UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549 FORM 10-Q (Mark One)x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES         
 EXCHANGE ACT OF 1934For the Quarterly Period Ended June 30,
 2006ORo
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES         
 EXCHANGE ACT OF 1934Commission File Number 0-26483 VaxGen, Inc.(Exact name of Registrant as Specified in
its Charter) Delaware

94-3236309(State or other jurisdiction of

(I.R.S. Employer Identification No.)incorporation or organization)349 Oyster Point BoulevardSouth San Francisco, California

94080(Address of Principal Executive Offices)

(Zip Code) (650) 624-1000(Registrants Telephone Number,
Including Area Code) Indicate by
check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes o     No x Indicate by
check mark whether the registrant is a large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definition of accelerated filer and
large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer o
Accelerated
 filer x
Non-accelerated
 filer o Indicate by
check mark whether the registrant is a shell company (as defined in Rule 12b-2
of the Exchange Act). Yes o     No x The issuer has
one class of common stock with 33,106,523 shares outstanding as of June 29,
2007.    VaxGen, Inc.

Form 10-Q

For the Quarter Ended June 30, 2006

Table of Contents

PagePart
 I
Financial
 InformationItem
 1
Financial
 Statements (unaudited):Condensed Consolidated Balance Sheets
3Condensed Consolidated Statements of
 Operations
4Condensed Consolidated Statements of Cash
 Flows
5Notes to Condensed Consolidated Financial
 Statements
6Item
 2
Managements
 Discussion and Analysis of Financial Condition and Results of OperationsOverview
17Critical Accounting Policies and Estimates
19Results of Operations
19Liquidity and Capital Resources
23Item
 3
Quantitative
 and Qualitative Disclosures About Market Risk
27Item
 4
Controls
 and Procedures
27Part
 II
Other
 InformationItem
 1
Legal
 Proceedings
30Item
 1A
Risk
 Factors
30Item
 2
Unregistered
 Sales of Equity Securities and Use of Proceeds
44Item
 3
Defaults
 Upon Senior Securities
44Item
 4
Submission
 of Matters to a Vote of Security Holders
45Item
 5
Other
 Information
45Item
 6
Exhibits
46Signatures
46Certifications2

PART I  FINANCIAL
INFORMATION

Item 1. Financial Statements

VaxGen, Inc.CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(in thousands)

June 30,
 2006

December 31,2005ASSETSCurrent assets:Cash and cash
equivalents:Cash and
commercial paper

$
46,480


$
1,901Reverse
repurchase agreements


35,005



2,659Total cash and
cash equivalents


81,485



4,560Investment securities


800



12,466Accounts receivable


1,471



1,820Unbilled accounts
receivable


7,380



1,455Due from related party


796



901Prepaid expenses and other
current assets


2,387



4,638Total current
assets


94,319



25,840Investment in
affiliate


7,216



17,761Property and equipment


31,258



32,275Restricted cash


3,338



3,278Other assets


2,298



2,679Total
assets

$
138,429


$
81,833LIABILITIES AND
STOCKHOLDERS EQUITYCurrent liabilities:Accounts
payable

$
9,748


$
10,005Accrued and
other current liabilities


10,203



11,272Derivative
liability


4,388



2,925Due to related
party


34



Total current
liabilities


24,373



24,202Convertible senior subordinated
notes


30,143



29,967Deferred rent and other
liabilities


3,897



3,519Total liabilities


58,413



57,688Contingencies (Note 11 and
13)Stockholders
equity:Common
stock


331



296Additional
paid-in capital


298,102



266,248Deferred stock
compensation






(348
)Accumulated
deficit


(221,203
)


(248,090
)Accumulated
other comprehensive income


2,786



6,039Total
stockholders equity


80,016



24,145Total
liabilities and stockholders equity

$
138,429


$
81,833See accompanying notes to condensed
consolidated financial statements.

