**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-K**

 

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

 

**For the fiscal year ended December 31,2005**

 

**or**

 

**o****    ****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES 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 mark if the registrant is a well-knownseasoned issuer, as defined in Rule 405 of the Securities Act. Yes o          No ý

 

Indicate by check if the registrant is not required tofile reports pursuant to Section 13 or Section 15(d) of the Act.

Yes ý          No o

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports) and (2) hasbeen subject to such filing requirements for the past 90 days. Yes  ý  No  o

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act.Large accelerated filer o          Acceleratedfiler ý          Non-acceleratedfiler o

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act). Yes  o  No  ý

 

As of June 30, 2005, the aggregate market valueof the voting stock held by non-affiliates of the registrant, computed byreference to the last sale price of such stock as of such date on the NASDAQNational Market, was approximately $235,467,000. Excludes an aggregate of 11,208,467shares of common stock held by officers and directors and by each person knownby the registrant to own 5% or more of the outstanding common stock as of June 30,2005. Exclusion of shares held by any of these persons should not be construedto indicate that such person possesses the power, direct or indirect, to director cause the direction of the management or policies of the registrant, or thatsuch person is controlled by or under common control with the registrant.

 

As of February 28, 2006, there were 29,803,263 sharesof the registrant’s Common Stock outstanding.

 

 

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**DOCUMENTSINCORPORATED BY REFERENCE:**

** **

Portionsof the registrant’s definitive Proxy Statement for the 2006 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, 2005**

 

**TABLE OFCONTENTS**

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

 

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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 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 except as required by law.*

 

**PART I**

** **

**Item1.    *Business***

 

**Overview**

 

We area leading company focused on 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 while maintaining orenhancing taste and may generate cost of goods savings. We license our flavoringredients to our collaborators on an exclusive or co-exclusive basis, whichwe believe we will provide these companies with the ability to differentiatetheir products. We have entered into product discovery and developmentcollaborations with five of the world’s leading packaged food and beveragecompanies: Cadbury Schweppes, Campbell Soup Company, The Coca-Cola Company,Kraft Foods Global, Inc. and Nestlé SA. We currently anticipate that wewill derive all of our revenues from existing and future collaborations. Dependingupon the collaboration, our existing collaboration agreements provide for upfrontfees, research and development funding, reimbursement of certain regulatorycosts, milestone payments based upon our achievement of research or developmentgoals and, in the event of commercialization, royalties on future sales of consumerproducts incorporating our flavors, flavor enhancers or taste modulators. Ourcurrent programs focus on the development of savory, sweet and salt flavorenhancers and bitter taste modulators.

 

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 monosodium glutamate, or MSG. The goals of our sweetprogram are to enhance the taste of natural and artificial sweeteners andenable a significant reduction in added sweeteners. The goals of our saltprogram are to enhance the taste of salt and enable a significant reduction inadded salt. The goals of our bitter taste modulation program are to reduce orblock bitter taste and improve the overall taste characteristics of packagedfoods, beverages, over the counter (or OTC) health care products andpharmaceutical products.

 

Ourinternet address is www.senomyx.com. We post links on our website to thefollowing filings as soon as reasonably practicable after they areelectronically filed with or furnished to the Securities and

 

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Exchange Commission (“SEC”): annual reports on Form10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and anyamendment to those reports filed or furnished pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934. All such filings are availablethrough our website free of charge. Our filings may also be read and copied atthe SEC’s Public Reference Room at 100 F Street, NE Washington, DC 20549.Information on the operation of the Public Reference Room may be obtained bycalling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet websitethat contains reports, proxy and information statements, and other informationregarding issuers that file electronically with the SEC. The address of thatsite is www.sec.gov.

 

**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 2004 were approximately $1.3 trillion, of which $270billion was generated in the United States. These figures represent growthrates of approximately 4% and 3%, respectively, over 2003 amounts. Based onthese estimates, of the worldwide total, sales of packaged foods wereapproximately $1.1 trillion and sales of non-alcoholic beverages wereapproximately $304 billion. Based on recent data from Euromonitor, InformationResources, Inc. and our collaborators’ 2004 annual reports, we estimatethat our collaborators’ combined worldwide sales in 2004 of their products thatfall within their exclusive product fields were over $45 billion. Ourcollaboration agreements provide that we will receive royalties of up to 4% onour collaborators’ sales of products containing our flavors, flavor enhancersor taste modulators. However, we do not anticipate that our collaborators willincorporate our flavors, flavor enhancers and taste modulators into all oftheir 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 fourprimary taste areas on which we are focused and, for each taste area, providesexamples of product categories that could incorporate ingredients in thosetaste areas, estimated worldwide sales and our estimates of the worldwide salesfor food and beverage products of our existing collaborators in their exclusiveor co-exclusive product fields.

 
| **Taste Areas** | ** ** | **Example Product Categories**                                                                                                                                                         | ** ** | **2004 Estimated  Worldwide Sales(1)** | ** **  | **2004 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           |       | $                                      | 365 billion |                                                                                      | $          | 6.8 billion |   |
|            |       |                                                                                                                                                                                   |       |                                   |        |                                                                                      |       |
| Sweet           |       | Confectionaries, cereal, ice cream, beverages,  yogurt, dessert, spreads and bakery products                                                                                           |       | $                                      | 483 billion |                                                                                      | $          | 20.9 billion |   |
|            |       |                                                                                                                                                                                   |       |                                   |        |                                                                                      |       |
| Salt            |       | Product categories are the same as those set forth  for savory taste area plus canned foods and bakery products                                                                        |       | $                                      | 402 billion |                                                                                      | $          | 12.0 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 |       | $                                      | 464 billion |                                                                                      | $          | 5.8 billion |   |
|                 |            |                                                                                                                                                                                        |            |                                        |             |                                                                                           |            |  |  |  |  |

 

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(1)          According to recent Euromonitor data forpackaged food and beverages, excluding pharmaceutical and OTC health careapplications.

 

(2)          Based on recent data from Euromonitor,Information Resources, Inc. and our collaborators’ 2004 annual reports.

 

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***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.

 

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 Generally Recognized as Safe, or GRAS, substances under theprovisions of the Federal Food, Drug and Cosmetic Act, or FD&C Act. GRASdeterminations for most new flavors, flavor enhancers and taste modulators aremade by an independent panel of scientists administered by the Flavor andExtract Manufacturers Association, or FEMA. Four compounds developed as part ofour savory program have received FEMA GRAS determination.  The processfrom selection for development until receipt of that determination tookapproximately 12 months.  Costs associated with the FEMA GRAS process,including synthesis of material for regulatory studies, contract safety studiesand preparation of the application, were less than $1 million. We expect thatfuture flavors, flavor enhancers and taste modulators we develop will take asimilar amount of time and cost a similar amount. However, the length of timemay vary depending on the properties of the flavor, flavor enhancer or tastemodulator. Once a flavor or flavor enhancer is determined to be FEMA GRAS, itmay be immediately incorporated into products for test marketing andcommercialization in the United States and in 20 other countries.

 

***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 2004 worldwide sales of soft drinks were approximately $260 billion.Thus, an increase of a tenth of a percentage point in overall worldwide marketshare would result in additional revenue of approximately $260 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

 

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or perceived improvements in flavor or healthprofiles. Flavors, flavor enhancers and taste modulators can potentiallyprovide an important way to differentiate a particular product through enhancedtaste, improvements in nutritional profile or labeling, flavor ingredientexclusivity and cost of goods savings.

 

•                     *Taste.*Product taste is a critical competitive factor forpackaged food and beverage companies. These companies seek to use flavors, flavorenhancers and taste modulators to improve or maintain taste while improving thenutritional profile of packaged food and beverage products or reducingingredient costs.

 

•                  *Health Benefits.*Packaged food andbeverage companies are exploring ways to improve overall nutritional quality oftheir products. It is widely accepted that poor diet contributes to adversehealth conditions such as cardiovascular disease, diabetes and obesity. Toaddress these concerns, many companies have introduced reduced calorie, reducedsodium and reduced fat content products to the market. Flavors, flavorenhancers and taste modulators with specific desired characteristics provide aninnovative way to reduce the levels of ingredients that may contribute to theseconcerns without compromising desirable taste attributes.

 

•                  *Flavor Ingredient Exclusivity.*Failure ofpackaged food and beverage companies to differentiate their brands from theircompetition, including private label products, may result in significant lossof market share, price pressure and erosion of profit margins. Packaged foodand beverage companies spend millions of dollars creating brands and brandimages to compete with other products. Many of these competitive productscontain the same or similar flavor ingredients. The limited availability ofproprietary flavors, flavor enhancers and taste modulators makes it difficultfor manufacturers to differentiate their products based on flavor ingredients.

 

•                  *Cost of Goods Savings.*The packaged foodand beverage industry purchases enormous volumes of raw materials to producetheir products. According to the Food and Agriculture Division of the UnitedNations, estimated worldwide sugar production in 2004 was approximately 141.1million metric tons, and consumption was over 143.1 million metric tons. Givensuch high demand for sugar, spot prices for processed sugar rose over 50% fromFebruary 2005 to February 2006 such that the market value of processed sugar producedworldwide during that period exceeded $100 billion, based on US spot prices inFebruary 2006. Similarly, according to the 2003 Chemical Economics Handbook,worldwide consumption of MSG was nearly 1.6 million metric tons in 2002 at acost of $1.4 billion. Flavors, flavor enhancers and taste modulators canpotentially facilitate a reduction in the volume of these ingredients used inpackaged food and beverage products, which could result in significantdecreases 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 desired characteristicscan be discovered and then optimized into novel flavors, flavor enhancers ortaste 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 aredeveloping flavors, flavor enhancers and taste modulators to enable ourcollaborators to improve or maintain taste while improving the nutritionalprofile of packaged food and beverage products or reducing ingredient costs.

 

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•                  *Reducing Sugar, Salt and MSG in Packaged Food andBeverage Products.*We are developing flavors, flavor enhancers andtaste modulators to enable our collaborators to significantly reduce the levelsof sugar, salt and MSG in packaged food and beverage products while maintainingor improving taste. We believe reducing the levels of such ingredients willimprove the nutritional profile of packaged food and beverage products.

 

•                  *Blocking Undesirable Tastes.*We are discoveringtaste modulators that we believe will be useful in blocking bitter and otherunwanted tastes associated with certain packaged food, beverage, OTC healthcare products and pharmaceutical products.

 

•                  *Obtaining Exclusive or Co-Exclusive Use ofProprietary Flavors, Flavor Enhancers and Taste Modulators.*We areable to offer our collaborators exclusive or co-exclusive use of ourproprietary flavors, flavor enhancers and taste modulators in defined packagedfood and beverage product categories. We believe this approach will assist ourcollaborators in differentiating their products from those of theircompetitors.

 

•                  *Reducing Cost of Goods.*We believe ourproprietary flavors, flavor enhancers and taste modulators will enable ourcollaborators to reduce overall raw material ingredient costs, particularly forthose products containing high levels of natural and artificial sweeteners andMSG.

 

**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 are collaborating with leading packaged food andbeverage companies to develop and commercialize our product candidates. Ourcollaborators are responsible for marketing, selling and distributing theirproducts incorporating our flavors, flavor enhancers and taste modulators thatare incorporated into their products. In addition, our collaborators areresponsible for all manufacturing costs of our flavors, flavor enhancers ortaste modulators. As a result, we expect to commercialize our flavors, flavorenhancers and taste modulators without incurring significant sales, marketing,manufacturing and distribution costs. We currently have collaborations with CadburySchweppes, Campbell Soup, Coca-Cola, Kraft Foods and Nestlé.

 

•                  *Developing Flavors, Flavor Enhancers and Taste Modulatorsthat are Eligible for FEMA GRAS Determination.*Our primary focus is onthe development of flavors, flavor enhancers and taste modulators that willqualify for a FEMA GRAS determination. Four compounds developed as part of oursavory program have received FEMA GRAS determination.  The process fromselection for development until receipt of that determination tookapproximately 12 months.  Costs associated with the FEMA GRAS process,including synthesis of material for regulatory studies, contract safety studiesand preparation of the application, were less than $1 million. We expect thatfuture flavors, flavor enhancers and taste modulators we develop will take asimilar amount of time and cost a similar amount. However, the length of timemay vary depending on the properties of the flavor, flavor enhancer or tastemodulator. Upon the GRAS determination, our collaborators can begin to testmarket and commercialize products incorporating our flavors, flavor enhancersor taste modulators. In the event that a particular flavor enhancer or tastemodulator is not eligible for FEMA GRAS determination, we may dedicate ourdevelopment efforts to alternative compounds.

 

•                  *Pursuing Additional Collaborations and Market Opportunities.*We seek to establish additional collaborations with leading packagedfood and beverage companies to use flavors, flavor enhancers or tastemodulators developed through our existing programs for exclusive orco-exclusive use within new packaged food and beverage product fields. Weintend to receive from

 

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futurecollaborators up-front fees, research and development funding, milestonepayments and royalties on future sales of products incorporating these flavors,flavor enhancers or taste modulators. In addition, we plan to target fields inwhich our collaborators can incorporate more than one of our flavors, flavorenhancers or taste modulators into a particular product.

 

•                  *Expanding Our Product Candidate Pipeline.*Wewill continue to focus on the discovery and development of additional flavoringredients based on additional taste receptors to address new taste areas. Webelieve potential new taste receptors include the fat taste and cold tastereceptors. We also intend to improve the beneficial characteristics of ourcurrent product candidates through the development of next-generation flavors,flavor enhancers and taste modulators. We will also continue to considerapplications of our current products and technologies outside of the packagedfood and beverage industry.

 

•                  *Maintaining and Expanding Our Technology Position.*Webelieve our proprietary taste receptor-based technologies, including ourreceptor discovery, assay development and high-throughput screeningtechnologies and natural and synthetic compound libraries, provide us and ourcollaborators with significant competitive advantages. We intend to continue todevelop and acquire proprietary technologies and related intellectual propertyrights to expand and enhance our ability to discover and develop newproprietary flavors, flavor enhancers 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 Assay Development.*Thefirst step in our discovery and development process is to develop proprietaryassays based on 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 in our discovery and development process isto use our proprietary taste receptor-based assays to identify compounds thatbind to human taste receptors, known as hits. We use automated high-throughputscreening to rapidly evaluate our libraries of diverse synthetic and naturalcompounds. A panel of taste testers then evaluates the taste effect of the mostpotent hits. Based on this evaluation, we designate hits that exhibit apositive taste effect as proof-of-concept compounds. We then select the mostpromising of those proof-of-concept compounds, which we call lead compounds,for optimization.

 

•                  *Optimization of Lead Compounds and Selection ofProduct Candidates.*The next step in our discovery and developmentprocess is to chemically enhance, or optimize, our lead compounds to allowlower amounts of the compound to be used in the finished product or improve theenhancement effect to meet the taste attribute goals of our collaborators.Optimization may also be required to enhance the safety profile or to improvethe physical properties of a compound so that it is stable under manufacturing,storage and food preparation conditions. We refer to optimized compounds thatprovide desirable taste attributes in packaged food and beverage product

 

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prototypes asproduct candidates.

 

•                  *Safety Studies and FEMA GRAS Determination of ProductCandidates.*The next step in our discovery and development processis to select, in conjunction with our collaborators, one or more productcandidates for commercialization. We then evaluate the selected productcandidate for safety. Following this evaluation, we submit the safety dataalong with the physical and chemical properties of the product candidate and adescription of manufacturing and conditions of intended use to the FEMA GRASexpert panel for review. Four compounds developed as part of our savory programhave received FEMA GRAS determination.  The process from selection fordevelopment until receipt of that determination took approximately 12months.  Costs associated with the FEMA GRAS process, including synthesisof material for regulatory studies, contract safety studies and preparation ofthe application, were less than $1 million. We expect that future flavors,flavor enhancers and taste modulators we develop will take a similar amount oftime and cost a similar amount. However, the length of time may vary dependingon the properties of the flavor, flavor enhancer or taste modulator.

 

Followinga FEMA GRAS determination, foods and beverages containing our proprietary flavors,flavor enhancers and taste modulators can be immediately commercialized in theUnited States and 20 other countries. We intend to use the data from the FEMAGRAS review to facilitate approval of our flavors, flavor enhancers and tastemodulators for use in products sold in additional countries. We anticipate,however, that our collaborators will test market their products containing our flavors,flavor enhancers and taste modulators through a series of consumer acceptancetests prior to initiating any wide-scale commercialization.

 

**Our Discovery and Development Programs**

 

We arecurrently pursuing the discovery and development of flavors, flavor enhancersand taste modulators through programs focused on savory, sweet, salt andbitter.

 

***Savory Enhancer Program***

 

UsingSavoryScreenHT, our high-throughput savory receptor-based assay system, we identifiedtwo product candidates, S336 and S807, that enhance the savory taste ofglutamate. Our collaborator evaluated S336 and S807 for savory tasteenhancement in product prototypes. S336 is approximately three times morepotent than S807 in taste tests and exhibits greater water solubility comparedto S807. Other characteristics, such as heat stability, are similar for the twocompounds. Based on the results of such studies, our collaborator formallyselected both S336 and S807 for development in May 2004.

 

Wecompleted the safety assessment studies for S807 and S336 and submittedapplications for GRAS determination to the FEMA Expert Panel in December 2004.In March 2005, S807 and S336 were determined to be GRAS. In addition, twoother flavor enhancers, S263 and S976, which are related to S336, were alsodetermined by FEMA to be GRAS. A more detailed description of the FEMA GRASprocess is provided in Item I, *Business – RegulatoryProcess*. With our having achieved FEMA GRAS status for the foursavory compounds, our collaborator initiated product development efforts toidentify initial applications, optimal concentrations and the development ofnew recipes. Application work and taste testing is being conducted at multipleproduct development sites. This work is expected to be completed no later than theend of September 2006. In parallel to this effort, we are conducting additionalapplication and product development work both in-house and in collaborationwith a number of consultants and potential partners.

 

***Sweet Enhancer Program***

 

UsingSweetScreenHT, our high-throughput sweet receptor-based assay system, weidentified S1395 and S888, proof-of-concept compounds. Optimization chemistryled to the identification of S679, which in taste tests was found to beapproximately three times more potent than S1395 and S888. We believe that the compoundswe are developing in our sweet enhancer program will function with bothcarbohydrate and

 

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artificial sweeteners used in a variety of packagedfood and beverage products and may provide for a significant reduction in addedsweetener in the finished product while maintaining or improving the desiredsweet taste.

 

During2005, we identified a number of novel compounds using our optimization chemistryprocess. One compound, S951, demonstrated enhanced potency in the receptorassay and in preliminary taste tests over the previous lead compound S679. At aconcentration of approximately 1.5 parts per million in a solution of 6%fructose, S951 tastes as sweet as a 10% fructose solution. This is equivalentto a 40% reduction of the added carbohydrate sweetener. S951 was also effectivein more complex product prototypes such as ice cream and cereal, but requiredapproximately 6 parts per million to significantly reduce the carbohydratesweetener and maintain the sweet taste.

 

Duringthe fourth quarter of 2005, we created derivatives of S951 and other compoundsto reduce the amounts needed in products and to optimize physical propertiessuch as solubility in food and beverages. Recently, we identified S8613, acompound that is approximately as potent as S951 in taste tests, but issignificantly more water soluble than S951. We expect such improvements inphysical properties to improve functionality in products. It is our goal toidentify a sweet product candidate and initiate development and safety studiesby the end of the third quarter of 2006, and to achieve the first commercialsale of a product containing an ingredient from the sweet program in 2007.

 

***Salt Enhancer Program***

 

Thegoal of our salt enhancer program is to identify compounds that enhance thetaste of salt and provide a significant reduction in sodium levels in a varietyof foods while maintaining or improving the desired salt taste. We are continuingto identify enhancers of the ion channel, ENaC, the most potent of which isS4613. In addition, during the fourth quarter of 2005, we completedcharacterization of a second form of ENaC in taste cells, termed Delta ENaC,which may also play a role in salt taste but has different properties fromAlpha ENaC, the form we had been studying previously. Based on our newfindings, we have initiated discovery of Delta ENaC enhancers and have isolateda set of active compounds using our proprietary screening methods. We willcontinue to identify enhancers of Alpha and Delta ENaC and optimize thesecompounds to improve potency with the goal of identifying a compound thatfunctions in taste tests by the end of the second quarter of 2006. As with thesweet program, our goal is to identify a product candidate and initiatedevelopment and safety studies by the end of the third quarter of 2006 in orderto achieve the first commercial sale of a product containing one of our saltenhancers in 2007.

 

***Bitter Taste Modulator Program***

 

Thegoal of our bitter taste modulator program is to identify compounds thatmodulate or eliminate the bitter taste associated with certain packaged foodand beverage products, OTC health care products and pharmaceutical products. In2005, we continued to make progress along several lines of research. The firststeps of this program involve the identification of taste receptors thatrespond to bitter ingredients known to be present in a variety of food andbeverages, followed by the use of these receptors to discover bitter tasteblockers. A key accomplishment during 2005 was our development of methods thatallow us to test fluorescent samples, which we previously could not test in ourbitter assay. These new methods allow us to test a broader range of bittercompounds in our screening process. Lastly, we continue to develophigh-throughput screening assays to identify bitter blockers. We anticipateinitiating screening for bitter blockers by the end of 2006.

 

**Product Discovery and Development Collaborations**

 

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 Cadbury Schweppes, Campbell Soup, Coca-Cola, Kraft Foodsand Nestlé.

 

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All ofour current collaboration agreements provide for research and developmentfunding, milestone payments upon achievement of pre-defined research ordevelopment targets, cost reimbursement and royalty payments based upon futureproduct sales in the event the collaborator commercializes a productincorporating our flavors, flavor enhancers or taste modulators. Certain of ourcurrent collaboration agreements also provide for upfront fees. The researchand development funding under each of these agreements is paid according to afixed payment schedule. Each of these collaborations provides us with a portionof the funding we require to pursue the discovery and development of flavors,flavor enhancers and taste modulators for the applicable program. Under each ofthese agreements, we are primarily responsible for the discovery, developmentand regulatory approval phases and any associated expenses, while ourcollaborator is primarily responsible for selecting the consumer products thatmay incorporate our flavors, flavor enhancers or taste modulators. Ourcollaborator is also responsible for manufacturing, marketing, selling anddistributing any of these consumer products, and any associated expenses. Webelieve our collaborations 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 steering committeesprovide strategic direction and establish performance criteria for theresearch, development and commercialization of our flavors, flavor enhancersand taste modulators. All decisions of the steering committees must beunanimous.

 

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 upon 60 dayswritten notice, provided that it pay a specified termination fee if itterminates the agreement prior to the end of the collaborative period. Ouragreement with Coca-Cola permits Coca-Cola to terminate the agreement uponspecified major corporate events. Our most recent agreement with Nestlé givesNestlé the right to terminate the agreement without cause on or after October 26,2006 upon 90 days written notice, provided that it pay a specified terminationfee if it terminates the agreement after October 26, 2006 but prior to theend of the collaborative period. Cadbury Schweppes may terminate its agreementwithout cause on or after April 15, 2006 upon 90 days written notice.

 

***Cadbury Schweppes***

 

InJuly 2005, we entered into a collaborative research and license agreement withCadbury Adams USA, LLC, a Cadbury Schweppes company, for the discovery andcommercialization of new flavor ingredients in the gum confectionary area. Underthe terms of the collaboration, Cadbury Schweppes has agreed to pay us researchfunding for up to two years based on research progress during the collaborativeperiod. We are also eligible to receive milestone payments upon our achievementof specific product discovery and development goals. Through December 31,2005, we have received $650,000 in research

 

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funding. If all milestones are achieved, and includingthe $650,000 in research funding paid through December 31, 2005, we may beentitled to up to $3.1 million in research funding and milestone payments. In addition,in the event of commercialization, we are entitled to receive royalties basedon sales of products containing new flavor ingredients developed under theagreement. We cannot assure you that we will receive any future milestonepayments or royalties under this collaboration.

 

***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. In February 2006, we extended thecollaborative period until the earlier of March 2009 or submission for aGRAS determination, subject to earlier termination under specifiedcircumstances.

 

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 31,2005, we have received $9.1 million in research and development funding. If allmilestones are achieved, and including the $9.1 million in research anddevelopment funding paid through December 31, 2005, we may be entitled toup to $13.1 million in research and development funding and milestone payments.In addition, in the event of commercialization, we are entitled to receiveroyalties on future net sales of products containing a discovered flavor or flavorenhancer from the date of introduction of each product in each country until 17years thereafter or until the expiration of relevant patents in such country,whichever is earlier. We cannot assure you that we will receive any futuremilestone payments or royalties under this collaboration.

 

***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, 2005, we have received $7.5million in research and development funding. If all milestones are achieved,and including all research and development funding paid or payable, we may beentitled to up to $14.8 million. In addition, in the event ofcommercialization, 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.

 

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***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. In April 2005and July 2005 we further amended our collaboration agreement to extend thecollaborative research phase for three months and an additional two yearsthrough July 2007, respectively. Under this program, we will work with KraftFoods for the discovery and development of flavor enhancers, on a co-exclusivebasis with Coca-Cola in a specified food and beverage product field. We willalso work with Kraft Foods on the discovery and development of novel flavormodifiers on an exclusive basis in a specified product field in the dessertproduct category. Under the collaboration agreement, as amended, Kraft Foodshas agreed to pay us certain research and development funding over a 6.5-yearcollaborative period. We are also eligible to receive milestone payments uponour achievement of specific product discovery and development goals. Through December 31,2005, we have received $8.4 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 to upto $11.7 million. In addition, in the event of commercialization, we are entitledto receive royalties on future net sales of products containing a discoveredflavor enhancer from the date of introduction of each product in each countryuntil the earlier of 17 years thereafter or until the expiration of relevantpatents in such country. We cannot assure you that we will receive any furthermilestone payments or royalties under this collaboration.

