult for ourcurrent board of directors to be removed and replaced, even if you and otherstockholders believe such actions are in the best interests of us and ourstockholders.

 

***Compliance with changing regulation of corporate governanceand public disclosure may result in additional expenses.***

 

Changinglaws, regulations and standards relating to corporate governance and publicdisclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations andNasdaq National Market rules, are creating uncertainty for companies such asours. These new or changed laws, regulations and standards are subject tovarying interpretations in many cases due to their lack of specificity, and asa result, their application in practice may evolve over time as new guidance isprovided by regulatory and governing bodies, which could result in continuinguncertainty regarding compliance matters and higher costs necessitated byongoing revisions to disclosure and governance practices. We are committed tomaintaining high standards of corporate governance and public disclosure. As a result,our efforts to comply with evolving laws, regulations and standards haveresulted in, and are likely to continue to result in, increased general andadministrative expenses and management time related to compliance activities.In particular, our efforts to comply with Section 404 of theSarbanes-Oxley Act of 2002 and the related regulations regarding our requiredassessment of our internal controls over financial reporting and our externalauditors’ audit of that assessment requires the commitment of significantfinancial and managerial resources. If our efforts to comply with new orchanged laws, regulations and standards differ from the activities intended byregulatory or governing bodies due to ambiguities related to practice, ourreputation may be harmed and we might be subject to sanctions or investigationby regulatory authorities, such as the Securities and Exchange Commission. Anysuch action could adversely affect our financial results and the market priceof our common stock.

 

***If our officers, directors and largest stockholders chooseto act together, they may be able to control our management and operations,acting in their best interests and not necessarily the interests of otherstockholders.***

 

As of September 30,2004, our executive officers, directors and stockholders with at least 5% ofour stock together beneficially owned approximately 63% of our common stock. Ifthese officers, directors and principal stockholders act together, they will beable to exert a significant degree of influence over our management and affairsand over matters requiring stockholder approval, including the election ofdirectors and approval of mergers or other business combination transactions.The interests of this concentration of ownership may not always coincide withour interests or the interests of investors in this offering or otherstockholders. For instance, officers, directors and principal stockholders,acting together, could cause us to enter into transactions or agreements thatwe would not otherwise consider. Similarly, this concentration of ownership mayhave the effect of delaying or preventing a change in control of our companyotherwise favored by our other stockholders. This concentration of ownershipcould depress our stock price.

 

***We have never paid cash dividends on our capital stock andwe do not anticipate paying dividends in the foreseeable future.***

 

Wehave paid no cash dividends on any of our classes of capital stock to date, andwe currently intend to retain our future earnings, if any, to fund thedevelopment and growth of our business. In addition, the terms of any futuredebt or credit facility may preclude us from paying any dividends. As a result,capital appreciation, if any, of our common stock will be your sole source ofpotential gain for the foreseeable future.

 

43

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**Item 7A****.    *Quantitative and Qualitative Disclosures About Market Risk***

 

Ourprimary exposure to market risk is interest income sensitivity, which isaffected by changes in the general level of United States interest rates. Dueto the nature of our short-term investments, we believe that we are not subjectto any material market risk exposure. We do not have any foreign currency orother derivative financial instruments.

 

**Item 8****.    *Financial Statements and Supplementary Data***

 

**Index to Financial Statements**

 
| **Description**                                                                       | ** ** | **Page** |
|---------------------------------------------------------------------------------------|------------|----------|
|                                                                                  |       |     |
| Report  of Ernst & Young, LLP, Independent Registered Public Accounting Firm |       | 45       |
|                                                                                  |       |     |
| Balance Sheets                                                                        |       | 46       |
|                                                                                  |       |     |
| Statements of Operations                                                              |       | 47       |
|                                                                                  |       |     |
| Statements of  Shareholders’ Equity                                              |       | 48       |
|                                                                                  |       |     |
| Statements of Cash Flows                                                              |       | 50       |
|                                                                                  |       |     |
| Notes to Financial  Statements                                                        |       | 51       |

 

44

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**Reportof Independent Registered Public Accounting Firm**

 

To the Board of Directorsand Stockholders of Senomyx, Inc.

 

We have audited theaccompanying balance sheets of Senomyx, Inc. as of December 31, 2004and 2003, and the related statements of operations, stockholders’ equity, andcash flows for each of the three years in the period ended December 31,2004. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. An audit includes consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of Senomyx, Inc. at December 31,2004 and 2003 and the results of its operations and its cash flows for each ofthe three years in the period ended December 31, 2004, in conformity withU.S. generally accepted accounting principles.

 

 
|                    | /s/  ERNST &  YOUNG LLP |
|-------------------------|--------------------------------------------|
|                    |                                       |
| San Diego,  California  |                                       |
| February 14,  2005 |                                       |

 

45

----

 

**Senomyx, Inc.**

 

**BalanceSheets**

 

**(In thousands, except share and pershare data)**

 
| ** **                                                                                                                                                                                                                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                     | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Assets:**                                                                                                                                                                                                                                    |       |                  |       |   |   |
| Current assets:                                                                                                                                                                                                                                |       |                  |       |   |   |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                      |       | $                     | 17,085     |   | $ | 13,493 |   |
| Investments available-for-sale                                                                                                                                                                                                                 |       | 23,762                |       | 3,565 |   |
| Other current assets                                                                                                                                                                                                                           |       | 1,213                 |       | 1,257 |   |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Total current assets                                                                                                                                                                                                                           |       | 42,060                |       | 18,315 |   |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Property and equipment, net                                                                                                                                                                                                                    |       | 1,742                 |       | 2,125 |   |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Total assets                                                                                                                                                                                                                                   |       | $                     | 43,802     |   | $ | 20,440 |   |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| **Liabilities and stockholders’ equity**                                                                                                                                                                                                  |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                                                                           |       |                  |       |   |   |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Accounts payable and accrued expenses                                                                                                                                                                                                          |       | $                     | 3,208      |   | $ | 1,679 |   |
| Other current liabilities                                                                                                                                                                                                                      |       | 153                   |       | 61 |   |
| Deferred revenue                                                                                                                                                                                                                               |       | 1,858                 |       | 1,415 |   |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Total current liabilities                                                                                                                                                                                                                      |       | 5,219                 |       | 3,155 |   |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Deferred rent                                                                                                                                                                                                                                  |       | 210                   |       | 181 |   |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Commitments                                                                                                                                                                                                                                    |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                                                                                                     |       |                  |       |   |   |
| Convertible preferred stock, $.001 par value;  7,500,000 and 37,079,311 shares authorized, 0 and 25,825,827 shares  designated, 0 and 25,825,826 issued and outstanding at December 31, 2004  and 2003; liquidation preference of $79,690 |       | —                |       | 70,150 |   |
| Common stock, $.001 par value, 120,000,000 and  51,495,732 shares authorized; 25,309,565 and 2,020,736 shares issued and  outstanding at December 31, 2004 and 2003, respectively                                                         |       | 25                    |       | 2 |   |
| Additional paid-in-capital                                                                                                                                                                                                                     |       | 126,243               |       | 20,173 |   |
| Deferred compensation                                                                                                                                                                                                                          |       | (3,492                | )          | (8,540 | ) |
| Accumulated other comprehensive income                                                                                                                                                                                                         |       | (7                    | )          | 1 |   |
| Accumulated deficit                                                                                                                                                                                                                            |       | (84,396               | )          | (64,682 | ) |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Total stockholders’ equity                                                                                                                                                                                                                |       | 38,373                |       | 17,104 |   |
|                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Total liability and stockholders’ equity                                                                                                                                                                                                  |       | $                     | 43,802     |   | $ | 20,440 |   |

 

See accompanying notes to financial statements.

 

46

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**Senomyx, Inc.**

 

**Statementsof Operations**

 

**(In thousands, except share and pershare data)**

 
| ** **                                                                                                              | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                              | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                                                                    |       |                              |       |   |   |   |   |
| Revenue under collaborative agreements                                                                                  |       | $                                 | 8,347      |   | $ | 9,537 |   | $ | 7,327 |   |
| Operating expenses:                                                                                                     |       |                              |       |   |   |   |   |
| Research and development                                                                                                |       | 16,907                            |       | 16,802 |   | 17,635 |   |
| General and administrative                                                                                              |       | 5,553                             |       | 4,096 |   | 4,154 |   |
| Stock-based compensation:                                                                                               |       |                              |       |   |   |   |   |
| Research and development                                                                                                |       | 1,411                             |       | 1,293 |   | 540 |   |
| General and administrative                                                                                              |       | 4,625                             |       | 4,997 |   | 158 |   |
|                                                                                                                    |       |                              |       |   |   |   |   |
| Total operating expenses                                                                                                |       | 28,496                            |       | 27,188 |   | 22,487 |   |
|                                                                                                                    |       |                              |       |   |   |   |   |
| Loss from operations                                                                                                    |       | (20,149                           | )          | (17,651 | ) | (15,160 | ) |
|                                                                                                                    |       |                              |       |   |   |   |   |
| Interest income                                                                                                         |       | 435                               |       | 268 |   | 496 |   |
| Interest expenses                                                                                                       |       | —                            |       | (70 | ) | (157 | ) |
|                                                                                                                    |       |                              |       |   |   |   |   |
| Net loss                                                                                                                |       | $                                 | (19,714    | ) | $ | (17,453 | ) | $ | (14,821 | ) |
|                                                                                                                    |       |                              |       |   |   |   |   |
| Basic and diluted net loss per share                                                                                    |       | $                                 | (1.40      | ) | $ | (10.03 | ) | $ | (9.60 | ) |
|                                                                                                                    |       |                              |       |   |   |   |   |
| Shares used to compute basic and diluted net loss  per share                                                            |       | 14,040,727                        |       | 1,739,380 |   | 1,544,268 |   |
|                                                                                                                    |       |                              |       |   |   |   |   |
| Pro forma net loss per common share assuming  conversion of preferred stock, basic and diluted                          |       | $                                 | (0.89      | ) | $ | (0.97 | ) | $ | (0.84 | ) |
|                                                                                                                    |       |                              |       |   |   |   |   |
| Shares used in computing pro forma net loss per  common share assuming conversion of preferred stock, basic and diluted |       | 22,143,380                        |       | 17,944,686 |   | 17,749,574 |   |

 

See accompanying notes tofinancial statements.