3

VaxGen, Inc.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share data)

Three Months Ended
 June 30,

Six Months Ended
 June 30,2006

2005

2006

2005Revenues

$
4,607

$
9,981

$
10,912

$
17,627Operating
 expenses:Research and
development


13,794


18,004


27,970


33,506General and
administrative


7,740


8,985


14,387


16,112Total operating
expenses


21,534


26,989


42,357


49,618Loss from
operations


(16,927
)

(17,008
)

(31,445
)

(31,991
)Other income
 (expense):Interest
expense


(614
)

(988
)

(1,244
)

(1,114
)Interest income
and other


187


415


453


467Valuation
adjustments


(1,858
)

(176
)

(1,463
)

(176
)Equity in loss
of affiliate


(2,784
)




(5,290
)

Gain on foreign
currency transactions


4,519





4,678


Gain on sale of
investment in affiliate


61,198





61,198


Total other
income (expense)


60,648


(749
)

58,332


(823
)Net income
(loss) before minority interest


43,721


(17,757
)

26,887


(32,814
)Minority
 interest in loss of variable interest entity





2,426





4,109Net income
(loss)

$
43,721

$
(15,331
)
$
26,887

$
(28,705
)Basic net
 income (loss) per share

$
1.32

$
(0.52
)
$
0.83

$
(0.97
)Diluted net
 income (loss) per share

$
1.32

$
(0.52
)
$
0.82

$
(0.97
)Weighted
 average shares used in computing basic net income (loss) per share


33,107


29,607


32,333


29,592Shares used
 in computing diluted net income (loss) per share


33,199


29,607


32,683


29,592See accompanying notes to condensed
consolidated financial statements.

4

VaxGen, Inc.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)

Six Months Ended
 June 30,2006

2005Cash flows from operating
activities:Net income
(loss)

$
26,887

$
(28,705
)Adjustments to
reconcile net income (loss)
 to net cash used in operating activities:Gain on sale of
investment in affiliate


(61,198
)

Gain on foreign
currency transactions


(4,678
)

Equity in loss
of affiliate


5,290


Valuation
adjustments


1,463


176Minority
interest in loss of variable
 interest entity





(4,109
)Depreciation
and amortization


3,077


2,469Stock-based
compensation


1,766


3,895Amortization of
premiums and discounts on
 investment securities


(6
)

67Non-cash
interest expense


354


176Changes in
assets and liabilities:Receivables


(5,576
)

(9,680
)Prepaid
expenses and other current assets


(722
)

240Accounts
payable


(259
)

2,340Accrued and
other current liabilities


166


5,268Due to/from
related parties


139


16Deferred rent
and other liabilities


1,074


322Net cash used in
operating activities


(32,223
)

(27,525
)Cash flows from investing
activities:Purchase of
property and equipment


(2,060
)

(28,760
)Proceeds from
sale of investment in
 affiliate, net


76,472


Proceeds from
sale and maturities of
 investment securities


11,732


7,070Change in
restricted cash


(60
)

(2,116
)Other


203


(1,960
)Net cash provided
by (used in) investing activities


86,287


(25,766
)Cash flows from financing
activities:Proceeds from
private placements, net


25,226


9,482Proceeds from
convertible debt and
 derivative liability, net





29,722Proceeds from
non-current obligations





10,493Other


(2,365
)

(79
)Net cash provided
by financing activities


22,861


49,618Effect of exchange rate changes
on cash and
 cash equivalents





125Increase (decrease) in cash and
cash
 equivalents


76,925


(3,548
)Cash and cash equivalents at
beginning of
 period


4,560


20,698Cash and cash equivalents at end
of period

$
81,485

$
17,150Supplemental schedule of non
cash
 activities:Accrued
purchases of property and equipment

$


$
1,002See accompanying notes to condensed
consolidated financial statements.

5

VaxGen, Inc.Notes to Condensed Consolidated Financial Statements

1.
OrganizationNature
of Business Activities

VaxGen, Inc.,
or VaxGen, is a biopharmaceutical company focused on the development,
manufacture and commercialization of biologic products for the prevention and
treatment of human infectious disease. VaxGens business strategy focuses on
the development and commercialization of biologic products to counter potential
bioterrorism threats, principally vaccines for the long-term prevention of
anthrax and smallpox.

VaxGen was
incorporated on November 27, 1995 and was formed to develop a vaccine intended
to prevent human immunodeficiency virus. In 2002, VaxGen broadened its product
development portfolio to also include biodefense vaccines.

VaxGens
activities involve inherent risks. These risks include, but are not limited to,
the possibility that internal controls are not or will not be adequate to
ensure timely and reliable financial information, the risk that VaxGen may not
be able to raise additional capital, the risk that VaxGen may fail to obtain
any future government biodefense contracts, the risk that VaxGen may fail to
perform under any existing or future contracts and the risk that VaxGen may be
unable to commercialize its vaccine product candidates.