 

InDecember 2005, we further amended the agreement to provide for a new three-yeardiscovery and development collaboration. In this new collaboration, we willwork with Kraft Foods on the discovery and development of novel flavormodifiers on a co-exclusive basis in the chilled and processed meat productcategory within North America. Under the terms of the new collaboration, KraftFoods has agreed to pay us an initial license fee and incremental discovery anddevelopment funding over the three-year period. In addition, we are eligible toreceive milestone payments upon achievement of specific product discovery anddevelopment goals. Through December 31, 2005, we have not received any paymentsin license fees or research and development funding. We received the upfrontlicense fee and first discovery and development funding payment for thiscollaboration in January 2006. If all milestones are achieved, and includingall license fees and research and development funding payable, we may beentitled to up to $4.6 million. In addition, in the event of commercialization,we are entitled to receive royalties on future net sales of products containinga discovered flavor enhancer from the date of introduction of each product ineach country until the earlier of 17 years thereafter or until the expirationof relevant patents in such country. We cannot assure you that we will receiveany further milestone payments or royalties under this collaboration.

 

***Nestlé SA***

 

In April 2002,we entered into an initial collaboration agreement with Nestlé, the world’slargest food company, to work for a three-year collaborative period to discoverspecified flavors and flavor enhancers in the food and beverage product fieldsof dehydrated and culinary food, frozen food and wet soup. In April 2005, weamended the agreement to provide for a three-year extension of thecollaborative research phase.

 

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, 2005, wehave received $7.9 million in research and development funding, reimbursementof certain regulatory expenses of $339,000 and four milestone payments of$375,000 each. If all milestones are achieved, and including all research anddevelopment funding paid or payable, we may be entitled to up to $16.0 millionunder the initial collaboration. In addition, in the event ofcommercialization, we are entitled to receive royalties on future net sales ofproducts 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.

 

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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, Nestléhas agreed to pay us certain research and development funding over five years,subject to earlier termination under specified circumstances. We are alsoeligible to receive milestone payments upon achievement of specific productdiscovery and development goals. Through December 31, 2005, we havereceived $2.3 million in research and development funding. If all milestonesare achieved, and including all research and development funding paid orpayable, we may be entitled to up to $13.1 million under the secondcollaboration. In addition, in the event of commercialization, we are entitledto receive 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 Development Technology***

 

Thereare currently five recognized primary senses of taste: umami (which is thesavory taste of glutamate), sweet, salt, bitter and sour. Scientists generallybelieve that each of these taste sensations is recognized by a distinct tastereceptor or family of taste receptors in the mouth or on the tongue. A tastereceptor functions either by physically binding to a flavor ingredient in aprocess analogous to the way a key fits into a lock or by acting as a channelto allow ions to flow directly into a taste cell. The brain recognizes tastesby determining which of the numerous receptors in the mouth have been contactedby a given flavor ingredient. Savory, sweet and bitter taste compounds 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 naturalcomponent of foods including tomatoes, mushrooms, parmesan cheese, and meats.It is often added to foods in the form of MSG to provide a savory flavor. Thehuman savory receptor is composed of two proteins called hT1R1 and hT1R3. TheT1R proteins are members of the G protein-coupled receptor, or GPCR, family andare expressed on the surface of certain taste bud cells. We created SavoryScreenHT,a proprietary high-throughput savory taste receptor-based assay system anddemonstrated that it responded to MSG and inosine monophosphate, or IMP. Wehave screened over 200,000 compounds in SavoryScreenHT and identified a numberof savory enhancers, including S807, S336, S263 and S976, which were determinedto be GRAS in March 2005.

 

•                  *Sweet Receptor.*The human sweet receptoris composed of two proteins called hT1R2 and hT1R3. The hT1R3 protein is sharedin common with the savory receptor. Like the savory receptor, the sweetreceptor is also a member of the GPCR family and is expressed on the surface ofcertain taste bud cells. We created SweetScreenHT, a proprietaryhigh-throughput sweet taste receptor-based assay system, and demonstrated thatit responded to many different sweet-tasting compounds including carbohydratesweeteners and high potency artificial sweeteners. We have

 

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screened over200,000 compounds in SweetScreenHT and identified novel compounds that modulatesweet taste.

 

•                  *Bitter Receptors.* There are 25 bitterreceptors in humans. These are also members of the GPCR protein family. Workfrom model systems showed that the 25 bitter receptors are likely presenttogether in the same taste cell. The bitter receptors are believed to haveevolved as a defense mechanism to warn of and prevent the ingestion ofpoisonous substances. It is thought that each bitter receptor recognizes adifferent set of bitter-tasting compounds. We have characterized many of the 25T2R receptors and we have initiated the development of receptor-based assays.

 

•                  *Salt Receptor.*In contrast to the GPCRsthat mediate savory, sweet, and bitter tastes, sodium ions and to a lesserextent potassium ions, are thought to produce a salt taste via ion channelspresent on the surface of taste bud cells. Ion channels are receptors that spanthe cell membrane and allow a flow of ions into or out of cells. Published worksuggests that the Epithelial Sodium Channel, or ENaC, is a mediator of salttaste. We have characterized two forms of ENaC from human taste cells, termedAlpha ENaC and Delta ENaC. For each form of ENaC, 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.

 

***ScreeningTechnologies and Compound Libraries***

 

Wehave developed or acquired access to expansive libraries of potential flavors,flavor enhancers and taste modulators currently comprised of over 250,000natural 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 United States Food and Drug Administration, orFDA. Flavor compounds sold in countries and regions outside of the UnitedStates are also subject to regulations imposed by national governments orregional regulatory authorities as is the case in the European Union.

 

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

 

In theUnited States, flavor compounds are regulated by the FDA as approved foodadditives, or as GRAS ingredients under the FD&C Act. The Food AdditiveAmendments of 1958 prompted the flavor industry to establish in 1960 the FEMA ExpertPanel. FEMA has administered the GRAS program for flavors on behalf of theindustry for over 40 years. Other possible routes to approval of aflavor-modifying compound would be a GRAS self-determination (independent ofFEMA) with or without FDA notification, or a food additive petition to the FDA;however, few flavors are currently approved via these routes. Our goal is thatthe flavor compounds, including flavors, flavor enhancers and taste modulatorswe may discover will be subject to the FEMA GRAS review process as describedbelow.

 

***GRAS Review Process.***Flavorcompounds that qualify for the GRAS review process are generally intended to beconsumed in small quantities and have data supporting their safety underconditions of intended use. An expert panel, convened to undertake a GRASreview, determines whether a compound is

 

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generally recognized as safe under the conditions ofits intended use. These experts are qualified by scientific training andexperience to evaluate the safety of chemicals used in food and may declarecertain compounds as having been adequately shown through scientific proceduresto be generally recognized as safe under the conditions of their intended use.Under the GRAS process, manufacturers are required to obtain safety data fromthe scientific literature or through the conduct of safety studies, determinethe estimated daily intake of the flavor compound per person and submit areport to the GRAS review panel describing the physical, chemical, safety, andmetabolic properties of the flavor compound. The entire GRAS determinationprocess, including the safety and metabolic studies, application preparationand GRAS panel review, can take up to two years or longer. However, if thereare prior safety data on the compound or a compound with a related structure,then fewer safety studies may be required for the GRAS review and the GRASreview process can be considerably shorter than two years.

 

Themost common types of GRAS review are:

 

•                  *FEMA Expert Panel.*The FEMA Expert Panelis an independent panel of experts established by FEMA. The FEMA Expert Panel,which may be used by FEMA members and certain other parties, meets at least threetimes per year. The conclusions of the Expert Panel regarding a flavor orflavor enhancer are provided directly to the FDA and published in the journalFood Technology. To our knowledge, the FDA has not challenged the FEMA ExpertPanel’s conclusion that the use of a flavoring substance is GRAS. In 2005, theFEMA Expert Panel published its findings on 185 new compounds determined to beGRAS for specific flavor applications. We have been an associate member of FEMAsince 2003. Four of our savory compounds were determined to be GRAS by the FEMAExpert Panel in 2005.

 

•                  *Specifically Convened Independent Panel.*Anindependent, qualified panel of experts in pertinent scientific disciplines maybe formed by the manufacturer to evaluate the safety of a specific compound forGRAS status. This process is known as a “self determination of GRAS status.”  The basis for the GRAS self determination isnot required to be submitted to the FDA. However, the FDA may requestinformation on compounds that have been self determined to be GRAS, or theinformation may be provided voluntarily.

 

***Food Additive Petition Process.***Foodingredients for which the GRAS process is not available may be evaluated asfood additives. Food additives require FDA approval prior to use in foods. Acompound may be ineligible for GRAS determination, and may be considered a foodadditive, because there is insufficient general knowledge or for a variety of otherreasons, including conditions of intended use resulting in high dietaryexposure or the compound’s safety profile. If the compound is considered a foodadditive, a food additive petition must be filed and approved by the FDA.Examples of compounds that have gone through a food additive petition includethe artificial sweeteners Aspartame, Acesulfame K, and Sucralose, and the fatsubstitute Olestra. The food additive petition approval process for such foodingredients can take eight years or more. In the event that a particular flavoror flavor enhancer is not eligible for GRAS determination and thereforerequires FDA approval prior to use, we may dedicate our development efforts toalternative compounds that would be eligible for a GRAS determination.

 

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

 

Thereare three key benefits of the FEMA GRAS review process:

 

•                  *Rapid Time for Commercialization.*Fourcompounds developed as part of our savory program have received FEMA GRASdetermination.  The process from selection for development until receiptof that determination took approximately 12 months. We expect that futureflavors, flavor enhancers and taste modulators we develop will take a similaramount of time. However, the length of time may vary depending on theproperties of the flavor, flavor enhancer or taste modulator. This is much shorterthan the typical eight years or longer to obtain FDA approval under the foodadditive petition process applicable to other food ingredients. Once thecompound is determined to be FEMA GRAS, it can be immediately commercialized inthe United States and 20 other countries that recognize the FEMA GRAS status.As described above, the initial phase of commercialization may include compoundmanufacturing, incorporation of the flavor enhancer

 

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into products, andthe commercialization of products in consumer test markets.

 

•                  *Low Development Costs.*The total costs forthe FEMA GRAS process, including synthesis of material for regulatory studies,contract safety studies and preparation of the FEMA GRAS application isgenerally under $1 million per compound.

 

•                  *Facilitated Approval in Other Countries.*Approvalof flavors for use outside of the United States varies widely by country. Accordingto FEMA, seven countries, including Brazil, New Zealand and Australia,recognize compounds on the FEMA GRAS list.  An additional set of countriesrecognize compounds on the FEMA GRAS list “in principle”. These include Canada,China, Philippines and Turkey. Approval in these countries may require specificapplications to the food safety authority of the individual countries but usuallynot additional safety testing.

 

**License Arrangements**

 

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

 

***University ofCalifornia***

 

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 required a license issue fee, payable in installments through2005, and calls for annual maintenance fees commencing in 2006 and royalties orservice revenues on sales of any products developed using technologies licensedunder the agreement. Royalties will accrue in each country for as long as thereexists a valid patent claim covering a product developed under the agreement.No royalty payments have accrued under the agreement to date. The agreementwill remain in effect until the later of the expiration of the last to expirepatent licensed under the agreement, or ten years from the date that the lastproduct to be developed under the agreement is introduced to market in theUnited States. We may terminate the agreement at any time, without cause, uponnotice to the University of California. The University of California mayterminate the agreement upon a breach of our obligations under the agreement.In addition, we are in discussions with the University of California to amendthe license agreement to include additional related technology related to thecoexpression of T1R taste receptors.

 

***Aurora Biosciences Corporation***

 

InNovember 2000, we entered into a technology collaboration and licenseagreement with Aurora to develop certain assay technologies, which was amendedApril 2002. Under the collaboration, we developed high-throughput screeningassays using Aurora’s proprietary screening technologies. The agreementterminated in October 2002 and Invitrogen Corporation subsequentlyacquired certain surviving rights and obligations under this agreement. Underthe surviving terms of the agreement, we maintain exclusive rights to usecertain proprietary screening technologies with our taste receptor targets forthe discovery of flavors, flavor enhancers and taste modulators. Theseexclusive rights are subject to rights granted under other current and futurelicense agreements in connection with the purchase of certain screeningsystems, as well as Invitrogen’s right to grant licenses under its proprietarytechnology to academic, government and other non-profit organizations. Ourrights with respect to the screening of flavors, flavor enhancers and tastemodulators are fully paid-up and will remain in effect, except in the eventthat we breach any remaining obligations to Invitrogen under the agreement. InNovember 2000, Aurora purchased 1,000,000 shares of our Series Cpreferred 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.

 

To ourknowledge, there are no other entities using a receptor-based approach todevelop flavors, flavor enhancers or taste modulators. Methods for reducingsodium include the use of potassium chloride in combination with flavors andmasking agents. Although savory flavor enhancers, such as IMP, are commerciallyavailable, they are not very potent, are not patent protected and are sold as acommodity. The blocking of bitter taste is typically accomplished by attemptingto mask the bitter taste with a sweetener or another flavor ingredient. AlthoughAMP has received GRAS determination, we do not believe this compound has beenwidely adopted into packaged food and beverage 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 competitorsmay obtain intellectual property protection or commercialize such productssooner than we do. Developments by others may render our product candidates orour technologies 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.

 

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**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, 2005 we had 3 issuedUnited States patents, 54 pending United States patent applications and 74pending foreign applications covering various aspects of our proprietarytechnology. Our issued patents have terms that expire in 2018 through 2021. Inaddition, we have exclusive license agreements with Johns Hopkins University,The University of California, Incyte Corporation and Aurora covering anadditional 41 issued United States patents, 31 pending United States patentapplications, 27 issued foreign patents and 53 pending foreign applications.

 

Ourpolicy is to file patent applications and to protect technologies, inventionsand improvements to inventions that are commercially important to thedevelopment of our business. For example, we may seek patent protection forreceptors and nucleic acid sequences encoding receptors that are involved intaste and the use of such receptors to identify ingredients that modulatetaste. We also rely on trademarks to protect our proprietary technology.Generally, United States patents have a term of 17 years from the date of issueor 20 years from the earliest claimed priority date, whichever is later, forpatents issued from applications filed with the United States Patent andTrademark Office prior to June 8, 1995 or 20 years from the applicationfiling date or earlier claimed priority date in the case of patents issued fromapplications filed on or after June 8, 1995. Patents in most othercountries have a term of 20 years from the date of filing the patentapplication. Our success depends significantly upon our ability to developingredients and technologies that are protected by our intellectual propertyand that do not infringe any competitor patents. We intend to continue to filepatent applications as we discover and develop new flavors or flavor enhancersand 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, Pfizer and the German Institute of Human Nutrition.If any of these companies or academic institutions are successful in obtainingbroad patent claims, such patents could potentially block our ability to usevarious aspects of our discovery and development process and might prevent usfrom developing or commercializing newly discovered flavors, flavor enhancersor taste modulators or otherwise conducting our business.

 

Wealso rely in part on trade secret protection for our confidential and proprietaryinformation and process. Our policy is to execute confidentiality agreementswith our employees and consultants upon the commencement of an employment orconsulting relationship. These agreements generally require that allconfidential 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 otherintellectual property proceedings, for example as a result of an allegedinfringement, or a third-party

 

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allegingan earlier date of invention, we may have to spend significant amounts of moneyand time and, in the event of an adverse ruling, we could be subject toliability for damages, invalidation of our intellectual property and injunctiverelief that could prevent us from using technologies or developing products,any of which could have a significant adverse effect on our business financialcondition and results of operation. In addition, any claims relating to theinfringement of third-party proprietary rights, or earlier date of invention,even if not meritorious, could result in costly litigation, lengthygovernmental proceedings, divert management’s attention and resources andrequire us to enter royalty or license agreements which are not advantageous ifavailable at all.

 

**Sales and Marketing**

 

Whilewe do not currently intend to establish internal sales and marketingcapabilities, we are developing the capability to enable us to work closelywith our collaborators and their suppliers in the incorporation of our flavors,flavor enhancers and taste modulators into their products. Under our currentcollaboration agreements, our collaborators are responsible for sales,marketing, and distribution of any packaged food or beverage productincorporating our flavors, flavor enhancers and taste modulators. As a result,we expect to commercialize our flavors, flavor enhancers and taste modulatorswithout incurring significant sales, marketing and distribution costs. Our fivecurrent collaborators, Cadbury Schweppes, Campbell Soup, Coca-Cola, Kraft Foodsand Nestlé, are recognized leaders in the sales, marketing, and distribution ofpackaged food and beverage products.

 

**Manufacturing**

 

Weintend to utilize third parties to manufacture our flavors, flavor enhancersand taste modulators. Under two of our existing product discovery anddevelopment collaborations, our collaborator may, in its sole discretion,manufacture itself or through a third party manufacturer the flavors, flavorenhancers or taste modulators it licenses from us. The remaining fouragreements require the collaborator to identify with us a mutually agreed uponthird party to manufacture the flavors, flavor enhancers or taste modulators itlicenses from us. In some of these agreements, we maintain either the firstright of negotiation 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 31,2005, we had 90 full-time employees, including 23 with Ph.D. degrees. Of ourfull-time workforce, 65 employees are engaged in research and development and 25are engaged in business development, finance and administration. We also retainoutside consultants. None of our employees are covered by collective bargainingarrangements, and our management considers its relationships with our employeesto be good. We have entered into employment letter agreements with Kent Snyder,Mark Zoller, Ph.D., Harry Leonhardt, Esq., John Poyhonen and Nigel R.A.Beeley, Ph.D., the terms of which are described in Item 11 of this Form 10-K.

 

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**Executive Officers**

 

Thefollowing table sets forth certain information concerning our executiveofficers and their ages as of December 31, 2005:

 
| **Name**                       | ** ** | **Age** | ** ** | **Position**                                                                          | ** ** |
|--------------------------------|------------|---------|------------|---------------------------------------------------------------------------------------|------------|
| Kent Snyder                    |       | 52      |       | President, Chief  Executive Officer and Director                                      |       |
| Mark J. Zoller, Ph.D.          |       | 52      |       | Executive Vice  President of Discovery & Development and Chief Scientific Officer |       |
| Harry J.  Leonhardt, Esq. |       | 49      |       | Senior Vice President,  General Counsel and Corporate Secretary                       |       |
| John Poyhonen                  |       | 45      |       | Senior Vice President,  Chief Financial and Business Officer                          |       |
| Nigel R.A. Beeley, Ph.D        |       | 54      |       | Vice President,  Discovery                                                            |       |

 

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**Kent Snyder**,President and Chief Executive Officer, joined us in June 2003 and hasserved as a member of our board of directors since that time. Prior to joiningus, from October 2001 to June 2003, Mr. Snyder was retired. FromJuly 1991 to October 2001, Mr. Snyder held various marketing andsales management positions with Agouron Pharmaceuticals, Inc., a Pfizercompany. Mr. Snyder was President of Global Commercial Operations atAgouron. Prior to holding the position of President of Global Commercialoperations, Mr. Snyder served as Senior Vice President of CommercialAffairs and Vice President of Business Development. Mr. Snyder receivedhis B.S. from the University of Kansas and 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 Executive Vice President of Discoveryand Development and Chief Scientific Officer in January 2006, 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.

 

**Harry J. Leonhardt, Esq.**, Senior VicePresident, General Counsel and Corporate Secretary, joined us in September 2003as Vice President, General Counsel and Corporate Secretary and was promoted inJanuary 2006 to Senior Vice President, General Counsel and Corporate Secretary.From February 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**, Senior Vice President andChief Financial and Business Officer, joined us in October 2003 as VicePresident and Chief Business Officer and was promoted in April 2004 to VicePresident, Chief Financial and Business Officer. In January 2006, he waspromoted to Senior Vice President, Chief Financial and Business Officer. From1996 until October 2003, Mr. Poyhonen served in various sales andmarketing positions for Agouron Pharmaceuticals, a Pfizer company, mostrecently as Vice President of National Sales. Prior to holding this position, Mr. Poyhonenserved as Vice President 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 1999 through June 2004, Dr. Beeleyserved as Vice President, Chief Chemical Officer of Arena Pharmaceuticals, abiopharmaceutical company. From 1994 to 1998, Dr. Beeley was SeniorDirector of Chemistry at Amylin Pharmaceuticals, Inc., a biotechnology company,and from 1988 to 1994, he served as Head of Oncology-Chemistry for Celltech, abiotechnology company. From 1980 to 1988, Dr. Beeley held positions ofincreasing seniority in the cardiovascular group at Synthelabo Research, apharmaceutical company, and, from 1978 to 1980, he was a CNS medicinal chemistin the pharmaceutical division of Reckitt and Coleman, a conglomerate. From1976 to 1978, Dr. Beeley held a Royal Society Overseas Research Fellow atETH, 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.

 

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**Item 1A. 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 key element of our strategy is to commercialize ourflavors, flavor enhancers and taste modulators through product discovery anddevelopment collaborations. To date, all of our revenue has been derived solelyfrom research and development payments and milestone payments received undercollaboration agreements with Cadbury Schweppes, Campbell Soup, Coca-Cola,Kraft Foods and Nestlé. Substantially all of our revenue in the foreseeablefuture will result from these types of payments from these collaborations,unless we successfully commercialize a product candidate through these or othercollaborators and earn royalties on future sales of consumer productsincorporating our flavors, flavor enhancers or taste modulators.

 

Our agreement, as amended, with Campbell Soup providesfor research and development funding until March 2009 and gives CampbellSoup the right to terminate the agreement earlier without cause, provided thatit pay a specified termination fee if it terminates the agreement prior toMarch 28, 2009. Our agreement with Coca-Cola provides for research anddevelopment funding until April 2008, and gives Coca-Cola the right toconclude the collaborative program earlier for any reason upon payment to us ofa termination fee, provided that Coca-Cola may terminate the collaborativeperiod without payment of an early conclusion fee in the event that we fail toachieve a specified research and development goal by April 22, 2006,subject to payment of research funding through July 22, 2006. Our agreementwith Kraft Foods provides for research and development funding until December2008, and gives Kraft Foods the right to conclude the agreement earlier for anyreason upon payment to us of a termination fee. Our initial agreement withNestlé (as amended in April 2005) provides for research and development fundingthrough April 2008 and gives Nestlé the right to terminate the agreementearlier without cause on or after April 18, 2006, provided that it payadditional specified research funding if it terminates the agreement afterApril 18, 2006 but prior to April 18, 2008. Our most recent agreement withNestlé provides for research and development funding through October 2009 andgives Nestlé the right to terminate the agreement earlier without cause on orafter October 26, 2006, provided that it pay additional specified researchfunding if it terminates the agreement after October 26, 2006 but prior toOctober 26, 2009.  Our agreement with Cadbury Schweppes provides forresearch and development funding through July 2007, and gives Cadbury Schweppesthe right to terminate the agreement earlier without cause on or after April15, 2006 upon 90 days’ written notice. If any or all of our material agreementswith our collaborators expire or are terminated, our revenue wouldsignificantly decline and if all of our agreements expire or are terminated,our revenue would be substantially eliminated, which would have a materialadverse effect on our business, financial condition and results of operations.Our collaborators may not renew their agreements with us or, if they do, theymay not be on terms that are as favorable to us as our current agreements.

 

Our current collaboration agreements provide that wewill receive royalties of up to 4% on our collaborators’ sales of productscontaining our flavors, flavor enhancers or taste modulators. The actualroyalties payable vary by agreement and depend on a number of factorsincluding, for example, the product field, cost of goods savings, degree offlavor enhancement and sales volume of collaborator products incorporating ourflavor ingredients. It is possible that our collaborators will not incorporateour flavors, flavor enhancers and taste modulators into any or all of theirproducts within their exclusive product fields.

 

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We do not currently have a commercialized product andcannot assure you we will have a commercialized product in the foreseeablefuture, or at all. We will be dependent on our current and any other possiblefuture collaborators to commercialize any flavors, flavor enhancers or tastemodulators that we successfully develop and to provide the sales, marketing anddistribution capabilities required for the success of our business. We havelimited or no control over the amount and timing of resources that our currentor any future collaborators may devote to our programs or potential products.Our collaborators may decide not to devote the necessary resources to thecommercialization of our flavors, flavor enhancers or taste modulators, or maypursue a competitor’s product if our flavors, flavor enhancers or tastemodulators do not have the characteristics desired by the collaborator. Thesecharacteristics include, among other things, enhancement properties,temperature stability, solubility, taste and cost. If these collaborators failto conduct their commercialization, sales and marketing or distributionactivities successfully and in a timely manner, we will earn little or noroyalty revenues from our flavors, flavor enhancers and taste modulators and wewill not be able to achieve our objectives or build a sustainable or profitablebusiness.

 

Our present and any future product discovery anddevelopment collaboration opportunities could be harmed if:

 

•                  ourexisting or any future collaborators terminate their collaboration agreementswith us prior to the expiration of the agreements;

•                  wedo not achieve our research and development objectives under our collaborationagreements prior to the termination of the collaboration periods;

•                  wedisagree with our collaborators as to the parties’ respective licensing rightsto our flavors, flavor enhancers and taste modulators, methods or otherintellectual property we develop;

•                  weare unable to manage multiple simultaneous collaborations;

•                  potentialcollaborators fail to spend their resources on research and development orcommercialization of our flavors, flavor enhancers and taste modulators due togeneral market conditions or for any other reason; or

•                  consolidationin our target markets limits the number of potential collaborators.

