UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549




FORM
10-K


(Mark
One)




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




For
the Fiscal Year Ended December 31, 2008




or




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




For
the Transition Period from _____________ to _____________




Commission
File Number:  000-30111


Lexicon
Pharmaceuticals, Inc.


(Exact
Name of Registrant as Specified in its Charter)





Delaware
            76-0474169(State
      or Other Jurisdiction of
              Incorporation
      or Organization)
            (I.R.S.
      Employer
              Identification
      Number)





8800
      Technology Forest Place
              The
      Woodlands, Texas 77381
              (Address
      of Principal Executive
              Offices
      and Zip Code)
            (281)
      863-3000
              (Registrant’s Telephone
      Number,
              Including
      Area Code)





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




Title
      of Each Class
            
            
            Name
      of Each Exchange on which RegisteredCommon
      Stock, par value $0.001 per share
            Nasdaq
      Global Market





Securities registered pursuant to
Section 12(g) of the Act:  None




Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act of 1933.  Yes o  No þ




Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Securities Exchange Act of
1934.   Yes o  No þ




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




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




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting
company.  See definitions of “large accelerated filer,” “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Securities Exchange
Act of 1934.  (check one):  Large accelerated filer o   Accelerated
filer þ   Non-accelerated
filer o   Smaller
reporting company o




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Securities Exchange Act of 1934).   Yes o No  þ




The
aggregate market value of voting stock held by non-affiliates of the registrant
as of the last day of the registrant’s most recently completed second quarter
was approximately $127.5 million, based on the closing price of the common stock
on the Nasdaq Global Market on June 30, 2008 of $1.60 per
share.  For purposes of the preceding sentence only, all directors,
executive officers and beneficial owners of ten percent or more of the
registrant’s common stock are assumed to be affiliates.  As of March
2, 2009, 137,330,254 shares of common stock were outstanding.




Documents
Incorporated by Reference




Certain
sections of the registrant’s definitive proxy statement relating to the
registrant’s 2009 annual meeting of stockholders, which proxy statement will be
filed under the Securities Exchange Act of 1934 within 120 days of the end of
the registrant’s fiscal year ended December 31, 2008, are incorporated by
reference into Part III of this annual report on Form 10-K.










Lexicon
Pharmaceuticals, Inc.





Table
of Contents





ItemPART
      I1.
                  
                  Business
                  11A.
                  
                  Risk Factors
                  131B.
                  
                  Unresolved Staff Comments
                  272.
                  
                  Properties
                  273.
                  
                  Legal Proceedings
                  284.
                  
                  Submission of Matters to a Vote of Security
      Holders
                  28PART
      II5.
                  
                  Market for Registrant’s Common Equity, Related Stockholder
      Matters and Issuer Purchases of Equity Securities
                  296.
                  
                  Selected Financial Data
                  307.
                  
                  Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
                  317A.
                  
                  Quantitative and Qualitative Disclosures About
      Market Risk
                  428.
                  
                  Financial Statements and Supplementary
      Data
                  429.
                  
                  Changes in and Disagreements with Accountants on
      Accounting and Financial Disclosure
                  429A.
                  
                  Controls and Procedures
                  429B.
                  
                  Other Information
                  43PART
      III10.
                  
                  Directors, Executive Officers and Corporate
      Governance
                  4411.
                  
                  Executive Compensation
                  4412.
                  
                  Security Ownership of Certain Beneficial Owners
      and Management and Related Stockholder Matters
                  4413.
                  
                  Certain Relationships and Related
      Transactions, and Director Independence
                  4414.
                  
                  Principal Accounting Fees and Services
                  44PART
      IV15.
                  
                  Exhibits and Financial Statement Schedules
                  45Signatures
                  49







The
Lexicon name and logo, LexVision® and
OmniBank® are
registered trademarks and Genome5000TM,
e-BiologyTM and
10TO10TM are
trademarks of Lexicon Pharmaceuticals, Inc.




In this
annual report on Form 10-K, “Lexicon Pharmaceuticals,” “Lexicon,” “we,” “us” and
“our” refer to Lexicon Pharmaceuticals, Inc.







Factors
Affecting Forward Looking Statements




This
annual report on Form 10-K contains forward-looking statements.  These
statements relate to future events or our future financial
performance.  We have attempted to identify forward-looking statements
by terminology including “anticipate,” “believe,” “can,” “continue,” “could,”
“estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “should”
or “will” or the negative of these terms or other comparable terminology. These
statements are only predictions and involve known and unknown risks,
uncertainties and other factors, including the risks outlined under “Item
1A.  Risk Factors,” that may cause our or our industry’s actual
results, levels of activity, performance or achievements to be materially
different from any future results, levels of activity, performance or
achievements expressed or implied by these forward-looking
statements.




Although
we believe that the expectations reflected in the forward-looking statements are
reasonable, we cannot guarantee future results, levels of activity, performance
or achievements. We are not under any duty to update any of the forward-looking
statements after the date of this annual report on Form 10-K to conform these
statements to actual results, unless required by law.









PART
I





Item
      1.
                        Business




Overview




Lexicon
Pharmaceuticals, Inc. is a biopharmaceutical company focused on the discovery
and development of breakthrough treatments for human disease.  We have
used our proprietary gene knockout technology and an integrated platform of
advanced medical technologies to systematically study the physiological and
behavioral functions of almost 5,000 genes in mice and assessed the utility of
the proteins encoded by the corresponding human genes as potential drug
targets.  We have identified and validated in living animals, or in vivo, more than 100
targets with promising profiles for drug discovery.  For targets that
we believe have high pharmaceutical value, we engage in programs for the
discovery and development of potential new drugs, focusing in the core
therapeutic areas of immunology, metabolism, cardiology and
ophthalmology.




We are
presently conducting a Phase 2 clinical trial of our most advanced drug
candidate, LX1031, an orally-delivered small molecule compound that we are
developing as a potential treatment for irritable bowel syndrome and other
gastrointestinal disorders.  We have completed Phase 1 clinical trials
and intend in the near term to initiate a Phase 2 clinical trial of LX1032, an
orally-delivered small molecule compound that we are developing as a potential
treatment for the symptoms associated with carcinoid syndrome.  We are
conducting Phase 1 clinical trials of two other drug
candidates:  LX2931, an orally-delivered small molecule compound that
we are developing as a potential treatment for rheumatoid arthritis and other
autoimmune diseases; and LX4211, an orally-delivered small molecule compound
that we are developing as a potential treatment for Type 2
diabetes.  We have advanced one other drug candidate into preclinical
development: LX7101, a topically-delivered small molecule compound that we are
developing as a potential treatment for glaucoma.  We have small
molecule compounds from a number of additional drug discovery programs in
various stages of preclinical research and believe that our systematic, target
biology-driven approach to drug discovery will enable us to substantially expand
our clinical pipeline.




We are
working both independently and through strategic collaborations and alliances to
capitalize on our technology, drug target discoveries and drug discovery and
development programs.  Consistent with this approach, we seek to
retain exclusive rights to the benefits of certain of our small molecule drug
programs by developing and commercializing drug candidates from such programs
internally and to collaborate with third parties with respect to the discovery,
development and commercialization of small molecule and biotherapeutics drug
candidates for other targets, particularly when the collaboration provides us
with access to expertise and resources that we do not possess internally or are
complementary to our own.  We have established drug discovery and
development collaborations with a number of leading pharmaceutical and
biotechnology companies which have enabled us to generate near-term cash while
offering us the potential to retain economic participation in products our
collaborators develop through the collaboration.  In addition, we have
established collaborations and license agreements with other leading
pharmaceutical and biotechnology companies, research institutes and academic
institutions under which we receive fees and, in some cases, are eligible to
receive milestone and royalty payments, in return for granting access to some of
our technologies and discoveries for use in the other organization’s own drug
discovery efforts.




Lexicon
Pharmaceuticals, Inc. was incorporated in Delaware in July 1995, and commenced
operations in September 1995.  Our corporate headquarters are located
at 8800 Technology Forest Place, The Woodlands, Texas 77381, and our telephone
number is (281) 863-3000.




Our
annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K, and amendments to those reports filed or furnished pursuant to Section
13(a) or 15(d) of the Securities Exchange Act of 1934 are made available free of
charge on our corporate website located at www.lexpharma.com as soon as
reasonably practicable after the filing of those reports with the Securities and
Exchange Commission.  Information found on our website should not be
considered part of this annual report on Form 10-K.




Our
Drug Development Pipeline




Human
clinical trials are currently underway for four of our drug candidates, with one
additional drug candidate in preclinical development and compounds from a number
of additional programs in various stages of preclinical research:


1
 Table
of Contents




Drug Program
                                  
                                  Potential Indication
                                  
                                  Stage of
      DevelopmentPreclinical
                                    Research
                                  Preclinical
                                    Development
                                  IND
                                  Phase
      1
                                  Phase
      2
                                  Phase
      3LX1031
                                  
                                  Irritable
      Bowel SyndromeLX1032
                                  
                                  Carcinoid
      SyndromeLX2931
                                  
                                  Rheumatoid
      ArthritisLX4211
                                  
                                  Type
      2 DiabetesLX7101
                                  
                                  Glaucoma




LX1031




LX1031 is
an orally-delivered small molecule compound that we are developing for the
potential treatment of irritable bowel syndrome and other gastrointestinal
disorders.  We initiated a Phase 2 clinical trial in December 2008 to
evaluate the safety and tolerability of LX1031 and its effects on symptoms
associated with irritable bowel syndrome.  The Phase 2 clinical trial
is expected to include 150 patients suffering from either diarrhea-predominant
or mixed irritable bowel syndrome.  We have completed a Phase 1a
single ascending-dose study, an initial Phase 1b multiple ascending-dose study
and an additional Phase 1b dose escalation study of LX1031.  In Phase
1 clinical trials, all dose levels were well tolerated, no dose-limiting
toxicities were observed and LX1031 was shown to reduce levels of urinary
5-HIAA, the primary metabolite of serotonin and a biomarker of serotonin
production.




We
designed LX1031 to reduce production of serotonin in the gastrointestinal tract
and therefore reduce the sertonin available for receptor activation without
affecting serotonin levels in the brain.  LX1031 was internally
generated by our medicinal chemists as an inhibitor of tryptophan hydroxylase,
or TPH, the rate-limiting enzyme for serotonin production found primarily in
enterochromaffin, or EC, cells of the gastrointestinal tract.  In our
Genome5000 program, our scientists found that mice lacking the non-neuronal form
of this enzyme, TPH1, have virtually no serotonin in the gastrointestinal tract,
but maintain normal levels of serotonin in the brain.  In preclinical
studies, LX1031 demonstrated a dose-dependent reduction of serotonin levels in
the gastrointestinal tract of multiple species without affecting brain serotonin
levels.  Clinical development of LX1031 is being funded through our
product development collaboration with Symphony Capital Partners,
L.P.




LX1032




LX1032 is
an orally-delivered small molecule compound that we are developing for the
potential treatment of symptoms associated with carcinoid
syndrome.  We intend to initiate a Phase 2 clinical trial in the
near-term to evaluate the safety and tolerability of LX1032 and its effects on
symptoms associated with carcinoid syndrome.  We have completed a
Phase 1a single ascending-dose study and a Phase 1b multiple ascending-dose
study of LX1032.  In Phase 1 clinical trials, LX1032 was well
tolerated at all dose levels and results demonstrated a potent dose-dependent
reduction in both blood serotonin levels and urinary 5-HIAA which was consistent
with the reductions observed in preclinical animal models.




LX1032
was internally generated by our medicinal chemists as an inhibitor of TPH, the
same target as LX1031, but LX1032 is chemically distinct and, unlike LX1031, was
specifically designed to achieve enhanced systemic exposure to address disorders
such as carcinoid syndrome that require regulation of serotonin levels beyond
the enterochromaffin cells in the gastrointestinal tract without impacting brain
serotonin production.  In preclinical studies, LX1032 was able to
reduce peripheral serotonin levels in several different species without
affecting serotonin levels in the brain.  LX1032 has received Fast
Track status from the United States Food and Drug Administration, or FDA, which
provides for an expedited review process that may shorten FDA approval
times.  Clinical development of LX1032 is being funded through our
product development collaboration with Symphony Capital Partners,
L.P.




LX2931




LX2931 is
an orally-delivered small molecule compound that we are developing for the
potential treatment of autoimmune diseases such as rheumatoid
arthritis.  We initiated a drug-drug interaction study in January 2009
of LX2931 in rheumatoid arthritis patients who are also taking methotrexate, a
standard therapy.  We have completed two Phase 1a single
ascending-dose studies, a Phase 1b multiple ascending-dose study and a
multiple dose study assessing the pharmacokinetics of a solid dose form of
LX2931.  In the Phase 1b clinical trial, LX2931 was well
tolerated at all doses and results demonstrated a dose-dependent reduction in
circulating lymphocytes similar to those associated with a beneficial response
observed in animal arthritis models after treatment with LX2931.  In
the Phase 1a clinical trials, LX2931 produced a dose-dependent decrease in
absolute lymphocyte counts with a maximal effect correlating with a plateauing
of systemic exposure at doses of 100 to 125 mg.  An episode of
acute abdominal pain resolving within 24 hours was observed in two out of
24 subjects in the single ascending-dose trials who received doses above
175 mg, potentially representing dose-limiting tolerability.


2
 Table
of Contents




LX2931
was internally generated by our medicinal chemists to target
sphingosine-1-phosphate lyase, or S1P lyase, an enzyme in the
sphingosine-1-phosphate (S1P) pathway associated with the activity of
lymphocytes.  Lymphocytes are a cellular component and key driver of
the immune system, and are involved in a number of autoimmune and inflammatory
disorders.  In our Genome5000 program, our scientists discovered that
mice lacking this enzyme have increased retention of immune cells in the thymus
and spleen with a corresponding reduction in the deployment of T-cells and
B-cells into the circulating blood.  In preclinical studies, LX2931
produced a consistent reduction in circulating lymphocyte counts in multiple
species, and reduced joint inflammation and prevented arthritic destruction of
joints in mouse and rat models of arthritis.




LX4211




LX4211 is
an orally-delivered small molecule compound that we are developing for the
potential treatment of Type 2 diabetes.  We initiated a
Phase 1 clinical trial in January 2009 to evaluate the safety, tolerability
and pharmacokinetics of LX4211.




LX4211
was internally generated by our medicinal chemists to target sodium-glucose
cotransporter type 2, or SGLT2, a transporter responsible for most of the
glucose reabsorption performed by the kidney.  In our Genome5000
program, our scientists discovered that mice lacking SGLT2 have improved glucose
tolerance and increased urinary glucose excretion.  In preclinical
studies, animals treated with LX4211 demonstrated increased urinary glucose
excretion and decreased blood HbA1c levels, a marker of average blood sugar
levels, with urinary glucose excretion returning to baseline after treatment was
discontinued.




LX7101




LX7101 is
a topically-delivered small molecule compound that we are developing for the
potential treatment of glaucoma.  We have commenced preclinical
studies of LX7101 and its associated back-up molecules.




LX7101
was internally generated by our medicinal chemists to target a kinase
responsible for regulating intraocular pressure and is designed to lower
intraocular pressure by enhancing the fluid outflow facility of the
eye.  In our Genome5000 program, our scientists found that mice
lacking the gene encoding the target of LX7101 exhibited lower intraocular
pressure compared to normal mice.  In preclinical studies, LX7101
significantly reduced intraocular pressure in an animal model of ocular
hypertension.




Discovery
Programs




We have
advanced a number of additional drug discovery programs into various stages of
preclinical research in preparation for formal preclinical development
studies.  Finally, through the end of 2008, we had identified and
validated, in vivo,
more than 100 targets with promising profiles for drug discovery.




Our
Drug Discovery and Development Process




Our drug
discovery and development process began with our Genome5000 program, in which we
used our gene knockout and medical evaluative technologies to discover the
putative physiological and behavioral functions of almost 5,000 human genes
through analysis of the corresponding mouse knockout models.  In our
Genome5000 program, we used our patented gene trapping and gene targeting
technologies to generate knockout mice – mice whose DNA has been modified to
disrupt, or knock out, the function of the altered gene – by altering the DNA of
genes in a special variety of mouse cells, called embryonic stem cells, which
were then cloned and used to generate mice with the altered gene.  We
then studied the physiology and behavior of the knockout mice using a
comprehensive battery of advanced medical technologies, each of which was
adapted specifically for the analysis of mouse physiology.  This
systematic use of these evaluative technologies allowed us to discover, in vivo, the physiological
and behavioral functions of the genes we knocked out and assess the prospective
pharmaceutical utility of the potential drug targets encoded by the
corresponding human genes.  The study of the effects of knocking out
genes in mice has historically proven to be a powerful tool for understanding
human genes because of the close similarity of gene function and physiology
between mice and humans, with approximately 99% of all human genes having a
counterpart in the mouse genome.




We engage
in programs for the discovery of potential small molecule drugs for those in vivo-validated drug
targets that we consider to have high pharmaceutical value.  We have
established extensive internal small molecule drug discovery capabilities, in
which we use our own sophisticated libraries of drug-like chemical compounds in
high-throughput screening assays to identify “hits,” or chemical compounds
demonstrating activity, against these targets.  We then employ
medicinal chemistry efforts to optimize the potency and selectivity of these
hits and to identify lead compounds for potential development.  We
have established extensive internal capabilities to characterize the absorption,
distribution, metabolism and excretion of our potential drug candidates and
otherwise evaluate their safety in mammalian models in preparation for
preclinical and clinical development.  In all of our drug discovery
programs, we use a parallel physiological analysis technology platform that we
used in the discovery of gene function to analyze the in vivo activity and safety
profiles of drug candidates in mice as part of our preclinical research
efforts.


3
 Table
of Contents




Once we
identify a potential drug candidate, we initiate formal preclinical development
studies in preparation for regulatory filings for the commencement of human
clinical trials.  We have established internal expertise in each of
the critical areas of preclinical and clinical development, including clinical
trial design, study implementation and oversight, and regulatory affairs, with
demonstrated experience by members of our clinical development team in the
successful implementation of Phase 1, 2 and 3 clinical trials and
regulatory approval for the commercialization of therapeutic
products.




We
believe that our systematic, biology-driven approach and our underlying
technology platform provide us with substantial advantages over alternative
approaches to drug target discovery.  In particular, we believe that
the comprehensive nature of our approach has allowed us to identify potential
drug targets within the context of mammalian physiology that might have been
missed by more narrowly focused efforts.  We also believe our approach
is more likely to reveal those side effects that may be a direct result of
inhibiting or otherwise modulating the drug target and may limit the utility of
potential therapeutics directed at the drug target.  We believe these
advantages will contribute to better target selection and, therefore, to a
greater likelihood of success for our drug discovery and development
efforts.




Our
Technology




The core
elements of our technology platform include our patented technologies for the
generation of knockout mice, our integrated platform of advanced medical
technologies for the systematic and comprehensive biological analysis of in vivo behavior and
physiology, and our specialized approach to medicinal chemistry and the
generation of high-quality, drug-like compound libraries.




Gene
Knockout Technologies




Gene
Targeting.  Our gene targeting technology, which is covered by
nine issued patents that we have licensed, enables us to generate
highly-specific alterations in targeted genes.  The technology
replaces DNA of a gene in a mouse embryonic stem cell through a process known as
homologous recombination to disrupt the function of the targeted gene,
permitting the generation of knockout mice.  By using this technology
in combination with one or more additional technologies, we are able to generate
alterations that selectively disrupt, or conditionally regulate, the function of
the targeted gene for the analysis of the gene’s function in selected tissues,
at selected stages in the animal’s development or at selected times in the
animal’s life.  We can also use this technology to replace the
targeted gene with its corresponding human gene for use for preclinical research
in our drug programs.




Gene Trapping.  Our
gene trapping technology, which is covered by ten issued patents that we own, is
a high-throughput method of generating knockout mouse clones that we
invented.  The technology uses genetically engineered retroviruses
that infect mouse embryonic stem cells in vitro, integrate into the
chromosome of the cell and disrupt the function of the gene into which it
integrates, permitting the generation of knockout mice.  This process
also allows us to identify and catalogue each embryonic stem cell clone by DNA
sequence from the trapped gene and to select embryonic stem cell clones by DNA
sequence for the generation of knockout mice.  We have used our gene
trapping technology in an automated process to create our OmniBank library of
more than 270,000 frozen gene knockout embryonic stem cell clones, each
identified by DNA sequence in a relational database.




Physiological
Analysis Technologies




We have
employed an integrated platform of advanced analytical technologies to rapidly
and systematically discover the physiological and behavioral effects resulting
from loss of gene function in the knockout mice we have generated using our gene
trapping and gene targeting technologies and catalogued those effects in our
comprehensive and relational LexVision database.  These analyses
include many of the most sophisticated diagnostic technologies and tests
currently available, many of which might be found in a major medical
center.  Each of these technologies was adapted specifically for the
analysis of mouse physiology.  This state-of-the-art technology
platform has enabled us to assess the consequences of loss of gene function in a
living mammal across a wide variety of parameters relevant to human
disease.


4
 Table
of Contents




We employ
portions of the same physiological analysis technology platform that we used in
the discovery of gene function to analyze the in vivo efficacy and safety
profiles of drug candidates in mice.  We believe that this approach
will allow us, at an early stage, to identify and optimize drug candidates for
further preclinical and clinical development that demonstrate in vivo efficacy and to
distinguish side effects caused by a specific compound from the target-related
side effects that we defined using the same comprehensive series of
tests.




Chemistry
Technologies




We have
used solution-phase chemistry to generate our own diverse libraries of optically
pure compounds that are targeted against the same pharmaceutically-relevant gene
families that we addressed in our Genome5000 program.  These libraries
have been built using highly robust and scalable organic reactions that allow us
to generate compound collections of great diversity and to specially tailor the
compound collections to address various therapeutic target
families.  We designed these libraries by analyzing the chemical
structures of drugs that have been proven safe and effective against human
disease and using that knowledge in the design of scaffolds and chemical
building blocks for the generation of large numbers of new drug-like
compounds.  When we identify a hit against one of our in vivo-validated targets, we
can rapidly reassemble these building blocks to create hundreds or thousands of
variations around the structure of the initial compound, enabling us to
accelerate our medicinal chemistry efforts.  We have supplemented our
internally-generated compound libraries with collections of compounds acquired
from third parties.  Finally, we have also established an alliance
with Nuevolution A/S providing us with access to Nuevolution’s Chemetics®
platform chemistry technology, allowing us to screen our targets against
ultra-large libraries of fragment-based chemical compounds.




Our
medicinal chemistry operations are housed in a state-of-the-art 76,000 square
foot facility in Princeton, New Jersey.  Our lead optimization
chemistry groups are organized around specific discovery targets and work
closely with their therapeutic area counterparts in our facilities in The
Woodlands, Texas.  The medicinal chemists optimize lead compounds in
order to select clinical candidates with the desired absorption, distribution,
metabolism, excretion and physicochemical characteristics.  We have
the capability to profile our compounds using portions of the same battery of
in vivo assays that we
used to characterize our drug targets.  This provides us with valuable
detailed information relevant to the selection of the highest quality compounds
for preclinical and clinical development.




Our
Commercialization Strategy




We are
working both independently and through strategic collaborations and alliances
with leading pharmaceutical and biotechnology companies, research institutes and
academic institutions to capitalize on our technology, drug target discoveries
and drug discovery and development programs.  Consistent with this
approach, we intend to develop and commercialize drug candidates from certain of
our small molecule drug programs internally and retain exclusive rights to the
benefits of such programs and to collaborate with third parties with respect to
the discovery, development and commercialization of small molecule and
biotherapeutics drug candidates for other targets, particularly when the
collaboration provides us with access to expertise and resources that we do not
possess internally or are complementary to our own.




Drug
Discovery and Development Collaborations




Bristol-Myers Squibb
Company.  We established a drug discovery alliance with
Bristol-Myers Squibb in December 2003 to discover, develop and commercialize
small molecule drugs in the neuroscience field.  We initiated the
alliance with a number of neuroscience drug discovery programs at various stages
of development and are using our gene knockout technology to identify additional
drug targets with promise in the neuroscience field.  For those
targets that are selected for the alliance, we and Bristol-Myers Squibb are
working together, on an exclusive basis, to identify, characterize and carry out
the preclinical development of small molecule drugs, and share equally both in
the costs and in the work attributable to those efforts.  As drugs
resulting from the alliance enter clinical trials, Bristol-Myers Squibb will
have the first option to assume full responsibility for clinical development and
commercialization.




We
received an upfront payment under the agreement and received research funding
during the initial three years of the agreement.  Bristol-Myers Squibb
extended the target discovery term of the alliance in May 2006 in exchange for
its payment to us of additional research funding.  We will also
receive clinical and regulatory milestone payments for each drug target for
which Bristol-Myers Squibb develops a drug under the alliance and royalties on
sales of drugs commercialized by Bristol-Myers Squibb.  The target
discovery portion of the alliance is expected to be completed in June
2009.


5
 Table
of Contents




Genentech, Inc.  We
established a drug discovery alliance with Genentech in December 2002 to
discover novel therapeutic proteins and antibody targets.  We and
Genentech expanded the alliance in November 2005 for the advanced research,
development and commercialization of new biotherapeutic drugs.  Under
the original alliance agreement, we used our target validation technologies to
discover the functions of secreted proteins and potential antibody targets
identified through Genentech’s internal drug discovery research.  In
the expanded alliance, we conducted additional, advanced research on a broad
subset of those proteins and targets.  We may develop and
commercialize biotherapeutic drugs for up to six of these targets, with
Genentech having exclusive rights to develop and commercialize biotherapeutic
drugs for the other targets.  Genentech retains an option on the
potential development and commercialization of the biotherapeutic drugs that we
develop from the alliance under a cost and profit sharing arrangement, while we
have certain conditional rights to co-promote drugs on a worldwide
basis.  We retain certain other rights to discoveries made in the
alliance, including non-exclusive rights, along with Genentech, for the
development and commercialization of small molecule drugs addressing the targets
included in the alliance.




We
received upfront payments in connection with both the initiation of the original
collaboration and its expansion and received performance payments for our work
in the collaboration as it was completed.  We are also entitled to
receive milestone payments and royalties on sales of therapeutic proteins and
antibodies for which Genentech obtains exclusive rights.  Genentech is
entitled to receive milestone payments and royalties on sales of therapeutic
proteins and antibodies for which we obtain exclusive rights.  The
collaboration term under the agreement expired in November 2008.




N.V. Organon.We
established a drug discovery alliance with Organon in May 2005 to discover,
develop and commercialize novel biotherapeutic drugs.  In the
collaboration, we are creating and analyzing knockout mice for up to 300 genes
selected by the parties that encode secreted proteins or potential antibody
targets, including two of our preexisting drug discovery programs.  We
and Organon are jointly selecting targets for further research and development
and will equally share costs and responsibility for research, preclinical and
clinical activities.  We and Organon will jointly determine the manner
in which collaboration products will be commercialized and will equally benefit
from product revenue.  If fewer than five development candidates are
designated under the collaboration, our share of costs and product revenue will
be proportionally reduced.  We will receive a milestone payment for
each development candidate in excess of five.  Either party may
decline to participate in further research or development efforts with respect
to a collaboration product, in which case such party will receive royalty
payments on sales of such collaboration product rather than sharing in
revenue.  Organon will have principal responsibility for manufacturing
biotherapeutic products resulting from the collaboration for use in clinical
trials and for worldwide sales.  Organon, formerly a subsidiary of
Akzo Nobel N.V., was acquired by Schering-Plough Corporation in November
2007.




We
received an upfront payment under the agreement and received committed research
funding during the first two years of the agreement.  The target
discovery portion of the alliance has an expected term of four
years.




Takeda Pharmaceutical Company
Limited.  We established a drug discovery alliance with Takeda
in July 2004 to discover new drugs for the treatment of high blood
pressure.  In the collaboration, we used our gene knockout technology
to identify drug targets that control blood pressure.  Takeda was
responsible for the screening, medicinal chemistry, preclinical and clinical
development and commercialization of drugs directed against targets selected for
the alliance, and bears all related costs.  We received an upfront
payment under the agreement and received research milestone payments for each
target selected for therapeutic development.  In addition, we are
entitled to receive clinical development and product launch milestone payments
for each product commercialized from the collaboration.  We will also
earn royalties on sales of drugs commercialized by Takeda.  The target
discovery portion of the alliance expired in July 2007.




Drug
Development Financing Collaborations




Symphony Icon,
Inc.  In June 2007, we entered into a series of related
agreements providing for the financing of the clinical development of certain
drug programs, including LX1031 and LX1032, along with any other pharmaceutical
compositions modulating the same targets as those drug
candidates.  Under the financing arrangement, we licensed to Symphony
Icon, a wholly-owned subsidiary of Symphony Icon Holdings LLC, our intellectual
property rights related to the programs and Holdings contributed $45 million to
Symphony Icon in order to fund the clinical development of the
programs.  We also entered into a share purchase agreement with
Holdings under which we issued and sold to Holdings shares of our common stock
in exchange for $15 million and an exclusive option to acquire all of the
equity of Symphony Icon, thereby allowing us to reacquire the
programs.  The purchase option is exercisable by us at any time, in
our sole discretion, until June 15, 2011 at an exercise price of (a) $72
million, if the purchase option is exercised before June 15, 2009, (b) $81
million, if the purchase option is exercised on or after the June 15, 2009
and before the June 15, 2010 and (c) $90 million, if the purchase option is
exercised on or after June 15, 2010 and before June 15,
2011.  The purchase option exercise price may be paid in cash or a
combination of cash and common stock, at our sole discretion, provided that the
common stock portion may not exceed 40% of the purchase option exercise
price.


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We and
Symphony Icon are developing the programs in accordance with a specified
development plan and related development budget.  We are the party
primarily responsible for the development of the programs. Our development
activities are supervised by Symphony Icon’s development committee, which is
comprised of an equal number of representatives from us and Symphony Icon. The
development committee reports to Symphony Icon’s board of directors, which is
currently comprised of five members, including one member we designated, two
members designated by Holdings, and two independent directors whom we and
Holdings selected mutually.




Upon the
recommendation of Symphony Icon’s development committee, Symphony Icon’s board
of directors may require us to pay Symphony Icon up to $15 million for Symphony
Icon’s use in the development of the programs in accordance with the specified
development plan and related development budget.  The development
committee’s right to recommend that Symphony Icon’s board of directors submit
such funding requirement to us will terminate on the one-year anniversary of the
expiration of the purchase option, subject to limited exceptions.




Other
Collaborations and Licenses




Texas Institute for Genomic
Medicine.  In July 2005, we received an award from the Texas
Enterprise Fund for the creation of a knockout mouse embryonic stem cell library
containing 350,000 cell lines using our proprietary gene trapping technology,
which we completed in 2007.  We created the library for the Texas
Institute for Genomic Medicine, or TIGM, a newly formed non-profit institute
whose founding members are Texas A&M University, the Texas A&M
University System Health Science Center and us.  TIGM researchers may
also access specific cells from our current OmniBank library of 270,000 mouse
embryonic stem cell lines and have certain rights to utilize our gene targeting
technologies.  In addition, we equipped TIGM with the bioinformatics
software required for the management and analysis of data relating to the
library.  The Texas Enterprise Fund also made an award to the Texas
A&M University System for the creation of facilities and infrastructure to
house the library.  Under the terms of the award, we are responsible
for the creation of a specified number of jobs beginning in 2012, but will
receive credits against those job obligations based on funding received by TIGM
and certain related parties.  We may be required to repay the state a
portion of the award if we fail to meet those job obligations.




The Wellcome
Trust.  In November 2006, we entered into a contract to provide
selected knockout mouse lines and related phenotypic data to the National
Research Center for Environment and Health GmbH, or GSF, under terms
substantially similar to those under which knockout mouse lines and related
phenotypic data are available to NIH.  Under the contract, the
Wellcome Trust Limited, in its capacity as trustee of The Wellcome Trust, will
work with GSF to select lines of knockout mice and related phenotypic data from
among lines that we have elected to make available and has separately agreed to
provide a grant to GSF to obtain such knockout mice and phenotypic
data.  These materials are related to genes that we have already
knocked out and analyzed.  GSF will make materials acquired from us
under the contract available to researchers at academic and other non-profit
research institutions, and we retain the sole right to provide these materials
to commercial entities.  We are entitled to receive staged payments
from GSF following delivery and acceptance of materials under the
contract.




Taconic Farms,
Inc.We established a collaboration with Taconic Farms, Inc.
in November 2005 for the marketing, distribution and licensing of certain lines
of our knockout mice.  Taconic is an industry leader in the breeding,
housing, quality control and global marketing and distribution of rodent models
for medical research and drug discovery.  Under the terms of the
collaboration, we are presently making available more than 2,500 distinct lines
of knockout mice for use by pharmaceutical and biotechnology companies and other
researchers.  Taconic provides breeding services and licenses for
these lines and distributes knockout mice to customers.  We receive
license fees and royalties from payments received by Taconic from customers
obtaining access to such knockout mice.




Target Validation
Collaborations.We have established target validation
collaboration agreements with a number of leading pharmaceutical and
biotechnology companies.  Under these collaboration agreements, we
generate and, in some cases, analyze knockout mice for genes requested by the
collaborator.  In addition, we grant non-exclusive licenses to the
collaborator for use of the knockout mice in its internal drug discovery
programs and, if applicable, analysis data that we generate under the
agreement.  We receive fees for knockout mice and, if applicable,
analysis data under these agreements.  In some cases, these agreements
also provide for annual minimum commitments and the potential for royalties on
products that our collaborators discover or develop using our
technology.


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LexVision
Collaborations.The collaboration periods have terminated
under each of our LexVision collaborations, pursuant to which our LexVision
collaborators obtained non-exclusive access to our LexVision database of in vivo-validated drug
targets for the discovery of small molecule compounds.  We remain
entitled to receive milestone payments and royalties on products those LexVision
collaborators develop using our technology.




Technology
Licenses.  We have granted non-exclusive, internal research-use
sublicenses under certain of our gene targeting patent rights to a total of 15
leading pharmaceutical and biotechnology companies.  Many of these
agreements extend for the life of the patents.  Others have terms of
one to three years, in some cases with provisions for subsequent
renewals.  We have typically received up-front license fees and, in
some cases, received additional license fees or milestone payments on products
that the sublicensee discovers or develops using our technology.




Our
Executive Officers




Our
executive officers and their ages and positions are listed below.




