**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

----

 

**FORM 10-Q**

 
| **ý**                                              | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|---------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
|                                                    |       |                                                                                                     |
| **FOR THE  QUARTERLY PERIOD ENDED JUNE 30, 2006.** |
|                                                    |       |                                                                                                     |
| **OR**                                                  |
|                                                    |       |                                                                                                     |
| **o**                                                   | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**FOR THETRANSITION PERIOD FROM          TO**

 

**CommissionFile Number 0-29889**

 

----

 

**Rigel Pharmaceuticals, Inc.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                    | ** ** | **94-3248524**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or  other jurisdiction of incorporation or organization) |       | (I.R.S.  Employer Identification No.) |
|                                                            |       |                                  |
| **1180  Veterans Blvd.**                                        | ** ** | ** **                            |
| **South  San Francisco, CA**                                    | ** ** | **94080**                             |
| (Address of  principal executive offices)                       |       | (Zip Code)                            |
|                                                            |       |                                  |
| **(650) 624-1100**                                         |       |                                  |
| (Registrant’s  telephone number, including area code)      |       |                                  |

 

Indicate by check mark whether theregistrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes  ý  No  o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act) (Check one):
| Large accelerated filer o |   | Accelerated filer ý |   | Non-accelerated filer o |
|---------------------------|--------|--------------------------|--------|-------------------------|

 

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

 

As of July 28, 2006, there were24,938,377 shares of the registrant’s common stock outstanding.

 

 

----

 

**RIGELPHARMACEUTICALS, INC.**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THEQUARTERLY PERIOD ENDED JUNE 30, 2006**

 

**INDEX**

 
| **PART I**  | **FINANCIAL INFORMATION**                                                                         | 3      |
|------------------|---------------------------------------------------------------------------------------------------|--------|
| **Item 1.**      | Financial Statements (unaudited)                                                                  | 3      |
|             | Balance  Sheets - June 30, 2006 and December 31, 2005                                   | 3      |
|             | Condensed Statements of Operations – three and six months ended June 30,  2006 and 2005 | 4      |
|             | Condensed Statements of Cash Flows - six months ended June 30,  2006 and 2005                | 5      |
|             | Notes to Condensed Financial Statements                                                           | 6      |
|             | Report of Independent Registered Public Accounting Firm                                           | 13     |
| **Item 2.**      | Management’s Discussion and Analysis of Financial Condition and  Results of Operations       | 14     |
| **Item 3.**      | Quantitative and Qualitative Disclosures About Market Risk                                        | 20     |
| **Item 4.**      | Controls and Procedures                                                                           | 20     |
| **PART II** | **OTHER  INFORMATION**                                                                            | 21     |
| **Item  1A.**    | Risk  Factors                                                                                     | 21     |
| **Item 4.**      | Submission of Matters to a Vote of Security Holders                                               | 28     |
| **Item 6.**      | Exhibits                                                                                          | 28     |
|             |                                                                                              |   |
| **Signatures**   |                                                                                              | 29     |

 

2

----

 

**PART I FINANCIAL INFORMATION**

** **

**Item 1.  Financial Statements**

 

**RIGELPHARMACEUTICALS, INC.**

**BALANCE SHEETS**

**(inthousands, except share amounts)**

 
| ** **                                                                                                                                                                               | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                               | ** ** | **2006**          | ** ** | **2005(1)**           | ** ** |
| ** **                                                                                                                                                                               | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                               |       |              |       |                  |       |
| Current  assets:                                                                                                                                                                         |       |              |       |                  |       |
| Cash and  cash equivalents                                                                                                                                                               |       | $                 | 62,228     |                  | $          | 76,779 |   |
| Available-for-sale  securities                                                                                                                                                           |       | 60,012            |       | 61,417                |       |
| Accounts  receivable                                                                                                                                                                     |       | 1,050             |       | 1,050                 |       |
| Other  receivables                                                                                                                                                                       |       | 850               |       | 777                   |       |
| Prepaid  expenses and other current assets                                                                                                                                               |       | 2,186             |       | 2,573                 |       |
| Total  current assets                                                                                                                                                                    |       | 126,326           |       | 142,596               |       |
|                                                                                                                                                                                     |       |              |       |                  |       |
| Property and  equipment, net                                                                                                                                                             |       | 3,378             |       | 3,457                 |       |
| Other assets                                                                                                                                                                             |       | 1,520             |       | 1,615                 |       |
|                                                                                                                                                                                     |       | $                 | 131,224    |                  | $          | 147,668 |   |
|                                                                                                                                                                                     |       |              |       |                  |       |
| Liabilities  and stockholders’ equity                                                                                                                                               |       |              |       |                  |       |
| Current  liabilities:                                                                                                                                                                    |       |              |       |                  |       |
| Accounts  payable                                                                                                                                                                        |       | $                 | 1,544      |                  | $          | 2,497 |   |
| Accrued  compensation                                                                                                                                                                    |       | 1,145             |       | 2,189                 |       |
| Other  accrued liabilities                                                                                                                                                               |       | 1,631             |       | 2,324                 |       |
| Deferred  revenue                                                                                                                                                                        |       | 7,221             |       | 15,567                |       |
| Capital  lease obligations                                                                                                                                                               |       | 1,257             |       | 1,070                 |       |
| Total  current liabilities                                                                                                                                                               |       | 12,798            |       | 23,647                |       |
|                                                                                                                                                                                     |       |              |       |                  |       |
| Long-term  portion of capital lease obligations                                                                                                                                          |       | 1,539             |       | 1,132                 |       |
| Long-term  portion of deferred revenue                                                                                                                                                   |       | —            |       | 2,771                 |       |
| Long-term  portion of deferred rent                                                                                                                                                      |       | 11,208            |       | 11,121                |       |
| Other  long-term liabilities                                                                                                                                                             |       | 386               |       | 409                   |       |
|                                                                                                                                                                                     |       |              |       |                  |       |
| Commitments                                                                                                                                                                              |       |              |       |                  |       |
|                                                                                                                                                                                     |       |              |       |                  |       |
| Stockholders’  equity:                                                                                                                                                              |       |              |       |                  |       |
| Common  stock, $0.001 par value; 100,000,000 shares authorized; 24,928,469 and  24,814,671 shares issued and outstanding on June 30, 2006 and December 31,  2005, respectively |       | 25                |       | 25                    |       |
| Additional  paid-in capital                                                                                                                                                              |       | 373,710           |       | 366,203               |       |
| Deferred  stock compensation                                                                                                                                                             |       | —            |       | (26                   | )          |
| Accumulated  other comprehensive loss                                                                                                                                                    |       | (121              | )          | (92                   | )          |
| Accumulated  deficit                                                                                                                                                                     |       | (268,321          | )          | (257,522              | )          |
| Total  stockholders’ equity                                                                                                                                                         |       | 105,293           |       | 108,588               |       |
|                                                                                                                                                                                     |       | $                 | 131,224    |                  | $          | 147,668 |   |

 

----

| Note (1) | The balance sheet at December 31, 2005  has been derived from the audited financial statements at that date included  in Rigel’s Annual Report on Form 10-K for the year ended  December 31, 2005. |
|----------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

See accompanying notes.

 

3

----

 

**RIGELPHARMACEUTICALS, INC.****CONDENSED STATEMENTS OF OPERATIONS(in thousands, except per share amounts)**

**(unaudited)**

 
| ** **                                                                              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Contract  revenues from collaborations                                                  |       | $                                                   | 14,321     |                                              | $          | 4,606 |   | $ | 24,218 |   | $ | 7,224 |   |
| Costs and  expenses:                                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Research and  development                                                               |       | 13,205                                              |       | 13,807                                            |       | 27,916 |   | 24,980 |   |
| General and  administrative                                                             |       | 4,725                                               |       | 3,429                                             |       | 9,728 |   | 6,303 |   |
|                                                                                    |       |                                                |       |                                              |       |   |   |   |   |
|                                                                                    |       | 17,930                                              |       | 17,236                                            |       | 37,644 |   | 31,283 |   |
|                                                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Loss from  operations                                                                   |       | (3,609                                              | )          | (12,630                                           | )          | (13,426 | ) | (24,059 | ) |
| Interest  income                                                                        |       | 1,426                                               |       | 402                                               |       | 2,840 |   | 732 |   |
|                                                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Interest  expense                                                                       |       | (147                                                | )          | (65                                               | )          | (213 | ) | (130 | ) |
|                                                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Net loss                                                                                |       | (2,330                                              | )          | (12,293                                           | )          | (10,799 | ) | (23,457 | ) |
|                                                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Net loss per  common share, basic and diluted                                           |       | $                                                   | (0.09      | )                                                 | $          | (0.62 | ) | $ | (0.43 | ) | $ | (1.18 | ) |
|                                                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Weighted  average shares used in computing net loss per common share, basic and diluted |       | 24,842                                              |       | 19,887                                            |       | 24,829 |   | 19,801 |   |

 

See accompanying notes.

 

4

----

 

**RIGELPHARMACEUTICALS, INC.****CONDENSED STATEMENTSOF CASH FLOWS****(in thousands)**

**(unaudited**)

 
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                   | ** ** | **June 30,**              | ** ** |
| ** **                                                                   | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| **Operating  activities**                                                    |       |                           |       |   |   |
| Net loss                                                                     |       | $                              | (10,799    | ) | $ | (23,457 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                           |       |   |   |
| Depreciation  and amortization                                               |       | 664                            |       | 587 |   |
| Amortization  of deferred stock compensation, net                            |       | —                         |       | 11 |   |
| Non-cash  stock compensation expense (recovery)                              |       | 6,688                          |       | (657 | ) |
| Changes in  assets and liabilities:                                          |       |                           |       |   |   |
| Accounts  receivable                                                         |       | —                         |       | (1,181 | ) |
| Other  receivables                                                           |       | (73                            | )          | 111 |   |
| Prepaid  expenses and other current assets                                   |       | 387                            |       | (187 | ) |
| Other assets                                                                 |       | 95                             |       | 81 |   |
| Accounts  payable                                                            |       | (953                           | )          | 1,240 |   |
| Accrued  compensation                                                        |       | (1,044                         | )          | (697 | ) |
| Other  accrued liabilities                                                   |       | (307                           | )          | 513 |   |
| Deferred  revenue                                                            |       | (11,117                        | )          | 7,132 |   |
| Deferred  rent and other long-term liabilities                               |       | (322                           | )          | (402 | ) |
|                                                                         |       |                           |       |   |   |
| Net cash  used in operating activities                                       |       | (16,781                        | )          | (16,906 | ) |
| ** **                                                                   |       |                           |       |   |   |
| **Investing  activities**                                                    |       |                           |       |   |   |
| Purchases of  available-for-sale securities                                  |       | (27,792                        | )          | (31,887 | ) |
| Maturities  of available-for-sale securities                                 |       | 29,168                         |       | 43,160 |   |
| Capital  expenditures                                                        |       | (585                           | )          | (554 | ) |
| Net cash  provided by investing activities                                   |       | 791                            |       | 10,719 |   |
| ** **                                                                   |       |                           |       |   |   |
| **Financing  activities**                                                    |       |                           |       |   |   |
| Proceeds  from capital lease financing                                       |       | 1,257                          |       | 1,191 |   |
| Payments on  capital lease obligations                                       |       | (663                           | )          | (1,025 | ) |
| Net proceeds  from issuances of common stock                                 |       | 845                            |       | 5,850 |   |
| Net cash  provided by financing activities                                   |       | 1,439                          |       | 6,016 |   |
|                                                                         |       |                           |       |   |   |
| Net decrease  in cash and cash equivalents                                   |       | (14,551                        | )          | (171 | ) |
|                                                                         |       |                           |       |   |   |
| Cash and  cash equivalents at beginning of period                            |       | 76,779                         |       | 10,495 |   |
| Cash and  cash equivalents at end of period                                  |       | $                              | 62,228     |   | $ | 10,324 |   |

 

See accompanying notes.

 

5

----

 

**RigelPharmaceuticals, Inc.**

**Notes to Condensed Financial Statements**

**(unaudited)**

 

In this Quarterly Report, “Rigel,” “we,” “us”and “our” refer to Rigel Pharmaceuticals, Inc.

 

**1. Nature of Operations**

 

We were incorporated in the state of Delawareon June 14, 1996. We are engaged in the discovery and development ofnovel, small-molecule drugs for the treatment of inflammatory diseases, cancerand viral diseases.

 

**2. Basis of Presentation**

 

Our accompanying unaudited condensedfinancial statements have been prepared in accordance with generally acceptedaccounting principles for interim financial information and pursuant to theinstructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the informationand notes required by generally accepted accounting principles for completefinancial statements. In our opinion, these unaudited condensed financialstatements include all adjustments, consisting only of normal recurringadjustments, which we consider necessary to fairly state our financial positionand the results of our operations and cash flows. Interim-period results arenot necessarily indicative of results of operations or cash flows for afull-year period. The balance sheet at December 31, 2005 has been derived fromaudited financial statements at that date, but does not include all disclosuresrequired by generally accepted accounting principles for complete financial statements.These unaudited condensed financial statements and the notes accompanying themshould be read in conjunction with our Annual Report on Form 10-K for the yearended December 31, 2005.

 

The preparation of financial statements inconformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the amounts reported in thefinancial statements and accompanying notes. Actual results could differ fromthese estimates.

 

Comprehensive net loss did not differmaterially from the net loss as reported.

 

**3. Basic and Diluted Net Loss Per Share**

 

Basic net loss per share was computed basedon the number of weighted average shares outstanding. The calculation ofdiluted net loss per share excluded shares of potential common stock,consisting of stock options and warrants, because their effect would have beenanti-dilutive.

 

**4. Stock Award Plans**

 

We have two stock option plans, the 2000 Equity Incentive Plan and 2000Non-Employee Directors Stock Option Plan, that provide for granting toofficers, directors, all other employees and other non-employees options topurchase shares of our common stock. Under the plans, we may issuenon-qualified options or incentive stock options. We also have an employeestock purchase plan, or ESPP, where eligible employees can purchase shares ofour common stock at a price per share equal to 85% of the lower of the fairmarket value on the first and last day of each six-month purchase period. Thebenefits provided under these plans are share-based payments subject to theprovisions of Statement of Financial Accounting Standards No. 123(R),“Share-Based Payment (Revised 2004)”, or SFAS 123(R).