 

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

 

We may not be able to enter into additional productdiscovery and development collaborations due to the exclusive nature of ourcurrent product discovery and development collaborations. Each of our currentcollaboration agreements provides that we will conduct research and developmenton flavors, flavor enhancers and taste modulators for use within one or moredefined packaged food and beverage product fields on an exclusive basis for therespective collaborator during the collaborative period specified in theagreement. Because each of these agreements is exclusive or co-exclusive, wewill not be able to enter into a collaboration agreement with any other 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 may not succeed in developing flavors, flavorenhancers or taste modulators with the appropriate attributes required for usein successful commercial products. Successful flavors, flavor enhancers andtaste modulators require, among other things, appropriate biological activity,including the correct flavor or flavor enhancer property for the productapplication, an acceptable safety profile, including lack of toxicity orallergenicity, and appropriate physical or chemical properties, includingrelative levels of stability, volatility and resistance to heat. Successfulflavors, flavor enhancers and taste modulators must also be cost-efficient forour collaborators. We may not be able to develop flavors, flavor enhancers ortaste modulators that meet these criteria.

 

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***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 GRAS determination forfour of our savory product candidates. Apart from these product candidates, wedo 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 FDA and in some instances othergovernment bodies. Obtaining and maintaining a GRAS determination or regulatoryapproval can be costly and take many years.

 

Depending on the amount or intended use of aparticular flavor, flavor enhancer or taste modulator added to a product andthe number of product categories in which the flavor, flavor enhancer or tastemodulator will be incorporated, specific safety assessment protocols andregulatory processes must be satisfied before we or our collaborators cancommercially market and sell products containing any flavors, flavor enhancersor taste modulators that we may discover. A key element of our strategy is todevelop flavors, flavor enhancers and taste modulators that will be subject toreview under the FEMA GRAS process, which, based on our experience with thesavory program, we expect will take approximately 12 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 12 months and cost more than $1 million depending onthe properties of the flavor, flavor enhancer or taste modulator, and ifadditional safety studies are requested by the FEMA Expert Panel or arenecessary to explain unexpected safety study findings. There is a risk that oneor more of our product candidates may not qualify for a FEMA GRASdetermination. This may occur for a variety of reasons, including the flavor,flavor enhancer or taste modulator’s intended use, the amount of the flavor,flavor enhancer or taste modulator intended to be added to packaged foods andbeverages, the number of product categories in which the flavor, flavorenhancer or taste modulator will be incorporated, whether the flavor, flavorenhancer or taste modulator imparts sweetness, the safety profile of theflavor, flavor enhancer or taste modulator and the FEMA Expert Panel’sinterpretation of the safety data. Even if we obtain a GRAS determination withrespect to a flavor, flavor enhancer or taste modulator, the FDA has theability to challenge such determination, which could materially adverselyaffect our ability to market products on schedule or at all. In the event thata particular flavor, flavor enhancer or taste modulator does not qualify forFEMA GRAS 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 theGRAS determination 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.

 

Sales of our flavors, flavor enhancers or tastemodulators outside of the United States will be subject to foreign regulatoryrequirements. In most cases, whether or not a GRAS determination or FDAapproval has been obtained, approval of a product by the comparable regulatoryauthorities of foreign countries must still be obtained prior to manufacturingor marketing the product in those countries. A GRAS determination or FDAapproval in the United States or in any other jurisdiction does not ensureapproval in other jurisdictions because the requirements from jurisdiction tojurisdiction may vary widely. Obtaining foreign approvals could result in significantdelays, difficulties and costs for us and require additional safety studies andadditional expenses. If we fail to comply with these regulatory requirements orto obtain and maintain required approvals, our ability to generate revenue willbe diminished.

 

We and our collaborators may not be successful inovercoming these regulatory hurdles, which could result in product launchdelays, unanticipated expenses, termination of collaborations, and flavors,flavor enhancers and taste modulators not being approved for incorporation intoconsumer products. These consequences would have a material adverse effect onour business financial condition and results of operations.

 

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***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.***

 

Even if we discover and develop flavors, flavorenhancers and taste modulators that obtain the necessary GRAS determination orregulatory approval, our success depends to a significant degree upon thecommercial success of packaged food and beverage products incorporating thoseflavors, flavor enhancers or taste modulators. If these products fail toachieve or subsequently maintain market acceptance or commercial viability, ourbusiness would be significantly harmed because our royalty revenue is dependentupon consumer sales of these products. In addition, we could be unable tomaintain our existing collaborations or attract new product discovery anddevelopment collaborators. Many factors may affect the market acceptance andcommercial success of any potential products incorporating flavors, flavorenhancers or taste modulators that we may discover, including:

 

•                  healthconcerns, whether actual or perceived, or unfavorable publicity regarding ourflavors, flavor enhancers and taste modulators or those of our competitors;

•                  thetiming of market entry as compared to competitive products;

•                  therate of adoption of products by our collaborators and other companies in theflavor industry; and

•                  anyproduct labeling that may be required by the FDA or other United States orforeign regulatory agencies for products incorporating our flavors, flavorenhancers and taste modulators.

 

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

 

We have not been profitable and have generatedsubstantial operating losses since we were incorporated in September 1998.We incurred net losses of approximately $19.8 million for the year endedDecember 31, 2005. As of December 31, 2005, we had an accumulated deficit ofapproximately $104.2 million. We expect to incur additional losses for at leastthe next two years. The extent of our future losses will depend, in part, onthe rate of increase in our operating expenses and the rate of growth, if any,in our revenue from our five existing and any future product discovery anddevelopment collaborations as well as from other sources that may becomeavailable to us in the future and on the level of our expenses. To date, ourrevenue has come solely from research and development funding, upfront fees,cost reimbursement and milestone payments under our product discovery anddevelopment collaboration agreements with Cadbury Schweppes, 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 anddevelopment collaborations and our collaborators must commercialize productsincorporating one or more of our flavors, flavor enhancers or taste modulators,from which we can derive royalty revenues. Our ability to generate royaltyrevenue is uncertain and will depend upon our ability to meet particularresearch, 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.***

 

Our operating results have fluctuated in the past andare likely to vary significantly in the future based upon a number of factors,many of which we have little or no control over. We operate in a highly dynamicindustry and future results could be subject to significant fluctuations. Thesefluctuations could cause us to fail to meet or exceed financial expectations ofsecurities analysts or investors, which could cause our stock price to declinerapidly and significantly. Revenue and expenses in future periods may begreater or less than revenue and expenses in the immediately preceding periodor in the comparable period of the prior year. Therefore, period-to-periodcomparisons of our operating results are not necessarily a good indication ofour future performance. Some of the factors that could cause our operatingresults to fluctuate include:

 

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

 

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•                  ourability to discover and develop flavors, flavor enhancers and taste modulatorsor the ability of our product discovery and development collaborators toincorporate them into packaged food and beverage products;

•                  ourreceipt of milestone payments in any particular period;

•                  theability and willingness of collaborators to commercialize productsincorporating our flavors, flavor enhancers and taste modulators on expectedtimelines, or at all;

•                  ourability to enter into new product discovery and development collaborations andtechnology collaborations or to extend the terms of our existing collaborationagreements and our payment obligations, expected revenue and other terms of anyother agreements of this type;

•                  ourability, or our collaborators’ ability, to successfully satisfy all pertinentregulatory requirements;

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

•                  generaland industry specific economic conditions, which may affect our collaborators’research and development expenditures.

 

***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 first quarter of fiscal 2006 couldnegatively affect our stock price and our stock price volatility.

 

***Compliance with regulation of corporate governance andpublic disclosure may result in additional expenses.***

 

Laws,regulations and standards relating to corporate governance and publicdisclosure, including the Sarbanes-Oxley Act of 2002, SEC regulations andNasdaq National Market rules, is costly. Our efforts to comply with these laws,regulations and standards, as they become applicable to us, have resulted in,and are likely to continue to result in, general and administrative expense andmanagement time related to compliance activities. In particular, our efforts tocomply with Section 404 of the Sarbanes-Oxley Act of 2002 and the relatedregulations regarding our required assessment of our internal controls overfinancial reporting and our external auditors’ audit of that assessmentrequires the commitment of significant financial and managerial resources. Ifour efforts to comply with laws, regulations and standards differ from theactivities intended by regulatory or governing bodies, our reputation may beharmed and we might be subject to sanctions or investigation by regulatoryauthorities, such as the Securities and Exchange Commission. Any such actioncould adversely affect our financial results and the market price of our commonstock.

 

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

 

If we are unable to successfully commercialize ourflavors, flavor enhancers and taste modulators, we may need to obtainadditional capital or change our strategy to continue our operations. Inaddition, our business and operations may change in a manner that would consumeavailable resources at a greater rate than anticipated. In such event, we may needto raise substantial additional capital to, among other things:

 

•                  fundnew research, discovery or development programs;

•                  advanceadditional product candidates into and through the regulatory approval process;and

•                  acquirerights to products or product candidates, technologies or businesses.

 

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If we require additional capital to continue ouroperations, we cannot assure you that additional financing will be available onterms acceptable to us, or at all. If adequate funds are not available or arenot available on acceptable terms, our ability to fund our operations, takeadvantage of opportunities, identify and develop flavors, flavor enhancers andtaste modulators, develop technologies or otherwise respond to competitivepressures could be significantly limited. In addition, if financing is notavailable, we may need to alter our strategy or cease operations. In addition,issuances of debt or additional equity could impact the rights of the holdersof our common stock, may dilute our stockholders’ ownership and may imposerestrictions on our operations. These restrictions could include limitations onadditional borrowing, 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.***

 

Our success depends to a significant degree upon thecontinued contributions of our executive officers, management and scientificstaff. If we lose the services of one or more of these people and, inparticular, Kent Snyder, our President and Chief Executive Officer, or MarkZoller, Ph.D., our Executive Vice President of Discovery & Development andChief Scientific Officer, 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., HarryLeonhardt, Esq., our Senior Vice President, General Counsel and CorporateSecretary, John Poyhonen, our Senior Vice President, Chief Financial andBusiness Officer and Nigel R.A. Beeley, Ph.D., our Vice President, Discovery. Allof our employees are at-will employees, which means that either we or theemployee may terminate their employment at any time. We currently have no keyperson insurance.

 

In addition, our discovery and development programsdepend on our ability to attract and retain highly skilled scientists,including molecular biologists, biochemists, chemists and engineers. We may notbe able to attract or retain qualified employees in the future due to theintense competition for qualified personnel among technology-based businesses,particularly in the San Diego area. We also face competition from universitiesand public and private research institutions in recruiting and retaining highlyqualified scientific and management personnel. If we are not able to attractand retain the necessary personnel to accomplish our business objectives, wemay experience constraints that will adversely affect our ability to meet thedemands of our current or any future product discovery and developmentcollaborators in a timely fashion or to support our independent discovery anddevelopment programs.

 

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

 

Our strategy includes entering into and working onsimultaneous flavor and flavor enhancer discovery and development programsacross multiple markets. We increased the number of our full-time employeesfrom seven on December 31, 1999 to 90 on December 31, 2005 and weexpect to continue to grow to meet our strategic objectives. If our growthcontinues, it will continue to place a strain on us, our management and ourresources. Our ability to effectively manage our operations, growth and variousprojects requires us to continue to improve our operational, financial andmanagement controls, reporting systems and procedures and to attract and retainsufficient numbers of talented employees. We may not be able to successfullyimplement these tasks on a larger scale and, accordingly, we may not achieveour research, development and commercialization goals. If we fail to improveour operational, financial and management information systems, or fail toeffectively monitor or manage our new and future employees or our growth, ourbusiness would suffer significantly. In addition, no assurance can be made thatwe will be able to secure adequate facilities to house our staff, conduct ourresearch or achieve our business objectives.

 

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

 

We do not have experience in manufacturing, nor do wehave the resources or facilities to manufacture, flavors, flavor enhancers andtaste modulators on a commercial scale. Therefore, the commercialization of ourflavors, flavor enhancers and taste modulators will depend in part on ouror our collaborators’ ability to contract with third-party manufacturers of ourflavors, flavor enhancers and taste modulators on a large scale, at acompetitive cost, with the specified quality and in accordance with relevantfood and beverage regulatory 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 intoagreements on acceptable terms with third-party manufacturers could delaycommercialization of any products we may develop and may harm ourrelationships with our existing and any future product discovery anddevelopment collaborators and our customers. Moreover, if we are required tochange from one third-party manufacturer to another for any reason, thecommercialization of our products may be delayed further. In addition, ifthird-party manufacturers fail to comply with the FDA’s good manufacturingpractice regulations or similar regulations in other countries, then we may besubject to adverse regulatory action including product recalls, warning lettersand withdrawal of our products, or our collaborators’ or customers’ products,from the market.

 

Further, because ourflavors, flavor enhancers and taste modulators are regulated as food productsunder the Federal Food, Drug and Cosmetic Act, we and the third parties withwhich we collaborate or contract to manufacture, process, pack, import orotherwise handle our products or our product ingredients, may be requiredto comply with certain registration, prior notice submission, recordkeeping andother regulatory requirements. Failure of any party in the chain ofdistribution to comply with any applicable requirements under the Federal Food,Drug and Cosmetic Act or the FDA’s implementing regulations, or similarregulations in other countries, may adversely affect the manufactureand/or distribution of our products in commerce.

 

***If we acquireproducts, technologies or other businesses, we will incur a variety of costs, may haveintegration difficulties and may experience numerous other risks thatcould adversely affect our business.***

 

If appropriate opportunities become available, we may consideracquiring businesses, technologies or products that we believe are a strategicfit with our business. We currently have no commitments or agreements withrespect to, and are not actively seeking, any material acquisitions. We havelimited experience in identifying acquisition targets, successfully acquiringthem and integrating them into our current infrastructure. We may not beable to successfully integrate any businesses, products, technologies orpersonnel that we might acquire in the future without a significant expenditureof operating, financial and management resources, if at all. In addition,future acquisitions might be funded by issuances of additional debt or equity,which could impact your rights as a holder of our common stock and may diluteyour ownership percentage. Any of the foregoing could have a significantadverse effect on our business, financial condition and results of operations.

 

**Risks Related To Our Industry**

 

***Our ability tocompete in the flavor and flavor enhancer market may decline if we do notadequately protect our proprietary technologies.***

 

Our success depends in part on our ability toobtain and maintain intellectual property that protects our technologies andflavors, flavor enhancers and taste modulators. Patent positions may behighly uncertain and may involve complex legal and factual questions,including the ability to establish patentability of sequences relating to tastereceptors, proteins, chemical synthesis techniques, compounds and methods forusing them to modulate taste for which we seek patent protection. No consistentstandard regarding the allowability or enforceability of claims in many of ourpending patent applications has

 

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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 have in-licensed or the extent to which we may enforcethese claims against our competitors. The degree of future protection for ourproprietary rights is therefore highly uncertain and we cannot assure you that:

 

•                  wewere the first to file patent applications or to invent the subject matterclaimed in patent applications relating to the technologies upon which we rely;

•                  otherswill not independently develop similar or alternative technologies or duplicateany of our technologies;

•                  othersdid not publicly disclose our claimed technology before we conceived thesubject matter included in any of our patent applications;

•                  anyof our patent applications will result in issued patents;

•                  anyof our patent applications will not result in interferences or disputes withthird parties regarding priority of invention;

•                  anypatents that have issued or may be issued to us, our collaborators or ourlicensors will provide a basis for commercially viable products or will provideus with any competitive advantages or will not be challenged by third parties;

•                  wewill develop additional proprietary technologies that are patentable;

•                  thepatents of others will not have an adverse effect on our ability to dobusiness; or

•                  newproprietary technologies from third parties, including existing licensors, willbe available for licensing to us on reasonable commercial terms, if at all.

 

In addition, patent law outside the United States isuncertain and in many countries intellectual property laws are undergoingreview and revision. The laws of some countries do not protect intellectualproperty rights to the same extent as domestic laws. It may be necessaryor useful for us to participate in opposition proceedings to determine thevalidity of our competitors’ patents or to defend the validity of any of our orour licensor’s future patents, which could result in substantial costs andwould divert our efforts and attention from other aspects of our business.

 

Technologies licensed to us by others, or in-licensedtechnologies, are important to our business. In particular, we depend onhigh-throughput screening technologies that we licensed from AuroraBiosciences, technology related to certain taste receptor sequences that welicense from the University of California and others and technology related tocompound libraries that we license from third parties. In addition, we may inthe future acquire rights to additional technologies by licensing such rightsfrom existing licensors or from third parties. Such in-licenses may becostly. Also, we generally do not control the patent prosecution, maintenanceor enforcement of in-licensed technologies. Accordingly, we are unable toexercise the same degree of control over this intellectual property as we doover our internally developed technologies. Moreover, some of our academicinstitution licensors, collaborators and scientific advisors have rights topublish data and information to which we have rights. If we cannot maintain theconfidentiality of our technologies and other confidential information inconnection with our collaborations, our ability to protect our proprietaryinformation or obtain patent protection in the future may be impaired,which could have a significant adverse effect on our business, financialcondition and results of operations.

 

***Many of the patentapplications we and our licensors have filed have not yet been substantivelyexamined and may not result in patents being issued.***

 

Many of the patent applications filed by us and ourlicensors were filed recently with the United States Patent and TrademarkOffice and most have not been substantively examined and may not result inpatents being issued. Some of these patent applications claim sequences thatwere identified from different publicly available sequence information sourcessuch as the High-Throughput Genomic Sequences division of GenBank. It isdifficult to predict whether any of our or our licensors’ applications willultimately be found to be patentable or, if so, to predict the scope of anyallowed claims. In addition, the disclosure in our or our licensors’ patentapplications, particularly in respect of the utility of our claimed inventions,may not be sufficient to meet the statutory requirements for patentabilityin all cases. As a result, it is difficult to predict whether any of our or ourlicensors’ applications will be allowed, or, if so, to predict the scope of

 

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any allowed claims or the enforceability of thepatents. Even if enforceable, others may be able to design around anypatents or develop similar technologies that are not within the scope of suchpatents. Our and our licensors’ patent applications may not issue aspatents that will provide us with any protection or competitive advantage.

 

***Disputes concerningthe infringement or misappropriation of our proprietary rights or theproprietary rights of others could be time consuming and extremely costly andcould delay our research and development efforts.***

 

Our commercialsuccess, if any, will be significantly harmed if we infringe the patent rightsof third parties or if we breach any license or other agreements that we haveentered into with regard to our technology or business.

 

We are aware of other companies and academicinstitutions that have been performing research in the areas of tastemodulation and flavors, flavor enhancers and taste modulators. In particular,other companies and academic institutions have announced that they haveconducted taste-receptor research and have published data on taste 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.,Pfizer, Inc., Virginia Commonwealth University and the German Institute ofHuman Nutrition. To the extent any of these companies or academic institutionscurrently have, or obtain in the future, broad patent claims, such patentscould block our ability to use various aspects of our discovery and developmentprocess and might prevent us from developing or commercializing newlydiscovered 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 may nothave been licensed to us. While our technology is focused on the use of humanT1R 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 patentableor may be covered by intellectual property of third parties.

 

We are not currently a party to any litigation,interference, opposition, protest, reexamination, reissue or any otherpotentially adverse governmental, ex parte or inter-party proceeding withregard to our patent or trademark positions. However, the life sciences andother technology industries are characterized by extensive litigation regardingpatents and other intellectual property rights. Many life sciences and othertechnology companies have employed intellectual property litigation as a way togain a competitive advantage. If we become involved in litigation, interferenceproceedings, 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 tothe infringement of third-party proprietary rights or proprietarydeterminations, even if not meritorious, could result in costly litigation,lengthy governmental proceedings, divert management’s attention and resources,or require us to enter into royalty or license agreements that are notadvantageous to us.

 

Should any person have filed patent applications orobtained patents that claim inventions also claimed by us, we may have toparticipate in an interference proceeding declared by the relevant patentregulatory agency to determine priority of invention and, thus, the right to apatent for these inventions in the United States. Such a proceeding couldresult in substantial cost to us even if the outcome is favorable. Even ifsuccessful on priority grounds, an interference action may result in lossof claims based on patentability grounds raised in the interference action.Litigation, interference proceedings or other proceedings could divertmanagement’s time and efforts. Even unsuccessful claims could result insignificant legal fees and other expenses, diversion of management’s time anddisruption in our business. Uncertainties resulting from initiation andcontinuation of any patent proceeding or related litigation could

 

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harm our ability to compete and could have asignificant adverse effect on our business, financial condition and results ofoperations.

 

An adverse ruling arising out of any intellectualproperty dispute, including an adverse decision as to the priority of ourinventions, could undercut or invalidate our intellectual property position. Anadverse ruling could also subject us to significant liability for damages, includingpossible treble damages, prevent us from using technologies or developingproducts, or require us to negotiate licenses to disputed rights from thirdparties. Although patent and intellectual property disputes in the technologyarea are often settled through licensing or similar arrangements, costsassociated with these arrangements may be substantial and could includelicense fees and ongoing royalties. Furthermore, necessary licenses may notbe available to us on satisfactory terms, if at all. Failure to obtain alicense in such a case could have a significant adverse effect on our business,financial condition and results of operations.

 

***If we are unable toprotect our trade secrets and other proprietary information, we could lose anycompetitive advantage we may have, which could adversely affect ourbusiness.***

 

We rely in part on trade secret protection forour confidential and proprietary information, know how and processes. Ourpolicy is to execute proprietary information and invention agreements with ouremployees and consultants upon the commencement of an employment or consultingrelationship. These agreements generally require that all confidentialinformation developed by the individual or made known to the individual by usduring the course of the individual’s relationship with us be kept confidentialand not be disclosed to third parties. These agreements also generally providethat inventions conceived by the individual in the course of their employmentshall be our exclusive property. There can be no assurance that we will be ableto effectively enforce these agreements or that proprietary information is ourexclusive property. There can be no assurance that the subject proprietaryinformation will not be disclosed, that others will not independently developsubstantially equivalent proprietary information and techniques or otherwisegain access to our trade secrets or that we can meaningfully protect our tradesecrets. Costly and time-consuming litigation could be necessary to enforce anddetermine the scope of our proprietary rights, and failure to obtain ormaintain trade secret protection could adversely affect our competitivebusiness position.

 

***Many potentialcompetitors, including those who have greater resources and experience than wedo, may develop products or technologies that make ours obsolete ornoncompetitive.***

 

The life sciences and other technology industries arecharacterized by rapid technological change, and the area of sensory or tastereceptor research is a rapidly evolving field. Our future success will dependon our ability to maintain a competitive position with respect to technologicaladvances. Technological developments by others may result in our flavors,flavor enhancers or taste modulators and technologies becoming obsolete.

 

In particular, we face substantial competition fromcompanies pursuing the commercialization of products and services relevant totaste using more traditional methods for the discovery of flavors, flavorenhancers and taste modulators, or for the reduction of salt, sugar, MSG orbitter taste. These competitors include leading flavor companies, such asInternational Flavors & Fragrances Inc., Givaudan SA,Symrise, Quest International and Firmenich. We currently compete and willcontinue to compete in the future with these companies in collaborating withand selling flavor products and technologies to manufacturers of packaged foodand beverage products. Many of these companies have substantially greatercapital resources, research and development resources and experience,manufacturing capabilities, regulatory expertise, sales and marketingresources, established relationships with consumer products companies andproduction facilities.

 

Savory flavor enhancers, particularly inosinemonophosphate, or IMP, are commercially available, and we will compete with thecompanies that produce these flavors. IMP is widely available and is agenerally accepted food additive by the packaged food and beverage industry. Asa result, our existing and future collaborators may choose to incorporateIMP or similar savory flavor enhancers into their packaged food and beverageproducts instead of our savory flavors, flavor enhancers and taste modulators. In

 

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addition, we may compete with bitter masking orbitter blocking compounds, such as adenosine 5’ monophosphate, or AMP.

 

We may in the future face competition from lifesciences and other technology companies and other commercial enterprises. Theseentities engage as we do in biotechnology, biology or chemistry and could applythis technology to the discovery and development of flavors, flavor enhancersand taste modulators. We are aware of one other company, Linguagen Corp., aprivately-held company that we believe is involved in research on sweetnesspotentiators, salt substitutes and bitter blockers, specifically AMP, and hasannounced research and development collaborations with several companies. Wecannot guarantee that products developed as a result of our competitors’existing or future collaborations will not compete with our flavors, flavorenhancers and taste modulators.

 

Universities and public and private researchinstitutions are also potential competitors. While these organizationsprimarily have educational objectives, they may develop proprietarytechnologies related to the sense of taste or secure patent protection that we may needfor the development of our technologies and products. We may attempt tolicense these proprietary technologies, but these licenses may not beavailable to us on acceptable terms, if at all.

 

Our competitors, either alone or with theircollaborative partners, may succeed in developing technologies ordiscovering flavors, flavor enhancers or taste modulators that are moreeffective, safer, more affordable or more easily commercialized than ours, andour competitors may obtain intellectual property protection orcommercialize products sooner than we do. Developments by others may renderour product candidates or our technologies obsolete. In addition, our currentproduct discovery and development collaborators are not prohibited fromentering into research and development collaboration agreements with thirdparties in any product field. Our failure to compete effectively would have a significantadverse effect on our business, financial condition and results of operations.

 

***We may be suedfor product liability, which could adversely affect our business.***

 

Because our business strategy involves the developmentand sale by our collaborators of commercial products incorporating our flavors,flavor enhancers and taste modulators, we may be sued for productliability. We may be held liable if any product we develop andcommercialize, or any product our collaborators commercialize that incorporatesany of our flavors, flavor enhancers or taste modulators, causes injury or isfound otherwise unsuitable during product testing, manufacturing, marketing,sale or consumer use. In addition, the safety studies we must perform andthe FEMA GRAS determination we must obtain prior to incorporating our flavors,flavor enhancers and taste modulators into a commercial product will notprotect us from any such liability.