Name
                    Age
                    Position with the
CompanyArthur
      T. Sands, M.D., Ph.D.
                    47
                    President
      and Chief Executive Officer and DirectorAlan
      J. Main, Ph.D.
                    55
                    Executive
      Vice President of Pharmaceutical ResearchJeffrey
      L. Wade, J.D.
                    44
                    Executive
      Vice President and General CounselBrian
      P. Zambrowicz, Ph.D.
                    46
                    Executive
      Vice President and Chief Scientific OfficerPhilip
      M. Brown, M.D., J.D.
                    47
                    Senior
      Vice President of Clinical DevelopmentJames
      F. Tessmer
                    49
                    Vice
      President, Finance and
Accounting





Arthur T. Sands, M.D., Ph.D.
co-founded our company and has been our president and chief executive officer
and a director since September 1995. At Lexicon, Dr. Sands pioneered the
development of large-scale gene knockout technology for use in drug
discovery.  Before founding our company, Dr. Sands served as an
American Cancer Society postdoctoral fellow in the Department of Human and
Molecular Genetics at Baylor College of Medicine.  Dr. Sands received
his B.A. in economics and political science from Yale University and his M.D.
and Ph.D. from Baylor College of Medicine.




Alan J. Main, Ph.D. has been
our executive vice president of pharmaceutical research since February 2007 and
served as our senior vice president, Lexicon Pharmaceuticals from July 2001
until February 2007.  Dr. Main was president and chief executive
officer of Coelacanth Corporation, a leader in using proprietary chemistry
technologies to rapidly discover new chemical entities for drug development,
from January 2000 until our acquisition of Coelacanth in
July 2001.  Dr. Main was formerly senior vice president,
U.S. Research at Novartis Pharmaceuticals Corporation, where he worked for
20 years before joining Coelacanth.  Dr. Main holds a B.S.
from the University of Aberdeen, Scotland and a Ph.D. in organic chemistry from
the University of Liverpool, England and completed postdoctoral studies at the
Woodward Research Institute.




Jeffrey L. Wade, J.D. has
been our executive vice president and general counsel since February 2000
and was our senior vice president and chief financial officer from
January 1999 to February 2000.  From 1988 through
December 1998, Mr. Wade was a corporate securities and finance
attorney with the law firm of Andrews & Kurth L.L.P., for the last
two years as a partner, where he represented companies in the biotechnology,
information technology and energy industries.  Mr. Wade is a
member of the boards of directors of the Texas Healthcare and Bioscience
Institute and the Texas Life Science Center for Innovation and
Commercialization.  He received his B.A. and J.D. from the University
of Texas.




Brian P. Zambrowicz, Ph.D.
co-founded our company and has been our executive vice president and chief
scientific officer since February 2007.  Dr. Zambrowicz served as our
executive vice president of research from August 2002 until February 2007,
senior vice president of genomics from February 2000 to August 2002,
vice president of research from January 1998 to February 2000 and
senior scientist from April 1996 to January 1998.  From 1993
to April 1996, Dr. Zambrowicz served as a National Institutes of
Health postdoctoral fellow at the Fred Hutchinson Cancer Center in Seattle,
Washington, where he studied gene trapping and gene targeting
technology.  Dr. Zambrowicz received his B.S. in biochemistry
from the University of Wisconsin.  He received his Ph.D. from the
University of Washington, where he studied tissue-specific gene regulation using
transgenic mice.


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Philip M. Brown, M.D., J.D.
has been our senior vice president of clinical development since February 2008
and was our vice president of clinical development from April 2003 to
February 2008.  Dr. Brown served as vice president of clinical
development for Encysive Pharmaceuticals Inc. (formerly Texas Biotechnology
Corporation), a biopharmaceutical company, from June 2000 until
April 2003, and was senior medical director within the organization from
December 1998 until June 2000. From July 1994 to
December 1998, Dr. Brown served as associate vice president of medical
affairs for Pharmaceutical Research Associates, a clinical research
organization. He has conducted numerous clinical trials as an investigator in a
variety of therapeutic areas, as well as managed programs from IND through NDA
and product commercialization. He is a fellow of the American College of Legal
Medicine and serves as an adjunct faculty member at the Massachusetts General
Hospital, Institute of Health Professions in Boston. He received his B.A. from
Hendrix College, his M.D. from Texas Tech University School of Medicine, and his
J.D. from the University of Texas.




James F. Tessmer has been our
vice president, finance and accounting since November 2007 and previously served
as our senior director of finance from February 2004 to November 2007 and
director of finance from April 2001 to February 2004.  From January
1997 to April 2001, Mr. Tessmer was assistant controller for Mariner Health
Network, Inc. and prior to that served in a variety of financial and accounting
management positions for HWC Distribution Corp. and American General
Corporation.  Mr. Tessmer is a certified public accountant and
received his B.B.A. from the University of Wisconsin – Milwaukee and his M.B.A.
from the University of Houston.




Patents
and Proprietary Rights




We will
be able to protect our proprietary rights from unauthorized use by third parties
only to the extent that those rights are covered by valid and enforceable
patents or are effectively maintained as trade secrets. Accordingly, patents and
other proprietary rights are an essential element of our business. We seek
patent protection for genes, proteins, drug targets, compounds and drug
candidates that we discover. Specifically, we seek patent protection
for:




·
            chemical
      compounds, antibodies and other potential therapeutic agents and their use
      in treating human diseases and
conditions;




·
            the
      sequences of genes that we believe to be novel, the proteins they encode
      and their predicted utility as a drug target or therapeutic
      protein;




·
            the
      utility of genes and the drug targets or proteins they encode based on our
      discoveries of their biological functions using knockout
    mice;




·
            drug
      discovery assays for our in vivo-validated
      targets; and




·
            various
      enabling technologies in the fields of mutagenesis, embryonic stem cell
      manipulation and transgenic or knockout
mice.




Additionally,
we hold rights to a number of patents and patent applications under license
agreements with third parties.  In particular, we license our
principal gene targeting technologies from GenPharm International,
Inc.  Many of these licenses are nonexclusive, although some are
exclusive in specified fields.  Most of the licenses, including those
licensed from GenPharm, have terms that extend for the life of the licensed
patents.  In the case of our license from GenPharm, the license
generally is exclusive in specified fields, subject to specific rights held by
third parties, and we are permitted to grant sublicenses.




All of
our employees, consultants and advisors are required to execute a proprietary
information agreement upon the commencement of employment or consultation. In
general, the agreement provides that all inventions conceived by the employee or
consultant, and all confidential information developed or made known to the
individual during the term of the agreement, shall be our exclusive property and
shall be kept confidential, with disclosure to third parties allowed only in
specified circumstances. We cannot assure you, however, that these agreements
will provide useful protection of our proprietary information in the event of
unauthorized use or disclosure of such information.




Competition




The
biotechnology and pharmaceutical industries are highly competitive and
characterized by rapid technological change. We face significant competition in
each of the aspects of our business from other pharmaceutical and biotechnology
companies.  In addition, a large number of universities and other
not-for-profit institutions, many of which are funded by the U.S. and foreign
governments, are also conducting research to discover genes and their functions
and to identify potential therapeutic products.  Many of our
competitors have substantially greater research and product development
capabilities and financial, scientific, marketing and human resources than we
do.  As a result, our competitors may succeed in developing products
earlier than we do, obtaining approvals from the FDA or other regulatory
agencies for those products more rapidly than we do, or developing products that
are more effective than those we propose to develop.  Similarly, our
collaborators face similar competition from other competitors who may succeed in
developing products more quickly, or developing products that are more
effective, than those developed by our collaborators.  Any products
that we may develop or discover are likely to be in highly competitive
markets.


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We
believe that our ability to successfully compete will depend on, among other
things:




·
            the
      efficacy, safety and reliability of our drug
  candidates;




·
            our
      ability, and the ability of our collaborators, to complete preclinical
      testing and clinical development and obtain regulatory approvals for our
      drug candidates;




·
            the
      timing and scope of regulatory approvals for our drug
      candidates;




·
            our
      ability, and the ability of our collaborators, to obtain product
      acceptance by physicians and other health care providers and reimbursement
      for product use in approved
indications;




·
            our
      ability, and the ability of our collaborators, to manufacture and sell
      commercial quantities of our
products;




·
            the
      skills of our employees and our ability to recruit and retain skilled
      employees;




·
            protection
      of our intellectual property; and




·
            the
      availability of substantial capital resources to fund development and
      commercialization activities.




Government
Regulation




Regulation
of Pharmaceutical Products




The
development, manufacture and sale of any drug or biologic products developed by
us or our collaborators will be subject to extensive regulation by United States
and foreign governmental authorities, including federal, state and local
authorities.  In the United States, new drugs are subject to
regulation under the Federal Food, Drug and Cosmetic Act and the regulations
promulgated thereunder, or the FDC Act, and biologic products are subject to
regulation both under certain provisions of the FDC Act and under the Public
Health Services Act and the regulations promulgated thereunder, or the PHS
Act.  The FDA regulates, among other things, the development,
preclinical and clinical testing, manufacture, safety, efficacy, record keeping,
reporting, labeling, storage, approval, advertising, promotion, sale,
distribution and export of drugs and biologics.




The
standard process required by the FDA before a drug candidate may be marketed in
the United States includes:




·
            preclinical
      laboratory and animal tests performed under the FDA’s current Good
      Laboratory Practices regulations;




·
            submission
      to the FDA of an Investigational New Drug application, or IND, which must
      become effective before human clinical trials may
  commence;




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




·
            for
      drug candidates regulated as drugs, submission of a New Drug Application,
      or NDA, and, for drug candidates regulated as biologics, submission of a
      Biologic License Application, or BLA, with the FDA;
  and




·
            FDA
      approval of the NDA or BLA prior to any commercial sale or shipment of the
      product.




This
process for the testing and approval of drug candidates requires substantial
time, effort and financial resources.  Preclinical development of a
drug candidate can take from one to several years to complete, with no guarantee
that an IND based on those studies will become effective to even permit clinical
testing to begin.  Before commencing the first clinical trial with a
drug candidate in the United States, we must submit an IND to the
FDA.  The IND automatically becomes effective 30 days after receipt by
the FDA, unless the FDA, within the 30-day time period, raises concerns or
questions about the conduct of the clinical trial.  In such a case, we
and the FDA must resolve any outstanding concerns before the clinical trial may
begin.  Our submission of an IND may not result in FDA authorization
to commence a clinical trial.  A separate submission to the existing
IND must be made for each successive clinical trial conducted during product
development, and the FDA must grant permission for each clinical trial to start
and continue.  Further, an independent institutional review board for
each medical center proposing to participate in the clinical trial must review
and approve the plan for any clinical trial before it commences at that
center.  Regulatory authorities or an institutional review board or
the sponsor may suspend a clinical trial at any time on various grounds,
including a finding that the subjects or patients are being exposed to an
unacceptable health risk.


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For
purposes of NDA or BLA approval, human clinical trials are typically conducted
in three sequential phases that may overlap.




·
            Phase
      1 clinical trials are conducted in a limited number of healthy human
      volunteers or, in some cases, patients to evaluate the safety, dosage
      tolerance, absorption, metabolism, distribution and excretion of the drug
      candidate;




·
            Phase
      2 clinical trials are conducted in groups of patients afflicted with a
      specified disease or condition to obtain preliminary data regarding
      efficacy as well as to further evaluate safety and optimize dosing of the
      drug candidate; and




·
            Phase
      3 clinical trials are conducted in larger patient populations at multiple
      clinical trial sites to obtain statistically significant evidence of the
      efficacy of the drug candidate for its intended use and to further test
      for safety in an expanded patient
population.




In
addition, the FDA may require, or companies may pursue, additional clinical
trials after a product is approved.  These so-called Phase 4 studies
may be made a condition to be satisfied after a drug receives
approval.




Completion
of the clinical trials necessary for an NDA or BLA submission typically takes
many years, with the actual time required varying substantially based on, among
other things, the nature and complexity of the drug candidate and of the disease
or condition.  Success in earlier-stage clinical trials does not
ensure success in later-stage clinical trials.  Furthermore, data
obtained from clinical activities is not always conclusive and may be
susceptible to varying interpretations, which could delay, limit or prevent
proceeding with further clinical trials, filing or acceptance of an NDA or BLA,
or obtaining marketing approval.




After
completion of clinical trials, FDA approval of an NDA or BLA must be obtained
before a new drug or biologic product may be marketed in the United
States.  An NDA or BLA, depending on the submission, must contain,
among other things, information on chemistry, manufacturing controls and potency
and purity, non-clinical pharmacology and toxicology, human pharmacokinetics and
bioavailability and clinical data.  There can be no assurance that the
FDA will accept an NDA or BLA for filing and, even if filed, that approval will
be granted.  Among other things, the FDA reviews an NDA to determine
whether a product is safe and effective for its intended use and a BLA to
determine whether a product is safe, pure and potent and the facility in which
it is manufactured, processed, packed, or held meets standards designed to
assure the product’s continued safety, purity and potency.  The FDA
may deny approval of an NDA or BLA if the applicable regulatory criteria are not
satisfied, or it may require additional clinical data or an additional pivotal
Phase 3 clinical trial.  Even if such data are submitted, the FDA may
ultimately decide that the NDA or BLA does not satisfy the criteria for
approval.  Once issued, the FDA may withdraw product approval if
ongoing regulatory standards are not met or if safety problems occur after the
product reaches the market.  In addition, the FDA may require testing
and surveillance programs to monitor the effect of approved products which have
been commercialized, and the FDA has the power to prevent or limit further
marketing of a product based on the results of these post-marketing
programs.  Limited indications for use or other conditions could also
be placed on any approvals that could restrict the commercial applications of a
product or impose costly procedures in connection with the commercialization or
use of the product.




In
addition to obtaining FDA approval for each product, each drug or biologic
manufacturing establishment must be inspected and approved by the
FDA.  All manufacturing establishments are subject to inspections by
the FDA and by other federal, state and local agencies and must comply with
current Good Manufacturing Practices requirements.  Non-compliance
with these requirements can result in, among other things, total or partial
suspension of production, failure of the government to grant approval for
marketing and withdrawal, suspension or revocation of marketing
approvals.


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Once the
FDA approves a product, a manufacturer must provide certain updated safety and
efficacy information.  Product changes as well as certain changes in a
manufacturing process or facility would necessitate additional FDA review and
approval.  Other post-approval changes may also necessitate further
FDA review and approval.  Additionally, a manufacturer must meet other
requirements including those related to adverse event reporting and record
keeping.




The FDA
closely regulates the marketing and promotion of drugs.  A company can
make only those claims relating to safety and efficacy that are approved by the
FDA.  Failure to comply with these requirements can result in adverse
publicity, warning letters, corrective advertising and potential civil and
criminal penalties.




Violations
of the FDC Act, the PHS Act or regulatory requirements may result in agency
enforcement action, including voluntary or mandatory recall, license suspension
or revocation, product seizure, fines, injunctions and civil or criminal
penalties.




In
addition to regulatory approvals that must be obtained in the United States, a
drug or biologic product is also subject to regulatory approval in other
countries in which it is marketed.  The conduct of clinical trials of
drugs and biologic products in countries other than the United States is
likewise subject to regulatory oversight in such countries.  The
requirements governing the conduct of clinical trials, product licensing,
pricing, and reimbursement vary widely from country to country.  No
action can be taken to market any drug or biologic product in a country until
the regulatory authorities in that country have approved an appropriate
application.  FDA approval does not assure approval by other
regulatory authorities.  The current approval process varies from
country to country, and the time spent in gaining approval varies from that
required for FDA approval.  In some countries, the sale price of a
drug or biologic product must also be approved.  The pricing review
period often begins after marketing approval is granted.  Even if a
foreign regulatory authority approves a drug or biologic product, it may not
approve satisfactory prices for the product.




Other
Regulations




In
addition to the foregoing, our business is and will be subject to regulation
under various state and federal environmental laws, including the Occupational
Safety and Health Act, the Resource Conservation and Recovery Act and the Toxic
Substances Control Act.  These and other laws govern our use, handling
and disposal of various biological, chemical and radioactive substances used in
and wastes generated by our operations.  We believe that we are in
material compliance with applicable environmental laws and that our continued
compliance with these laws will not have a material adverse effect on our
business.  We cannot predict, however, whether new regulatory
restrictions will be imposed by state or federal regulators and agencies or
whether existing laws and regulations will adversely affect us in the
future.




Research
and Development Expenses




In 2008,
2007 and 2006, respectively, we incurred expenses of $108.6 million,
$104.3 million and $106.7 million in company-sponsored as well as
collaborative research and development activities, including $3.9 million,
$5.2 million and $4.4 million of stock-based compensation expense in
2008, 2007 and 2006, respectively.




Employees
and Consultants




We
believe that our success will be based on, among other things, achieving and
retaining scientific and technological superiority and identifying and retaining
capable management.  We have assembled a highly qualified team of
scientists as well as executives with extensive experience in the biotechnology
industry.




As of
February 28, 2009, we employed 347 persons, of whom 95 hold M.D., Ph.D. or
D.V.M. degrees and another 51 hold other advanced degrees.  We believe
that our relationship with our employees is good.


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Item
      1A.
                      Risk
Factors


The
following risks and uncertainties are important factors that could cause actual
results or events to differ materially from those indicated by forward-looking
statements.  The factors described below are not the only ones we face
and additional risks and uncertainties not presently known to us or that we
currently deem immaterial also may impair our business operations.




Risks
Related to Our Need for Additional Financing and Our Financial
Results




We
will need additional capital in the future and, if it is unavailable, we will be
forced to significantly curtail or cease operations.  If it is not
available on reasonable terms we will be forced to obtain funds by entering into
financing agreements on unattractive terms.




As of
December 31, 2008, we had $142.2 million in cash, cash equivalents and
investments, including $55.7 million of auction rate securities and related
rights and $16.6 million in investments held by Symphony
Icon.  We anticipate that our existing capital resources, funds
available under a credit line with an affiliate of UBS AG that we entered
into in January 2009 in connection with a settlement of auction rate securities
claims against UBS, and the cash and revenues we expect to derive from drug
discovery and development collaborations and other collaborations and licenses
will enable us to fund our currently planned operations for at least the next
12 months.  Our currently planned operations for that time period
consist of the completion of our ongoing clinical trials, the initiation and
conduct of additional clinical trials and the continuation of our small molecule
drug discovery and preclinical research efforts.  However, we caution
you that we may generate less cash and revenues or incur expenses more rapidly
than we currently anticipate.




Although
difficult to accurately predict, the amount of our future capital requirements
will be substantial and will depend on many factors, including:




·
            our
      ability to obtain additional funds from collaborations and technology
      licenses;




·
            the
      amount and timing of payments under such
  agreements;




·
            the
      level and timing of our research and development
    expenditures;




·
            the
      timing and progress of the clinical development of our drug candidates
      LX1031 and LX1032, and our election whether to exercise our exclusive
      option to acquire all of the equity of Symphony Icon, thereby allowing us
      to reacquire the programs;




·
            future
      results from clinical trials of our drug
  candidates;




·
            the
      cost and timing of regulatory approvals of drug candidates that we
      successfully develop;




·
            market
      acceptance of products that we successfully develop and commercially
      launch;




·
            the
      effect of competing programs and products, and of technological and market
      developments;




·
            the
      filing, maintenance, prosecution, defense and enforcement of patent claims
      and other intellectual property rights;
and




·
            the
      cost and timing of establishing or contracting for sales, marketing and
      distribution capabilities.




Our
capital requirements will increase substantially as we advance our drug
candidates into and through clinical development.  Our capital
requirements will also be affected by any expenditures we make in connection
with license agreements and acquisitions of and investments in complementary
products and technologies.  For all of these reasons, our future
capital requirements cannot easily be quantified.




If our
capital resources are insufficient to meet future capital requirements, we will
have to raise additional funds to continue our currently planned
operations.  If we raise additional capital by issuing equity
securities, our then-existing stockholders will experience dilution and the
terms of any new equity securities may have preferences over our common
stock.  We cannot be certain that additional financing, whether debt
or equity, will be available in amounts or on terms acceptable to us, if at
all.  We may be unable to raise sufficient additional capital on
reasonable terms; if so, we will be forced to significantly curtail or cease
operations or obtain funds by entering into financing agreements on unattractive
terms.


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In June
2007, we entered into a securities purchase agreement with Invus, L.P., under
which Invus made an initial investment of $205.4 million to purchase 50,824,986
shares of our common stock in August 2007 and has the right to require us to
initiate up to two pro rata rights offerings to our stockholders, which would
provide all stockholders with non-transferable rights to acquire shares of our
common stock, in an aggregate amount of up to $344.5 million, less the
proceeds of any “qualified offerings” that we may complete in the interim
involving the sale of our common stock at prices above $4.50 per
share.  Invus may exercise its right to require us to conduct the
first rights offering by giving us notice within a period of 90 days beginning
on November 28, 2009 (which we refer to as the first rights offering
trigger date), although we and Invus may agree to change the first rights
offering trigger date to as early as August 28, 2009 with the approval of the
members of our board of directors who are not affiliated with
Invus.  Invus may exercise its right to require us to conduct the
second rights offering by giving us notice within a period of 90 days beginning
on the date that is 12 months after Invus’ exercise of its right to require
us to conduct the first rights offering or, if Invus does not exercise its right
to require us to conduct the first rights offering, within a period of 90 days
beginning on the first anniversary of the first rights offering trigger
date.  The initial investment and subsequent rights offerings,
combined with any qualified offerings, were designed to achieve up to
$550 million in proceeds to us.  Invus would participate in each
rights offering for up to its pro rata portion of the offering, and would commit
to purchase the entire portion of the offering not subscribed for by other
stockholders.  Under the securities purchase agreement, until the
later of the completion of the second rights offering or the expiration of the
90-day period following the second rights offering trigger date, we have agreed
not to issue any of our common stock for a per share price of less than $4.50
without the prior written consent of Invus, except pursuant to an employee or
director stock option, incentive compensation or similar plan or to persons
involved in the pharmaceutical industry in connection with simultaneous
strategic transactions involving such persons in the ordinary
course.  If we are not able to issue common stock at prices equal to
or greater than $4.50 per share, due to market conditions or otherwise, this
obligation will limit our ability to raise capital by issuing additional equity
securities without the consent of Invus.  In the event Invus declines
to grant such consent and, in addition, elects not to exercise its right to
require us to initiate the first rights offering, or elects to limit the size of
the first rights offering, our ability during this period to satisfy our future
capital requirements by issuing equity securities will be limited if we are
unable to do so by issuing common stock at prices equal to or greater than $4.50
per share.




We
have a history of net losses, and we expect to continue to incur net losses and
may not achieve or maintain profitability.




We have
incurred net losses since our inception, including net losses of
$76.9 million for the year ended December 31, 2008, $58.8 million for
the year ended December 31, 2007 and $54.3 million for the year ended
December 31, 2006.  As of December 31, 2008, we had an
accumulated deficit of $487.4 million.  We are unsure when we
will become profitable, if ever.  The size of our net losses will
depend, in part, on the rate of growth, if any, in our revenues and on the level
of our expenses.




We derive
substantially all of our revenues from drug discovery and development
collaborations and other collaborations and technology licenses, and will
continue to do so for the foreseeable future.  Our future revenues
from collaborations and technology licenses are uncertain because our existing
agreements have fixed terms or relate to specific projects of limited duration
and we depend, in part, on securing new agreements.  Our ability to
secure future revenue-generating agreements will depend upon our ability to
address the needs of our potential future collaborators, granting agencies and
licensees, and to negotiate agreements that we believe are in our long-term best
interests.  We may determine that our interests are better served by
retaining rights to our discoveries and advancing our therapeutic programs to a
later stage, which could limit our near-term revenues.  Given the
early-stage nature of our operations, we do not currently derive any revenues
from sales of pharmaceutical products.




A large
portion of our expenses is fixed, including expenses related to facilities,
equipment and personnel.  In addition, we expect to spend significant
amounts to fund our research and development activities, including the conduct
of clinical trials and the advancement of additional potential therapeutics into
clinical development.  As a result, we expect that our operating
expenses will continue to increase significantly as our drug programs progress
into and through human clinical trials and, consequently, we will need to
generate significant additional revenues to achieve
profitability.  Even if we do achieve profitability, we may not be
able to sustain or increase profitability on a quarterly or annual
basis.


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We
have licensed the intellectual property, including commercialization rights, to
our drug candidates LX1031 and LX1032 to Symphony Icon and will not receive any
future royalties or revenues with respect to these drug candidates unless we
exercise our option to purchase Symphony Icon.




Our
option to purchase all of the equity of Symphony Icon, thereby allowing us to
reacquire these drug candidates, is exercisable by us at any time, in our sole
discretion, until June 15, 2011 at an exercise price of (a) $72
million, if the purchase option is exercised before June 15, 2009, (b) $81
million, if the purchase option is exercised on or after the June 15, 2009 and
before June 15, 2010 and (c) $90 million, if the purchase option is exercised on
or after June 15, 2010 and before June 15, 2011.  The purchase option
exercise price may be paid in cash or a combination of cash and common stock, at
our sole discretion, provided that the common stock portion may not exceed 40%
of the purchase option exercise price.




If we
elect to exercise the purchase option, we will be required to make a substantial
cash payment or to make a lesser but still substantial cash payment and issue a
substantial number of shares of our common stock, which may in turn require us
to enter into a financing arrangement or license arrangement with one or more
third parties.  The amount of any such cash payment would reduce our
capital resources.  Payment in shares of our common stock could result
in dilution to our stockholders at that time.  Other financing or
licensing alternatives may be expensive or impossible to obtain.  If
we do not exercise the purchase option prior to its expiration, our rights to
purchase all of the equity in Symphony Icon and to reacquire LX1031 and LX1032
will terminate.  We may not have the financial resources to exercise
the option, which may result in our loss of these
rights.  Additionally, we may not have sufficient clinical data in
order to determine whether we should exercise the option.




At
December 31, 2008, we held $57.0 million (par value), with an
estimated fair value of $43.6 million, of auction rate securities for which
auctions have failed and, as a result, we may not be able to access at least a
portion of these funds without a loss of principal.




At
December 31, 2008, we held $57.0 million (par value), with an estimated fair
value of $43.6 million, of AAA rated investments with an auction interest rate
reset feature, known as auction rate securities.  Until February 2008,
the market for our auction rate securities was highly
liquid.  Starting in February 2008, a substantial number of auctions
“failed,” meaning that there was not enough demand to sell all of the securities
that holders desired to sell at auction.




In
November 2008, we accepted an offer from UBS AG, the investment bank that sold
us our auction rate securities, providing us with certain rights related to our
auction rate securities.  The rights permit us to require UBS to
purchase our auction rate securities from us at par value during the period from
June 30, 2010 through July 2, 2012.  Conversely, UBS has the
right, in its discretion, to purchase or sell the securities at any time by
paying us the par value of the securities.  In connection with our
acceptance of UBS’s offer, in January 2009, we entered into a credit line
agreement with UBS Bank USA that provides up to an aggregate amount of $35.9
million in the form of an uncommitted, demand, revolving line of
credit.  The credit line is secured only by the auction rate
securities and advances under the credit line will be made on a “no net cost”
basis, meaning that the interest paid by us on advances will not exceed the
interest or dividends paid to us by the issuer of the auction rate
securities.




Although
we expect to access the maximum amount permitted under the credit line and
exercise the rights and sell our auction rate securities to UBS on June 30,
2010, the earliest date allowable under the rights, we will have no means to
access $21.1 million (par value) invested in auction rate securities before such
date without a loss of principal.  Further, UBS and its affiliates may
not be able to maintain the financial resources necessary to perform its
obligations under the rights or credit line.  As a result, we cannot
provide any assurance that we will be able to access the funds invested in
auction rate securities without a loss of principal, unless a future auction on
these investments is successful or the issuer redeems the
securities.




Our
operating results have been and likely will continue to fluctuate, and we
believe that period-to-period comparisons of our operating results are not a
good indication of our future performance.




Our
operating results and, in particular, our ability to generate additional
revenues are dependent on many factors, including:




·
            our
      ability to establish new collaborations and technology licenses, and the
      timing of such arrangements;




·
            the
      expiration or other termination of collaborations, which may not be
      renewed or replaced;




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·
            the
      success rate of our discovery and development efforts leading to
      opportunities for new collaborations and licenses, as well as milestone
      payments and royalties;




·
            the
      timing and willingness of our collaborators to commercialize
      pharmaceutical products that would result in milestone payments and
      royalties; and




·
            general
      and industry-specific economic conditions, which may affect our and our
      collaborators’ research and development
  expenditures.




Because
of these and other factors, including the risks and uncertainties described in
this section, our operating results have fluctuated in the past and are likely
to do so in the future.  Due to the likelihood of fluctuations in our
revenues and expenses, we believe that period-to-period comparisons of our
operating results are not a good indication of our future
performance.




Risks
Related to Discovery and Development of Our Drug Candidates




We
are an early-stage company, and have not proven our ability to successfully
develop and commercialize drug candidates based on our drug target
discoveries.




Our
business strategy of using our technology platform and, specifically, the
discovery of the functions of genes using knockout mice to select promising drug
targets and developing and commercializing drug candidates based on our target
discoveries, in significant part through collaborations, is
unproven.  Our success will depend upon our ability to successfully
generate, select and develop drug candidates for targets we consider to have
pharmaceutical value, whether on our own or through collaborations, and to
select an appropriate commercialization strategy for each potential therapeutic
we choose to pursue.




We have
not proven our ability to develop or commercialize drug candidates based on our
drug target discoveries.  The generation and selection of potential
drug candidates for a target is a difficult, expensive and time-consuming
process that is subject to substantial technical and scientific challenges and
uncertainties, without any assurance of ever identifying a drug candidate
warranting clinical testing.  The process involves the optimization of
a wide variety of variables, including among many other things potency against
the target, selectivity for the intended target relative to other proteins,
absorption, metabolism, distribution and excretion characteristics, activity in
animal models of disease and the results of other preclinical research, and
feasibility and cost of manufacture, each of which may affect one or more of the
others in ways that conflict with the desired profile.




Furthermore,
we do not know that any pharmaceutical products based on our drug target
discoveries can be successfully developed or commercialized.  Our
strategy is focused principally on the discovery and development of drug
candidates for targets that have not been clinically validated in humans by
drugs or drug candidates generated by others.  As a result, the drug
candidates we develop are subject to uncertainties as to the effects of
modulating the human drug target as well as to those relating to the
characteristics and activity of the particular compound.




In
addition, we may experience unforeseen technical complications in the processes
we use to identify potential drug targets or discover and develop potential drug
candidates.  These complications could materially delay or limit the
use of our resources, substantially increase the anticipated cost of conducting
our drug target or drug candidate discovery efforts or prevent us from
implementing our processes at appropriate quality and throughput
levels.




Clinical
testing of our drug candidates in humans is an inherently risky and
time-consuming process that may fail to demonstrate safety and efficacy, which
could result in the delay, limitation or prevention of regulatory
approval.




In order
to obtain regulatory approvals for the commercial sale of any products that we
may develop, we will be required to complete extensive clinical trials in humans
to demonstrate the safety and efficacy of our drug candidates.  We or
our collaborators may not be able to obtain authority from the FDA, or other
equivalent foreign regulatory agencies to initiate or complete any clinical
trials.  In addition, we have limited internal resources for making
regulatory filings and dealing with regulatory authorities.




Clinical
trials are inherently risky and the results from preclinical testing of a drug
candidate that is under development may not be predictive of results that will
be obtained in human clinical trials.  In addition, the results of
early human clinical trials may not be predictive of results that will be
obtained in larger-scale, advanced stage clinical trials.  A number of
companies in the pharmaceutical industry have suffered significant setbacks in
advanced clinical trials, even after achieving positive results in earlier
trials.  Negative or inconclusive results from a preclinical study or
a clinical trial could cause us, one of our collaborators or the FDA to
terminate a preclinical study or clinical trial or require that we repeat
it.  Furthermore, we, one of our collaborators or a regulatory agency
with jurisdiction over the trials may suspend clinical trials at any time if the
subjects or patients participating in such trials are being exposed to
unacceptable health risks or for other reasons.


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Any
preclinical or clinical test may fail to produce results satisfactory to the FDA
or foreign regulatory authorities.  Preclinical and clinical data can
be interpreted in different ways, which could delay, limit or prevent regulatory
approval.  The FDA or institutional review boards at the medical
institutions and healthcare facilities where we sponsor clinical trials may
suspend any trial indefinitely if they find deficiencies in the conduct of these
trials.  Clinical trials must be conducted in accordance with the
FDA’s current Good Clinical Practices.  The FDA and these
institutional review boards have authority to oversee our clinical trials, and
the FDA may require large numbers of test subjects.  In addition, we
must manufacture, or contract for the manufacture of, the drug candidates that
we use in our clinical trials under the FDA’s current Good Manufacturing
Practices.




The rate
of completion of clinical trials is dependent, in part, upon the rate of
enrollment of patients.  Patient accrual is a function of many
factors, including the size of the patient population, the proximity of patients
to clinical sites, the eligibility criteria for the study, the nature of the
study, the existence of competitive clinical trials and the availability of
alternative treatments.  Delays in planned patient enrollment may
result in increased costs and prolonged clinical development, which in turn
could allow our competitors to bring products to market before we do and impair
our ability to commercialize our products or potential products.




We or our
collaborators may not be able to successfully complete any clinical trial of a
potential product within any specified time period.  In some cases, we
or our collaborators may not be able to complete the trial at all. Moreover,
clinical trials may not show our potential products to be both safe and
effective.  Thus, the FDA and other regulatory authorities may not
approve any products that we develop for any indication or may limit the
approved indications or impose other conditions.




Risks
Related to Our Relationships with Third Parties




Disagreements
with Symphony Icon regarding the development of our drug candidates LX1031 or
LX1032 could negatively affect or delay their development.




While we
are the party primarily responsible for development of our drug candidates
LX1031 and LX1032 in accordance with a specified development plan and related
development budget, our development activities are supervised by Symphony Icon’s
development committee, which is comprised of an equal number of representatives
from us and Symphony Icon.  Any disagreements between us and Symphony
Icon regarding a development decision may cause delays in the development and
commercialization of those drug candidates or lead to development decisions that
do not reflect our interests.  Any such delays or development
decisions not in our interest could negatively affect the value of LX1031 or
LX1032.