VaxGens
principal source of revenue is the U.S. government, principally the National
Institutes of Health, or NIH, and related entities.

Delisting
from the Nasdaq National Market

As a result of
VaxGens inability to timely file financial statements, it was delisted
effective August 9, 2004 from the Nasdaq National Market, now the Nasdaq Global
Market, or Nasdaq. Since that time, VaxGens common stock has traded over the
counter, or OTC, and has been quoted on the Pink Sheets LLC under the symbol,
VXGN.PK.

Basis
of Presentation

The unaudited
condensed consolidated financial statements of VaxGen and its subsidiaries,
collectively referred to as the Company, included herein have been prepared
pursuant to the rules and regulations of the Securities and Exchange
Commission, or SEC. The unaudited condensed consolidated financial statements
include the accounts of VaxGen, its subsidiaries, VaxGen-Celltrion, Inc., or
VCI, and Celltrion, Inc., or Celltrion, a company developing and operating a
mammalian cell culture biomanufacturing facility in the Republic of Korea. All
intercompany accounts and transactions have been eliminated in consolidation.
The unaudited condensed consolidated financial statements include the accounts of
VaxGen and VCI and Celltrion from January 1, 2004 through June 30, 2005. The
condition for control of entities is the ownership of a majority voting
interest or the ability to otherwise exercise control over the entity.

Certain
information or footnote disclosure normally included in financial statements
prepared in accordance with generally accepted accounting principles in the
United States of America, or GAAP, have been condensed or omitted pursuant to
such rules and regulations. In the opinion of the Companys management, the
accompanying unaudited condensed consolidated financial statements contain all
adjustments, consisting only of normal recurring adjustments, considered
necessary for a fair statement of the unaudited condensed consolidated financial
information included herein. While VaxGen believes that the disclosures are
adequate to make the information not misleading, these unaudited condensed
consolidated financial statements should be read in conjunction with VaxGens
audited financial statements contained in its Annual Report on Form 10-K for
the year ended December 31, 2005.

The results of
operations for the six month period ended June 30, 2006 are not necessarily
indicative of the operating results for the full year. The preparation of financial
statements in conformity with GAAP requires management to make estimates,
judgments and assumptions that affect the reported amounts of assets,
liabilities, revenues, expenses and related disclosures. While management
believes its estimates, judgments and assumptions are reasonable, the inherent
nature of estimates is that actual results will likely be different from the
estimates made.

In September
2005, VaxGen entered into an agreement to sell 1.2 million of its shares in
Celltrion to a group of Korean investors. Nexol Co., Ltd., or Nexol, purchased
250,000 of these shares. Subsequent to this transaction, Nexol and its
affiliates, collectively, became the largest stockholder of Celltrion. Upon
this reconsideration event, VaxGen was no longer the primary beneficiary of
Celltrion and, in accordance with Interpretation No. 46, Consolidation of Variable Interest Entities,
was originally issued by the Financial Accounting Standards Board, or FASB, in
January 2003 and was revised in December 2003, referred to, as revised, as FIN
46R, Celltrion has been deconsolidated from VaxGen effective July 1, 2005. From
July 1, 2005 through June 30, 2006 VaxGens investment in Celltrion was
accounted for under the equity method.

6

In June 2006, VaxGen entered
into agreements to sell and option its remaining Celltrion common stock to
Nexol and its affiliates. As a result of these agreements, VaxGen was no longer
entitled to hold two seats on Celltrions Board of Directors or appoint a
Representative Director. Accordingly, VaxGen no longer had the ability to
exercise significant influence over operating and financial policies of
Celltrion, and as of July 1 2006, VaxGen will account for its investment in
Celltrion under the cost method. At June 30, 2006, VaxGens ownership
interest in Celltrion was 8%.

2.
Summary of Significant Accounting PoliciesThe Companys significant accounting policies are disclosed in the
Companys annual report of Form 10-K for the year ended December 31, 2005 and
have not changed significantly as of June 30, 2006, with the exception of the
following:

Cash
Equivalents

All short-term
investments with an original maturity at date of purchase of less than three
months are considered to be cash equivalents. Cash equivalents include
securities purchased under an overnight resale agreement, or Reverse Repo, which are recorded at the amount
at which the securities were purchased. The Company maintains its Reverse Repos
at a financial institution which pledges securities with a market value in
excess of the Reverse Repo amounts as collateral.