 

If we and our collaborators commence sale ofcommercial products we will need to obtain product liability insurance, andthis insurance may be prohibitively expensive, or may not fully coverour potential liabilities. Inability to obtain sufficient insurance coverage atan acceptable cost or otherwise to protect against potential product liabilityclaims could prevent or inhibit the commercialization of products developed byus or our product discovery and development collaborators. We may beobligated to indemnify our product discovery and development collaborators forproduct liability or other losses they incur as a result of our flavors, flavorenhancers and taste modulators. Any indemnification we receive from suchcollaborators for product liability that does not arise from our flavors,flavor enhancers and taste modulators may not be sufficient to satisfy ourliability to injured parties. If we are sued for any injury caused by ourflavors, flavor enhancers and taste modulators or products incorporating ourflavors, flavor enhancers and taste modulators, our liability could exceed ourtotal assets.

 

***We use hazardousmaterials. Any claims relating to improper handling, storage or disposal ofthese materials could be time consuming and costly.***

 

Our discovery and development process requires ouremployees to routinely handle hazardous chemical, radioactive and biologicalmaterials. Our operations also produce hazardous waste products. Federal, stateand local laws and regulations govern the use, manufacture, storage, handlingand disposal of these materials. As a result of the increase in size of ouroperations, we were recently re-classified from a

 

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small quantity to a large quantity generator ofhazardous waste. This reclassification may result in increased scrutiny ofour operations by the Environmental Protection Agency. Compliance withapplicable environmental laws and regulations may be expensive, andcurrent or future environmental regulations may impair our discovery anddevelopment efforts.

 

In addition, wecannot entirely eliminate the risk of accidental contamination or discharge andany resultant injury from these materials. Our property and casualty policy hasvery limited coverage for damages or cleanup costs related to radioactivecontamination and pollutants and our general liability insurance policyexcludes coverage for damages and fines arising from biological or hazardouswaste disposal or contamination. We do not carry specific biological orhazardous waste insurance. We may be forced to curtail operations or besued for any injury or contamination that results from our use or the use byothers of these materials, and our liability may exceed our total assets.

 

**RisksRelated To Our Common Stock**

 

***The price of ourcommon stock is volatile.***

 

The market prices for securities of biotechnologycompanies historically have been highly volatile, and the market has from timeto time experienced significant price and volume fluctuations that areunrelated to the operating performance of particular companies. Since ourinitial public offering in June 2004, the price of our common stock hasranged from approximately $5 per share to approximately $23 per share. Themarket price of our common stock may fluctuate in response to manyfactors, including:

 

•                  developmentsrelated to the FEMA GRAS determination and international regulatory approval ofour products;

•                  developmentsconcerning our collaborative agreements;

•                  announcementsof technological innovations by us or others;

•                  developmentsin patent or other proprietary rights;

•                  resultsof safety evaluation of our flavors, flavor enhancers and taste modulators;

•                  resultsof consumer acceptance testing of our flavors, flavor enhancers and tastemodulators by our collaborators;

•                  delaysin commercialization of our flavors, flavor enhancers and taste modulators;

•                  futuresales of our common stock by existing stockholders;

•                  commentsby securities analysts;

•                  generalmarket conditions;

•                  fluctuationsin our operating results;

•                  governmentregulation;

•                  failureof any of our flavors, flavor enhancers or taste modulators, if approved, toachieve commercial success; and

•                  publicconcern as to the safety of our flavors, flavor enhancers, and tastemodulators.

 

***Anti-takeoverprovisions in our charter documents and under Delaware law may make anacquisition of us more complicated and the removal and replacement of ourdirectors and management more difficult.***

 

Provisions of our amended and restated certificate ofincorporation and bylaws, as well as provisions of Delaware law, could make itmore difficult for a third party to acquire us, even if doing so would benefitour stockholders. These provisions may also make it difficult forstockholders to remove and replace our board of directors and management. Theseprovisions:

 

•                  authorizethe issuance of “blank check” preferred stock by our board of directors,without stockholder approval, which could increase the number of outstandingshares and prevent or delay a takeover attempt;

•                  limitwho may call a special meeting of stockholders;

•                  prohibitstockholder action by written consent, thereby requiring all stockholderactions to be taken at a meeting of our stockholders; and

 

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•                  establishadvance notice requirements for nominations for election to the board of directorsor for proposing matters that can be acted upon at stockholder meetings.

 

In addition, the requirements of Section 203 ofthe Delaware General Corporation Law may discourage, delay or prevent athird party from acquiring us.

 

***Our shareholderrights plan may hinder or prevent change of control transactions.***

 

Our shareholder rights plans may discouragetransactions involving an actual or potential change in our ownership. Inaddition, our board of directors may issue shares of preferred stockwithout any further action by you. Such issuances may have the effect ofdelaying or preventing a change in our ownership. 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.

 

***If our officers,directors and largest stockholders choose to act together, they may beable to control our management and operations, acting in their best interestsand not necessarily the interests of other stockholders.***

 

As of February 28, 2006, our executive officers,directors and stockholders with at least 5% of our stock together beneficiallyowned approximately 27% of our common stock. If these officers, directors andprincipal stockholders act together, they will be able to exert a significantdegree of influence over our management and affairs and over matters requiringstockholder approval, including the election of directors and approval ofmergers or other business combination transactions. The interests of thisconcentration of ownership may not always coincide with our interests orthe interests of investors in this offering or other stockholders. Forinstance, officers, directors and principal stockholders, acting together,could cause us to enter into transactions or agreements that we would nototherwise consider. Similarly, this concentration of ownership may havethe 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 paidcash dividends on our capital stock and we do not anticipate paying dividendsin the foreseeable future.***

 

We have paid no cash dividends on any of our classesof capital stock to date, and we currently intend to retain our futureearnings, if any, to fund the development and growth of our business. Inaddition, the terms of any future debt or credit facility may preclude usfrom paying any dividends. As a result, capital appreciation, if any, of ourcommon stock will be your sole source of potential gain for the foreseeablefuture.

 

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**Item 1B.****            *Unresolved Staff Comments***

 

None.

 

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

 

We currently lease 86,962 square feet of laboratoryand office space at 11099 North Torrey Pines Road, La Jolla, California 92037.Of this leased space, as of December 31, 2005 we subleased approximately26,102 square feet to other companies. Our lease for this facility expires on December 31,2006. Our current monthly lease obligations for rent are approximately$272,000, which includes space that has been sublet to other companies. Inaddition, we are responsible for expenses associated with the use andmaintenance of the building, such as utilities and common area maintenance.These costs vary each month, and historically have been approximately $134,000per month.

 

On January 12, 2006 we entered into a leaseagreement with ARE-NEXUS CENTRE II, LLC (“the Nexus Lease”), pursuant to whichwe will lease up to approximately 64,000 square feet of real estate space inSan Diego, California, consisting of laboratory and office space. The lease istargeted to commence on September 1, 2006, with rent targeted to commence April 1,2007 and ending on February 28, 2017. We have the right to extend the termof the Nexus Lease for an additional five years, and we have the right toterminate the Nexus Lease early effective March 31, 2014 upon payment ofan early termination fee.

 

As both leases described above are with the samelandlord, in connection with the execution of the Nexus Lease, on January 12,2006 we amended our existing lease with ARE-11099 North Torrey Pines, LLC forour current property to provide for the extension of the lease term, subject tocertain limitations, until we move all of our operations to the new location,which we expect to occur in the fourth quarter of 2006. As a result of enteringinto two leases with the same landlord, we anticipate that we will be able toavoid making rent payments on two facilities at the same time. Furthermore, weanticipate a period of three months in early 2007 when we will not be requiredto make a payment for rent.

 

We believe that our existing facilities and our newfacilities are adequate to meet our business requirements for the near-term andthat additional space will be available on commercially reasonable terms, ifrequired.

 

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

 

We are not a party to any material legal proceedingsat this time.

 

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

 

No matters were submitted to a vote of our securityholders during the quarter ended December 31, 2005.

 

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**PART II**

 

**Item 5.****           *Market for the Registrant’s Common Equity, RelatedStockholder Matters and Issuer Purchase of Equity Securities***

 

**Common Stock Market Price**

 

Our common stock commenced trading on the NASDAQNational Market on June 22, 2004 under the symbol “SNMX.” The followingtable sets forth the high and low sales prices per share of our common stock astraded on the NASDAQ National Market for the periods indicated.

 
| **Fiscal 2005 Quarter ended** | ** ** | **March 31,  2005** | ** ** | **June 30,  2005** | ** ** | **September  30, 2005** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------|------------|--------------------------|------------|-------------------------|------------|-------------------------|------------|-----------------------------|------------|
| High                          |       | $                        | 13.73      |                    | $          | 16.84                   |       | $                           | 22.80      |   | $ | 17.05 |   |
| Low                           |       | $                        | 7.91       |                    | $          | 9.99                    |       | $                           | 16.01      |   | $ | 11.50 |   |

 
| **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 last sale price for our common stock as reportedby the NASDAQ National Market on February 28, 2006 was $16.26 per share.As of February 28, 2006, there were approximately 97 shareholders ofrecord of our common stock.

 

We have never declared or paid any cash dividends toour shareholders. We do not presently plan to pay cash dividends in theforeseeable future and intend to retain any future earnings for reinvestment inour business.

 

Information about our equity compensation plans isincluded in Item 12 of Part III of this Annual Report.

 

**Repurchases of Equity Securities**

 

There were norepurchases of equity securities in the fourth quarter of 2005.

 

**Use of Proceeds**

 

Our initial public offering, referred to as theOffering, of our common stock, par value $0.001, was effected through aRegistration Statement on Form S-1 (File No. 333-113998) that wasdeclared effective by the SEC on June 21, 2004. The Registration Statementcovered the 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 of common stock were sold for anaggregate offering price of $36.0 million. On July 23, 2004, 450,000 sharesof our common stock were sold for an aggregate offering price of $2.7 millionupon the exercise of the underwriters’ over-allotment option. The Offeringterminated following the sale of all of the foregoing securities and theexpiration of the underwriters’ over-allotment option. The Offering resulted inaggregate proceeds to us of approximately $34.3 million, net of underwritingdiscounts and commissions of approximately $2.7 million and offering expensesof approximately $1.7 million, through a syndicate of underwriters managed byCitigroup Global Markets Inc., Deutsche Bank Securities Inc., Needham &Company, Inc. and First Albany Capital Inc.

 

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No offering expenses were paid directly or indirectlyto any of our directors or officers (or their associates) or person owning tenpercent or more of any class of our equity securities or to any otheraffiliates. All offering expenses were paid directly to others.

 

As of December 31, 2005, we estimate that we hadused approximately $2.4 million for the purchase of equipment and approximately$19.7 million for working capital expenditures. The remainder of the proceedshas been invested into short-term securities and cash equivalents.

 

The foregoing payments were direct payments made tothird parties who were not our directors or officers (or their associates),persons owning ten percent or more of any class of our equity securitiesor any other affiliate, except that the proceeds used for working capitalincluded regular compensation for officers and directors. The use of proceedsdoes not 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.

 

On November 9, 2005, we completed a publicoffering of 4,049,295 shares of common stock for proceeds of $57.3 million, netof underwriting discounts, commissions and offering expenses. The offering wasmade under a shelf registration statement and included the exercise by theunderwriters of an over-allotment option of 528,169 shares of common stock. Noproceeds from this offering had been used as of December 31, 2005.

 

**Item 6.****           *Selected Financial Data***

 

The Statement of Operations Data and Balance SheetData presented below should be read in conjunction with Item 7, Management’sDiscussion and Analysis of Financial Condition and Results of Operations, andItem 8, Financial Statement included in this Annual Report on Form 10-K.Amounts are in thousands, except share and per share amounts.

 
| ** **                                                       | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                       | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Statements  of Operations Data:**                              |       |                              |       |   |   |   |   |   |   |   |   |
| Revenue  under collaborative agreements                          |       | $                                 | 9,385      |   | $ | 8,347 |   | $ | 9,537 |   | $ | 7,327 |   | $ | 2,275 |   |
| Operating  expenses:                                             |       |                              |       |   |   |   |   |   |   |   |   |
| Research and  development                                        |       | 17,683                            |       | 16,907 |   | 16,802 |   | 17,635 |   | 16,263 |   |
| General and  administrative                                      |       | 7,528                             |       | 5,553 |   | 4,096 |   | 4,154 |   | 4,952 |   |
| Stock-based  compensation:                                       |       |                              |       |   |   |   |   |   |   |   |   |
| Research and  development                                        |       | 2,647                             |       | 1,411 |   | 1,293 |   | 540 |   | 1,240 |   |
| General and  administrative                                      |       | 2,701                             |       | 4,625 |   | 4,997 |   | 158 |   | 378 |   |
| Total  operating expenses                                        |       | 30,559                            |       | 28,496 |   | 27,188 |   | 22,487 |   | 22,833 |   |
| Loss from  operations                                            |       | (21,174                           | )          | (20,149 | ) | (17,651 | ) | (15,160 | ) | (20,558 | ) |
| Interest  income, net                                            |       | 1,344                             |       | 435 |   | 198 |   | 339 |   | 329 |   |
| Net loss                                                         |       | $                                 | (19,830    | ) | $ | (19,714 | ) | $ | (17,453 | ) | $ | (14,821 | ) | $ | (20,229 | ) |
| Basic and  diluted net loss per share(1):                        |       |                              |       |   |   |   |   |   |   |   |   |
| Historical                                                       |       | $                                 | (0.77      | ) | $ | (1.40 | ) | $ | (10.03 | ) | $ | (9.60 | ) | $ | (17.30 | ) |
| Pro Forma                                                        |       | $                                 | (0.77      | ) | $ | (0.89 | ) | $ | (0.97 | ) |   |   |   |   |
| Shares used  to compute basic and diluted net loss per share(1): |       |                              |       |   |   |   |   |   |   |   |   |
| Historical                                                       |       | 25,916,229                        |       | 14,040,727 |   | 1,739,380 |   | 1,544,268 |   | 1,169,134 |   |
| Pro Forma                                                        |       | 25,916,229                        |       | 22,143,380 |   | 17,944,686 |   |   |   |   |   |

 

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(1)          Please see Note 1to our financial statements for an explanation of the method used to calculatethe historical and pro forma net loss per share and the number of shares usedin the computation of the per share amounts.

 

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| ** **                                                 | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                 | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Balance  Sheet Data:**                                   |       |                        |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and investments available-for-sale |       | $                           | 83,813     |   | $ | 40,847 |   | $ | 17,058 |   | $ | 27,586 |   | $ | 24,726 |   |
| Working  capital                                           |       | 80,178                      |       | 36,841 |   | 15,160 |   | 22,667 |   | 20,862 |   |
| Total assets                                               |       | 88,531                      |       | 43,802 |   | 20,440 |   | 34,720 |   | 34,402 |   |
| Long-term  obligations                                     |       | —                      |       | — |   | — |   | 906 |   | 729 |   |
| Accumulated  deficit                                       |       | (104,226                    | )          | (84,396 | ) | (64,682 | ) | (47,229 | ) | (32,408 | ) |
| Total  stockholders’ equity                           |       | 82,445                      |       | 38,373 |   | 17,104 |   | 28,219 |   | 29,057 |   |
|                                                            |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Item 7.****           *Management’s Discussion and Analysis of FinancialCondition and Results of Operations***

 

*The following discussion of ourfinancial condition and results of operations should be read in conjunctionwith our Financial Statements and the related Notes to Financial Statements inItem 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.*

 

*Certain statements contained in this annual report on Form 10-K,including statements regarding the development, growth and expansion of ourbusiness, our intent, belief or current expectations, primarily with respect toour future operating performance, and the products we expect to offer and otherstatements regarding matters that are not historical facts, are “forward-lookingstatements” within the meaning of Section 27A of the Securities Act and Section 21Eof the Securities Exchange Act of 1934, as amended, or Exchange Act, and aresubject to the “safe harbor” created by these sections. Future filings with theSEC, future press releases and future oral or written statements made by us orwith our approval, which are not statements of historical fact, may alsocontain forward-looking statements. Because such statements include risks anduncertainties, many of which are beyond our control, actual results may differmaterially from those expressed or implied by such forward-looking statements.Some of the factors that could cause actual results to differ materially fromthose expressed or implied by such forward-looking statements can be foundunder the caption “Risk Factors,” and elsewhere in this annual report on Form 10-K.Readers are cautioned not to place undue reliance on forward-lookingstatements. The forward-looking statements speak only as of the date on whichthey are made, and we undertake no obligation to update such statements toreflect events that occur or circumstances that exist after the date on whichthey are made.*

 

**Overview and RecentDevelopments**

** **

We are a leading company focused on using proprietarytaste receptor-based assays, screening technologies and optimization chemistryto discover and develop novel flavors, flavor enhancers and taste modulatorsfor the packaged food and beverage industry. We believe our flavor ingredientswill enable packaged food and beverage companies to improve the nutritionalprofile of their products while maintaining or enhancing taste and may generatecost of goods savings. We license our flavor ingredients to our collaboratorson an exclusive or co-exclusive basis, which we believe will provide these companieswith the ability to differentiate their products. We have entered into productdiscovery and development collaborations with five of the world’s leadingpackaged food and beverage companies: Cadbury Schweppes, Campbell Soup Company(or Campbell Soup), The Coca-Cola Company (or Coca-Cola), Kraft Foods Global, Inc.(or Kraft Foods) and Nestlé SA (or Nestlé). We currently anticipate that wewill derive all of our revenues from existing and future collaborations.Depending upon the collaboration, our existing collaboration agreements providefor upfront fees, research and development funding, reimbursement of certainregulatory costs, milestone payments based upon our achievement of research ordevelopment goals and, in the event of commercialization, royalties on futuresales of consumer products incorporating our flavors, flavor enhancers or tastemodulators. Our current programs focus on the development of savory, sweet andsalt flavor enhancers and bitter taste modulators.

 

We have incurred significant losses since ourinception in 1998 and, as of December 31, 2005 our accumulated deficit was$104.2 million. We expect to incur additional losses over at least the next two

 

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years as we continue to develop flavors, flavorenhancers and taste modulators. Our results of operations have fluctuated fromperiod to period and likely will continue to fluctuate substantially in thefuture based upon:

 

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

 

•                  our ability to discover and developnew flavors, flavor enhancers and taste modulators or the ability of ourproduct discovery and development collaborators to incorporate them into theirproducts;

 

•                  our ability to enter into new, orextend existing, product discovery and development collaborations andtechnology collaborations;

 

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

 

•                  variability of our stock-based compensationexpense in conjunction with fluctuations of our stock price.

 

In March 2005, we were notified by the Flavor andExtract Manufacturers Association (FEMA) that our savory enhancers S807 andS336 have been determined to be Generally Recognized as Safe (GRAS) under theprovisions of the Federal Food, Drug and Cosmetic Act, administered by theUnited States Food and Drug Administration (FDA). In addition, two of our othersavory enhancers, S263 and S976, which are related to S336, were alsodetermined to be GRAS.

 

In April 2005, we announced an agreement for athree-year extension of the collaborative research phase of our initialdiscovery and development agreement with Nestlé. Under the terms of theextension, based upon research progress, Nestlé has agreed to pay usincremental discovery and development funding of up to $6.6 million over aperiod of up to an additional three years, subject to certain terminationprovisions.

 

In May 2005, we announced an agreement for anexpansion and extension of the collaborative research phase under our discoveryand development agreement with Kraft Foods. During the extension period, whichran through July 30, 2005, we began working with Kraft Foods on anexclusive basis on the discovery and development of novel flavor modifiers in anew product field in the dessert category. We also agreed to continue to workwith Kraft Foods for the discovery and development of novel flavor enhancers ona co-exclusive basis in an existing specified food and beverage product field. KraftFoods agreed to continue its existing research funding to us during theextension period.

 

In July 2005, we entered into an agreement for atwo-year extension of the collaborative research phase under our discovery anddevelopment agreement with Kraft Foods. During the extension period, we willcontinue working with Kraft Foods on the discovery and development of novelflavor modifiers on an exclusive basis in a specified product field in thedessert product category and on a co-exclusive basis in an existing specifiedfood and beverage product field. Under the terms of the extension, Kraft Foodshas agreed to pay us incremental discovery and development funding of over $2.7million over the two-year extension period, subject to certain termination provisions.Upon commercialization, we will be entitled to royalty payments based on salesof Kraft products containing any flavor enhancers developed under theagreement.

 

In July 2005, we entered into a CollaborativeResearch and License Agreement with Cadbury Schweppes for the discovery andcommercialization of new flavor ingredients in the gum confectionary area.Under the terms of the agreement, Cadbury Schweppes agreed to pay us researchfunding for up to two years based on research progress during the collaborativeperiod, subject to certain termination provisions. In addition, we are eligibleto receive milestone payments upon achievement of specific

 

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product discovery and development goals. The combinedtotal of research funding and milestone payments could exceed $3.0 million ifall milestones are met. Upon commercialization, we will receive royaltypayments based on sales of products containing new flavor ingredients developedunder the agreement.

 

In November 2005, we completed a public offeringof 4.0 million shares of common stock for proceeds of $57.3 million, net ofunderwriting discounts, commissions and offering expenses. The offering wasmade under a shelf registration statement and included the exercise by theunderwriters of an over-allotment option of 528,000 shares of common stock.

 

In December 2005, we amended our existingagreement with Kraft Foods to provide for a new three-year discovery anddevelopment collaboration. In this new collaboration, we will work with KraftFoods on the discovery and development of novel flavor modifiers on aco-exclusive basis in the chilled and processed meat product category withinNorth America. Under the terms of the new collaboration, Kraft Foods has agreedto pay us an initial license fee and incremental discovery and developmentfunding over the collaborative period, subject to certain terminationprovisions. In addition, we are eligible to receive milestone payments upon theachievement of specific product discovery and development goals. The combinedtotal of initial license fees, research funding and milestone payments couldreach $4.6 million, if all milestones are met. Upon commercialization, we willbe entitled to royalty payments based on sales of Kraft products containing anyflavor modifiers developed under the agreement.

 

In February 2006, we amended our existingagreement with Campbell Soup to extend the collaborative research phase for anadditional research phase of up to three years, through March 2009. Duringthe extension period, we will continue to work with Campbell on the discoveryand commercialization of new ingredients that improve the taste of wet soupsand savory beverages. Under the terms of the extension, Campbell Soup hasagreed to pay us incremental research funding of up to $3.0 million, assumingwe meet specified research goals, over the three-year extension period. Theother payment terms of the existing agreement, including milestones androyalties based on net sales of products using the new ingredients, remainunchanged.

 

**Revenue**

** **

We derive revenue from our product discovery anddevelopment collaborations. To date, our revenue has come solely from upfrontfees, research and development funding, reimbursement of certain regulatorycosts and milestone payments under our product discovery and developmentcollaboration agreements with Cadbury Schweppes, Campbell Soup, Coca-Cola,Kraft Foods and Nestlé. As of December 31, 2005, we have recognizedcumulative revenue under our collaborations of $37.0 million. If any of thesecollaborative agreements were to be terminated, this could have a significanteffect on future revenues.

 

From our inception date to the present, research anddevelopment payments represented the primary source of our revenue. Based oncurrent collaborations, we anticipate that substantially all of our revenues inthe near future will be derived from research and development payments, and we may receiveadditional milestone payments in the future upon the achievement of certaingoals set forth in our collaboration agreements.

 

In addition, in the event our collaborators launchproducts incorporating our flavors, flavor enhancers or taste modulators, wewill receive royalty payments based upon the future sales of those products,which, if received, could be significantly larger than research and developmentfunding or milestone payments. In order for us to generate royalty revenue andbecome profitable, we must retain our existing or establish new productdiscovery and development collaborations and our collaborators mustcommercialize products incorporating one or more of our flavors, flavorenhancers or taste modulators. Our ability to generate royalty revenue isuncertain and will depend upon our ability to meet particular research,development and commercialization objectives.

 

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**Research and Development**

** **

Our research and development expenses consistprimarily of costs associated with our discovery and development efforts inconnection with our four primary programs: savory, sweet, salt and bitter. Wetrack research and development costs by the type of cost incurred rather thanby project. Research and development costs are comprised of salaries and otherpersonnel related expenses, facilities and depreciation, research anddevelopment supplies, patent and licensing, and outside services. We chargeresearch and development expenses to operations as incurred.

 

The research and development payments we have receivedfrom our collaboration agreements with Cadbury Schweppes, Campbell Soup,Coca-Cola, Kraft Foods and Nestlé historically have not covered all of ourresearch and development expenses. We expect that our research and developmentexpenses are likely to increase in the future as a result of our existingproduct discovery and development collaborations, internal product discoveryand development activities and technology development and any expansion ofthese activities.

 

At this time, due to the risks inherent in thediscovery of flavors, flavor enhancers and taste modulators, we are unable toestimate with any certainty the costs we will incur in the continueddevelopment of our flavors, flavor enhancers and taste modulators forcommercialization. We anticipate that we will make determinations regarding theresearch and development projects to pursue and the funding of each project onan ongoing basis in response to the progress of each discovery and developmentprogram, as well as an ongoing assessment of its market potential. We cannot becertain when any net cash inflow from the commercialization of our flavors,flavor enhancers and taste modulators will commence.

 

Our ability to complete the development of our currentproduct candidates is subject to many risks and uncertainties. These risksinclude the risks, among others, that:

 

•                  we are substantially dependent uponour collaborators for research and development funding;

 

•                  our collaborators may terminatetheir respective collaboration programs early;

 

•                  we may not be able to discoverflavors, flavor enhancers or taste modulators with the desired tasteattributes;

 

•                  we may not be successful indeveloping flavors, flavor enhancers or taste modulators with attributesrequired for use in commercial products;

 

•                  we may be unable to maintainFEMA GRAS determination for our savory product candidates; and

 

•                  we may be unable to obtain FEMAGRAS determination for candidates in our other programs.