We
are dependent in many ways upon our collaborations with major pharmaceutical
companies.  If we are unable to achieve milestones under those
collaborations or if our collaborators’ efforts fail to yield pharmaceutical
products on a timely basis, our opportunities to generate revenues and earn
royalties will be reduced.




We have
derived a substantial majority of our revenues to date from collaborative drug
discovery and development alliances with a limited number of major
pharmaceutical companies.  Revenues from our drug discovery and
development alliances depend upon continuation of the collaborations, the
achievement of milestones and payment of royalties we earn from any future
products developed under the collaborations.  If our relationship
terminates with any of our collaborators, our reputation in the business and
scientific community may suffer and revenues will be negatively impacted to the
extent such losses are not offset by additional collaboration
agreements.  If we are unable to achieve milestones or our
collaborators are unable to successfully develop products from which royalties
are payable, we will not earn the revenues contemplated by those drug discovery
and development collaborations.  In addition, some of our alliances
are exclusive and preclude us from entering into additional collaborative
arrangements with other parties in the field of exclusivity.




We have
limited or no control over the resources that any collaborator may devote to the
development and commercialization of products under our
alliances.  Any of our present or future collaborators may not perform
their obligations as expected.  These collaborators may breach or
terminate their agreements with us or otherwise fail to conduct product
discovery, development or commercialization activities successfully or in a
timely manner.  Further, our collaborators may elect not to develop
pharmaceutical products arising out of our collaborative arrangements or may not
devote sufficient resources to the development, approval, manufacture, marketing
or sale of these products.  If any of these events occurs, we may not
be able to develop or commercialize potential pharmaceutical
products.


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Conflicts
with our collaborators could jeopardize the success of our collaborative
agreements and harm our product development efforts.




We may
pursue opportunities in specific disease and therapeutic modality fields that
could result in conflicts with our collaborators, if any of our collaborators
takes the position that our internal activities overlap with those activities
that are exclusive to our collaboration.  Moreover, disagreements
could arise with our collaborators over rights to our intellectual property or
our rights to share in any of the future revenues of compounds or therapeutic
approaches developed by our collaborators.  Any conflict with or among
our collaborators could result in the termination of our collaborative
agreements, delay collaborative research or development activities, impair our
ability to renew or obtain future collaborative agreements or lead to costly and
time consuming litigation.  Conflicts with our collaborators could
also have a negative impact on our relationship with existing collaborators,
materially impairing our business and revenues.  Some of our
collaborators are also potential competitors or may become competitors in the
future.  Our collaborators could develop competing products, preclude
us from entering into collaborations with their competitors or terminate their
agreements with us prematurely.  Any of these events could harm our
product development efforts.




We
lack the capability to manufacture materials for preclinical studies, clinical
trials or commercial sales and rely on third parties to manufacture our drug
candidates, which may harm or delay our product development and
commercialization efforts.




We
currently do not have the manufacturing capabilities or experience necessary to
produce materials for preclinical studies, clinical trials or commercial sales
and intend in the future to continue to rely on collaborators and third-party
contractors to produce such materials.  We will rely on selected
manufacturers to deliver materials on a timely basis and to comply with
applicable regulatory requirements, including the current Good Manufacturing
Practices of the FDA, which relate to manufacturing and quality control
activities.  These manufacturers may not be able to produce material
on a timely basis or manufacture material at the quality level or in the
quantity required to meet our development timelines and applicable regulatory
requirements.  In addition, there are a limited number of
manufacturers that operate under the FDA’s current Good Manufacturing Practices
and that are capable of producing such materials, and we may experience
difficulty finding manufacturers with adequate capacity for our
needs.  If we are unable to contract for the production of sufficient
quantity and quality of materials on acceptable terms, our product development
and commercialization efforts may be delayed.  Moreover, noncompliance
with the FDA’s current Good Manufacturing Practices can result in, among other
things, fines, injunctions, civil and criminal penalties, product recalls or
seizures, suspension of production, failure to obtain marketing approval and
withdrawal, suspension or revocation of marketing approvals.




We
rely on third parties to carry out drug development activities.




We rely
on clinical research organizations and other third party contractors to carry
out many of our drug development activities, including the performance of
preclinical laboratory and animal tests under the FDA’s current Good Laboratory
Practices regulations and the conduct of clinical trials of our drug candidates
in accordance with protocols we establish.  If these third parties do
not successfully carry out their contractual duties or regulatory obligations or
meet expected deadlines, our drug development activities may be delayed,
suspended or terminated.  Such a failure by these third parties could
significantly impair our ability to develop and commercialize the affected drug
candidates.




Risks
Related to Regulatory Approval of Our Drug Candidates




Our
drug candidates are subject to a lengthy and uncertain regulatory process that
may not result in the necessary regulatory approvals, which could adversely
affect our ability to commercialize products.




Our drug
candidates, as well as the activities associated with their research,
development and commercialization, are subject to extensive regulation by the
FDA and other regulatory agencies in the United States and by comparable
authorities in other countries.  Failure to obtain regulatory approval
for a drug candidate would prevent us from commercializing that drug
candidate.  We have not received regulatory approval to market any of
our drug candidates in any jurisdiction and have only limited experience in
preparing and filing the applications necessary to gain regulatory
approvals.  The process of obtaining regulatory approvals is
expensive, and often takes many years, if approval is obtained at all, and can
vary substantially based upon the type, complexity and novelty of the drug
candidates involved.  Before a new drug application can be filed with
the FDA, the drug candidate must undergo extensive clinical trials, which can
take many years and may require substantial expenditures.  Any
clinical trial may fail to produce results satisfactory to the
FDA.  For example, the FDA could determine that the design of a
clinical trial is inadequate to produce reliable results.  The
regulatory process also requires preclinical testing, and data obtained from
preclinical and clinical activities are susceptible to varying interpretations,
which could delay, limit or prevent regulatory approval.  In addition,
delays or rejections may be encountered based upon changes in regulatory policy
for product approval during the period of product development and regulatory
agency review.  Changes in regulatory approval policy, regulations or
statutes or the process for regulatory review during the development or approval
periods of our drug candidates may cause delays in the approval or rejection of
an application.  Even if the FDA or a comparable authority in another
country approves a drug candidate, the approval may impose significant
restrictions on the indicated uses, conditions for use, labeling, advertising,
promotion, marketing and/or production of such product and may impose ongoing
requirements for post-approval studies, including additional research and
development and clinical trials.  These agencies also may impose
various civil or criminal sanctions for failure to comply with regulatory
requirements, including withdrawal of product approval.


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If
our potential products receive regulatory approval, we or our collaborators will
remain subject to extensive and rigorous ongoing regulation.




If we or
our collaborators obtain initial regulatory approvals from the FDA or foreign
regulatory authorities for any products that we may develop, we or our
collaborators will be subject to extensive and rigorous ongoing domestic and
foreign government regulation of, among other things, the research, development,
testing, manufacture, labeling, promotion, advertising, distribution and
marketing of our products and drug candidates.  The failure to comply
with these requirements or the identification of safety problems during
commercial marketing could lead to the need for product marketing restrictions,
product withdrawal or recall or other voluntary or regulatory action, which
could delay further marketing until the product is brought into
compliance.  The failure to comply with these requirements may also
subject us or our collaborators to stringent penalties.




Risks
Related to Commercialization of Products




The
commercial success of any products that we may develop will depend upon the
degree of market acceptance of our products among physicians, patients, health
care payors, private health insurers and the medical community.




Our
ability to commercialize any products that we may develop will be highly
dependent upon the extent to which these products gain market acceptance among
physicians, patients, health care payors, such as Medicare and Medicaid, private
health insurers, including managed care organizations and group purchasing
organizations, and the medical community.  If these products do not
achieve an adequate level of acceptance, we may not generate adequate product
revenues, if at all, and we may not become profitable.  The degree of
market acceptance of our drug candidates, if approved for commercial sale, will
depend upon a number of factors, including:




·
            the
      effectiveness, or perceived effectiveness, of our products in comparison
      to competing products;




·
            the
      existence of any significant side effects, as well as their severity in
      comparison to any competing
products;




·
            potential
      advantages over alternative
treatments;




·
            the
      ability to offer our products for sale at competitive
    prices;




·
            relative
      convenience and ease of
administration;




·
            the
      strength of marketing and distribution support;
  and




·
            sufficient
      third-party coverage or
reimbursement.




If
we are unable to establish sales and marketing capabilities or enter into
agreements with third parties to market and sell our drug candidates, we may be
unable to generate product revenues.




We have
no experience as a company in the sales, marketing and distribution of
pharmaceutical products and do not currently have a sales and marketing
organization.  Developing a sales and marketing force would be
expensive and time-consuming, could delay any product launch, and we may never
be able to develop this capacity.  To the extent that we enter into
arrangements with third parties to provide sales, marketing and distribution
services, our product revenues are likely to be lower than if we market and sell
any products that we develop ourselves.  If we are unable to establish
adequate sales, marketing and distribution capabilities, independently or with
others, we may not be able to generate product revenues.




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If
we are unable to obtain adequate coverage and reimbursement from third-party
payors for any products that we may develop, our revenues and prospects for
profitability will suffer.




Our
ability to commercialize any products that we may develop will be highly
dependent on the extent to which coverage and reimbursement for our products
will be available from third-party payors, including governmental payors, such
as Medicare and Medicaid, and private health insurers, including managed care
organizations and group purchasing organizations.  Many patients will
not be capable of paying themselves for some or all of the products that we may
develop and will rely on third-party payors to pay for, or subsidize, their
medical needs.  If third-party payors do not provide coverage or
reimbursement for any products that we may develop, our revenues and prospects
for profitability will suffer.  In addition, even if third-party
payors provide some coverage or reimbursement for our products, the availability
of such coverage or reimbursement for prescription drugs under private health
insurance and managed care plans often varies based on the type of contract or
plan purchased.




A primary
trend in the United States health care industry is toward cost
containment.  Current and future prescription drug benefit programs,
including any programs that may be proposed as a result of the change in the
presidential administration in January 2009, may have the effect of reducing the
prices that we are able to charge for products we develop and sell through plans
under the programs.  These prescription drug programs may also cause
third-party payors other than the federal government, including the states under
the Medicaid program, to discontinue coverage for products we develop or to
lower the price that they will pay.




Proponents
of drug reimportation may attempt to pass legislation, which would allow direct
reimportation under certain circumstances.  If legislation or
regulations were passed allowing the reimportation of drugs, it could decrease
the price we receive for any products that we may develop, thereby negatively
affecting our revenues and prospects for profitability.




In
addition, in some foreign countries, particularly the countries in the European
Union, the pricing of prescription pharmaceuticals is subject to governmental
control.  In these countries, price negotiations with governmental
authorities can take six to 12 months or longer after the receipt of regulatory
marketing approval for a product.  To obtain reimbursement and/or
pricing approval in some countries, we may be required to conduct a clinical
trial that compares the cost effectiveness of our drug candidates or products to
other available therapies.  The conduct of such a clinical trial could
be expensive and result in delays in the commercialization of our drug
candidates.  Third-party payors are challenging the prices charged for
medical products and services, and many third-party payors limit reimbursement
for newly approved health care products.  In particular, third-party
payors may limit the indications for which they will reimburse patients who use
any products that we may develop.  Cost-control initiatives could
decrease the price we might establish for products that we may develop, which
would result in lower product revenues to us.




Our
competitors may develop products and technologies that make our products and
technologies obsolete.




The
biotechnology industry is highly fragmented and is characterized by rapid
technological change.  We face, and will continue to face, intense
competition from biotechnology and pharmaceutical companies, as well as academic
research institutions, clinical reference laboratories and government agencies
that are pursuing research activities similar to ours.  In addition,
significant delays in the development of our drug candidates could allow our
competitors to bring products to market before us, which would impair our
ability to commercialize our drug candidates.  Our future success will
depend upon our ability to maintain a competitive position with respect to
technological advances.  Any products that are developed through our
technologies will compete in highly competitive markets.  Further, our
competitors may be more effective at using their technologies to develop
commercial products.  Many of the organizations competing with us have
greater capital resources, larger research and development staff and facilities,
more experience in obtaining regulatory approvals and more extensive product
manufacturing and marketing capabilities.  As a result, our
competitors may be able to more easily develop technologies and products that
would render our technologies and products, and those of our collaborators,
obsolete and noncompetitive.  In addition, there may be drug
candidates of which we are not aware at an earlier stage of development that may
compete with our drug candidates.




We
may not be able to manufacture our drug candidates in commercial quantities,
which would prevent us from commercializing our drug candidates.




To date,
our drug candidates have been manufactured in small quantities for preclinical
and clinical trials.  If any of these drug candidates are approved by
the FDA or other regulatory agencies for commercial sale, we will need to
manufacture them in larger quantities.  We may not be able to
successfully increase the manufacturing capacity, whether in collaboration with
third-party manufacturers or on our own, for any of our drug candidates in a
timely or economic manner, or at all.  Significant scale-up of
manufacturing may require additional validation studies, which the FDA must
review and approve.  If we are unable to successfully increase the
manufacturing capacity for a drug candidate, the regulatory approval or
commercial launch of that drug candidate may be delayed or there may be a
shortage in supply.  Our drug candidates require precise, high-quality
manufacturing.  The failure to achieve and maintain these high
manufacturing standards, including the incidence of manufacturing errors, could
result in patient injury or death, product recalls or withdrawals, delays or
failures in product testing or delivery, cost overruns or other problems that
could seriously hurt our business.


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Risks
Related to Our Intellectual Property




If
we are unable to adequately protect our intellectual property, third parties may
be able to use our technology, which could adversely affect our ability to
compete in the market.




Our
success will depend in part upon our ability to obtain patents and maintain
adequate protection of the intellectual property related to our technologies and
products.  The patent positions of biotechnology companies, including
our patent position, are generally uncertain and involve complex legal and
factual questions.  We will be able to protect our intellectual
property rights from unauthorized use by third parties only to the extent that
our technologies are covered by valid and enforceable patents or are effectively
maintained as trade secrets.  We will continue to apply for patents
covering our technologies and products as and when we deem
appropriate.  Pending patent applications do not provide protection
against competitors because they are not enforceable until they issue as
patents.  Further, the disclosures contained in our current and future
patent applications may not be sufficient to meet statutory requirements for
patentability.  Once issued, patents still may not provide
commercially meaningful protection.  Our existing patents and any
future patents we obtain may not be sufficiently broad to prevent others from
practicing our technologies or from developing competing
products.  Furthermore, others may independently develop similar or
alternative technologies or design around our patents.  If anyone
infringes upon our or our collaborators’ patent rights, enforcing these rights
may be difficult, costly and time-consuming and, as a result, it may not be
cost-effective or otherwise expedient to pursue litigation to enforce those
patent rights.  In addition, our patents may be challenged or
invalidated or may fail to provide us with any competitive advantages, if, for
example, others were the first to invent or to file patent applications for
these inventions.




Because
patent applications can take many years to issue, there may be currently pending
applications, unknown to us, which may later result in issued patents that cover
the production, manufacture, commercialization or use of our technologies, drug
targets or drug candidates.   If any such patents are issued to
other entities, we will be unable to obtain patent protection for the same or
similar discoveries that we make.  Moreover, we may be blocked from
using or developing some of our existing or proposed technologies and products,
or may be required to obtain a license that may not be available on reasonable
terms, if at all.  Further, others may discover uses for our
technologies or products other than those covered in our issued or pending
patents, and these other uses may be separately patentable.  Even if
we have a patent claim on a particular technology or product, the holder of a
patent covering the use of that technology or product could exclude us from
selling a product that is based on the same use of that product.




The laws
of some foreign countries do not protect intellectual property rights to the
same extent as the laws of the United States, and many companies have
encountered significant problems in protecting and defending such rights in
foreign jurisdictions.  Many countries, including certain countries in
Europe, have compulsory licensing laws under which a patent owner may be
compelled to grant licenses to third parties (for example, the patent owner has
failed to “work” the invention in that country or the third party has patented
improvements).  In addition, many countries limit the enforceability
of patents against government agencies or government contractors.  In
these countries, the patent owner may have limited remedies, which could
materially diminish the value of the patent.  Compulsory licensing of
life-saving drugs is also becoming increasingly popular in developing countries
either through direct legislation or international initiatives.  Such
compulsory licenses could be extended to include some of our drug candidates,
which could limit our potential revenue opportunities.  Moreover, the
legal systems of certain countries, particularly certain developing countries,
do not favor the aggressive enforcement of patent and other intellectual
property protection, which makes it difficult to stop infringement.




We rely
on trade secret protection for our confidential and proprietary
information.  We have taken security measures to protect our
proprietary information and trade secrets, but these measures may not provide
adequate protection.  While we seek to protect our proprietary
information by entering into confidentiality agreements with employees,
collaborators and consultants, we cannot assure you that our proprietary
information will not be disclosed, or that we can meaningfully protect our trade
secrets.  In addition, our competitors may independently develop
substantially equivalent proprietary information or may otherwise gain access to
our trade secrets.


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We
may be involved in patent litigation and other disputes regarding intellectual
property rights and may require licenses from third parties for our discovery
and development and planned commercialization activities.  We may not
prevail in any such litigation or other dispute or be able to obtain required
licenses.




Our
discovery and development efforts as well as our potential products and those of
our collaborators may give rise to claims that they infringe the patents of
others.  We are aware that other companies and institutions have
conducted research on many of the same targets that we have identified and have
filed patent applications potentially covering many of the genes and encoded
drug targets that are the focus of our drug discovery programs.  In
some cases, patents have issued from these applications.  In addition,
many companies and institutions have well-established patent portfolios directed
to common techniques, methods and means of developing, producing and
manufacturing pharmaceutical products.  Other companies or
institutions could bring legal actions against us or our collaborators for
damages or to stop us or our collaborators from engaging in certain discovery or
development activities or from manufacturing and marketing any resulting
therapeutic products.  If any of these actions are successful, in
addition to our potential liability for damages, these entities would likely
require us or our collaborators to obtain a license in order to continue
engaging in the infringing activities or to manufacture or market the resulting
therapeutic products or may force us to terminate such activities or
manufacturing and marketing efforts.




We may
need to pursue litigation against others to enforce our patents and intellectual
property rights and may be the subject of litigation brought by third parties to
enforce their patent and intellectual property rights.  In addition,
we may become involved in litigation based on intellectual property
indemnification undertakings that we have given to certain of our
collaborators.  Patent litigation is expensive and requires
substantial amounts of management attention.  The eventual outcome of
any such litigation is uncertain and involves substantial risks.




We
believe that there will continue to be significant litigation in our industry
regarding patent and other intellectual property rights.  We have
expended and many of our competitors have expended and are continuing to expend
significant amounts of time, money and management resources on intellectual
property litigation.  If we become involved in future intellectual
property litigation, it could consume a substantial portion of our resources and
could negatively affect our results of operations.




We
use intellectual property that we license from third parties.  If we
do not comply with these licenses, we could lose our rights under
them.




We rely,
in part, on licenses to use certain technologies that are important to our
business, such as certain gene targeting technology licensed from GenPharm
International, Inc.  We do not own the patents that underlie these
licenses.  Most of these licenses, however, including those licensed
from GenPharm, have terms that extend for the life of the licensed
patents.  Our rights to use these technologies and practice the
inventions claimed in the licensed patents are subject to our abiding by the
terms of those licenses and the licensors not terminating them.  We
believe we are currently in material compliance with all requirements of these
licenses.  In many cases, we do not control the filing, prosecution or
maintenance of the patent rights to which we hold licenses and rely upon our
licensors to prosecute infringement of those rights.  The scope of our
rights under our licenses may be subject to dispute by our licensors or third
parties.




We
have not sought patent protection outside of the United States for some of our
inventions, and some of our licensed patents only provide coverage in the United
States.  As a result, our international competitors could be granted
foreign patent protection with respect to our discoveries.




We have
decided not to pursue patent protection with respect to some of our inventions
outside the United States, both because we do not believe it is cost-effective
and because of confidentiality concerns.  Accordingly, our
international competitors could develop, and receive foreign patent protection
for, genes or gene sequences, uses of those genes or gene sequences, gene
products and drug targets, assays for identifying potential therapeutic
products, potential therapeutic products and methods of treatment for which we
are seeking United States patent protection.  In addition, most of our
gene trapping patents and our licensed gene targeting patents cover only the
United States and do not apply to discovery activities conducted outside of the
United States or, in some circumstances, to importing into the United States
products developed using this technology.




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We
may be subject to damages resulting from claims that we, our employees or
independent contractors have wrongfully used or disclosed alleged trade secrets
of their former employers.




Many of
our employees and independent contractors were previously employed at
universities, other biotechnology or pharmaceutical companies, including our
competitors or potential competitors.  We may be subject to claims
that these employees, independent contractors or we have inadvertently or
otherwise used or disclosed trade secrets or other proprietary information of
their former employers.  Litigation may be necessary to defend against
these claims.  Even if we are successful in defending against these
claims, litigation could result in substantial costs and divert management’s
attention.  If we fail in defending such claims, in addition to paying
money claims, we may lose valuable intellectual property rights or
personnel.  A loss of key research personnel and/or their work product
could hamper or prevent our ability to commercialize certain drug candidates,
which could severely harm our business.




Risks
Related to Employees, Growth and Facilities Operations




The
loss of key personnel or the inability to attract and retain additional
personnel could impair our ability to expand our operations.




We are
highly dependent upon the principal members of our management and scientific
staff, the loss of whose services might adversely impact the achievement of our
objectives and the continuation of existing
collaborations.  Recruiting and retaining qualified clinical and
scientific personnel will be critical to support activities related to advancing
our clinical and preclinical development programs, and supporting our
collaborative arrangements and our internal proprietary research and development
efforts.  Competition is intense for experienced clinical personnel,
in particular, and we may be unable to retain or recruit clinical personnel with
the expertise or experience necessary to allow us to pursue collaborations,
develop our products and core technologies or expand our operations to the
extent otherwise possible.  Further, all of our employees are employed
“at will” and, therefore, may leave our employment at any time.




Our
collaborations with outside scientists may be subject to restriction and
change.




We work
with scientific and clinical advisors and collaborators at academic and other
institutions that assist us in our research and development
efforts.  These advisors and collaborators are not our employees and
may have other commitments that limit their availability to
us.  Although these advisors and collaborators generally agree not to
do competing work, if a conflict of interest between their work for us and their
work for another entity arises, we may lose their services.  In such a
circumstance, we may lose work performed by them, and our development efforts
with respect to the matters on which they were working maybe significantly
delayed or otherwise adversely affected.  In addition, although our
advisors and collaborators sign agreements not to disclose our confidential
information, it is possible that valuable proprietary knowledge may become
publicly known through them.




Security
breaches may disrupt our operations and harm our operating results.




Our
network security and data recovery measures may not be adequate to protect
against computer viruses, break-ins, and similar disruptions from unauthorized
tampering with our computer systems.  The misappropriation, theft,
sabotage or any other type of security breach with respect to any of our
proprietary and confidential information that is electronically stored,
including research or clinical data, could have a material adverse impact on our
business, operating results and financial condition.  Additionally,
any break-in or trespass of our facilities that results in the misappropriation,
theft, sabotage or any other type of security breach with respect to our
proprietary and confidential information, including research or clinical data,
or that results in damage to our research and development equipment and assets
could have a material adverse impact on our business, operating results and
financial condition.




Because
most of our operations are located at a single facility, the occurrence of a
disaster could significantly disrupt our business.




Most of
our operations are conducted at our facility in The Woodlands,
Texas.  While we have developed redundant and emergency backup systems
to protect our resources and the facilities in which they are stored, they may
be insufficient in the event of a severe fire, flood, hurricane, tornado,
mechanical failure or similar disaster.  If such a disaster
significantly damages or destroys the facility in which our resources are
maintained, our business could be disrupted until we could regenerate the
affected resources.  Our business interruption insurance may not be
sufficient to compensate us in the event of a major interruption due to such a
disaster.




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Risks
Related to Environmental and Product Liability




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




Our
research and development processes involve the controlled use of hazardous
materials, including chemicals and radioactive and biological
materials.  Our operations produce hazardous waste
products.  We cannot eliminate the risk of accidental contamination or
discharge and any resultant injury from these materials.  Federal,
state and local laws and regulations govern the use, manufacture, storage,
handling and disposal of hazardous materials.  We may face liability
for any injury or contamination that results from our use or the use by third
parties of these materials, and such liability may exceed our insurance coverage
and our total assets.  Compliance with environmental laws and
regulations may be expensive, and current or future environmental regulations
may impair our research, development and production efforts.




In
addition, our collaborators may use hazardous materials in connection with our
collaborative efforts. In the event of a lawsuit or investigation, we could be
held responsible for any injury caused to persons or property by exposure to, or
release of, these hazardous materials used by these parties.  Further,
we may be required to indemnify our collaborators against all damages and other
liabilities arising out of our development activities or products produced in
connection with these collaborations.




We
may be sued for product liability.




We or our
collaborators may be held liable if any product that we or our collaborators
develop, or any product that is made with the use or incorporation of any of our
technologies, causes injury or is found otherwise unsuitable during product
testing, manufacturing, marketing or sale.  Although we currently have
and intend to maintain product liability insurance, this insurance may become
prohibitively expensive or may not fully cover our potential
liabilities.  Our inability to obtain sufficient insurance coverage at
an acceptable cost or otherwise to protect against potential product liability
claims could prevent or inhibit the commercialization of products developed by
us or our collaborators.  If we are sued for any injury caused by our
or our collaborators’ products, our liability could exceed our total
assets.




Risks
Related to Our Common Stock




Our
stock price may be extremely volatile.




The
trading price of our common stock has been highly volatile, and we believe the
trading price of our common stock will remain highly volatile and may fluctuate
substantially due to factors such as the following:




·
            adverse
      results or delays in clinical
trials;




·
            announcement
      of FDA approval or non-approval, or delays in the FDA review process, of
      our or our collaborators’ product candidates or those of our competitors
      or actions taken by regulatory agencies with respect to our, our
      collaborators’ or our competitors’ clinical
  trials;




·
            the
      announcement of new products by us or our
  competitors;




·
            quarterly
      variations in our or our competitors’ results of
    operations;




·
            conflicts
      or litigation with our
collaborators;




·
            litigation,
      including intellectual property infringement and product liability
      lawsuits, involving us;




·
            failure
      to achieve operating results projected by securities
    analysts;




·
            changes
      in earnings estimates or recommendations by securities
      analysts;




·
            financing
      transactions;




·
            developments
      in the biotechnology or pharmaceutical
industry;




·
            sales
      of large blocks of our common stock or sales of our common stock by our
      executive officers, directors and significant
  stockholders;




·
            departures
      of key personnel or board members;




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·
            developments
      concerning current or future
collaborations;




·
            FDA
      or international regulatory
actions;




·
            third-party
      reimbursement policies;




·
            acquisitions
      of other companies or technologies;




·
            disposition
      of any of our subsidiaries, technologies or compounds;
  and




·
            general
      market conditions and other factors, including factors unrelated to our
      operating performance or the operatingperformance of our
      competitors.




These
factors, as well as general economic, political and market conditions, may
materially adversely affect the market price of our common stock.




In the
past, following periods of volatility in the market price of a company’s
securities, securities class action litigation has often been
instituted.  A securities class action suit against us could result in
substantial costs and divert management’s attention and resources, which could
have a material and adverse effect on our business.




We
may engage in future acquisitions, which may be expensive and time consuming and
from which we may not realize anticipated benefits.




We may
acquire additional businesses, technologies and products if we determine that
these businesses, technologies and products complement our existing technology
or otherwise serve our strategic goals.  If we do undertake any
transactions of this sort, the process of integrating an acquired business,
technology or product may result in operating difficulties and expenditures and
may not be achieved in a timely and non-disruptive manner, if at all, and may
absorb significant management attention that would otherwise be available for
ongoing development of our business.  If we fail to integrate acquired
businesses, technologies or products effectively or if key employees of an
acquired business leave, the anticipated benefits of the acquisition would be
jeopardized.  Moreover, we may never realize the anticipated benefits
of any acquisition, such as increased revenues and earnings or enhanced business
synergies.  Future acquisitions could result in potentially dilutive
issuances of our equity securities, the incurrence of debt and contingent
liabilities and amortization expenses related to intangible assets, which could
materially impair our results of operations and financial
condition.




Future
sales of our common stock may depress our stock price.




If our
stockholders sell substantial amounts of our common stock (including shares
issued upon the exercise of options and warrants) in the public market, the
market price of our common stock could fall.  These sales also might
make it more difficult for us to sell equity or equity-related securities in the
future at a time and price that we deem appropriate.  For example,
following an acquisition, a significant number of shares of our common stock
held by new stockholders may become freely tradable or holders of registration
rights could cause us to register their shares for resale.  Sales of
these shares of common stock held by existing stockholders could cause the
market price of our common stock to decline.




Invus’
ownership of our common stock and its other rights under the stockholders’
agreement we entered into in connection with Invus’ $205.4 million initial
investment in our common stock provide Invus with substantial influence over
matters requiring stockholder approval, including the election of directors and
approval of significant corporate transactions, as well as other corporate
matters.




Under the
stockholders’ agreement we entered into in connection with Invus’ $205.4 million
initial investment in our common stock, Invus currently has the right to
designate the greater of three members or 30% (or the percentage of all the
outstanding shares of our common stock owned by Invus and its affiliates, if
less than 30%) of all members of our board of directors, rounded up to the
nearest whole number of directors, pursuant to which Invus has designated
Raymond Debbane, president and chief executive officer of The Invus Group, LLC,
an affiliate of Invus, and Philippe J. Amouyal and Christopher J. Sobecki, each
of whom are managing directors of The Invus Group, LLC.  In the event
that the number of shares of our common stock owned by Invus and its affiliates
ever exceeds 50% of the total number of shares of our common stock then
outstanding (not counting for such purpose any shares acquired by Invus from
third parties in excess of 40% (or, if higher, its then pro rata amount) of the
total number of outstanding shares of common stock, as permitted by the
standstill provisions of the stockholders’ agreement), from and after that time,
Invus will have the right to designate a number of directors equal to the
percentage of all the outstanding shares of our common stock owned by Invus and
its affiliates (not counting for such purpose any shares acquired by Invus from
third parties in excess of 40% (or, if higher, its then pro rata amount) of the
total number of outstanding shares of common stock, as permitted by the
standstill provisions of the stockholders’ agreement), rounded up to the nearest
whole number of directors.  The directors appointed by Invus have
proportionate representation on the compensation committee and corporate
governance committee of our board of directors.


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Invus’
rights with respect to the designation of members of our board of directors and
its compensation and corporate governance committees will terminate if the
percentage of all the outstanding shares of our common stock owned by Invus and
its affiliates falls below ten percent.  Invus will also have the
right to terminate these provisions at any time following the date on which the
percentage of all the outstanding shares of our common stock owned by Invus and
its affiliates exceeds 50% (not counting for such purpose any shares acquired by
Invus and its affiliates from third parties in excess of 40% (or, if higher, its
then pro rata amount) of the total number of outstanding shares of our common
stock, as permitted by the standstill provisions of the stockholders’
agreement).




Invus has
preemptive rights under the stockholders’ agreement to participate in future
equity issuances by us (including any qualified offering), subject to certain
exceptions, so as to maintain its then-current percentage ownership of our
capital stock.  Subject to certain limitations, Invus will be required
to exercise its preemptive rights in advance with respect to certain marketed
offerings, in which case it will be obligated to buy its pro rata share of the
number of shares being offered in such marketed offering, including any
overallotment (or such lesser amount specified in its exercise of such rights),
so long as the sale of the shares were priced within a range within ten percent
above or below the market price on the date we notified Invus of the offering
and we met certain other conditions.




The
provisions of the stockholders’ agreement relating to preemptive rights will
terminate on the earlier to occur of August 28, 2017 and the date on which the
percentage of all the outstanding shares of our common stock owned by Invus and
its affiliates falls below ten percent.




Invus is
subject to standstill provisions restricting its ability to purchase or
otherwise acquire additional shares of common stock from third parties to an
amount that would result in its ownership of our common stock not exceeding 49%
of the total number of shares outstanding.  These standstill
provisions will not apply to the acquisitions of securities by way of stock
splits, stock dividends, reclassifications, recapitalizations, or other
distributions by us, acquisitions contemplated by the securities purchase
agreement and the stockholders’ agreement, including in the rights offerings and
upon Invus’ exercise of preemptive rights under the stockholders’
agreement.




Except
for acquisitions pursuant to the provisions described above, and subject to
certain exceptions, Invus has agreed that it will not, and will cause its
affiliates not to, without the approval of our unaffiliated board, directly or
indirectly:




·
            solicit
      proxies to vote any of our voting securities or any voting securities of
      our subsidiaries;




·
            submit
      to our board of directors a written proposal for any merger,
      recapitalization, reorganization, business combination or other
      extraordinary transaction involving an acquisition of us or any of our
      subsidiaries or any of our or our subsidiaries’ securities or assets by
      Invus and its affiliates;




·
            enter
      into discussions, negotiations, arrangements or understandings with any
      third party with respect to any of the foregoing;
  or




·
            request
      us or any of our representatives, directly or indirectly, to amend or
      waive any of these standstill
provisions.




The
standstill provisions of the stockholders’ agreement will terminate on the
earliest to occur of (a) August 28, 2017, (b) the date on which the percentage
of all the outstanding shares of our common stock owned by Invus and its
affiliates falls below ten percent, (c) the date on which the percentage of all
of the outstanding shares of our common stock owned by Invus and its affiliates
exceeds 50% (not counting for such purpose any shares acquired by Invus from
third parties in excess of 40% (or, if higher, its then pro rata amount) of the
total number of outstanding shares of common stock, as permitted by the
standstill provisions of the stockholders’ agreement), (d) the date on which any
third party makes a public proposal to acquire (by purchase, exchange, merger or
otherwise) assets or business constituting 50% or more of our revenues, net
income or assets or 50% of any class of our equity securities our board of
directors recommends or approves, or proposes to recommend or approve, any such
transaction or (e) the date on which any third party acquires beneficial
ownership (by purchase, exchange, merger or otherwise) of assets or business
constituting 20% or more of our revenues, net income or assets or 20% of any
class of our equity securities or our board of directors recommends or approves,
or proposes to recommend or approve, any such transaction.


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Subject
to certain exceptions, Invus has agreed that neither it nor its affiliates will
sell any shares of common stock to third parties that are not affiliated with
Invus if, to Invus’ knowledge, such transfer would result in any such third
party (or any person or group including such third party) owning more than 14.9%
of the total number of outstanding shares of our common stock.