 

47

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**Senomyx, Inc.**

**Statements of Stockholders’Equity**

**(In thousands,except for share data)**

 
| ** **                                                                                                         | ** ** | **Preferred  Stock** | ** ** | **Common  Stock** | ** ** | **Common  stock** | ** ** | **Additional  paid-in** | ** ** | **Deferred** | ** ** | **Unrealized  gain (loss) on** | ** ** | **Accumulated**  | ** ** | **Total  stockholders’** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|-------------------|------------|-------------------|------------|-------------------------|------------|--------------|------------|--------------------------------|------------|------------------|------------|-------------------------------|------------|
| ** **                                                                                                         | ** ** | **Shares**           | ** ** | **Amount**        | ** ** | **Shares**        | ** ** | **Amount**              | ** ** | **issuable** | ** ** | **capital**                    | ** ** | **compensation** | ** ** | **investments**               | ** ** | **deficit** | ** ** | **equity** | ** ** |
| ** **                                                                                                         | ** ** | ** **           | ** ** | ** **        | ** ** | ** **        | ** ** | ** **              | ** ** | ** **   | ** ** | ** **                     | ** ** | ** **       | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at December 31, 2001                                                                                  |       | 21,312,752           |       | $                 | 57,147     |              | 1,769,257  |                    | $          | 2            |       | $                              | 6          |             | $          | 5,305                         |       | $ | (996 | ) | $ | — |   | $ | (32,408 | ) | $ | 29,056 |   |
|                                                                                                               |       |                 |       |              |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Issuance of Series E Convertible preferred stock  at $2.8999 per share for cash, net of issuance costs of $85 |       | 4,513,074            |       | 13,003            |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | —                        |       | — |   | 13,003 |   |
| Issuance of common stock related to license agreement                                                              |       | —               |       | —            |       | 1,632             |       | —                  |       | (4           | )          | 4                              |       | —           |       | —                        |       | — |   | — |   |
| Issuance of common stock to consultants                                                                            |       | —               |       | —            |       | 1,020             |       | —                  |       | (2           | )          | 2                              |       | —           |       | —                        |       | — |   | — |   |
| Issuance of common stock to employees related to the  exercise of options                                          |       | —               |       | —            |       | 218,225           |       | —                  |       | —       |       | 290                            |       | —           |       | —                        |       | — |   | 290 |   |
| Repurchase of common stock from employees                                                                          |       | —               |       | —            |       | (46,243           | )          | —                  |       | —       |       | (16                            | )          | —           |       | —                        |       | — |   | (16 | ) |
| Compensation related to restricted stock issued to  consultants                                                    |       | —               |       | —            |       | —            |       | —                  |       | —       |       | 63                             |       | —           |       | —                        |       | — |   | 63 |   |
| Compensation related to common stock issuable related  to license agreement                                        |       | —               |       | —            |       | —            |       | —                  |       | 3            |       | —                         |       | —           |       | —                        |       | — |   | 3 |   |
| Amortization of deferred compensation                                                                              |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | 635              |       | —                        |       | — |   | 635 |   |
| Reduction of deferred compensation for unvested  employee common stock options and restricted shares repurchased   |       | —               |       | —            |       | —            |       | —                  |       | —       |       | (73                            | )          | 73               |       | —                        |       | — |   | — |   |
| Comprehensive loss:                                                                                                |       |                 |       |              |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Unrealized gain on investments                                                                                     |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | 6                             |       | — |   | 6 |   |
| Net loss                                                                                                           |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | —                        |       | (14,821 | ) | (14,821 | ) |
| Comprehensive loss                                                                                                 |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | —                        |       | — |   | (14,815 | ) |
| Balance at December 31, 2002                                                                                  |       | 25,825,826           |       | 70,150            |       | 1,943,891         |       | 2                       |       | 3            |       | 5,575                          |       | (288             | )          | 6                             |       | (47,229 | ) | 28,219 |   |
|                                                                                                               |       |                 |       |              |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Issuance of common stock related to license agreement                                                              |       | —               |       | —            |       | 4,080             |       | —                  |       | (3           | )          | 3                              |       | —           |       | —                        |       | — |   | — |   |
| Issuance of common stock to employees related to the  exercise of options                                          |       | —               |       | —            |       | 29,273            |       | —                  |       | —       |       | 23                             |       | —           |       | —                        |       | — |   | 23 |   |
| Repurchase of unvested common stock from employees                                                                 |       | —               |       | —            |       | (23,826           | )          | —                  |       | —       |       | (19                            | )          | —           |       | —                        |       | — |   | (19 | ) |
| Compensation related to stock options to employees                                                                 |       | —               |       | —            |       | —            |       | —                  |       | —       |       | 13,329                         |       | (13,329          | )          | —                        |       | — |   | — |   |
| Issuance of restricted stock issued to consultants                                                                 |       | —               |       | —            |       | 67,318            |       | —                  |       | —       |       | 49                             |       | —           |       | —                        |       | — |   | 49 |   |
| Compensation related to restricted stock issued to  consultants                                                    |       | —               |       | —            |       | —            |       | —                  |       | —       |       | 1,253                          |       | —           |       | —                        |       | — |   | 1,253 |   |
| Amortization of deferred compensation                                                                              |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | 5,037            |       | —                        |       | — |   | 5,037 |   |
| Reduction of deferred compensation for unvested  employee common stock options and restricted shares repurchased   |       | —               |       | —            |       | —            |       | —                  |       | —       |       | (40                            | )          | 40               |       | —                        |       | — |   | — |   |
| Comprehensive loss:                                                                                                |       |                 |       |              |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Unrealized loss on investments                                                                                     |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | (5                            | )          | — |   | (5 | ) |
| Net loss                                                                                                           |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | —                        |       | (17,453 | ) | (17,453 | ) |
| Comprehensive loss                                                                                                 |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | —                        |       | — |   | (17,458 | ) |
|                                                                                                               |       |                 |       |              |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Balance at December 31, 2003                                                                                  |       | 25,825,826           |       | 70,150            |       | 2,020,736         |       | 2                       |       | —       |       | 20,173                         |       | (8.540           | )          | 1                             |       | (64,682 | ) | 17,104 |   |
|                                                                                                                    |            |                      |            |                   |            |                   |            |                         |            |              |            |                                |            |                  |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

48

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**Senomyx, Inc.**

**Statementsof Stockholders’ Equity**

**(In thousands,except for share data)**

 
| ** **                                                                  | ** ** | **Preferred  Stock** | ** ** | **Common  Stock** | ** ** | **Common  stock** | ** ** | **Additional  paid-in** | ** ** | **Deferred** | ** ** | **Unrealized  gain (loss) on** | ** ** | **Accumulated**  | ** ** | **Total  stockholders’** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------|------------|-------------------|------------|-------------------|------------|-------------------------|------------|--------------|------------|--------------------------------|------------|------------------|------------|-------------------------------|------------|
| ** **                                                                  | ** ** | **Shares**           | ** ** | **Amount**        | ** ** | **Shares**        | ** ** | **Amount**              | ** ** | **issuable** | ** ** | **capital**                    | ** ** | **compensation** | ** ** | **investments**               | ** ** | **deficit** | ** ** | **equity** | ** ** |
| ** **                                                                  | ** ** | ** **           | ** ** | ** **        | ** ** | ** **        | ** ** | ** **              | ** ** | ** **   | ** ** | ** **                     | ** ** | ** **       | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at December 31, 2003                                           |       | 25,825,826           |       | $                 | 70,150     |              | 2,020,736  |                    | $          | 2            |       | $                              | —     |             | $          | 20,173                        |       | $ | (8,540 | ) | $ | 1 |   | $ | (64,682 | ) | $ | 17,104 |   |
|                                                                        |       |                 |       |              |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Issuance of common stock to employees related to the  exercise of options   |       | —               |       | —            |       | 667,509           |       | 1                       |       | —       |       | 688                            |       | —           |       | —                        |       | — |   | 689 |   |
| Repurchase of unvested common stock from employees  and consultants         |       | —               |       | —            |       | (41,661           | )          | —                  |       | —       |       | (31                            | )          | —           |       | —                        |       | — |   | (31 | ) |
| Compensation related to stock options to employees                          |       | —               |       | —            |       | —            |       | —                  |       | —       |       | 442                            |       | (442             | )          | —                        |       | — |   | — |   |
| Compensation related to restricted stock issued to  consultants             |       | —               |       | —            |       | —            |       | —                  |       | —       |       | 1,119                          |       | —           |       | —                        |       | — |   | 1,119 |   |
| Amortization of deferred compensation                                       |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | 4,917            |       | —                        |       | — |   | 4,917 |   |
| Reduction of deferred compensation for unvested  employee stock options     |       | —               |       | —            |       | —            |       | —                  |       | —       |       | (573                           | )          | 573              |       | —                        |       | — |   | — |   |
| Issuance of common stock related to exercise of  warrant                    |       | —               |       | —            |       | 7,675             |       | —                  |       | —       |       | —                         |       | —           |       | —                        |       | — |   | — |   |
| Conversion of preferred stock to common stock                               |       | (25,825,826          | )          | (70,150           | )          | 16,205,306        |       | 16                      |       | —       |       | 70,134                         |       | —           |       | —                        |       | — |   | — |   |
| Issuance of common stock in initial public offering,  net of issuance costs |       | —               |       | —            |       | 6,450,000         |       | 6                       |       | —       |       | 34,291                         |       | —           |       | —                        |       | — |   | 34,297 |   |
| Comprehensive loss:                                                         |       |                 |       |              |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Unrealized loss on investments                                              |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | (8                            | )          | — |   | (8 | ) |
| Net loss                                                                    |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | —                        |       | (19,714 | ) | (19,714 | ) |
| Comprehensive loss                                                          |       | —               |       | —            |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | —                        |       | — |   | (19,722 | ) |
|                                                                        |       |                 |       |              |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Balance at December 31, 2004                                           |       | —               |       | $                 | —     |              | 25,309,565 |                    | $          | 25           |       | $                              | —     |             | $          | 126,243                       |       | $ | (3,492 | ) | $ | (7 | ) | $ | (84,396 | ) | $ | 38,373 |   |

 

See accompanying notes to financial statements.

 

49

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**Senomyx, Inc.**

**Statementsof Cash Flows**

**(In thousands)**

 
| ** **                                                                      | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                      | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Operating Activities**                                                        |       |                              |       |   |   |   |   |
| Net loss                                                                        |       | $                                 | (19,714    | ) | $ | (17,453 | ) | $ | (14,821 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities:    |       |                              |       |   |   |   |   |
| Depreciation and amortization                                                   |       | 1,462                             |       | 2,017 |   | 1,829 |   |
| Common stock issued for license                                                 |       | —                            |       | — |   | 3 |   |
| Amortization of loan discount                                                   |       | —                            |       | 8 |   | 5 |   |
| Stock-based compensation for non-employees                                      |       | 1,119                             |       | 1,253 |   | 63 |   |
| Amortization of deferred compensation                                           |       | 4,917                             |       | 5,037 |   | 635 |   |
| Amortization of license fees                                                    |       | —                            |       | 2,868 |   | 3,007 |   |
| Change in operating assets and liabilities:                                     |       |                              |       |   |   |   |   |
| Other assets                                                                    |       | 44                                |       | (581 | ) | 77 |   |
| Accounts payable and accrued expenses                                           |       | 1,621                             |       | (435 | ) | 87 |   |
| Deferred revenue                                                                |       | 443                               |       | (1,151 | ) | 387 |   |
| Deferred rent                                                                   |       | 29                                |       | 181 |   | — |   |
| Net cash used in operating activities                                           |       | (10,079                           | )          | (8,256 | ) | (8,728 | ) |
|                                                                            |       |                              |       |   |   |   |   |
| **Investing activities**                                                        |       |                              |       |   |   |   |   |
| Purchases of property and equipment                                             |       | (1,079                            | )          | (552 | ) | (2,370 | ) |
| Purchases of available-for-sale securities                                      |       | (27,505                           | )          | (9,715 | ) | (30,953 | ) |
| Maturities of available-for-sale securities                                     |       | 7,300                             |       | 11,927 |   | 25,177 |   |
| Net cash (used in) provided by investing activities                             |       | (21,284                           | )          | 1,660 |   | (8,146 | ) |
|                                                                            |       |                              |       |   |   |   |   |
| **Financing activities**                                                        |       |                              |       |   |   |   |   |
| Proceeds from loans                                                             |       | —                            |       | — |   | 1,580 |   |
| Repayment of loans                                                              |       | —                            |       | (1,768 | ) | (905 | ) |
| Proceeds from issuance of preferred stock                                       |       | —                            |       | — |   | 13,003 |   |
| Proceeds from issuance of common stock                                          |       | 34,986                            |       | 53 |   | 274 |   |
| Repurchase of common stock                                                      |       | (31                               | )          | — |   | — |   |
| Net cash provided by (used in) financing activities                             |       | 34,955                            |       | (1,715 | ) | 13,952 |   |
|                                                                            |       |                              |       |   |   |   |   |
| Net increase (decrease) in cash and cash equivalents                            |       | 3,592                             |       | (8,311 | ) | (2,922 | ) |
| Cash and cash equivalents at beginning of year                                  |       | 13,493                            |       | 21,804 |   | 24,726 |   |
| Cash and cash equivalents at end of year                                        |       | $                                 | 17,085     |   | $ | 13,493 |   | $ | 21,804 |   |
|                                                                            |       |                              |       |   |   |   |   |
| **Supplemental disclosure of cash flow  information:**                          |       |                              |       |   |   |   |   |
| Cash paid during the year for interest                                          |       | $                                 | —     |   | $ | 74 |   | $ | 147 |   |
|                                                                            |       |                              |       |   |   |   |   |
| **Supplemental schedule of non-cash investing  and financing activities:** |       |                              |       |   |   |   |   |
| Conversion of preferred stock into common stock                                 |       | $                                 | 70,150     |   | $ | — |   | $ | — |   |

 

See accompanying notes to financial statements.