 

If we do not complete the development of our flavors,flavor enhancers and taste modulators on a timely basis, our collaborators may terminateor not renew our collaboration agreements, we may begin receiving revenuefrom the commercialization of products incorporating our flavors, flavorenhancers and taste modulators later than anticipated, or not at all, and it may bemore difficult to enter into new collaboration agreements. In any of thesecases, we may require substantial additional funding in order to continuedevelopment of our flavors, flavor enhancers and taste modulators.

 

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**General andAdministrative**

** **

General and administrative expenses consist primarilyof salaries and other personnel-related expenses related to businessdevelopment, legal, financial and other administrative functions andSarbanes-Oxley compliance. We expect that our general and administrativeexpenses will increase in 2006 primarily as a result of the implementation ofrevised Statement of Financial Accounting Standards (“SFAS”) No. 123 (SFASNo.123(R)), *Share-Based Payment*.

 

**Stock-Based Compensation**

** **

We have recorded deferred compensation for stockoptions and stock awards granted equal to the difference between the exerciseprice and the fair value of our common stock on the date of grant as determinedfor the purpose of recording our initial public offering (IPO) cheap stockcalculation. We record options or awards issued to non-employees at their fairvalue in accordance with the Statement of Financial Accounting Standards (“SFAS”)No. 123, *Accounting for Stock-Based Compensation*,and periodically remeasure them in accordance with Emerging Issues Task Force No. (“EITF”)96-18, *Accounting for Equity Instruments That Are Issuedto Other Than Employees for Acquiring or in Conjunction with Selling Goods or Services*,and recognize them over the service period. In connection with the grant ofstock options to 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. We recorded employee and non-employeestock-based compensation expense of $5.3 million, $6.0 million and $6.3 millionfor the years ended December 31, 2005, 2004 and 2003, respectively.

 

In December 2004, the Financial AccountingStandards Board (“FASB”) issued revised statement No. 123 (SFAS No. 123(R)),*Share-Based Payment,* which requires companies to expensethe estimated fair value of employee stock options and similar awards. Thisstatement is a revision to SFAS No. 123, *Accountingfor Stock-Based Compensation*, and supersedes Accounting PrinciplesBoard (“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. 123(R)will be effective for the first quarter of fiscal 2006. In conjunction with theadoption of SFAS No. 123(R), the unamortized balance of deferredcompensation recorded for our IPO cheap stock calculation will be written offagainst stockholders’ equity. As of December 31, 2005, the unamortizedbalance of deferred compensation was $1.1 million.

 

SFAS No. 123(R) permits public companies tochoose between the following two adoption methods:

 

1. A “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) basedon the requirements of SFAS No. 123(R) for all share-based paymentsgranted after the effective date and (b) based on the requirements of SFASNo. 123 for all awards granted to employees prior to the effective date ofSFAS No. 123(R) that remain unvested on the effective date, or

 

2. A “modified retrospective” method which includesthe requirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underSFAS No. 123 for purposes of pro forma disclosures for either (a) allprior periods presented or (b) prior interim periods of the year ofadoption.

 

As permitted by SFAS No. 123, we currentlyaccount for share-based payments to employees using APB Opinion No. 25’sintrinsic value method. The impact of the adoption of SFAS No. 123 (R) 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. 123 (R) is similar to SFAS No. 123, with minorexceptions. For information about what our reported results of operations andearnings per share would have been for the year ended December 31, 2005had we 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. 123(R)’s fair value method will have a significant impact onour results of operations, although it will have no impact on our liquidity oroverall financial condition. Use of an option valuation model, as required bySFAS No. 123 and SFAS No. 123(R), includes highly subjective

 

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assumptions based on long-term predictions, includingthe expected stock price volatility and average life of each stock optiongrant. The Black-Scholes option-pricing model was developed for use inestimating the fair value of traded options that have no restrictions and arefully transferable and negotiable in a free trading market. This model does notconsider the employment, transfer or vesting restrictions that are inherent inour employee stock options or purchase rights granted pursuant to the EmployeeStock Purchase Plans. Because our share-based payments have characteristicssignificantly different from those of freely traded options, and becausechanges in the subjective input assumptions can materially affect our estimateof the fair values, in our opinion, existing valuation models may not bereliable single measures of the fair values of our share-based payments. SFAS No. 123(R)also requires the benefits of tax deductions in excess of recognizedcompensation cost to be reported as a financing cash flow, rather than as anoperating cash flow as required under current literature. This requirement willreduce net operating cash flows and increase net financing cash flows inperiods after adoption.

 

**Results of Operations**

 

**Years Ended December 31,2005, 2004 and 2003**

 

***Revenue UnderCollaboration Agreements***

 

We recorded revenue of $9.4 million, $8.3 million and$9.5 million during the years ended December 31, 2005, 2004 and 2003,respectively. Research and development payments, reimbursement of certainregulatory expenses, upfront fees and milestone payments under collaborationswith Cadbury Schweppes, Campbell Soup, Coca-Cola, Kraft Foods, and Nestléaccounted for approximately 100% of total revenue for the year ended December 31,2005. Research and development payments and milestone payments undercollaborations with Campbell Soup, Coca-Cola, Kraft Foods, and Nestlé accountedfor 100% of total revenue for the years ended December 31, 2004 and 2003.

 

***Research andDevelopment Expenses***

 

Our research and development expenses (excludingstock-based compensation expenses charged to research and development) were$17.7 million, $16.9 million, and $16.8 million for the years ended December 31,2005, 2004 and 2003. Stock-based compensation expenses charged to research anddevelopment for the years ended December 31, 2005, 2004 and 2003 were $2.6million, $1.4 million and $1.3 million, respectively. A comparison of researchand development expenses exclusive of stock-based compensation expenses bycategory is as follows (in thousands):

 
| ** **                               | ** ** | **Year Ended  December 31,** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|
| ** **                               | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Salaries and  personnel                  |       | $                                 | 7,685      |   | $ | 7,211 |   | $ | 5,466 |   |
| Facilities  and depreciation             |       | 4,568                             |       | 4,449 |   | 4,498 |   |
| Research and  development supplies       |       | 2,742                             |       | 1,989 |   | 2,299 |   |
| Patent and  licensing                    |       | 1,406                             |       | 1,588 |   | 3,741 |   |
| Outside  services                        |       | 806                               |       | 1,357 |   | 479 |   |
| Miscellaneous                            |       | 476                               |       | 313 |   | 317 |   |
| Total  research and development expenses |       | $                                 | 17,683     |   | $ | 16,907 |   | $ | 16,802 |   |

 

***Salaries andPersonnel.***Our expenses for research and developmentpersonnel, including consultants, were $7.7 million, $7.2 million and $5.5million for the years ended December 31, 2005, 2004 and 2003, respectively.The increase of $474,000 from 2004 to 2005 was primarily due to increases inpayroll expenses of approximately $575,000, partially offset by a decrease inconsulting expense of approximately $103,000. Our research and developmentstaff increased from an average of 56 for the year ended December 31, 2004to an average of 61 for the year ended December 31, 2005. The increase instaff was primarily to support continuing optimization of product candidatesfrom our discovery and development programs. The increase of $1.7 million from2003 to 2004 was primarily due to increases in payroll expenses, recruitingexpenses and employee benefits expenses of approximately $1.4 million, $158,000and $125,000, respectively. Our research and development staff increased from anaverage of 50 for the year

 

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ended December 31, 2003 to an average of 56 forthe year ended December 31, 2004. The increase in staff was primarily tosupport continuing optimization of product candidates from our discovery anddevelopment programs.

 

***Facilities andDepreciation.***  Our facilities and depreciationexpenses were $4.6 million, $4.4 million and $4.5 million for the yearsended December 31, 2005, 2004 and 2003, respectively. The increase of $119,000from 2004 to 2005 was primarily attributable to an increase in rent expense andrelated costs of approximately $349,000, incurred as a result of reducedsublease rental income and increased rent expense due to inflation adjustments.This increase was partially offset by a reduction in our depreciation expenseof approximately $230,000. The decrease of $49,000 from 2003 to 2004 wasprimarily attributable to a reduction of depreciation expense of approximately$506,000, offset by an increase in rent expense and other related costs ofapproximately $436,000 incurred as a result of occupying additional spacewithin our facility for the full year, as opposed to part of the year in2003.

 

***Research andDevelopment Supplies.***Our expenses for supplies used inresearch and development were $2.7 million, $2.0 million and $2.3 million forthe years ended December 31, 2005, 2004 and 2003, respectively. Theincrease of $753,000 from 2004 to 2005 was primarily attributable to increasedpurchases of scientific supplies and compound acquisition expenses associatedwith increased screening activity in 2005. The decrease of $310,000 from 2003to 2004 was primarily attributable to reduced screening activities as ourresearch and development activities were focused on certain less expensiveoptimization activities during 2004.

 

***Patent andLicensing.***Our patent and licensing expenses were $1.4million, $1.6 million and $3.7 million for the years ended December 31,2005, 2004 and 2003, respectively. The decrease of $182,000 from 2004 to 2005was primarily attributable to reduced licensing fees in 2005 compared to 2004.The decrease of $2.2 million from 2003 to 2004 was primarily attributable toreduced licensing fees in 2004 compared to 2003. Included in licensing fees wasthe amortization of certain licenses totaling $2.9 million for the year ended December 31,2003. The related licenses were fully amortized at December 31, 2003, thuswe did not have any costs relating to the amortization of these licenses forthe year ended 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.

 

***Outside Services.***Ouroutside services expenses were $806,000, $1.4 million and $479,000 for theyears ended December 31, 2005, 2004 and 2003, respectively. The decreaseof $551,000 from 2004 to 2005 was primarily attributable to a reduction ofcosts incurred for outsourced development activities related to the developmentof our savory compounds, which were determined to be FEMA GRAS in March 2005.The increase of $878,000 from 2003 to 2004 was primarily attributable to costsincurred for outsourced development activities, including regulatory studiesand product candidate synthesis scale-up.

 

***General andAdministrative Expenses***

 

Our general and administrative expenses (excludingstock-based compensation expenses charged to general and administrative) were$7.5 million, $5.6 million and $4.1 million for the years ended December 31,2005, 2004 and 2003, respectively. Stock-based compensation expenses charged togeneral and administrative for the years ended December 31, 2005, 2004 and2003 were $2.7 million, $4.6 million and $5.0 million, respectively. The $2.0million increase in expenses (other than stock-based compensation expense) from2004 to 2005 was primarily attributable to an increase in expenses forpersonnel and related expenses of approximately $1.0 million due to increasedheadcount reflecting our increased business development activities, reportingactivities and Sarbanes-Oxley compliance activities. Additionally, the increasein expense was due to increases in audit, legal and consulting fees ofapproximately, $358,000, $178,000 and $53,000, respectively, due toSarbanes-Oxley compliance requirements and increased reporting obligations as aresult of being a public company for a full year, as opposed to part ofthe year in 2004. The $1.5 million increase in expenses (other than stock-basedcompensation expense) from 2003 to 2004 was primarily attributable to anincrease in expenses for personnel and related expenses of approximately$849,000, an increase in facilities expense of approximately $319,000, and anincrease in public relations and marketing costs of approximately $263,000.

 

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***Stock-basedCompensation***

 

Our aggregate stock-based compensation expensescharged to both research and development and general and administrativeexpenses decreased to $5.3 million for the year ended December 31, 2005from $6.0 million for the year ended December 31, 2004. The decrease inoverall stock-based compensation expense is primarily due to a decrease instock-based compensation expense in 2005 compared to 2004 for stock optionsgranted to employees, as the amortization of deferred compensation related tothese stock options is recognized on an accelerated basis, partially offset byan increase in compensation expense in 2005 compared to 2004 for stock optionsgranted to non-employees, as the fair value of these options at December 31,2005 was revalued in accordance with EITF Issue No. 96-18. Our aggregatestock-based compensation expenses charged to both research and development andgeneral and administrative expenses decreased to $6.0 million for the yearended December 31, 2004 from $6.3 million for the year ended December 31,2003. The decrease in overall stock-based compensation expense is primarily dueto a decrease in compensation expense in 2004 compared to 2003 for stockoptions granted to employees, partially offset by an increase in compensationexpense in 2004 compared to 2003 for stock options granted to non-employees, asthe fair value of these options at December 31, 2004 was revalued inaccordance with EITF Issue No. 96-18. In connection with the grant ofstock options to 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. Commencing in the first quarter of2006, we will adopt SFAS No. 123(R), which requires companies to expensethe estimated fair value of employee stock options and similar awards. Inconjunction with the adoption of SFAS No. 123(R), the unamortized balanceof deferred compensation will be written off against stockholders’ equity. Asof December 31, 2005, the unamortized balance of deferred compensation was$1.1 million.

 

***Interest Income,net***

 

Interest income was $1.3 million, $435,000 and$268,000 for the years ended December 31, 2005, 2004 and 2003,respectively. The increase of $909,000 from 2004 to 2005 was primarilyattributable to our higher average cash balances for the year ended December 31,2005 as a result of our initial public offering in June 2004 and our November 2005public offering of common stock, which generated higher interest earnings onthose balances. The increase of $167,000 from 2003 to 2004 was primarilyattributable to our higher average cash balances for the year ended December 31,2004 as a result of our initial public offering in June 2004, whichgenerated higher interest earnings on those balances. Interest expense was $0,$0 and $70,000 for the years ended December 31, 2005, 2004 and 2003,respectively. Interest expense decreased $70,000 from 2004 to 2003 due to thepayment in full of equipment financing debt in July 2003.

 

***Liquidity and Capital Resources***

 

Since our inception, we have financed our businessprimarily through private and public placements of stock, research anddevelopment payments under our product discovery and development collaborationswith Cadbury Schweppes, Campbell Soup, Coca-Cola, Kraft Foods, and Nestlé, andinterest income. As of December 31, 2005 we had received in excess of$164.9 million in proceeds from the sales of common and preferred stock. Inaddition, we had received $38.0 million in non-refundable license fees,research and development payments, cost reimbursements and milestone paymentsfrom our collaboration agreements, and $3.6 million in interest income. As of December 31,2005, over the remaining life of our current collaboration agreements, weexpect to receive an additional $27.7 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.

 

At December 31, 2005, we had $83.8 million incash, cash equivalents and investments available-for-sale as compared to $40.8million at December 31, 2004, an increase of $43.0 million. This overallincrease resulted primarily from the sale of common stock for net proceeds of$58.7 million.

 

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***OperatingActivities***

 

Operating activities used cash of $13.9 million for theyear ended December 31, 2005 compared to $10.1 million for the year ended December 31,2004. Operating cash flow in 2005 compared to the prior year period reflects anincrease in our net loss of $116,000. Non-cash expenses for the year ended December 31,2005 decreased $1.2 million to $6.3 million for the year ended December 31,2005 from $7.5 million for the year ended December 31, 2004. This decreasewas primarily due to a relative decrease in the amortization of employeedeferred compensation of approximately $2.6 million for the year ended December 31,2005, partially offset by an increase in stock-based compensation expense fornon-employees of $1.9 million for the year ended December 31, 2005. Additionally,net increases in operating assets and liabilities over the year ended December 31,2005 used cash of $456,000, while net increases in operating assets andliabilities over the year ended December 31, 2004 provided cash of $2.1million.

 

Operating activities used cash of $10.1 million forthe year ended December 31, 2004 compared to $8.3 million for the yearended December 31, 2003. Operating cash flow in 2004 compared to the prioryear period reflects an increase in our net loss of $2.3 million. Non-cashexpenses for the year ended December 31, 2004 decreased $3.7 million to$7.5 million for the year ended December 31, 2004 from $11.2 million forthe year ended December 31, 2003. This decrease was primarily due torelative decreases in depreciation and license amortization expense ofapproximately $3.6 million, specifically the amortization of certain licensestotaling $2.9 million for the year ended December 31, 2003. The relatedlicenses were fully amortized at December 31, 2003, thus we did not haveany non-cash amortization expense relating to the amortization of theselicenses for the year ended December 31, 2004. Additionally, net increasesin operating 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.

 

***InvestingActivities***

 

Investing activities provided cash of $12.1 millionfor the year ended December 31, 2005, and used cash of $21.3 million forthe year ended December 31, 2004. Cash provided in 2005 reflects thematurities of available-for-sale securities of $45.8 million, offset bypurchases of available-for-sale securities of $31.8 million with the proceedsfrom our public offering in November 2005 to obtain higher rates ofinterest income.   Cash used in 2004 reflects the purchases ofavailable-for-sale securities with the proceeds from our initial publicoffering in June 2004 to obtain higher rates of interest income.

 

Investing activities used cash of $21.3 million forthe year ended December 31, 2004, and provided cash of $1.7 million forthe year ended December 31, 2003. Cash used in 2004 reflects the purchasesof available-for-sale securities with the proceeds from our initial publicoffering in June 2004 to obtain higher rates of interest income.   Cashprovided in 2003 reflects the maturities of available-for-sale securities,partially offset by purchases of available-for-sale securities.

 

***FinancingActivities***

 

Financing activities provided cash of $58.7 millionfor the year ended December 31, 2005, provided cash of $35.0 million forthe year ended December 31, 2004 and used cash of $1.7 million for theyear ended December 31, 2003. Cash provided by financing activities in2005 reflects the net proceeds from the sale of common stock of $58.7 million,primarily from the sale of common stock during our November 2005 publicoffering of common stock. Cash provided by financing activities in 2004reflects the net proceeds from the sale of common stock of $35.0 million,primarily from the sale of common stock during our initial public offering. Cashused by financing activities in 2003 reflects the repayment of equipmentfinancing arrangements of $1.8 million, offset by the net proceeds of $53,000from the issuance of common stock.

 

48

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As of December 31, 2005 future minimum paymentsdue under our contractual obligations are as follows (in thousands):

 
| ** **       | ** ** | **Payments Due by Period** | ** ** |
|------------------|------------|----------------------------|------------|
| ** **       | ** ** | **Total**                  | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **After 5 years** | ** ** |
| Operating leases |       | $                          | 4,211      |   | $ | 4,182 |   | $ | 29 |   | $ | — |   | $ | — |   |
| License payments |       | 257                        |       | 85 |   | 74 |   | 44 |   | 54 |   |
| Total            |       | $                          | 4,468      |   | $ | 4,267 |   | $ | 103 |   | $ | 44 |   | $ | 54 |   |

 

In January 2006, we entered into a leaseagreement with ARE-NEXUS CENTRE II, LLC (the “Nexus Lease”) to leaseapproximately 64,000 square feet of office, research and development space fora term targeted to commence on September 1, 2006, with rent paymentstargeted to commence April 1, 2007 and ending on February 28, 2017.Annual rent payments are expected to be approximately $2.3 million, subject toannual rent increases of 3%. In connection with the execution of the NexusLease, we amended our existing lease with ARE-11099 North Torrey Pines, LLC forour current property to provide for the extension of the lease term, subject tocertain limitations, until we move all of our operations to the new location,which we expect to occur in the fourth quarter of 2006.

 

As of December 31, 2005, we had no long-term debtobligations.

 

As of December 31, 2005, we have net openpurchase orders (defined as total open purchase orders at year end less anyaccruals or invoices charged to or amounts paid against such purchase orders)totaling approximately $88,000. In the next twelve months, we also plan tospend approximately $4.0 to $4.5 million on capital expenditures.

 

Our future capital uses and requirements depend onnumerous forward-looking factors. These factors may include, but are notlimited to, the following:

 

•                  the rate of progress and cost ofresearch and development activities;

•                  the number and scope of our researchactivities;

•                  the costs of filing, prosecuting,defending and enforcing any patent claims and other intellectual propertyrights;

•                  our ability to establish and maintainproduct discovery and development collaborations;

•                  the effect of competing technologicaland market developments;

•                  the terms and timing of anycollaborative, licensing and other arrangements that we may establish; and

•                  the extent to which we acquire orin-license new products, technologies or businesses.

 

We believe our available cash, cash equivalents,investments and existing sources of funding will be sufficient to satisfy ouranticipated operating and capital requirements through at least the next 12months.

 

Until we can generate significant cash from ouroperations, we expect to continue to fund our operations with existing cashresources that were primarily generated from the proceeds of offerings of ourequity securities and research and development payments and milestone paymentsunder our product discovery and development collaborations. As of December 31,2005, under our existing collaboration agreements, assuming all milestones areachieved and we receive all research and development funding, we may beentitled to up to $38.3 million. In 2006, we anticipate receiving $10.2 millionin non-refundable research and development funding. This does not include anyadditional payments we may receive related to the achievement ofadditional milestones, or to new collaborations or extensions of existingcollaborations. We may not receive the payments if the collaborations areterminated or not renewed, or if we do not achieve the milestones set forth inthe collaboration agreements. In addition, the timing of the receipt of milestonepayments in particular is uncertain, as we may achieve milestonessignificantly earlier or later than we currently expect. We continue to pursueadditional collaborations, which could result in additional revenue. We may notrecognize revenues for research and development funding or milestones if

 

49

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the collaborations are terminated, or if we do notachieve the milestones set forth in the collaboration agreements. Our expenseswill vary based upon (but not limited to) the forward-looking factors listedabove. Upon the implementation of SFAS No. 123(R) or other similaraccounting changes, our non-cash stock-based compensation expense will varyupon the volatility of our stock price, the risk-free interest rate, theexpected life of our stock options, the closing price of our stock, the strikeprice at which stock options are granted and the number of options granted.

 

As of December 31, 2005 and 2004, we did not haveany relationships with unconsolidated entities or financial partnerships, suchas entities often referred to as special purpose or structured financeentities, which would have been established for the purposes of facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes. As such, we are not materially exposed to any financing, liquidity,market or credit risk that could arise if we had engaged in theserelationships.

 

**Critical Accounting Policies**

 

Our discussion and analysis of our financial conditionand results of operations are based on our financial statements, which havebeen prepared in accordance with U.S. generally accepted accounting principles,or GAAP. The preparation of these financial statements requires management tomake 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, including thoserelated to revenue recognition, long-lived assets, accrued liabilities, andincome taxes. These estimates are based on historical experience and variousother assumptions that we believe to be reasonable under the circumstances, theresults of which form the basis for judgments about the carrying values ofassets and liabilities. Actual results may differ from these estimatesunder different assumptions or conditions. While our significant accountingpolicies are described in more detail in Note 1 to our financial statements, webelieve the following accounting policies to be critical to the judgments andestimates used in the preparation of our financial statements:

 

***Revenue Recognition***

 

Our revenue recognition policies are in compliancewith the Staff Accounting Bulletin (“SAB”) No. 104, *Revenue Recognition in Financial Statements*and EITF Issue No. 00-21, *RevenueArrangements with Multiple Deliverables*. Revenue is deferred forfees received before earned. Some of our agreements contain multiple elements,including upfront fees, research funding, reimbursement of certain regulatorycosts, milestones, and royalties.

 

Revenue from milestones is recognized when earned, asevidenced by written acknowledgement from the collaborator or other persuasiveevidence that the milestone has been achieved, provided that (i) the milestoneevent is substantive and its achievability was not reasonably assured at theinception of the agreement, and (ii) our 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 our performance obligations under the agreement. Non-refundable upfrontfees, if not associated with our future performance, are recognized whenreceived. Non-refundable license fees, if associated with our futureperformance, are recognized over the related service period. Amounts receivedfor research funding are recognized as revenues as the services are performed. Royaltiesto be received based on product sales made by our collaborators incorporatingour product, if any, will be recognized as earned. To date, we have not earnedany royalties.

 

***Stock-based Compensation***

 

As permitted by SFAS No. 123, *Accounting for Stock-Based Compensation*, we account forstock options granted to employees using the intrinsic value method inaccordance with Accounting Principles Board, or APB, Opinion No. 25, *Accounting for Stock Issued to Employees*, and the FinancialAccounting Standards Board, or FASB, Interpretation No. 44, *Accounting for Certain Transactions Involving Stock Compensation – AnInterpretation of APB 25*. Pursuant to these guidelines, we measurethe intrinsic value of the option or restricted stock award on its grant dateas the 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

 

50

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date of issuance or grant, and expense the difference,if any, over the vesting period of the option or restricted stock award.

 

SFAS No. 123 required stock-based compensation tobe accounted for under the fair value method. 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 methodis disclosed in the notes to the financial statements.

 

Options or stock awards are issued to non-employeesare recorded at their fair value in accordance with SFAS No. 123, andperiodically remeasured in accordance with EITF No. 96-18, *Accounting for Equity Instruments That Are Issued to Other ThanEmployees for Acquiring or in Conjunction with Selling Goods or Services*,and recognized over the related service period.

 

**New Accounting Pronouncements**

 

In December 2004, the FASB issued SFAS No. 123(R),*Share-Based Payment,* which requires companies to expensethe estimated fair value of employee stock options and similar awards. Thisstatement is a revision to SFAS No. 123 and supersedes APB Opinion No. 25,*Accounting for Stock Issued to Employees,*and amends FASB Statement No. 95, *Statement of Cash Flows.*Theaccounting provisions of SFAS No. 123(R) will be effective for the firstquarter of fiscal 2006.

 

SFAS No. 123(R) permits public companies tochoose between the following two adoption methods:

 

1. A “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) basedon the requirements of SFAS No. 123(R) for all share-based paymentsgranted after the effective date and (b) based on the requirements of SFASNo. 123 for all awards granted to employees prior to the effective date ofSFAS No. 123(R) that remain unvested on the effective date, or

 

2. A “modified retrospective” method which includesthe requirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underSFAS No. 123 for purposes of pro forma disclosures for either (a) allprior periods presented or (b) prior interim periods of the year ofadoption.