 

Effective January 1, 2006, we adoptedthe provisions of SFAS 123(R) using the modified prospective applicationtransition method. Under this method, the share-based compensation costrecognized beginning January 1, 2006 includes compensation cost for (i) allshare-based payments granted prior to, but not vested as of January 1,2006, based on the grant date fair value originally estimated in accordancewith the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”,or SFAS 123, and calculated for pro forma disclosures under SFAS No. 148, “Accountingfor Stock-Based Compensation – Transition and Disclosure”, or SFAS 148, and (ii) allshare-based payments granted subsequent to January 1, 2006, based on thegrant date fair value estimated in accordance with the provisions of SFAS123(R). Compensation cost under SFAS 123(R) for awards granted prior to January 1,2006 is recognized using an accelerated method pursuant to the FinancialAccounting Standards Board, or FASB, Interpretation No. 28, “Accountingfor Stock Appreciation Rights and Other Variable Stock Option or Award Plans”, orFIN 28. For awards granted after January 1, 2006, we have adopted the useof the straight-line attribution method over the requisite service period forthe entire award. Results of prior periods do not reflect any restated amounts,and we had no cumulative effect adjustment upon adoption of SFAS No. 123(R)under the modified prospective method.

 

6

----

 

***Impact of theAdoption of FAS 123(R)***

 

Total stock-based compensation expense,related to all of the Company’s share-based awards, recognized for the threeand six months ended June 30, 2006 and 2005 was comprised as follows (inthousands, except per share amounts):

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                             | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Research and  development                              |       | $                                | 1,543      |                           | $          | 566 |   | $ | 3,464 |   | $ | (461 | ) |
| General and  administrative                            |       | 1,584                            |       | 256                            |       | 3,224 |   | (185 | ) |
| Stock-based  compensation expense/(recovery)           |       | $                                | 3,127      |                           | $          | 822 |   | $ | 6,688 |   | $ | (646 | ) |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Stock-based  compensation expense/(recovery) per share |       |                             |       |                           |       |   |   |   |   |
| Basic and  diluted                                     |       | $                                | 0.13       |                           | $          | 0.04 |   | $ | 0.27 |   | $ | (0.03 | ) |

 

We recorded approximately $3.1 million instock-based compensation expense for the three months ended June 30, 2006,consisting of approximately $3.2 million in stock-based awards granted toofficers, directors and all other employees from our stock option plans andESPP, offset by a recovery of approximately $93,000 in options originallygranted to consultants, which is discussed below. We recorded approximately$6.7 million in stock-based compensation expense for the six months ended June 30,2006, consisting of approximately $6.5 million in stock-based awards granted toofficers, directors and all other employees from our stock option plans andESPP and approximately $184,000 in options granted to consultants. Pursuant toSFAS 123(R), we are required to estimate the amount of expected forfeitureswhen calculating the compensation costs, instead of accounting for forfeituresas incurred, which was our previous method. Our annual weighted averageforfeiture rate was 7.6% as of June 30, 2006 as compared to 4.7% as of March 31,2006. The increase in the forfeiture rate was due to the forfeiture of anexecutive officer’s unvested options resulting from his departure from thecompany. We will record actual forfeitures as they occur, and we will reviewour forfeiture rates each quarter and make changes to our estimate.

 

For the three months ended June 30,2006, we recorded a recovery of approximately $93,000, and for the six monthsended June 30, 2006, we recorded an expense of approximately $184,000,associated with options granted to consultants, reflecting the fair value andperiodic fair value remeasurement of outstanding consultant options under EmergingIssues Task Force No. 96-18, “Accounting for Equity Instruments That are Issuedto Other Than Employees for Acquiring, or in Conjunction with Selling Goods orServices”, or EITF 96-18.  The valuationis based upon the current market value of our common stock and otherassumptions, including the expected future volatility of our stock price,risk-free interest rate and expected term. For consultant options granted in2006, we amortized stock-based compensation using a straight-line attributionmethod consistent with the method used for employees and with the attributionelection we made upon adoption of FAS 123(R). For options granted prior to January 1,2006, we used the accelerated method for expensing stock-based compensation,which was the method we used prior to adoption. We recorded stock-basedcompensation expense of approximately $92,000 for the three months ended June 30,2005 and a recovery of approximately $115,000 for the six months ended June 30,2005 relating to consultant options. We expect to see continued fluctuations inthe future as a portion of these options are remeasured based on the changes inthe current market price of our common stock.

 

In 2005, we recorded charges associated with the stock options thatwere eligible for re-pricing under a tender offer initiated in June 2003.All replacement options, as well as the eligible options that were notsurrendered under the original offer to exchange, were treated for financialreporting purposes as variable awards. Therefore, for the period prior toadoption of FAS 123(R), we recorded a non-cash charge, generally for theintrinsic value of the options as they vested under Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees, or APB 25, utilizingthe accelerated vesting method, reflecting increases and decreases (down to,but not below, the exercise price) in the price of our common stock ascompensation expense (recovery) in connection with the replacement options andthe eligible options that were not exchanged. For the three months ended June 30,2005, we recorded stock-based compensation expense of approximately $715,000related to all employee options eligible for replacement options. The expenseresulted from the increase in the market price of our common stock during theperiod. For the six months ended June 30, 2005, we recorded stock-basedcompensation recovery of approximately $551,000 related to all employee optionseligible for replacement options. The recovery resulted from the decrease inthe market price of our common stock during the period. For periods after theadoption of FAS 123(R), we account for the vested portion of the optionsrepriced prior to the adoption of SFAS 123(R) in accordance with provisions ofSFAS 123. In May 2006, our board of directors approved a plan to grant newoptions in August 2006 to employees who hold repriced options that expirein the same period. We will record stock-based compensation expense relating tothe new options in the third quarter of 2006.

 

7

----

 

Under FAS 123(R), the fair value of eachoption award is estimated on the date of grant using the Black-Scholes optionpricing model. We have segregated option awards into three homogenous groups(i.e., Officers and Directors, All Other Employees and Non-employees orConsultants) for purposes of determining fair values of options.

 

We determined weighted-average valuationassumptions separately for the groups as follows:

 

•                  Volatility- We estimated volatility using the historical share price performance over theexpected life of the option up to the point where we have historical marketdata. As our publicly listed options are not actively traded, impliedvolatility was not representative of our current volatility. We also consideredother factors such as our current clinical trials and other company activitiesthat may affect volatility of our stock in the future but determined thatat this time, the historical volatility was more indicative of our expectedfuture stock performance.

 

•                  Expectedterm - We worked with various data points to determine the most applicableexpected term for each option group. The data points included: (1) expectedterm of the options from option date to exercise date; (2) cancellationterm of options from grant date to cancellation date and excluding unvestedoption forfeitures from the determination; and (3) term of options thatremain outstanding from grant date to the end of the reporting period. Theanalysis of the above data points gave us a range of expected terms to consider;however, we also considered the vesting schedules of the options granted andfactors surrounding exercise behavior of our groups, our current market priceand company activity that may affect our market price. In addition, wealso considered the vesting schedules of the options, the optionee type (i.e.,officers and directors and all other employees) and other factors that may affectthe expected term of the option. For non-employee options, we use thecontractual term of the option, which is generally ten years, for the initialvaluation of the option and the remaining contractual term of the option forthe succeeding years.

 

•                  Risk-freeinterest rate - The risk-free interest rate is based on the U.S. Treasury ofconstant maturity rates with similar terms to the expected term of the optionsfor each option group.

 

•                  Forfeiturerate - We estimated the forfeiture rate using our historical experience withpre-vesting options. Our annual weighted-average forfeiture rate wasapproximately 7.6% as of June 30, 2006 as compared to 4.7% as of March 31,2006. The increase in the forfeiture rate was due to the forfeiture of anexecutive officer’s unvested options resulting from his departure from thecompany. We review our forfeiture rates each quarter and make changes asfactors affecting our forfeiture rate calculations and assumptions change.

 

•                  Dividendyield - The expected dividend yield is 0% as we have not and do not expect topay dividends.

 

The following table summarizes theweighted-average assumptions relating to our employee options for the three andsix months ended June 30, 2006 and 2005 as permitted under FAS 123(R) for2006 and FAS 123 for 2005:

 
| ** **                | ** ** | **Stock Option Plans** | ** ** | **Stock Option Plans** | ** ** |
|---------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
| ** **                | ** ** | **June 30,**                | ** ** | **June 30,**                | ** ** |
| ** **                | ** ** | **2006**                         | ** ** | **2005**                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Risk-free  interest rate  |       | 5.0                              | %          | 3.7                              | %          | 4.6 | % | 4.1 | % |
| Expected  life (in years) |       | 4.9                              |       | 3.1                              |       | 4.6 |   | 2.4 |   |
| Dividend  yield           |       | 0.0                              | %          | 0.0                              | %          | 0.0 | % | 0.0 | % |
| Expected  volatility      |       | 94.0                             | %          | 75.0                             | %          | 98.2 | % | 75.0 | % |

 

Option prices are not less than the marketprice of our common stock on the date of grant, become exercisable at varyingdates and generally expire ten years from the date of grant. At June 30,2006, options to purchase 1,543,293 shares of common stock were available forgrant under our stock option plans.

 

***Employee Stock Purchase Plan***

 

The fair value of each option element of ouremployee stock purchase plan (ESPP) is estimated on the date of grant using theBlack-Scholes option pricing model that uses weighted-average assumptions in thetable below. Our ESPP provides for a twenty-four month offering periodcomprised of four six-month purchase periods with a look-back option. Alook-back option is a provision in an ESPP that establishes the purchase priceas an amount based on the lesser of the stock’s market price at the grant dateor its market price at the exercise or purchase date. The plan also includes areset feature whereby participants reset to a new offering when the marketprice of the stock falls below the market price on the first day of atwenty-four month offering period. Expected volatilities are based onhistorical volatility of our stock. Expected term represents the purchaseperiods within our offering period. The risk-free rate for periods within thecontractual life of the option is based on the U.S. Treasury of constantmaturity rates. Stock-basedcompensation expense relating to our employee stock purchase plan is recognizedaccording to the FASB Technical Bulletin No. 97-1, “Accounting underStatement 123 for Certain Employee Stock Purchase Plans with a Look-back Option”,or FTB 97-1. As of June 30, 2006, there were approximately 56,000 sharesin reserve for future issuance under the plan. The following tablesummarizes the weighted-average assumptions relating to our employee stockpurchase plan for the six months ended June 30, 2006 and 2005:

 
| ** **                | ** ** | **Employee Stock Purchase Plan** | ** ** |
|---------------------------|------------|-------------------------------------------------|------------|
| ** **                | ** ** | **Six Months Ended**                  | ** ** |
| ** **                | ** ** | **June 30,**                               | ** ** |
| ** **                | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
| Risk-free  interest rate  |       | 4.6                                             | %          | 4.1 | % |
| Expected  life (in years) |       | 1.2                                             |       | 0.5 |   |
| Dividend  yield           |       | 0.0                                             | %          | 0.0 | % |
| Expected  volatility      |       | 110.3                                           | %          | 75.0 | % |

 

8

----

 

***Stock-basedCompensation Award Activity***

 

The following table summarizes activity underour equity incentive and stock option plans as of June 30, 2006 (inthousands, except per share amounts):

 
| ** **                                         | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------------------------|------------|------------|------------|---------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                         | ** ** | ** ** | ** ** | ** **                                  | ** ** | **(Years)**                                          | ** ** | ** **                          | ** ** |
| Outstanding  at December 31, 2005             |       | 3,893,219  |       | $                                           | 15.98      |                                                 |       |                                |       |   |
| Granted                                            |       | 841,685    |       | $                                           | 8.16       |                                                 |       |                                |       |   |
| Exercised                                          |       | (31,668    | )          | $                                           | 8.04       |                                                 |       |                                |       |   |
| Forfeited/Expired/Cancelled                        |       | (190,144   | )          | $                                           | 17.34      |                                                 |       |                                |       |   |
| Outstanding  at June 30, 2006                 |       | 4,513,092  |       | $                                           | 14.52      |                                                 | 7.82       |                                | $          | 4,106,597 |   |
| Vested and  expected to vest at June 30, 2006 |       | 4,356,604  |       | $                                           | 15.05      |                                                 |       |                                |       |   |
| Exercisable  at June 30, 2006                 |       | 2,440,405  |       | $                                           | 13.25      |                                                 | 7.02       |                                | $          | 2,706,408 |   |

 

The aggregate intrinsic value is calculated as the difference betweenthe exercise price of the underlying awards and the quoted price of our commonstock for the options to acquire 2.2 million shares that were in-the-money at June 30,2006. During the six months ended June 30, 2006 and 2005, the aggregateintrinsic values of options exercised under our stock option plans wereapproximately $88,000 and $612,332, respectively, determined as of the date ofoption exercise. As of June 30, 2006, there were approximately $13.3million of total unrecognized compensation cost, net of forfeitures, related tounvested share-based compensation arrangements granted under our stock optionplans and $833,000 of total unamortized compensation cost related to our ESPP.That cost is expected to be recognized over a weighted-average period of 1.45years. We also had approximately 2.1 million of unvested stock options at June 30,2006. Future option grants and their valuation will increase our compensationcost in the future as the options are granted, valued and expensed ratablyaccording to their vesting periods. The weighted average grant-date fair valuesof options granted in the six months ended June 30, 2006 and 2005 were$6.01 and $9.30, respectively.

 

***Pro Forma Information under FAS123 for Periods Prior to Fiscal 2006***

 

Prior to adopting SFAS 123(R) on January 1,2006, we accounted for equity-based employee compensation costs under therecognition and measurement principles of APB 25. Under APB 25, the intrinsicvalue method of accounting, no compensation expense is recognized, because theexercise price of our employee stock options equals the market price of theunderlying stock on the date of grant. Pro forma information regarding net lossand net loss per share was determined as if we had accounted for our employeestock options and employee stock purchase plan under the fair value methodprescribed by FAS 123, as amended by FAS No. 148. The fair valuefor these options was estimated at the date of grant using the Black-Scholesmodel. See the weighted-average assumptions discussed above.