The
provisions of the stockholders’ agreement relating to sales to third parties
will terminate on the earliest to occur of (a) August 28, 2017,
(b) the date on which the percentage of all the outstanding shares of our
common stock owned by Invus and its affiliates falls below ten percent, and
(c) the date on which the percentage of all the outstanding shares of our
common stock owned by Invus and its affiliates exceeds 50% (not counting for
such purpose any shares acquired by Invus and its affiliates from third parties
in excess of 40% (or, if higher, its then pro rata amount) of the total number
of outstanding shares of our common stock, as permitted by the standstill
provisions of the stockholders’ agreement).




In any
election of persons to serve on our board of directors, Invus will be obligated
to vote all of the shares of common stock held by it and its affiliates in favor
of the directors nominated by our board of directors, as long as we have
complied with our obligation with respect to the designation of members of our
board of directors described above and the individuals designated by Invus for
election to our board of directors have been nominated, and, if applicable, are
serving on our board of directors.  With respect to all other matters
submitted to a vote of the holders of our common stock, Invus will be obligated
to vote any shares that it acquired from third parties in excess of 40% (or, if
higher, its then pro rata amount) of the total number of outstanding shares of
common stock, as permitted by the standstill provisions of the stockholders’
agreement, in the same proportion as all the votes cast by other holders of our
common stock, unless Invus and we (acting with the approval of the unaffiliated
board) agree otherwise.  Invus may vote all other shares of our common
stock held by it in its sole discretion.




The
provisions of the stockholders’ agreement relating to voting will terminate on
the earliest to occur of (a) August 28, 2017, (b) the date on which
the percentage of all the outstanding shares of our common stock held by Invus
and its affiliates falls below ten percent, (c) the date on which the
percentage of all outstanding shares of our common stock owned by Invus and its
affiliates exceeds 50% (not counting for such purpose any shares acquired by
Invus from third parties in excess of 40% (or, if higher, its then pro rata
amount) of the total number of outstanding shares of our common stock, as
permitted by the provisions of the stockholders’ agreement), and (d) the
termination of the standstill provisions in accordance with the stockholders’
agreement.




Invus is
entitled to certain minority protections, including consent rights over (a) the
creation or issuance of any new class or series of shares of our capital stock
(or securities convertible into or exercisable for shares of our capital stock)
having rights, preferences or privileges senior to or on parity with our common
stock, (b) any amendment to our certificate of incorporation or bylaws, or
amendment to the certificate of incorporation or bylaws of any of our
subsidiaries, in a manner adversely affecting Invus’ rights under the securities
purchase agreement and the related agreements, (c) the repurchase, retirement,
redemption or other acquisition of our or our subsidiaries’ capital stock (or
securities convertible into or exercisable for shares of our or our
subsidiaries’ capital stock), (d) any increase in the size of our board of
directors to more than 12 members and (e) the adoption or proposed adoption of
any stockholders’ rights plan, “poison pill” or other similar plan or agreement,
unless Invus is exempt from the provisions of such plan or
agreement.




The
provisions of the stockholders’ agreement relating to minority protections will
terminate on the earlier to occur of August 28, 2017 and the date on which Invus
and its affiliates hold less than 15% of the total number of outstanding shares
of our common stock.




Item
      1B.
                    Unresolved Staff
  Comments




None.


Item
      2.
                  Properties




We
currently own approximately 300,000 square feet of space for our corporate
offices and laboratories in buildings located in The Woodlands, Texas, a suburb
of Houston, Texas, and lease approximately 76,000 square feet of space for
offices and laboratories near Princeton, New Jersey.


27
 Table
of Contents




In April
2004, we purchased our facilities in The Woodlands, Texas from the lessor under
our previous synthetic lease agreement.  In connection with such
purchase, we obtained a $34.0 million mortgage which has a ten-year term with a
20-year amortization and bears interest at a fixed rate of 8.23%.




In May
2002, our subsidiary Lexicon Pharmaceuticals (New Jersey), Inc. entered into a
lease for a 76,000 square-foot facility in Hopewell, New Jersey.  The term
of the lease extends until June 30, 2013.  The lease provides for an
escalating yearly base rent payment of $1.3 million in the first year, $2.1
million in years two and three, $2.2 million in years four to six, $2.3
million in years seven to nine and $2.4 million in years ten and
eleven.  We are the guarantor of the obligations of our subsidiary
under the lease.




We
believe that our facilities are well-maintained, in good operating condition and
acceptable for our current operations.




Item
      3.
                Legal
  Proceedings


On
October 20, 2008, we received correspondence from counsel to the University of
Utah Research Foundation, or UURF, alleging that we were in breach of certain
obligations purported to exist under our license agreement with GenPharm
International, Inc., under which we obtained a sublicense under certain patents
exclusively licensed from UURF by GenPharm, and related letter agreements
between us and UURF governing the payment of royalties.  The
correspondence alleged that we breached the relevant agreements by, among other
things, purportedly failing to pay all required royalties and ignoring
obligations that UURF contends are expressed or implied in the relevant
agreements. On December 16, 2008, we filed a complaint against UURF in the
District Court of Montgomery County, Texas seeking a declaration that we are in
full compliance with our license and royalty obligations.  On January
26, 2009, UURF filed a notice seeking to remove the case to the United States
District Court for the Southern District of Texas.   UURF filed
an answer and counterclaims on February 2, 2009 asserting breach of contract
claims consistent with the claims made by UURF in its October 2008
correspondence and patent infringement which it claims has occurred since
approximately December 17, 2008.




We
believe that we have materially complied with all of our obligations under the
relevant agreements, including those relating to royalty payments due to UURF,
and that UURF’s claims are inconsistent with the express provisions of the
relevant agreements.  We accordingly believe UURF’s claims are without
merit.  While the litigation of these matters is at a very early
stage, we intend to vigorously pursue our complaint against UURF and dispute
UURF’s counterclaims.




We are
from time to time party to other claims and legal proceedings that we believe
will not have, individually or in the aggregate, a material adverse effect on
our results of operations, financial condition or liquidity.


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


None.




28
 Table
of Contents


PART
II




Item
      5.
            Marketfor
      Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity
Securities




Our
common stock is quoted on The Nasdaq Global Market under the symbol
“LXRX.”  The following table sets forth, for the periods indicated,
the high and low sales prices for our common stock as reported on The Nasdaq
Global Market.




High
                
                
                Low2007First
      Quarter
                
                $
                4.40
                
                
                $
                3.10Second
      Quarter
                
                $
                3.87
                
                
                $
                2.91Third
      Quarter
                
                $
                3.69
                
                
                $
                3.04Fourth
      Quarter
                
                $
                4.03
                
                
                $
                2.802008First
      Quarter
                
                $
                3.07
                
                
                $
                1.27Second
      Quarter
                
                $
                2.44
                
                
                $
                1.57Third
      Quarter
                
                $
                2.60
                
                
                $
                1.51Fourth
      Quarter
                
                $
                1.90
                
                
                $
                0.74





As of
February 28, 2009, there were approximately 221 holders of record of our common
stock.




We have
never paid cash dividends on our common stock. We anticipate that we will retain
all of our future earnings, if any, for use in the expansion and operation of
our business and do not anticipate paying cash dividends in the foreseeable
future.




Performance
Graph




The
following performance graph compares the performance of our common stock to the
Nasdaq Composite Index and the Nasdaq Biotechnology Index for the period
beginning December 31, 2003 and ending December 31, 2008. The graph assumes that
the value of the investment in our common stock and each index was $100 at
December 31, 2003, and that all dividends were reinvested.













December
      31,2003
              
              2004
              
              2005
              
              2006
              
              2007
              
              2008Lexicon
      Pharmaceuticals, Inc.
              
              100
              
              132
              
              62
              
              61
              
              51
              
              24Nasdaq
      Composite Index
              
              100
              
              109
              
              110
              
              121
              
              132
              
              79Nasdaq
      Biotechnology Index
              
              100
              
              106
              
              109
              
              110
              
              115
              
              101





The
foregoing stock price performance comparisons shall not be deemed “filed” for
purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise
subject to the liabilities of that section, nor shall it be deemed incorporated
by reference by any general statement incorporating by reference this annual
report on Form 10-K into any filing under the Securities Act of 1933 or under
the Securities Exchange Act of 1934, except to the extent that we specifically
incorporate such comparisons by reference.




29
 Table
of Contents


Item
      6.
              Selected Financial
      Data


The
statement of operations data for the years ended December 31, 2008, 2007
and 2006 and the balance sheet data as of December 31, 2008 and 2007 have
been derived from our audited financial statements included elsewhere in this
annual report on Form 10-K.  The statements of operations data
for the years ended December 31, 2005 and 2004, and the balance sheet data as of
December 31, 2006, 2005 and 2004 have been derived from our audited financial
statements not included in this annual report on Form 10-K.  Our
historical results are not necessarily indicative of results to be expected for
any future period.  The data presented below has been derived from
financial statements that have been prepared in accordance with accounting
principles generally accepted in the United States and should be read with our
financial statements, including the notes, and with “Management’s Discussion and
Analysis of Financial Condition and Results of Operations” included elsewhere in
this annual report on Form 10-K.




Year
      Ended December 31,2008
                          
                          
                          2007
                          
                          
                          2006
                          
                          
                          2005
                          
                          
                          2004Statements
      of Operations Data:
                          
                          (in
      thousands, except per share data)Revenues
                          
                          $
                          32,321
                          
                          
                          $
                          50,118
                          
                          
                          $
                          72,798
                          
                          
                          $
                          75,680
                          
                          
                          $
                          61,740Operating
      expenses:Research and development,
      including stock-based compensation of $3,941 in  2008, $5,150 in
      2007, $4,394 in 2006, ($21) in 2005 and $426 in 2004
                          
                          
                          108,575
                          
                          
                          
                          104,332
                          
                          
                          
                          106,695
                          
                          
                          
                          93,625
                          
                          
                          
                          90,586General and administrative,
      including stock-based compensation of $2,559 in 2008, $2,776 in 2007,
      $2,636 in 2006, $0 in 2005 and $412 in 2004
                          
                          
                          20,281
                          
                          
                          
                          20,740
                          
                          
                          
                          21,334
                          
                          
                          
                          18,174
                          
                          
                          
                          18,608Total
      operating expenses
                          
                          
                          128,856
                          
                          
                          
                          125,072
                          
                          
                          
                          128,029
                          
                          
                          
                          111,799
                          
                          
                          
                          109,194Loss
      from operations
                          
                          
                          (96,535
                          )
                          
                          
                          (74,954
                          )
                          
                          
                          (55,231
                          )
                          
                          
                          (36,119
                          )
                          
                          
                          (47,454
                          )Interest
      and other income (expense), net
                          
                          
                          (349
                          )
                          
                          
                          3,721
                          
                          
                          
                          801
                          
                          
                          
                          (77
                          )
                          
                          
                          282Loss
      before noncontrolling interest in Symphony Icon, Inc.
                          
                          
                          (96,884
                          )
                          
                          
                          (71,233
                          )
                          
                          
                          (54,430
                          )
                          
                          
                          (36,196
                          )
                          
                          
                          (47,172
                          )Loss
      attributable to noncontrolling interest in Symphony Icon,
    Inc.
                          
                          
                          20,024
                          
                          
                          
                          12,439
                          
                          
                          
                          —
                          
                          
                          
                          —
                          
                          
                          
                          —Loss
      before taxes
                          
                          
                          (76,860
                          )
                          
                          
                          (58,794
                          )
                          
                          
                          (54,430
                          )
                          
                          
                          (36,196
                          )
                          
                          
                          (47,172
                          )Income
      tax provision
                          
                          
                          —
                          
                          
                          
                          —
                          
                          
                          
                          119
                          
                          
                          
                          (119
                          )
                          
                          
                          —Net
      loss
                          
                          $
                          (76,860
                          )
                          
                          $
                          (58,794
                          )
                          
                          $
                          (54,311
                          )
                          
                          $
                          (36,315
                          )
                          
                          $
                          (47,172
                          )Net
      loss per common share, basic and diluted
                          
                          $
                          (0.56
                          )
                          
                          $
                          (0.59
                          )
                          
                          $
                          (0.81
                          )
                          
                          $
                          (0.57
                          )
                          
                          $
                          (0.74
                          )Shares
      used in computing net loss per common share, basic and
    diluted
                          
                          
                          136,797
                          
                          
                          
                          99,798
                          
                          
                          
                          66,876
                          
                          
                          
                          63,962
                          
                          
                          
                          63,327





As
      of December 31,2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004Balance
      Sheet Data:
                
                (in
      thousands)Cash,
      cash equivalents and short-term investments, including restricted cash and
      investments of $430
                
                $
                86,502
                
                
                $
                222,109
                
                
                $
                79,999
                
                
                $
                99,695
                
                
                $
                87,558Short-term
      investments held by Symphony Icon, Inc.
                
                
                16,610
                
                
                
                36,666
                
                
                
                —
                
                
                
                —
                
                
                
                —Long-term
      investments
                
                
                55,686
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —Working
      capital
                
                
                87,991
                
                
                
                229,303
                
                
                
                39,586
                
                
                
                48,584
                
                
                
                60,038Total
      assets
                
                
                261,508
                
                
                
                369,296
                
                
                
                190,266
                
                
                
                218,714
                
                
                
                211,980Long-term
      debt, net of current portion
                
                
                29,529
                
                
                
                30,493
                
                
                
                31,372
                
                
                
                32,189
                
                
                
                32,940Accumulated
      deficit
                
                
                (487,395
                )
                
                
                (410,535
                )
                
                
                (351,741
                )
                
                
                (297,430
                )
                
                
                (261,115
                )Stockholders’
      equity
                
                
                185,580
                
                
                
                256,300
                
                
                
                85,501
                
                
                
                85,802
                
                
                
                121,594
 30
 Table
of Contents


Item
      7.
                Management’s Discussion and Analysisof Financial
      Condition and Results of
Operations


The
following discussion and analysis should be read with “Selected Financial Data”
and our financial statements and notes included elsewhere in this annual report
on Form 10-K.




Overview




We are a
biopharmaceutical company focused on the discovery and development of
breakthrough treatments for human disease.  We have used our
proprietary gene knockout technology and an integrated platform of advanced
medical technologies to identify and validate, in vivo, more than 100
targets with promising profiles for drug discovery.  For targets that
we believe have high pharmaceutical value, we engage in programs for the
discovery and development of potential new drugs, focusing in the core
therapeutic areas of immunology, metabolism, cardiology and
ophthalmology.  Human clinical trials are currently underway for four
of our drug candidates, with one additional drug candidate in preclinical
development and compounds from a number of additional programs in various stages
of preclinical research.




We are
working both independently and through strategic collaborations and alliances to
capitalize on our technology, drug target discoveries and drug discovery and
development programs.  Consistent with this approach, we seek to
retain exclusive rights to the benefits of certain of our small molecule drug
programs by developing and commercializing drug candidates from such programs
internally and to collaborate with third parties with respect to the discovery,
development and commercialization of small molecule and biotherapeutics drug
candidates for other targets, particularly when the collaboration provides us
with access to expertise and resources that we do not possess internally or are
complementary to our own.  We have established drug discovery and
development collaborations with a number of leading pharmaceutical and
biotechnology companies which have enabled us to generate near-term cash while
offering us the potential to retain economic participation in products our
collaborators develop through the collaboration.  In addition, we have
established collaborations and license agreements with other leading
pharmaceutical and biotechnology companies, research institutes and academic
institutions under which we receive fees and, in some cases, are eligible to
receive milestone and royalty payments, in return for granting access to some of
our technologies and discoveries for use in the other organization’s own drug
discovery efforts.




We derive
substantially all of our revenues from drug discovery and development
collaborations and other collaborations and technology licenses.  To
date, we have generated a substantial portion of our revenues from a limited
number of sources.




Our
operating results and, in particular, our ability to generate additional
revenues are dependent on many factors, including our success in establishing
new collaborations and technology licenses, expirations of our existing
collaborations and alliances, the success rate of our discovery and development
efforts leading to opportunities for new collaborations and licenses, as well as
milestone payments and royalties, the timing and willingness of collaborators to
commercialize products which may result in royalties, and general and
industry-specific economic conditions which may affect research and development
expenditures.  Our future revenues from collaborations and technology
licenses are uncertain because our existing agreements have fixed terms or
relate to specific projects of limited duration and we depend, in part, on
securing new agreements.  Our ability to secure future
revenue-generating agreements will depend upon our ability to address the needs
of our potential future collaborators and licensees, and to negotiate agreements
that we believe are in our long-term best interests.  We may determine
that our interests are better served by retaining rights to our discoveries and
advancing our therapeutic programs to a later stage, which could limit our
near-term revenues.  Because of these and other factors, our operating
results have fluctuated in the past and are likely to do so in the future, and
we do not believe that period-to-period comparisons of our operating results are
a good indication of our future performance.




Since our
inception, we have incurred significant losses and, as of December 31, 2008, we
had an accumulated deficit of $487.4 million. Our losses have resulted
principally from costs incurred in research and development, general and
administrative costs associated with our operations, and non-cash stock-based
compensation expenses associated with stock options granted to employees and
consultants.  Research and development expenses consist primarily of
salaries and related personnel costs, external research costs related to our
preclinical and clinical efforts, material costs, facility costs, depreciation
on property and equipment, legal expenses resulting from intellectual property
prosecution and other expenses related to our drug discovery and development
programs, the development and analysis of knockout mice and our other target
validation research efforts, and the development of compound libraries. General
and administrative expenses consist primarily of salaries and related expenses
for executive and administrative personnel, professional fees and other
corporate expenses including information technology, facilities costs and
general legal activities.  In connection with the expansion of our
drug discovery and development programs, we expect to continue to incur
significant research and development costs. As a result, we will need to
generate significantly higher revenues to achieve profitability.


31
 Table
of Contents




Critical
Accounting Policies




Revenue
Recognition




We
recognize revenues when persuasive evidence of an arrangement exists, delivery
has occurred or services have been rendered, the price is fixed or determinable,
and collectibility is reasonably assured.  Payments received in
advance under these arrangements are recorded as deferred revenue until
earned.




Upfront
fees under our drug discovery and development alliances are recognized as
revenue on a straight-line basis over the estimated period of service, generally
the contractual research term, as this period is our best estimate of the period
over which the services will be rendered, to the extent they are
non-refundable.  We have determined that the level of effort we
perform to meet our obligations is fairly constant throughout the estimated
periods of service.  As a result, we have determined that it is
appropriate to recognize revenue from such agreements on a straight-line basis,
as we believe this reflects how the research is provided during the initial
period of the agreement.  When it becomes probable that a collaborator
will extend the research period, we adjust the revenue recognition method as
necessary based on the level of effort required under the agreement for the
extension period.




Research
funding under these alliances is recognized as services are performed to the
extent they are non-refundable, either on a straight-line basis over the
estimated service period, generally the contractual research term; or as
contract research costs are incurred.  Milestone-based fees are
recognized upon completion of specified milestones according to contract
terms.  Payments received under target validation collaborations and
government grants and contracts are recognized as revenue as we perform our
obligations related to such research to the extent such fees are
non-refundable.  Non-refundable technology license fees are recognized
as revenue upon the grant of the license, when performance is complete and there
is no continuing involvement.




Revenues
recognized from multiple element contracts are allocated to each element of the
arrangement based on the relative fair value of the elements.  An
element of a contract can be accounted for separately if the delivered elements
have standalone value to the collaborator and the fair value of any undelivered
elements is determinable through objective and reliable evidence.  If
an element is considered to have standalone value but the fair value of any of
the undelivered items cannot be determined, all elements of the arrangement are
recognized as revenue over the period of performance for such undelivered items
or services.




A change
in our revenue recognition policy or changes in the terms of contracts under
which we recognize revenues could have an impact on the amount and timing of our
recognition of revenues.




Research
and Development Expenses




Research
and development expenses consist of costs incurred for research and development
activities solely sponsored by us as well as collaborative research and
development activities.  These costs include direct and
research-related overhead expenses and are expensed as
incurred.  Patent costs and technology license fees for technologies
that are utilized in research and development and have no alternative future use
are expensed when incurred.




We are
presently conducting a Phase 2 clinical trial of our most advanced drug
candidate, LX1031, an orally-delivered small molecule compound that we are
developing as a potential treatment for irritable bowel syndrome and other
gastrointestinal disorders.  We have completed Phase 1 clinical
trials and intend in the near term to initiate a Phase 2 clinical trial of
LX1032, an orally-delivered small molecule compound that we are developing as a
potential treatment for the symptoms associated with carcinoid
syndrome.  We are conducting Phase 1 clinical trials of two other
drug candidates:  LX2931, an orally-delivered small molecule compound
that we are developing as a potential treatment for rheumatoid arthritis and
other autoimmune diseases; and LX4211, an orally-delivered small molecule
compound that we are developing as a potential treatment for Type 2
diabetes.  We have advanced one other drug candidate into preclinical
development: LX7101, a topically-delivered small molecule compound that we are
developing as a potential treatment for glaucoma.  We have small
molecule compounds from a number of additional drug discovery programs in
various stages of preclinical research and believe that our systematic, target
biology-driven approach to drug discovery will enable us to substantially expand
our clinical pipeline.  The drug development process takes many years
to complete.  The cost and length of time varies due to many factors
including the type, complexity and intended use of the drug
candidate.  We estimate that drug development activities are typically
completed over the following periods:




32
 Table
of Contents




Phase
              
              Estimated
      Completion PeriodPreclinical
      development
              
              1-2
      yearsPhase
      1 clinical trials
              
              1-2
      yearsPhase
      2 clinical trials
              
              1-2
      yearsPhase
      3 clinical trials
              
              2-4
      years





We expect
research and development costs to increase in the future as our drug programs
advance in preclinical development and clinical trials.  Due to the
variability in the length of time necessary for drug development, the
uncertainties related to the cost of these activities and ultimate ability to
obtain governmental approval for commercialization, accurate and meaningful
estimates of the ultimate costs to bring our potential drug candidates to market
are not available.




We record
significant accrued liabilities related to unbilled expenses for products or
services that we have received from service providers, specifically related to
ongoing preclinical studies and clinical trials.  These costs
primarily relate to clinical study management, monitoring, laboratory and
analysis costs, drug supplies, toxicology studies and investigator
grants.  We have multiple drugs in concurrent preclinical studies and
clinical trials at clinical sites throughout the world.  In order to
ensure that we have adequately provided for ongoing preclinical and clinical
development costs during the period in which we incur such costs, we maintain
accruals to cover these expenses.  We update our estimates for these
accruals on a monthly basis.  Although we use consistent milestones or
subject enrollment to drive expense recognition, the assessment of these costs
is a subjective process that requires judgment.  Upon settlement,
these costs may differ materially from the amounts accrued in our consolidated
financial statements.




We record
our research and development costs by type or category, rather than by
project.  Significant categories of costs include personnel,
facilities and equipment costs, laboratory supplies and third-party and other
services.  In addition, a significant portion of our research and
development expenses is not tracked by project as it benefits multiple
projects.  Consequently, fully-loaded research and development cost
summaries by project are not available.




Consolidation
of Variable Interest Entity




We
consolidate the financial condition and results of operations of Symphony Icon
in accordance with FASB Interpretation No. 46 (revised 2003),
“Consolidation of Variable Interest Entities,” or FIN 46R.  While
Symphony Icon is defined under FIN46R to be a variable interest entity for which
we are the primary beneficiary, Symphony Icon is wholly-owned by the
noncontrolling interest holders.  Therefore, we reduce the amount of
our reported net loss in our consolidated statements of operations by the loss
attributed to the noncontrolling interest and we also reduce the noncontrolling
interest holders’ ownership interest in the consolidated balance sheets by
Symphony Icon’s losses.




Stock-based
Compensation Expense




Our
stock-based compensation plans are accounted for under the recognition and
measurement provisions of SFAS, No. 123 (Revised), “Share-Based Payment,” (SFAS
No. 123(R)).  This statement requires companies to recognize
compensation expense in the statements of operations for share-based payments,
including stock options issued to employees, based on their fair values on the
date of the grant, with the compensation expense recognized over the period in
which an employee is required to provide service in exchange for the stock
award.  Stock-based compensation expense is recognized on a
straight-line basis.  We had stock-based compensation expense under
SFAS No. 123(R) of $6.5 million for the year ended December 31, 2008, or $0.05
per share.  Stock-based compensation expense under SFAS No. 123(R) has
no impact on cash flows from operating activities or financing
activities.  As of December 31, 2008, stock-based compensation cost
for all outstanding unvested options was $8.1 million, which is expected to
be recognized over a weighted-average vesting period of 1.2 years.




The fair
value of stock options is estimated at the date of grant using the Black-Scholes
option-pricing model.  For purposes of determining the fair value of
stock options granted subsequent to the adoption of SFAS No. 123(R), we
segregated our options into two homogeneous groups, based on exercise and
post-vesting employment termination behaviors, resulting in a change in the
assumptions used for expected option lives and forfeitures.  Expected
volatility is based on the historical volatility in our stock
price.  The following weighted-average assumptions were used for
options granted in the years ended December 31, 2008, 2007 and 2006,
respectively:




33
 Table
of Contents




Expected
      Volatility
                
                Risk-free
      Interest Rate
                
                Expected
      Term
                
                Estimated
      Forfeitures
                
                Dividend
                  RateDecember
      31, 2008:Employees,
      officers and non-employee directors
                66%
                
                2.9%
                
                6
                
                22%
                
                0%Officers
      and non-employee directors
                66%
                
                3.8%
                
                9
                
                6%
                
                0%December
      31, 2007:Employees
                66%
                
                4.5%
                
                6
                
                21%
                
                0%Officers
      and non-employee directors
                67%
                
                4.6%
                
                9
                
                4%
                
                0%December
      31, 2006:Employees
                69%
                
                4.6%
                
                7
                
                18%
                
                0%Officers
      and non-employee directors
                69%
                
                4.7%
                
                9
                
                3%
                
                0%


Goodwill
Impairment




Goodwill
is not amortized, but is tested at least annually for impairment at the
reporting unit level.  We have determined that the reporting unit is
the single operating segment disclosed in our current financial
statements.  Impairment is the condition that exists when the carrying
amount of goodwill exceeds its implied fair value.  The first step in
the impairment process is to determine the fair value of the reporting unit and
then compare it to the carrying value, including goodwill.  We
determined that the market capitalization approach is the most appropriate
method of measuring fair value of the reporting unit.  Under this
approach, fair value is calculated as the average closing price of our common
stock for the 30 days preceding the date that the annual impairment test is
performed, multiplied by the number of outstanding shares on that
date.  A control premium, which is representative of premiums paid in
the marketplace to acquire a controlling interest in a company, is then added to
the market capitalization to determine the fair value of the reporting
unit.  If the fair value exceeds the carrying value, no further action
is required and no impairment loss is recognized.  Additional
impairment assessments may be performed on an interim basis if we encounter
events or changes in circumstances that would indicate that, more likely than
not, the carrying value of goodwill has been impaired.  There was no
impairment of goodwill in 2008.




Valuation
of Investments that Do Not Have Active Markets




At
December 31, 2008, we held $57.0 million (par value) of AAA rated
investments with an auction interest rate feature, known as auction rate
securities.  The securities have historically traded at par and are
redeemable at par plus accrued interest at the option of the
issuer.  Until February 2008, the carrying value of our auction rate
securities approximated fair value.  With the liquidity issues
experienced in the global credit and capital markets, our auction rate
securities have experienced multiple failed auctions and the estimated market
value of these securities is less than cost.




We
estimated the fair value of these auction rate securities using a discounted
cash flow analysis that considered the following key inputs: (a) the
underlying structure of each security; (b) the present value of the future
principal and interest payments discounted at rates considered to reflect
current market conditions and the relevant risk associated with each security;
and (c) consideration of the time horizon that the market value of each
security could return to its cost.  We also considered secondary
market trading date in estimating the fair value of these auction rate
securities.  We estimate that the fair market value of these
securities at December 31, 2008 was $43.6 million.  Because
we do not intend to hold these securities until the par value is recoverable
through the auction process and we believe the decline in fair values is
other-than-temporary, we recorded a loss of $13.4 million for the year
ended December 31, 2008 to reflect the decline in value of these
securities, which is shown as loss on long-term investments in the consolidated
statement of operations.




In
November 2008, we accepted an offer from UBS AG, the investment bank that sold
us the auction rate securities, providing us with rights related to our auction
rate securities.  These rights permit us to require UBS to purchase
our $57.0 million (par value) of auction rate securities at par value
during the period from June 30, 2010 through July 2,
2012.  Conversely, UBS has the right, in its discretion, to purchase
or sell the securities at any time by paying us the par value of such
securities.  We expect to exercise these rights and sell our auction
rate securities back to UBS on June 30, 2010, the earliest date allowable
under the rights.




The
enforceability of the rights results in a separate asset that will be measured
at its fair value.  We elected to measure the rights under the fair
value option of SFAS 159, “The Fair Value Option for Financial Assets and
Financial Liabilities – including an amendment of FASB Statement No. 115,”
and recorded a gain of approximately $12.1 million, which is reflected in
loss on long-term investments, net, and recorded a corresponding long-term
investment.  As a result of accepting the rights, we elected to
classify the rights and reclassify our investments in auction rate securities as
trading securities, as defined by SFAS No. 115, “Accounting for Certain
Investments in Debt and Equity Securities.”  As a result, we will be
required to assess the fair value of these two individual assets and record
changes each period until the rights are exercised and the auction rate
securities are redeemed.  We expect that subsequent changes in the
value of the rights will largely offset the subsequent fair value movements of
the auction rate securities, subject to the continued expected performance by
the investment bank of its obligations under the agreement.


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The fair
value of the auction rate securities and the associated rights could further
change significantly in the future and we may be required to record additional
other-than-temporary impairment charges related to the auction rate securities
and gains related to the rights if there are further reductions in fair value of
the auction rate securities in future periods.




Recent
Accounting Pronouncements




In
September 2006, the FASB issued Statement of Financial Accounting Standards, or
SFAS, No. 157, “Fair Value Measurements.”  The statement defines fair
value, establishes a framework for measuring fair value in generally accepted
accounting principles, and expands disclosures about fair value
measurements.  This statement applies under other accounting
pronouncements that require or permit fair value measurements, the FASB having
previously concluded in those accounting pronouncements that fair value is the
relevant measurement attribute.  Accordingly, this statement does not
require any new fair value measurements.  More specifically, SFAS
No. 157 emphasizes that fair value is a market-based measurement, not an
entity-specific measurement, and sets out a fair value hierarchy, which ranks
the quality and reliability of the information used to determine fair
value.  SFAS No. 157 was effective January 1, 2008 for financial
assets and liabilities and will be effective January 1, 2009 for non-financial
assets and liabilities.  The adoption of SFAS No. 157 for financial
assets and liabilities did not have an effect on our financial condition or
results of operations.  We are currently evaluating the effect, if
any, of the adoption of this statement for non-financial assets and liabilities
on our financial condition and results of operations.




In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities - including an amendment of FASB
Statement No. 115,” which provides a fair value option election that permits
entities to irrevocably elect to measure many financial instruments and certain
other items at fair value, with changes in fair value recognized in earnings as
they occur.  SFAS No. 159 also establishes presentation and disclosure
requirements designed to facilitate comparisons between entities that choose
different measurement attributes for similar types of assets and
liabilities.  SFAS No. 159 does not affect any existing accounting
literature that requires certain assets and liabilities to be carried at fair
value.  SFAS No. 159 is effective as of the beginning of an entity’s
first fiscal year that begins after November 15, 2007.  Our adoption
of SFAS No. 159 on January 1, 2008 did not materially affect our financial
position or results of operations.




In
December 2007, the FASB issued SFAS No. 141(Revised), “Business Combinations,”
which replaces SFAS No. 141, “Business Combinations,” and requires an acquirer
to recognize the assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree at the acquisition date, measured at
their fair values as of that date, with limited exceptions. This statement also
requires the acquirer in a business combination achieved in stages to recognize
the identifiable assets and liabilities, as well as the noncontrolling interest
in the acquiree, at the full amounts of their fair values. SFAS No. 141(R) makes
various other amendments to authoritative literature intended to provide
additional guidance or to confirm the guidance in that literature to that
provided in this statement. This statement applies prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15,
2008.  We expect to adopt this statement on January 1,
2009.  SFAS No. 141(R)’s impact on accounting for business
combinations is dependent upon acquisitions, if any, made on or after that
time.




In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements,” which amends Accounting Research Bulletin
No. 51, “Consolidated Financial Statements,” to improve the relevance,
comparability, and transparency of the financial information that a reporting
entity provides in its consolidated financial statements. SFAS No. 160
establishes accounting and reporting standards that require the ownership
interests in subsidiaries not held by the parent to be clearly identified,
labeled and presented in the consolidated statement of financial position within
equity, but separate from the parent’s equity.  This statement also
requires the amount of consolidated net income attributable to the parent and to
the noncontrolling interest to be clearly identified and presented on the face
of the consolidated statement of income.  Changes in a parent’s
ownership interest while the parent retains its controlling financial interest
must be accounted for consistently, and when a subsidiary is deconsolidated, any
retained noncontrolling equity investment in the former subsidiary must be
initially measured at fair value.  The gain or loss on the
deconsolidation of the subsidiary is measured using the fair value of any
noncontrolling equity investment.  The statement also requires
entities to provide sufficient disclosures that clearly identify and distinguish
between the interests of the parent and the interests of the noncontrolling
owners. This statement applies prospectively to all entities that prepare
consolidated financial statements and applies prospectively for fiscal years,
and interim periods within those fiscal years, beginning on or after
December 15, 2008.  We are currently evaluating the effect, if
any, of this statement on our financial condition and results of
operations.


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Results
of Operations – Comparison of Years Ended December 31, 2008, 2007 and
2006




Revenues




Total
revenues and dollar and percentage changes as compared to the prior year are as
follows (dollar amounts are presented in millions):




Year
      Ended December 31,2008
                
                
                2007
                
                
                2006Total
      revenues
                
                $
                32.3
                
                
                $
                50.1
                
                
                $
                72.8Dollar
      decrease
                
                $
                (17.8
                )
                
                $
                (22.7
                )Percentage
      decrease
                
                
                (36
                %)
                
                
                (31
                %)





Years
Ended December 31, 2008 and 2007




·
            Collaborative research
      – Revenue from collaborative research decreased 43% to $27.2 million,
      primarily due to the completion in 2007 of the project funded by our award
      from the Texas Enterprise Fund, reduced revenues under our alliance with
      N.V. Organon due to our progress towards completing the target discovery
      portion of the alliance, and the completion in 2007 of the target
      discovery portion of our alliance with Takeda Pharmaceutical
      Limited.