Stock-Based
Compensation

In January
2006, the Company adopted the fair value recognition provision of Financial
Accounting Standards, or FAS, No. 123 (revised 2004), Share-Based Payment, or FAS 123R, which requires the
recognition of the fair value of stock-based compensation for all stock-based
payment awards, including grants of stock options made to the Companys
employees and directors. Under the fair value recognition provision of FAS 123R,
stock-based compensation is measured at the grant date based on the fair value
of the awards expected to vest and is recognized as expense ratably over the
requisite service period of the award. The Company uses the Black-Scholes
valuation model to measure the fair value of its stock-based awards utilizing
various assumptions with respect to stock price volatility, forfeiture rates,
risk-free interest rates and expected life. If any of the assumptions used in
the Black-Scholes model change significantly, stock-based compensation may
differ materially in the future from that recorded in the current period.

The Company
adopted FAS 123R using the modified prospective method which requires the
application of the accounting standard as of January 1, 2006. The Companys
unaudited condensed consolidated financial statements for the three and six
months ended June 30, 2006 reflect the impact of FAS 123R. In accordance with
the modified prospective method, the financial statements for prior periods
have not been restated to reflect, and do not include, the impact of FAS 123R.
Upon the adoption of FAS 123R in January 2006, the deferred stock compensation
balance of $0.3 million was reclassified to additional paid-in-capital. The
Company adopted the short-cut method for calculating the beginning
balance of the additional paid in capital pool, or APIC Pool, related to the
tax effects of employee stock-based compensation, and to determine the
subsequent impact on the APIC pool and Statement of Cash Flows of the tax effects
of employee stock-based compensation awards that are outstanding upon adoption
of FAS 123R. The Company has not recognized excess tax benefits related to
employee stock-based compensation and, therefore, does not currently have an
APIC Pool because the related deductions are embedded in the Companys net
operating loss carryforwards.

Prior to
January 1, 2006, the Company accounted for stock-based compensation based upon
the provisions of Accounting Principles Board, or APB, Opinion No. 25, Accounting
for Stock Issued to Employees, or APB 25, and had adopted the
disclosure-only provisions of FAS No. 123, Accounting for Stock-Based Compensation
and FAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosurean
Amendment of FASB Statement No. 123,or FAS 123.

Had
compensation cost for the Companys stock-based compensation plans been
determined in a manner consistent with the fair value approach described in FAS
123, the Companys net loss and net loss per share would have been increased to
the pro forma amounts, estimated on the date of grant using the Black-Scholes
option pricing model, indicated below (in thousands, except per share data):

Three Months 
 Ended
 June 30, 2005

Six Months
 Ended
 June 30, 2005Net loss  as
reported


$
(15,331
)


$
(28,705
)Add: Stock-based employee
compensation
 expense included in reported net loss, net of minority interest



728




3,696Less: Total stock-based employee
 compensation expense determined under fair value based method for all awards,
 net of minority interest



(2,789
)



(7,098
)Net loss 
pro forma


$
(17,392
)


$
(32,107
)Net loss per share basic
and diluted, as
 reported


$
(0.52
)


$
(0.97
)Net loss per share basic
and diluted, pro
 forma


$
(0.59
)


$
(1.08
)During the six
months ended June 30, 2005, there were no stock options granted by VaxGen and
there were no enrollments in the Employee Stock Purchase Plan, or ESPP. See
Note 8, Stock Options, for further discussion regarding stock-based
compensation.

7

New
Accounting Pronouncements

In April 2005,
the FASB issued FASB Interpretation Number, or FIN, 46(R)-6, Determining the Variability to Be Considered in
Applying FASB Interpretation No. 46(R), or FSP FIN 46R-6. FSP FIN
46R-6 addresses certain major implementation issues related to FIN 46(R).
Specifically, FSP FIN 46R-6 addresses how a reporting enterprise should
determine the variability to be considered in applying FIN 46R. The variability
that is considered in applying FIN 46R affects the determination of (a) whether
the entity is a variable interest entity or VIE, (b) which interests are
variable interests in the entity, and (c) which party, if any, is the primary
beneficiary of the VIE. That variability will affect any calculation of
expected losses and expected residual returns, if such a calculation is
necessary. The effective date and transition requirements prescribed by FSP FIN
46R-6 are complex. For example, an enterprise is required to apply the guidance
in the FSP prospectively to all entities (including newly created entities)
with which that enterprise first becomes involved and to all entities
previously required to be analyzed under FIN 46R when a reconsideration event
has occurred as defined in FIN 46R beginning the first day of the first
reporting period beginning after June 15, 2006. Retrospective application is
permitted but not required; however, a company that chooses retrospective
application must do so no later than the end of the first annual reporting
period ending after July 15, 2006. The Company does not expect the adoption of
FSP FIN 46R-6 will have a material impact on its consolidated financial
position, results of operations or cash flows.