 

For purposes of pro forma disclosures, the estimated fair value of theoptions was amortized to expense over the vesting period of the options priorto adopting SFAS 123(R). Our pro forma information was as follows (inthousands, except per share amounts):

 
| ** **                                                                                                        | ** ** | **Three Months Ended,** | ** ** | **Six Months Ended,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                        | ** ** | **June 30, 2005**       | ** ** | **June 30, 2005**     | ** ** |
| Net loss—as  reported:                                                                                       |       | $                                 | (12,293    | )                               | $          | (23,457 | ) |
| Add  (Deduct): Total stock-based employee compensation expense/(recovery) determined  under APB 25                |       | 730                               |       | (531                            | )          |
| Add: Total  stock-based employee compensation expense determined under the fair value  based method of all awards |       | 2,048                             |       | 3,862                           |       |
| Pro forma  net loss                                                                                               |       | $                                 | (13,611    | )                               | $          | (27,850 | ) |
| Basic and  diluted net loss per common share:                                                                     |       |                              |       |                            |       |
| As reported                                                                                                       |       | $                                 | (0.62      | )                               | $          | (1.18 | ) |
| Pro forma                                                                                                         |       | $                                 | (0.68      | )                               | $          | (1.41 | ) |

 

9

----

 

**5. Revenue Recognition**

 

We recognize revenue from our contractarrangements. Our revenue arrangements with multiple elements are evaluatedunder EITF No. 00-21, *“RevenueArrangements with Multiple Deliverables,”* and are divided intoseparate units of accounting if certain criteria are met, including whether thedelivered element has stand-alone value to the customer and whether there isobjective and reliable evidence of the fair value of the undelivered items. Theconsideration we receive is allocated among the separate units based on theirrespective fair values, and the applicable revenue recognition criteria areapplied to each of the separate units. Advance payments received in excess ofamounts earned are classified as deferred revenue until earned.

 

Non-refundable, up-front payments received inconnection with research and development collaboration agreements, includingtechnology access fees, are deferred and recognized on a straight-line basisover the relevant periods of continuing involvement, generally the researchterm. When a research term is not specified, we estimate the time it will takeus to complete our deliverables under the contract and recognize the upfrontfee using the straight-line method over that time period. We review ourestimates every quarter for reasonableness.

 

Revenues related to collaborative researchwith our corporate collaborators are recognized as research services areperformed over the related development funding periods for each contract. Underthese agreements, we are required to perform research and developmentactivities as specified in each respective agreement. The payments received arenot refundable and are generally based on a contractual cost per full-timeequivalent employee working on the project. Research and development expensesunder the collaborative research agreements, except for the Merck collaborationsigned in November 2004 related to ubiquitin ligases, approximate orexceed the revenue recognized under such agreements over the term of therespective agreements. For the Merck collaboration, we are recognizing apro-rata portion of the invoiced amounts for funding of our research scientistsbased on the headcount dedicated to the project. It is our policy to recognizerevenue based on our level of effort expended, however, revenue recognized willnot exceed amounts billable under the arrangement which corresponds to cashreceipts.

 

Milestones are recognized pursuant tocollaborative agreements upon the achievement of these at risk milestones.

 

Royalties will be recognized as earned in accordancewith the contract terms when the third party results are reliably measurableand collectibility is reasonably assured.

 

**6. Cash, Cash Equivalents andAvailable-For-Sale Securities**

 

Cash, cash equivalents and available-for-salesecurities consist of the following (in thousands):

 
| ** **                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Checking  account              |       | $                 | 154        |                  | $          | 742 |   |
| Money market  funds            |       | 10,057            |       | 3,421                 |       |
| Federal  agency securities     |       | 17,917            |       | 21,067                |       |
| Corporate  bonds and notes     |       | 94,112            |       | 112,966               |       |
|                           |       |              |       |                  |       |
|                           |       | $                 | 122,240    |                  | $          | 138,196 |   |
| Reported as:                   |       |              |       |                  |       |
| Cash and  cash equivalents     |       | $                 | 62,228     |                  | $          | 76,779 |   |
| Available-for-sale  securities |       | 60,012            |       | 61,417                |       |
|                           |       |              |       |                  |       |
|                           |       | $                 | 122,240    |                  | $          | 138,196 |   |

 
| ** **                  | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** |
|-----------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------------|------------|
| ** **                  | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | ** **          | ** ** |
| **June 30, 2006** | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| Federal  agency securities  |       | $             | 17,975     |           | $          | —         |       | $                   | (57        | ) | $ | 17,918 |   |
| Corporate  bonds and note   |       | 42,158        |       | 4              |       | (68            | )          | 42,094              |       |
|                        |       |          |       |           |       |           |       |                |       |
| Total                       |       | $             | 60,133     |           | $          | 4              |       | $                   | (125       | ) | $ | 60,012 |   |

 
| ** **                      | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** |
|---------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------------|------------|
| ** **                      | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | ** **          | ** ** |
| **December 31, 2005** | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| Federal  agency securities      |       | $             | 17,090     |           | $          | 1              |       | $                   | (17        | ) | $ | 17,074 |   |
| Corporate  bonds and note       |       | 44,419        |       | 1              |       | (77            | )          | 44,343              |       |
|                            |       |          |       |           |       |           |       |                |       |
| Total                           |       | 61,509        |       | 2              |       | (94            | )          | 61,417              |       |
|                                 |            |               |            |                |            |                |            |                     |            |  |  |  |  |

 

At June 30, 2006, the above debtsecurities had a weighted average maturity of approximately 134 days with twofederal agency securities with a fair market value of $3.0 million having amaturity greater than 360 days.

 

10

----

 

The following table shows the grossunrealized losses and fair values of our investments in individual securitiesthat are in an unrealized loss position aggregated by investment category, (inthousands):

 
| ** **                  | ** ** | ** **          | ** ** | **Unrealized**     | ** ** |
|-----------------------------|------------|---------------------|------------|--------------------|------------|
| **June 30, 2006** | ** ** | **Fair Value** | ** ** | **(Losses)/gains** | ** ** |
| Federal  agency securities  |       | $                   | 17,975     |               | $          | (57 | ) |
| Corporate  bonds and notes  |       | 32,527              |       | (68                | )          |
|                        |       |                |       |               |       |
| Total                       |       | $                   | 50,502     |               | $          | (125 | ) |

 
| ** **                      | ** ** | ** **          | ** ** | **Unrealized**     | ** ** |
|---------------------------------|------------|---------------------|------------|--------------------|------------|
| **December 31, 2005** | ** ** | **Fair Value** | ** ** | **(Losses)/gains** | ** ** |
| Federal  agency securities      |       | $                   | 12,879     |               | $          | (17 | ) |
| Corporate  bonds and notes      |       | 40,615              |       | (75                | )          |
|                            |       |                |       |               |       |
| Total                           |       | $                   | 53,494     |               | $          | (92 | ) |

 

As of June 30, 2006, there were noinvestments that had been in a continuous unrealized loss position for morethan twelve months. As of December 31, 2005, we had an investment incorporate bonds and notes with a fair market value of approximately $1.0million that was in a continuous unrealized loss position for more than twelvemonths. During the periods presented, there were no recorded realized gains orlosses on investments.

 

As of June 30, 2006, a total of 33individual securities were in an unrealized loss position for less than twelvemonths and deemed to be temporary. As of December 31, 2005, 34 individualsecurities were in an unrealized loss position for less than twelve months anddeemed to be temporary.

 

**7. Serono Collaboration**

 

InOctober 2005, we entered into a collaborative research and licenseagreement with Serono granting it an exclusive license to develop andcommercialize product candidates from our Aurora kinase inhibitor program. Eventhough the agreement includes a basket of compounds within the Aurora kinaseinhibitor program, the collaboration and our efforts under the agreement arefocused on R763. We are responsible for all costs associated with thepreparation and filing of an Investigational New Drug, or IND, for R763, whichwe filed in December 2005, while Serono is responsible for all developmentof R763 following regulatory acceptance of the IND and will bear all coststhereafter. In connection with this collaboration, Serono paid us $10.0 millionupfront and paid $15.0 million to purchase our common stock at a premium.

 

DuringFebruary 2006, we received a payment of $5.0 million triggered by theregulatory acceptance of the R763 IND in January 2006. We have amortized thepayment on a straight-line basis thru April 2006 when our involvement withthe amended IND was completed. We will be eligible to receive milestonepayments, under certain conditions, upon commencement of a Phase I clinicaltrial for R763, other clinical events, marketing approval and royalties on anyfuture product sales.

 

Wewere originally amortizing the $10.0 million upfront amount into revenue overnine months from the initiation of the collaboration in October 2005. Thiswas the period of time during which we originally estimated it would take toperform our deliverables under the contract. When we evaluated thisestimate in the second quarter of 2006, we concluded that we had achieved allour deliverables and should therefore recognize all of the remainingunamortized amount that would have been amortized in full in July 2006.The change in estimate resulted in approximately $860,000 of revenue that werecognized in the second quarter of 2006 instead of in the third quarter of2006.

 

**8. Pfizer Collaboration**

 

InJanuary 2005, we signed a collaborative research and license agreementwith Pfizer for the development of inhaled products for the treatment ofallergic asthma and chronic obstructive pulmonary disease. The agreement givesPfizer the exclusive right to nominate up to two Syk inhibitors under certainconditions, to commence advanced preclinical development. Pfizer will have theexclusive right to develop any nominated compound, and we will earn milestonesupon the selection of each of the two compounds and other clinical events aswell as royalties on any future product sales. Pfizer is responsible for themanufacture of all preclinical and clinical materials for each compound orproduct and all costs associated with development and commercialization.

 

InMay 2006, we achieved the first milestone when Pfizer nominated R343 tocommence advanced preclinical development in allergic asthma. Pfizer paid us$5.0 million for the exclusive right to R343 and will be responsible for alldevelopment related to R343 going forward.

 

11

----

 

**9. Equipment Lease Line**

 

In July 2005, our equipment credit line under an original masteragreement was extended to create a total borrowing limit of $1.5 millionthrough June 2006. In June 2006, we drew down the remaining leaseline balance of $153,000 and obtained approval to extend our lease line tocreate a new total borrowing limit of $1.5 million. We have the ability to drawdown on this line through June 2007. The repayment period will be forthree years beginning on the first draw down with the interest rate on the linefixed at each drawdown. Each line has a bargain purchase buyout provision of$101. During the three months ended June 30, 2006, we drew down $222,000on this new 2006 extension, which is included in capital lease obligation onthe balance sheet. Approximately $1.3 million remained available under the lineas of June 30, 2006.

 

**10.Subsequent Event**

** **

 In July 2006,we amended our facility lease in order to defer certain rent payments for 2006and 2007. The amended lease agreement also included warrants to purchase sharesof our common stock.

 

12

----

 

## **Report of Independent Registered PublicAccounting Firm**

##  

TheBoard of Directors

RigelPharmaceuticals, Inc.

 

Wehave reviewed the accompanying balance sheet of Rigel Pharmaceuticals, Inc.as of June 30, 2006, the related condensed statements of operations forthe three and six-month periods ended June 30, 2006 and 2005, and thecondensed statements of cash flows for the six-month period ended June 30,2006 and 2005. These interim financial statements are the responsibility of theCompany’s management.

 

Weconducted our review in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). A review of interim financialinformation consists principally of applying analytical procedures and makinginquiries of persons responsible for financial and accounting matters. It issubstantially less in scope than an audit conducted in accordance with thestandards of the Public Company Accounting Oversight Board, the objective ofwhich is the expression of an opinion regarding the financial statements takenas a whole. Accordingly, we do not express such an opinion.

 

Basedon our review, we are not aware of any material modifications that should bemade to the condensed interim financial statements referred to above for themto be in conformity with U.S. generally accepted accounting principles.

 

Wehave previously audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the balance sheet of RigelPharmaceuticals, Inc. as of December 31, 2005, and the relatedstatements of operations, shareholders’ equity, and cash flows for the yearthen ended (not presented herein), and in our report dated March 3, 2006,we expressed an unqualified opinion on those financial statements. In ouropinion, the information set forth in the accompanying balance sheet as of December 31,2005, is fairly stated, in all material respects, in relation to the balancesheet from which it has been derived.

 
|                  | /s/ Ernst & Young LLP |
|-----------------------|--------------------------------|
| Palo Alto, California |                           |
| July 21, 2006    |                           |

 

13

----

 

**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*This discussion and analysis should be readin conjunction with our financial statements and accompanying notes included inthis report and the 2005 audited financial statements and accompanying notesincluded in our Annual Report on Form 10-K for the year ended December 31,2005. Operating results for the three and six months ended June 30, 2006are not necessarily indicative of results that may occur in futureperiods.*

 

*We usuallyuse words such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,”“believe,” “estimate,” “predict,” “future,” “intend,” “potential” or “continue”or the negative of these terms or similar expressions to identify theseforward-looking statements. These statements appear throughout this quarterlyreport on Form 10-Q and are statements regarding our current intent,belief or expectation, primarily with respect to our operations and relatedindustry developments. Examples of these statements include, but are notlimited to, statements regarding the following: our business and scientificstrategies; the progress of our product development programs, includingclinical testing; our corporate collaborations, including revenues that may bereceived from these collaborations; our drug discovery technologies; ourresearch and development expenses; protection of our intellectual property;sufficiency of our cash resources; and our operations and legal risks. Youshould not place undue reliance on these forward-looking statements. Our actualresults could differ materially from those anticipated in these forward-lookingstatements for many reasons, including as a result of the risks anduncertainties discussed in the “Risk Factors” in Item 1A of Part II ofthis quarterly report on Form 10-Q. Any forward-looking statement speaksonly as of the date on which it is made, and we undertake no obligation toupdate any forward-looking statement to reflect events or circumstances afterthe date on which the statement is made or to reflect the occurrence ofunanticipated events. New factors emerge from time to time, and it is notpossible for us to predict which factors will arise. In addition, we cannotassess the impact of each factor on our business or the extent to which anyfactor, or combination of factors, may cause actual results to differmaterially from those contained in any forward-looking statements*

* *

**Overview**

 

Rigel is a clinical-stage drug developmentcompany that discovers and develops novel, small-molecule drugs for thetreatment of inflammatory diseases, cancer and viral diseases. Our goal is tofile one new drug (IND) application in a significant indication each year. Wehave achieved this goal each year beginning in 2002. Our pioneering researchfocuses on intracellular signaling pathways and related targets that arecritical to disease mechanisms. Our productivity has resulted in strategiccollaborations with large pharmaceutical partners to develop and market ourproduct candidates. We have product development programs ininflammatory/autoimmune diseases such as rheumatoid arthritis,thrombocytopenia, asthma and allergy as well as in cancer*.*

 

Rigel has multiple product candidates indevelopment as follows:

 

•                  *R788—Product Candidate for Rheumatoid Arthritis (RA). *R788 is our lead product candidate. It has anovel mechanism of action-blocking IgG receptor signaling in macrophages andB-cells. Previously, we studied R788 in a Phase I single center, double-blind,randomized, placebo-controlled trial evaluating the safety and pharmacokineticsof escalating single and multiple doses of R788. We have completed R788 studiesto evaluate its safety and pharmacokinetics in combination with methotrexate, acommonly prescribed treatment for RA. Results of this trial suggest no adverseinteraction. We expect to commence Phase II clinical trials of R788 forRA in the second half of 2006.