·
            Subscription and license
      fees – Revenue from subscriptions and license fees increased 152%
      to $5.1 million, primarily due to an increase in technology license
      fees.




Years
Ended December 31, 2007 and 2006




·
            Collaborative research
      – Revenue from collaborative research decreased 30% in 2007 to
      $48.1 million, primarily due to decreased revenue under our alliance
      with Bristol-Myers Squibb resulting from the conclusion of the revenue
      recognition period for the upfront payment we received under the
      alliance.  Additionally, the prior year included the achievement
      of a performance milestone under our Takeda
  alliance.




·
            Subscription and license
      fees – Revenue from subscriptions and license fees decreased 54% in
      2007 to $2.0 million primarily due to lower royalties received under
      a technology license agreement with
Deltagen.




In 2008,
Bristol-Myers Squibb, Organon and Genentech represented 32%, 29% and 13% of
revenues, respectively.  In 2007, Organon, Bristol-Myers Squibb and
the Texas Enterprise Fund represented 27%, 23% and 22% of revenues,
respectively.  In 2006, Bristol-Myers Squibb, Organon and Takeda
represented 35%, 21% and 12% of revenues, respectively.




Research
and Development Expenses




Research
and development expenses and dollar and percentage changes as compared to the
prior year are as follows (dollar amounts are presented in
millions):




Year
      Ended December 31,2008
                
                
                2007
                
                
                2006Total
      research and development expense
                
                $
                108.6
                
                
                $
                104.3
                
                
                $
                106.7Dollar
      increase (decrease)
                
                $
                4.2
                
                
                $
                (2.4
                )Percentage
      increase (decrease)
                
                
                4
                %
                
                
                (2
                %)





Research
and development expenses consist primarily of salaries and other
personnel-related expenses, facility and equipment costs, laboratory supplies,
third-party and other services principally related to preclinical and clinical
development activities and stock-based compensation expenses.




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Years
Ended December 31, 2008 and 2007




·
            Personnel – Personnel
      costs decreased 7% to $41.4 million, primarily due to lower salary, bonus
      and benefit costs as a result of a reduction in personnel in May 2008 as
      part of our reorganization reallocating resources from research and
      discovery to our drug development pipeline, offset in part by associated
      severance costs.  Salaries, bonuses, employee benefits, payroll
      taxes, recruiting and relocation costs are included in personnel
      costs.




·
            Facilities and
      equipment – Facilities and equipment costs decreased 8% to
      $18.5 million, primarily due to a decrease in depreciation
      expense.




·
            Laboratory supplies –
      Laboratory supplies expense decreased 25% to $8.6 million, primarily
      due to the reduction in personnel in May
2008.




·
            Third-party and other
      services – Third-party and other services increased 69% to
      $31.3 million, primarily due to an increase in external preclinical
      and clinical research and development costs.  Third-party and
      other services include third-party research, technology licenses, legal
      and patent fees and subscriptions to third-party
  databases.




·
            Stock-based
      compensation – Stock-based compensation expense decreased 23% to
      $3.9 million, primarily as a result of the reduction in our
      personnel.




·
            Other – Other costs
      increased by 2% to
$4.9 million.




Years
Ended December 31, 2007 and 2006




·
            Personnel –Personnel
      costs decreased 13% in 2007 to $44.4 million, primarily due to lower
      salary and benefit costs as a result of a reduction in our personnel in
      January 2007 as part of our strategic realignment reallocating resources
      from genetics research efforts to drug development, offset in part by
      associated severance costs.




·
            Facilities and equipment –Facilities and equipment costs decreased 5% in 2007 to
      $20.1 million, primarily due to a decrease in depreciation
      expense.




·
            Laboratory supplies –Laboratory supplies expense decreased 23% in 2007 to
      $11.4 million, primarily due to the reduction in personnel in January
      2007.




·
            Third-party and other services
      –Third-party and other services increased 87% in 2007 to
      $18.4 million, primarily due an increase in external preclinical and
      clinical research and development
costs.




·
            Stock-based compensation
      – Stock-based compensation expense increased 17% in 2007 to
      $5.1 million.




·
            Other –Other costs
      decreased 7% in 2007 to
$4.8 million.




General
and Administrative Expenses




General
and administrative expenses and dollar and percentage changes as compared to the
prior year are as follows (dollar amounts are presented in
millions):




Year
      Ended December 31,2008
                
                
                2007
                
                
                2006Total
      general and administrative expense
                
                $
                20.3
                
                
                $
                20.7
                
                
                $
                21.3Dollar
      decrease
                
                $
                (0.5
                )
                
                $
                (0.6
                )Percentage
      decrease
                
                
                (2
                %)
                
                
                (3
                %)





General
and administrative expenses consist primarily of personnel costs to support our
research and development activities, facility and equipment costs, professional
fees such as legal fees, and stock-based compensation expenses.




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Years
Ended December 31, 2008 and 2007




·
            Personnel – Personnel
      costs decreased 3% to $10.4 million, primarily due to lower bonus and
      benefit costs, offset in part by severance costs associated with
      reductions in personnel.  Salaries, bonuses, employee benefits,
      payroll taxes, recruiting and relocation costs are included in personnel
      costs.




·
            Facilities and
      equipment – Facilities and equipment costs were $2.5 million,
      consistent with the prior year.




·
            Professional fees –
      Professional fees increased 19% to $2.9 million, primarily due to
      increased market research and other consulting
  costs.




·
            Stock-based
      compensation – Stock-based compensation expense decreased 8% to
      $2.6 million.




·
            Other – Other costs
      decreased 16% to $1.9 million.




Years
Ended December 31, 2007 and 2006




·
            Personnel – Personnel
      costs decreased 10% in 2007 to $10.6 million, primarily due to lower
      salary and benefit costs as a result of a reduction in personnel in
      January 2007, offset in part by associated severance
  costs.




·
            Facilities and
      equipment – Facilities and equipment costs decreased 18% in 2007 to
      $2.5 million, primarily due to a decrease in depreciation
      expense.




·
            Professional fees –
      Professional fees increased 55% in 2007 to $2.5 million primarily due
      to increased professional, consulting and litigation
  costs.




·
            Stock-based
      compensation – Stock-based compensation expense increased 5% in
      2007 to $2.8 million.




·
            Other –Other costs
      increased 3% in 2007 to
$2.3 million.




Loss
on Long-term Investments, net, Interest Income, Interest Expense and Other
(Expense) Income, Net




Loss on Long-term Investments,
Net.  Loss on long-term investments was $13.4 million for
the year ended December 31, 2008, representing the other-than-temporary
decline in fair value of our student loan auction rate
securities.  This loss was partially offset by a gain on long-term
investments of $12.1 million for the year ended December 31, 2008,
representing the fair value of the rights obtained from UBS AG, the investment
bank that sold us our auction rate securities.




Interest Income.Interest income decreased
21% in 2008 to $5.8 million from $7.3 million in 2007 primarily due to
lower average cash and investment balances as well as lower yields on our
investments.  Interest income increased 99% in 2007 from
$3.7 million in 2006, primarily due to higher average cash and investment
balances.




Interest Expense.Interest expense
decreased 3% in 2008 to $2.7 million from $2.8 million in 2007 and 15%
in 2007 from $3.3 million in 2006.




Other (Expense) Income,
Net.  Other expense, net was $2.1 million in 2008 compared
to other expense, net of $0.8 million in 2007.  The change was
primarily due to the increase in amortization of the asset related to the option
to purchase the equity of Symphony Icon.  We have recorded the value
of the purchase option as an asset, and we are amortizing this asset over the
four-year option period (see Note 10, Arrangements with Symphony Icon,
Inc., of the Notes to Consolidated Financial Statements, for more
information).  Other income, net was $0.4 million in
2006.




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Noncontrolling
Interest in Symphony Icon, Inc.




For the
years ended December 31, 2008, 2007 and 2006, the losses attributed to the
noncontrolling interest holders of Symphony Icon were $20.0 million,
$12.4 million and none, respectively.




Net
Loss and Net Loss per Common Share




Net Loss and Net Loss per Common
Share.  Net loss increased to $76.9 million in 2008 from
$58.8 million in 2007 and $54.3 million in 2006.  Net loss
per common share decreased to $0.56 in 2008 from $0.59 in 2007 and $0.81 in
2006.




Liquidity
and Capital Resources




We have
financed our operations from inception primarily through sales of common and
preferred stock, contract and milestone payments to us under our drug discovery
and development collaborations, target validation, database subscription and
technology license agreements, government grants and contracts, and financing
obtained under debt and lease arrangements.  We have also financed
certain of our research and development activities under our agreements with
Symphony Icon, Inc.  From our inception through December 31, 2008, we
had received net proceeds of $550.0 million from issuances of common and
preferred stock, including $203.2 million of net proceeds from the initial
public offering of our common stock in April 2000, $50.1 million from our
July 2003 common stock offering, $37.5 million from our October 2006 common
stock offering and $198.0 million from our August 2007 sale of common stock to
Invus, L.P.  In addition, from our inception through December 31,
2008, we received $443.0 million in cash payments from drug discovery and
development collaborations, target validation, database subscription and
technology license agreements, sales of compound libraries and reagents and
government grants and contracts, of which $424.0 million had been
recognized as revenues through December 31, 2008.




As of
December 31, 2008, we had $142.2 million in cash, cash equivalents and
investments, including $55.7 million of auction rate securities and related
rights as discussed below in Disclosure about Market Risk, and
$16.6 million in investments held by Symphony Icon.  We had
$222.1 million in cash, cash equivalents and short-term investments as of
December 31, 2007.  We used cash of $95.6 million in operations
in 2008.  This consisted primarily of the net loss for the year of
$76.9 million, a $20.0 million loss attributable to noncontrolling
interest, a $14.3 million decrease in deferred revenue, a
$12.1 million non-cash gain on auction rate security rights and a net
increase in other operating assets net of liabilities of $2.3 million,
partially offset by non-cash charges of $13.4 million related to loss on
auction rate securities, $7.9 million related to depreciation expense,
$6.5 million related to stock-based compensation expense and
$2.1 million related to the non-cash amortization of the Symphony Icon
purchase option.  Investing activities provided cash of
$159.4 million in the year ended December 31, 2008, primarily due to
net maturities of investments of $161.6 million, partially offset by
purchases of property and equipment of $2.2 million.  Financing
activities used cash of $0.9 million in the year ended December 31,
2008, due primarily to $0.9 million in principal repayments on our mortgage
loan.




In
January 2009, we entered into a credit line agreement with UBS Bank USA that
provides up to an aggregate amount of $35.9 million in the form of an
uncommitted, demand, revolving line of credit.  We entered into the
credit line in connection with our acceptance of an offer from UBS AG, the
investment bank that sold us our auction rate securities, providing us with
rights to require UBS to purchase our $57.0 million (par value) of auction rate
securities at par value during the period from June 30, 2010 through
July 2, 2012.  The credit line is secured only by these auction
rate securities and advances under the credit line will be made on a “no net
cost” basis, meaning that the interest paid by us on advances will not exceed
the interest or dividends paid to us by the issuer of the auction rate
securities.




In June
2007, we entered into a securities purchase agreement with Invus, L.P, pursuant
to which Invus purchased 50,824,986 shares of our common stock for approximately
$205.4 million in August 2007.  This purchase resulted in Invus’
ownership of 40% of the post-transaction outstanding shares of our common
stock.  Pursuant to the securities purchase agreement, Invus, at its
option, also has the right to require us to initiate up to two pro rata rights
offerings to our stockholders, which would provide all stockholders with
non-transferable rights to acquire shares of our common stock, in an aggregate
amount of up to $344.5 million, less the proceeds of any “qualified
offerings” that we may complete in the interim involving the sale of our common
stock at prices above $4.50 per share.  Invus may exercise its right
to require us to conduct the first rights offering by giving us notice within a
period of 90 days beginning on November 28, 2009 (which we refer to as the
first rights offering trigger date), although we and Invus may agree to change
the first rights offering trigger date to as early as August 28, 2009 with the
approval of the members of our board of directors who are not affiliated with
Invus.  Invus may exercise its right to require us to conduct the
second rights offering by giving us notice within a period of 90 days beginning
on the date that is 12 months after Invus’ exercise of its right to require
us to conduct the first rights offering or, if Invus does not exercise its right
to require us to conduct the first rights offering, within a period of 90 days
beginning on the first anniversary of the first rights offering trigger
date.  The initial investment and subsequent rights offerings,
combined with any qualified offerings, were designed to achieve up to
$550 million in proceeds to us.  Invus would participate in each
rights offering for up to its pro rata portion of the offering, and would commit
to purchase the entire portion of the offering not subscribed for by other
stockholders.


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In
connection with the securities purchase agreement, we entered into a
stockholders’ agreement with Invus under which Invus (a) has specified rights
with respect to designation of directors and participation in future equity
issuances by us, (b) is subject to certain standstill restrictions, as well as
restrictions on transfer and the voting of the shares of common stock held by it
and its affiliates, and (c), as long as Invus holds at least 15% of the total
number of outstanding shares of our common stock, is entitled to certain
minority protections.




In June
2007, we entered into a series of related agreements providing for the financing
of the clinical development of certain of our drug candidates, including LX1031
and LX1032, along with any other pharmaceutical compositions modulating the same
targets as those drug candidates.  Under the financing arrangement, we
licensed to Symphony Icon, a wholly-owned subsidiary of Symphony Icon Holdings
LLC, our intellectual property rights related to the programs and Holdings
contributed $45 million to Symphony Icon in order to fund the clinical
development of the programs.  We also entered into a share purchase
agreement with Holdings under which we issued and sold to Holdings 7,650,622
shares of our common stock in exchange for $15 million and an exclusive option
to acquire all of the equity of Symphony Icon, thereby allowing us to reacquire
the programs.  The purchase option is exercisable by us at any time,
in our sole discretion, until June 15, 2011 at an exercise price of (a) $72
million, if the purchase option is exercised before June 15, 2009, (b) $81
million, if the purchase option is exercised on or after the June 15, 2009 and
before June 15, 2010 and (c) $90 million, if the purchase option is exercised on
or after June 15, 2010 and before June 15, 2011.  The purchase option
exercise price may be paid in cash or a combination of cash and common stock, at
our sole discretion, provided that the common stock portion may not exceed 40%
of the purchase option exercise price.




Upon the
recommendation of Symphony Icon’s development committee, which is comprised of
an equal number of representatives from us and Symphony Icon, Symphony Icon’s
board of directors may require us to pay Symphony Icon up to $15 million for
Symphony Icon’s use in the development of the programs in accordance with the
specified development plan and related development budget.  The
development committee’s right to recommend that Symphony Icon’s board of
directors submit such funding requirement to us will terminate on the one-year
anniversary of the expiration of the purchase option, subject to limited
exceptions.




In April
2004, we obtained a $34.0 million mortgage on our facilities in The Woodlands,
Texas.  The mortgage loan has a ten-year term with a 20-year
amortization and bears interest at a fixed rate of 8.23%.  In May
2002, our subsidiary Lexicon Pharmaceuticals (New Jersey), Inc. signed a
ten-year lease for a 76,000 square-foot facility in Hopewell, New Jersey. 
The term of the lease extends until June 30, 2013.  The lease
provides for an escalating yearly base rent payment of $1.3 million in the first
year, $2.1 million in years two and three, $2.2 million in years four
to six, $2.3 million in years seven to nine and $2.4 million in years
ten and eleven.  We are the guarantor of the obligations of our
subsidiary under the lease.




Including
the lease and debt obligations described above, we had incurred the following
contractual obligations as of December 31, 2008:




Payments
      due by period (in millions)Contractual
      Obligations
                
                Total
                
                
                Less
      than 1 year
                
                
                1-3
      years
                
                
                3-5
      years
                
                
                More
      than 5 yearsDebt
                
                $
                30.5
                
                
                $
                1.0
                
                
                $
                2.2
                
                
                $
                2.6
                
                
                $
                24.7Interest
      payment obligations
                
                
                12.3
                
                
                
                2.5
                
                
                
                4.7
                
                
                
                4.4
                
                
                
                0.7Operating
      leases
                
                
                11.5
                
                
                
                2.5
                
                
                
                5.1
                
                
                
                3.9
                
                
                
                —Licensing
      agreements
                
                
                5.0
                
                
                
                5.0
                
                
                
                —
                
                
                
                —
                
                
                
                —Total
                
                $
                59.3
                
                
                $
                11.0
                
                
                $
                12.0
                
                
                $
                10.9
                
                
                $
                25.4





Our
future capital requirements will be substantial and will depend on many factors,
including our ability to obtain drug discovery and development collaborations
and other collaborations and technology license agreements, the amount and
timing of payments under such agreements, the level and timing of our research
and development expenditures, market acceptance of our products, the resources
we devote to developing and supporting our products and other
factors.  Our capital requirements will also be affected by any
expenditures we make in connection with license agreements and acquisitions of
and investments in complementary technologies and businesses.  We
expect to devote substantial capital resources to continue our research and
development efforts, to expand our support and product development activities,
and for other general corporate activities.  We believe that our
current unrestricted cash and investment balances, the UBS credit line entered
into in January 2009 and cash and revenues we expect to derive from drug
discovery and development collaborations and other collaborations and technology
licenses will be sufficient to fund our operations for at least the next 12
months.  During or after this period, if cash generated by operations
is insufficient to satisfy our liquidity requirements, we will need to sell
additional equity or debt securities or obtain additional credit
arrangements.  Additional financing may not be available on terms
acceptable to us or at all. The sale of additional equity or convertible debt
securities may result in additional dilution to our stockholders.


40
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Disclosure
about Market Risk




We are
exposed to limited market and credit risk on our cash equivalents which have
maturities of three months or less at the time of purchase.  We
maintain a short-term investment portfolio which consists of U.S. Treasury
bills, money market accounts, corporate debt securities and certificates of
deposit that mature three to 12 months from the time of purchase and a long-term
investment portfolio which consists of auction rate securities that mature
greater than 12 months from the time of purchase, which we believe are subject
to limited market and credit risk, other than as discussed below.  We
currently do not hedge interest rate exposure or hold any derivative financial
instruments in our investment portfolio.




At
December 31, 2008, we held $57.0 million (par value), with an estimated fair
value of $43.6 million, of AAA rated investments with an auction interest rate
reset feature, known as auction rate securities.  These notes are
issued by various state agencies for the purpose of financing student
loans.  The securities have historically traded at par and are
redeemable at par plus accrued interest at the option of the
issuer.  Interest is typically paid at the end of each auction period
or semiannually.  Until February 2008, the market for our auction rate
securities was highly liquid.  Starting in February 2008, a
substantial number of auctions “failed,” meaning that there was not enough
demand to sell all of the securities that holders desired to sell at
auction.  The immediate effect of a failed auction is that such
holders cannot sell the securities at auction and the interest rate on the
security generally resets to a maximum interest rate.  In the case of
funds invested by us in auction rate securities which are the subject of a
failed auction, we may not be able to access the funds without a loss of
principal, unless a future auction on these investments is successful or the
issuer redeems the security.  As of December 31, 2008, we
classified the entire auction rate security investment balance as long-term
investments on our consolidated balance sheet because of our inability to
determine when our investments in auction rate securities would be
sold.  We have also modified our current investment strategy to
reallocate our investments more into U.S. treasury securities and U.S.
treasury-backed money market investments.




At
December 31, 2008, observable auction rate securities market information
was not available to determine the fair value of our investments. We have
estimated the fair value of these securities at $43.6 million as of
December 31, 2008 using models of the expected future cash flows related to
the securities and taking into account assumptions about the cash flows of the
underlying student loans, as well as secondary market data.  The
assumptions used in preparing the discounted cash flow model include estimates
of interest rates, timing and amount of cash flows, liquidity premiums and
expected holding periods of the auction rate securities, based on data available
as of December 31, 2008.  The underlying sources of these
assumptions are volatile and the assumptions are subject to change as those
sources and market conditions change.  Because we do not intend to
hold these securities until the par value is recoverable through the auction
process and we believe the decline in fair value is other-than-temporary, we
recorded a loss of $13.4 million in the year ended December 31, 2008 to
reflect the decline in value of these securities, which is shown as loss on
long-term investments in the consolidated statement of operations.  If
the current market conditions deteriorate further, or a recovery in market
values does not occur, we may be required to record additional unrealized or
realized losses in future quarters.




In
November 2008, we accepted an offer from UBS AG, the investment bank that sold
us our auction rate securities, providing us with rights related to our auction
rate securities.  The rights permit us to require UBS to purchase our
$57.0 million (par value) of auction rate securities at par value during the
period from June 30, 2010 through July 2, 2012.  Conversely,
UBS has the right, in its discretion, to purchase or sell the securities at any
time by paying us the par value of such securities.  We expect to
exercise the rights and sell our auction rate securities back to UBS on
June 30, 2010, the earliest date allowable under the rights.




The
enforceability of the rights results in a separate asset that will be measured
at its fair value.  We elected to measure the rights under the fair
value option of SFAS 159, and recorded a gain of approximately
$12.1 million, which is reflected in loss on long-term investments, net,
and recorded a corresponding long-term investment.  As a result of
accepting the rights, we have elected to classify the rights and reclassify our
investments in auction rate securities as trading securities, as defined by SFAS
No. 115.  As a result, we will be required to assess the fair
value of these two individual assets and record changes each period until the
rights are exercised and the auction rate securities are redeemed.  We
expect that subsequent changes in the value of the rights will largely offset
the subsequent fair value movements of the auction rate securities, subject to
the continued expected performance by the investment bank of its obligations
under the agreement.


41
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Excluding
auction rate securities and the related rights, at December 31, 2008, we
had approximately $103.1 million in cash and cash equivalents and
short-term investments, including $16.6 million in investments held by
Symphony Icon.  We believe that the working capital available to us
excluding the funds held in auction rate securities and the UBS credit line
entered into in January 2009 will be sufficient to meet our cash requirements
for at least the next 12 months.




We have
operated primarily in the United States and substantially all sales to date have
been made in U.S. dollars. Accordingly,
we have not had any material exposure to foreign currency rate
fluctuations.




Item
7A.  Quantitativeand Qualitative Disclosures About Market Risk




See
“Disclosure about Market Risk” under “Item 7. Management’s Discussion and
Analysisof
Financial Condition and Results of Operations” for quantitative and qualitative
disclosures about market risk.




Item
8.              FinancialStatements and Supplementary
Data




The
financial statements required by this Item are incorporated under Item 15 in
Part IV of this report.




Item
9.             Changesin
and Disagreements with Accountants on Accounting and Financial
Disclosure




None.




Item
9A.   Controlsand
Procedures




Our
principal executive officer and principal financial officer have concluded that
our disclosure controls and procedures (as defined in rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934) are sufficiently effective
to ensure that the information required to be disclosed by us in the reports we
file under the Securities Exchange Act is gathered, analyzed and disclosed with
adequate timeliness, accuracy and completeness, based on an evaluation of such
controls and procedures as of the end of the period covered by this
report.




Subsequent
to our evaluation, there were no significant changes in internal controls or
other factors that could significantly affect internal controls, including any
corrective actions with regard to significant deficiencies and material
weaknesses.




Management
Report on Internal Control over Financial Reporting




Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f)
under the Securities Exchange Act).




Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.




Our
management assessed the effectiveness of our internal control over financial
reporting as of December 31, 2008.  In making this assessment,
management used the criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission in Internal Control-Integrated
Framework.




Based on
such assessment using those criteria, management believes that, as of December
31, 2008, our internal control over financial reporting is
effective.




Our
independent auditors have also audited our internal control over financial
reporting as of December 31, 2008 as stated in the audit report which
appears on page F-2 and is incorporated under Item 15 in Part IV of
this report.




42
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Item
9B.   Other
Information




None.




43
 Table
of Contents


PART
III




Item
10.               Directors, Executive Officers and Corporate
Governance




The
information required by this Item is hereby incorporated by reference from (a)
the information appearing under the captions “Election of Directors,” “Stock
Ownership of Certain Beneficial Owners and Management,” “Corporate Governance”
and “Executive and Director Compensation” in our definitive proxy statement
which involves the election of directors and is to be filed with the Securities
and Exchange Commission pursuant to the Securities Exchange Act of 1934 within
120 days of the end of our fiscal year on December 31, 2008 and (b) the
information appearing under Item 1 in Part Iof this
report.




Item
11.   ExecutiveCompensation




The
information required by this Item is hereby incorporated by reference from the
information appearing under the captions “Corporate Governance” and “Executive
and Director Compensation” in our definitive proxy statement which involves the
election of directors and is to be filed with the Commission pursuant to the
Securities Exchange Act of 1934 within 120 days of the end of our fiscal year on
December 31, 2008. Notwithstanding the foregoing, in accordance with the
instructions to Item 407(e)(5) of Regulation S-K, the information contained in
our proxy statement under the sub-heading “Compensation Committee Report” shall
not be deemed to be filed as part of or incorporated by reference into this
annual report on Form 10-K.




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




The
information required by this Item is hereby incorporated by reference from the
information appearing under the captions “Stock Ownership of Certain Beneficial
Owners and Management” and “Equity Compensation Plan Information” in our
definitive proxy statement which involves the election of directors and is to be
filed with the Commission pursuant to the Securities Exchange Act of 1934 within
120 days of the end of our fiscal year on December 31, 2008.




Item
13.          CertainRelationships and Related Transactions,
and Director Independence




The
information required by this Item is hereby incorporated by reference from the
information appearing under the captions “Corporate Governance” and
“Transactions with Related Persons” in our definitive proxy statement which
involves the election of directors and is to be filed with the Commission
pursuant to the Securities Exchange Act of 1934 within 120 days of the end of
our fiscal year on December 31, 2008.




Item
14.          PrincipalAccounting Fees and Services




The
information required by this Item as to the fees we pay our principal accountant
is hereby incorporated by reference from the information appearing under the
caption “Ratification and Approval of Independent Auditors” in our definitive
proxy statement which involves the election of directors and is to be filed with
the Commission pursuant to the Securities Exchange Act of 1934 within 120 days
of the end of our fiscal year on December 31, 2008.




44
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PART
IV




Item
15.           Exhibitsand
Financial Statement Schedules




(a)
            Documents
      filed as a part of this report:




1.           Consolidated
Financial Statements




PageReport
      of Independent Registered Public Accounting Firm
            F-1Report
      of Independent Registered Public Accounting Firm
            F-2Consolidated
      Balance Sheets
            F-3Consolidated
      Statements of Operations
            F-4Consolidated
      Statements of Stockholders’ Equity
            F-5Consolidated
      Statements of Cash Flows
            F-6Notes
      to Consolidated Financial Statements
            F-7





2.           Financial
Statement Schedules




All other
financial statement schedules are omitted because they are not applicable or not
required, or because the required information is included in the financial
statements or notes thereto.




3.           Exhibits




Exhibit
      No.
                
                Description3.1
                —
                Restated
      Certificate of Incorporation (filed as Exhibit 3.1 to the Company’s
      Registration Statement on Form S-1 (Registration No. 333-96469) and
      incorporated by reference herein).3.2
                —
                First
      Certificate of Amendment to Restated Certificate of Incorporation (filed
      as Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the period
      ended December 31, 2007 and incorporated by reference
    herein).3.3
                —
                Second
      Certificate of Amendment to Restated Certificate of Incorporation (filed
      as Exhibit 3.3 to the Company’s Annual Report on Form 10-K for the period
      ended December 31, 2007 and incorporated by reference
    herein).3.4
                —
                Amended
      and Restated Bylaws (filed as Exhibit 3.1 to the Company’s Current Report
      on Form 8-K dated October 24, 2007 and incorporated by reference
      herein).4.1
                —
                Securities
      Purchase Agreement, dated June 17, 2007, with Invus, L.P. (filed as
      Exhibit 10.1 to the Company’s Current Report on Form 8-K dated June 17,
      2007 and incorporated by reference herein).4.2
                —
                Registration
      Rights Agreement, dated June 17, 2007, with Invus, L.P. (filed as Exhibit
      10.3 to the Company’s Current Report on Form 8-K dated June 17, 2007 and
      incorporated by reference herein).4.3
                —
                Stockholders’
      Agreement, dated June 17, 2007, with Invus, L.P. (filed as Exhibit 10.4 to
      the Company’s Current Report on Form 8-K dated June 17, 2007 and
      incorporated by reference herein).10.1
                —
                Restated
      Employment Agreement with Arthur T. Sands, M.D., Ph.D. (filed as Exhibit
      10.1 to the Company’s Annual Report on Form 10-K for the period ended
      December 31, 2005 and incorporated by reference
herein).10.2
                —
                Employment
      Agreement with Alan Main, Ph.D. (filed as Exhibit 10.1 to the Company’s
      Quarterly Report on Form 10-Q for the period ended September 30, 2001 and
      incorporated by reference herein).10.3
                —
                Employment
      Agreement with Jeffrey L. Wade, J.D. (filed as Exhibit 10.3 to the
      Company’s Registration Statement on Form S-1 (Registration No. 333-96469)
      and incorporated by reference
herein).






45
 Table
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Exhibit
      No.
                
                Description10.4
                —
                Employment
      Agreement with Brian P. Zambrowicz, Ph.D. (filed as Exhibit 10.4 to the
      Company’s Registration Statement on Form S-1 (Registration No. 333-96469)
      and incorporated by reference herein).10.5
                —
                Employment
      Agreement with Julia P. Gregory (filed as Exhibit 10.5 to the Company’s
      Registration Statement on Form S-1 (Registration No. 333-96469) and
      incorporated by reference herein).10.6
                —
                Consulting
      Agreement with Alan S. Nies, M.D. dated February 19, 2003, as amended
      (filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for
      the period ended March 31, 2004 and incorporated by reference
      herein).10.7
                —
                Consulting
      Agreement with Robert J. Lefkowitz, M.D. dated March 31, 2003 (filed as
      Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period
      ended March 31, 2003 and incorporated by reference
      herein).10.8
                —
                Consulting
      Agreement with Julia P. Gregory dated April 29, 2008 (filed as Exhibit
      10.1 to the Company’s Current Report on Form 8-K dated April 29, 2008 and
      incorporated by reference herein).10.9
                —
                Form
      of Indemnification Agreement with Officers and Directors (filed as Exhibit
      10.7 to the Company’s Registration Statement on Form S-1 (Registration No.
      333-96469) and incorporated by reference herein).10.10
                —
                Summary
      of Non-Employee Director Compensation (filed as Exhibit 10.11 to the
      Company’s Annual Report on Form 10-K for the period ended December 31,
      2005 and incorporated by reference herein).10.11
                —
                Summary
      of 2009 Named Executive Officer Cash Compensation (filed as Exhibit 10.1
      to the Company’s Current Report on Form 8-K dated February 12, 2009 and
      incorporated by reference herein).10.12
                —
                2000
      Equity Incentive Plan (filed as Exhibit 10.10 to the Company’s Annual
      Report on Form 10-K for the period ended December 31, 2004 and
      incorporated by reference herein).10.13
                —
                2000
      Non-Employee Directors’ Stock Option Plan (filed as Exhibit 10.14 to the
      Company’s Annual Report on Form 10-K for the period ended December 31,
      2005 and incorporated by reference herein).10.14
                —
                Coelacanth
      Corporation 1999 Stock Option Plan (filed as Exhibit 99.1 to the Company’s
      Registration Statement on Form S-8 (Registration No. 333-66380) and
      incorporated by reference herein).10.15
                —
                Form
      of Stock Option Agreement with Chairman of Board of Directors under the
      2000 Equity Incentive Plan (filed as Exhibit 10.17 to the Company’s Annual
      Report on Form 10-K for the period ended December 31, 2005 and
      incorporated by reference herein).10.16
                —
                Form
      of Stock Option Agreement with Directors under the 2000 Non-Employee
      Directors’ Stock Option Plan (filed as Exhibit 10.3 to the Company’s
      Quarterly Report on Form 10-Q for the period ended September 30, 2004 and
      incorporated by reference herein).10.17
                —
                Form
      of Stock Option Agreement with Officers under the 2000 Equity Incentive
      Plan (filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K
      dated February 7, 2008 and incorporated by reference
    herein).10.18
                —
                Form
      of Restricted Stock Bonus Agreement with Officers under the 2000 Equity
      Incentive Plan (filed as Exhibit 10.2 to the Company’s Current Report on
      Form 8-K dated February 12, 2009 and incorporated by reference
      herein).†10.19
                —
                Collaboration
      and License Agreement, dated December 17, 2003, with Bristol-Myers
      Squibb Company (filed as Exhibit 10.15 to the amendment to the Company’s
      Annual Report on Form 10-K/A for the period ended December 31, 2003, as
      filed on July 16, 2004, and incorporated by reference
    herein).






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 Table
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Exhibit
      No.
              