 

As permitted by SFAS No. 123, we currentlyaccount for share-based payments to employees using APB Opinion No. 25’sintrinsic value method. The impact of the adoption of SFAS No. 123(R)cannot be predicted at this time because it will be depend on levels ofshare-based payments granted in the future. However, valuation of employeestock options under SFAS No. 123(R) is similar to SFAS No. 123, withminor exceptions. For information about what our reported results of operationsand earnings per share would have been had we adopted SFAS No. 123, pleasesee the discussion under the heading “Stock-based Compensation” in Note 1 toour Financial Statements. Accordingly, the adoption of SFAS No. 123(R)’sfair value method will have a significant impact on our results of operations,although it will have no impact on our overall financial position. Use of anoption valuation model, as required by SFAS No. 123 and SFAS No. 123(R),includes highly subjective assumptions based on long-term predictions,including the expected stock price volatility and average life of each stockoption grant. The Black-Scholes option-pricing model was developed for use inestimating the fair value of traded options that have no restrictions and arefully transferable and negotiable in a free trading market. This model does notconsider the employment, transfer or vesting restrictions that are inherent inour employee stock options or purchase rights granted pursuant to the EmployeeStock Purchase Plans. Because our share-based payments have characteristicssignificantly different from those of freely traded options, and becausechanges in the subjective input assumptions can materially affect our estimateof the fair values, in our opinion, existing valuation models may not bereliable single measures of the fair values of our share-based payments. SFAS No. 123(R)also requires the benefits of tax deductions in excess of recognizedcompensation cost to be reported as a financing cash flow, rather than as anoperating cash flow as required under current literature. This requirement willreduce net operating cash flows and increase net financing cash flows inperiods after adoption. In conjunction with the adoption of SFAS No. 123(R),the unamortized balance of deferred compensation on our balance sheet at December 31,2005 will be written off against stockholders’

 

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equity. As of December 31, 2005, the unamortizedbalance of deferred compensation was $1.1 million.

 

**Item 7A. *Quantitative and QualitativeDisclosures About Market Risk***

 

Our primary exposure to market risk is interest incomesensitivity, which is affected by changes in the general level of United Statesinterest rates. Due to the nature of our short-term investments, we believethat we are not subject to any material market risk exposure. We do not haveany foreign currency or other derivative financial instruments.

 

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

 

**Index to Financial Statements**

 
| **Description**                                         | ** ** | ** ** |
|---------------------------------------------------------|------------|------------|
|                                                    |       |       |
| Report of Independent Registered Public Accounting Firm |       |       |
|                                                    |       |       |
| Balance  Sheets                                         |       |       |
|                                                    |       |       |
| Statements  of Operations                               |       |       |
|                                                    |       |       |
| Statements of Shareholders’ Equity                 |       |       |
|                                                    |       |       |
| Statements  of Cash Flows                               |       |       |
|                                                    |       |       |
| Notes to Financial Statements                           |       |       |

 

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**Reportof Independent Registered Public Accounting Firm**

 

To theBoard of Directors and Stockholders of Senomyx, Inc.

 

 We have audited the accompanying balancesheets of Senomyx, Inc. as of December 31, 2005 and 2004, and therelated statements of operations, stockholders’ equity, and cash flows foreach of the three years in the period ended December 31, 2005. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

 We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

 In our opinion, the financial statementsreferred to above present fairly, in all material respects, the financialposition of Senomyx, Inc. at December 31, 2005 and 2004, and theresults of its operations and its cash flows for each of the three years in theperiod ended December 31, 2005, in conformity with U.S. generally acceptedaccounting principles.

 

 We also have audited, in accordance with thestandards of the Public Company Accounting Oversight Board (United States), theeffectiveness of Senomyx, Inc.’s internal control over financial reportingas of December 31, 2005, based on criteria established in Internal Control — Integrated Frameworkissued by the Committee of Sponsoring Organizations of the TreadwayCommission and our report dated March 3, 2006 expressed an unqualifiedopinion thereon.

 
|                  | /s/  ERNST & YOUNG LLP |
|-----------------------|-------------------------------------------|
|                  |                                      |
| San Diego, California |                                      |
| March 3, 2006    |                                      |

 

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**Senomyx, Inc.**

**Balance Sheets**

 

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

 
| ** **                                                                                                                                                                | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Assets:**                                                                                                                                                               |       |                  |       |   |   |
| Current  assets:                                                                                                                                                          |       |                  |       |   |   |
|                                                                                                                                                                      |       |                  |       |   |   |
| Cash and  cash equivalents                                                                                                                                                |       | $                     | 73,908     |   | $ | 17,085 |   |
| Investments  available-for-sale                                                                                                                                           |       | 9,905                 |       | 23,762 |   |
| Other  current assets                                                                                                                                                     |       | 2,300                 |       | 1,213 |   |
|                                                                                                                                                                      |       |                  |       |   |   |
| Total  current assets                                                                                                                                                     |       | 86,113                |       | 42,060 |   |
|                                                                                                                                                                      |       |                  |       |   |   |
| Property and  equipment, net                                                                                                                                              |       | 2,418                 |       | 1,742 |   |
|                                                                                                                                                                      |       |                  |       |   |   |
| Total assets                                                                                                                                                              |       | $                     | 88,531     |   | $ | 43,802 |   |
|                                                                                                                                                                      |       |                  |       |   |   |
| **Liabilities  and stockholders’ equity**                                                                                                                            |       |                  |       |   |   |
| Current  liabilities:                                                                                                                                                     |       |                  |       |   |   |
|                                                                                                                                                                      |       |                  |       |   |   |
| Accounts  payable and accrued expenses                                                                                                                                    |       | $                     | 4,096      |   | $ | 3,208 |   |
| Other  current liabilities                                                                                                                                                |       | 111                   |       | 153 |   |
| Deferred  revenue                                                                                                                                                         |       | 1,728                 |       | 1,858 |   |
|                                                                                                                                                                      |       |                  |       |   |   |
| Total  current liabilities                                                                                                                                                |       | 5,935                 |       | 5,219 |   |
|                                                                                                                                                                      |       |                  |       |   |   |
| Deferred  rent                                                                                                                                                            |       | 151                   |       | 210 |   |
|                                                                                                                                                                      |       |                  |       |   |   |
| Commitments                                                                                                                                                               |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                                                               |       |                  |       |   |   |
| Common  stock, $.001 par value, 120,000,000 shares authorized; 29,678,697 and  25,309,565 shares issued and outstanding at December 31, 2005 and 2004,  respectively |       | 30                    |       | 25 |   |
| Additional  paid-in-capital                                                                                                                                               |       | 187,792               |       | 126,243 |   |
| Deferred  compensation                                                                                                                                                    |       | (1,143                | )          | (3,492 | ) |
| Accumulated  other comprehensive loss                                                                                                                                     |       | (8                    | )          | (7 | ) |
| Accumulated  deficit                                                                                                                                                      |       | (104,226              | )          | (84,396 | ) |
|                                                                                                                                                                      |       |                  |       |   |   |
| Total  stockholders’ equity                                                                                                                                          |       | 82,445                |       | 38,373 |   |
|                                                                                                                                                                      |       |                  |       |   |   |
| Total  liability and stockholders’ equity                                                                                                                            |       | $                     | 88,531     |   | $ | 43,802 |   |

 

See accompanying notes to financial statements.

 

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**Senomyx, Inc.**

**Statements of Operations**

 

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

 
| ** **                                                                                                               | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                               | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                     |       |                              |       |   |   |   |   |
| Revenue  under collaborative agreements                                                                                  |       | $                                 | 9,385      |   | $ | 8,347 |   | $ | 9,537 |   |
| Operating  expenses:                                                                                                     |       |                              |       |   |   |   |   |
| Research and  development                                                                                                |       | 17,683                            |       | 16,907 |   | 16,802 |   |
| General and  administrative                                                                                              |       | 7,528                             |       | 5,553 |   | 4,096 |   |
| Stock-based  compensation:                                                                                               |       |                              |       |   |   |   |   |
| Research and  development                                                                                                |       | 2,647                             |       | 1,411 |   | 1,293 |   |
| General and  administrative                                                                                              |       | 2,701                             |       | 4,625 |   | 4,997 |   |
|                                                                                                                     |       |                              |       |   |   |   |   |
| Total  operating expenses                                                                                                |       | 30,559                            |       | 28,496 |   | 27,188 |   |
|                                                                                                                     |       |                              |       |   |   |   |   |
| Loss from  operations                                                                                                    |       | (21,174                           | )          | (20,149 | ) | (17,651 | ) |
|                                                                                                                     |       |                              |       |   |   |   |   |
| Interest  income                                                                                                         |       | 1,344                             |       | 435 |   | 268 |   |
| Interest  expense                                                                                                        |       | —                            |       | — |   | (70 | ) |
|                                                                                                                     |       |                              |       |   |   |   |   |
| Net loss                                                                                                                 |       | $                                 | (19,830    | ) | $ | (19,714 | ) | $ | (17,453 | ) |
|                                                                                                                     |       |                              |       |   |   |   |   |
| Basic and  diluted net loss per share                                                                                    |       | $                                 | (0.77      | ) | $ | (1.40 | ) | $ | (10.03 | ) |
|                                                                                                                     |       |                              |       |   |   |   |   |
| Shares used  to compute basic and diluted net loss per share                                                             |       | 25,916,229                        |       | 14,040,727 |   | 1,739,380 |   |
|                                                                                                                     |       |                              |       |   |   |   |   |
| Pro forma  net loss per common share assuming conversion of preferred stock, basic and  diluted                          |       | $                                 | (0.77      | ) | $ | (0.89 | ) | $ | (0.97 | ) |
|                                                                                                                     |       |                              |       |   |   |   |   |
| Shares used  in computing pro forma net loss per common share assuming conversion of  preferred stock, basic and diluted |       | 25,916,229                        |       | 22,143,380 |   | 17,944,686 |   |

 

Seeaccompanying notes to financial statements.

 

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**Senomyx, Inc.**

**Statementsof Stockholders’ Equity**

**(Inthousands, 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, 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 |   |
|                                                                                                             |       |                |       |             |       |              |       |                    |       |         |       |                            |       |             |       |                          |       |   |   |   |   |
| 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 cancellation  of 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 |   |
|                                                                                                                  |            |                     |            |                  |            |                   |            |                         |            |              |            |                                 |            |                  |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

57

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| ** **                                                                          | ** ** | **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, 2004                                                   |       | —              |       | $                | —     |              | 25,309,565 |                    | $          | 25           |       | $                              | —     |             | $          | 126,243                       |       | $ | (3,492 | ) | $ | (7 | ) | $ | (84,396 | ) | $ | 38,373 |   |
|                                                                                |       |                |       |             |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Issuance of common stock related to the exercise of  options                        |       | —              |       | —           |       | 196,270           |       | 1                       |       | —       |       | 617                            |       | —           |       | —                        |       | — |   | 618 |   |
| Issuance of common stock related to employee stock  plan purchases                  |       | —              |       | —           |       | 123,567           |       | —                  |       | —       |       | 640                            |       | —           |       | —                        |       | — |   | 640 |   |
| Issuance of common stock in a public offering, net of  issuance costs               |       | —              |       | —           |       | 4,049,295         |       | 4                       |       | —       |       | 57,294                         |       | —           |       | —                        |       | — |   | 57,298 |   |
| Compensation related to restricted stock issued to  consultants                     |       | —              |       | —           |       | —            |       | —                  |       | —       |       | 2,870                          |       | —           |       | —                        |       | — |   | 2,870 |   |
| Compensation related to acceleration of vesting of  stock option issued to director |       | —              |       | —           |       | —            |       | —                  |       | —       |       | 128                            |       | —           |       | —                        |       | — |   | 128 |   |
| Amortization of deferred compensation                                               |       | —              |       | —           |       | —            |       | —                  |       | —       |       | —                         |       | 2,349            |       | —                        |       | — |   | 2,349 |   |
| Comprehensive loss:                                                                 |       |                |       |             |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Unrealized loss on investments                                                      |       | —              |       | —           |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | (1                            | )          | — |   | (1 | ) |
| Net loss                                                                            |       | —              |       | —           |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | —                        |       | (19,830 | ) | (19,830 | ) |
| Comprehensive loss                                                                  |       | —              |       | —           |       | —            |       | —                  |       | —       |       | —                         |       | —           |       | —                        |       | — |   | (19,831 | ) |
|                                                                                |       |                |       |             |       |              |       |                    |       |         |       |                           |       |             |       |                          |       |   |   |   |   |
| Balance at December 31, 2005                                                   |       | —              |       | $                | —     |              | 29,678,697 |                    | $          | 30           |       | $                              | —     |             | $          | 187,792                       |       | $ | (1,143 | ) | $ | (8 | ) | $ | (104,226 | ) | $ | 82,445 |   |

 

See accompanying notes to financial statements.

 

58

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**Senomyx, Inc.**

**Statements of Cash Flows**

**(In thousands)**

 
| ** **                                                                                                                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Operating  Activities**                                                                                                   |       |                              |       |   |   |   |   |
| Net loss                                                                                                                    |       | $                                 | (19,830    | ) | $ | (19,714 | ) | $ | (17,453 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:                                                |       |                              |       |   |   |   |   |
| Depreciation  and amortization                                                                                              |       | 1,215                             |       | 1,462 |   | 2,017 |   |
| Amortization  of bond discount                                                                                              |       | (215                              | )          | — |   | — |   |
| Amortization  of loan discount                                                                                              |       | —                            |       | — |   | 8 |   |
| Stock-based  compensation for non-employees                                                                                 |       | 2,998                             |       | 1,119 |   | 1,253 |   |
| Amortization  of deferred compensation                                                                                      |       | 2,349                             |       | 4,917 |   | 5,037 |   |
| Amortization  of license fees                                                                                               |       | —                            |       | — |   | 2,868 |   |
| Change in  operating assets and liabilities:                                                                                |       |                              |       |   |   |   |   |
| Other  current assets                                                                                                       |       | (978                              | )          | 44 |   | (581 | ) |
| Accounts  payable and accrued expenses                                                                                      |       | 711                               |       | 1,621 |   | (435 | ) |
| Deferred  revenue                                                                                                           |       | (130                              | )          | 443 |   | (1,151 | ) |
| Deferred  rent                                                                                                              |       | (59                               | )          | 29 |   | 181 |   |
| Net cash  used in operating activities                                                                                      |       | (13,939                           | )          | (10,079 | ) | (8,256 | ) |
|                                                                                                                        |       |                              |       |   |   |   |   |
| **Investing  activities**                                                                                                   |       |                              |       |   |   |   |   |
| Purchases of  property and equipment                                                                                        |       | (1,941                            | )          | (1,079 | ) | (552 | ) |
| Proceeds  from sale of property and equipment                                                                               |       | 84                                |       | — |   | — |   |
| Purchases of  available-for-sale securities                                                                                 |       | (31,813                           | )          | (27,505 | ) | (9,715 | ) |
| Maturities  of available-for-sale securities                                                                                |       | 45,775                            |       | 7,300 |   | 11,927 |   |
| Net cash  provided by (used in) investing activities                                                                        |       | 12,105                            |       | (21,284 | ) | 1,660 |   |
|                                                                                                                        |       |                              |       |   |   |   |   |
| **Financing  activities**                                                                                                   |       |                              |       |   |   |   |   |
| Repayment of  loans                                                                                                         |       | —                            |       | — |   | (1,768 | ) |
| Proceeds  from issuance of common stock                                                                                     |       | 58,657                            |       | 34,986 |   | 53 |   |
| Repurchase  of common stock                                                                                                 |       | —                            |       | (31 | ) | — |   |
| Net cash  provided by (used in) financing activities                                                                        |       | 58,657                            |       | 34,955 |   | (1,715 | ) |
|                                                                                                                        |       |                              |       |   |   |   |   |
| Net increase  (decrease) in cash and cash equivalents                                                                       |       | 56,823                            |       | 3,592 |   | (8,311 | ) |
| Cash and  cash equivalents at beginning of year                                                                             |       | 17,085                            |       | 13,493 |   | 21,804 |   |
| Cash and  cash equivalents at end of year                                                                                   |       | $                                 | 73,908     |   | $ | 17,085 |   | $ | 13,493 |   |
|                                                                                                                        |       |                              |       |   |   |   |   |
| **Supplemental  disclosure of cash flow information:**                                                                      |       |                              |       |   |   |   |   |
| Cash paid  during the year for interest                                                                                     |       | $                                 | —     |   | $ | — |   | $ | 74 |   |
|                                                                                                                        |       |                              |       |   |   |   |   |
| **Supplemental  schedule of non-cash investing and financing activities:**                                             |       |                              |       |   |   |   |   |
| Purchases of  property and equipment included in accounts payable, accrued expenses and  other current liabilities          |       | $                                 | 34         |   | — |   | — |   |
| Proceeds  from issuance of common stock (net) included in accounts payable, accrued  expenses and other current liabilities |       | $                                 | 101        |   | — |   | — |   |
| Conversion  of preferred stock into common stock                                                                            |       | —                            |       | $ | 70,150 |   | — |   |

 

See accompanying notes to financial statements.

 

59

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**Senomyx, Inc.**

**Notes toFinancial Statements**

 

**1. Organization and Summary of Significant AccountingPolicies**

 

***Organization and Business***

 

Senomyx, Inc. (the “Company”) was incorporated onSeptember 16, 1998 in Delaware and commenced operations in January 1999.The Company is a biotechnology company using proprietary taste receptor-basedassays, screening technologies and optimization chemistry to discover anddevelop novel flavors, flavor enhancers and taste modulators for the packagedfood and beverage industry. The Company has entered into product discovery anddevelopment collaborations with five of the world’s leading packaged food andbeverage companies: Cadbury Schweppes, Campbell Soup Company (“Campbell Soup”),The Coca-Cola Company (“Coca-Cola”), Kraft Foods Global, Inc. (“KraftFoods”), and Nestlé SA (“Nestlé”). The Company’s collaboration agreementsprovide for upfront license fees, research funding, reimbursement of certainregulatory costs, milestone payments if the Company achieves development goalsand royalties on future sales of consumer products incorporating the Company’sflavors, flavor enhancers and taste modulators. The Company currently hasprograms focused on the development of savory, sweet, salt and bitter flavors,flavor enhancers and taste modulators.

 

***Use of Estimates***

 

The preparation of financial statements in conformitywith U. S. generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

 

***Cash and Cash Equivalents***

 

The Company considers all highly liquid investmentswith a remaining maturity of less than three months when purchased to be cashequivalents. Cash equivalents are recorded at cost, which approximates marketvalue.

 

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

 

The Company’s surplus cash is invested in commercialpaper and United States government agency bonds 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 all amortizationand accretion included in interest income. The Company’s short-term investmentsare classified as available-for-sale and carried at estimated fair value, asdetermined by quoted market prices, with unrealized gains and losses reportedin a separate component of accumulated other comprehensive income. Realizedgains and losses and declines in value judged to be other-than-temporary, ifany, on available-for-sale securities are included in interest income. The costof securities sold is based on the specific identification method. Interest onsecurities classified as available-for-sale is included in interest income.

 

***Fair Value of Financial Instruments***

 

The carrying amount of cash and cash equivalents,investments available-for-sale, accounts payable and accrued expenses areconsidered to be representative of their respective fair value because of theshort-term nature of those items.

 

***Concentration of Credit Risk and MajorCollaborations***

 

Financial instruments, which potentially subject theCompany to concentrations of credit risk, consist of cash, cash equivalents andinvestments available-for-sale. The Company limits its exposure to credit lossby placing its cash, cash equivalents, and investments with high credit qualityfinancial institutions in instruments with short maturities.

 

60

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The Company derives its revenues from a relativelysmall number of collaborators. For the year ended December 31, 2005,revenues from five collaborators accounted for 16%, 16%, 21%, 43% and 4%,respectively, of total revenues. For the year ended December 31, 2004,revenues from four collaborators accounted for 17%, 23%, 24% and 36%,respectively, of total revenues. For the year ended December 31, 2003,revenues from four collaborators accounted for 22%, 28%, 28% and 22%,respectively, of total revenues.

 

***Property and Equipment***

 

Property and equipment are stated at cost lessaccumulated depreciation and are depreciated over the estimated useful lives ofthe assets (ranging from three to five years) using the straight-line method.Leasehold improvements are amortized over the estimated useful life of theasset or the lease term, whichever is shorter.

 

***Patent Costs***

 

Costs related to filing and pursuing patent applicationsare expensed as incurred, as recoverability of such expenditures is uncertain.

 

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

 

In accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*, if indicatorsof impairment exist, the Company assesses the recoverability of the affectedlong-lived assets by determining whether the carrying value of such assets canbe recovered through undiscounted future operating cash flows. If impairment isindicated, the Company measures the amount of such impairment by comparing thefair value to the carrying value. There have been no indicators of impairmentthrough December 31, 2005.

 

***Revenue Recognition***

 

The Company’s revenue recognition policies are incompliance with the Staff Accounting Bulletin (“SAB”) No. 104, *Revenue Recognition in Financial Statements*and Emerging Issues Task Force (“EITF”) Issue 00-21, *Revenue Arrangements with Multiple Deliverables*. Revenue isdeferred for fees received before earned. Some of the Company’s agreementscontain multiple elements, including research funding, milestones androyalties.

 

Revenue from milestones is recognized when earned, asevidenced by written acknowledgment from the collaborator or other persuasiveevidence that the milestone has been achieved, provided that (i) themilestone event is substantive and its achievability was not reasonably assuredat the inception of the agreement, and (ii) the Company’s performanceobligations after the milestone achievement will continue to be funded by thecollaborator at a level comparable to before the milestone achievement. If bothof these criteria are not met, the milestone payment is recognized over theremaining minimum period of the Company’s performance obligations under theagreement. Non-refundable license fees, if not associated with future Companyperformance, are recognized when received. Non-refundable license fees, ifassociated with future Company performance, are recognized over the associatedperiod of service. Amounts received for research funding are recognized asrevenues 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.

 

61

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***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.

 

***Comprehensive Income (Loss)***

 

SFAS No. 130, *ReportingComprehensive Income*, requires that all components of comprehensiveincome, including net income, be reported in the financial statements in theperiod in which they are recognized. Comprehensive income (loss) is defined asthe change in equity during a period from transactions and other events andcircumstances from non-owner sources. The Company’s accumulated othercomprehensive loss, as of December 31, 2005 and 2004, consisted ofunrealized losses on investments available-for-sale and is reported instockholders’ equity.

 

***Deferred Rent***

 

Rent expense is recorded on a straight-line basis overthe term of the lease. The difference between rent expense accrued and amountspaid under the lease agreement is recorded as deferred rent in the accompanyingbalance sheets.

 

***Stock-Based Compensation***

 

As permitted by SFAS No. 123, *Accounting for Stock-Based Compensation*,the Company has elected to follow Accounting Principles Board Opinion No. 25,*Accounting for Stock Issued to Employees*(“APB No. 25”), and related interpretations in accounting for its employeestock option plan and employee stock purchase plan. Under APB No. 25, whenthe purchase price of restricted stock or the exercise price of the Company’semployee stock options equals or exceeds the fair value of the underlying stockon the date of issuance or grant, no compensation expense is recognized. TheCompany has recorded deferred stock compensation of $0, $442,000, and $13.3million during the years ended December 31, 2005, 2004 and 2003, respectively,for the difference between the original exercise price per share determined bythe Board of Directors and the revised estimate of fair value per share at therespective grant dates. Deferred stock compensation is recognized and amortizedon an accelerated basis in accordance with Financial Accounting Standards BoardInterpretation (“FIN”) No. 28, *Accountingfor Stock Appreciation Rights and Other Variable Stock Option or Award Plans*,over the vesting period of the related options, generally four years.

 

Options or stock awards issued to non-employees arerecorded at their fair value in accordance with SFAS No. 123, *Accounting for Stock-Based Compensation*,and EITF No. 96-18, *Accounting forEquity Instruments That Are Issued to Other Than Employees for Acquiring or inConjunction with Selling Goods or Services*, and are periodicallyrevalued as the options vest and are recognized as expense over the relatedservice period. The Company granted stock options and stock awards tonon-employees as follows: 0, 468,937 and 97,508 for the years ended December 31,2005, 2004 and 2003, respectively. Compensation expense related to non-employeestock option grants and stock awards was $2.9 million, $1.1 million and$1.3 million for the years ended December 31, 2005, 2004 and 2003,respectively. The options and stock awards were valued using the Black-Scholesoption pricing model with the following weighted-average assumptions for theyears ended December 31, 2005, 2004 and 2003: (a) risk free interestrates of 4.1%, 3.0% and 3.0%; (b) dividend yield of 0% for all periods, (c) expectedvolatility of 70% for all periods; and (d) expected life of five years forall periods.

 

As required under SFAS No. 123, the pro formaeffects of employee stock-based compensation on net loss are estimated at thedate of grant using the Black-Scholes option-pricing model. The Black-Scholesoption valuation model was developed for use in estimating the fair value oftraded options that have no vesting restrictions and are fully transferable.Because the Company’s employee stock options have characteristics significantlydifferent from those of traded options, and because changes in the subjectiveinput assumptions can materially affect the fair value estimate, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock options.

 

62

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The fair value of options issued to employees wasestimated at the date of grant using the Black-Scholes option valuation modelwith the following weighted average assumptions for the years ended December 31,2005, 2004, and 2003: (a) risk-free interest rates of 4.1%, 3.0% and 3.0%;(b) expected dividend yield of 0% for all periods; (c) volatilityfactor of 70% for all periods; and (d) five-year estimated life of theoptions for all periods. The estimated weighted average fair value of stockoptions granted during 2005, 2004 and 2003 was $6.03, $6.55 and $15.74,respectively.