 

•                  *R788**—*ProductCandidate for Immune Thombocytopenia Purpura (ITP).* *Plateletdestruction from ITP is mediated by IgG signaling. R788 is a potent inhibitorof IgG signaling. In preclinical studies, Rigel has shown R788 to improvethrombocytopenia in an ITP mouse model. We plan to commence Phase II clinicaltrials of R788 to evaluate its safety and efficacy in refractory ITP patientsin the second half of 2006.

 

•                  *R763—Product Candidate for Oncology. *In July 2004,we identified R763 as a lead compound in our Aurora kinase inhibition program,targeting cancer cell proliferation. R763 is a potent, highly-selective,small-molecule inhibitor of Aurora kinase. In October 2005, we signed alicensing agreement with Serono that grants to Serono an exclusive license todevelop and commercialize R763, in addition to other product candidates arisingfrom our Aurora kinase inhibitor program. Under the agreement, we wereresponsible for filing an IND for R763 while Serono will be responsible for thefurther development and commercialization of R763. We filed the IND for R763with the Food and Drug Administration, or FDA, in December 2005, and wereallowed to proceed under the IND in January 2006. During February 2006,we received a payment of $5.0 million from Serono triggered by the regulatoryacceptance. We anticipate that Serono will initiate clinical trials for R763 inthe second half of 2006.

 

In the first quarter of 2005, we announced that we entered into acollaborative research and license agreement with Pfizer for the development ofinhaled products for the treatment of allergic asthma and other respiratorydiseases, such as chronic obstructive pulmonary disease, or COPD. Thecollaboration is focused on our preclinical small molecule compounds, whichinhibit IgE receptor signaling in respiratory tract mast cells by blocking thesignaling enzyme Syk, or spleen tyrosine kinase, a novel drug target forrespiratory diseases. Mast cells play important roles in both early and latephase allergic reactions, and Syk inhibitors could prevent both phases. In May 2006,we achieved the first collaboration milestone when Pfizer nominated R343 tocommence advanced

 

14

----

 

preclinicaldevelopment in allergic asthma. Pfizer paid us $5.0 million for the exclusiveright to R343, which will be delivered using Pfizer’s dry powder inhaler and isprojected to enter the clinic in 2007.

 

In addition to the above mentioned productcandidates, we have ongoing research programs involving back-up candidates forthe product candidates above as well as drug discovery efforts in ourimmunology/inflammation, virology, and oncology programs. For example, we arepursuing JAK3 inhibition in transplant rejection and in a variety of autoimmunediseases and Axl inhibition in oncology.

 

**Corporate Collaborations**

 

We carry on research and development programs in connection with ourcorporate collaborations. As of June 30, 2006, we had collaborations withsix major pharmaceutical/biotech companies comprised of: one with JanssenPharmaceutica N.V., a division of Johnson & Johnson, relating tooncology therapeutics and diagnostics, two with Pfizer Inc., one initiatedin 1999 and the other in the first quarter of 2005, relating to intrapulmonaryasthma and allergy therapeutics, one with Novartis Pharma AG with respect tofour different programs relating to immunology, oncology and chronicbronchitis, one with Daiichi Pharmaceuticals Co., Ltd. in the area ofoncology, one with Merck, in the area of oncology, and one with Serono in thearea of oncology. All of these collaborations, excluding the recent Pfizer andthe Serono collaborations, have a research phase during which we receive orreceived funding based on the level of headcount allocated to a program. In allof these collaborations if certain conditions are met, we are entitled to receivefuture milestone payments and royalties. We cannot guarantee that theseconditions will be met or that research and development efforts will besuccessful. As a result, we may not receive any further milestone paymentsor royalties under these agreements. Only the Merck program currently providesfor regular research reimbursement payments.

 

We are exploring new opportunities withexisting and potential collaborators. Our earliest partnerships focused on theearly stages of drug discovery, specifically on target discovery andvalidation. Our collaborations with Daiichi and recently with Merck are bothlater stage, focusing on drug discovery and development. Our 2005 collaborationwith Pfizer covers compounds at the preclinical and lead designation stageswhile our 2005 collaboration with Serono covers a compound for which an IND wasfiled in December 2005 and obtained FDA approval in January 2006. Wecurrently anticipate that in order to support our current research programs wewill need to self-fund our own research programs, which involves an increasedrate of spending on later stages of development prior to partnering withcollaborative partners. Therefore, it is expected that future collaborations may havean expanded focus and could include high throughput screening, combinatorialand medicinal chemistry, preclinical evaluations and/or clinical development ofcompounds we have discovered. In addition, we believe these futurecollaborations could be structured to consist of upfront payments, the purchaseof our common stock, milestone payments upon meeting certain conditions,research or development reimbursement payments and/or royalties uponcommercialization of products resulting from the collaboration.

 

**Critical Accounting Policies and the Use ofEstimates**

 

Our discussion and analysis of our financialcondition and results of operations are based upon our financial statements,which have been prepared in accordance with U.S generally accepted accountingprinciples. The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate our estimates, including thoserelated to terms of the research collaborations (i.e., amortization of upfrontfees and certain milestones), investments, stock compensation, impairmentissues, the estimated useful life of assets and contingencies. In June 2006,we evaluated the period for amortizing the Serono upfront payment and concludedwe had achieved all of our deliverables under the contract. See furtherdiscussion in Note 7 above. We base our estimates on historical experience andon various other assumptions that we believe to be reasonable under thecircumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions. We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our financial statements.

 

We believe that there have been nosignificant changes in our critical accounting policies during the period endedJune 30, 2006 as compared to those previously disclosed in our AnnualReport on Form 10-K for the year ended December 31, 2005, except forthe adoption of SFAS 123(R) for equity-based compensation costs in January 2006.

 

***Revenue Recognition***

 

We recognize revenue from our contractarrangements. Our revenue arrangements with multiple elements are evaluatedunder Emerging Issues Task Force No. 00-21, *“Revenue Arrangements with Multiple Deliverables,”* are dividedinto separate units of accounting if certain criteria are met, includingwhether the delivered element has stand-alone value to the customer and whetherthere is objective and reliable evidence of the fair value of the undelivereditems. The consideration we receive is allocated among the separate units basedon their respective fair values, and the applicable revenue recognitioncriteria are applied to each of the separate units. Advance payments receivedin excess of amounts earned are classified as deferred revenue until earned.

 

Non-refundable, up-front payments received inconnection with research and development collaboration agreements, includingtechnology access fees, are deferred and recognized on a straight-line basisover the relevant periods of continuing involvement, generally the researchterm. When a research term is not specified, we estimate the time it will takeus to complete our deliverables under the contract and recognize the upfrontfee using the straight-line method over that time period. We review ourestimates every quarter for reasonableness.

 

15

----

 

Revenues related to collaborative researchwith our corporate collaborators are recognized as research services areperformed over the related development funding periods for each contract. Underthese agreements, we are required to perform research and developmentactivities as specified in each respective agreement. The payments received arenot refundable and are generally based on a contractual cost per full-timeequivalent employee working on the project. Research and development expensesunder the collaborative research agreements, except for the Merck collaborationsigned in November 2004 related to ubiquitin ligases, approximate orexceed the revenue recognized under such agreements over the term of therespective agreements. For the Merck collaboration, we are recognizing apro-rata portion of the invoiced amounts for funding of our research scientistsbased on the headcount dedicated to the project. It is our policy to recognizerevenue based on our level of effort expended; however, revenue recognized willnot exceed amounts billable under the arrangement which corresponds to cashreceipts.

 

Milestones are recognized pursuant tocollaborative agreements upon the achievement of these at risk milestones.

 

Royalties will be recognized as earned in accordancewith the contract terms when the third party results are reliably measurableand collectibility is reasonably assured.

 

***Stock-basedCompensatio**n***

 
| ** **                                             | ** ** | **Three months ended** | ** ** | ** **                | ** ** | **Six months ended** | ** ** | ** **                | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|---------------------------|------------|--------------------------------|------------|---------------------------|------------|
| ** **                                             | ** ** | **June 30,**                | ** ** | **Aggregate Change** | ** ** | **June 30,**              | ** ** | **Aggregate Change** | ** ** |
| ** **                                             | ** ** | **2006**                         | ** ** | **2005**                  | ** ** | **2006 from 2005**   | ** ** | **2006**                  | ** ** | **2005** | ** ** | **2006 from 2005** | ** ** |
| ** **                                             | ** ** | **(in thousands)**          | ** ** | **(in thousands)**   | ** ** |
| **Stock-based  compensation expense/(recovery) from:** |       |                             |       |                      |       |                           |       |                      |       |   |   |   |   |
| ***Officer, director and employee options***           |       | $                                | 3,220      |                      | $          | 715                            |       | $                         | 2,505      |   | $ | 6,504 |   | $ | (551 | ) | $ | 7,055 |   |
| ***Consultant options***                               |       | (93                              | )          | 92                        |       | (185                           | )          | 184                       |       | (115 | ) | 299 |   |
| ***Other employee options***                           |       | —                           |       | 15                        |       | (15                            | )          | —                    |       | 20 |   | (20 | ) |
| *** ***                                           |       |                             |       |                      |       |                           |       |                      |       |   |   |   |   |
| ***Total***                                            |       | $                                | 3,127      |                      | $          | 822                            |       | $                         | 2,305      |   | $ | 6,688 |   | $ | (646 | ) | $ | 7,334 |   |

 

We grant options to purchase our common stockto our employees, directors and consultants under our stock option plans.Eligible employees can also purchase shares of our common stock at 85% of thelower of the fair market value on the first and last day of each six-monthpurchase period under our employee stock purchase plan. The benefits providedunder these plans are share-based payments subject to the provisions of SFAS123(R). Effective January 1, 2006, we adopted the provisions of SFAS123(R) using the modified prospective application transition method. Under thismethod, the share-based compensation cost recognized beginning January 1,2006 includes compensation cost for (i) all share-based payments grantedprior to, but not vested as of January 1, 2006, based on the grant datefair value originally estimated in accordance with the provisions of SFAS 123and calculated for pro forma disclosures under SFAS No. 148, and (ii) allshare-based payments granted subsequent to January 1, 2006, based on thegrant date fair value estimated in accordance with the provisions of SFAS123(R). Compensation cost under SFAS 123(R) for awards granted prior to January 1,2006 is recognized using an accelerated method pursuant to the FASBInterpretation No. 28, “Accounting for Stock Appreciation Rights and OtherVariable Stock Option or Award Plans”, or FIN 28. For awards granted after January 1,2006, we have adopted the use of the straight-line attribution method over therequisite service period for the entire award. Results of prior periods do notreflect any restated amounts, and the cumulative effect of a change inaccounting principle was insignificant upon adoption of SFAS No. 123(R)under the modified prospective method. In addition pursuant to SFAS 123(R), weare required to estimate the amount of expected forfeitures when calculatingthe compensation costs, instead of accounting for forfeitures as incurred,which was our previous method. We will record actual forfeitures as they occur,and we will review our forfeiture rates each quarter and make any necessarychanges our estimates.

 

Prior to adopting SFAS 123(R) on January 1,2006, we accounted for equity-based employee compensation costs under therecognition and measurement principles of APB 25. Under APB 25, the intrinsicvalue method of accounting, no compensation expense is recognized, because theexercise price of our employee stock options equals the market price of theunderlying stock on the date of grant. Pro forma information regarding net lossand net loss per share was determined as if we had accounted for our employeestock options and employee stock purchase plan under the fair value methodprescribed by FAS 123, as amended by FAS 148. The fair value for theseoptions was estimated at the date of grant using the Black-Scholes model.

 

In 2005, we recorded charges associated with the stock options thatwere eligible for re-pricing under a tender offer initiated in June 2003.All replacement options, as well as the eligible options that were notsurrendered under the original offer to exchange, were treated for financialreporting purposes as variable awards. Therefore, for the period prior toadoption of FAS 123(R), we recorded a non-cash charge, generally for theintrinsic value of the options as they vested, utilizing the acceleratedvesting method, reflecting increases and decreases (down to, but not below, theexercise price) in the price of our common stock as compensation expense(recovery) in connection with the replacement options and the eligible optionsthat were not exchanged. For the three

 

16

----

 

months ended June 30, 2005, we recordednon-cash compensation expense of approximately $715,000 related to all employeeoptions eligible for replacement options. This expense resulted from theincrease in the market price of our common stock during the period. For the sixmonths ended June 30, 2005, we recorded a non-cash compensation recoveryof approximately $551,000 related to all employee options eligible forreplacement options. The recovery resulted from the decrease in the marketprice of our common stock during the six-month period ended June 30, 2005.For periods after the adoption of SFAS 123(R), we are continuing to account forthe repriced options prior to the adoption of SFAS 123(R) in accordance withprovisions of SFAS 123. In May 2006, our board of directors approved aplan to grant new options in August 2006 to employees who hold repricedoptions that expire in the same period. We will record stock-based compensationexpense relating to the new options in the third quarter of 2006.

 

We also record charges associated withoptions granted to consultants reflecting the fair value valuation and periodicfair value remeasurement of outstanding consultant options under EITF 96-18, “Accountingfor Equity Instruments That are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling Goods or Services.”   The valuation is based upon the currentmarket value of our common stock and other assumptions, including the expectedfuture volatility of our stock price, risk-free interest rate and expectedterm. For consultant options granted in 2006, we amortize stock-basedcompensation using a straight-line attribution method consistent with themethod used for employees and with the attribution election we made uponadoption of FAS 123(R). For options granted prior to January 1, 2006, weused the accelerated method for expensing stock-based compensation, which wasthe method we used prior to adoption. We expect to see continued fluctuationsin the future as a portion of these options are remeasured based on the changesin the current market price of our common stock.

 

The determination of the fair value of share-basedpayment awards on the date of grant using an option-pricing model is affectedby our stock price as well as assumptions regarding a number of complex andsubjective variables. These variables include, but are not limited to, ourexpected stock price volatility over the term of the awards, actual andprojected employee stock option exercise behaviors, risk-free interest rate andexpected dividends.

 

If factors change and we employ differentassumptions in the application of SFAS 123(R) in future periods, thecompensation expense that we record under SFAS 123(R) may differsignificantly from what we have recorded in the current period. Therefore, webelieve it is important to be aware of the high degree of subjectivity involvedwhen using option pricing models to estimate share-based compensation underSFAS 123(R).