              Description†10.20
              —
              First
      Amendment, dated May 30, 2006, to Collaboration and License Agreement,
      dated December 17, 2003, with Bristol-Myers Squibb Company (filed as
      Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the period
      ended June 30, 2006, and incorporated by reference
  herein).†10.21
              —
              Collaboration
      Agreement, dated July 27, 2004, with Takeda Pharmaceutical Company Limited
      (filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for
      the period ended September 30, 2004 and incorporated by reference
      herein).†10.22
              —
              Collaboration
      and License Agreement, dated May 16, 2005, with N.V. Organon and (only
      with respect to Section 9.4 thereof) Intervet Inc. (filed as Exhibit 10.1
      to the Company’s Quarterly Report on Form 10-Q for the period ended June
      30, 2005 and incorporated by reference herein).†10.23
              —
              Second
      Amended and Restated Collaboration and License Agreement, dated November
      30, 2005, with Genentech, Inc. (filed as Exhibit 10.22 to the Company’s
      Annual Report on Form 10-K for the period ended December 31, 2005 and
      incorporated by reference herein).10.24
              —
              Economic
      Development Agreement dated July 15, 2005, with the State of Texas and the
      Texas A&M University System (filed as Exhibit 10.1 to the Company’s
      Quarterly Report on Form 10-Q for the period ended September 30, 2005 and
      incorporated by reference herein).10.25
              —
              Amendment,
      dated April 30, 2008, to Economic Development Agreement, dated July 15,
      2005, with the State of Texas and the Texas A&M University System
      (filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K dated
      April 30, 2008 and incorporated by reference herein).†10.26
              —
              Collaboration
      and License Agreement, dated July 15, 2005, with the Texas A&M
      University System and the Texas Institute for Genomic Medicine (filed as
      Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the
      period ended September 30, 2005 and incorporated by reference
      herein).†10.27
              —
              Novated
      and Restated Technology License Agreement, dated June 15, 2007, with
      Symphony Icon Holdings LLC and Symphony Icon, Inc. (filed as Exhibit 10.1
      to the Company’s Quarterly Report on Form 10-Q for the period ended June
      30, 2007 and incorporated by reference herein).†10.28
              —
              Amended
      and Restated Research and Development Agreement, dated June 15, 2007, with
      Symphony Icon Holdings LLC and Symphony Icon, Inc. (filed as Exhibit 10.2
      to the Company’s Quarterly Report on Form 10-Q for the period ended June
      30, 2007 and incorporated by reference herein).†10.29
              —
              Purchase
      Option Agreement, dated June 15, 2007, with Symphony Icon Holdings LLC and
      Symphony Icon, Inc. (filed as Exhibit 10.3 to the Company’s Quarterly
      Report on Form 10-Q for the period ended June 30, 2007 and incorporated by
      reference herein).†10.30
              —
              Research
      Cost Sharing, Payment and Extension Agreement, dated June 15, 2007, with
      Symphony Icon Holdings LLC and Symphony Icon, Inc. (filed as Exhibit 10.4
      to the Company’s Quarterly Report on Form 10-Q for the period ended June
      30, 2007 and incorporated by reference herein).10.31
              —
              Credit
      Line Agreement, dated January 27, 2009, with UBS Bank USA (filed as
      Exhibit 10.1 to the Company’s Current Report on Form 8-K dated January 27,
      2009 and incorporated by reference herein).10.32
              —
              Loan
      and Security Agreement, dated April 21, 2004, between Lex-Gen Woodlands,
      L.P. and iStar Financial Inc. (filed as Exhibit 10.18 to the Company’s
      Annual Report on Form 10-K for the period ended December 31, 2004 and
      incorporated by reference
herein).




47
 Table
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Exhibit
      No.
                
                Description10.33
                —
                Lease
      Agreement, dated May 23, 2002, between Lexicon Pharmaceuticals (New
      Jersey), Inc. and Townsend Property Trust Limited Partnership (filed as
      Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the
      period ended June 30, 2002 and incorporated by reference
      herein).21.1
                —
                Subsidiaries
      (filed as Exhibit 21.1 to the Company’s Annual Report on Form 10-K for the
      year ended December 31, 2004 and incorporated by reference
      herein).*23.1
                —
                Consent
      of Independent Registered Public Accounting Firm*24.1
                —
                Power
      of Attorney (contained in signature page)*31.1
                —
                Certification
      of Principal Executive Officer Pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002*31.2
                —
                Certification
      of Principal Financial Officer Pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002*32.1
                —
                Certification
      of Principal Executive and Principal Financial Officers Pursuant to
      Section 906 of the Sarbanes-Oxley Act of
2002
 
  *
                Filed
      herewith.†
                Confidential
      treatment has been requested for a portion of this exhibit.  The
      confidential portions of this exhibit have been omitted and filed
      separately with the Securities and Exchange
  Commission.




48
 Table
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Signatures




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




Lexicon
      Pharmaceuticals, Inc.Date:  March
      4, 2009
            By:
            /s/
      Arthur T. SandsArthur
      T. Sands, M.D., Ph.D.President
      and Chief Executive OfficerDate:  March
      4, 2009
            By:
            /s/
      James F. TessmerJames
      F. TessmerVice
      President, Finance and Accounting





Power
of Attorney




KNOW ALL
PERSONS BY THESE PRESENTS, that each person whose signature appears below
constitutes and appoints Jeffrey L. Wade and James F. Tessmer, or either of
them, each with the power of substitution, his or her attorney-in-fact, to sign
any amendments to this Form 10-K, and to file the same, with exhibits thereto
and other documents in connection therewith, with the Securities and Exchange
Commission, here ratifying and confirming all that each of said
attorneys-in-fact, or his or her substitute or substitutes, may do or cause to
be done by virtue hereof.




Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.




Signature
              Title
              Date/s/
      Arthur T. Sands
              
              President
      and Chief Executive Officer
                (Principal
      Executive Officer)
              March
      4, 2009Arthur
      T. Sands, M.D., Ph.D./s/
      James F. Tessmer
              
              Vice
      President, Finance and Accounting
                (Principal
      Financial and Accounting Officer)
              March
      4, 2009James
      F. Tessmer/s/
      Samuel L. Barker
              
              Chairman
      of the Board of Directors
              March
      4, 2009Samuel
      L. Barker, Ph.D./s/
      Philippe J. Amouyal
              
              Director
              March
      4, 2009Philippe
      J. Amouyal/s/
      Raymond Debbane
              
              Director
              March
      4, 2009Raymond
      Debbane/s/
      Robert J. Lefkowitz
              
              Director
              March
      4, 2009Robert
      J. Lefkowitz, M.D./s/
      Alan S. Nies
              
              Director
              March
      4, 2009Alan
      S. Nies, M.D./s/
      Frank P. Palantoni
              
              Director
              March
      4, 2009Frank
      P. Palantoni/s/
      Christopher J. Sobecki
              
              Director
              March
      4, 2009Christopher
      J. Sobecki/s/
      Judith L. Swain
              
              Director
              March
      4, 2009Judith
      L. Swain, M.D./s/
      Kathleen M. Wiltsey
              
              Director
              March
      4, 2009Kathleen
      M. Wiltsey






49
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Report
of Independent
 Registered
Public Accounting Firm
  
 
 The Board
of Directors and Stockholders
 of
Lexicon Pharmaceuticals, Inc.:
  We have
audited the accompanying consolidated balance sheets of Lexicon Pharmaceuticals,
Inc. and subsidiaries as of December 31, 2008 and 2007, and the related
consolidated statements of operations, stockholders’ equity, and cash flows for
each of the three years in the period ended December 31, 2008.  These
financial statements are the responsibility of the Company’s
management.  Our responsibility is to express an opinion on these
financial statements based on our audits.
  We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
  In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Lexicon
Pharmaceuticals, Inc. and subsidiaries as of December 31, 2008 and 2007,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 2008, in conformity
with U.S. generally accepted accounting principles.
  We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), Lexicon Pharmaceuticals, Inc.’s internal
control over financial reporting as of December 31, 2008, based on criteria
established in Internal Control—Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission and our report dated
March 3, 2009 expressed an unqualified opinion thereon.
  
 /s/ Ernst & Young
LLP
 
 Houston,
Texas
 March 3,
2009
   F-1
 Table
of Contents
 Report
of Independent
 Registered
Public Accounting Firm
  
 The Board
of Directors and Stockholders
 of
Lexicon Pharmaceuticals, Inc.:
 
 We have
audited Lexicon Pharmaceuticals, Inc.’s  internal control over
financial reporting as of December 31, 2008, based on criteria established
in Internal Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the COSO criteria). Lexicon
Pharmaceuticals, Inc.’s management is responsible for maintaining effective
internal control over financial reporting, and for its assessment of the
effectiveness of internal control over financial reporting included in the
accompanying Management Report on Internal Control over Financial Reporting. Our
responsibility is to express an opinion on the company’s internal control over
financial reporting based on our audit.
  We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, testing
and evaluating the design and operating effectiveness of internal control based
on the assessed risk, and performing such other procedures as we considered
necessary in the circumstances. We believe that our audit provides a reasonable
basis for our opinion.
  A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that receipts and expenditures of
the company are being made only in accordance with authorizations of management
and directors of the company; and (3) provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use or
disposition of the company’s assets that could have a material effect on the
financial statements.
  Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
  In our
opinion, Lexicon Pharmaceuticals, Inc. maintained, in all material respects,
effective internal control over financial reporting as of December 31,
2008, based on the COSO criteria.
  We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of Lexicon
Pharmaceuticals, Inc. and subsidiaries as of December 31, 2008 and 2007,
and the related consolidated statements of operations, stockholders’ equity, and
cash flows for each of the three years in the period ended December 31,
2008 and our report dated March 3, 2009 expressed an unqualified opinion
thereon.
  
 /s/ Ernst & Young
LLP
 
 
 Houston,
Texas
 March 3,
2009
   F-2
 Table
of Contents
 Lexicon
Pharmaceuticals, Inc.
  Consolidated
Balance Sheets
 (In
thousands, except par value)
  As
      of December 31,2008
                          
                          
                          2007AssetsCurrent
      assets:Cash and cash equivalents
                          
                          $
                          85,873
                          
                          
                          $
                          22,938Short-term investments,
      including restricted investments of $430
                          
                          
                          629
                          
                          
                          
                          199,171Short-term investments held by
      Symphony Icon, Inc.
                          
                          
                          16,610
                          
                          
                          
                          36,666Accounts receivable, net of
      allowances of $35
                          
                          
                          568
                          
                          
                          
                          1,763Prepaid expenses and other
      current assets
                          
                          
                          5,487
                          
                          
                          
                          4,112Total current assets
                          
                          
                          109,167
                          
                          
                          
                          264,650Long-term
      investments
                          
                          
                          55,686
                          
                          
                          
                          —Property
      and equipment, net of accumulated depreciation and amortization of $71,102
      and $65,004, respectively
                          
                          
                          65,087
                          
                          
                          
                          70,829Goodwill
                          
                          
                          25,798
                          
                          
                          
                          25,798Other
      assets
                          
                          
                          5,770
                          
                          
                          
                          8,019Total assets
                          
                          $
                          261,508
                          
                          
                          $
                          369,296Liabilities,
      Noncontrolling Interest and Stockholders’ EquityCurrent
      liabilities:Accounts payable
                          
                          $
                          7,926
                          
                          
                          $
                          7,344Accrued liabilities
                          
                          
                          6,615
                          
                          
                          
                          9,093Current portion of deferred
      revenue
                          
                          
                          5,672
                          
                          
                          
                          18,030Current portion of long-term
      debt
                          
                          
                          963
                          
                          
                          
                          880Total current liabilities
                          
                          
                          21,176
                          
                          
                          
                          35,347Deferred
      revenue, net of current portion
                          
                          
                          14,212
                          
                          
                          
                          16,126Long-term
      debt
                          
                          
                          29,529
                          
                          
                          
                          30,493Other
      long-term liabilities
                          
                          
                          764
                          
                          
                          
                          759Total liabilities
                          
                          
                          65,681
                          
                          
                          
                          82,725Noncontrolling
      interest in Symphony Icon, Inc.
                          
                          
                          10,247
                          
                          
                          
                          30,271Commitments
      and contingenciesStockholders’
      equity:Preferred stock, $.01 par
      value; 5,000 shares authorized; no shares issued and
      outstanding
                          
                          
                          —
                          
                          
                          
                          —Common stock, $.001 par value;
      300,000 shares authorized; 136,797 and 136,796 shares issued and
      outstanding, respectively
                          
                          
                          137
                          
                          
                          
                          137Additional paid-in capital
                          
                          
                          672,838
                          
                          
                          
                          666,702Accumulated deficit
                          
                          
                          (487,395
                          )
                          
                          
                          (410,535
                          )Accumulated other
      comprehensive loss
                          
                          
                          —
                          
                          
                          
                          (4
                          )Total stockholders’ equity
                          
                          
                          185,580
                          
                          
                          
                          256,300Total liabilities and
      stockholders’ equity
                          
                          $
                          261,508
                          
                          
                          $
                          369,296
 The
accompanying notes are an integral part of these consolidated financial
statements.
  F-3
 Table
of Contents
  Lexicon
Pharmaceuticals, Inc.
  Consolidated
Statements of Operations
 (In
thousands, except per share amounts)
  
 Year
      Ended December 31,2008
                            
                            
                            2007
                            
                            
                            2006Revenues:Collaborative research
                            
                            $
                            27,177
                            
                            
                            $
                            48,080
                            
                            
                            $
                            68,373Subscription and license fees
                            
                            
                            5,144
                            
                            
                            
                            2,038
                            
                            
                            
                            4,425Total revenues
                            
                            
                            32,321
                            
                            
                            
                            50,118
                            
                            
                            
                            72,798Operating
      expenses:Research and development,
      including stock-based compensation of $3,941, $5,150 and $4,394,
      respectively
                            
                            
                            108,575
                            
                            
                            
                            104,332
                            
                            
                            
                            106,695General and administrative,
      including stock-based compensation of $2,559, $2,776 and $2,636,
      respectively
                            
                            
                            20,281
                            
                            
                            
                            20,740
                            
                            
                            
                            21,334Total operating
      expenses
                            
                            
                            128,856
                            
                            
                            
                            125,072
                            
                            
                            
                            128,029Loss
      from operations
                            
                            
                            (96,535
                            )
                            
                            
                            (74,954
                            )
                            
                            
                            (55,231
                            )Loss
      on long-term investments, net
                            
                            
                            (1,314
                            )
                            
                            
                            —
                            
                            
                            
                            —Interest
      income
                            
                            
                            5,762
                            
                            
                            
                            7,286
                            
                            
                            
                            3,653Interest
      expense
                            
                            
                            (2,691
                            )
                            
                            
                            (2,771
                            )
                            
                            
                            (3,253
                            )Other
      (expense) income, net
                            
                            
                            (2,106
                            )
                            
                            
                            (794
                            )
                            
                            
                            401Loss
      before noncontrolling interest in Symphony Icon, Inc.
                            
                            
                            (96,884
                            )
                            
                            
                            (71,233
                            )
                            
                            
                            (54,430
                            )Loss
      attributable to noncontrolling interest in Symphony Icon,
    Inc.
                            
                            
                            20,024
                            
                            
                            
                            12,439
                            
                            
                            
                            —Loss
      before taxes
                            
                            
                            (76,860
                            )
                            
                            
                            (58,794
                            )
                            
                            
                            (54,430
                            )Income
      tax provision
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            119Net
      loss
                            
                            $
                            (76,860
                            )
                            
                            $
                            (58,794
                            )
                            
                            $
                            (54,311
                            )Net
      loss per common share, basic and diluted
                            
                            $
                            (0.56
                            )
                            
                            $
                            (0.59
                            )
                            
                            $
                            (0.81
                            )Shares
      used in computing net loss per common share, basic and
    diluted
                            
                            
                            136,797
                            
                            
                            
                            99,798
                            
                            
                            
                            66,876
 
  The
accompanying notes are an integral part of these consolidated financial
statements.
 
  F-4
 Table
of Contents
 
 Lexicon
Pharmaceuticals, Inc.
  Consolidated
Statements of Stockholders’ Equity
 (In
thousands)
  Common
      StockShares
                      
                      Par
      Value
                      
                      
                      Additional
                        Paid-In
                        Capital
                      
                      
                      Deferred
                        Stock
                        Compensation
                      
                      
                      Accumulated
                        Deficit
                      
                      
                      Accumulated
      Other Comprehensive
                        Loss
                      
                      
                      Total
                        Stockholders’
                        EquityBalance
      at December 31, 2005
                      
                      
                      64,554
                      
                      
                      $
                      64
                      
                      
                      $
                      383,222
                      
                      
                      $
                      (2
                      )
                      
                      $
                      (297,430
                      )
                      
                      $
                      (52
                      )
                      
                      $
                      85,802Stock-based
      compensation
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      7,030
                      
                      
                      
                      2
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      7,032Direct
      placement of common stock, net of offering costs
                      
                      
                      11,582
                      
                      
                      
                      12
                      
                      
                      
                      41,084
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      41,096Common
      stock issued for note repayment
                      
                      
                      1,512
                      
                      
                      
                      2
                      
                      
                      
                      5,489
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      5,491Exercise
      of common stock options
                      
                      
                      156
                      
                      
                      
                      —
                      
                      
                      
                      355
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      355Net
      loss
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      (54,311
                      )
                      
                      
                      —
                      
                      
                      
                      (54,311
                      )Unrealized
      gain on investments
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      36
                      
                      
                      
                      36Comprehensive
      loss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (54,275
                      )Balance
      at December 31, 2006
                      
                      
                      77,804
                      
                      
                      
                      78
                      
                      
                      
                      437,180
                      
                      
                      
                      —
                      
                      
                      
                      (351,741
                      )
                      
                      
                      (16
                      )
                      
                      
                      85,501Stock-based
      compensation
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      7,926
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      7,926Issuance
      of common stock to Invus, L.P., net of fees
                      
                      
                      50,825
                      
                      
                      
                      51
                      
                      
                      
                      197,911
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      197,962Issuance
      of common stock to Symphony Holdings, LLC, net of fees
                      
                      
                      7,651
                      
                      
                      
                      8
                      
                      
                      
                      22,793
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      22,801Issuance
      of common stock
                      
                      
                      516
                      
                      
                      
                      —
                      
                      
                      
                      892
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      892Net
      loss
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      (58,794
                      )
                      
                      
                      —
                      
                      
                      
                      (58,794
                      )Unrealized
      gain on investments
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      12
                      
                      
                      
                      12Comprehensive
      loss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (58,782
                      )Balance
      at December 31, 2007
                      
                      
                      136,796
                      
                      
                      
                      137
                      
                      
                      
                      666,702
                      
                      
                      
                      —
                      
                      
                      
                      (410,535
                      )
                      
                      
                      (4
                      )
                      
                      
                      256,300Stock-based
      compensation
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      6,135
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      6,135Exercise
      of common stock options
                      
                      
                      1
                      
                      
                      
                      —
                      
                      
                      
                      1
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      1Net
      loss
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      (76,860
                      )
                      
                      
                      —
                      
                      
                      
                      (76,860
                      )Unrealized
      gain on investments
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      4
                      
                      
                      
                      4Comprehensive
      loss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (76,856
                      )Balance
      at December 31, 2008
                      
                      
                      136,797
                      
                      
                      $
                      137
                      
                      
                      $
                      672,838
                      
                      
                      $
                      —
                      
                      
                      $
                      (487,395
                      )
                      
                      $
                      —
                      
                      
                      $
                      185,580
  The
accompanying notes are an integral part of these consolidated financial
statements.
  F-5
 Table
of Contents
  Lexicon
Pharmaceuticals, Inc.
  Consolidated
Statements of Cash Flows
 (In
thousands)
  Year
      Ended December 31,2008
                          
                          
                          2007
                          
                          
                          2006Cash
      flows from operating activities:Net loss
                          
                          $
                          (76,860
                          )
                          
                          $
                          (58,794
                          )
                          
                          $
                          (54,311
                          )Adjustments to reconcile net
      loss to net cash used in operating activities:Depreciation
                          
                          
                          7,929
                          
                          
                          
                          9,262
                          
                          
                          
                          10,561Amortization of intangible
      assets, other than goodwill
                          
                          
                          —
                          
                          
                          
                          —
                          
                          
                          
                          640Amortization of Symphony Icon
      purchase option
                          
                          
                          2,141
                          
                          
                          
                          1,160
                          
                          
                          
                          —Loss attributable to
      noncontrolling interest
                          
                          
                          (20,024
                          )
                          
                          
                          (12,439
                          )
                          
                          
                          —Stock-based compensation
                          
                          
                          6,500
                          
                          
                          
                          7,926
                          
                          
                          
                          7,030Loss on auction rate securities
                          
                          
                          13,374
                          
                          
                          
                          —
                          
                          
                          
                          —Gain on ARS Rights
                          
                          
                          (12,060
                          )
                          
                          
                          —
                          
                          
                          
                          —Loss on disposal of property and
      equipment
                          
                          
                          —
                          
                          
                          
                          —
                          
                          
                          
                          35Changes in operating assets and
      liabilities:(Increase) decrease in
      receivables
                          
                          
                          1,195
                          
                          
                          
                          (577
                          )
                          
                          
                          1,423(Increase) decrease in prepaid
      expenses and other current assets
                          
                          
                          (1,375
                          )
                          
                          
                          255
                          
                          
                          
                          (623
                          )Decrease in other assets
                          
                          
                          108
                          
                          
                          
                          109
                          
                          
                          
                          240Increase (decrease) in accounts
      payable and other liabilities
                          
                          
                          (2,256
                          )
                          
                          
                          2,619
                          
                          
                          
                          1,678Decrease in deferred revenue
                          
                          
                          (14,272
                          )
                          
                          
                          (23,844
                          )
                          
                          
                          (23,582
                          )Net cash used in operating
      activities
                          
                          
                          (95,600
                          )
                          
                          
                          (74,323
                          )
                          
                          
                          (56,909
                          )Cash
      flows from investing activities:Purchases of property and
      equipment
                          
                          
                          (2,187
                          )
                          
                          
                          (1,900
                          )
                          
                          
                          (3,579
                          )Proceeds from disposal of
      property and equipment
                          
                          
                          —
                          
                          
                          
                          1
                          
                          
                          
                          56Purchases of investments held
      by Symphony Icon, Inc.
                          
                          
                          —
                          
                          
                          
                          (44,991
                          )
                          
                          
                          —Maturities of investments held
      by Symphony Icon, Inc.
                          
                          
                          20,056
                          
                          
                          
                          8,325
                          
                          
                          
                          —Purchase of short-term
      investments
                          
                          
                          (39,847
                          )
                          
                          
                          (260,739
                          )
                          
                          
                          (67,688
                          )Sale of short-term investments
                          
                          
                          181,393
                          
                          
                          
                          111,353
                          
                          
                          
                          95,676Net cash provided by (used in)
      investing activities
                          
                          
                          159,415
                          
                          
                          
                          (187,951
                          )
                          
                          
                          24,465Cash
      flows from financing activities:Proceeds from issuance of
      common stock to Invus, L.P., net of fees
                          
                          
                          —
                          
                          
                          
                          197,962
                          
                          
                          
                          —Proceeds from issuance of
      common stock to Symphony Holdings, LLC, net of fees
                          
                          
                          —
                          
                          
                          
                          14,237
                          
                          
                          
                          —Proceeds from issuance of
      common stock
                          
                          
                          1
                          
                          
                          
                          892
                          
                          
                          
                          41,451Repayment of debt borrowings
                          
                          
                          (881
                          )
                          
                          
                          (815
                          )
                          
                          
                          (751
                          )Proceeds from purchase of
      noncontrolling interest by preferred shareholders of Symphony Icon,
      Inc.
                          
                          
                          —
                          
                          
                          
                          42,710
                          
                          
                          
                          —Net cash provided by (used in)
      financing activities
                          
                          
                          (880
                          )
                          
                          
                          254,986
                          
                          
                          
                          40,700Net
      increase (decrease) in cash and cash equivalents
                          
                          
                          62,935
                          
                          
                          
                          (7,288
                          )
                          
                          
                          8,256Cash
      and cash equivalents at beginning of year
                          
                          
                          22,938
                          
                          
                          
                          30,226
                          
                          
                          
                          21,970Cash
      and cash equivalents at end of year
                          
                          $
                          85,873
                          
                          
                          $
                          22,938
                          
                          
                          $
                          30,226Supplemental
      disclosure of cash flow information:Cash paid for interest
                          
                          $
                          2,599
                          
                          
                          $
                          2,665
                          
                          
                          $
                          2,725Supplemental
      disclosure of noncash investing and financing activities:Common
      stock issued for purchase option in conjunction with Symphony Icon
      financing
                          
                          $
                          —
                          
                          
                          $
                          8,564
                          
                          
                          $
                          —Unrealized
      gain on investments
                          
                          $
                          4
                          
                          
                          $
                          12
                          
                          
                          $
                          36Deferred
      stock compensation, net of reversals
                          
                          $
                          —
                          
                          
                          $
                          —
                          
                          
                          $
                          2Issuance
      of common stock to repay note and accrued interest
                          
                          $
                          —
                          
                          
                          $
                          —
                          
                          
                          $
                          5,491
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
 F-6
 Table
of Contents
 Lexicon
Pharmaceuticals, Inc.
  Notes
to Consolidated Financial Statements
  December
31, 2008
  1. Organization
and Operations
  Lexicon
Pharmaceuticals, Inc. (“Lexicon” or the “Company”) is a Delaware corporation
incorporated on July 7, 1995. Lexicon was organized to discover the
functions and pharmaceutical utility of genes and use those gene function
discoveries in the discovery and development of pharmaceutical products for the
treatment of human disease.
  Lexicon
has financed its operations from inception primarily through sales of common and
preferred stock, payments received under collaboration and alliance agreements,
database subscription agreements, government grants and contracts, technology
licenses, and financing obtained under debt and lease arrangements. The
Company’s future success is dependent upon many factors, including, but not
limited to, its ability to discover and develop pharmaceutical products for the
treatment of human disease, discover additional promising candidates for drug
discovery and development using its gene knockout technology, establish
additional collaboration and license agreements, achieve milestones under such
agreements, obtain and enforce patents and other proprietary rights in its
discoveries, comply with federal and state regulations, and maintain sufficient
capital to fund its activities.  As a result of the aforementioned
factors and the related uncertainties, there can be no assurance of the
Company’s future success.
  2. Summary of
Significant Accounting Policies
  Basis of Presentation:The
accompanying consolidated financial statements include the accounts of Lexicon
and its wholly-owned subsidiaries, as well as one variable interest entity,
Symphony Icon, Inc. (“Symphony Icon”), for which the Company is the primary
beneficiary as defined by the Financial Accounting Standards Board (“FASB”)
Interpretation No. 46 (revised 2003), “Consolidation of Variable Interest
Entities” (“FIN 46R”).  Intercompany transactions and balances
are eliminated in consolidation.
  Use of Estimates:The
preparation of financial statements in conformity with U. S. generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the period. Actual results
could differ from those estimates.
  Cash, Cash Equivalents and
Short-term Investments:Lexicon considers all highly-liquid investments
with original maturities of three months or less to be cash
equivalents.  As of December 31, 2008, short-term investments
consist of certificates of deposit.  As of December 31, 2007,
short-term investments consisted of certificates of deposit, U.S. government
agency debt obligations, corporate debt securities and auction rate
securities.  Short-term investments are classified as
available-for-sale securities and are carried at fair value, based on quoted
market prices of the securities.  The Company views its
available-for-sale securities as available for use in current operations
regardless of the stated maturity date of the security.  Unrealized
gains and losses on such securities are reported as a separate component of
stockholders’ equity.  Net realized gains and losses, interest and
dividends are included in interest income.  The cost of securities
sold is based on the specific identification method.
  Restricted Cash and
Investments:  Lexicon is required to maintain restricted cash
or investments to collateralize standby letters of credit for the lease on its
office and laboratory facilities in Hopewell, New Jersey (see
Note 11).  As of December 31, 2008 and 2007, restricted cash
and investments were $0.4 million.
  Long-term
Investments:  Lexicon classifies its investments as either
current or long-term based upon the investments' contractual maturities and
Lexicon’s intent and ability to convert such instruments to cash within one
year.  As of December 31, 2008, long-term investments consist of
auction rate securities and auction rate security rights (“ARS Rights”) obtained
from UBS AG, the investment bank that sold Lexicon the auction rate securities
it currently holds (see Note 4).  Lexicon has elected to classify
its long-term investments as trading securities, as defined by Statement of
Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain
Investments in Debt and Equity Securities,” which requires recording these
securities at fair value.
  F-7
 Table
of Contents
 Accounts
Receivable:  Lexicon records trade accounts receivable in the
normal course of business related to the sale of products or
services.   The allowance for doubtful accounts takes into
consideration such factors as historical write-offs, the economic climate and
other factors that could affect collectibility.  Write-offs are
evaluated on a case by case basis.
  Concentration of Credit Risk:Lexicon’s cash equivalents, investments and accounts receivable represent
potential concentrations of credit risk. The Company attempts to minimize
potential concentrations of risk in cash equivalents and investments by placing
investments in high-quality financial instruments. The Company’s accounts
receivable are unsecured and are concentrated in pharmaceutical and
biotechnology companies located in the United States, Europe and
Japan.  The Company has not experienced any significant credit losses
to date.  In 2008, customers in the United States and Europe
represented 68% and 32% of revenue, respectively.  In 2007, customers
in the United States, Europe and Japan represented 66%, 29% and 5% of revenue,
respectively.  In 2006, customers in the United States, Europe and
Japan represented 66%, 21% and 13% of revenue, respectively. At
December 31, 2008, management believes that the Company has no significant
concentrations of credit risk.
  Segment Information and Significant
Customers:Lexicon operates in one business segment, which primarily
focuses on the discovery of the functions and pharmaceutical utility of genes
and the use of those gene function discoveries in the discovery and development
of pharmaceutical products for the treatment of human disease. Substantially all
of the Company’s revenues have been derived from drug discovery alliances,
target validation collaborations for the development and, in some cases,
analysis of the physiological effects of genes altered in knockout mice,
technology licenses, subscriptions to its databases, government grants and
contracts and compound library sales.  In 2008, Bristol-Myers Squibb
Company, N.V. Organon and Genentech, Inc. represented 32%, 29% and 13% of
revenues, respectively.   In 2007, Organon, Bristol-Myers Squibb
and the Texas Enterprise Fund represented 27%, 23% and 22% of revenues,
respectively.  In 2006, Bristol-Myers Squibb, Organon and Takeda
Pharmaceutical Company Limited represented 35%, 21% and 12% of revenues,
respectively.
  Property and Equipment:Property and equipment are carried at cost and depreciated using the
straight-line method over the estimated useful life of the assets which ranges
from three to 40 years.  Maintenance, repairs and minor replacements
are charged to expense as incurred.  Leasehold improvements are
amortized over the shorter of the estimated useful life or the remaining lease
term.  Significant renewals and betterments are
capitalized.
  Impairment of Long-Lived
Assets:  Under SFAS No. 144, “Accounting for the
Impairment or Disposal of Long-Lived Assets,” long-lived assets and certain
identifiable intangible assets to be held and used are reviewed for impairment
when events or changes in circumstances indicate that the carrying amount of
such assets may not be recoverable.  Determination of recoverability
is based on an estimate of undiscounted future cash flows resulting from the use
of the asset and its eventual disposition.  In the event that such
cash flows are not expected to be sufficient to recover the carrying amount of
the assets, the assets are written down to their estimated fair
values.
  Goodwill
Impairment:  Under SFAS No. 142, “Goodwill and Other
Intangible Assets,” goodwill is not amortized, but is tested at least annually
for impairment at the reporting unit level.  Impairment is the
condition that exists when the carrying amount of goodwill exceeds its implied
fair value.  The first step in the impairment process is to determine
the fair value of the reporting unit and then compare it to the carrying value,
including goodwill.  If the fair value exceeds the carrying value, no
further action is required and no impairment loss is
recognized.  Additional impairment assessments may be performed on an
interim basis if the Company encounters events or changes in circumstances that
would indicate that, more likely than not, the carrying value of goodwill has
been impaired.  There was no impairment of goodwill in 2008, 2007 or
2006.
  Revenue Recognition:Revenues
are recognized under Staff Accounting Bulletin (“SAB”) No. 104, “Revenue
Recognition,” when persuasive evidence of an arrangement exists, delivery has
occurred or services have been rendered, the price is fixed or determinable and
collectibility is reasonably assured.  Payments received in advance
under these arrangements are recorded as deferred revenue until
earned.  Revenues are earned from drug discovery and development
collaborations, target validation collaborations, database subscriptions,
technology licenses, and government grants and contracts.
  Upfront
fees under drug discovery and development collaborations are recognized as
revenue on a straight-line basis over the estimated period of service, generally
the contractual research term, as this period is Lexicon’s best estimate of the
period over which the services will be rendered, to the extent they are
non-refundable.  Lexicon has determined that the level of effort it
performs to meet its obligations is fairly constant throughout the estimated
periods of service.  As a result, Lexicon has determined that it is
appropriate to recognize revenue from such agreements on a straight-line basis,
as management believes this reflects how the research is provided during the
initial period of the agreement.  When it becomes probable that a
collaborator will extend the research period, Lexicon adjusts the revenue
recognition method as necessary based on the level of effort required under the
agreement for the extension period.
 F-8
 Table
of Contents
  Research
funding under these alliances is recognized as services are performed to the
extent they are non-refundable, either on a straight-line basis over the
estimated service period, generally the contractual research term, or as
contract research costs are incurred.  Milestone-based fees are
recognized upon completion of specified milestones according to contract
terms.  Payments received under target validation collaborations and
government grants and contracts are recognized as revenue as Lexicon performs
its obligations related to such research to the extent such fees are
non-refundable.  Non-refundable technology license fees are recognized
as revenue upon the grant of the license when performance is complete and there
is no continuing involvement.
  The
Company analyzes its multiple element arrangements to determine whether the
elements can be separated and accounted for individually as separate units of
accounting in accordance with Emerging Issues Task Force (“EITF”)
No. 00-21, “Revenue Arrangements with Multiple Deliverables.” An element of
a contract can be accounted for separately if the delivered elements have
standalone value to the collaborator and the fair value of any undelivered
elements is determinable through objective and reliable evidence. If an element
is considered to have standalone value but the fair value of any of the
undelivered items cannot be determined, all elements of the arrangement are
recognized as revenue over the period of performance for such undelivered items
or services.
  Research and Development Expenses:Research and development expenses consist of costs incurred for
company-sponsored as well as collaborative research and development activities.
These costs include direct and research-related overhead expenses and are
expensed as incurred. Patent costs and technology license fees for technologies
that are utilized in research and development and have no alternative future use
are expensed when incurred.
  Stock-Based Compensation:
Lexicon’s stock-based compensation plans are accounted for under the recognition
and measurement provisions of SFAS No. 123 (Revised), “Share-Based Payment”
(“SFAS No. 123(R)”).  This statement requires companies to recognize
compensation expense in the statement of operations for share-based payments,
including stock options issued to employees, based on their fair values on the
date of the grant, with the compensation expense recognized over the period in
which an employee is required to provide service in exchange for the stock
award.  Stock-based compensation expense is recognized on a
straight-line basis.  As of December 31, 2008, stock-based
compensation cost for all outstanding unvested options was $8.1 million,
which is expected to be recognized over a weighted-average period of
1.2 years.
  The fair
value of stock options is estimated at the date of grant using the Black-Scholes
method.  The Black-Scholes option-pricing model requires the input of
subjective assumptions.  Because the Company’s employee stock options
have characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management’s opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its employee
stock options.  For purposes of determining the fair value of stock
options granted subsequent to the adoption of SFAS No. 123(R), the Company
segregated its options into two homogeneous groups, based on exercise and
post-vesting employment termination behaviors, resulting in a change in the
assumptions used for expected option lives and forfeitures.  Expected
volatility is based on the historical volatility in the Company’s stock
price.  The following weighted-average assumptions were used for
options granted in the years ended December 31, 2008, 2007 and 2006,
respectively:
  F-9
 Table
of Contents
  Expected
      Volatility
                