 

50

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**Senomyx, Inc.**

**Notes to Financial Statements**

 

**1.Organization and Summary of Significant Accounting Policies**

 

***Organization and Business***

 

Senomyx, Inc. (the “Company”)was incorporated on September 16, 1998 in Delaware and commencedoperations in January 1999. The Company is a biotechnology company usingproprietary taste receptor-based assays, screening technologies andoptimization chemistry to discover and develop novel flavors, flavor enhancersand taste modulators for the packaged food and beverage industry. The Companyhas entered into product discovery and development collaborations with four ofthe world’s leading packaged food and beverage companies: Campbell Soup Company(“Campbell Soup”), The Coca-Cola Company (“Coca-Cola”), Kraft Foods Global, Inc.(“Kraft Foods”), and Nestlé SA (“Nestlé”). The Company’s collaborationagreements provide for research funding, milestone payments if the Companyachieves development goals and royalties on future sales of consumer productsincorporating the Company’s flavors, flavor enhancers and taste modulators. TheCompany currently has programs focused on the development of savory, sweet,salt and bitter flavors, flavor enhancers and taste modulators.

 

***Use of Estimates***

 

The preparation offinancial statements in conformity with accounting principles generally acceptedin the United States requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.Actual results could differ from those estimates.

 

***Cash and Cash Equivalents***

 

TheCompany considers all highly liquid investments with a remaining maturity ofless than three months when purchased to be cash equivalents. Cash equivalentsare recorded at cost, which approximates market value.

 

***Investments Available-for-Sale***

 

TheCompany’s surplus cash is invested in auction rate securities, governmentagency bonds and United States Treasury securities with maturity dates of lessthan one year. The amortized cost of debt securities is adjusted foramortization of premiums and accretion of discounts to maturity with allamortization and accretion included in interest income. The Company’sshort-term investments are classified as available-for-sale and carried atestimated fair value, as determined by quoted market prices, with unrealizedgains and losses reported in a separate component of accumulated othercomprehensive income. Realized gains and losses and declines in value judged tobe other-than-temporary, if any, on available-for-sale securities are includedin interest income. The cost of securities sold is based on the specificidentification method. Interest on securities classified as available-for-saleis included in interest income.

 

***Fair Value of Financial Instruments***

 

Thecarrying amount of cash and cash equivalents, investments available-for-sale,accounts payable and accrued expenses are considered to be representative oftheir respective fair value because of the short-term nature of those items.

 

***Concentration of Credit Risk and Major Collaborations***

 

Financialinstruments, which potentially subject the Company to concentrations of creditrisk, consist of cash, cash equivalents and investments available-for-sale. TheCompany limits its exposure to credit loss by placing its cash, cashequivalents, and investments with high credit quality financial institutions ininstruments with short maturities.

 

51

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TheCompany derives its revenues from a relatively small number of collaborators.For the year ended December 31, 2004, revenues from four collaboratorsaccounted for 17%, 23%, 24% and 36%, respectively, of total revenues. For theyear ended December 31, 2003, revenues from four collaborators accountedfor 22%, 28%, 28% and 22%, respectively, of total revenues. For the year ended December 31,2002, revenues from four collaborators accounted for 31%, 23%, 27% and 19%,respectively, of total revenues.

 

***Property and Equipment***

 

Propertyand equipment are stated at cost less accumulated depreciation and aredepreciated over the estimated useful lives of the assets (ranging from threeto five years) using the straight-line method. Leasehold improvements are amortizedover the estimated useful life of the asset or the lease term, whichever isshorter.

 

***Patent Costs***

 

Costsrelated to filing and pursuing patent applications are expensed as incurred, asrecoverability of such expenditures is uncertain.

 

***Intangible Assets***

 

TheCompany amortizes intangible assets over their estimated useful lives. To date,the intangible assets have consisted of certain technology and databasesacquired from Aurora Biosciences Corporation (“Aurora”) and Incyte Genomics, Inc.(“Incyte”) which were amortized to research and development expense over threeyears. As of December 31, 2003, the intangible assets were fullyamortized.

 

***Impairment of Long-Lived Assets***

 

Inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets*, if indicators of impairment exist, the Companyassesses the recoverability of the affected long-lived assets by determiningwhether the carrying value of such assets can be recovered through undiscountedfuture operating cash flows. If impairment is indicated, the Company measuresthe amount of such impairment by comparing the fair value to the carryingvalue. There have been no indicators of impairment through December 31,2004.

 

***Revenue Recognition***

 

TheCompany’s revenue recognition policies are in compliance with the StaffAccounting Bulletin (“SAB”) No. 101 (as amended by SAB No. 104), *Revenue Recognition in Financial Statements*and Emerging Issues Task Force (“EITF”) Issue 00-21, *Revenue Arrangements with Multiple Deliverables*.Revenue is deferred for fees received before earned. Some of the Company’sagreements contain multiple elements, including research funding, milestonesand royalties.

 

Revenuefrom milestones is recognized when earned, as evidenced by writtenacknowledgment from the collaborator or other persuasive evidence that themilestone has been achieved, provided that (i) the milestone event issubstantive and its achievability was not reasonably assured at the inceptionof the agreement, and (ii) the Company’s performance obligations after themilestone achievement will continue to be funded by the collaborator at a levelcomparable to before the milestone achievement. If both of these criteria arenot met, the milestone payment is recognized over the remaining minimum periodof the Company’s performance obligations under the agreement. Non-refundableupfront fees, if any, not associated with future Company performance, will berecognized when received. Amounts received for research funding are recognizedas revenues as the services are performed. Royalties to be received based onproduct sales made by our collaborators incorporating our product, if any, willbe recognized as earned. To date, the Company has not earned any royalties.

 

***Research and Development***

 

Researchand development costs, including those incurred in relation to the Company’scollaborative agreements, are expensed in the period incurred. Research anddevelopment costs primarily consist of salaries and related expenses forpersonnel, facilities and depreciation, research and development supplies,patents and licenses and outside services. The Company has licensed certaintechnology and databases used in its collaborative agreements, which have beencapitalized in accordance with SFAS No. 2,

 

52

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*Accountingfor Research and Development Costs*, and amortized to research and development expenseover their estimated useful lives.

 

***Comprehensive Income (Loss)***

 

SFAS No. 130,*Reporting Comprehensive Income*,requires that all components of comprehensive income, including net income, bereported in the financial statements in the period in which they arerecognized. Comprehensive income (loss) is defined as the change in equityduring a period from transactions and other events and circumstances fromnon-owner sources. The Company’s accumulated other comprehensive income (loss),as of December 31, 2004 and 2003, consisted of unrealized gains and losseson investments available-for-sale and is reported in stockholders’ equity.

 

***Deferred Rent***

 

Rentexpense is recorded on a straight-line basis over the term of the lease. Thedifference between rent expense accrued and amounts paid under the leaseagreement is recorded as deferred rent in the accompanying balance sheets.

 

***Stock-Based Compensation***

 

Aspermitted by SFAS No. 123, *Accountingfor Stock-Based Compensation*, the Company has elected to followAccounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB No. 25”),and related interpretations in accounting for its employee stock options. UnderAPB No. 25, when the purchase price of restricted stock or the exerciseprice of the Company’s employee stock options equals or exceeds the fair valueof the underlying stock on the date of issuance or grant, no compensationexpense is recognized. The Company has recorded deferred stock compensation of$13.3 million during the year ended December 31, 2003 and $442,000during the year ended December 31, 2004 for the difference between theoriginal exercise price per share determined by the Board of Directors and therevised estimate of fair value per share at the respective grant dates.Deferred stock compensation is recognized and amortized on an accelerated basisin accordance with Financial Accounting Standards Board Interpretation (“FIN”) No. 28,*Accounting for Stock Appreciation Rights andOther Variable Stock Option or Award Plans*, over the vesting periodof the related options, generally four years.

 

Optionsor stock awards issued to non-employees are recorded at their fair value inaccordance with SFAS No. 123, *Accountingfor Stock-Based Compensation*, and EITF No. 96-18, *Accounting for Equity Instruments That Are Issued toOther Than Employees for Acquiring or in Conjunction with Selling Goods orServices*, and are periodically revalued as the options vest and arerecognized as expense over the related service period. The Company grantedstock options and stock awards to non-employees as follows: 468,937, 97,508,and 134,636 for the years ended December 31, 2004, 2003 and 2002,respectively. Compensation expense related to non-employee stock option grantsand stock awards was $1.1 million, $1.3 million and $63,000 for the yearsended December 31, 2004, 2003 and 2002, respectively. The options werevalued using the Black-Scholes option pricing model with the followingweighted-average assumptions for the years ended December 31, 2004, 2003and 2002: (a) risk free interest rates of 3.0%; (b) dividend yield of0%, (c) expected volatility of 70%; and (d) expected life of fiveyears for all periods.

 

Asrequired under SFAS No. 123, the pro forma effects of employee stock-basedcompensation on net loss are estimated at the date of grant using theBlack-Scholes option-pricing model. The Black-Scholes option valuation modelwas developed for use in estimating the fair value of traded options that haveno vesting restrictions and are fully transferable. Because the Company’semployee stock options have characteristics significantly different from thoseof traded options, and because changes in the subjective input assumptions canmaterially affect the fair value estimate, in management’s opinion, theexisting models do not necessarily provide a reliable single measure of thefair value of its employee stock options.

 

Thefair value of options issued to employees was estimated at the date of grantusing the Black-Scholes option valuation model with the following weightedaverage assumptions for the years ended December 31, 2004, 2003, and 2002:(a) risk-free interest rate of 3.0%; (b) expected dividend yield of0%; (c) volatility factor of 70%; and (d) five-year estimated life ofthe options. The estimated weighted average fair value of stock options grantedduring 2004, 2003 and 2002 was $6.55, $15.74 and $0.45, respectively.