 

The guidance in SFAS 123(R) and SAB 107 isrelatively new, and best practices are not well established. The application ofthese principles may be subject to further interpretation and refinementover time. There are significant differences among valuation models, and thereis a possibility that we may adopt different valuation models in thefuture. This may result in a lack of consistency in future periods andmaterially affect the fair value estimate of share-based payments. It may alsoresult in a lack of comparability with other companies that use differentmodels, methods and assumptions.

 

**Three and Six Months Ended June 30, 2006and 2005**

 

**Revenues**

 
| ** **                                  | ** ** | **Three months  ended** | ** ** | ** **                | ** ** | **Six months ended** | ** ** | ** **                | ** ** |
|---------------------------------------------|------------|------------------------------|------------|---------------------------|------------|--------------------------------|------------|---------------------------|------------|
| ** **                                  | ** ** | **June 30,**            | ** ** | **Aggregate Change** | ** ** | **June 30,**              | ** ** | **Aggregate Change** | ** ** |
| ** **                                  | ** ** | **2006**                     | ** ** | **2005**                  | ** ** | **2006 from 2005**   | ** ** | **2006**                  | ** ** | **2005** | ** ** | **2006 from 2005** | ** ** |
| ** **                                  | ** ** | **(in thousands)**      | ** ** | **(in thousands)**   | ** ** |
| ***Contract revenues from collaborations*** |       | $                            | 14,321     |                      | $          | 4,606                          |       | $                         | 9,715      |   | $ | 24,218 |   | $ | 7,224 |   | $ | 16,994 |   |
|                                             |            |                              |            |                           |            |                                |            |                           |            |  |  |  |  |  |  |  |  |  |  |

 

Revenues by collaborator were:

 
| ** **    | ** ** | **Three months  ended** | ** ** | ** **                | ** ** | **Six months ended** | ** ** | ** **                | ** ** |
|---------------|------------|------------------------------|------------|---------------------------|------------|--------------------------------|------------|---------------------------|------------|
| ** **    | ** ** | **June 30,**            | ** ** | **Aggregate Change** | ** ** | **June 30,**              | ** ** | **Aggregate Change** | ** ** |
| ** **    | ** ** | **2006**                     | ** ** | **2005**                  | ** ** | **2006 from 2005**   | ** ** | **2006**                  | ** ** | **2005** | ** ** | **2006 from 2005** | ** ** |
| ** **    | ** ** | **(in thousands)**      | ** ** | **(in thousands)**   | ** ** |
| ***Pfizer***  |       | $                            | 6,250      |                      | $          | 1,250                          |       | $                         | 5,000      |   | $ | 7,500 |   | $ | 1,741 |   | $ | 5,759 |   |
| ***Serono***  |       | 5,693                        |       | —                    |       | 5,693                          |       | 12,527                    |       | — |   | 12,527 |   |
| ***Merck***   |       | 2,378                        |       | 1,795                     |       | 583                            |       | 4,191                     |       | 3,260 |   | 931 |   |
| ***Daiichi*** |       | —                       |       | 1,561                     |       | (1,561                         | )          | —                    |       | 2,223 |   | (2,223 | ) |
| *** ***  |       |                         |       |                      |       |                           |       |                      |       |   |   |   |   |
| ***Total***   |       | $                            | 14,321     |                      | $          | 4,606                          |       | $                         | 9,715      |   | $ | 24,218 |   | $ | 7,224 |   | $ | 16,994 |   |

 

Contract revenues from collaborations for thethree and six months ended June 30, 2006 and 2005 consisted primarily ofresearch support and amortization of upfront fees and milestone payments fromthe continuation of our collaborations above. The

 

17

----

 

increase in revenues for the three and six months ended June 30,2006 compared to the similar periods in 2005 was primarily due to therecognition of the Pfizer milestone of $5.0 million for the nomination of R343in May 2006 and the amortization of approximately $5.7 million related toupfront payments from Serono, which consisted of the payment we received in February 2006upon the regulatory acceptance of the IND in January 2006 and the fullamortization of the remaining balance of the Serono upfront payment due to thecompletion of all deliverables under the contract. As of June 30, 2006, noamounts relating to Serono were remaining to be amortized in future periods,therefore, future revenue from Serono in 2006, if any, will only includepotential milestone payments. Research support under the Daiichi collaborationended in August 2005. We have deferred approximately $922,000 of researchreimbursement revenue from Merck in order to only account for the headcounteffort expended by us for the time period invoiced, which covers the periodfrom the initiation of the collaboration through June 30, 2006. We expectthis amount will be recognized as revenue no later than at the end of theresearch phase of the collaboration, which is scheduled to be in May 2007.We expect contract revenues from collaborations to be a significant componentof our total revenues for the foreseeable future.

 

**Research and Development Expenses**

 
| ** **                                                                                       | ** ** | **Three months  ended** | ** ** | ** **                | ** ** | **Six months ended** | ** ** | ** **                | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------|------------|--------------------------------|------------|---------------------------|------------|
| ** **                                                                                       | ** ** | **June 30,**            | ** ** | **Aggregate Change** | ** ** | **June 30,**              | ** ** | **Aggregate Change** | ** ** |
| ** **                                                                                       | ** ** | **2006**                     | ** ** | **2005**                  | ** ** | **2006 from 2005**   | ** ** | **2006**                  | ** ** | **2005** | ** ** | **2006 from 2005** | ** ** |
| ** **                                                                                       | ** ** | **(in thousands)**      | ** ** | **(in thousands)**   | ** ** |
| ***Research and development expenses***                                                          |       | $                            | 13,205     |                      | $          | 13,807                         |       | $                         | (602       | ) | $ | 27,916 |   | $ | 24,980 |   | $ | 2,936 |   |
| ***Stock-based compensation expense/(recovery) included in research and  development expenses*** |       | 1,543                        |       | 566                       |       | 977                            |       | 3,464                     |       | (461 | ) | 3,925 |   |
|                                                                                                  |            |                              |            |                           |            |                                |            |                           |            |  |  |  |  |  |  |  |  |  |  |

 

The decrease in research and developmentexpenses of $602,000 for the three months ended June 30, 2006, compared tothe similar period in 2005, was primarily attributable to a decrease inpreclinical and clinical costs, offset by an increase in stock-basedcompensation expense upon the adoption of SFAS 123(R) as previously discussedunder “Stock-based Compensation” in the “Critical Accounting Policies and theUse of Estimates” section. Preclinical and clinical costs decreased in thethree months ended June 30, 2006, compared to the similar period in 2005,due to the termination of R112 and R803 programs in 2005 and the transfer ofsponsorship relating to R763 to Serono in 2006. The increase in research anddevelopment expenses of approximately $2.9 million for the six months ended June 30,2006 compared to the similar period in 2005 was primarily due to an increase instock-based compensation expense upon adoption of SFAS 123(R), offset by adecrease in preclinical and clinical costs. The decrease in preclinical andclinical costs in the six months ended June 30, 2006 compared to the sameperiod in 2005 was primarily attributable to the decrease in costs relating toour R112, R803 and R763 programs as discussed above, offset by increased costsrelating to our R788 program. We expect that our research and developmentexpenses will increase through the second half of 2006 as we initiate our PhaseII trial of R788 for RA.

 

The scope and magnitude of future research anddevelopment expenses are difficult to predict at this time given the number ofstudies that we will need to conduct for any of our potential products, as wellas our limited capital resources. In general, biopharmaceutical developmentinvolves a series of steps—beginning with identification of a potentialtarget and including, among others, proof of concept in animals and Phase I, IIand III clinical studies in humans—each of which is typically more expensivethan the previous step. Success in development, therefore, results inincreasing expenditures. Our research and development expenditures currentlyinclude costs for scientific personnel, supplies, equipment, consultants,sponsored research, allocated facility costs, costs related to preclinical andclinical trials, and stock-based compensation.

 

**General and Administrative Expenses**

 
| ** **                                                                                         | ** ** | **Three months  ended** | ** ** | ** **                | ** ** | **Six months ended** | ** ** | ** **                | ** ** |
|----------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------|------------|--------------------------------|------------|---------------------------|------------|
| ** **                                                                                         | ** ** | **June 30,**            | ** ** | **Aggregate Change** | ** ** | **June 30,**              | ** ** | **Aggregate Change** | ** ** |
| ** **                                                                                         | ** ** | **2006**                     | ** ** | **2005**                  | ** ** | **2006 from 2005**   | ** ** | **2006**                  | ** ** | **2005** | ** ** | **2006 from 2005** | ** ** |
| ** **                                                                                         | ** ** | **(in thousands)**      | ** ** | **(in thousands)**   | ** ** |
| ***General and administrative expenses***                                                          |       | $                            | 4,725      |                      | $          | 3,429                          |       | $                         | 1,296      |   | $ | 9,728 |   | $ | 6,303 |   | $ | 3,425 |   |
| ***Stock-based compensation expense/(recovery) included in general and  administrative expenses*** |       | 1,584                        |       | 256                       |       | 1,328                          |       | 3,224                     |       | (185 | ) | 3,409 |   |
|                                                                                                    |            |                              |            |                           |            |                                |            |                           |            |  |  |  |  |  |  |  |  |  |  |

 

The increases in general and administrativeexpenses of approximately $1.3 million and $3.4 million for the three and sixmonths ended June 30, 2006 compared to the similar periods in 2005 isprimarily attributable to an increase in stock-based compensation expense uponthe adoption of SFAS 123(R) as previously discussed under “Stock-basedCompensation” in the “Critical Accounting Policies and the Use of Estimates”section.

 

18

----

 

**Interest Income**

 
| ** **            | ** ** | **Three months  ended** | ** ** | ** **                | ** ** | **Six months ended** | ** ** | ** **                | ** ** |
|-----------------------|------------|------------------------------|------------|---------------------------|------------|--------------------------------|------------|---------------------------|------------|
| ** **            | ** ** | **June 30,**            | ** ** | **Aggregate Change** | ** ** | **June 30,**              | ** ** | **Aggregate Change** | ** ** |
| ** **            | ** ** | **2006**                     | ** ** | **2005**                  | ** ** | **2006 from 2005**   | ** ** | **2006**                  | ** ** | **2005** | ** ** | **2006 from 2005** | ** ** |
| ** **            | ** ** | **(in thousands)**      | ** ** | **(in thousands)**   | ** ** |
| ***Interest income*** |       | $                            | 1,426      |                      | $          | 402                            |       | $                         | 1,024      |   | $ | 2,840 |   | $ | 732 |   | $ | 2,108 |   |
|                       |            |                              |            |                           |            |                                |            |                           |            |  |  |  |  |  |  |  |  |  |  |

 

Interest income results from ourinterest-bearing cash and investment balances. The increase in the three andsix months ended June 30, 2006 compared to the similar periods in 2005 isattributable to an increase in our overall investment balances as a result ofthe public offering we completed in July 2005 in which we raised $81.6million in net proceeds, combined with an increase in the rate of interest weearned on the balances.

 

**Interest Expense**

 
| ** **             | ** ** | **Three months  ended** | ** ** | ** **                | ** ** | **Six months ended** | ** ** | ** **                | ** ** |
|------------------------|------------|------------------------------|------------|---------------------------|------------|--------------------------------|------------|---------------------------|------------|
| ** **             | ** ** | **June 30,**            | ** ** | **Aggregate Change** | ** ** | **June 30,**              | ** ** | **Aggregate Change** | ** ** |
| ** **             | ** ** | **2006**                     | ** ** | **2005**                  | ** ** | **2006 from 2005**   | ** ** | **2006**                  | ** ** | **2005** | ** ** | **2006 from 2005** | ** ** |
| ** **             | ** ** | **(in thousands)**      | ** ** | **(in thousands)**   | ** ** |
| ***Interest expense*** |       | $                            | 147        |                      | $          | 65                             |       | $                         | 82         |   | $ | 213 |   | $ | 130 |   | $ | 83 |   |
|                        |            |                              |            |                           |            |                                |            |                           |            |  |  |  |  |  |  |  |  |  |  |

 

Interest expense is the result of our capital leaseobligations associated with fixed asset acquisitions. Interest expenseincreased for the three and six months ended June 30, 2006 and 2005 due tothe increase in debt obligations outstanding during those periods.

 

**Liquidity and Capital Resources**

** **

**Cash Requirements**

 

We have financed our operations frominception primarily through sales of equity securities, contract payments underour collaboration agreements and equipment financing arrangements. We haveconsumed substantial amounts of capital to date, and operating expenditures areexpected to increase over the next several years as we expand ourinfrastructure and research and development activities. We believe that ourexisting capital resources and anticipated proceeds from current collaborationswill be sufficient to support our current operating plan through at least thenext 12 months. Our operations will require significant additional fundingin large part due to our research and development expenses, future preclinicaland clinical-testing costs, and the absence of any meaningful revenues for theforeseeable future. The amount of future funds needed will depend largely onthe timing and structure of potential future collaborations. We do not knowwhether additional financing will be available when needed, or that, ifavailable, we will obtain financing on terms favorable to our stockholders orus.

 

To the extent we raise additional capital byissuing equity securities, our stockholders could at that time experiencesubstantial dilution. To the extent that we raise additional funds throughcollaboration and licensing arrangements, we may be required to relinquishsome rights to our technologies or product candidates, or grant licenses onterms that are not favorable to us.

 

Our future funding requirements will depend upon many factors,including, but not limited to:

 

•                                          theprogress and success of clinical trials and preclinical activities (includingstudies and manufacture of materials) of our product candidates conducted by usor our collaborative partners or licensees;

•                                          ourability to establish new collaborations and to maintain our existingcollaboration partnerships;

•                                          theprogress of research programs carried out by us;

•                                          anychanges in the breadth of our research and development programs;

•                                          ourability to meet the milestones identified in our collaborative agreements thattrigger payments;

•                                          theprogress of the research and development efforts of our collaborative partners;

•                                          ourability to acquire or license other technologies or compounds that we seek topursue;

•                                          ourability to manage our growth;

•                                          competingtechnological and market developments;

•                                          thecosts and timing of obtaining, enforcing and defending our patent andintellectual property rights;

•                                          thecosts and timing of regulatory approvals and filings by us and ourcollaborators; and

•                                          expensesassociated with unforeseen litigation.