                Risk-free
      Interest Rate
                
                Expected
      Term
                
                Estimated
      Forfeitures
                
                Dividend
                  RateDecember
      31, 2008:Employees
                66%
                
                2.9%
                
                6
                
                22%
                
                0%Officers
      and non-employee directors
                66%
                
                3.8%
                
                9
                
                6%
                
                0%December
      31, 2007:Employees
                66%
                
                4.5%
                
                6
                
                21%
                
                0%Officers
      and non-employee directors
                67%
                
                4.6%
                
                9
                
                4%
                
                0%December
      31, 2006:Employees
                69%
                
                4.6%
                
                7
                
                18%
                
                0%Officers
      and non-employee directors
                69%
                
                4.7%
                
                9
                
                3%
                
                0%
 
 Net Loss per Common Share:Net loss per common share is computed using the weighted average number
of shares of common stock outstanding. Shares associated with stock options and
warrants are not included because they are antidilutive.
  Comprehensive
Loss:Comprehensive loss is comprised of net loss and
unrealized gains and losses on available-for-sale
securities.  Comprehensive loss is reflected in the consolidated
statements of stockholders’ equity.  There were $4,000, $12,000 and
$36,000 of unrealized gains in the years ended December 31, 2008, 2007 and 2006,
respectively.
  3. Recent
Accounting Pronouncements
  In
September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurements.”  The statement defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principles,
and expands disclosures about fair value measurements.  This statement
applies under other accounting pronouncements that require or permit fair value
measurements, the FASB having previously concluded in those accounting
pronouncements that fair value is the relevant measurement
attribute.  Accordingly, this statement does not require any new fair
value measurements.  More specifically, SFAS No. 157 emphasizes that
fair value is a market-based measurement, not an entity-specific measurement,
and sets out a fair value hierarchy, which ranks the quality and reliability of
the information used to determine fair value.  SFAS No. 157 was
effective January 1, 2008 for financial assets and liabilities and will be
effective January 1, 2009 for non-financial assets and
liabilities.  The adoption of SFAS No. 157 for financial assets and
liabilities did not have an effect on the Company’s financial condition or
results of operations.  The Company is currently evaluating the
effect, if any, of the adoption of this statement for non-financial assets and
liabilities on its financial condition and results of operations.
  In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities - including an amendment of FASB
Statement No. 115,” which provides a fair value option election that permits
entities to irrevocably elect to measure many financial instruments and certain
other items at fair value, with changes in fair value recognized in earnings as
they occur.  SFAS No. 159 also establishes presentation and disclosure
requirements designed to facilitate comparisons between entities that choose
different measurement attributes for similar types of assets and
liabilities.  SFAS No. 159 does not affect any existing accounting
literature that requires certain assets and liabilities to be carried at fair
value.  SFAS No. 159 is effective as of the beginning of an entity’s
first fiscal year that begins after November 15, 2007.  The Company’s
adoption of SFAS No. 159 on January 1, 2008 did not materially affect its
financial position or results of operations.
  In
December 2007, the FASB issued SFAS No. 141(Revised), “Business Combinations,”
which replaces SFAS No. 141, “Business Combinations,” and requires an
acquirer to recognize the assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree at the acquisition date, measured at
their fair values as of that date, with limited exceptions. This statement also
requires the acquirer in a business combination achieved in stages to recognize
the identifiable assets and liabilities, as well as the noncontrolling interest
in the acquiree, at the full amounts of their fair values. SFAS No. 141(R) makes
various other amendments to authoritative literature intended to provide
additional guidance or to confirm the guidance in that literature to that
provided in this statement. This statement applies prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15,
2008.  The Company expects to adopt this statement on January 1,
2009.  SFAS No. 141(R)’s impact on accounting for business
combinations is dependent upon acquisitions, if any, made on or after that
time.
  F-10
 Table
of Contents
 In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements,” which amends Accounting Research Bulletin
No. 51, “Consolidated Financial Statements,” to improve the relevance,
comparability, and transparency of the financial information that a reporting
entity provides in its consolidated financial statements. SFAS No. 160
establishes accounting and reporting standards that require the ownership
interests in subsidiaries not held by the parent to be clearly identified,
labeled and presented in the consolidated statement of financial position within
equity, but separate from the parent’s equity. This statement also requires the
amount of consolidated net income attributable to the parent and to the
noncontrolling interest to be clearly identified and presented on the face of
the consolidated statement of income. Changes in a parent’s ownership interest
while the parent retains its controlling financial interest must be accounted
for consistently, and when a subsidiary is deconsolidated, any retained
noncontrolling equity investment in the former subsidiary must be initially
measured at fair value. The gain or loss on the deconsolidation of the
subsidiary is measured using the fair value of any noncontrolling equity
investment. The statement also requires entities to provide sufficient
disclosures that clearly identify and distinguish between the interests of the
parent and the interests of the noncontrolling owners. This statement applies
prospectively to all entities that prepare consolidated financial statements and
applies prospectively for fiscal years, and interim periods within those fiscal
years, beginning on or after December 15, 2008. The Company is currently
evaluating the effect, if any, of this statement on its financial condition and
results of operations.
  4. Cash and Cash
Equivalents and Investments
  The fair
value of cash and cash equivalents and investments held at December 31,
2008 and 2007 are as follows:
  As
      of December 31, 2008Amortized
      Cost
                                                          
                                                          
                                                          Gross
      Unrealized Gains
                                                          
                                                          
                                                          Gross
      Unrealized Losses
                                                          
                                                          
                                                          Estimated
      Fair Value(In
      thousands)Cash
      and cash equivalents
                                                          
                                                          $
                                                          85,873
                                                          
                                                          
                                                          $
                                                          —
                                                          
                                                          
                                                          $
                                                          —
                                                          
                                                          
                                                          $
                                                          85,873Securities
      maturing within one year:Certificates of deposit
                                                          
                                                          
                                                          629
                                                          
                                                          
                                                          
                                                          —
                                                          
                                                          
                                                          
                                                          —
                                                          
                                                          
                                                          
                                                          629Total short-term investments
                                                          
                                                          $
                                                          629
                                                          
                                                          
                                                          $
                                                          —
                                                          
                                                          
                                                          $
                                                          —
                                                          
                                                          
                                                          $
                                                          629Securities
      maturing after one year through five years:ARS Rights
                                                          
                                                          
                                                          —
                                                          
                                                          
                                                          
                                                          12,060
                                                          
                                                          
                                                          
                                                          —
                                                          
                                                          
                                                          
                                                          12,060Securities
      maturing after ten years:Auction rate securities
                                                          
                                                          
                                                          57,000
                                                          
                                                          
                                                          
                                                          —
                                                          
                                                          
                                                          
                                                          (13,374
                                                          )
                                                          
                                                          
                                                          43,626Total
      long-term investments
                                                          
                                                          $
                                                          57,000
                                                          
                                                          
                                                          $
                                                          12,060
                                                          
                                                          
                                                          $
                                                          (13,374
                                                          )
                                                          
                                                          $
                                                          55,686Short-term
      investments held by Symphony Icon, Inc.:Cash and cash equivalents
                                                          
                                                          
                                                          16,610
                                                          
                                                          
                                                          
                                                          —
                                                          
                                                          
                                                          
                                                          —
                                                          
                                                          
                                                          
                                                          16,610Total
      short-term investments held by Symphony Icon, Inc.
                                                          
                                                          $
                                                          16,610
                                                          
                                                          
                                                          $
                                                          —
                                                          
                                                          
                                                          $
                                                          —
                                                          
                                                          
                                                          $
                                                          16,610Total
      cash and cash equivalents and investments
                                                          
                                                          $
                                                          160,112
                                                          
                                                          
                                                          $
                                                          12,060
                                                          
                                                          
                                                          $
                                                          (13,374
                                                          )
                                                          
                                                          $
                                                          158,798
 
 
 F-11
 Table
of Contents
  As
      of December 31, 2007Amortized
      Cost
                                                  
                                                  
                                                  Gross
      Unrealized Gains
                                                  
                                                  
                                                  Gross
      Unrealized Losses
                                                  
                                                  
                                                  Estimated
      Fair Value(In
      thousands)Cash
      and cash equivalents
                                                  
                                                  $
                                                  22,950
                                                  
                                                  
                                                  $
                                                  —
                                                  
                                                  
                                                  $
                                                  (12
                                                  )
                                                  
                                                  $
                                                  22,938Securities
      maturing within one year:Certificates of deposit
                                                  
                                                  
                                                  6,312
                                                  
                                                  
                                                  
                                                  —
                                                  
                                                  
                                                  
                                                  (3
                                                  )
                                                  
                                                  
                                                  6,309Corporate debt securities
                                                  
                                                  
                                                  41,162
                                                  
                                                  
                                                  
                                                  12
                                                  
                                                  
                                                  
                                                  (51
                                                  )
                                                  
                                                  
                                                  41,123Commercial papers
                                                  
                                                  
                                                  71,214
                                                  
                                                  
                                                  
                                                  47
                                                  
                                                  
                                                  
                                                  —
                                                  
                                                  
                                                  
                                                  71,261U.S. government agencies
      securities
                                                  
                                                  
                                                  2,500
                                                  
                                                  
                                                  
                                                  3
                                                  
                                                  
                                                  
                                                  —
                                                  
                                                  
                                                  
                                                  2,503Total securities maturing within
      one year
                                                  
                                                  
                                                  121,188
                                                  
                                                  
                                                  
                                                  62
                                                  
                                                  
                                                  
                                                  (54
                                                  )
                                                  
                                                  
                                                  121,196Securities
      maturing after ten years:Auction rate securities
                                                  
                                                  
                                                  77,975
                                                  
                                                  
                                                  
                                                  —
                                                  
                                                  
                                                  
                                                  —
                                                  
                                                  
                                                  
                                                  77,975Total
      available-for-sale investments
                                                  
                                                  $
                                                  199,163
                                                  
                                                  
                                                  $
                                                  62
                                                  
                                                  
                                                  $
                                                  (54
                                                  )
                                                  
                                                  $
                                                  199,171Short-term
      investments held by Symphony Icon, Inc.:Cash and cash equivalents
                                                  
                                                  
                                                  36,666
                                                  
                                                  
                                                  
                                                  —
                                                  
                                                  
                                                  
                                                  —
                                                  
                                                  
                                                  
                                                  36,666Total
      short-term investments held by Symphony Icon, Inc.
                                                  
                                                  $
                                                  36,666
                                                  
                                                  
                                                  $
                                                  —
                                                  
                                                  
                                                  $
                                                  —
                                                  
                                                  
                                                  $
                                                  36,666Total
      cash and cash equivalents and investments
                                                  
                                                  $
                                                  258,779
                                                  
                                                  
                                                  $
                                                  62
                                                  
                                                  
                                                  $
                                                  (66
                                                  )
                                                  
                                                  $
                                                  258,775
 
 There
were $123,000 of realized gains for the year ended December 31,
2008.  There were no realized gains or losses for the years ended
December 31, 2007 and 2006.
  At
December 31, 2008, Lexicon held $57.0 million (par value), with an
estimated fair value of $43.6 million, of AAA rated investments with an
auction interest rate reset feature, known as auction rate
securities.  These notes are issued by various state agencies for the
purpose of financing student loans.  The securities have historically
traded at par and are redeemable at par plus accrued interest at the option of
the issuer. Interest is typically paid at the end of each auction period or
semiannually.  Until February 2008, the market for Lexicon’s auction
rate securities was highly liquid. Starting in February 2008, a substantial
number of auctions “failed,” meaning that there was not enough demand to sell
all of the securities that holders desired to sell at auction. The immediate
effect of a failed auction is that such holders cannot sell the securities at
auction and the interest rate on the security generally resets to a maximum
interest rate. In the case of funds invested by Lexicon in auction rate
securities which are the subject of a failed auction, Lexicon may not be able to
access the funds without a loss of principal, unless a future auction on these
investments is successful or the issuer redeems the security.  As of
December 31, 2008, Lexicon classified its entire auction rate security
investment balance as long-term investments on its consolidated balance sheet
because of the Company’s inability to determine when its investments in auction
rate securities would be sold.  Lexicon has also modified its current
investment strategy to reallocate its investments more into U.S. treasury
securities and U.S. treasury-backed money market investments.
  At
December 31, 2008, observable auction rate securities market information
was not available to determine the fair value of Lexicon’s investments. Lexicon
has estimated the fair value of these securities at $43.6 million as of
December 31, 2008 using models of the expected future cash flows related to
the securities and taking into account assumptions about the cash flows of the
underlying student loans, as well as secondary market trading
data.  The assumptions used in preparing the discounted cash flow
model include estimates of interest rates, timing and amount of cash flows,
liquidity premiums and expected holding periods of the auction rate securities,
based on data available as of December 31, 2008.  The underlying
sources of these assumptions are volatile and the assumptions are subject to
change as those sources and market conditions change.  Because Lexicon
does not intend to hold these securities until the par value is recoverable
through the auction process and management believes the decline in fair value is
other-than-temporary, Lexicon recorded a loss of $13.4 million for the year
ended December 31, 2008 to reflect the decline in value of these
securities, which is shown as loss on long-term investments in the consolidated
statement of operations.  If the current market conditions deteriorate
further, or a recovery in market values does not occur, Lexicon may be required
to record additional unrealized or realized losses in future
quarters.
  F-12
 Table
of Contents
 In
November 2008, Lexicon accepted an offer from UBS AG, the investment bank that
sold Lexicon the auction rate securities, providing Lexicon with rights related
to its auction rate securities (“ARS Rights”).  The ARS Rights permit
Lexicon to require UBS to purchase its $57.0 million (par value) of auction
rate securities at par value during the period from June 30, 2010 through
July 2, 2012.  Conversely, UBS has the right, in its discretion,
to purchase or sell the securities at any time by paying Lexicon the par value
of such securities.  Management expects to exercise the ARS Rights and
sell Lexicon’s auction rate securities back to UBS on June 30, 2010, the
earliest date allowable under the ARS Rights.  Lexicon is also
eligible to borrow from an affiliate of UBS at no net cost up to 75% of the
market value of the securities, as determined by such affiliate, which loans
would become payable upon the investment bank’s purchase or sale of the
securities (see note 9).
  The
enforceability of the ARS Rights results in a separate asset that will be
measured at its fair value.  Lexicon elected to measure the ARS Rights
under the fair value option of SFAS 159, and recorded a gain of
approximately $12.1 million, which is reflected in loss on long-term
investments, net, and recorded a corresponding long-term
investment.  As a result of accepting the ARS Rights, Lexicon has
elected to classify the ARS Rights and reclassify its investments in auction
rate securities as trading securities, as defined by SFAS
No. 115.  As a result, Lexicon will be required to assess the
fair value of these two individual assets and record changes each period until
the ARS Rights are exercised and the auction rate securities are
redeemed.  Lexicon expects that subsequent changes in the value of the
ARS Rights will largely offset the subsequent fair value movements of the
auction rate securities, subject to the continued expected performance by the
investment bank of its obligations under the agreement.
  Excluding
auction rate securities and the ARS Rights, at December 31, 2008, Lexicon
had approximately $103.1 million in cash and cash equivalents and
short-term investments, including $16.6 million in investments held by
Symphony Icon.  Management believes that the working capital available
to Lexicon excluding the funds held in auction rate securities will be
sufficient to meet its cash requirements for at least the next 12
months.
  5. Fair Value of
Financial Instruments
  The
Company uses various inputs in determining the fair value of its investments and
measures these assets on a quarterly basis.  Financial assets recorded
at fair value in the consolidated balance sheet are categorized by the level of
objectivity associated with the inputs used to measure their fair
value.  SFAS No. 157 defines the following levels directly
related to the amount of subjectivity associated with the inputs to fair
valuation of these financial assets:
  ·
              Level
      1 – quoted prices in active markets for identical
    investments
  ·
              Level
      2 – other significant observable inputs (including quoted prices for
      similar investments, market corroborated inputs,
  etc.)
  ·
              Level
      3 – significant unobservable inputs (including the Company’s own
      assumptions in determining the fair value of
  investments)
  The
inputs or methodology used for valuing securities are not necessarily an
indication of the credit risk associated with investing in those
securities.  Based on market conditions and the unavailability of
Level 1 inputs, during the year ended December 31, 2008, the Company
adopted a valuation methodology that involves discounted cash flow analysis and
secondary market data for its auction rate securities.  Accordingly,
the investments in auction rate securities changed from Level 1 to
Level 3 within SFAS No. 157’s valuation levels since the Company’s
initial adoption of SFAS No. 157 on January 1, 2008.  In
addition, the Company obtained ARS Rights from UBS, and the ARS Rights have been
recorded at fair value as determined using a discounted cash flow valuation
methodology.  The following tables provide the fair value measurements
of applicable Company financial assets according to the fair value levels
defined by SFAS No. 157 as of December 31, 2008 and 2007.
  Financial
      Assets at Fair Value
                                          as
      of December 31, 2008Level
      1
                                        
                                        
                                        Level
      2
                                        
                                        
                                        Level
      3(in
      thousands)Cash
      and cash equivalents
                                        
                                        $
                                        85,873
                                        
                                        
                                        $
                                        —
                                        
                                        
                                        $
                                        —Short-term
      investments
                                        
                                        
                                        629
                                        
                                        
                                        
                                        —
                                        
                                        
                                        
                                        —Short-term
      investments held by Symphony Icon, Inc.
                                        
                                        
                                        16,610
                                        
                                        
                                        
                                        —
                                        
                                        
                                        
                                        —Long-term
      investments
                                        
                                        
                                        —
                                        
                                        
                                        
                                        —
                                        
                                        
                                        
                                        55,686Total cash and cash equivalents
      and investments
                                        
                                        $
                                        103,112
                                        
                                        
                                        $
                                        —
                                        
                                        
                                        $
                                        55,686
  
 F-13
 Table
of Contents
  Financial
      Assets at Fair Value
                                              as
      of December 31, 2007Level
      1
                                            
                                            
                                            Level
      2
                                            
                                            
                                            Level
      3(in
      thousands)Cash
      and cash equivalents
                                            
                                            $
                                            22,938
                                            
                                            
                                            $
                                            —
                                            
                                            
                                            $
                                            —Short-term
      investments
                                            
                                            
                                            199,171
                                            
                                            
                                            
                                            —
                                            
                                            
                                            
                                            —Short-term
      investments held by Symphony Icon, Inc.
                                            
                                            
                                            36,666
                                            
                                            
                                            
                                            —
                                            
                                            
                                            
                                            —Total cash and cash equivalents
      and investments
                                            
                                            $
                                            258,775
                                            
                                            
                                            $
                                            —
                                            
                                            
                                            $
                                            —
 
 The table
presented below summarizes the change in consolidated balance sheet carrying
value associated with Level 3 financial assets for the year ended
December 31, 2008.
  Long-term
      Investments(in
      thousands)Balance
      at December 31, 2007
                        
                        $
                        —Unrealized
      losses included in earnings as loss on long-term
    investments
                        
                        
                        (13,374
                        )Unrealized
      gains included in earnings as gain on long-term
investments
                        
                        
                        12,060Net
      sales and settlements
                        
                        
                        (21,050
                        )Transfers
      into Level 3
                        
                        
                        78,050Balance
      at December 31, 2008
                        
                        $
                        55,686
 
 6. Property and
Equipment
  Property
and equipment at December 31, 2008 and 2007 are as follows:
  Estimated
      Useful Lives
                              
                              
                              As
      of December 31,In
      Years
                              
                              
                              2008
                              
                              
                              2007(In
      thousands)Computers
      and software
                              
                              
                              3-5
                              
                              
                              $
                              12,328
                              
                              
                              $
                              12,166Furniture
      and fixtures
                              
                              
                              5-7
                              
                              
                              
                              7,648
                              
                              
                              
                              7,594Laboratory
      equipment
                              
                              
                              3-7
                              
                              
                              
                              39,385
                              
                              
                              
                              39,427Leasehold
      improvements
                              
                              
                              7-10
                              
                              
                              
                              9,756
                              
                              
                              
                              9,740Buildings
                              
                              
                              15-40
                              
                              
                              
                              63,508
                              
                              
                              
                              63,342Land
                              
                              
                              —
                              
                              
                              
                              3,564
                              
                              
                              
                              3,564Total
      property and equipment
                              
                              
                              
                              
                              
                              
                              136,189
                              
                              
                              
                              135,833Less:
      Accumulated depreciation and amortization
                              
                              
                              
                              
                              
                              
                              (71,102
                              )
                              
                              
                              (65,004
                              )Net
      property and equipment
                              
                              
                              
                              
                              
                              $
                              65,087
                              
                              
                              $
                              70,829
 
 7. Income
Taxes
  Lexicon
recognizes deferred tax liabilities and assets for the expected future tax
consequences of events that have been recognized differently in the financial
statements and tax returns. Under this method, deferred tax liabilities and
assets are determined based on the difference between the financial statement
carrying amounts and tax bases of liabilities and assets using enacted tax rates
and laws in effect in the years in which the differences are expected to
reverse. Deferred tax assets are evaluated for realization based on a
more-likely-than-not criteria in determining if a valuation allowance should be
provided.
  F-14
 Table
of Contents
 The
components of Lexicon’s deferred tax assets (liabilities) at December 31, 2008
and 2007 are as follows:
  As
      of December 31,2008
                                
                                
                                2007(In
      thousands)Deferred
      tax assets:Net
      operating loss carryforwards
                                
                                $
                                159,917
                                
                                
                                $
                                121,473Research and development tax
      credits
                                
                                
                                25,000
                                
                                
                                
                                21,291Stock-based compensation
                                
                                
                                8,815
                                
                                
                                
                                7,855Deferred revenue
                                
                                
                                6,368
                                
                                
                                
                                13,478Other
                                
                                
                                902
                                
                                
                                
                                699Total deferred tax assets
                                
                                
                                201,002
                                
                                
                                
                                164,796Deferred
      tax liabilities:Property and equipment
                                
                                
                                —
                                
                                
                                
                                (165
                                )Other
                                
                                
                                (397
                                )
                                
                                
                                (394
                                )Total deferred tax liabilities
                                
                                
                                (397
                                )
                                
                                
                                (559
                                )Less: valuation allowance
                                
                                
                                (200,605
                                )
                                
                                
                                (164,237
                                )Net deferred tax assets
                                
                                $
                                —
                                
                                
                                $
                                —
 
 At
December 31, 2008, Lexicon had both federal and state NOL carryforwards of
approximately $441.5 million and $104.0 million,
respectively.  The federal and state NOL carryforwards begin to expire
in 2011.  The Company has R&D tax credit carryforwards of
approximately $25.0 million expiring beginning in
2011.  Utilization of the NOL and R&D credit carryforwards may be
subject to a significant annual limitation due to ownership changes that have
occurred previously or could occur in the future provided by Section 382 of
the Internal Revenue Code.  Based on the federal tax law limits and
the Company’s cumulative loss position, Lexicon concluded it was appropriate to
establish a full valuation allowance for its net deferred tax assets until an
appropriate level of profitability is sustained.  During the year
ended December 31, 2008, the valuation allowance increased
$36.4 million, primarily due to the Company’s current year net
loss.  Lexicon reversed a previously recorded income tax provision of
$119,000 representing alternative minimum tax payable in the year ended December
31, 2006.  As of December 31, 2008 and 2007, the Company did not
have any unrecognized tax benefits.
  The
Company is primarily subject to U.S. federal and New Jersey and Texas state
income taxes.  The tax years 1995 to current remain open to
examination by U.S. federal authorities and 2004 to current remain open to
examination by state authorities.  The Company’s policy is to
recognize interest and penalties related to income tax matters in income tax
expense.  As of December 31, 2008 and 2007, the Company had no
accruals for interest or penalties related to income tax matters.
  8. Goodwill and
Other Intangible Assets
  On July
12, 2001, Lexicon completed the acquisition of Coelacanth Corporation in a
merger. Coelacanth, now Lexicon Pharmaceuticals (New Jersey), Inc., forms the
core of the Company’s division responsible for small molecule compound
discovery.  The results of Lexicon Pharmaceuticals (New Jersey), Inc.
are included in the Company’s results of operations for the period subsequent to
the acquisition.
  Goodwill
associated with the acquisition of $25.8 million, which represents the
excess of the $36.0 million purchase price over the fair value of the
underlying net identifiable assets, was assigned to the consolidated entity,
Lexicon.  There was no change in the carrying amount of goodwill for
the year ended December 31, 2008.  In accordance with SFAS
No. 142, the goodwill balance is not subject to amortization, but is tested
at least annually for impairment at the reporting unit level, which is the
Company’s single operating segment.  The Company performed an
impairment test of goodwill on its annual impairment assessment
date.  This test did not result in an impairment of
goodwill.
  Other
intangible assets represented Coelacanth’s technology platform, which consists
of its proprietary ClickChemTM reactions, novel building blocks and compound
sets, automated production systems, high-throughput ADMET (Absorption,
Distribution, Metabolism, Excretion and Toxicity) capabilities, and its know-how
and trade secrets.  The Company amortized other intangible assets on a
straight-line basis over an estimated life of five years.
  The
amortization expense for the year ended December 31, 2006 was
$0.6 million.  Other intangible assets are now fully
amortized.
  F-15
 Table
of Contents
 9. Debt
Obligations
  Genentech Loan:  On
December 31, 2002, Lexicon borrowed $4.0 million under an unsecured note
agreement with Genentech, Inc.  The proceeds of the loan were to be
used to fund research efforts under the alliance agreement with Genentech
discussed in Note 16.  On November 30, 2005, the note agreement was
amended to extend the maturity date of the loan by one year to December 31,
2006.  No other terms of the note agreement were
changed.  The note permitted the Company to repay the note, at any
time, at its option, in cash, in shares of common stock valued at the
then-current market price, or in a combination of cash and shares, subject to
certain limitations.  The note accrued interest at an annual rate of
8%, compounded quarterly.  On December 31, 2006, the Company repaid in
full the principal and accrued interest outstanding under the note by issuing to
Genentech 1,511,670 shares of common stock.
  Mortgage Loan:In April 2004,
Lexicon purchased its existing laboratory and office buildings and animal
facilities in The Woodlands, Texas with proceeds from a $34.0 million
third-party mortgage financing and $20.8 million in cash.  The
mortgage loan has a ten-year term with a 20-year amortization and bears interest
at a fixed rate of 8.23%.  The buildings and land that serve as
collateral for the mortgage loan are included in property and equipment at
$63.5 million and $3.6 million, respectively, before accumulated
depreciation.
  The
following table includes the aggregate future principal payments of the
Company’s long-term debt as of December 31, 2008:
  For
      the Year Ending December 31(In
      thousands)2009
                  
                  $
                  9632010
                  
                  
                  1,0472011
                  
                  
                  1,1382012
                  
                  
                  1,2302013
                  
                  
                  1,343Thereafter
                  
                  
                  24,77130,492Less
      current portion
                  
                  
                  (963
                  )Total
      long-term debt
                  
                  $
                  29,529
 
 The fair
value of Lexicon’s debt financial instruments approximates their carrying
value.  The fair value of Lexicon’s long-term debt is estimated using
discounted cash flow analysis, based on the Company’s estimated current
incremental borrowing rate.
  UBS Credit
Line:  In January 2009, Lexicon entered into a credit line
agreement with UBS Bank USA that provides up to an aggregate amount of $35.9
million in the form of an uncommitted, demand, revolving line of
credit.  Lexicon entered into the credit line in connection with its
acceptance of an offer from UBS AG, the investment bank that sold Lexicon its
auction rate securities, providing Lexicon with rights to require UBS to
purchase its $57.0 million (par value) of auction rate securities at par value
during the period from June 30, 2010 through July 2, 2012.  The credit
line is secured only by these auction rate securities and advances under the
credit line will be made on a “no net cost” basis, meaning that the interest
paid by Lexicon on advances will not exceed the interest or dividends paid to
Lexicon by the issuer of the auction rate securities.
  10. Arrangements
with Symphony Icon, Inc.
  On June
15, 2007, Lexicon entered into a series of related agreements providing for the
financing of the clinical development of LX6171, LX1031 and LX1032, along with
any other pharmaceutical compositions modulating the same targets as those drug
candidates (the “Programs”).  The agreements include a Novated and
Restated Technology License Agreement pursuant to which the Company licensed to
Symphony Icon, a wholly-owned subsidiary of Symphony Icon Holdings LLC
(“Holdings”), the Company’s intellectual property rights related to the
Programs.  Holdings contributed $45 million to Symphony Icon in order
to fund the clinical development of the Programs.
  F-16
 Table
of Contents
 Under a
Share Purchase Agreement, dated June 15, 2007, between the Company and Holdings,
the Company issued and sold to Holdings 7,650,622 shares of its common stock on
June 15, 2007 in exchange for $15 million and the Purchase Option (as defined
below).
  Under a
Purchase Option Agreement, dated June 15, 2007, among the Company, Symphony Icon
and Holdings, the Company has received from Holdings an exclusive purchase
option (the “Purchase Option”) that gives the Company the right to acquire all
of the equity of Symphony Icon, thereby allowing the Company to reacquire all of
the Programs.  The Purchase Option is exercisable by the Company at
any time, in its sole discretion, until June 15, 2011 (subject to an
earlier exercise right in limited circumstances) at an exercise price of (i) $72
million, if the Purchase Option is exercised before June 15, 2009, (ii)
$81 million, if the Purchase Option is exercised on or after June 15,
2009 and before June 15, 2010 and (iii) $90 million, if the Purchase
Option is exercised on or after June 15, 2010 and before June 15,
2011.  The Purchase Option exercise price may be paid in cash or a
combination of cash and common stock, at the Company’s sole discretion, provided
that the common stock portion may not exceed 40% of the Purchase Option exercise
price.  Lexicon has calculated the value of the Purchase Option as the
difference between the fair value of the common stock issued to Holdings of
$23.6 million and the $15.0 million in cash received from Holdings for
the issuance of the common stock.  Lexicon has recorded the value of
the Purchase Option as an asset, and is amortizing this asset over the four-year
option period.  The unamortized balance of $5.3 million and
$7.4 million is recorded in other assets in the accompanying consolidated
balance sheets as of December 31, 2008 and 2007, respectively, and the
amortization expense of $2.1 million and $1.2 million is recorded in
other expense, net in the accompanying consolidated statements of operations for
the years ended December 31, 2008 and 2007, respectively.
  Under an
Amended and Restated Research and Development Agreement, dated June 15, 2007,
among the Company, Symphony Icon and Holdings (the “R&D Agreement”),
Symphony Icon and the Company are developing the Programs in accordance with a
specified development plan and related development budget.  The
R&D Agreement provides that the Company will continue to be primarily
responsible for the development of the Programs.  The Company’s
development activities are supervised by Symphony Icon’s Development Committee,
which is comprised of an equal number of representatives from the Company and
Symphony Icon.  The Development Committee will report to Symphony
Icon’s Board of Directors, which is currently comprised of five members,
including one member designated by the Company and two independent
directors.
  Under a
Research Cost Sharing, Payment and Extension Agreement, dated June 15, 2007,
among the Company, Symphony Icon and Holdings, upon the recommendation of the
Development Committee, Symphony Icon’s Board of Directors may require the
Company to pay Symphony Icon up to $15 million for Symphony Icon’s use in
the development of the Programs in accordance with the specified development
plan and related development budget.  The Development Committee’s
right to recommend that Symphony Icon’s Board of Directors submit such funding
requirement to the Company will terminate on the one-year anniversary of the
expiration of the Purchase Option, subject to limited exceptions.
  In
accordance with FIN 46R, Lexicon has determined that Symphony Icon is a variable
interest entity for which it is the primary beneficiary.  This
determination was based on Holdings’ lack of controlling rights with respect to
Symphony Icon’s activities and the limitation on the amount of expected residual
returns Holdings may expect from Symphony Icon if Lexicon exercises its Purchase
Option.  Lexicon has determined it is a variable interest holder of
Symphony Icon due to its contribution of the intellectual property relating to
the Programs and its issuance of shares of its common stock in exchange for the
Purchase Option, which Lexicon intends to exercise if the development of the
Programs is successful.  Lexicon has determined that it is a primary
beneficiary as a result of certain factors, including its primary responsibility
for the development of the Programs and its contribution of the intellectual
property relating to the Programs.  As a result, Lexicon has included
the financial condition and results of operations of Symphony Icon in its
consolidated financial statements.  Symphony Icon’s cash and cash
equivalents have been recorded on Lexicon’s consolidated financial statements as
short-term investments held by Symphony Icon.  The noncontrolling
interest in Symphony Icon on Lexicon’s consolidated balance sheet initially
reflected the $45 million proceeds contributed into Symphony Icon less
$2.3 million of structuring and legal fees.  As the collaboration
progresses, this line item will be reduced by Symphony Icon’s losses, which were
$20.0 million and $12.4 million in the years ended December 31,
2008 and 2007, respectively. The reductions to the noncontrolling interest in
Symphony Icon will be reflected in Lexicon’s consolidated statements of
operations using a similar caption and will reduce the amount of Lexicon’s
reported net loss.  Through December 31, 2008, Lexicon has not
charged any license fees and has not recorded any revenue from Symphony Icon,
and does not expect to do so based on the current agreements with Symphony Icon
and Holdings.
 F-17
 Table
of Contents
  11. Commitments
and Contingencies
  Operating Lease
Obligations:  A Lexicon subsidiary leases laboratory and office
space in Hopewell, New Jersey under an agreement that expires in June
2013.  The lease provides for two five-year renewal options at 95% of
the fair market rent and includes escalating lease payments.  Rent
expense is recognized on a straight-line basis over the original lease
term.  Lexicon is the guarantor of the obligation of its subsidiary
under this lease.  The Company is required to maintain restricted
investments to collateralize a standby letter of credit for this
lease.  The Company had $0.4 million in restricted investments as
collateral as of December 31, 2008
and  2007.  Additionally, Lexicon leases certain equipment
under operating leases.
  Rent
expense for all operating leases was approximately $2.5 million,
$2.5 million and $2.4 million for the years ended December 31, 2008,
2007 and 2006, respectively.  The following table includes
non-cancelable, escalating future lease payments for the facility in New
Jersey:
  For
      the Year Ending December 31(In
      thousands)2009
                    