In February
2006, the FASB issued FAS No. 155, Accounting
for Certain Hybrid Financial Instruments, or FAS 155, which amends
FAS No. 133, Accounting for Derivative
Instruments and Hedging Activities,and FAS No. 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities, and improves the
financial reporting of certain hybrid financial instruments by requiring more
consistent accounting that eliminates exemptions and provides a means to
simplify the accounting for these instruments. Specifically, FAS 155 allows
financial instruments that have embedded derivatives to be accounted for as a
whole (eliminating the need to bifurcate the derivative from its host) if the
holder elects to account for the whole instrument on a fair value basis. FAS
155 is effective for all financial instruments acquired or issued after the
beginning of an entitys first fiscal year that begins after September 15,
2006. The Company does not expect the adoption of FAS 155 will have a material
impact on its consolidated financial position, results of operations or cash
flows.

In March 2006,
the FASB Emerging Issues Task Force, or EITF, reached a tentative
consensus on Issue No. 06-3, How Sales Taxes
Collected from Customers and Remitted to Governmental Authorities Should Be
Presented in the Income Statement (That Is, Gross Versus Net Presentation),
or EITF 06-3. EITF 06-3 addresses income statement classification and
disclosure requirements of externally-imposed taxes on revenue-producing
transactions. EITF 06-3 is effective for periods beginning after December 15,
2006. The Company does not expect the implementation of EITF 06-3 to have a
material impact on the Companys consolidated financial position, results of
operations or cash flows.

In July 2006,
the FASB issued FIN 48, Accounting for
Uncertainty in Income Taxesan interpretation of FASB Statement No. 109,
or FIN 48, which clarifies the accounting for uncertainty in tax positions. FIN
48 requires that the Company recognize in its financial statements the impact
of a tax position if that position is more likely than not of being sustained
upon audit, based on the technical merits of the position. FIN 48 is effective
for fiscal years beginning after December 15, 2006 which is the beginning of
the Companys fiscal 2007. The Company does not expect the adoption of FIN 48
will have a material impact on its consolidated financial position, results of
operations or cash flows.

In September
2006, the FASB issued FAS No. 157, Fair
Value Measurement,or FAS
157. FAS 157 defines fair value, establishes a framework for measuring fair
value and expands disclosures about fair value measurements. FAS 157 is
effective for financial statements issued for fiscal years beginning after
November 15, 2007 and interim periods within those fiscal years. The Company is
evaluating the impact of adopting FAS 157 on the Companys consolidated
financial position, results of operations and cash flows.

In September
2006, the SEC published Staff Accounting Bulletin Topic 1N, Financial Statements  Considering the Effects of
Prior Year Misstatements When Quantifying Misstatements in Current Year
Financial Statements, or SAB 108. SAB 108 addresses how a company
should quantify the effect of an error on the financial statements. The SEC
staff concludes in SAB 108 that a dual approach should be used to compute the
amount of a misstatement. Specifically, the amount should be computed using
both the rollover (current year income statement perspective) and iron
curtain (year-end balance sheet perspective) methods. SAB 108 does not address
how to evaluate materiality, that is, how to assess the quantitative and
qualitative effects of a misstatement on the financial statements. The SEC
staffs views on evaluating the materiality of an error are covered in SAB
Topic 1M, Financial Statements  Materiality,
or SAB 99. Companies that will need to change their method for computing the
amount of an error must adopt the dual approach for fiscal years ending after
November 15, 2006, which is effective with the Companys year ended December
31, 2006. A change in the method of quantifying errors represents a change in
accounting policy. Accordingly, if the use of the dual approach results in a
larger, material misstatement, the Company will have to adjust its financial
statements. Under FAS 154, changes in accounting policy generally are accounted
for using retrospective application; however, SAB 108 permits public companies
to report the cumulative effect of the new policy as an adjustment to opening
retained earnings. The Company does not expect the adoption of SAB 108 to have
a material impact on its consolidated financial position, results of operations
or cash flows.