 

19

----

 

Insufficientfunds may require us to delay, scale back or eliminate some or all of ourresearch or development programs, to lose rights under existing licenses or torelinquish greater or all rights to product candidates at an earlier stage ofdevelopment or on less favorable terms than we would otherwise choose or may adverselyaffect our ability to operate as a going concern. As of June 30, 2006, wehad approximately $122.2 million in cash, cash equivalents andavailable-for-sale securities, as compared to $138.2 million as of December 31,2005, a decrease of $16.0 million. The decrease was attributable tooperating spending in the period, offset by the receipt of $5.0 million fromSerono and $5.0 million from Pfizer. We also received approximately $1.3million under our equipment financing arrangements, which was offset by debtservice payments of approximately $663,000 relating to the equipmentfinancing arrangements. We expect that our net cash used in operations for thesecond half of 2006 will increase as compared to the first half of 2006 as wecommence our Phase II clinical trial of R788 for RA. For the three and sixmonths ended June 30, 2006 and 2005, we maintained an investment portfolioprimarily in money market funds, federal agency securities and corporate bondsand notes. Cash in excess of immediate requirements is invested with regard toliquidity and capital preservation. Wherever possible, we seek to minimize thepotential effects of concentration and degrees of risk.

 

**Contractual Obligations**

 

The following are our contractual commitments(by fiscal year) as of June 30, 2006 associated with debt obligations,contracted research obligations, and lease obligations:

 
| ** **                                | ** ** | **Total**               | ** ** | **2006** | ** ** | **2007-2009** | ** ** | **2010-2012** | ** ** | **2013-2018** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|----------|------------|---------------|------------|---------------|------------|---------------|------------|
| ** **                                | ** ** | **(in thousands)** | ** ** |
| Debt  obligations (1)                     |       | $                       | 3,148      |     | $          | 749           |       | $             | 2,399      |          | $          | — |   | $ | — |   |
| Facilities  lease, net of sublease (2)(3) |       | 162,047                 |       | 5,836    |       | 41,581        |       | 38,507        |       | 76,123        |       |
|                                      |       |                    |       |     |       |          |       |          |       |          |       |
| Total                                     |       | $                       | 165,195    |     | $          | 6,585         |       | $             | 43,980     |          | $          | 38,507 |   | $ | 76,123 |   |

 

----

(1)           Asof June 30, 2006, we had approximately $2.8 million in debtobligations associated with our equipment additions. All existing debtagreements as of June 30, 2006 are secured by the equipment financed, bearinterest at rates in a range of 8.8% to 12.2% and are due in monthlyinstallments through 2009.

 

(2)           DuringMay 2004, we initiated a sublease of approximately 15,000 square feet ofour premises to a tenant for a period of two years. This sublease was amendedin September 2005 to extend the term for an additional year. Thefacilities lease obligations above are reflective of the new sublease incomestream of $606,000.

 

(3)           Thepayments above reflect the remaining approximately twelve years of the leaseterm.

 

**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

The primary objective of our investmentactivities is to preserve principal while at the same time maximizing theincome we receive from our investments without significantly increasing risk.Some of the securities in which we invest may have market risk. This meansthat a change in prevailing interest rates may cause the fair value amountof the investment to fluctuate. For example, if we hold a security that wasissued with a fixed interest rate at the then-prevailing rate and theprevailing interest rate later rises, the market value amount of our investmentwill decline. To minimize this risk in the future, we intend to maintain ourportfolio of cash equivalents and available-for-sale securities in a variety ofsecurities, including money market funds and government and non-government debtsecurities. For the three and six months ended June 30, 2006 and 2005, wemaintained an investment portfolio primarily in money market funds, federalagency securities and corporate bonds and notes. Due to the short-term natureof the majority of these investments, we believe we do not have a materialexposure to interest rate risk arising from our investments. Therefore, noquantitative tabular disclosure is provided.

 

We have operated primarily in the UnitedStates, and all funding activities with our collaborators to date have beenmade in U.S. dollars. Accordingly, we have had minimal exposure to foreigncurrency rate fluctuations.

 

**Item 4.  Controls and Procedures**

 

*Evaluation of Disclosure Controls andProcedures.*Based on our management’s evaluation (withthe participation of our chief executive officer and chief financial officer),our chief executive officer and chief financial officer have concluded that ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended), wereeffective as of June 30, 2006.

 

*Changes in Internal Controls.*Therewere no changes in our internal controls over financial reporting during thequarter ended June 30, 2006 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

*Limitations on the Effectiveness of Controls*.A control system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the controls aremet. Because of the inherent limitations in all control

 

20

----

 

systems, no evaluation of controls can provide absolute assurance thatall control issues, if any, within a company have been detected. Accordingly,our disclosure controls and procedures are designed to provide reasonable, notabsolute, assurance that the objectives of our disclosure control system aremet and, as set forth above, our chief executive officer and chief financialofficer have concluded, based on their evaluation as of the end of the periodcovered by this quarterly report on Form 10-Q, that our disclosurecontrols and procedures were sufficiently effective to provide reasonableassurance that the objectives of our disclosure control system were met.

 

**PART II.OTHER INFORMATION**

 

**Item 1A. Risk Factors**

** **

*In evaluating ourbusiness, you should carefully consider the following risks, as well as theother information contained in this quarterly report on Form 10-Q. If anyof the following risks actually occurs, our business could be harmed. The risksand uncertainties described below are not the only ones facing us. Additionalrisks and uncertainties not presently known to us, or that we currently see asimmaterial, may also harm our business.*

 

*We have marked withan asterisk(*) those risk factors below that reflect material changes from therisk factors included in our Annual Report on Form 10-K filed with theSecurities and Exchange Commission on March 8, 2006.*

 

**Wewill need additional capital in the future to sufficiently fund our operationsand research.***

** **

We have consumed substantial amounts ofcapital to date, and operating expenditures are expected to increase over thenext several years as we expand our infrastructure and research and developmentactivities. We believe that our existing capital resources and anticipatedproceeds from current collaborations will be sufficient to support our currentoperating plan through at least the next 12 months. Our operations willrequire significant additional funding in large part due to our researchand development expenses, future preclinical and clinical-testing costs, andthe absence of any meaningful revenues for the foreseeable future. The amountof future funds needed will depend largely on the timing and structure ofpotential future collaborations. We do not know whether additional financingwill be available when needed, or that, if available, we will obtain financingon terms favorable to our stockholders or us.

 

To the extent we raise additional capital byissuing equity securities, our stockholders could at that time experiencesubstantial dilution. To the extent that we raise additional funds throughcollaboration and licensing arrangements, we may be required to relinquishsome rights to our technologies or product candidates, or grant licenses onterms that are not favorable to us.

 

**Our future funding requirements will dependon many uncertain factors**.

 

Our future funding requirements will dependupon many factors, including, but not limited to:

 

•                                          theprogress and success of clinical trials and preclinical activities (includingstudies and manufacture of materials) of our product candidates conducted by usor our collaborative partners or licensees;

•                                          ourability to establish new collaborations and to maintain our existingcollaboration partnerships;

•                                          theprogress of research programs carried out by us;

•                                          anychanges in the breadth of our research and development programs;

•                                          ourability to meet the milestones identified in our collaborative agreements thattrigger payments;

•                                          theprogress of the research and development efforts of our collaborative partners;

•                                          ourability to acquire or license other technologies or compounds that we seek topursue;

•                                          ourability to manage our growth;

•                                          competingtechnological and market developments;

•                                          thecosts and timing of obtaining, enforcing and defending our patent andintellectual property rights;

•                                          thecosts and timing of regulatory approvals and filings by us and ourcollaborators; and

•                                          expensesassociated with unforeseen litigation.

 

Insufficient funds may require us todelay, scale back or eliminate some or all of our research or developmentprograms, to lose rights under existing licenses or to relinquish greater orall rights to product candidates at an earlier stage of development or on lessfavorable terms than we would otherwise choose or may adversely affect ourability to operate as a going concern.

 

**Oursuccess as a company is uncertain due to our history of operating losses andthe uncertainty of future profitability.***

** **

Due in large part to the significantresearch and development expenditures required to identify and validate newproduct candidates and pursue our development efforts, we have not beenprofitable and have incurred operating losses since we were incorporated in June 1996.The extent of our future losses and the timing of potential profitability arehighly uncertain, and we may never achieve profitable operations. Weincurred net losses of approximately $10.8 million for the first sixmonths of 2006, $45.3 million in 2005 and $56.3 million in 2004. Currently, ourrevenues are generated solely from research payments pursuant to ourcollaboration agreements and licenses and are insufficient to generateprofitable operations. As of June 30, 2006, we had an accumulated deficitof approximately $268.3 million. We expect to incur losses for at leastthe next several years and expect that these losses could increase as we expandour research and development activities and incur significant clinical andtesting costs.

 

21

----

 

**Thereis a high risk that drug discovery and development efforts might notsuccessfully generate good product candidates.***

** **

At the present time, the majority of ouroperations are in various stages of drug identification and development. Wecurrently have two product compounds in the clinical testing stage: one is forboth RA and ITP, which is proprietary to our company and the other is foroncology, which is partnered with Serono. In our industry, it isstatistically unlikely that the limited number of compounds that we haveidentified as potential product candidates will actually lead to successfulproduct development efforts, and we do not expect any drugs resulting from ourresearch to be commercially available for several years, if at all. Our productcompounds in the clinic and our future leads for potential drug compounds aresubject to the risks and failures inherent in the development of pharmaceuticalproducts. These risks include, but are not limited to, the inherent difficultyin selecting the right drug and drug target and avoiding unwanted side effectsas well as unanticipated problems relating to product development, testing,regulatory compliance, manufacturing, marketing, competition and costs andexpenses that may exceed current estimates. The results of preliminarystudies do not necessarily predict clinical or commercial success, and largerlater-stage clinical trials may fail to confirm the results observed in thepreliminary studies. With respect to our own compounds in development, we haveestablished anticipated timelines for clinical development based on existingknowledge of the compound. However, we cannot provide assurance that we willmeet any of these timelines with respect to the initiation or completion ofclinical studies. For example, in December 2005, we completed a Phase IItrial of R112 for the treatment of allergic rhinitis, which did not achieve theprimary endpoint.

 

Because of the uncertainty of whether theaccumulated preclinical evidence (pharmacokinetic, pharmacodynamic, safetyand/or other factors) or early clinical results will be observed in laterclinical trials, we can make no assurance regarding the likely results from ourfuture clinical trials or the impact of those results on our business.

 

**Wemight not be able to commercialize our product candidates successfully ifproblems arise in the clinical testing and approval process.***

** **

Commercialization of our product candidatesdepends upon successful completion of preclinical studies and clinical trials.Preclinical testing and clinical development are long, expensive and uncertainprocesses. We do not know whether we, or any of our collaborative partners,will be permitted to undertake clinical trials of potential products beyond thetrials already concluded and the trials currently in process. It will take usor our collaborative partners several years to complete any such testing, andfailure can occur at any stage of testing. Interim results of trials do notnecessarily predict final results, and acceptable results in early trials may notbe repeated in later trials. A number of companies in the pharmaceuticalindustry, including biotechnology companies, have suffered significant setbacksin advanced clinical trials, even after achieving promising results in earliertrials. Moreover, we or our collaborative partners or regulators may decideto discontinue development of any or all of these projects at any time forcommercial, scientific or other reasons.

 

**Delaysin clinical testing could result in increased costs to us.**

** **

Significant delays in clinical testing couldmaterially impact our product development costs and timing. We do not knowwhether planned clinical trials will begin on time, will need to be halted orrevamped or will be completed on schedule, or at all. Clinical trials can bedelayed for a variety of reasons, including delays in obtaining regulatoryapproval to commence a study, delays from scale up delays in reaching agreementon acceptable clinical study agreement terms with prospective clinical sites,delays in obtaining institutional review board approval to conduct a study at aprospective clinical site or delays in recruiting subjects to participate in astudy. Environmental conditions may impact the execution of some clinicaltrials, particularly during the allergy season for our allergic rhinitisprogram.

 

In addition, we typically rely on third-partyclinical investigators to conduct our clinical trials and other third-partyorganizations to oversee the operations of such trials and to perform datacollection and analysis. As a result, we may face additional delayingfactors outside our control if these parties do not perform theirobligations in a timely fashion. While we have not yet experienced delays thathave materially impacted our clinical trials or product development costs,delays of this sort could occur for the reasons identified above or otherreasons. If we have delays in testing or approvals, our product developmentcosts will increase. For example, we may need to make additional paymentsto third-party investigators and organizations to retain their services or we may needto pay recruitment incentives. If the delays are significant, our financialresults and the commercial prospects for our product candidates will be harmed,and our ability to become profitable will be delayed.

 

**We lack the capability to manufacturecompounds for development and rely on third parties to manufacture our productcandidates, and we may be unable to obtain required material in a timelymanner, at an acceptable cost or at a quality level required to receiveregulatory approval**.

 

We currently do not have manufacturing capabilities or experiencenecessary to produce our product candidates, including R788 for clinicaltrials. We relied on a single third-party contractor to produce R763. We alsorely on a single manufacturer for R788 product for clinical testing. We willrely on manufacturers to deliver materials on a timely basis and to comply withapplicable regulatory requirements, including the U.S. Food and DrugAdministration’s, or FDA’s current Good Manufacturing Practices, or GMP. Theseoutsourcing efforts with respect to manufacturing preclinical and clinicalsupplies will result in a dependence on our suppliers to timely manufacture anddeliver sufficient quantities of materials produced under GMP conditions toenable us to conduct planned preclinical studies, clinical trials and, ifpossible, to bring products to market in a timely manner.

 

Our current and anticipated future dependenceupon these third-party manufacturers may adversely affect our ability todevelop and commercialize product candidates on a timely and competitive basis.These manufacturers may not be able to produce material on a timely basisor manufacture material at the quality level or in the quantity required tomeet our development timelines

 

22

----

 

and applicable regulatory requirements. We may not be able to maintainor renew our existing third-party manufacturing arrangements, or enter into newarrangements, on acceptable terms, or at all. Our third-party manufacturerscould terminate or decline to renew our manufacturing arrangements based ontheir own business priorities, at a time that is costly or inconvenient for us.If we are unable to contract for the production of materials in sufficientquantity and of sufficient quality on acceptable terms, our planned clinicaltrials may be significantly delayed. Manufacturing delays could postponethe filing of our IND applications and/or the initiation of clinical trialsthat we have currently planned.