 

53

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Forpurposes of pro forma disclosures, the estimated fair value of the options isamortized to expense over the vesting period of the related options. TheCompany’s pro forma information follows (in thousands, except per share data): 

 
| ** **                                                                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                            | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net loss as reported                                                                  |       | $                                 | (19,714    | ) | $ | (17,453 | ) | $ | (14,821 | ) |
| Add: Stock-based employee compensation expense  included in net loss                  |       | 4,917                             |       | 5,037 |   | 635 |   |
| Deduct: Stock-based employee compensation expense  determined under fair value method |       | (6,452                            | )          | (5,120 | ) | (436 | ) |
|                                                                                  |       |                              |       |   |   |   |   |
| Pro forma net loss                                                                    |       | $                                 | (21,249    | ) | $ | (17,536 | ) | $ | (14,622 | ) |
|                                                                                  |       |                              |       |   |   |   |   |
| Basic and diluted net loss per share as reported                                      |       | $                                 | (1.40      | ) | $ | (10.03 | ) | $ | (9.60 | ) |
|                                                                                  |       |                              |       |   |   |   |   |
| Pro forma basic and diluted net loss per share                                        |       | $                                 | (1.51      | ) | $ | (10.08 | ) | $ | (9.47 | ) |

 

***Net Loss Per Share***

 

TheCompany calculated net loss per share in accordance with SFAS No. 128, *Earnings Per Share*, and SAB No. 98.Basic earnings per share (“EPS”) is calculated by dividing the net income orloss by the weighted average number of common shares outstanding for theperiod, without consideration for common stock equivalents. Diluted EPS iscomputed by dividing the net income or loss by the weighted average number ofcommon share equivalents outstanding for the period determined using thetreasury-stock method. For purposes of this calculation, common stock subjectto repurchase by the Company, convertible preferred stock, options, andwarrants are considered to be common stock equivalents and are only included inthe calculation of diluted earnings per share when their effect is dilutive.Under the provisions of SAB No. 98, common shares issued for nominalconsideration (as defined), if any, would be included in the per sharecalculations as if they were outstanding for all periods presented. No commonshares have been issued for nominal consideration.

 

Thefollowing table sets forth the computation of basic and diluted, and unauditedpro forma basic and diluted, net loss per share for the respective periods. Theunaudited pro forma basic and diluted net loss per share represent the weightedaverage common shares outstanding reduced by the weighted average unvestedcommon shares subject to repurchase, and gives the effect to the conversion ofthe convertible preferred stock into shares of common stock as if converted atthe date of original issuance. 

 
| ** **                                                                                        | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                        | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Historical:**                                                                                   |       |                             |       |   |   |   |   |
| Net loss                                                                                          |       | $                                | (19,714    | ) | $ | (17,453 | ) | $ | (14,821 | ) |
|                                                                                              |       |                             |       |   |   |   |   |
| Weighted average common shares                                                                    |       | 14,354,942                       |       | 1,975,074 |   | 1,890,369 |   |
| Weighted average unvested common shares subject to  repurchase                                    |       | (314,215                         | )          | (235,694 | ) | (346,101 | ) |
|                                                                                              |       |                             |       |   |   |   |   |
| Denominator for basic and diluted earnings per share                                              |       | 14,040,727                       |       | 1,739,380 |   | 1,544,268 |   |
|                                                                                              |       |                             |       |   |   |   |   |
| Basic and diluted net loss per share                                                              |       | $                                | (1.40      | ) | $ | (10.03 | ) | $ | (9.60 | ) |
|                                                                                              |       |                             |       |   |   |   |   |
| **Pro forma:**                                                                                    |       |                             |       |   |   |   |   |
| Net loss                                                                                          |       | $                                | (19,714    | ) | $ | (17,453 | ) | $ | (14,821 | ) |
|                                                                                              |       |                             |       |   |   |   |   |
| Pro forma basic and diluted net loss per share                                                    |       | $                                | (0.89      | ) | $ | (0.97 | ) | $ | (0.84 | ) |
|                                                                                              |       |                             |       |   |   |   |   |
| Shares used above                                                                                 |       | 14,040,727                       |       | 1,739,380 |   | 1,544,268 |   |
| Pro forma adjustment to reflect assumed weighted  average effect of conversion of preferred stock |       | 8,102,653                        |       | 16,205,306 |   | 16,205,306 |   |
|                                                                                              |       |                             |       |   |   |   |   |
| Pro forma shares used to compute basic and diluted  net loss per share                            |       | 22,143,380                       |       | 17,944,686 |   | 17,749,574 |   |

 

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| ** **                                                                                                  | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                  | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                                                        |       |                             |       |   |   |   |   |
| **Historical outstanding antidilutive securities  not included in diluted net loss per share calculation:** | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred stock*                                                                                            |       | 8,102,653                        |       | 16,205,306 |   | 16,205,306 |   |
| Common stock subject to repurchase                                                                          |       | 228,092                          |       | 211,862 |   | 297,123 |   |
| Options to purchase common stock                                                                            |       | 1,992,710                        |       | 1,404,598 |   | 631,678 |   |
| Warrants                                                                                                    |       | —                           |       | 10,199 |   | 10,199 |   |
|                                                                                                        |       |                             |       |   |   |   |   |
|                                                                                                        |       | 10,323,455                       |       | 17,831,965 |   | 17,144,306 |   |

 

----

* Represents the number of shares of common stock intowhich preferred stock was convertible.

 

***Segment Reporting***

 

TheCompany currently operates in a single operating segment.  The Company generates revenues fromcollaborations that result primarily from its underlying research anddevelopment activities.  In addition,financial results are prepared and reviewed by management as a single operatingsegment.  The Company periodicallyevaluates the benefits of operating in distinct segments and will reportaccordingly when such distinction is made.

 

***Effect of New Accounting Standards***

 

In March 2004, the EITF reached a final consensuson Issue 03-1, *The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments*.EITF Issue No. 03-1 requires that when the fair value of aninvestment security is less than its carrying value, an impairment exists forwhich the determination must be made as to whether the impairment isother-than-temporary. The EITF Issue No. 03-1 impairment modelapplies to all investment securities accounted for under SFAS No. 115, *Accounting for Certain Investments in Debt and Equity Securities*and to investment securities accounted for under the cost method to the extentan impairment indicator exists. Under the guidance, the determination ofwhether an impairment is other-than-temporary and therefore would result in arecognized loss depends on market conditions and management’s intent andability to hold the securities with unrealized losses. In September 2004,the Financial Accounting Standards Board (“FASB”) approved FASB Staff PositionEITF 03-1-1, which defers the effective date for recognition andmeasurement guidance contained in EITF Issue No. 03-1 until certainissues are resolved.  As of December 31,2004 these issues have not been resolved. The Company does not expect theadoption of EITF Issue No. 03-1 to have a material effect on itsresults of operations and financial condition.

 

In December 2004, the FASB issued SFAS No. 123R,*Share Based Payment.* This statement is arevision to SFAS No. 123 and supersedes APB Opinion No. 25,*Accounting for Stock Issued to Employees,* and amends SFAS No. 95,*Statement of Cash Flows.*This statementrequires a public entity to expense the cost of employee services received inexchange for an award of equity instruments. This statement also providesguidance on valuing and expensing these awards, as well as disclosurerequirements of these equity arrangements. This statement is effective for thefirst interim reporting period that begins after June 15, 2005.

 

SFAS No. 123R permits public companies to choosebetween the following two adoption methods:

 

1. A “modifiedprospective” method in which compensation cost is recognized beginning with theeffective date (a) based on the requirements of SFAS No. 123R for allshare-based payments granted after the effective date and (b) based on therequirements of

 

55

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SFAS No. 123for all awards granted to employees prior to the effective date of SFAS No. 123Rthat remain unvested on the effective date, or

 

2. A “modifiedretrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS No. 123 for purposes ofpro forma disclosures for either (a) all prior periods presented or (b) priorinterim periods of the year of adoption.

 

As permitted by SFAS No. 123, the Companycurrently accounts for share-based payments to employees using APB Opinion No. 25’sintrinsic value method. The impact of the adoption of SFAS No. 123R cannotbe predicted at this time because it will be depend on levels of share-basedpayments granted in the future. However, valuation of employee stock optionsunder SFAS No. 123R is similar to SFAS No. 123, with minorexceptions. The impact on the results of operations and earnings per share hadthe Company adopted SFAS No. 123, is described in stock based compensationsection of Note 1 above. Accordingly, the adoption of SFAS No. 123R’sfair value method will have a significant impact on the Company’s results ofoperations, although it will have no impact on the Company’s overall financialposition. SFAS No. 123R also requires the benefits of tax deductions inexcess of recognized compensation cost to be reported as a financing cash flow,rather than as an operating cash flow as required under current literature.This requirement will reduce net operating cash flows and increase netfinancing cash flows in periods after adoption. Due to timing of the release ofSFAS No. 123R, the Company has not yet completed the analysis of theultimate impact that this new pronouncement will have on the results ofoperations, nor the method of adoption for this new standard.

 

**2.Balance Sheet Details**

 

***Investments Available-for-Sale***

 

Thefollowing is a summary of investments available-for-sale securities at December 31,2004 (in thousands): 

 
| ** **              | ** ** | **Amortized Cost** | ** ** | **Unrealized Gain** | ** ** | **Unrealized Loss** | ** ** | **Estimated  Fair Value** | ** ** |
|-------------------------|------------|--------------------|------------|---------------------|------------|---------------------|------------|---------------------------|------------|
| Auction Rate Securities |       | $                  | 13,775     |                | $          | —              |       | $                         | —     |   | $ | 13,775 |   |
| Government Agency Bonds |       | 9,994              |       | —              |       | (7                  | )          | 9,987                     |       |
|                    |       |               |       |                |       |                |       |                      |       |
|                    |       | $                  | 23,769     |                | $          | —              |       | $                         | (7         | ) | $ | 23,762 |   |

 

Thefollowing is a summary of investments available-for-sale securities at December 31,2003 (in thousands): 

 
| ** **                        | ** ** | **Amortized Cost** | ** ** | **Unrealized Gain** | ** ** | **Unrealized Loss** | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------------|------------|--------------------|------------|---------------------|------------|---------------------|------------|---------------------------|------------|
| Government Agency Bonds           |       | $                  | 2,792      |                | $          | 1                   |       | $                         | —     |   | $ | 2,793 |   |
| United States Treasury Securities |       | 772                |       | —              |       | —              |       | 772                       |       |
|                              |       |               |       |                |       |                |       |                      |       |
|                              |       | $                  | 3,564      |                | $          | 1                   |       | $                         | —     |   | $ | 3,565 |   |

 

Grossrealized gains and losses on available-for-sale securities were immaterialduring the years ended December 31, 2004 and 2003. All of theavailable-for-sale securities have a contractual maturity at December 31,2004 of one year or less.

 

56

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***Property and Equipment***

 

Propertyand equipment consists of the following (in thousands): 

 
| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Scientific equipment                           |       | $                     | 5,648      |   | $ | 5,158 |   |
| Computer equipment                             |       | 1,974                 |       | 1,711 |   |
| Furniture and fixtures                         |       | 346                   |       | 223 |   |
| Leasehold improvements                         |       | 790                   |       | 587 |   |
|                                           |       |                  |       |   |   |
|                                           |       | 8,758                 |       | 7,679 |   |
| Less accumulated depreciation and amortization |       | (7,016                | )          | (5,554 | ) |
|                                           |       |                  |       |   |   |
|                                           |       | $                     | 1,742      |   | $ | 2,125 |   |

 

Depreciationand amortization expense was $1.5 million, $2.0 million, and$1.8 million for the years ended December 31, 2004, 2003 and 2002,respectively.