In November
2006, the FASB ratified EITF Issue No. 06-6, Application
of EITF Issue No. 05-7, Accounting for Modifications to Conversion Options
Embedded in Debt Instruments and Related Issues, or EITF 06-6. EITF
06-6 addresses the modification of a convertible debt instrument that changes
the fair value of an embedded conversion option and the subsequent recognition
of interest

8

expense for
the associated debt instrument when the modification does not result in a debt
extinguishment pursuant to EITF 96-19. The consensus should be applied
to modifications or exchanges of debt instruments occurring in interim or
annual periods beginning after November 29, 2006. The Company does not
expect the adoption of EITF 06-6 to have a material impact on its consolidated
financial position, results of operations or cash flows.

In November
2006, the FASB ratified EITF Issue No. 06-7, Issuers
Accounting for a Previously Bifurcated Conversion Option in a Convertible Debt
Instrument When the Conversion Option No Longer Meets the Bifurcation Criteria
in FASB Statement No. 133, Accounting for Derivative Instruments and Hedging
Activities, or EITF 06-7. At the time of issuance, an embedded
conversion option in a convertible debt instrument may be required to be
bifurcated from the debt instrument and accounted for separately by the issuer
as a derivative under FAS 133, based on the application of EITF Issue 00-19, Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Companys Own Stock, or
EITF 00-19. Subsequent to the issuance of the convertible debt, facts may
change and cause the embedded conversion option to no longer meet the
conditions for separate accounting as a derivative instrument, such as when the
bifurcated instrument meets the conditions of EITF 00-19 to be classified in
stockholders equity. Under EITF 06-7, when an embedded conversion option
previously accounted for as a derivative under FAS 133 no longer meets the
bifurcation criteria under that standard, an issuer shall disclose a
description of the principal changes causing the embedded conversion option to
no longer require bifurcation under FAS 133 and the amount of the liability for
the conversion option reclassified to stockholders equity. EITF 06-7 should be
applied to all previously bifurcated conversion options in convertible debt
instruments that no longer meet the bifurcation criteria in FAS 133 in interim
or annual periods beginning after December 15, 2006, regardless of whether the
debt instrument was entered into prior or subsequent to the effective date of
EITF 06-7. Earlier application of EITF 06-7 is permitted in periods for which
financial statements have not yet been issued. The Company does not expect the
adoption of EITF 06-7 to have a material impact on its consolidated financial
position, results of operations or cash flows.

In February 2007,
the FASB issued FAS No. 159, The Fair Value
Option for Financial Assets and Financial Liabilities - Including an Amendment
of FASB Statement No. 115, or FAS 159, which permits all entities to
choose to measure eligible items, including many financial instruments, at fair
value at specified election dates. A business entity will report unrealized
gains and losses on items for which the fair value option has been elected in
earnings at each subsequent reporting date. The fair value option: (a) may be applied
instrument by instrument, with a few exceptions, such as investments otherwise
accounted for by the equity method; (b) is irrevocable (unless a new election
date occurs); and (c) is applied only to entire instruments and not to portions
of instruments. Most of the provisions in FAS 159 are elective; however, the
amendment to FAS No. 115, Accounting for
Certain Investments in Debt and Equity Securities,applies to all
entities with available-for-sale and trading securities. FAS 159 is effective
for fiscal years beginning after November 15, 2007. The Company is evaluating
the impact of adopting FAS 159 on its consolidated financial position, results
of operations and cash flows.

In June 2007, the EITF
published Issue No. 07-3, Accounting for Nonrefundable Advance Payments for
Goods or Services to Be Used in Future Research and Development Activities,
or EITF 07-3. The EITF
reached a consensus that these payments made by an entity to third parties
should be deferred and capitalized. Such amounts should be recognized as an
expense as the related goods are delivered or the related services are
performed. Entities should report the effects of applying this Issue as a
change in accounting principle through a cumulative-effect adjustment to
retained earnings as of the beginning of the year of adoption. EITF 07-3 is
effective beginning on January 1, 2008. Earlier application is not
permitted. The Company does not expect that adoption of this new Standard will
have a material effect on its financial position or results of operations.

3.
Net Income (Loss) per ShareBasic net income (loss) per
share is calculated based on net income (loss) and the weighted-average number
of shares of common stock outstanding during the reported period. Diluted net
income (loss) per share is calculated by increasing the weighted-average number
of common shares outstanding during the period- if not anti-dilutive- by the
number of additional shares of common stock that would have been outstanding if
the dilutive potential shares of common stock had been issued. The dilutive
effect of potential common stock (including outstanding stock options, common
stock warrants and convertible senior subordinated debt) is reflected in
diluted net income per share by application of the treasury stock method, which
includes consideration of share-based compensation as required by FAS 123R in
the three and six months ended June 30, 2006.