 

Our third-party manufacturers may not beable to comply with the GMP regulations, other applicable FDA regulatory requirementsor similar regulations applicable outside of the United States. Additionally,if we are required to enter into new supply arrangements, we may not beable to obtain approval from the FDA of any alternate supplier in a timelymanner, or at all, which could delay or prevent the clinical development andcommercialization of any related product candidates. Failure of our third-partymanufacturers or us to obtain approval from the FDA or to comply withapplicable regulations could result in sanctions being imposed on us, includingfines, civil penalties, delays in or failure to grant marketing approval of ourproduct candidates, injunctions, delays, suspension or withdrawal of approvals,license revocation, seizures or recalls of products and compounds, operatingrestrictions and criminal prosecutions, any of which could significantly andadversely affect our business.

 

**Becausemost of our expected future revenues are contingent upon collaborative andlicense agreements, we might not meet our strategic objectives.**

** **

Our ability to generate revenue in the nearterm depends on our ability to enter into additional collaborative agreementswith third parties and to maintain the agreements we currently have in place.Our ability to enter into new collaborations and the revenue, if any, that may berecognized under these collaborations is highly uncertain. If we are unable toenter into new collaborations, our business prospects could be harmed, whichcould have an immediate adverse effect on the trading price of our stock.

 

To date, most of our revenues have beenrelated to the research phase of each of our collaborative agreements. Suchrevenues are for specified periods, and the impact of such revenues on ourresults of operations is partially offset by corresponding research costs.Following the completion of the research phase of each collaborative agreement,additional revenues may come only from milestone payments and royalties,which may not be paid, if at all, until some time well into the future.The risk is heightened due to the fact that unsuccessful research efforts may precludeus from receiving any milestone payments under these agreements. Our receipt ofrevenues from collaborative arrangements is also significantly affected by thetiming of efforts expended by us and our collaborators and the timing of leadcompound identification. In late 2001, we recorded the first revenue fromachievement of milestones in both the Pfizer and Johnson & Johnsoncollaborations. In addition, we have subsequently received milestone paymentsfrom Novartis, Daiichi, Merck, Serono and Pfizer. Under many agreements,however, milestone payments may not be earned until the collaborator hasadvanced product candidates into clinical testing, which may never occuror may not occur until some time well into the future. If we are not ableto generate revenue under our collaborations when and in accordance with ourexpectations or the expectations of industry analysts, this failure could harmour business and have an immediate adverse effect on the trading price of ourstock.

 

Our business requires us to generatemeaningful revenue from royalties and licensing agreements. To date, we havenot received any revenue from royalties for the commercial sale of drugs, andwe do not know when we will receive any such revenue, if at all. Likewise, wehave not licensed any lead compounds or drug development candidates to thirdparties, and we do not know whether any such license will be entered into onacceptable terms in the future, if at all.

 

**Ifour current corporate collaborations or license agreements are unsuccessful,our research and development efforts could be delayed.**

** **

Our strategy depends upon the formation andsustainability of multiple collaborative arrangements and license agreementswith third parties in the future. We rely on these arrangements for not onlyfinancial resources, but also for expertise that we expect to need in thefuture relating to clinical trials, manufacturing, sales and marketing, and forlicenses to technology rights. To date, we have entered into several sucharrangements with corporate collaborators; however, we do not know if suchthird parties will dedicate sufficient resources or if any development orcommercialization efforts by third parties will be successful. Should acollaborative partner fail to develop or commercialize a compound or product towhich it has rights from us for any reason including corporate restructuring,such failure might delay ongoing research and development efforts at Rigel, becausewe might not receive any future milestone payments, and we would not receiveany royalties associated with such compound or product. In addition, thecontinuation of some of our partnered drug discovery and development programs may bedependent on the periodic renewal of our corporate collaborations.

 

The research phase of our collaboration withJohnson & Johnson ended in 2003, and the research phases conducted atour facilities under our broad collaboration with Novartis ended in 2004.The research phase of our corporate collaboration agreement with Daiichi endedin 2005. In 2004, we signed a new corporate collaboration with Merck and in2005, we signed additional collaborations with Pfizer and Serono. Theseagreements could be terminated by the other party, and we may not be ableto renew these collaborations on acceptable terms, if at all, or negotiateadditional corporate collaborations on acceptable terms, if at all. If thesecollaborations terminate or are not renewed, any resultant loss of revenues fromthese collaborations or loss of the expertise of our collaborative partnerscould adversely affect our business.

 

Conflicts also might arise with collaborativepartners concerning proprietary rights to particular compounds. While ourexisting collaborative agreements typically provide that we retain milestonepayments and royalty rights with respect to drugs

 

23

----

 

developed from certain derivative compounds, any such payments orroyalty rights may be at reduced rates, and disputes may arise overthe application of derivative payment provisions to such drugs, and we may notbe successful in such disputes.

 

We are also a party to various licenseagreements that give us rights to use specified technologies in our researchand development processes. The agreements pursuant to which we have in-licensedtechnology permit our licensors to terminate the agreements under certaincircumstances. If we are not able to continue to license these and futuretechnologies on commercially reasonable terms, our product development andresearch may be delayed.

 

**Ifconflicts arise between our collaborators or advisors and us, any of them may actin their self-interest, which may be adverse to our stockholders’interests.**

** **

If conflicts arise between us and ourcorporate collaborators or scientific advisors, the other party may act inits self-interest and not in the interest of our stockholders. Some of ourcorporate collaborators are conducting multiple product development effortswithin each disease area that is the subject of the collaboration with us or may beacquired or merged with a company having a competing program. In some of ourcollaborations, we have agreed not to conduct, independently or with any thirdparty, any research that is competitive with the research conducted under ourcollaborations. Our collaborators, however, may develop, either alone orwith others, products in related fields that are competitive with the productsor potential products that are the subject of these collaborations. Competingproducts, either developed by our collaborators or to which our collaboratorshave rights, may result in their withdrawal of support for our productcandidates.

 

If any of our corporate collaborators were tobreach or terminate its agreement with us or otherwise fail to conduct thecollaborative activities successfully and in a timely manner, the preclinicalor clinical development or commercialization of the affected product candidatesor research programs could be delayed or terminated. We generally do notcontrol the amount and timing of resources that our corporate collaboratorsdevote to our programs or potential products. We do not know whether current orfuture collaborative partners, if any, might pursue alternative technologies ordevelop alternative products either on their own or in collaboration withothers, including our competitors, as a means for developing treatments for thediseases targeted by collaborative arrangements with us.

 

**Oursuccess is dependent on intellectual property rights held by us and thirdparties, and our interest in such rights is complex and uncertain.**

** **

Our success will depend to a large part onour own, our licensees’ and our licensors’ ability to obtain and defend patentsfor each party’s respective technologies and the compounds and other products,if any, resulting from the application of such technologies. We have over 150pending patent applications and over 50 issued patents in the United Statesthat are owned or exclusively licensed in our field as well as pendingcorresponding foreign patent applications. In the future, our patent positionmight be highly uncertain and involve complex legal and factual questions. Forexample, we may be involved in interferences before the United StatesPatent and Trademark Office. Interferences are complex and expensive legalproceedings and there is no assurance we will be successful in suchproceedings. An interference could result in our losing our patent rightsand/or our freedom to operate and/or require us to pay significant royalties.Additional uncertainty may result because no consistent policy regardingthe breadth of legal claims allowed in biotechnology patents has emerged todate. Accordingly, we cannot predict the breadth of claims allowed in our orother companies’ patents.

 

Because the degree of future protection forour proprietary rights is uncertain, we cannot ensure that:

 

•                                          wewere the first to make the inventions covered by each of our pending patentapplications;

•                                          wewere the first to file patent applications for these inventions;

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

•                                          anyof our pending patent applications will result in issued patents;

•                                          anypatents issued to us or our collaborators will provide a basis forcommercially-viable products or will provide us with any competitive advantagesor will not be challenged by third parties;

•                                          wewill develop additional proprietary technologies that are patentable; or

•                                          thepatents of others will not have a negative effect on our ability to dobusiness.

 

We rely on trade secrets to protecttechnology where we believe patent protection is not appropriate or obtainable.However, trade secrets are difficult to protect. While we require employees,collaborators and consultants to enter into confidentiality agreements, we may notbe able to adequately protect our trade secrets or other proprietaryinformation in the event of any unauthorized use or disclosure or the lawfuldevelopment by others of such information.

 

We are a party to certain in-licenseagreements that are important to our business, and we generally do not controlthe prosecution of in-licensed technology. Accordingly, we are unable toexercise the same degree of control over this intellectual property as weexercise over our internally-developed technology. Moreover, some of ouracademic institution licensors, research collaborators and scientific advisorshave rights to publish data and information in which we have rights. If wecannot maintain the confidentiality of our technology and other confidentialinformation in connection with our collaborations, then our ability to receivepatent protection or protect our proprietary information will be impaired. Inaddition, some of the technology we have licensed relies on patented inventionsdeveloped using U.S. government resources. The U.S. government retains certainrights, as defined by law, in

 

24

----

 

such patents, and may choose to exercise such rights. Certain ofour in-licenses may be terminated if we fail to meet specifiedobligations. If we fail to meet such obligations and any of our licensorsexercise their termination rights, we could lose our rights under thoseagreements. If we lose any of our rights, it may adversely affect the waywe conduct our business. In addition, because certain of our licenses aresublicenses, the actions of our licensors may affect our rights underthose licenses.

 

**Ifa dispute arises regarding the infringement or misappropriation of theproprietary rights of others, such dispute could be costly and result in delaysin our research and development activities and partnering.**

** **

Our success will also depend, in part, on our ability to operatewithout infringing or misappropriating the proprietary rights of others. Thereare many issued patents and patent applications filed by third parties relatingto products or processes that are similar or identical to ours or ourlicensors, and others may be filed in the future. There can be noassurance that our activities, or those of our licensors, will not infringepatents owned by others. We believe that there may be significantlitigation in the industry regarding patent and other intellectual propertyrights, and we do not know if we or our collaborators would be successful inany such litigation. Any legal action against our collaborators or us claimingdamages or seeking to enjoin commercial activities relating to the affectedproducts, our methods or processes could:

 

•                                          requireour collaborators or us to obtain a license to continue to use, manufacture ormarket the affected products, methods or processes, which may not beavailable on commercially reasonable terms, if at all;

•                                          preventus from using the subject matter claimed in the patents held by others;

•                                          subjectus to potential liability for damages;

•                                          consumea substantial portion of our managerial and financial resources; and

•                                          resultin litigation or administrative proceedings that may be costly, whether wewin or lose.

 

**Ifwe are unable to obtain regulatory approval to market products in the UnitedStates and foreign jurisdictions, we might not be permitted to commercializeproducts from our research and development.**

** **

Due, in part, to the early stage of our product candidate research anddevelopment process, we cannot predict whether regulatory clearance will beobtained for any product that we, or our collaborative partners, hope todevelop. Satisfaction of regulatory requirements typically takes many years, isdependent upon the type complexity and novelty of the product and requires theexpenditure of substantial resources. Of particular significance to us are therequirements relating to research and development and testing.

 

Before commencing clinical trials in humans in the United States, we,or our collaborative partners, will need to submit and receive approval fromthe FDA of an IND. Clinical trials are subject to oversight by institutionalreview boards and the FDA and:

 

•                                          mustbe conducted in conformance with the FDA’s good clinical practices and otherapplicable regulations;

•                                          mustmeet requirements for institutional review board oversight;

•                                          mustmeet requirements for informed consent;

•                                          aresubject to continuing FDA oversight;

•                                          may requirelarge numbers of test subjects; and

•                                          may besuspended by us, our collaborators or the FDA at any time if it is believedthat the subjects participating in these trials are being exposed tounacceptable health risks or if the FDA finds deficiencies in the IND or theconduct of these trials.

 

While we have stated that we intend to fileadditional INDs, this is only a statement of intent, and we may not beable to do so because we may not be able to identify potential productcandidates. In addition, the FDA may not approve any IND in a timelymanner, or at all.

 

Before receiving FDA approval to market aproduct, we must demonstrate that the product is safe and effective in thepatient population and the indication that will be treated. Data obtained frompreclinical and clinical activities are susceptible to varying interpretationsthat could delay, limit or prevent regulatory approvals. In addition, delays orrejections may be encountered based upon additional government regulationfrom future legislation or administrative action or changes in FDA policyduring the period of product development, clinical trials and FDA regulatoryreview. Failure to comply with applicable FDA or other applicable regulatoryrequirements may result in criminal prosecution, civil penalties, recallor seizure of products, total or partial suspension of production orinjunction, as well as other regulatory action against our potential productsor us. Additionally, we have limited experience in conducting and managing theclinical trials necessary to obtain regulatory approval.

 

If regulatory approval of a product isgranted, this approval will be limited to those indications or disease statesand conditions for which the product is demonstrated through clinical trials tobe safe and efficacious. We cannot ensure that any compound developed by us,alone or with others, will prove to be safe and efficacious in clinical trialsand will meet all of the applicable regulatory requirements needed to receivemarketing approval.

 

Outside the United States, our ability, orthat of our collaborative partners, to market a product is contingent uponreceiving a marketing authorization from the appropriate regulatoryauthorities. This foreign regulatory approval process typically includes all ofthe risks associated with FDA approval described above and may alsoinclude additional risks.

 

25

----

 

**Ifour competitors develop technologies that are more effective than ours, ourcommercial opportunity will be reduced or eliminated.**

** **

The biotechnology and pharmaceuticalindustries are intensely competitive and subject to rapid and significanttechnological change. Many of the drugs that we are attempting to discover willbe competing with existing therapies. In addition, a number of companies arepursuing the development of pharmaceuticals that target the same diseases andconditions that we are targeting. We face competition from pharmaceutical andbiotechnology companies both in the United States and abroad.

 

Our competitors may utilize discoverytechnologies and techniques or partner with collaborators in order to developproducts more rapidly or successfully than we, or our collaborators, are ableto do. Many of our competitors, particularly large pharmaceutical companies,have substantially greater financial, technical and human resources than we do.In addition, academic institutions, government agencies and other public andprivate organizations conducting research may seek patent protection withrespect to potentially competitive products or technologies and may establishexclusive collaborative or licensing relationships with our competitors.

 

We believe that our ability to compete isdependent, in part, upon our ability to create, maintain and licensescientifically-advanced technology and upon our and our collaborators’ abilityto develop and commercialize pharmaceutical products based on this technology,as well as our ability to attract and retain qualified personnel, obtain patentprotection or otherwise develop proprietary technology or processes and securesufficient capital resources for the expected substantial time period betweentechnological conception and commercial sales of products based upon ourtechnology. The failure by us or any of our collaborators in any of those areasmay prevent the successful commercialization of our potential drugtargets.