 

***Accounts Payable and Accrued Expenses***

 

Accountspayable and accrued expenses consist of the following (in thousands): 

 
| ** **                | ** ** | **December 31,** | ** ** |
|---------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Accounts payable          |       | $                     | 463        |   | $ | 372 |   |
| Accrued employee benefits |       | 1,648                 |       | 906 |   |
| Other accrued liabilities |       | 1,097                 |       | 401 |   |
|                      |       |                  |       |   |   |
|                      |       | $                     | 3,208      |   | $ | 1,679 |   |

 

**3.Product Discovery and Development Collaborations**

 

*Campbell Soup Company.*    In March 2001, theCompany entered into a collaboration agreement with Campbell Soup to work for athree-year collaborative period for the discovery and development of specifiedflavors and flavor enhancers. The agreement requires Campbell Soup to makeresearch funding payments over three years totaling $3.6 million. TheCompany is also eligible to receive milestone payments upon the achievement ofa specific product development goal and, in the event of commercialization,receive royalties on future net sales of collaborator products containing adiscovered ingredient.

 

Theagreement was amended in July 2002 to provide for an option to negotiatethe right to expand the field to include additional specified products. TheCompany received $1.8 million from Campbell Soup for the option, which wasrecorded as deferred revenue and recognized as revenue ratably over theremaining term of the agreement (20 months). The agreement was furtheramended in November 2002 to redefine earned royalties during the royaltyterm.

 

In July 2003,the Company received $650,000 in additional research support funding andexpense reimbursement. The payment was recorded as deferred revenue and isbeing recognized as revenue ratably over the remaining term of the agreement(eight months).

 

Theagreement was further amended in March 2004 to extend the collaborativeperiod until the earlier of March 2006 or when a flavor or flavor enhancerselected by Campbell’s receives Generally Recognized as Safe determination,subject to earlier termination under specified circumstances. Under the termsof the extension, the Company will provide additional research and receive additionalresearch funding totaling $3.0 million for two additional years.

 

57

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ThroughDecember 31, 2004, the Company has received $7.9 million in research anddevelopment funding. If all milestones are achieved, and including all researchand development funding paid or payable, the Company may be entitled topayments which total up to $10.1 million. There is no guarantee that theCompany will receive any milestone payments or royalties under this collaboration.

 

*The Coca-Cola Company.*    In April 2002, theCompany entered into a collaboration agreement with Coca-Cola for the discoveryand development of specified flavors and flavor enhancers. The agreementrequires Coca-Cola to make research funding payments over three years totaling$6.0 million. The Company is also eligible to receive milestone paymentsupon the achievement of specific product development goals and, in the event ofcommercialization, receive royalties on future sales of collaborator products containinga discovered ingredient.

 

Theagreement was amended in April 2004 to extend the collaborative perioduntil April 2008, subject to earlier termination under specifiedcircumstances. Under terms of the extension, the Company will provide additionalresearch and receive additional research funding totaling $6.0 million forthree additional years.

 

ThroughDecember 31, 2004, the Company has received $5.5 million in researchand development funding. If all milestones are achieved, and including all researchand development funding paid or payable, the Company may be entitled topayments which total up to $14.8 million. There is no guarantee that theCompany will receive any milestone payments or royalties under thiscollaboration.

 

*Kraft Foods Global, Inc.*    In December 2000, theCompany entered into a collaboration agreement with Kraft Foods for thediscovery and development of flavor enhancers. Under the terms of thecollaboration, Kraft Foods agreed to pay research funding of approximately$1.4 million per year for three years. In May 2002, the agreement wasamended to provide for an additional collaborative program. The level ofresearch support under the original program was reduced from $1.4 millionto $1.1 million per year for the remainder of the research term. TheCompany is eligible to receive milestone payments upon the achievement ofspecific product development goals and, in the event of commercialization,receive royalties on future net sales of collaborator products containing adiscovered ingredient.

 

KraftFoods agreed to make research funding payments related to the additionalprogram of $1.8 million over the period from May 2002 through December 2003and $1.8 million over the period from January 2004 through May 2005.The research effort approximates the funding levels. The Company is alsoeligible to receive milestone payments upon the achievement of specific productdevelopment goals and receive royalties on net sales of collaborator productscontaining a discovered ingredient related to this additional program. TheCompany earned a milestone in 2002 from the additional research program.

 

ThroughDecember 31, 2004, the Company has received $7.2 million in researchand development funding and one milestone payment of $375,000. If all milestonesare achieved, and including all research and development funding paid orpayable, the Company may be entitled to payments which total up to$8.6 million. There is no guarantee that the Company will receive anyfurther milestone payments or royalties under this collaboration.

 

*Nestlé.*    In April 2002, theCompany entered into a collaboration agreement with Nestlé for the discoveryand development of specified flavors and flavor enhancers. The agreementrequires Nestlé to make research funding payments over three years totaling$7.0 million. The Company is also eligible to receive milestone paymentsupon the achievement of specific product development goals and, in the event ofcommercialization, receive royalties on future net sales of collaborator productscontaining a discovered ingredient. The Company received payments for theachievement of three milestones in 2002, 2003, and 2004.

 

Through December 31,2004, the Company has received $7.0 million in research and developmentfunding and three milestone payments of $375,000 each. If all milestones areachieved, and including all research and development funding paid or payable,the Company may be entitled to payments which total up to $9.6 million.There is no guarantee that the Company will receive any further milestonepayments or royalties under this collaboration.

 

In October 2004, theCompany entered into a second product discovery and development collaborationagreement with Nestlé to work for a five-year collaborative period focusing onthe discovery and commercialization of specified novel flavor ingredients.  Under the terms of the agreement, Nestlé hasagreed to pay to the Company certain research and development funding totaling$11.7 million over five years, subject to earlier termination under specifiedcircumstances. The Company is also eligible to receive milestone payments uponachievement of specific product discovery and development goals, and in theevent of commercialization, is entitled to receive royalties on future netsales of products containing a discovered novel flavor ingredient.  There is no guarantee that the Company willreceive any milestone payments or royalties under this collaboration.

 

58

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Underthis second agreement, through December 31, 2004, the Company has received$450,000 in research and development funding. If all milestones are achieved,and including all research and development funding paid or payable, the Companymay be entitled to payments which total up to $13.1 million. There is noguarantee that the Company will receive any milestone payments or royaltiesunder this collaboration.

 

Inconnection with the above listed collaboration agreements, the Company hasrecognized revenue of $8.3 million, $9.5 million and$7.3 million for the years ended December 31, 2004, 2003 and 2002,respectively. As of December 31, 2004 and 2003, the Company has deferredrevenue of $1.9 million and $1.4 million, respectively.

 

**4.Technology Collaborations and License Agreements**

 

*Aurora Biosciences Corporation.*    In November 2000,the Company entered into a technology collaboration and license agreement withAurora to develop certain assay technologies, which was amended in April 2002.Under the collaboration, Aurora employed its proprietary technologies todevelop high-throughput screening assays for the Company. The agreementterminated in October 2002 and Invitrogen Corporation subsequentlyacquired certain surviving rights and obligations under this agreement. Underthe surviving terms of the agreement, the Company maintains exclusive rights touse certain proprietary screening technologies with its taste receptor targetsfor the discovery of flavors and flavor enhancers. These exclusive rights aresubject to rights granted under other current and future license agreements inconnection with the purchase of certain screening systems, as well asInvitrogen’s right to grant licenses under its proprietary technology toacademic, government and other non-profit organizations. The Company paid alicensing fee of $2.5 million that was capitalized and amortized toresearch and development expense over the estimated useful life of three years.As of December 31, 2003, the license was fully amortized. The Company madecash research funding payments to Aurora totaling $4.7 million fordevelopment services provided from November 2000 through October 2002and a $100,000 milestone payment following the delivery of specified assays forthe discovery of flavor and fragrance molecules. All of these amounts wereexpensed as incurred in each accounting period. In addition, in November 2000,Aurora purchased 1,000,000 shares of the Company’s Series CConvertible Preferred Stock for $4.8 million in cash. The Companyrecognized expense related to research funding and amortization of the licensefee of $0, $694,000 and $2.8 million for the years ended December 31,2004, 2003 and 2002.

 

*Incyte Genomics, Inc.*    In December 2000, theCompany entered into a three-year agreement with Incyte that provided the Companywith access to Incyte’s databases for the identification of receptors that playa role in taste and smell in order to accelerate the Company’s discovery offlavor and fragrance molecules. Under the terms of the agreement, the Companywas required to pay $6.5 million for the databases. Concurrent with thesigning of the agreement, Incyte agreed to purchase 869,328 shares of theCompany’s Series D Convertible Preferred Stock for $6.5 million.Since the amounts exchanged were equal, the Company accounted for thetransaction as a non-monetary exchange in 2000. The Company capitalized thecost of the database and amortized the cost to research and development expenseover the three-year term of the agreement. The value ascribed to the databasesof $6.5 million was based on the fair value of the preferred stock issued.The Company recorded amortization expense of $0, $2.2 million and $2.2million for the years ended December 31, 2004, 2003 and 2002,respectively.

 

The Company also hasother license agreements, of which the Company recognized expenses of $1.1million, $934,000 and $442,000 for the years ended December 31, 2004, 2003and 2002, respectively. The fees were charged to research and developmentexpense.

 

**5.Commitments**

 

***Leases and Loans***

 

TheCompany leases its primary office facility under an operating lease agreementthat expires on December 31, 2006, subject to a five-year extension optionby the Company. The lease provides for an annual minimum 3% rent increase.Gross rent expense for the years ended December 31, 2004, 2003 and 2002was $4.0 million, $3.9 million, and $2.9 million, respectively.The Company subleases part of the facility, and the sublease rental income forthe years ended December 31, 2004, 2003 and 2002 was $899,000,$1.4 million and $1.4 million, respectively. Sublease income isrecorded as an offset to the Company’s allocated facilities costs. The Companyhas also entered into various operating lease agreements for office equipment.

 

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At December 31,2004, estimated annual future minimum rental payments under the Company’soperating leases for the years ending December 31 are as follows (inthousands): 

 

| ** **                   | ** ** | **Operating  Leases** | ** ** |
|------------------------------|------------|-----------------------|------------|
| 2005                         |       | $                     | 4,054      |   |
| 2006                         |       | 4,166                 |       |
| 2007                         |       | 7                     |       |
| 2008                         |       | 1                     |       |
|                         |       |                  |       |
| Total minimum lease payments |       | $                     | 8,228      |   |

 

Futureminimum rentals to be received under non-cancelable subleases, which expirethrough 2006, total $676,000 and $735,000 for the years ended December 31,2005 and 2006, respectively.

 

In July 2001,the Company entered into a loan and security agreement with Silicon Valley Bankfor loan disbursements up to $3.0 million on capital equipment purchases.From 2001 through 2003, the Company received advances totaling$2.6 million on the Silicon Valley Bank loan for capital equipmentpurchases. The advances accrued interest at 7.0% to 9.0%. In July 2003,the Company paid off the remaining principal portion of the equipment loansfrom Silicon Valley Bank in the amount of $1.3 million. In connection withthe equipment loan, warrants to purchase up to 10,199 shares of commonstock at $2.45 per share were issued to Silicon Valley Bank. The estimated fairmarket value of the warrants of $16,000 was recorded as a discount on theequipment loan and was amortized to interest expense over the term of theequipment loan. The fair value was determined using the Black-Scholes option valuationmodel.  These warrants were exercised bySilicon Valley Bank in November 2004.