 

For purposes of pro forma disclosures, the estimatedfair value of the options is amortized to expense over the vesting period ofthe related options. The Company’s pro forma information follows (in thousands,except per share data):

 
| ** **                                                                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss as  reported                                                                 |       | $                                 | (19,830    | ) | $ | (19,714 | ) | $ | (17,453 | ) |
| Add:  Stock-based employee compensation expense included in net loss                  |       | 2,477                             |       | 4,917 |   | 5,037 |   |
| Deduct:  Stock-based employee compensation expense determined under fair value method |       | (6,538                            | )          | (6,452 | ) | (5,120 | ) |
|                                                                                  |       |                              |       |   |   |   |   |
| Pro forma  net loss                                                                   |       | $                                 | (23,891    | ) | $ | (21,249 | ) | $ | (17,536 | ) |
|                                                                                  |       |                              |       |   |   |   |   |
| Basic and  diluted net loss per share as reported                                     |       | $                                 | (0.77      | ) | $ | (1.40 | ) | $ | (10.03 | ) |
|                                                                                  |       |                              |       |   |   |   |   |
| Pro forma  basic and diluted net loss per share                                       |       | $                                 | (0.92      | ) | $ | (1.51 | ) | $ | (10.08 | ) |

 

***Net Loss Per Share***

 

The Company calculated net loss per share inaccordance with SFAS No. 128, *EarningsPer Share*, and SAB No. 98. Basic earnings per share (“EPS”) iscalculated by dividing the net income or loss by the weighted average number ofcommon shares outstanding for the period, without consideration for commonstock equivalents. Diluted EPS is computed by dividing the net income or lossby the weighted average number of common share equivalents outstanding for theperiod determined using the treasury-stock method. For purposes of thiscalculation, common stock subject to repurchase by the Company, convertiblepreferred stock, options, and warrants are considered to be common stockequivalents and are only included in the calculation of diluted earnings pershare when their effect is dilutive.

 

The following table sets forth the computation ofbasic and diluted, and unaudited pro forma basic and diluted, net loss pershare for the respective periods. The unaudited pro forma basic and diluted netloss per share represent the weighted average common shares outstanding reducedby the weighted average unvested common shares subject to repurchase, and givesthe effect to the conversion of the convertible preferred stock into shares ofcommon stock as if converted at the date of original issuance.

 

63

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| ** **                                                                                         | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                         | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Historical:**                                                                                    |       |                             |       |   |   |   |   |
| Net loss (in  thousands)                                                                           |       | $                                | (19,830    | ) | $ | (19,714 | ) | $ | (17,453 | ) |
| Weighted  average common shares                                                                    |       | 26,090,294                       |       | 14,354,942 |   | 1,975,074 |   |
| Weighted  average unvested common shares subject to repurchase                                     |       | (174,065                         | )          | (314,215 | ) | (235,694 | ) |
| Denominator  for basic and diluted earnings per share                                              |       | 25,916,229                       |       | 14,040,727 |   | 1,739,380 |   |
| Basic and  diluted net loss per share                                                              |       | $                                | (0.77      | ) | $ | (1.40 | ) | $ | (10.03 | ) |
|                                                                                               |       |                             |       |   |   |   |   |
| **Pro  forma:**                                                                                    |       |                             |       |   |   |   |   |
| Net loss (in  thousands)                                                                           |       | $                                | (19,830    | ) | $ | (19,714 | ) | $ | (17,453 | ) |
| Pro forma  basic and diluted net loss per share                                                    |       | $                                | (0.77      | ) | $ | (0.89 | ) | $ | (0.97 | ) |
| Shares used  above                                                                                 |       | 25,916,229                       |       | 14,040,727 |   | 1,739,380 |   |
| Pro forma  adjustment to reflect assumed weighted average effect of conversion of  preferred stock |       | —                           |       | 8,102,653 |   | 16,205,306 |   |
| Pro forma  shares used to compute basic and diluted net loss per share                             |       | 25,916,229                       |       | 22,143,380 |   | 17,944,686 |   |

 
| ** **                                                                                                   | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                   | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                         |       |                             |       |   |   |   |   |
| **Historical  outstanding antidilutive securities not included in diluted net loss per  share calculation:** | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred  stock*                                                                                            |       | —                           |       | 8,102,653 |   | 16,205,306 |   |
| Common stock  subject to repurchase                                                                          |       | 148,779                          |       | 228,092 |   | 211,862 |   |
| Options to  purchase common stock                                                                            |       | 2,483,417                        |       | 1,992,710 |   | 1,404,598 |   |
| Warrants                                                                                                     |       | —                           |       | — |   | 10,199 |   |
|                                                                                                         |       |                             |       |   |   |   |   |
|                                                                                                         |       | 2,632,196                        |       | 10,323,455 |   | 17,831,965 |   |

 

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* Represents the number of shares of commonstock into which preferred stock was convertible.

 

***Segment Reporting***

 

The Company currently operates in a single operatingsegment. The Company generates revenues from collaborations that resultprimarily from its underlying research and development activities. In addition,financial results are prepared and reviewed by management as a single operatingsegment. The Company periodically evaluates the benefits of operating indistinct segments and will report accordingly when such distinction is made.

 

***Recent Accounting Pronouncements***

 

In March 2004, the EITF reached a finalconsensus on 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 an investmentsecurity is less than its carrying value, an impairment exists for which thedetermination must be made as to whether the impairment isother-than-temporary. The EITF Issue No. 03-1 impairment model applies toall 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

 

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FASB Staff Position (“FSP”) EITF 03-1-1, which defers the effectivedate for recognition and measurement guidance contained in EITF Issue No. 03-1until certain issues are resolved. In November 2005, the FASB issued FSPFAS 115-1. FSP FAS 115-1 replaces the impairment evaluation guidance of EITFIssue No. 03-1 with references to the existing other-than-temporaryimpairment guidance. EITF 03-1’s disclosure requirements remain in effect. TheFSP also supersedes EITF Topic No. D-44, *Recognitionof Other-Than-Temporary Impairment upon the Planned Sale of a Security WhoseCost Exceeds Fair Value*,” and clarifies that an investor shouldrecognize an impairment loss no later than when the impairment is deemedother-than-temporary, even if a decision to sell an impaired security has notbeen made. The guidance in this FSP will be applied in the Company’s firstquarter of 2006. The Company does not expect the adoption of EITF Issue No. 03-1or FSP FAS 115-1 to have a material effect on its liquidity, results ofoperations and financial condition.

 

In December 2004, the FASB issued SFAS No. 123(R),*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 provides guidanceon valuing and expensing these awards, as well as disclosure requirements ofthese equity arrangements. This statement is effective for the Company in thefirst quarter of 2006.

 

SFAS No. 123(R) permits public companiesto choose between the following two adoption methods:

 

1. A “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) basedon the requirements of SFAS No. 123(R) for all share-based paymentsgranted after the effective date and (b) based on the requirements of SFASNo. 123 for all awards granted to employees prior to the effective date ofSFAS No. 123(R) that remain unvested on the effective date, or

 

2. A “modified retrospective” method which includesthe requirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underSFAS No. 123 for purposes of pro forma disclosures for either (a) allprior periods presented or (b) prior interim periods of the year ofadoption.

 

As permitted by SFAS No. 123, theCompany currently accounts for share-based payments to employees using APBOpinion No. 25’s intrinsic value method. The impact of the adoption ofSFAS No. 123(R) cannot be predicted at this time because it will be dependon levels of share-based payments granted in the future. However, valuation ofemployee stock options under SFAS No. 123(R) is similar to SFAS No. 123,with minor exceptions. The impact on the results of operations and earnings pershare had the Company adopted SFAS No. 123, is described in stock basedcompensation section of Note 1 above. Accordingly, the adoption of SFAS No. 123(R)’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. Use of an option valuation model, as required by SFAS No. 123and SFAS No. 123(R), includes highly subjective assumptions based onlong-term predictions, including the expected stock price volatility andaverage life of each stock option grant. The Black-Scholes option-pricing modelwas developed for use in estimating the fair value of traded options that haveno restrictions and are fully transferable and negotiable in a free tradingmarket. This model does not consider the employment, transfer or vestingrestrictions that are inherent in the Company’s employee stock options orpurchase rights granted pursuant to the Employee Stock Purchase Plans. Becausethe Company’s share-based payments have characteristics significantly differentfrom those of freely traded options, and because changes in the subjectiveinput assumptions can materially affect the Company’s estimate of the fairvalues, in the Company’s opinion, existing valuation models may not be reliablesingle measures of the fair values of our share-based payments. SFAS No. 123(R)also requires the benefits of tax deductions in excess of recognizedcompensation cost to be reported as a financing cash flow, rather than as anoperating cash flow as required under current literature. This requirement willreduce net operating cash flows and increase net financing cash flows inperiods after adoption.

 

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**2. Balance Sheet Details**

 

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

 

The following is a summary of investmentsavailable-for-sale securities at December 31, 2005 (in thousands):

 
| ** **               | ** ** | **Amortized Cost** | ** ** | **Unrealized Gain** | ** ** | **Unrealized Loss** | ** ** | **Estimated  Fair Value** | ** ** |
|--------------------------|------------|--------------------|------------|---------------------|------------|---------------------|------------|---------------------------|------------|
| Commercial  Paper        |       | $                  | 2,186      |                | $          | —              |       | $                         | (1         | ) | $ | 2,185 |   |
| Government  Agency Bonds |       | 7,727              |       | —              |       | (7                  | )          | 7,720                     |       |
|                     |       |               |       |                |       |                |       |                      |       |
|                     |       | $                  | 9,913      |                | $          | —              |       | $                         | (8         | ) | $ | 9,905 |   |

 

The following is a summary of investmentsavailable-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 |   |

 

Gross realized gains and losses on available-for-salesecurities were immaterial during the years ended December 31, 2005 and2004. All of the available-for-sale securities have a contractual maturity at December 31,2005 of one year or less.

 

***Property and Equipment***

 

Property and equipment consists of the following (inthousands):

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Scientific  equipment                           |       | $                     | 7,019      |   | $ | 5,648 |   |
| Computer  equipment                             |       | 2,237                 |       | 1,974 |   |
| Furniture  and fixtures                         |       | 362                   |       | 346 |   |
| Leasehold  improvements                         |       | 892                   |       | 790 |   |
|                                            |       |                  |       |   |   |
|                                            |       | 10,510                |       | 8,758 |   |
| Less  accumulated depreciation and amortization |       | (8,092                | )          | (7,016 | ) |
|                                            |       |                  |       |   |   |
|                                            |       | $                     | 2,418      |   | $ | 1,742 |   |

 

Depreciation and amortization expense was $1.2million, $1.5 million, and $2.0 million for the years ended December 31,2005, 2004 and 2003, respectively.

 

***Accounts Payable and Accrued Expenses***

 

Accounts payable and accrued expenses consist of thefollowing (in thousands):

 
| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Accounts  payable          |       | $                     | 1,018      |   | $ | 463 |   |
| Accrued  employee benefits |       | 2,214                 |       | 1,648 |   |
| Other  accrued expenses    |       | 864                   |       | 1,097 |   |
|                       |       | $                     | 4,096      |   | $ | 3,208 |   |

 

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**3. Product Discovery and Development Collaborations**

 

*Cadbury Schweppes.*  In July 2005, theCompany entered into a collaboration agreement with Cadbury Schweppes for thediscovery and commercialization of new flavor ingredients in the gumconfectionary area. The agreement requires Cadbury Schweppes to make researchfunding payments for up to two years. The Company is also eligible to receivemilestone payments upon the achievement of specific product discovery anddevelopment goals and, in the event of commercialization, receive royalties onsales of products containing new flavor ingredients developed under theagreement.

 

Through December 31, 2005, the Company hasreceived $650,000 in upfront license fees and research and development funding.If all milestones are achieved, and including all research and developmentfunding paid or payable, the Company may be entitled to up to$3.1 million. There is no guarantee that the Company will receive anymilestone payments or royalties under this collaboration.

 

*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 specified flavorsand flavor enhancers. The agreement requires Campbell Soup to make researchfunding payments over three years totaling $3.6 million. The Company isalso eligible to receive milestone payments upon the achievement of a specificproduct development goal and, in the event of commercialization, receiveroyalties on future net sales of collaborator products containing a discoveredingredient.

 

The agreement was amended in July 2002 to providefor an option to negotiate the right to expand the field to include additionalspecified products. The Company received $1.8 million from Campbell Soupfor the option, which was recorded as deferred revenue and recognized asrevenue ratably over the remaining term of the agreement (20 months). Theagreement was further amended in November 2002 to redefine earnedroyalties during the royalty term.

 

In July 2003, the Company received $650,000 inadditional research support funding and expense reimbursement. The payment wasrecorded as deferred revenue and is being recognized as revenue ratably overthe remaining term of the agreement (eight months).

 

The agreement was further amended in March 2004to extend the collaborative period until the earlier of March 2006 or whena flavor or flavor enhancer selected by Campbell Soup receives GenerallyRecognized as Safe determination, subject to earlier termination underspecified circumstances. Under the terms of the extension, the Company willprovide additional research and receive additional research funding totaling$3.0 million for two additional years.

 

The agreement was further amended in February 2006to extend the collaborative period until the earlier of March 2009 or whena flavor or flavor enhancer selected by Campbell Soup receives GenerallyRecognized as Safe determination, subject to earlier termination underspecified circumstances. Under the terms of the extension, the Company willprovide additional research and receive additional research funding totaling upto $3.0 million for three additional years.

 

Through December 31, 2005, the Company hasreceived $9.1 million in research and development funding. If all milestonesare achieved, and including all research and development funding paid orpayable, the Company may be entitled to up to $13.1 million. There isno guarantee that the Company will receive any milestone payments or royaltiesunder 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 agreementrequired 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 productscontaining a discovered ingredient. The agreement was amended in April 2004to extend the collaborative period until April 2008, subject to earliertermination under specified circumstances. Under terms of the extension, theCompany will provide additional research and receive additional researchfunding totaling $6.0 million for three additional years.

 

Through December 31, 2005, the Company hasreceived $7.5 million in research and development

 

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funding.If all milestones are achieved, and including all research and developmentfunding paid or payable, the Company may be entitled to up to$14.8 million. There is no guarantee that the Company will receive anymilestone payments or royalties under this collaboration.

 

*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. In May 2005and July 2005, the agreement was further amended to extend thecollaborative period until June 2005 and July 2007, respectively, andto provide for an additional specified product field. The Company is eligibleto receive milestone payments upon the achievement of specific productdevelopment goals and, in the event of commercialization, receive royalties onfuture net sales of collaborator products containing a discovered ingredient.

 

Kraft Foods agreed to make research funding paymentsrelated to the additional program of $1.8 million over the period from May 2002through December 2003, $1.8 million over the period from January 2004through May 2005, $339,000 over the period May 2005 through July 2005,and $2.7 million from July 2005 though July 2007. 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 payment of $375,000 in 2002 from the additionalresearch program.

 

Through December 31, 2005, the Company hasreceived $8.4 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, the Company may beentitled to up to $11.7 million. There is no guarantee that the Companywill receive any further milestone payments or royalties under thiscollaboration.

 

In December 2005, the Company further amended theagreement to provide for a new three-year discovery and developmentcollaboration. Under the terms of the new collaboration, Kraft Foods has agreedto pay the Company an initial license fee and incremental discovery anddevelopment funding over the three-year period. The Company is eligible toreceive milestone payments upon achievement of specific product discovery anddevelopment goals, and, in the event of commercialization, receive royaltiesbased on sales of Kraft Foods products containing any flavor modifiersdeveloped under the agreement.

 

 Through December 31,2005, the Company has not received any payments in license fees or research anddevelopment funding related to the new collaboration. In January 2006, theCompany received $675,000 for the upfront license fee and first discovery anddevelopment funding payment for this collaboration. If all milestones areachieved, and including all license fees and research and development fundingpayable, the Company may be entitled to up to $4.6 million for the newcollaboration. There is no guarantee that the Company will receive anymilestone payments or royalties under this collaboration.

 

*Nestlé.*  In April 2002, asamended in April 2005, the Company entered into a collaboration agreementwith Nestlé for the discovery and development of specified flavors and flavorenhancers. The agreement requires Nestlé to make research funding paymentsthrough 2008 totaling $13.6 million. The Company is also eligible toreceive milestone payments upon the achievement of specific product developmentgoals and, in the event of commercialization, receive royalties on future netsales of collaborator products containing a discovered ingredient. The Companyreceived payments for the achievement of four milestones in 2002, 2003, 2004and 2005. The Company also received payment for the reimbursement of certainregulatory expenses in 2005. Through December 31, 2005, the Company hasreceived $7.9 million in research and development funding, four milestonepayments of $375,000 each and $339,000 in reimbursement of certain regulatorycosts. If all milestones are achieved, and including all research anddevelopment funding paid or payable, the Company may be entitled to up to$16.0 million. There is no guarantee that the Company will receive anyfurther milestone payments or royalties under this collaboration.

 

68

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In October 2004, the Company entered into asecond product discovery and development collaboration agreement with Nestlé towork for a five-year collaborative period focusing on the discovery andcommercialization of specified novel flavor ingredients. Under the terms of theagreement, Nestlé has agreed to pay to the Company certain research anddevelopment funding totaling $11.7 million over five years, subject to earliertermination under specified circumstances. The Company is also eligible toreceive milestone payments upon achievement of specific product discovery anddevelopment goals, and in the event of commercialization, is entitled toreceive royalties on future net sales of products containing a discovered novelflavor ingredient. There is no guarantee that the Company will receive anymilestone payments or royalties under this collaboration.

 

Under this second agreement, through December 31,2005, the Company has received $2.3 million in research and developmentfunding. If all milestones are achieved, and including all research anddevelopment funding paid or payable, the Company may be entitled to up to$13.1 million. There is no guarantee that the Company will receive any milestonepayments or royalties under this collaboration.

 

In connection with the above listed collaborationagreements, the Company has recognized revenue of $9.4 million,$8.3 million and $9.5 million for the years ended December 31,2005, 2004 and 2003, respectively. As of December 31, 2005 and 2004, theCompany has deferred revenue of $1.7 million and $1.9 million,respectively.

 

**4. Technology Collaborations and License Agreements**

 

*Incyte Genomics, Inc.*  In December 2000, theCompany entered into a three-year agreement with Incyte that provided theCompany with access to Incyte’s databases for the identification of receptorsthat play a role in taste and smell in order to accelerate the Company’sdiscovery of flavor and fragrance molecules. Under the terms of the agreement,the Company was required to pay $6.5 million for the databases. Concurrentwith the signing of the agreement, Incyte agreed to purchase869,328 shares of the Company’s Series D Convertible Preferred Stockfor $6.5 million. Since the amounts exchanged were equal, the Companyaccounted for the transaction as a non-monetary exchange in 2000. The Companycapitalized the cost of the database and amortized the cost to research anddevelopment expense over the three-year term of the agreement. The valueascribed to the databases of $6.5 million was based on the fair value ofthe preferred stock issued. The Company recorded amortization expense of$2.2 million for the year ended December 31, 2003. The asset wasfully amortized by December 31, 2003.

 

The Company also has other license agreements, ofwhich the Company recognized expenses of $418,000, $1.1 million and $934,000for the years ended December 31, 2005, 2004 and 2003, respectively. Thefees were charged to research and development expense.

 

**5. Commitments**

 

***Leases and Loans***

 

The Company leases its primary office facility underan operating lease agreement that expires on December 31, 2006. The leaseprovides for an annual minimum 3% rent increase. Gross rent expense for theyears ended December 31, 2005, 2004 and 2003 was $4.1 million,$4.0 million and $3.9 million, respectively. The Company subleases part ofthe facility, and the sublease rental income for the years ended December 31,2005, 2004 and 2003 was $742,000, $899,000 and $1.4 million, respectively.Sublease income is recorded as an offset to the Company’s allocated facilitiescosts. The Company has also entered into various operating lease agreements foroffice equipment.

 

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The estimated annual future minimum rental paymentsunder the Company’s operating leases in effect at December 31, 2005, whichexpire through 2008, for the years ending December 31 are as follows (inthousands):

 
| ** **                   | ** ** | **Operating  Leases** | ** ** |
|------------------------------|------------|-----------------------|------------|
| 2006                         |       | $                     | 4,182      |   |
| 2007                         |       | 21                    |       |
| 2008                         |       | 8                     |       |
|                         |       |                  |       |
| Total minimum lease payments |       | $                     | 4,211      |   |

 

Future minimum rentals to be received undernon-cancelable subleases, which expire through 2006, total $801,000.

 

In January 2006, the Company entered into a leaseagreement with ARE-NEXUS CENTRE II, LLC (the “Nexus Lease”) to leaseapproximately 64,000 square feet of office, research and development space fora term targeted to commence on September 1, 2006, with rent paymentstargeted to commence April 1, 2007 and ending on February 28, 2017.Annual rent payments are expected to be approximately $2.3 million, subject toannual rent increases of 3%. In connection with the execution of the NexusLease, the Company amended its existing lease with ARE-11099 North TorreyPines, LLC for its current property to provide for the extension of the leaseterm, subject to certain limitations, until the Company moves all operations tothe new location, which the Company expects to occur in the fourth quarter of2006.

 

In connection with certain license and collaborationagreements, the Company’s annual future minimum obligation payments are asfollows, $86,000, $48,000, $26,000, $26,000, $18,000 and $54,000 for the yearsending December 31, 2006, 2007, 2008, 2009, 2010 and thereafter,respectively.

 

**6. Stockholders’ Equity**

 

***Reverse Stock Split***

 

On April 30, 2004 the Company’s board ofdirectors approved a 4-for-7 reverse stock split of the outstanding commonstock, which was effected on June 7, 2004. On June 15, 2004 theCompany’s board of directors approved a 1-for-1.4005989 reverse stock split ofthe outstanding common stock, which was effected on June 16, 2004. Theaccompanying financial statements give retroactive effect to the reverse stocksplits.

 

***Initial Public Offering***

 

On June 25, 2004, the Company completed aninitial public offering, or IPO, of 6.0 million shares of common stock forproceeds to the Company of $31.9 million, net of underwriting 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.

 

***Public Offering***

 

On November 9, 2005, the Company completed apublic offering of 4.0 million shares of common stock for proceeds to theCompany of $57.3 million, net of underwriting discounts, commissions andoffering expenses. The offering was made under a shelf registration statement andincluded the exercise by the underwriters of an over-allotment option of528,000 shares of common stock.

 

***Convertible Preferred Stock***

 

The Company’s certificate of incorporation, as amendedand restated, authorizes the Company to issue up to 7,500,000 shares ofPreferred Stock, with a par value of $0.001, in one or more series. The Boardof Directors may authorize the issuance of Convertible Preferred Stockwith voting or conversion rights that could adversely affect the voting poweror other rights of the holders of the common stock. The issuance of ConvertiblePreferred Stock, while providing flexibility in connection with possibleacquisitions and other corporate purposes, could, among other things, have theeffect of delaying, deferring or preventing a

 

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changein control of the Company and may adversely affect the market price of thecommon stock and the voting and other rights of the holders of common stock.

 

Upon the closing of the initial public offering in June 2004,25,825,826 shares of convertible preferred stock outstanding automaticallyconverted into 16,205,306 shares of common stock. No shares of convertiblepreferred stock were outstanding as of December 31, 2005 or 2004.

 

***Warrants***

 

In 2001, in connection with equipment financing, theCompany issued to the 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 warrantswere outstanding as of December 31, 2005 or 2004.

 

***Equity Incentive Plan***

 

During 1999, the Company adopted the 1999 EquityIncentive Plan (the “Plan”), which provides for the grant of incentive andnon-statutory stock options and restricted stock purchase rights to employees,directors and consultants of the Company. The Plan, as amended, authorizes theCompany to issue up to 6,230,478 shares of common stock. At December 31,2005, the Company has repurchased a total of 131,153 shares and2,258,946 shares remain available for grant under the Plan.

 

The Plan allows the Company to grant restricted stockpurchase rights at no less than 85% of the fair value of the Company’s commonstock as determined by the Board of Directors at the date of the grant. Allrestricted stock purchase rights vest in accordance with a vesting schedule determinedby the Board of Directors, typically over a four-year period. Under the Plan,457,069 restricted stock purchase rights have been granted at exercise pricesranging from $0.35 to $0.94 per share, all of which have been exercised as of December 31,2005, of which no shares are subject to repurchase.

 

Options granted under the Plan generally expire nolater than ten years from the date of grant (five years for a 10% stockholder).Options generally vest and become fully exercisable over a period of fouryears. In certain cases, grants to officers, directors and consultants can bemade fully exercisable at the date of grant. The exercise price of incentivestock options must be equal to at least the fair value of the Company’s commonstock on the date of grant, and the exercise price of non-statutory stockoptions may be no less than 85% of the fair value of the Company’s commonstock on the date of grant. The exercise price of any option granted to a 10%stockholder may be no less than 110% of the fair value of the Company’scommon 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. At December 31, 2005, 148,779 shares of commonstock were unvested and subject to repurchase.