 

Our competitors might develop technologiesand drugs that are more effective or less costly than any that are beingdeveloped by us or that would render our technology and potential drugsobsolete and noncompetitive. In addition, our competitors may succeed inobtaining the approval of the FDA or other regulatory agencies for productcandidates more rapidly. Companies that complete clinical trials, obtainrequired regulatory agency approvals and commence commercial sale of theirdrugs before their competitors may achieve a significant competitiveadvantage, including certain patent and FDA marketing exclusivity rights thatwould delay or prevent our ability to market certain products. Any drugsresulting from our research and development efforts, or from our joint effortswith our existing or future collaborative partners, might not be able tocompete successfully with competitors’ existing or future products or obtainregulatory approval in the United States or elsewhere.

 

**Ourability to generate revenues will be diminished if our collaborative partnersfail to obtain acceptable prices or an adequate level of reimbursement forproducts from third-party payors or government agencies.**

** **

The drugs we hope to develop may be rejected by the marketplacedue to many factors, including cost. Our ability to commercially exploit a drugmay be limited due to the continuing efforts of government and third-partypayors to contain or reduce the costs of health care through various means. Forexample, in some foreign markets, pricing and profitability of prescriptionpharmaceuticals are subject to government control. In the United States, weexpect that there will continue to be a number of federal and state proposalsto implement similar government control. In addition, increasing emphasis onmanaged care in the United States will likely continue to put pressure on thepricing of pharmaceutical products. Cost control initiatives could decrease theprice that any of our collaborators would receive for any products in thefuture. Further, cost control initiatives could adversely affect ourcollaborators’ ability to commercialize our products and our ability to realizeroyalties from this commercialization.

 

Our ability tocommercialize pharmaceutical products with collaborators may depend, inpart, on the extent to which reimbursement for the products will be availablefrom:

 

•                                          governmentand health administration authorities;

•                                          privatehealth insurers; and

•                                          otherthird-party payors.

 

Significant uncertainty exists as to the reimbursement status ofnewly-approved healthcare products. Third-party payors, including Medicare, arechallenging the prices charged for medical products and services. Governmentand other third-party payors increasingly are attempting to contain healthcarecosts by limiting both coverage and the level of reimbursement for new drugsand by refusing, in some cases, to provide coverage for uses of approvedproducts for disease indications for which the FDA has not granted labelingapproval. Third-party insurance coverage may not be available to patientsfor any products we discover and develop, alone or with collaborators. Ifgovernment and other third-party payors do not provide adequate coverage andreimbursement levels for our products, the market acceptance of these products may bereduced.

 

**Ifproduct liability lawsuits are successfully brought against us, we may incursubstantial liabilities and may be required to limit commercialization ofour products.**

** **

The testing and marketing of medical products entail an inherent riskof product liability. If we cannot successfully defend ourselves againstproduct liability claims, we may incur substantial liabilities or berequired to limit commercialization of our products although we are notcurrently aware of any specific causes for concern with respect to clinicalliability claims. We currently do not have product liability insurance, and ourinability to obtain sufficient product liability insurance at an acceptablecost to protect against potential product liability claims could prevent orinhibit the commercialization of pharmaceutical products we develop, alone orwith corporate collaborators. We, or our corporate collaborators, might not beable to obtain insurance at a reasonable cost, if at all.

 

26

----

 

While under various circumstances we areentitled to be indemnified against losses by our corporate collaborators,indemnification may not be available or adequate should any claim arise.

 

**Ourresearch and development efforts will be seriously jeopardized, if we areunable to attract and retain key employees and relationships.**

** **

As a small company with only 149 employees as of June 30, 2006,our success depends on the continued contributions of our principal managementand scientific personnel and on our ability to develop and maintain importantrelationships with leading academic institutions, scientists and companies inthe face of intense competition for such personnel. In particular, our researchprograms depend on our ability to attract and retain highly skilled chemists,other scientists, and development, regulatory and clinical personnel. If welose the services of any of our personnel, our research and development effortscould be seriously and adversely affected. Our employees can terminate theiremployment with us at any time.

 

**Wedepend on various scientific consultants and advisors for the success andcontinuation of our research and development efforts.**

** **

We work extensively with various scientific consultants and advisors.The potential success of our drug discovery and development programs depends,in part, on continued collaborations with certain of these consultants andadvisors. We, and various members of our management and research staff, rely oncertain of these consultants and advisors for expertise in our research,regulatory and clinical efforts. Our scientific advisors are not our employeesand may have commitments to, or consulting or advisory contracts with,other entities that may limit their availability to us. We do not know ifwe will be able to maintain such consulting agreements or that such scientificadvisors will not enter into consulting arrangements, exclusive or otherwise,with competing pharmaceutical or biotechnology companies, any of which wouldhave a detrimental impact on our research objectives and could have a materialadverse effect on our business, financial condition and results of operations.

 

**Ifwe use biological and hazardous materials in a manner that causes injury orviolates laws, we may be liable for damages.**

** **

Our research and development activities involve the controlled use ofpotentially harmful biological materials as well as hazardous materials,chemicals and various radioactive compounds. We cannot completely eliminate therisk of accidental contamination or injury from the use, storage, handling ordisposal of these materials. In the event of contamination or injury, we couldbe held liable for damages that result, and such liability could exceed ourresources. We are also subject to federal, state and local laws and regulationsgoverning the use, storage, handling and disposal of these materials andspecified waste products. The cost of compliance with, or any potentialviolation of, these laws and regulations could be significant.

 

**Ourfacilities are located near known earthquake fault zones, and the occurrence ofan earthquake or other catastrophic disaster could cause damage to ourfacilities and equipment, which could require us to cease or curtailoperations.**

** **

Our facilities are located in the SanFrancisco Bay Area near known earthquake fault zones and are vulnerable tosignificant damage from earthquakes. We are also vulnerable to damage fromother types of disasters, including fires, floods, power loss, communicationsfailures and similar events. If any disaster were to occur, our ability tooperate our business at our facilities would be seriously, or potentiallycompletely, impaired, and our research could be lost or destroyed. In addition,the unique nature of our research activities and of much of our equipment couldmake it difficult for us to recover from a disaster. The insurance we maintain may notbe adequate to cover our losses resulting from disasters or other businessinterruptions.

 

**Ourstock price may be volatile, and our stockholders’ investment in our stockcould decline in value.**

** **

The market prices for our securities and those of other biotechnologycompanies have been highly volatile and may continue to be highly volatilein the future. The following factors, in addition to other risk factorsdescribed in this section, may have a significant impact on the marketprice of our common stock:

 

•                                          theprogress and success of clinical trials and preclinical activities (i.e.,studies, manufacture of materials) of our product candidates conducted by us orour collaborative partners or licensees;

•                                          thereceipt or failure to receive the additional funding necessary to conduct ourbusiness;

•                                          sellingby large stockholders;

•                                          announcementsof technological innovations or new commercial products by our competitors orus;

•                                          developmentsconcerning proprietary rights, including patents;

•                                          developmentsconcerning our collaborations;

•                                          publicityregarding actual or potential medical results relating to products underdevelopment by our competitors or us;

•                                          regulatorydevelopments in the United States and foreign countries;

•                                          litigation;

•                                          economicand other external factors or other disaster or crisis; and

•                                          period-to-periodfluctuations in financial results.

 

27

----

 

**Anti-takeoverprovisions in our charter documents and under Delaware law may make an acquisitionof us, which may be beneficial to our stockholders, more difficult.**

** **

Provisions of our amended and restatedcertificate of incorporation and bylaws, as well as provisions of Delaware law,could make it more difficult for a third party to acquire us, even if doing sowould benefit our stockholders. These provisions:

 

•                                          establishthat members of the board of directors may be removed only for cause uponthe affirmative vote of stockholders owning a majority of our capital stock;

•                                          authorizethe issuance of “blank check” preferred stock that could be issued by our boardof directors to increase the number of outstanding shares and thwart a takeoverattempt;

•                                          limitwho may call a special meeting of stockholders;

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

•                                          establishadvance notice requirements for nominations for election to the board ofdirectors or for proposing matters that can be acted upon at stockholder meetings;

•                                          providefor a board of directors with staggered terms; and

•                                          providethat the authorized number of directors may be changed only by aresolution of our board of directors.

 

In addition, Section 203 of the Delaware General Corporation Law,which imposes certain restrictions relating to transactions with majorstockholders, may discourage, delay or prevent a third party fromacquiring us.

 

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

 

We held our 2006 Annual Meeting of Stockholders on May 30,2006. At such meeting, the following actions were voted upon.

 

(a)          To elect a director,James M. Gower, to hold office until our 2009 Annual Meeting of Stockholders.

 
| **Votes in Favor** | ** ** | **Votes Withheld** | ** ** |
|------------------------------|------------|-------------------------|------------|
| 20,564,369                   |       | 538,198                 |       |

 

(b)         To elect a director, GaryA. Lyons, to hold office until our 2009 Annual Meeting of Stockholders.

 
| **Votes in Favor** | ** ** | **Votes Withheld** | ** ** |
|--------------------|------------|--------------------|------------|
| 19,573,001         |       | 1,529,566          |       |

 

(c)          To elect a director,Donald G. Payan, M.D., to hold office until our 2009 Annual Meeting ofStockholders.

 
| **Votes in Favor** | ** ** | **Votes Withheld** | ** ** |
|--------------------|------------|--------------------|------------|
| 21,033,774         |       | 68,793             |       |

 

(d)         To approve our 2000Equity Incentive Plan as amended.

 
| **Votes in Favor** | ** ** | **Votes Against** | ** ** | **Abstentions** | ** ** | **Broker Non-Votes** | ** ** |
|--------------------|------------|-------------------|------------|-----------------|------------|----------------------|------------|
| 13,344,529         |       | 4,091,752         |       | 16,830          |       | 3,649,456            |       |

 

(e)          To ratify the selectionby the audit committee of our board of directors of Ernst & Young LLPas independent auditors of Rigel for our fiscal year ending December 31,2006.

 
| **Votes in Favor** | ** ** | **Votes Against** | ** ** | **Abstentions** | ** ** | **Broker Non-Votes** | ** ** |
|--------------------|------------|-------------------|------------|-----------------|------------|----------------------|------------|
| 20,605,211         |       | 492,864           |       | 4,492           |       | 0                    |       |

 

**Continuing Directors**

 

Our directors whose termsof office continued after the 2006 Annual Meeting of Stockholders were: (1)Jean Deleage, Ph.D., Alan D. Frazier and Peter S. Ringrose, Ph.D., whosecurrent terms expire at the 2007 Annual Meeting of the Stockholders, and (2)Walter H. Moos, Ph.D., Hollings C. Renton, and Stephen A. Sherwin, M.D., whosecurrent terms expire at the 2008 Annual Meeting of the Stockholders.

 

**Item 6.****           Exhibits**

 

The exhibits listed on the accompanying indexto exhibits are filed or incorporated by reference (as stated therein) as part ofthis Quarterly Report on Form 10-Q.

 

28

----

 

**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, as amended, the registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
|   | RIGEL PHARMACEUTICALS, INC. |
|--------|----------------------------------|
|   |                             |   |
|   |                             |   |
|   | By:                              | /s/ JAMES M. GOWER |
|   |                             | James M. Gower |
|   |                             | Chief Executive Officer |
|   |                             |   |
|   |                             |   |
|   | Date:                            | August 2, 2006 |
|   |                             |   |
|   |                             |   |
|   | By:                              | /s/ RYAN D. MAYNARD |
|   |                             | Ryan D. Maynard |
|   |                             | Vice President of Finance and Acting Chief  Financial  Officer |
|   |                             | (Principal Financial and Accounting  Officer) |
|   |                             |   |
|   |                             |   |
|   | Date:                            | August 2, 2006 |

 

29

----

 

**INDEX TO EXHIBITS**

 
| **Exhibit Number** | ** ** | **Description of Document**                                                                                                                                                            |
|-------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                     |       | Amended and Restated Certificate of  Incorporation.(1)                                                                                                                                           |
| 3.2                     |       | Amended and Restated Bylaws.(2)                                                                                                                                                                  |
| 4.1                     |       | Specimen Common Stock Certificate.(1)                                                                                                                                                            |
| 4.3                     |       | Form of warrant to purchase shares of  common stock.(2)                                                                                                                                     |
| 4.7                     |       | Amended and Restated Warrant issued to  Kwacker Limited for the purchase of shares of common stock.(3)                                                                                           |
| 4.8                     |       | Warrant issued to TBCC Funding Trust II for  the purchase of shares of common stock.(4)                                                                                                          |
| 4.10                    |       | Warrant issued to Kwacker Limited for the  purchase of shares of common stock.(3)                                                                                                                |
| 4.23                    |       | Second Investor Rights Agreement between  Rigel and certain investors, dated June 26, 2003.(5)                                                                                              |
| 10.33                   |       | 2006 Base Salaries for Named Executive Officers.(6)                                                                                                                                              |
| 10.34                   |       | 2006 Bonus Plan for Executive Officers.                                                                                                                                                          |
| 15.1                    |       | Letter re: unaudited interim financial  information.                                                                                                                                             |
| 31.1                    |       | Certification required by Rule 13a-14(a) or  Rule 15d-14(a) of the Exchange Act.                                                                                             |
| 31.2                    |       | Certification required by Rule 13a-14(a) or  Rule 15d-14(a) of the Exchange Act.                                                                                             |
| 32.1                    |       | Certification required by Rule 13a-14(b) or  Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter  63 of Title 18 of the United States Code (18 U.S.C. 1350). |

 

----

| (1) | Filed as an exhibit to Rigel’s Current Report on Form 8-K on  June 24, 2003 and incorporated herein by reference.                             |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Filed as an exhibit to Rigel’s Registration Statement on  Form S-1, as amended, and incorporated herein by reference.                              |
| (3) | Filed as an exhibit to Rigel’s Annual  Report on Form 10-K for the fiscal year ended December 31, 2002 and  incorporated herein by reference. |
| (4) | Filed as an exhibit to Rigel’s  Quarterly Report on Form 10-Q for the quarter ended March 31, 2002  and incorporated herein by reference.     |
| (5) | Filed as an exhibit to Rigel’s Annual  Report on Form 10-K for the fiscal year ended December 31, 2003 and  incorporated herein by reference. |
| (6) | Filed as an exhibit to Rigel’s Current  Report on Form 8-K on January 30, 2006 and incorporated herein by  reference.                         |

 

30

----