 

Inconnection with certain license and collaboration agreements, the Company’sannual future minimum obligation payments are as follows, $120,000, $63,000, $26,000$26,000 and $26,000 for the years ending December 31, 2005, 2006, 2007,2008 and 2009, respectively.

 

**6.Stockholders’ Equity**

 

***Reverse Stock Split***

 

On April 30,2004 the Company’s board of directors approved a 4-for-7 reversestock split of the outstanding common stock, which was effected on June 7,2004. On June 15, 2004 the Company’s board of directors approved a 1-for-1.4005989reverse stock split of the outstanding common stock, which was effected on June 16,2004.  The accompanying financialstatements give retroactive effect to the reverse stock splits.

 

***Initial Public Offering***

 

On June 25,2004, the Company completed an initial public offering, or IPO, of 6.0 millionshares of common stock for proceeds to the Company of $31.9 million, net ofunderwriting discounts, commissions and offering expenses.  On July 23, 2004 the Company closed thesale of an additional 450,000 shares of common stock pursuant to the exerciseby the underwriters of an over-allotment option which resulted in proceeds tothe Company of $2.4 million, net of underwriting discounts, commissions andoffering expenses.

 

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***Convertible Preferred Stock***

 

The Company’s certificateof incorporation, as amended and restated, authorizes the Company to issue upto 7,500,000 shares of Preferred Stock, with a par value of $0.001, in one ormore series. The Board of Directors may authorize the issuance of ConvertiblePreferred Stock with voting or conversion rights that could adversely affectthe voting power or other rights of the holders of the common stock. Theissuance of Convertible Preferred Stock, while providing flexibility in connectionwith possible acquisitions and other corporate purposes, could, among otherthings, have the effect of delaying, deferring or preventing a change incontrol of the Company and may adversely affect the market price of the commonstock and the voting and other rights of the holders of common stock.  As of December 31, 2004 and 2003convertible preferred stock authorized and outstanding is as follows: 

 
| ** **      | ** ** | **As of December 31,** | ** ** |
|-----------------|------------|-----------------------------|------------|
| ** **      | ** ** | **2004**                    | ** ** | **2003** | ** ** |
| ** **      | ** ** | **Shares  Authorized**      | ** ** | **Shares  Issued and  Outstanding** | ** ** | **Liquidation  Value** | ** ** | **Shares  Authorized** | ** ** | **Shares Issued  and  Outstanding** | ** ** | **Liquidation Value** | ** ** |
| ** **      | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Series A   |       | —                      |       | — |   | $ | — |   | 8,648,158 |   | 8,648,158 |   | $ | 8,648,158 |   |
| Series A-1 |       | —                      |       | — |   | — |   | 8,648,158 |   | — |   | 8,648,158 |   |
| Series B   |       | —                      |       | — |   | — |   | 2,605,326 |   | 2,605,326 |   | 2,605,326 |   |
| Series B-1 |       | —                      |       | — |   | — |   | 2,605,326 |   | — |   | 2,605,326 |   |
| Series C   |       | —                      |       | — |   | — |   | 1,000,000 |   | 1,000,000 |   | 1,000,000 |   |
| Series D   |       | —                      |       | — |   | — |   | 869,328 |   | 869,328 |   | 869,328 |   |
| Series E   |       | —                      |       | — |   | — |   | 12,703,015 |   | 12,703,014 |   | 12,703,015 |   |
| Undesignated    |       | 7,500,000                   |       | — |   | — |   | — |   | — |   | — |   |
|            |       |                        |       |   |   |   |   |   |   |   |   |   |   |
|            |       | 7,500,000                   |       | — |   | $ | — |   | 37,079,311 |   | 25,825,826 |   | $ | 37,079,311 |   |

 

Uponthe closing of the initial public offering in June 2004, 25,825,826 sharesof convertible preferred stock outstanding automatically converted into16,205,306 shares of common stock.

 

***Warrants***

 

In2001, in connection with equipment financing (see Note 5), the Companyissued to Silicon Valley Bank warrants to purchase 10,199 shares of commonstock at a price of $2.45 per share. The warrants expire five years from theclosing of the sale and issuance of the Company’s common stock in an initialpublic offering. The warrants were exercised in November 2004.  No warrants were outstanding as of December 31,2004.

 

***Equity Incentive Plan***

 

During1999, the Company adopted the 1999 Equity Incentive Plan (the “Plan”), whichprovides for the grant of incentive and non-statutory stock options andrestricted stock purchase rights to employees, directors and consultants of theCompany. The Plan, as amended, authorizes the Company to issue up to4,965,000 shares of common stock.  At December 31, 2004, the Company hasrepurchased a total of 131,153 shares and 1,680,446 shares remainavailable for grant under the Plan.

 

ThePlan allows the Company to grant restricted stock purchase rights at no lessthan 85% of the fair value of the Company’s common stock as determined by theBoard of Directors at the date of the grant. All restricted stock purchaserights vest in accordance with a vesting schedule determined by the Boardof Directors, typically over a four-year period.  Under the Plan, 457,069 restricted stockpurchase rights have been granted at exercise prices ranging from $0.35 to$0.94 per share, all of which have been exercised as of December 31, 2004,of which no shares are subject to repurchase.

 

Optionsgranted under the Plan generally expire no later than ten years from the dateof grant (five years for a 10% stockholder). Options generally vest and becomefully exercisable over a period of five years, except for officers, directorsand consultants that may be made fully exercisable. The exercise price ofincentive stock options must be equal to at least the fair value of the Company’s

 

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common stock on the date of grant, and theexercise price of non-statutory stock options may be no less than 85% of thefair value of the Company’s common stock on the date of grant. The exerciseprice of any option granted to a 10% stockholder may be no less than 110% ofthe fair value of the Company’s common stock on the date of grant.  The Company has an option to repurchase allunvested shares, at the original purchase price, upon the voluntary orinvoluntary termination of employment with, or consulting services provided to,the Company for any reason.

 

Thefollowing is a further breakdown of the options outstanding as of December 31,2004: 

 
| ** **                    | ** ** | ** **              | ** ** | **Options Outstanding**                             | ** ** | **Options Vested and Exercisable**     | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|
| **Range of Exercise  Prices** | ** ** | **Number  of  Options** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                          |       |                    |       |                                                |       |                                   |       |   |   |   |   |
| $                             | 0.34-0.34  |                    | 1,828      |                                                | 5.6        |                                   | $          | 0.34 |   | 1,828 |   | $ | 0.34 |   |
| $                             | 0.74-0.74  |                    | 568,115    |                                                | 8.5        |                                   | $          | 0.74 |   | 126,265 |   | $ | 0.74 |   |
| $                             | 0.74-6.00  |                    | 169,656    |                                                | 6.3        |                                   | $          | 2.12 |   | 150,513 |   | $ | 1.98 |   |
| $                             | 6.02-6.02  |                    | 1,025,674  |                                                | 8.6        |                                   | $          | 6.02 |   | 27,487 |   | $ | 6.02 |   |
| $                             | 6.30-9.50  |                    | 227,437    |                                                | 9.6        |                                   | $          | 8.50 |   | — |   | $ | — |   |
|                          |       |                    |       |                                                |       |                                   |       |   |   |   |   |
|                          |       | 1,992,710               |       | 8.5                                                 |       |                                   |       | 306,093 |   |   |   |

 

Thefollowing is a summary of stock option and stock award activity under theequity incentive plan through December 31, 2004: 

 
| ** **                            | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|---------------------------------------|------------|-----------------------|------------|--------------------------------------|------------|
|                                  |       |                  |       |                                 |       |
| Outstanding at January 1, 2002   |       | 633,237               |       | $                                    | 2.13       |   |
| Granted                               |       | 394,364               |       | $                                    | 0.74       |   |
| Exercised                             |       | (218,225              | )          | $                                    | 1.33       |   |
| Cancelled                             |       | (177,822              | )          | $                                    | 2.25       |   |
|                                  |       |                  |       |                                 |       |
| Outstanding at December 31, 2002 |       | 631,554               |       | $                                    | 1.50       |   |
| Granted                               |       | 888,702               |       | $                                    | 0.74       |   |
| Exercised                             |       | (29,273               | )          | $                                    | 0.78       |   |
| Cancelled                             |       | (86,509               | )          | $                                    | 1.50       |   |
|                                  |       |                  |       |                                 |       |
| Outstanding at December 31, 2003 |       | 1,404,474             |       | $                                    | 1.04       |   |
| Granted                               |       | 1,358,778             |       | $                                    | 6.28       |   |
| Exercised                             |       | (667,509              | )          | $                                    | 1.03       |   |
| Cancelled                             |       | (103,033              | )          | $                                    | 4.02       |   |
|                                  |       |                  |       |                                 |       |
| Outstanding at December 31, 2004 |       | 1,992,710             |       | $                                    | 4.46       |   |

 

Thefollowing shares of common stock are reserved for future issuance: 

 
| ** **                                              | ** ** | **December 31, 2004** | ** ** |
|---------------------------------------------------------|------------|----------------------------|------------|
| Common stock options granted and outstanding            |       | 1,992,710                  |       |
| Common stock options reserved for future grant          |       | 1,680,446                  |       |
|                                                    |       |                       |       |
| Total common stock shares reserved for future  issuance |       | 3,673,156                  |       |

 

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***Shareholders’ Rights Plan***

 

In February 2005,the Company entered into a Share Purchase Rights Plan (the “Plan”).  Terms of the Plan provide for a dividenddistribution of one preferred share purchase right (a “Right”) for each outstanding share ofcommon stock, par value $0.001 per share (the “Common Shares”), of the Company. The dividend is payable on February 21, 2005 to the stockholders of recordon that date.  Each Right entitles the registered holder to purchase fromthe Company one one-hundredth of a share of Series A Junior ParticipatingPreferred Stock, par value $0.001 per share (the “Preferred Shares”), at a price of$100.00 per one one-hundredth of a Preferred Share, subject toadjustment.  Each one one-hundredth of a share of Preferred Shares hasdesignations and powers, preferences and rights, and the qualifications,limitations and restrictions which make its value approximately equal to thevalue of a Common Share.  The description and terms of the Rights are setforth in a Rights Agreement, dated as of February 14, 2005 entered intobetween the Company and Mellon Investor Services LLC, as rights agent.

 

**7.Income Taxes**

 

Significantcomponents of the Company’s net deferred tax assets at December 31, 2004and 2003 are shown below (in thousands). A valuation allowance of $29.5 millionand $23.4 million has been established to offset the net deferred taxassets as of December 31, 2004 and 2003, respectively, as realization ofsuch assets is uncertain. 

 
| ** **                                  | ** ** | **Years ended  December 31,** | ** ** |
|---------------------------------------------|------------|------------------------------------|------------|
| ** **                                  | ** ** | **2004**                           | ** ** | **2003** | ** ** |
|                                        |       |                               |       |   |   |
| Deferred tax assets:                        |       |                               |       |   |   |
| Net operating loss carryforwards            |       | $                                  | 22,728     |   | $ | 18,230 |   |
| Capitalized research and development        |       | 2,847                              |       | 2,210 |   |
| Research and development credits            |       | 2,633                              |       | 1,995 |   |
| Deferred revenue                            |       | 757                                |       | 577 |   |
| Other, net                                  |       | 551                                |       | 339 |   |
|                                        |       |                               |       |   |   |
| Total deferred tax assets                   |       | 29,516                             |       | 23,351 |   |
|                                        |       |                               |       |   |   |
| Total deferred tax liabilities              |       | —                             |       | — |   |
|                                        |       |                               |       |   |   |
| Net deferred tax assets                     |       | 29,516                             |       | 23,351 |   |
| Valuation allowance for deferred tax assets |       | (29,516                            | )          | (23,351 | ) |
|                                        |       |                               |       |   |   |
| Net deferred tax assets                     |       | $                                  | —     |   | $ | — |   |

 

At December 31,2004, the Company had federal and California tax net operating losscarryforwards of approximately $62.7 million and $13.4 million,respectively. The federal and California tax loss carryforwards will begin toexpire in 2019 and 2009, respectively, unless previously utilized. The Companyalso had federal and California research and development tax creditcarryforwards of approximately $1.8 million and $1.3 million,respectively, which will begin to expire in 2019 unless previously utilized.