 

The following is a further breakdown of the optionsoutstanding as of December 31, 2005:

 
| ** **                     | ** ** | ** **             | ** ** | **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** | ** ** |
|                           |       |                   |       |                                                |       |                                   |       |   |   |   |   |
| $                              | 0.74-6.00  |                   |       | 612,272                                             |       | 7.2                                    |       | $ | 0.99 |   | 357,872 |   | $ | 1.13 |   |
| $                              | 6.02-6.02  |                   |       | 937,832                                             |       | 7.9                                    |       | $ | 6.02 |   | 341,419 |   | $ | 6.02 |   |
| $                              | 6.30-8.74  |                   |       | 599,850                                             |       | 9.0                                    |       | $ | 8.56 |   | 10,213 |   | $ | 7.28 |   |
| $                              | 9.01-18.99 |                   |       | 333,463                                             |       | 8.4                                    |       | $ | 11.65 |   | 96,310 |   | $ | 10.74 |   |
|                           |       |                   |       |                                                |       |                                   |       |   |   |   |   |
|                           |       | 2,483,417              |       | 8.1                                                 |       |                                   |       | 805,814 |   |   |   |
|                                |            |                        |            |                                                     |            |                                        |            |  |  |  |  |  |  |  |  |  |

 

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The following is a summary of stock option and stockaward activity under the equity incentive plan through December 31, 2005:

 
| ** **                             | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------------|------------|-----------------------|------------|---------------------------------------|------------|
|                                   |       |                  |       |                                  |       |
| Outstanding  at January 1, 2003   |       | 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       |   |
| Granted                                |       | 753,733               |       | $                                     | 9.88       |   |
| Exercised                              |       | (196,270              | )          | $                                     | 3.14       |   |
| Cancelled                              |       | (66,756               | )          | $                                     | 6.64       |   |
|                                   |       |                  |       |                                  |       |
| Outstanding  at December 31, 2005 |       | 2,483,417             |       | $                                     | 6.15       |   |

 

***Employee Stock Purchase Plan***

 

*** ***During 2004, theCompany adopted the 2004 Employee Stock Purchase Plan (the “Purchase Plan”),which allows all eligible employees to purchase shares of common stock at 85%of the lower of the fair market value on the first or the last day of eachsix-month purchase period. Employees may authorize the Company to withholdup to 15% of their compensation during any purchase period, subject to certainlimitations. The Purchase Plan authorizes up to 393,096 shares to be granted.At December 31, 2005, 123,567 shares of common stock have been issuedunder the Purchase Plan at an average price of $5.26 per share.

 

***Shares Reserved for Future Issuance***

 

The following shares of common stock are reserved forfuture issuance:

 
| ** **                                              | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------|------------|-----------------------------|------------|
| Common stock  options granted and outstanding           |       | 2,483,417                   |       |
| Common stock  options reserved for future grant         |       | 2,258,946                   |       |
| Common stock  reserved under Purchase Plan              |       | 269,529                     |       |
| Total common  stock shares reserved for future issuance |       | 5,011,892                   |       |

 

***Shareholders’ Rights Plan***

 

In February 2005, the Company entered into aShare Purchase Rights Plan (the “Plan”). Terms of the Plan provide for adividend distribution of one preferred share purchase right (a “Right”) foreach outstanding share of common stock, par value $0.001 per share (the “Common Shares”),of the Company. The dividend was payable on February 21, 2005 to thestockholders of record on that date. Each Right entitles the registered holderto purchase from the Company one one-hundredth of a share of Series AJunior Participating Preferred 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 set forthin a Rights Agreement, dated as of February 14, 2005 entered into betweenthe Company and Mellon Investor Services LLC, as rights agent.

 

72

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**7. Income Taxes**

 

Significant components of the Company’s net deferredtax assets at December 31, 2005 and 2004 are shown below (in thousands). Avaluation allowance of $37.0 million and $29.5 million has beenestablished to offset the net deferred tax assets as of December 31, 2005and 2004, respectively, as realization of such assets is uncertain.

 
| ** **                                   | ** ** | **Years ended  December 31,** | ** ** |
|----------------------------------------------|------------|------------------------------------|------------|
| ** **                                   | ** ** | **2005**                           | ** ** | **2004** | ** ** |
|                                         |       |                               |       |   |   |
| Deferred tax  assets:                        |       |                               |       |   |   |
| Net  operating loss carryforwards            |       | $                                  | 28,819     |   | $ | 22,728 |   |
| Capitalized  research and development        |       | 3,309                              |       | 2,847 |   |
| Research and  development credits            |       | 3,159                              |       | 2,633 |   |
| Deferred  revenue                            |       | 704                                |       | 757 |   |
| Other, net                                   |       | 969                                |       | 551 |   |
|                                         |       |                               |       |   |   |
| Total  deferred tax assets                   |       | 36,960                             |       | 29,516 |   |
|                                         |       |                               |       |   |   |
| Total  deferred tax liabilities              |       | —                             |       | — |   |
|                                         |       |                               |       |   |   |
| Net deferred  tax assets                     |       | 36,960                             |       | 29,516 |   |
| Valuation  allowance for deferred tax assets |       | (36,960                            | )          | (29,516 | ) |
|                                         |       |                               |       |   |   |
| Net deferred  tax assets                     |       | $                                  | —     |   | $ | — |   |

 

The provision for income taxes on earningssubject to income taxes differs from the statutory Federal rate at December 31,2005, 2004 and 2003, due to the following (in thousands):

 
| ** **                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal  income taxes at 35%                       |       | $        | (6,940     | )        | $          | (6,900   | )          | $ | (6,108 | ) |
| State income  tax, net of Federal benefit          |       | (963     | )          | (793     | )          | (641     | )          |
| Tax effect  on non-deductible expenses and credits |       | 459      |       | 1,528    |       | 2,092    |       |
| Increase in  valuation allowance                   |       | 7,444    |       | 6,165    |       | 4,657    |       |
|                                               |       | $        | —     |     | $          | —   |       | $ | — |   |

 

At December 31, 2005, the Company had federal andCalifornia tax net operating loss carryforwards of approximately$78.8 million and $21.5 million, respectively. The federal andCalifornia tax loss carryforwards will begin to expire in 2019 and 2009,respectively, unless previously utilized. The Company also had federal andCalifornia research and development tax credit carryforwards of approximately$2.1 million and $1.6 million, respectively, which will begin toexpire in 2019 unless previously utilized. Approximately $2.4 million of thenet operating loss carryforwards relate to stock option exercises, the benefitof which will be credited to additional paid in capital when utilized.

 

Pursuant to Internal Revenue Code Section 382 and383, use of the Company’s net operating loss and credit carryforwards may belimited if a cumulative change in ownership of more than 50% occurs within athree-year period.

 

73

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

 

The following is a summary of the unaudited quarterlyresults of operations for the years ended December 31, 2005 and 2004 (inthousands, except per share amounts).

 
| ** **                                   | ** ** | **Year Ended December 31,  2005** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                   | ** ** | **First  Quarter**                     | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| **Selected  Quarterly Financial Data:**      |       |                                   |       |   |   |   |   |   |   |
| Revenues                                     |       | $                                      | 2,966      |   | $ | 2,022 |   | $ | 2,130 |   | $ | 2,267 |   |
| Total  operating expenses                    |       | 7,783                                  |       | 7,457 |   | 7,050 |   | 8,269 |   |
| Net loss                                     |       | (4,592                                 | )          | (5,185 | ) | (4,663 | ) | (5,390 | ) |
| Basic and  diluted net loss per common share |       | $                                      | (0.18      | ) | $ | (0.20 | ) | $ | (0.18 | ) | $ | (0.19 | ) |

 
| ** **                                   | ** ** | **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 | ) |

 

**9. Subsequent Events**

 

 On January 12, 2006 the Companyentered into a Lease Agreement with ARE-NEXUS CENTRE II, LLC (the “Nexus Lease”).Under the terms of the Nexus Lease, the Company will be leasing approximately64,000 square feet of office, research and development space at 4767 NexusCenter Drive, San Diego, California for a term targeted to commence on September 1,2006 with rent targeted to commence April 1, 2007 and ending on February 28,2017. The Company has the right to extend the term of the Nexus Lease for anadditional five years, and the Company has the right to terminate the NexusLease early effective December 31, 2013 upon payment of an earlytermination fee.

 

Inconnection with the execution of the Nexus Lease, the Company amended itsexisting lease with ARE-11099 North Torrey Pines, LLC for the property locatedat 11099 North Torrey Pines Road, La Jolla, California (the “Torrey Pines LeaseAmendment”) on January 12, 2006 to provide for the extension of the leaseterm, subject to certain limitations, until the Company moves all of ouroperations to the new location, which the Company expects to occur in thefourth quarter of 2006.

 

On February 27, 2006, the Company amended itsagreement with Campbell Soup to extend the collaborative research phase for anadditional research phase of up to three years, through March 2009. Duringthe extension period, the Company will continue to work with Campbell on thediscovery and commercialization of new ingredients that improve the taste ofwet soups and savory beverages. Under the terms of the extension, Campbell Souphas agreed to pay the Company incremental research funding of up to $3.0million, assuming the Company meets specified research goals, over thethree-year extension period. The other payment terms, including milestones androyalties based on net sales of products using the new ingredients, remainunchanged.

 

74

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**Item 9.   *Changes in and Disagreements with Accountants onAccounting and Financial Disclosure***

 

There were no changes in or disagreements with Ernst &Young LLP on accounting and financial disclosure required to be reported underthis Item 9.

 

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

 

**Conclusion Regarding the Effectiveness ofDisclosure Controls and Procedures**

 

Under the supervision and with the participation of our management,including our principal executive officer and principal financial officer, weconducted an evaluation of our disclosure controls and procedures, as such termis defined under Rule 13a-15(e) promulgated under the SecuritiesExchange Act of 1934, as amended (the Exchange Act). Based on this evaluation,our principal executive officer and our principal financial officer concludedthat our disclosure controls and procedures were effective as of the end of theperiod covered by this annual report.

 

**Management’s Report on Internal Control OverFinancial Reporting**

 

Our management is responsible for establishing and maintaining adequateinternal control over financial reporting, as such term is defined in ExchangeAct Rule 13a-15(f). Under the supervision and with the participation ofour management, including our President and Chief Executive Officer and ourSenior Vice President and Chief Financial and Business Officer, we conducted anevaluation of the effectiveness of our internal control over financialreporting based on the framework in *InternalControl - Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission. Based on our evaluation under theframework in *Internal Control — IntegratedFramework*, our management concluded that our internal control overfinancial reporting was effective as of December 31, 2005.

 

Our management’s assessment of the effectiveness of our internalcontrol over financial reporting as of December 31, 2005, has been auditedby Ernst &Young LLP, an independent registered public accounting firm,as stated in their report which is included herein.

 

**Changes in Internal Control Over FinancialReporting**

 

There was no change in our internal controls over financial reportingduring the fourth quarter of the period covered by this Annual Report that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrols over financial reporting.

 

**Report of Independent Registered PublicAccounting Firm on Internal Control over Financial Reporting**

 

The Board of Directors and Stockholders ofSenomyx, Inc.

 

We have audited management’s assessmentincluded in the accompanying “Management’s Report of Internal Control OverFinancial Reporting”, that Senomyx, Inc. maintained effective internalcontrol over financial reporting as of December 31, 2005, based on criteriaestablished in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (the COSO criteria).Senomyx’s management is responsible for maintaining effective internal controlover financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of thecompany’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtainreasonable assurance about whether effective internal control over financialreporting was maintained in all material respects. Our audit included obtainingan understanding of internal control over financial reporting,

 

75

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evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

A company’s internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples. A company’s internal control over financial reporting includesthose policies and procedures that (1) pertain to the maintenance ofrecords that, in reasonable detail, accurately and fairly reflect thetransactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements. Also, projections ofany evaluation of effectiveness to future periods are subject to the risk thatcontrols may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that Senomyx, Inc.maintained effective internal control over financial reporting as of December 31,2005, is fairly stated, in all material respects, based on the COSO criteria.Also, in our opinion, Senomyx, Inc. maintained, in all material respects,effective internal control over financial reporting as of December 31,2005, based on****the COSO criteria**.**

 

We also have audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the balance sheets ofSenomyx, Inc. as of December 31, 2005 and 2004, and the relatedstatements of operations, stockholders’ equity, and cash flows for each of thethree years in the period ended December 31, 2005 of Senomyx, Inc.and our report dated March 3, 2006 expressed an unqualified opinionthereon.

 
|                  | /s/ ERNST & YOUNG LLP |   |
|-----------------------|--------------------------------|--------|
|                  |                           |
| San Diego, California |                           |
| March 3, 2006    |                           |

 

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

 

None.

 

76

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**PART III**

 

Certain information required by Part III of this Form 10-Kis omitted from this report because registrant will file a definitive ProxyStatement within 120 days after the end of its fiscal year pursuant toRegulation 14A for its 2005 Annual Meeting of Shareholders to be held on May 24,2006 (the “Proxy Statement”), and the information included therein isincorporated herein by reference.

 

**Item 10.  *Directors and Executive Officersof the Registrant***

 

The information with respect to executive officersrequired by this item is set forth in Part I of this report.

 

We have adopted a Code of Business Conduct and EthicsPolicy that applies to our directors and employees (including our principalexecutive officer, principal financial officer, principal accounting officerand controller), and have posted the text of the policy on our website(www.senomyx.com) in connection with “Investor Relations” materials. Inaddition, we intend to promptly disclose (i) the nature of any amendmentto the policy that applies to our principal executive officer, principalfinancial officer, principal accounting officer or controller, or personsperforming similar functions and (ii) the nature of any waiver, includingan implicit waiver, from a provision of the policy that is granted to one ofthese specified individuals, the name of such person who is granted the waiverand the date of the waiver on our website in the future.

 

The other information required by this item isincorporated by reference to the proxy statement to be filed with the SECpursuant to Regulation 14A in connection with our 2006 annual meeting.

 

**Item 11.   *Executive Compensation***

 

The information required by this Item is incorporatedherein by reference to the information from the Proxy Statement under the section entitled“Executive Compensation.”

 

**Item 12.  *Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters***

 

The information required by this Item is incorporatedherein by reference to the information from the Proxy Statement under thesections entitled “Security Ownership of Certain Beneficial Owners andManagement” and “Securities Authorized for Issuance under Equity CompensationPlans.”

 

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

 

The information required by this Item is incorporatedherein by reference to the information from the Proxy Statement under the section entitled“Certain Relationships and Related Transactions.”

 

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

 

The information required by this Item is incorporatedby herein by reference to the information from the Proxy Statement under the section entitled“Principal Accountant Fees and Services.”

 

77

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**PART IV**

 

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

 

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

 

See Index to Financial Statements in Item 8 of thisAnnual Report on Form 10-K, which is incorporated herein by reference.

 

2. ***Financial Statement Schedules***

 

All schedules have been omitted because they are notapplicable or required, or the information required to be set forth therein isincluded in the Financial Statements or notes thereto included in Item 8 (“FinancialStatements and Supplementary 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. |
| (2)                   |       | 3.3                     |       |                        | Certificate of Designation of Series A  Junior Participating Preferred Stock, as filed with the Secretary of State of  Delaware on February 14, 2005. |
| (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. |
| (2)                   |       | 4.4                     |       |                        | Form of Rights Certificate. |
| (2)                   |       | 4.5                     |       |                        | Rights Agreement, dated February 14,  2005 by and between Senomyx, Inc. and Mellon Investor Services LLP. |
| (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)                   |       | 10.1                    | 0          |                        | 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)                   |       | 10.1                    | 1*         |                        | Exclusive License and Bailment Agreement  dated March 10, 2000 between the Registrant and the Regents of the  University of California. |
| (1)                   |       | 10.1                    | 2*         |                        | Collaborative Research and License  Agreement dated November 1, 2000, as amended April 16, 2002,  between the Registrant and Aurora Biosciences Corporation. |
| (1)                   |       | 10.1                    | 3*         |                        | Collaborative Research and License  Agreement dated December 6, 2000, as amended May 2, 2002, between  the Registrant and Kraft Foods, Inc. |

 

78

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| (1)    |   | 10.1 | 4*     |   | 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)    |   | 10.1 | 5*     |   | Collaborative Research and License  Agreement dated April 18, 2002, as amended October 23, 2003,  between the Registrant and Nestec, Ltd.                                                                                                                                      |
| (1)    |   | 10.1 | 6*     |   | Collaborative Research, Development,  Commercialization and License Agreement dated April 22, 2002 between the  Registrant and the Coca-Cola Company.                                                                                                                               |
| (1)    |   | 10.1 | 7+     |   | 1999 Equity Incentive Plan and Form of  Stock Option Agreement thereunder.                                                                                                                                                                                                          |
| (2)    |   | 10.1 | 8*     |   | Collaborative Research and License  Agreement, dated October 26, 2004, between the Registrant and Nestec  Ltd.                                                                                                                                                                      |
| (3)    |   | 10.1 | 9*     |   | Second Amendment to the Collaborative  Research and License Agreement dated April 18, 2002, as amended October 23,  2003, between the Registrant and Nestec, Ltd.                                                                                                              |
| (4)    |   | 10.2 | 0*     |   | Second Amendment to the Collaborative  Research and License Agreement dated December 6, 2000, as amended May 2,  2002, between the Registrant and Kraft Foods Global, Inc.                                                                                                |
| (5)    |   | 10.2 | 1*     |   | Third Amendment to the Collaborative  Research and License Agreement dated December 6, 2000, as amended May 2,  2002 and April 29, 2005, between the Registrant and Kraft Foods Global, Inc.                                                                         |
| (6)    |   | 10.2 | 2+     |   | Summary Description of Senomyx, Inc.  Incentive Cash Bonus Program                                                                                                                                                                                                                  |
|   |   | 10.2 | 3*     |   | Lease Agreement between ARE-NEXUS CENTRE  II, LLC and Registrant                                                                                                                                                                                                                         |
|   |   | 10.2 | 4      |   | Seventh Amendment to Expansion Lease by and  between ARE-11099 NORTH TORREY PINES, LLC, and Registrant.                                                                                                                                                                                  |
|   |   | 10.2 | 5*     |   | Amended and Restated Fourth Amendment to  the Collaborative Research and License Agreement dated December 6, 2000,  as amended May 2, 2002, April 29, 2005 and July 29, 2005,  between the Registrant and Kraft Foods Global, Inc                                    |
|   |   | 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, President,  Chief Executive Officer and Director, and John Poyhonen, Senior Vice  President and 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.

 

*                                         Confidentialtreatment has been requested with respect to certain portions of this exhibit.Omitted portions have been filed separately with the Securities and ExchangeCommission.

 

(1)                                  Filedas an exhibit to Registration Statement File No. 333-113998 andincorporated herein by reference.

 

(2)                                  Filedas an exhibit to our Quarterly Report of Form 10-Q for the quarterended September 30, 2004 and incorporated herein by reference.

 

(3)                                  Filedas an exhibit to our Quarterly Report of Form 10-Q for the quarterended March 31, 2005 and incorporated herein by reference.

 

(4)                                  Filedas an exhibit to our Quarterly Report of Form 10-Q for the quarterended June 30, 2005 and 

 

79

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incorporated herein by reference.

 

(5)                                  Filedas an exhibit to our Quarterly Report of Form 10-Q for the quarterended September 30, 2005 and incorporated herein by reference.

 

(6)                                  Filedas an exhibit to our Current Report on Form 8-K filed with theSecurities and Exchange Commission on February 6, 2006 and incorporatedherein by reference.

 

**(b) Exhibits**

 

See Item 15(a) above.

 

**(c) Financial StatementSchedules**

 

See Item 15(a) above.

 

80

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**SIGNATURES**

 

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

 
|                      | Senomyx, Inc. |
|---------------------------|--------------------|
|                      | By:                | /S/ KENT  SNYDER |   |
|                      |               | Kent Snyder |
|                      |               | President and Chief Executive  Officer |
|                      |               |   |
| Dated: March 6, 2006 |               |   |

 

81

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**POWEROF ATTORNEY**

 

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints Kent Snyder, MarkLeschly and John Poyhonen, and each of them, as his or her true and lawfulattorneys-in-fact and agents, with full power of substitution andresubstitution, for him or her and in his or her name, place, and stead, in anyand all capacities, to sign any and all amendments to this Report, and to filethe same, with all exhibits thereto, and other documents in connectiontherewith, with the Securities and Exchange Commission, granting unto saidattorneys-in-fact and agents, and each of them, full power and authority to doand perform each and every act and thing requisite and necessary to bedone in connection therewith, as fully to all intents and purposes as he or shemight or could do in person, hereby ratifying and confirming that all saidattorneys-in-fact and agents, or any of them or their or his substitute orsubstituted, may lawfully do or cause to be done by virtue hereof.

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this Report has been signed below by the followingpersons on behalf of the Registrant and in the capacities and on the datesindicated.

 
| **Signature**               | ** ** | **Title**                                         | ** ** | **Date**           |
|-----------------------------|------------|---------------------------------------------------|------------|--------------------|
|                        |       |                                              |       |               |
| /S/ KENT SNYDER             |       | President , Chief Executive Officer and  Director |       | March 6, 2006 |
| Kent Snyder                 |       |                                              |       |               |
|                        |       |                                              |       |               |
|                        |       |                                              |       |               |
| /S/ JOHN POYHONEN           |       | Senior Vice President and Chief Financial  and    |       | March 6, 2006 |
| John Poyhonen               |       | Business Officer                                  |       |               |
|                        |       |                                              |       |               |
|                        |       |                                              |       |               |
| /S/ MARK LESCHLY            |       | Chairman of the Board of Directors                |       | March 7, 2006      |
| Mark Leschly                |       |                                              |       |               |
|                        |       |                                              |       |               |
| /S/ STEPHEN A. BLOCK        |       | Director                                          |       | March 9, 2006      |
| Stephen A. Block, Esq. |       |                                              |       |               |
|                        |       |                                              |       |               |
|                        |       |                                              |       |               |
|                        |       | Director                                          |       |               |
| Michael E. Herman           |       |                                              |       |               |
|                        |       |                                              |       |               |
|                        |       |                                              |       |               |
| /S/ DAVID SCHNELL           |       | Director                                          |       | March 7, 2006      |
| David Schnell, M.D.         |       |                                              |       |               |
|                        |       |                                              |       |               |
|                        |       |                                              |       |               |
|                        |       | Director                                          |       |               |
| Jay Short, Ph.D.       |       |                                              |       |               |
|                        |       |                                              |       |               |
|                        |       |                                              |       |               |
| /S/ TIMOTHY WOLLAEGER       |       | Director                                          |       | March 8, 2006      |
| Timothy Wollaeger           |       |                                              |       |               |

 

82

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**EXHIBIT INDEX**

 
| **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)                   |       | 10.1                | 0          |                        | 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)                   |       | 10.1                | 1*         |                        | Exclusive  License and Bailment Agreement dated March 10, 2000 between the  Registrant and the Regents of the University of California. |
| (1)                   |       | 10.1                | 2*         |                        | Collaborative  Research and License Agreement dated November 1, 2000, as amended April 16,  2002, between the Registrant and Aurora Biosciences Corporation. |
| (1)                   |       | 10.1                | 3*         |                        | Collaborative  Research and License Agreement dated December 6, 2000, as amended May 2,  2002, between the Registrant and Kraft Foods, Inc. |
| (1)                   |       | 10.1                | 4*         |                        | 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)                   |       | 10.1                | 5*         |                        | Collaborative  Research and License Agreement dated April 18, 2002, as amended October 23,  2003, between the Registrant and Nestec, Ltd. |
| (1)                   |       | 10.1                | 6*         |                        | Collaborative  Research, Development, Commercialization and License Agreement dated April 22,  2002 between the Registrant and the Coca-Cola Company. |
| (1)                   |       | 10.1                | 7+         |                        | 1999 Equity  Incentive Plan and Form of Stock Option Agreement thereunder. |
| (2)                   |       | 10.1                | 8*         |                        | Collaborative  Research and License Agreement, dated October 26, 2004, between The  Registrant and Nestec Ltd. |
| (3)                   |       | 10.1                | 9*         |                        | Second  Amendment to the Collaborative Research and License Agreement dated April 18,  2002, as amended October 23, 2003, between the Registrant and Nestec,  Ltd. |
| (4)                   |       | 10.2                | 0*         |                        | Second  Amendment to the Collaborative Research and License Agreement dated December 6,  2000, as amended May 2, 2002, between the Registrant |

 

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|   |   |   |   |   | and Kraft  Foods Global, Inc.                                                                                                                                                                                                                                                        |
|--------|--------|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (5)    |   | 10.2   | 1*     |   | Third  Amendment to the Collaborative Research and License Agreement dated December 6,  2000, as amended May 2, 2002 and April 29, 2005, between the  Registrant and Kraft Foods Global, Inc.                                                                         |
| (6)    |   | 10.2   | 2+     |   | Summary  Description of Senomyx, Inc. Incentive Cash Bonus Program                                                                                                                                                                                                                   |
|   |   | 10.2   | 3*     |   | Lease  Agreement between ARE-NEXUS CENTRE II, LLC and Senomyx, Inc.                                                                                                                                                                                                                  |
|   |   | 10.2   | 4      |   | Seventh  Amendment to Expansion Lease by and between ARE-11099 NORTH TORREY PINES,  LLC, and Registrant.                                                                                                                                                                                  |
|   |   | 10.2   | 5*     |   | Amended and  Restated Fourth Amendment to the Collaborative Research and License Agreement  dated December 6, 2000, as amended May 2, 2002, April 29, 2005  and July 29, 2005, between the Registrant and Kraft Foods Global, Inc                                     |
|   |   | 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, President, Chief Executive Officer and Director, and John  Poyhonen, Senior Vice President and 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. |

 

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**+****                                        **Indicatesmanagement contract or compensatory plan.

 

*                                         Confidentialtreatment has been requested with respect to certain portions of this exhibit.Omitted portions have been filed separately with the Securities and ExchangeCommission.

 

(1)                                  Filedas an exhibit to Registration Statement File No. 333-113998 and incorporatedherein by reference.

 

(2)                                  Filedas an exhibit to our Quarterly Report of Form 10-Q for the quarterended September 30, 2004 and incorporated herein by reference.

 

(3)                                  Filedas an exhibit to our Quarterly Report of Form 10-Q for the quarterended March 31, 2005 and incorporated herein by reference.

 

(4)                                  Filedas an exhibit to our Quarterly Report of Form 10-Q for the quarterended June 30, 2005 and incorporated herein by reference.

 

(5)                                  Filedas an exhibit to our Quarterly Report of Form 10-Q for the quarterended September 30, 2005 and incorporated herein by reference.

 

(6)                                  Filedas an exhibit to our Current Report on Form 8-K filed with theSecurities and Exchange Commission on February 6, 2006 and incorporatedherein by reference.

 

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