                    $
                    2,5162010
                    
                    
                    2,5182011
                    
                    
                    2,5552012
                    
                    
                    2,6092013
                    
                    
                    1,304Total
                    
                    $
                    11,502
 
 Employment Agreements:Lexicon has entered into employment agreements with certain of its
corporate officers. Under the agreements, each officer receives a base salary,
subject to adjustment, with an annual discretionary bonus based upon specific
objectives to be determined by the compensation committee. The employment
agreements are at-will and contain non-competition agreements. The agreements
also provide for a termination clause, which requires either a six or 12-month
payment based on the officer’s salary and payment of a specified portion of the
officer’s bonus target for such year, in the event of termination.
  Legal
Proceedings:  On October 20, 2008, Lexicon received
correspondence from counsel to the University of Utah Research Foundation
(“UURF”) alleging that Lexicon was in breach of certain obligations purported to
exist under its license agreement with GenPharm International, Inc., under which
Lexicon obtained a sublicense under certain patents exclusively licensed from
UURF by GenPharm, and related letter agreements between Lexicon and UURF
governing the payment of royalties.  The correspondence alleged that
Lexicon breached the relevant agreements by, among other things, purportedly
failing to pay all required royalties and ignoring obligations that UURF
contends are expressed or implied in the relevant agreements. On December 16,
2008, Lexicon filed a complaint against UURF in the District Court of Montgomery
County, Texas seeking a declaration that Lexicon is in full compliance with its
license and royalty obligations.  On January 26, 2009, UURF filed a
notice seeking to remove the case to the United States District Court for the
Southern District of Texas.  UURF filed an answer and counterclaims on
February 2, 2009 asserting breach of contract claims consistent with the claims
made by UURF in its October 2008 correspondence and patent infringement which it
claims has occurred since approximately December 17, 2008.
  Lexicon
believes that it has materially complied with all of its obligations under the
relevant agreements, including those relating to royalty payments due to UURF,
and that UURF’s claims are inconsistent with the express provisions of the
relevant agreements.  Lexicon accordingly believes UURF’s claims are
without merit.  While the litigation of these matters is at a very
early stage, Lexicon intends to vigorously pursue its complaint against UURF and
dispute UURF’s counterclaims.
  Lexicon
is from time to time party to other claims and legal proceedings that
it believes will not have, individually or in the aggregate, a material
adverse effect on its results of operations, financial condition or
liquidity.
  F-18
 Table
of Contents
 12. Agreements
with Invus, L.P.
  On June
17, 2007, Lexicon entered into a series of agreements with Invus, L.P. (“Invus”)
under which Invus made an investment in the Company’s common stock and has
certain other rights described below.
  Lexicon
entered into a Securities Purchase Agreement (the “Securities Purchase
Agreement”) with Invus under which the Company issued and sold to Invus
50,824,986 shares in an initial investment (the “Initial Investment”) and
permitted Invus to require, subject to specific conditions, that the Company
conduct certain rights offerings (the “Rights Offerings”).  In
connection with the Securities Purchase Agreement, Lexicon also entered into a
Warrant Agreement with Invus under which the Company issued to Invus warrants
(the “Warrants”) to purchase 16,498,353 shares of its common stock at an
exercise price of $3.0915 per share.  The Warrant Agreement provided
that, to the extent not previously exercised, the Warrants would terminate
concurrently with the closing of the Initial Investment.
  Initial
Investment:  In the Initial Investment, which closed on August
28, 2007, Invus purchased 50,824,986 shares of Lexicon’s common stock for a
total of approximately $205.4 million, resulting in net proceeds of
$198.0 million after deducting fees and expenses of approximately
$7.5 million.  Simultaneously with the closing of the Initial
Investment, all Warrants issued under the Warrant Agreement terminated
unexercised according to their terms.  This purchase resulted in
Invus’ ownership of 40% of the post-transaction outstanding shares of Lexicon’s
common stock.
  Rights
Offerings:  For a period of 90 days following November 28,
2009 (the “First Rights Offering Trigger Date”), Invus will have the right to
require Lexicon to make a pro rata offering of non-transferable rights to
acquire common stock to all of its stockholders (the “First Rights Offering”) in
an aggregate amount to be designated by Invus not to exceed $172.3 million,
minus the aggregate net proceeds received in all Qualified Offerings (as defined
below), if any, completed prior to the First Rights Offering Trigger
Date.  The price per share of the First Rights Offering would be
designated by Invus in a range between $4.50 and a then-current average market
price of the Company’s common stock.  The First Rights Offering
Trigger Date could be changed to as early as August 28, 2009 with the
approval of the members of the Company’s board of directors who are not
affiliated with Invus (the “Unaffiliated Board”).  All stockholders
would have oversubscription rights with respect to the First Rights Offering,
and Invus would be required to purchase the entire portion of the First Rights
Offering that is not subscribed for by other stockholders.
  For a
period of 90 days following the date (the “Second Rights Offering Trigger Date”)
which is 12 months after (a) Invus’ exercise of its right to require us to
conduct the First Rights Offering or (b) if Invus does not exercise its
right to require Lexicon to conduct the First Rights Offering, the First Rights
Offering Trigger Date, Invus would have the right to require the Company to make
a pro rata offering of non-transferable rights to acquire common stock to all of
its stockholders (the “Second Rights Offering” and, together with the First
Rights Offering, the “Rights Offerings”) in an aggregate amount to be designated
by Invus not to exceed an amount equal to $344.5 million, minus the amount of
the First Rights Offering, minus the aggregate net proceeds received in all
Qualified Offerings, if any, completed prior to the Second Rights Offering
Trigger Date.  The price per share of the Second Rights Offering would
be designated by Invus in a range between $4.50 and a then-current average
market price of the Company’s common stock.  All stockholders would
have oversubscription rights with respect to the Second Rights Offering, and
Invus would be required to purchase the entire portion of the Second Rights
Offering that is not subscribed for by other stockholders.  Lexicon
has determined that the First Rights Offering and the Second Rights Offering
should be treated as equity instruments in accordance with EITF 00-19,
“Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company’s Own Stock,” and accordingly has not recorded a liability
for the future settlement of any rights offerings.
  A
“Qualified Offering” consists of a bona fide financing transaction comprised of
Lexicon’s issuance of shares of its common stock at a price greater than $4.50
per share, which transaction is not entered into in connection with the
Company’s entry into any other transaction (including, a collaboration or
license for the discovery, development or commercialization of pharmaceutical
products) involving the purchaser of such common stock.  Until the
later of the completion of the Second Rights Offering or the expiration of the
90-day period following the Second Rights Offering Trigger Date, Lexicon will
not, without Invus’ prior consent, issue any shares of its common stock at a
price below $4.50 per share, subject to certain exceptions.
  F-19
 Table
of Contents
 In
connection with the Securities Purchase Agreement, Lexicon entered into a
Stockholders’ Agreement with Invus under which Invus (a) has specified rights
with respect to designation of directors and to participate in future equity
issuances by the Company, (b) is subject to certain standstill restrictions, as
well as restrictions on transfer and the voting of the shares of common stock
held by it and its affiliates, and (c), as long as Invus holds at least 15% of
the total number of outstanding shares of the Company’s common stock, is
entitled to certain minority protections.
  13. Other Capital
Stock Agreements
  Common Stock: In September 2006,
Lexicon issued and sold 1,000,000 shares of its common stock to Azimuth
Opportunity Ltd. under its June 2006 equity line agreement with Azimuth at a
purchase price of approximately $3.67 per share.  After deducting
offering expenses, Lexicon received net proceeds from the sale of approximately
$3.6 million.
  In
October 2006, Lexicon completed the registered direct offering and sale of
10,582,011 shares of its common stock to selected institutional investors at a
price of $3.78 per share, resulting in net proceeds of $37.5 million, after
deducting placement agent fees of $2.4 million and offering expenses of
$0.1 million.
  14. Stock Options
and Warrants
  Stock
Option Plans
  2000 Equity Incentive
Plan:  In September 1995, Lexicon adopted the 1995 Stock Option
Plan, which was subsequently amended and restated in February 2000 as the 2000
Equity Incentive Plan (the “Equity Incentive Plan”). The Equity Incentive Plan
will terminate in 2010 unless the Board of Directors terminates it sooner. The
Equity Incentive Plan provides that it will be administered by the Board of
Directors, or a committee appointed by the Board of Directors, which determines
recipients and types of options to be granted, including number of shares under
the option and the exercisability of the shares.  The Equity Incentive
Plan is presently administered by the Compensation Committee of the Board of
Directors.
  The
Equity Incentive Plan provides for the grant of incentive stock options to
employees and nonstatutory stock options to employees, directors and consultants
of the Company. The plan also permits the grant of stock bonuses and restricted
stock purchase awards. Incentive stock options have an exercise price of 100% or
more of the fair market value of our common stock on the date of grant.
Nonstatutory stock options may have an exercise price as low as 85% of fair
market value on the date of grant. The purchase price of other stock awards may
not be less than 85% of fair market value. However, the plan administrator may
award bonuses in consideration of past services without a purchase payment.
Shares may be subject to a repurchase option in the discretion of the plan
administrator.  Most options granted under the Equity Incentive Plan
become vested and exercisable over a period of four years; however some have
been granted with different vesting schedules.  Options granted under
the Equity Incentive Plan have a term of ten years from the date of
grant.
  The Board
of Directors initially authorized and reserved an aggregate of 11,250,000 shares
of common stock for issuance under the Equity Incentive Plan. On January 1 of
each year for ten years, beginning in 2001, the number of shares reserved for
issuance under the Equity Incentive Plan automatically will be increased by the
greater of:
  ·
              5%
      of Lexicon’s outstanding shares on a fully-diluted basis;
    or
  ·
              that
      number of shares that could be issued under awards granted under the
      Equity Incentive Plan during the prior 12-month
  period;
  provided
that the Board of Directors may provide for a lesser increase in the number of
shares reserved under the Equity Incentive Plan for any year.  The
total number of shares reserved in the aggregate may not exceed 30,000,000
shares over the ten-year period.
  As of
December 31, 2008, an aggregate of 26,000,000 shares of common stock had been
reserved for issuance, options to purchase 16,336,404 shares were outstanding,
and 4,189,629 shares had been issued upon the exercise of stock options issued
under the Equity Incentive Plan.
  2000 Non-Employee Directors’ Stock
Option Plan:  In February 2000, Lexicon adopted the 2000
Non-Employee Directors’ Stock Option Plan (the “Directors’ Plan”) to provide for
the automatic grant of options to purchase shares of common stock to
non-employee directors of the Company. Under the Directors’ Plan, non-employee
directors first elected after the closing of the Company’s initial public
offering receive an initial option to purchase 30,000 shares of common
stock.  In addition, on the day following each of the Company’s annual
meetings of stockholders, beginning with the annual meeting in 2001, each
non-employee director who has been a director for at least six months was
automatically granted an option to purchase 6,000 shares of common
stock.  Beginning with the annual meeting in 2005, the annual grant
was increased to an option to purchase 10,000 shares of common
stock.  Initial option grants become vested and exercisable over a
period of five years and annual option grants become vested over a period of
12 months from the date of grant.  Options granted under the
Directors’ Plan have an exercise price equal to the fair market value of the
Company’s common stock on the date of grant and term of ten years from the date
of grant.
 F-20
 Table
of Contents
  The Board
of Directors initially authorized and reserved a total of 600,000 shares of its
common stock for issuance under the Directors’ Plan. On the day following each
annual meeting of Lexicon’s stockholders, for 10 years, starting in 2001, the
share reserve will automatically be increased by a number of shares equal to the
greater of:
  ·
              0.3%
      of the Company’s outstanding shares on a fully-diluted basis;
      or
  ·
              that
      number of shares that could be issued under options granted under the
      Directors’ Plan during the prior 12-month
  period;
  provided
that the Board of Directors may provide for a lesser increase in the number of
shares reserved under the Directors’ Plan for any year.
  As of
December 31, 2008, an aggregate of 650,000 shares of common stock had been
reserved for issuance, options to purchase 504,000 shares were outstanding, and
no options had been exercised under the Directors’ Plan.
  Coelacanth Corporation 1999 Stock
Option Plan:  Lexicon assumed the Coelacanth Corporation 1999
Stock Option Plan (the “Coelacanth Plan”) and the outstanding stock options
under the plan in connection with our July 2001 acquisition of Coelacanth
Corporation.  The Company will not grant any further options under the
plan.  As outstanding options under the plan expire or terminate, the
number of shares authorized for issuance under the plan will be correspondingly
reduced.
  The
purpose of the plan was to provide an opportunity for employees, directors and
consultants of Coelacanth to acquire a proprietary interest, or otherwise
increase their proprietary interest, in Coelacanth as an incentive to continue
their employment or service.  Both incentive and nonstatutory options
are outstanding under the plan.  Most outstanding options vest over
time and expire ten years from the date of grant.  The exercise price
of options awarded under the plan was determined by the plan administrator at
the time of grant.  In general, incentive stock options have an
exercise price of 100% or more of the fair market value of Coelacanth common
stock on the date of grant and nonstatutory stock options have an exercise price
as low as 85% of fair market value on the date of grant.
  As of
December 31, 2008, an aggregate of 85,677 shares of common stock had been
reserved for issuance, options to purchase 57,760 shares of common stock were
outstanding and 27,917 shares of common stock had been issued upon the exercise
of stock options issued under the Coelacanth Plan.
  Stock Option
Activity:  The following is a summary of option activity under
Lexicon’s stock option plans:
  2008
                              
                              
                              2007
                              
                              
                              2006(In
      thousands, except exercise price data)
                              
                              Options
                              
                              
                              Weighted
      Average Exercise Price
                              
                              
                              Options
                              
                              
                              Weighted
      Average Exercise Price
                              
                              
                              Options
                              
                              
                              Weighted
      Average Exercise PriceOutstanding
      at beginning of year
                              
                              
                              16,351
                              
                              
                              $
                              5.65
                              
                              
                              
                              15,815
                              
                              
                              $
                              5.99
                              
                              
                              
                              13,802
                              
                              
                              $
                              6.36Granted
                              
                              
                              4,077
                              
                              
                              
                              2.08
                              
                              
                              
                              2,952
                              
                              
                              
                              3.85
                              
                              
                              
                              2,651
                              
                              
                              
                              4.07Exercised
                              
                              
                              (1
                              )
                              
                              
                              1.89
                              
                              
                              
                              (516
                              )
                              
                              
                              1.80
                              
                              
                              
                              (156
                              )
                              
                              
                              2.30Expired
                              
                              
                              (2,663
                              )
                              
                              
                              4.32
                              
                              
                              
                              (1,137
                              )
                              
                              
                              8.11
                              
                              
                              
                              (248
                              )
                              
                              
                              8.96Forfeited
                              
                              
                              (866
                              )
                              
                              
                              3.03
                              
                              
                              
                              (763
                              )
                              
                              
                              4.68
                              
                              
                              
                              (234
                              )
                              
                              
                              5.23Outstanding
      at end of year
                              
                              
                              16,898
                              
                              
                              
                              5.13
                              
                              
                              
                              16,351
                              
                              
                              
                              5.65
                              
                              
                              
                              15,815
                              
                              
                              
                              5.99Exercisable
      at end of year
                              
                              
                              11,410
                              
                              
                              $
                              6.28
                              
                              
                              
                              11,946
                              
                              
                              $
                              6.21
                              
                              
                              
                              11,675
                              
                              
                              $
                              6.40
  
 F-21
 Table
of Contents
 The
weighted average estimated grant date fair value of options granted during the
years ended December 31, 2008, 2007 and 2006 were $1.43,  $2.71 and
$2.99, respectively.  The total intrinsic value of options exercised
during the years ended December 31, 2008, 2007 and 2006 were $300, $982,000
and $343,000, respectively.  The weighted average remaining
contractual term of options outstanding and exercisable was 5.5 and 4.0 years,
respectively, as of December 31, 2008.  At December 31, 2008, the
aggregate intrinsic value of the outstanding options and the exercisable options
was $310 and none, respectively.
  The
following is a summary of the nonvested options as of December 31, 2008,
and changes during the year then ended, under Lexicon’s stock option
plans:
  Options
                  
                  
                  Weighted
      Average Grant Date Fair ValueNonvested
      at beginning of year
                  
                  
                  4,405
                  
                  
                  $
                  2.96Granted
                  
                  
                  4,077
                  
                  
                  
                  1.43Vested
                  
                  
                  (2,128
                  )
                  
                  
                  3.07Canceled
                  
                  
                  (866
                  )
                  
                  
                  2.10Nonvested
      at end of year
                  
                  
                  5,488
                  
                  
                  $
                  1.91
 
 Warrants
  In
connection with the acquisition of Coelacanth in July 2001, Lexicon assumed
Coelacanth’s outstanding warrants to purchase 25,169 shares of common
stock.  The warrants expire on March 31, 2009.  The
fair value of the warrants was included in the total purchase price for the
acquisition.  As of December 31, 2008, warrants to purchase
16,483 shares of common stock, with an exercise price of $11.93 per share,
remained outstanding.
  Aggregate
Shares Reserved for Issuance
  As of
December 31, 2008, an aggregate of 16,914,647 shares of common stock were
reserved for issuance upon exercise of outstanding stock options and warrants
and 5,601,994 additional shares were available for future grants under Lexicon’s
stock option plans.
  15. Benefit
Plans
  Lexicon
has established an Annual Profit Sharing Incentive Plan (the “Profit Sharing
Plan”). The purpose of the Profit Sharing Plan is to provide for the payment of
incentive compensation out of the profits of the Company to certain of its
employees. Participants in the Profit Sharing Plan are entitled to an annual
cash bonus equal to their proportionate share (based on salary) of 15 percent of
the Company’s annual pretax income, if any.
  Lexicon
maintains a defined-contribution savings plan under Section 401(k) of the
Internal Revenue Code.  The plan covers substantially all full-time
employees.  Participating employees may defer a portion of their
pretax earnings, up to the Internal Revenue Service annual contribution
limit.  Beginning in 2000, the Company was required to match employee
contributions according to a specified formula.  The matching
contributions totaled $828,000, $862,000 and $907,000, in the years ended
December 31, 2008, 2007 and 2006, respectively.  Company
contributions are vested based on the employee’s years of service, with full
vesting after four years of service.
  16. Collaboration
and License Agreements
  Lexicon
has derived substantially all of its revenues from drug discovery and
development alliances, target validation collaborations for the development and,
in some cases, analysis of the physiological effects of genes altered in
knockout mice, government grants and contracts, technology licenses,
subscriptions to its databases and compound library sales.
  Drug
Discovery and Development Alliances
  Lexicon
has entered into the following alliances for the discovery and development of
therapeutics based on its in
vivo drug target discovery efforts:
  F-22
 Table
of Contents
 Bristol-Myers Squibb Company:
Lexicon established an alliance with Bristol-Myers Squibb in December 2003 to
discover, develop and commercialize small molecule drugs in the neuroscience
field.  Lexicon initiated the alliance with a number of drug discovery
programs at various stages of development and is continuing to use its gene
knockout technology to identify additional drug targets with promise in the
neuroscience field.  For those targets that are selected for the
alliance, Lexicon and Bristol-Myers Squibb are working together, on an exclusive
basis, to identify, characterize and carry out the preclinical development of
small molecule drugs, and will share equally both in the costs and in the work
attributable to those efforts.  As drugs resulting from the
collaboration enter clinical trials, Bristol-Myers Squibb will have the first
option to assume full responsibility for clinical development and
commercialization.
  Lexicon
received an upfront payment of $36.0 million and research funding of $30.0
million in the initial three years of the agreement, or the target function
discovery term.  This funding was in consideration for access to
Lexicon’s technology and infrastructure and for Lexicon’s production and
specified phenotypic analysis of knockout mice in support of the target function
discovery portion of the alliance.  Bristol-Myers Squibb extended the
target discovery term of the alliance in May 2006 for an additional two years in
exchange for $20.0 million in additional research funding over the two year
extension, which commenced in January 2007.  This additional funding
is in consideration for additional research and phenotypic analysis of knockout
mice which supplements the phenotypic analysis conducted in the initial target
function discovery term.  Lexicon will also receive clinical and
regulatory milestone payments for each drug target for which Bristol-Myers
Squibb develops a drug under the alliance.  Lexicon will earn
royalties on sales of drugs commercialized by Bristol-Myers
Squibb.  The party with responsibility for the clinical development
and commercialization of drugs resulting from the alliance will bear the costs
of those efforts.  The original upfront payment of $36.0 million
and research funding of $30.0 million was recognized over the initial
estimated period of service of three years.  The additional research
funding of $20.0 million is being recognized over the estimated performance
period of two and one-half additional years subject to the extension, beginning
in January 2007.  Lexicon recorded a change in estimate that increased
net loss and net loss per share by $1.7 million and $0.01 per share,
respectively, in the year ended December 31, 2008 due to an increase in
estimated performance period of this extension.
  The
upfront payment of $36.0 million was not related to a deliverable with
standalone value at inception, and Lexicon accounted for the entire agreement
with Bristol-Myers Squibb as a single unit of accounting.  Milestone
payments received are in consideration for additional
performance.  Therefore, Lexicon recognizes revenue from such
milestone payments upon achievement of the milestones.
  Revenue
recognized under this agreement was $9.3 million, $10.0 million and
$21.8 million for the years ended December 31, 2008, 2007 and 2006,
respectively.
  Genentech,
Inc.  Lexicon established an alliance with Genentech in
December 2002 to discover novel therapeutic proteins and antibody
targets.  Under the original alliance agreement, Lexicon used its
target validation technologies to discover the functions of secreted proteins
and potential antibody targets identified through Genentech’s internal drug
discovery research.  Lexicon received an upfront payment of $9.0
million and funding under a $4.0 million loan in 2002.  The terms of
the loan are discussed in Note 9.  In addition, Lexicon received
$24.0 million in performance payments for its work in the collaboration as
it was completed.  The original upfront payment of $9.0 million
was recognized over the initial estimated period of service of three years,
which was subsequently extended to three and one-half years.
  In
November 2005, Lexicon and Genentech expanded the alliance to include additional
research, as well as the development and commercialization of new biotherapeutic
drugs.  Lexicon received a total of $25.0 million in upfront and
milestone payments and research funding for the three-year advanced research
portion of the expanded alliance.  In the expanded alliance, Lexicon
conducted advanced research on a broad subset of targets validated in the
original collaboration using Lexicon’s proprietary gene knockout
technology.  The upfront payment under the new agreement was
recognized over the estimated period of service of three years.
  Lexicon
may develop and commercialize drugs for up to six of the targets included in the
alliance.  Genentech retains an option on the potential development
and commercialization of these drugs under a cost and profit sharing
arrangement, with Lexicon having certain conditional rights to co-promote drugs
on a worldwide basis.  Genentech is entitled to receive milestone
payments in the event of regulatory approval and royalties on net sales of
products commercialized by Lexicon outside of a cost and profit sharing
arrangement.  Lexicon will receive payments from Genentech upon
achievement of milestones related to the development and regulatory approval of
certain drugs resulting from the alliance that are developed and commercialized
by Genentech.  Lexicon is also entitled to receive royalties on net
sales of these products, provided they are not included in a cost and profit
sharing arrangement.  Lexicon retains non-exclusive rights for the
development and commercialization of small molecule drugs addressing the targets
included in the alliance.
 F-23
 Table
of Contents
  The
upfront payment was not related to a deliverable with standalone value at
inception and Lexicon accounted for the entire agreement with Genentech as a
single unit of accounting.  Milestone payments received are in
consideration for additional performance.  Therefore, Lexicon
recognizes revenue from such milestone payments upon achievement of the
milestones.
  Revenue
recognized under this agreement was $4.0 million, $4.3 million and
$5.0 million for the years ended December 31, 2008, 2007 and 2006,
respectively.
  N.V.
Organon.  Lexicon established an alliance with Organon in May
2005 to jointly discover, develop and commercialize novel biotherapeutic
drugs.  In the alliance, Lexicon is creating and analyzing knockout
mice for up to 300 genes selected by the parties that encode secreted proteins
or potential antibody targets, including two of Lexicon’s existing drug
discovery programs.  The parties are jointly selecting targets for
further research and development and will equally share costs and responsibility
for research, preclinical and clinical activities.  The parties will
jointly determine the manner in which alliance products will be commercialized
and will equally benefit from product revenue.  If fewer than five
development candidates are designated under the alliance, Lexicon’s share of
costs and product revenue will be proportionally reduced.  Lexicon
will receive a milestone payment for each development candidate in excess of
five.  Either party may decline to participate in further research or
development efforts with respect to an alliance product, in which case such
party will receive royalty payments on sales of such alliance product rather
than sharing in revenue.  Organon will have principal responsibility
for manufacturing biotherapeutic products resulting from the alliance for use in
clinical trials and for worldwide sales.  Organon, formerly a
subsidiary of Akzo Nobel N.V., was acquired by Schering-Plough Corporation in
November 2007.
  Lexicon
received an upfront payment of $22.5 million from Organon in exchange for access
to Lexicon’s drug target discovery capabilities and the exclusive right to
co-develop biotherapeutic drugs for the 300 genes selected for the
alliance.  Organon will also provide Lexicon with annual research
funding totaling up to $50.0 million for its 50% share of the alliance’s costs
during this same period.
  The
upfront payment of $22.5 million was not related to a deliverable with
standalone value at inception, and Lexicon accounted for the entire agreement
with Organon as a single unit of accounting.  Revenue from the upfront
payment is recognized on a straight-line basis over the four-year period that
Lexicon expects to perform its obligations under the target function discovery
portion of the alliance.  Revenue from the research funding fees is
recognized as Lexicon performs its obligations under the target function
discovery portion of the alliance, reflecting the gross amount billed to Organon
on the basis of shared costs during the period.  Milestone payments
received are in consideration for additional performance.  Therefore,
Lexicon recognizes revenue from such milestone payments upon achievement of the
milestones.
  Revenue
recognized under this agreement was $9.2 million, $13.5 million and
$15.5 million for the years ended December 31, 2008, 2007 and 2006,
respectively.
  Takeda Pharmaceutical Company
Limited.  Lexicon established an alliance with Takeda in July
2004 to discover new drugs for the treatment of high blood
pressure.  In the collaboration, Lexicon used its gene knockout
technology to identify drug targets that control blood
pressure.  Takeda is responsible for the screening, medicinal
chemistry, preclinical and clinical development and commercialization of drugs
directed against targets selected for the alliance, and bears all related
costs.  Lexicon received an upfront payment of $12.0 million from
Takeda for the initial, three-year term of the agreement. This payment was in
consideration for access to Lexicon’s technology and infrastructure during the
target discovery portion of the alliance.  Takeda will make research
milestone payments to Lexicon for each target selected for therapeutic
development.  In addition, Takeda will make clinical development and
product launch milestone payments to Lexicon for each product commercialized
from the collaboration.  Lexicon will also earn royalties on sales of
drugs commercialized by Takeda.  The target discovery portion of the
alliance, which ended in 2007, had a term of three years.
  F-24
 Table
of Contents
 The
upfront payment of $12.0 million was not related to a deliverable with
standalone value at inception, and Lexicon accounted for the entire agreement
with Takeda as a single unit of accounting.  Revenue was recognized
from the upfront payment on a straight-line basis over the three-year period
Lexicon expected to perform its obligations under the
agreement.  Milestone payments received are in consideration for
additional performance.  Therefore, Lexicon recognizes revenue from
such milestone payments upon achievement of the milestones.
  Revenue
recognized under this agreement was $2.3 million and $9.0 million for
the years ended December 31, 2007 and 2006, respectively.
  Other Collaborations and
Arrangements
  Lexicon
has entered into the following other collaborationsand
arrangements:
  Bristol-Myers Squibb
Company.  Lexicon entered into a drug target validation
agreement with Bristol-Myers Squibb in December 2004.  Under this
agreement, Lexicon developed mice and phenotypic data for certain genes
previously requested by Bristol-Myers Squibb under its LexVision agreement (but
that Lexicon was not required to deliver thereunder) and certain additional
genes requested by Bristol-Myers Squibb.  The collaboration term under
the agreement expired after the final phenotypic data set was delivered by
Lexicon.  The Company received payments totaling $5.0 million
under the agreement.  Revenue recognized under this agreement was
none, $0.2 million and $1.4 million for the years ended
December 31, 2008, 2007 and 2006, respectively.
  Lexicon
also entered into separate drug target validation agreements with Bristol-Myers
Squibb in January 2006, October 2006 and November 2007, under which Lexicon
is developing mice and phenotypic data for certain additional genes requested by
Bristol-Myers Squibb under those agreements.  The collaboration term
under each of these agreements will expire after the final phenotypic data set
has been delivered by Lexicon under that agreement.  The Company
received payments totaling $4.8 million under these agreements through
December 31, 2008.  Revenue recognized under these agreements was
$1.1 million, $1.5 million and $1.4 million for the years ended
December 31, 2008, 2007 and 2006, respectively.
  Genentech,
Inc.  Lexicon entered into a drug target validation agreement
with Genentech, Inc. in February 2007.  Under this agreement, Lexicon
developed mice with mutations requested by Genentech.  The
collaboration term under the agreement expired after the final delivery of the
selected mice has been performed by Lexicon.  The Company received
payments totaling $1.0 million under the agreement through December 31,
2008.  Revenue recognized under this agreement was $0.1 and
$0.9 million for the years ended December 31, 2008 and 2007,
respectively.
  Texas Institute for Genomic
Medicine.   In July 2005, Lexicon was awarded
$35.0 million from the Texas Enterprise Fund for the creation of a knockout
mouse embryonic stem cell library containing 350,000 cell lines using Lexicon’s
proprietary gene trapping technology, which Lexicon completed in
2007.  Lexicon created the library for the Texas Institute for Genomic
Medicine (“TIGM”), a newly formed non-profit institute whose founding members
are Texas A&M University, the Texas A&M University System Health Science
Center and Lexicon.  TIGM researchers may also access specific cells
from Lexicon’s current gene trap library of 270,000 mouse embryonic stem cell
lines and have certain rights to utilize Lexicon’s patented gene targeting
technologies.  In addition, Lexicon equipped TIGM with the
bioinformatics software required for the management and analysis of data
relating to the library.  The Texas Enterprise Fund also awarded
$15.0 million to the Texas A&M University System for the creation of
facilities and infrastructure to house the library.  Revenue
recognized under this agreement was $0.1 million, $10.6 million and
$7.0 million for the years ended December 31, 2008, 2007 and 2006,
respectively.  Lexicon recorded a change in estimate that increased
revenue and therefore decreased net loss and net loss per share by
$3.7 million and $0.04 per share, respectively, in the year ended
December 31, 2007 due to a reduction in the estimated performance period of
this agreement.
  Under the
terms of the award, Lexicon is responsible for the creation of a specified
number of jobs beginning in 2012, reaching an aggregate of 1,616 new jobs in
Texas by December 31, 2016.  Lexicon will obtain credits based on
funding received by TIGM and certain related parties from sources other than the
State of Texas that it may offset against its potential liability for any job
creation shortfalls.  Lexicon will also obtain credits against future
jobs commitment liabilities for any surplus jobs it creates.  Subject
to these credits, if Lexicon fails to create the specified number of jobs, the
state may require Lexicon to repay $2,415 for each job Lexicon falls
short.  Lexicon’s maximum aggregate exposure for such payments, if
Lexicon fails to create any new jobs, is approximately $14.2 million,
without giving effect to any credits to which Lexicon may be
entitled.  Lexicon has recorded this obligation as deferred revenue in
the accompanying consolidated balance sheets.  The Texas A&M
University System, together with TIGM, has independent job creation obligations
and is obligated for an additional period to maintain an aggregate of 5,000
jobs, inclusive of those Lexicon creates.
 F-25
 Table
of Contents
  17. Selected
Quarterly Financial Data
  The table
below sets forth certain unaudited statements of operations data, and net loss
per common share data, for each quarter of 2008 and 2007:
  (In
thousands, except per share data)
 
 Quarter
      EndedMarch 31
                                      
                                      
                                      June 30
                                      
                                      
                                      September 30
                                      
                                      
                                      December 31(Unaudited)2008Revenues
                                      
                                      $
                                      8,893
                                      
                                      
                                      $
                                      9,566
                                      
                                      
                                      $
                                      7,512
                                      
                                      
                                      $
                                      6,350Loss
      from operations
                                      
                                      $
                                      (24,438
                                      )
                                      
                                      $
                                      (26,386
                                      )
                                      
                                      $
                                      (24,822
                                      )
                                      
                                      $
                                      (20,889
                                      )Net
      loss
                                      
                                      $
                                      (17,950
                                      )
                                      
                                      $
                                      (20,034
                                      )
                                      
                                      $
                                      (23,459
                                      )
                                      
                                      $
                                      (15,417
                                      )Net
      loss per common share, basic and diluted
                                      
                                      $
                                      (0.13
                                      )
                                      
                                      $
                                      (0.15
                                      )
                                      
                                      $
                                      (0.17
                                      )
                                      
                                      $
                                      (0.11
                                      )Shares
      used in computing net loss per common share
                                      
                                      
                                      136,795
                                      
                                      
                                      
                                      136,796
                                      
                                      
                                      
                                      136,796
                                      
                                      
                                      
                                      136,7972007Revenues
                                      
                                      $
                                      13,495
                                      
                                      
                                      $
                                      12,648
                                      
                                      
                                      $
                                      10,167
                                      
                                      
                                      $
                                      13,808Loss
      from operations
                                      
                                      $
                                      (19,095
                                      )
                                      
                                      $
                                      (17,950
                                      )
                                      
                                      $
                                      (19,442
                                      )
                                      
                                      $
                                      (18,467
                                      )Net
      loss
                                      
                                      $
                                      (18,915
                                      )
                                      
                                      $
                                      (13,591
                                      )
                                      
                                      $
                                      (14,111
                                      )
                                      
                                      $
                                      (12,177
                                      )Net
      loss per common share, basic and diluted
                                      
                                      $
                                      (0.24
                                      )
                                      
                                      $
                                      (0.17
                                      )
                                      
                                      $
                                      (0.14
                                      )
                                      
                                      $
                                      (0.09
                                      )Shares
      used in computing net loss per common share
                                      
                                      
                                      77,938
                                      
                                      
                                      
                                      79,568
                                      
                                      
                                      
                                      104,196
                                      
                                      
                                      
                                      136,794


F-26