 

Pursuantto Internal Revenue Code Section 382 and 383, use of the Company’s netoperating loss and credit carryforwards may be limited if a cumulative changein ownership of more than 50% occurs within a three-year period.

 

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**8.Summary of Quarterly Financial Data (unaudited)**

 

Thefollowing is a summary of the unaudited quarterly results of operations for theyears ended December 31, 2004 and 2003 (in thousands, except per shareamounts).

 
| ** **                                  | ** ** | **Year Ended December 31 ,2004** | ** ** |
|---------------------------------------------|------------|---------------------------------------|------------|
| ** **                                  | ** ** | **First Quarter**                     | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
| **Selected Quarterly Financial Data:**      |       |                                  |       |   |   |   |   |   |   |
| Revenues                                    |       | $                                     | 2,241      |   | $ | 2,177 |   | $ | 1,802 |   | $ | 2,127 |   |
| Total operating expenses                    |       | 7,240                                 |       | 5,643 |   | 7,257 |   | 8,356 |   |
| Net loss                                    |       | (4,959                                | )          | (3,430 | ) | (5,304 | ) | (6,021 | ) |
| Basic and diluted net loss per common share |       | $                                     | (2.63      | ) | $ | (0.79 | ) | $ | (0.21 | ) | $ | (0.24 | ) |

 
| ** **                                  | ** ** | **Year Ended December 31 ,2003** | ** ** |
|---------------------------------------------|------------|---------------------------------------|------------|
| ** **                                  | ** ** | **First Quarter**                     | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
| **Selected Quarterly Financial Data:**      |       |                                  |       |   |   |   |   |   |   |
| Revenues                                    |       | $                                     | 2,203      |   | $ | 2,203 |   | $ | 2,365 |   | $ | 2,766 |   |
| Total operating expenses                    |       | 5,555                                 |       | 6,162 |   | 7,363 |   | 8,108 |   |
| Net loss                                    |       | (3,296                                | )          | (3,916 | ) | (4,950 | ) | (5,291 | ) |
| Basic and diluted net loss per common share |       | $                                     | (1.97      | ) | $ | (2.27 | ) | $ | (2.80 | ) | $ | (2.95 | ) |

 

**9.Subsequent Events (unaudited)**

 

In March 2005,the Company announced that the Company has been notified by the Flavor andExtract Manufacturers Association (“FEMA”) that its savory enhancers S807,S336, S263 and S976 have been determined to be Generally Recognized as Safe (“GRAS”)under the provisions of the Federal Food, Drug and Cosmetic Act, administeredby the United States Food and Drug Administration.  The FEMA GRAS determination will enableincorporation of the Company’s savory enhancers into a variety of food products.

 

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**Item9****.****    *Changes in and Disagreements with Accountants on Accounting andFinancial Disclosure***

 

Therewere no changes in or disagreements with Ernst & Young LLP on accountingand financial disclosure required to be reported under this Item 9.

 

**Item 9A****.****    *Controls and Procedures***

 

Priorto the filing of this annual report on Form 10-K, we carried out anevaluation, under the supervision and with the participation of our management,including our President and Chief Executive Officer and our Vice President andChief Financial and Business Officer, of the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a - 15(e) or 15d -15(e) ofthe Exchange Act) as of the end of the period covered by this annual report on Form 10-K.Disclosure controls and procedures are designed to ensure that informationrequired to be disclosed in our periodic reports filed or submitted under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and forms. Based upon thatevaluation, our President and Chief Executive Officer and our Vice Presidentand Chief Financial and Business Officer concluded that our disclosure controlsand procedures were effective as of the end of the period covered by thisannual report on Form 10-K.

 

Anevaluation was also performed under the supervision and with the participationof our management, including our President and Chief Executive Officer and ourVice President and Chief Financial and Business Officer, of any change in ourinternal control over financial reporting that occurred during our last fiscalquarter and that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting. That evaluation did notidentify any change in our internal control over financial reporting thatoccurred during our latest fiscal quarter and that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.

 

Ourmanagement, including our President and Chief Executive Officer and our VicePresident and Chief Financial and Business Officer, does not expect that itsdisclosure controls will prevent all errors or potential fraud. A controlsystem, no matter how well conceived and operated, can provide only reasonableand not absolute assurance that the objectives of the control system are met.Further, the design of a control system must reflect the fact that there areresource constraints, and the benefits of controls must be considered relativeto their cost. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within our company have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and that breakdowns can occur because of simple error ormistake. Additionally, controls can be circumvented by the individual acts ofsome persons or by collusion of two or more people. The design of any system ofcontrols also is based in part upon certain assumptions about the likelihood offuture events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions; over time,control may become inadequate because of changes in conditions, or the degreeof compliance with policies or procedures may deteriorate. Because of theinherent limitations in a cost-effective control system, misstatements due toerror or fraud may occur and not be detected.

 

**Item 9B.****    *Other Information***

 

None.

 

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**PART III**

 

Certaininformation required by Part III of this Form 10-K is omittedfrom this report because registrant will file a definitive Proxy Statementwithin 120 days after the end of its fiscal year pursuant to Regulation 14A forits 2005 Annual Meeting of Shareholders to be held on May 25, 2005 (the “ProxyStatement”), and the information included therein is incorporated herein byreference.

 

**Item 10****.****    *Directors and Executive Officers of the Registrant***

 

Theinformation with respect to executive officers required by this item is set forthin Part I of this report.

 

Wehave adopted a Code of Business Conduct and Ethics Policy that applies to ourdirectors and employees (including our principal executive officer, principalfinancial officer, principal accounting officer and controller), and haveposted the text of the policy on our website (www.senomyx.com) in connectionwith “Investor Relations” materials. In addition, we intend to promptlydisclose (i) the nature of any amendment to the policy that applies to ourprincipal executive officer, principal financial officer, principal accountingofficer or controller, or persons performing similar functions and (ii) thenature of any waiver, including an implicit waiver, from a provision of thepolicy that is granted to one of these specified individuals, the name of suchperson who is granted the waiver and the date of the waiver on our website inthe future.

 

Theother information required by this item is incorporated by reference to theproxy statement to be filed with the SEC pursuant to Regulation 14A inconnection with our 2005 annual meeting.

 

**Item 11****.****    *Executive Compensation***

 

Theinformation required by this Item is incorporated herein by reference to theinformation from the Proxy Statement under the section entitled “ExecutiveCompensation.”

 

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

 

Theinformation required by this Item is incorporated herein by reference to theinformation from the Proxy Statement under the sections entitled “SecurityOwnership of Certain Beneficial Owners and Management” and “SecuritiesAuthorized for Issuance under Equity Compensation Plans.”

 

**Item 13****.****    *Certain Relationships and Related Transactions***

 

Theinformation required by this Item is incorporated herein by reference to theinformation from the Proxy Statement under the section entitled “CertainRelationships and Related Transactions.”

 

**Item 14****.****    *Principle Accountant Fees and Services***

 

Theinformation required by this Item is incorporated by herein by reference to theinformation from the Proxy Statement under the section entitled “PrincipalAccountant Fees and Services.”

 

66

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**PART IV**

 

**Item 15****.****    *Exhibits, Financial Statement Schedules***

 

**(a)**           1. ***Financial Statements***

 

SeeIndex to Financial Statements in Item 8 of this Annual Report on Form 10-K,which is incorporated herein by reference.

 

2. ***Financial Statement Schedules***

 

Allschedules have been omitted because they are not applicable or required, or theinformation required to be set forth therein is included in the FinancialStatements or notes thereto included in Item 8 (“Financial Statements andSupplementary Data”).

 

3.***Exhibits***

 

** **
| **Exhibit  Footnote** | ** ** | **Exhibit Number** | ** ** | **Description of Document**                                                                                                                                                                                                                                                             | ** ** |
|-----------------------|------------|--------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| (1)                   |       | 3.1                |       | Amended and Restated  Certificate of Incorporation as currently in effect.                                                                                                                                                                                                              |       |
| (1)                   |       | 3.2                |       | Amended and Restated  Bylaws as currently in effect.                                                                                                                                                                                                                                    |       |
| (1)                   |       | 4.1                |       | Form of Common  Stock Certificate.                                                                                                                                                                                                                                                 |       |
| (1)                   |       | 4.2                |       | Warrant dated  July 17, 2001, as amended November 14, 2001, issued to Silicon  Valley Bank.                                                                                                                                                                                   |       |
| (1)                   |       | 4.3                |       | Fourth Amended and  Restated Investor Rights Agreement dated November 14, 2001, as amended  February 27, 2002, between the Registrant and certain of its  stockholders.                                                                                                       |       |
| (1)                   |       | 10.1+              |       | Form of Indemnity  Agreement.                                                                                                                                                                                                                                                      |       |
| (1)                   |       | 10.2+              |       | Amended and Restated  2004 Equity Incentive Plan and Form of Stock Option Agreement  thereunder.                                                                                                                                                                                   |       |
| (1)                   |       | 10.3+              |       | 2004 Non-Employee  Directors’ Stock Option Plan and Form of Stock Option Agreement  thereunder.                                                                                                                                                                               |       |
| (1)                   |       | 10.4+              |       | 2004 Employee Stock  Purchase Plan and Form of Offering Document thereunder.                                                                                                                                                                                                       |       |
| (1)                   |       | 10.5+              |       | Employment letter  agreement dated February 21, 2000 between the Registrant and Mark  Zoller, Ph.D.                                                                                                                                                                                |       |
| (1)                   |       | 10.6+              |       | Employment letter  agreement dated June 7, 2000 between the Registrant and Klaus  Gubernator, Ph.D.                                                                                                                                                                                |       |
| (1)                   |       | 10.7+              |       | Employment letter  agreement dated June 2, 2003 between the Registrant and Kent Snyder.                                                                                                                                                                                            |       |
| (1)                   |       | 10.8+              |       | Employment letter  agreement dated August 25, 2003 between the Registrant and Harry  Leonhardt, Esq.                                                                                                                                                                          |       |
| (1)                   |       | 10.9+              |       | Employment letter  agreement dated September 8, 2003 between the Registrant and John  Poyhonen.                                                                                                                                                                                    |       |
| (1)                   |       | 10.10              |       | Expansion Lease dated  November 20, 1995 between Health Science Properties, Inc. and  Sequana Therapeutics, Inc., as amended, and Assignment and Assumption of  Lease, dated July 12, 2000, as amended, between the Registrant and Axys  Pharmaceuticals, Inc. |       |
| (1)                   |       | 10.11*             |       | Exclusive License and  Bailment Agreement dated March 10, 2000 between the Registrant and the  Regents of the University of California.                                                                                                                                            |       |
| (1)                   |       | 10.12*             |       | Collaborative Research  and License Agreement dated November 1, 2000, as amended April 16,  2002, between the Registrant and Aurora Biosciences Corporation.                                                                                                                  |       |
| (1)                   |       | 10.13*             |       | Collaborative Research  and License Agreement dated December 6, 2000, as amended May 2,  2002, between the Registrant and Kraft Foods, Inc.                                                                                                                              |       |
| (1)                   |       | 10.14*             |       | Collaborative Research  and License Agreement dated March 28, 2001, as amended July 26,  2002, November 5, 2002 and February 19, 2004 between the Registrant  and Campbell Soup Company.                                                                            |       |
| (1)                   |       | 10.15*             |       | Collaborative Research  and License Agreement dated April 18, 2002, as amended October 23,  2003, between the Registrant and Nestec, Ltd.                                                                                                                                     |       |
| (1)                   |       | 10.16*             |       | Collaborative Research,  Development, Commercialization and License Agreement dated April 22,  2002 between the Registrant and the Coca-Cola Company.                                                                                                                              |       |
| (1)                   |       | 10.17+             |       | 1999 Equity Incentive  Plan and Form of Stock Option Agreement thereunder.                                                                                                                                                                                                         |       |
| (2)                   |       | 10.18*             |       | Collaborative Research  and License Agreement, dated October 26, 2004, between The Registrant  and Nestec Ltd.                                                                                                                                                                     |       |
|                  |       | 23.1               |       | Consent of Independent  Registered Public Accounting Firm.                                                                                                                                                                                                                              |       |
|                  |       | 24.1               |       | Power of Attorney.  Reference is made to the signature page.                                                                                                                                                                                                                            |       |
|                  |       | 31.1               |       | Certification of Kent  Snyder, Chief Executive Officer, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                |       |
|                  |       | 31.2               |       | Certification of John  Poyhonen, Chief Financial and Business Officer, pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                 |       |
|                  |       | 32.1               |       | Certification of Kent  Snyder, Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as  adopted                                                                                                                                                                            |       |

 

67

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|   |   |   |   | pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                             |   |
|--------|--------|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |   | 32.2   |   | Certification of John  Poyhonen, Chief Financial and Business Officer, pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |   |

 

----

**+             **Indicatesmanagement contract or compensatory plan.

 

*              Confidential treatment has beenrequested with respect to certain portions of this exhibit. Omitted portionshave been filed separately with the Securities and Exchange Commission.

 

(1)           Filed as an exhibit to RegistrationStatement File No. 333-113998 and incorporated herein by reference.

 

(2)           Filed as an exhibit to our QuarterlyReport of Form 10-Q for the quarter ended September 30, 2004and incorporated herein by reference.

 

**(b) Exhibits**

 

SeeItem 15(a) above.

 

**(c) Financial StatementSchedules**

 

SeeItem 15(a) above.

 

68

----

 

**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this Report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|                   | Senomyx, Inc. |
|------------------------|--------------------|
|                   | By:                | /S/ KENT SNYDER |
|                   |               | Kent Snyder |
|                   |               | President and  Chief Executive Officer |
|                   |               |   |
|                   |               |   |
| Dated: March 10,  2005 |               |   |
|                   |               |   |

 

**POWEROF ATTORNEY**

 

KNOWALL PERSONS BY THESE PRESENTS, that each person whose signature appears belowconstitutes and appoints Kent Snyder, Mark Leschly and John Poyhonen, and eachof them, as his or her true and lawful attorneys-in-fact and agents, with fullpower of substitution and resubstitution, for him or her and in his or hername, place, and stead, in any and all capacities, to sign any and allamendments to this Report, and to file the same, with all exhibits thereto, andother documents in connection therewith, with the Securities and ExchangeCommission, granting unto said attorneys-in-fact and agents, and each of them,full power and authority to do and perform each and every act and thingrequisite and necessary to be done in connection therewith, as fully to allintents and purposes as he or she might or could do in person, hereby ratifyingand confirming that all said attorneys-in-fact and agents, or any of them ortheir or his substitute or substituted, may lawfully do or cause to be done byvirtue hereof.

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this Report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.

 

 
| **Signature**           | ** ** | **Title**                                         | ** ** | **Date**       | ** ** |
|-------------------------|------------|---------------------------------------------------|------------|----------------|------------|
|                    |       |                                              |       |           |       |
| /S/ KENT SNYDER         |       | President , Chief  Executive Officer and Director |       | March 10, 2005 |       |
| Kent Snyder             |       |                                              |       |           |       |
|                    |       |                                              |       |           |       |
| /S/ MARK LESCHLY        |       | Chairman of the Board  of Directors               |       | March 10, 2005 |       |
| Mark Leschly            |       |                                              |       |           |       |
|                    |       | Vice President and  Chief Financial and Business  |       | March 9, 2005  |       |
| /S/ JOHN POYHONEN       |       | Officer                                           |       |           |       |
| John Poyhonen           |       |                                              |       |           |       |
|                    |       |                                              |       |           |       |
| /S/ LORI ROBSON         |       | Director                                          |       | March 9, 2005  |       |
| Lori Robson, Ph.D. |       |                                              |       |           |       |
|                    |       |                                              |       |           |       |
| /S/ DAVID SCHNELL       |       | Director                                          |       | March 9, 2005  |       |
| David Schnell, M.D.     |       |                                              |       |           |       |
|                    |       |                                              |       |           |       |
| /S/ JAY SHORT           |       | Director                                          |       | March 10, 2005 |       |
| Jay Short, Ph.D.   |       |                                              |       |           |       |
|                    |       |                                              |       |           |       |
| /S/ TIMOTHY WOLLAEGER   |       | Director                                          |       | March 9, 2005  |       |
| Timothy Wollaeger       |       |                                              |       |           |       |

 

69

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**EXHIBITINDEX**

 
| **Exhibit  Footnote** | ** ** | **Exhibit  Number** | ** ** | **Description of Document**                                                                                                                                                                                                                                                             |   |
|-----------------------|------------|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| (1)                   |       | 3.1                 |       | Amended and Restated  Certificate of Incorporation as currently in effect.                                                                                                                                                                                                              |   |
| (1)                   |       | 3.2                 |       | Amended and Restated  Bylaws as currently in effect.                                                                                                                                                                                                                                    |   |
| (1)                   |       | 4.1                 |       | Form of Common  Stock Certificate.                                                                                                                                                                                                                                                 |   |
| (1)                   |       | 4.2                 |       | Warrant dated  July 17, 2001, as amended November 14, 2001, issued to Silicon  Valley Bank.                                                                                                                                                                                   |   |
| (1)                   |       | 4.3                 |       | Fourth Amended and  Restated Investor Rights Agreement dated November 14, 2001, as amended  February 27, 2002, between the Registrant and certain of its  stockholders.                                                                                                       |   |
| (1)                   |       | 10.1+               |       | Form of Indemnity  Agreement.                                                                                                                                                                                                                                                      |   |
| (1)                   |       | 10.2+               |       | Amended and Restated  2004 Equity Incentive Plan and Form of Stock Option Agreement  thereunder.                                                                                                                                                                                   |   |
| (1)                   |       | 10.3+               |       | 2004 Non-Employee  Directors’ Stock Option Plan and Form of Stock Option Agreement  thereunder.                                                                                                                                                                               |   |
| (1)                   |       | 10.4+               |       | 2004 Employee Stock  Purchase Plan and Form of Offering Document thereunder.                                                                                                                                                                                                       |   |
| (1)                   |       | 10.5+               |       | Employment letter  agreement dated February 21, 2000 between the Registrant and Mark  Zoller, Ph.D.                                                                                                                                                                                |   |
| (1)                   |       | 10.6+               |       | Employment letter  agreement dated June 7, 2000 between the Registrant and Klaus  Gubernator, Ph.D.                                                                                                                                                                                |   |
| (1)                   |       | 10.7+               |       | Employment letter  agreement dated June 2, 2003 between the Registrant and Kent Snyder.                                                                                                                                                                                            |   |
| (1)                   |       | 10.8+               |       | Employment letter  agreement dated August 25, 2003 between the Registrant and Harry  Leonhardt, Esq.                                                                                                                                                                          |   |
| (1)                   |       | 10.9+               |       | Employment letter  agreement dated September 8, 2003 between the Registrant and John  Poyhonen.                                                                                                                                                                                    |   |
| (1)                   |       | 10.10               |       | Expansion Lease dated  November 20, 1995 between Health Science Properties, Inc. and  Sequana Therapeutics, Inc., as amended, and Assignment and Assumption of  Lease, dated July 12, 2000, as amended, between the Registrant and Axys  Pharmaceuticals, Inc. |   |
| (1)                   |       | 10.11*              |       | Exclusive License and  Bailment Agreement dated March 10, 2000 between the Registrant and the  Regents of the University of California.                                                                                                                                            |   |
| (1)                   |       | 10.12*              |       | Collaborative Research  and License Agreement dated November 1, 2000, as amended April 16,  2002, between the Registrant and Aurora Biosciences Corporation.                                                                                                                  |   |
| (1)                   |       | 10.13*              |       | Collaborative Research  and License Agreement dated December 6, 2000, as amended May 2,  2002, between the Registrant and Kraft Foods, Inc.                                                                                                                              |   |
| (1)                   |       | 10.14*              |       | Collaborative Research  and License Agreement dated March 28, 2001, as amended July 26,  2002, November 5, 2002 and February 19, 2004 between the Registrant  and Campbell Soup Company.                                                                            |   |
| (1)                   |       | 10.15*              |       | Collaborative Research  and License Agreement dated April 18, 2002, as amended October 23,  2003, between the Registrant and Nestec, Ltd.                                                                                                                                     |   |
| (1)                   |       | 10.16*              |       | Collaborative Research,  Development, Commercialization and License Agreement dated April 22,  2002 between the Registrant and the Coca-Cola Company.                                                                                                                              |   |
| (1)                   |       | 10.17+              |       | 1999 Equity Incentive  Plan and Form of Stock Option Agreement thereunder.                                                                                                                                                                                                         |   |
| (2)                   |       | 10.18*              |       | Collaborative Research  and License Agreement, dated October 26, 2004, between The Registrant  and Nestec Ltd.                                                                                                                                                                     |   |
|                  |       | 23.1                |       | Consent of Independent  Registered Public Accounting Firm.                                                                                                                                                                                                                              |   |
|                  |       | 24.1                |       | Power of Attorney.  Reference is made to the signature page.                                                                                                                                                                                                                            |   |
|                  |       | 31.1                |       | Certification of Kent  Snyder, Chief Executive Officer, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                |   |
|                  |       | 31.2                |       | Certification of John  Poyhonen, Chief Financial and Business Officer, pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                 |   |
|                  |       | 32.1                |       | Certification of Kent  Snyder, Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                            |   |
|                  |       | 32.2                |       | Certification of John  Poyhonen, Chief Financial and Business Officer, pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                            |   |

 

----

**+             **Indicatesmanagement contract or compensatory plan.

 

*              Confidential treatment has beenrequested with respect to certain portions of this exhibit. Omitted portionshave been filed separately with the Securities and Exchange Commission.

 

(1)           Filed as an exhibit to RegistrationStatement File No. 333-113998 and incorporated herein by reference.

 

----

 

(2)           Filed as an exhibit to our QuarterlyReport of Form 10-Q for the quarter ended September 30, 2004and incorporated herein by reference.

 

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