A reconciliation of
weighted-average basic shares outstanding to weighted-average diluted shares
outstanding follows (in thousands):

Three Months Ended
 June 30,

Six Months Ended
 June 30,2006

2005

2006

2005Weighted-average number of
common shares
 outstanding used in computing basic net income (loss) per share


33,107


29,607


32,333


29,592Dilutive potential common shares
used in
 computing diluted net income (loss) per share


92





350


Total weighted-average number of
shares
 used in computing diluted net income (loss) per share


33,199


29,607


32,683


29,5929

Basic net
income (loss) per share is computed as net income (loss) divided by the
weighted average number of common shares outstanding for the period. For all
periods presented, the following potential common shares were excluded from the
computation of diluted net income (loss) per share, as their effect was
antidilutive (in thousands):

Three
 Months Ended
 June 30,

Six Months
 Ended
 June 30,2006

2005

2006

2005Options to purchase common
stock


3,949


4,556


3,106


4,556Warrants to purchase common
stock


1,659


959


1,480


959Convertible senior subordinated
notes


2,134


2,134


2,134


2,134Total


7,742


7,649


6,720


7,6494.
Comprehensive
 Income (Loss)Comprehensive
income (loss) combines net income (loss) and other comprehensive income (loss).
Other comprehensive income (loss) represents certain amounts that are reported
as components of stockholders equity in the consolidated balance sheet,
including foreign currency translation adjustments and unrealized gains or
losses on investment securities. The Companys comprehensive income (loss)
consists of the following (in thousands):

Three
 Months Ended
 June 30,

Six Months
 Ended
 June 30,2006

2005

2006

2005Net income
 (loss)

$
43,721

$
(15,331
)
$
26,887

$
(28,705
)Foreign
 currency translation adjustments


(4,011
)

(1,286
)

(3,325
)

7,652Unrealized
 gains (losses) on investment securities


34


38


72


(59
)Comprehensive
income (loss)

$
39,744

$
(16,579
)
$
23,634

$
(21,112
)5.
Balance Sheet ComponentsCash
Equivalents

At June 30,
2006 and December 31, 2005, the Company maintained $35.0 million and $2.7
million, respectively, of its cash equivalents in overnight Reverse Repos.

Accrued
and Other Current Liabilities

On September
30, 2003, the National Institute of Allergy and Infectious Diseases, or NIAID,
awarded the Company a second cost-plus contract valued at $80.3 million for the
advanced development of the Companys anthrax vaccine candidate, or 2003
Anthrax Contract. In December 2004, NIAID terminated, for its convenience, a
portion of the 2003 Anthrax Contract and redirected the funds earmarked for the
terminated portion into other contract milestones, leaving the total contract
value unchanged. The portion of the contract which was terminated included
activities VaxGen had subcontracted to a fill/finish service provider. In March
2006, VaxGen agreed to pay this fill/finish service provider $1.5 million for
costs relating to the termination of the subcontract, which are not reimbursable
under the terms of VaxGens contract with NIAID.

The Companys
accrued and other current liabilities consist of the following (in thousands):

June 30,2006

December 31,
 2005Employment
 benefits


$
3,182



$
6,380Cash
 overdraft



2,365




Sub-contractor
 settlement



450




1,530Other



4,206




3,362$
10,203



$
11,2726.
Related Party TransactionsVaxGen provides services to
assist Celltrion with their operations. VaxGen is paid for out-of-pocket
expenses and services rendered. VaxGen recognized $0.6 million and $1.0 million
of revenue from Celltrion during the three and six months ended June 30, 2006.
These services were considered to be inter-company in 2005, while Celltrion was
consolidated with VaxGen, and therefore were eliminated.

10

In February
2006, Celltrion and VaxGen entered into an agreement, or Agreement to Provide
U.S. GAAP Financial Information, whereby Celltrion agreed to use its best
efforts to timely prepare annual and quarterly financial statements in
accordance with U.S. GAAP. Under the agreement, VaxGen agreed to reimburse
Celltrion for all invoiced costs of the independent accountants relating to the
preparation of U.S. GAAP financial statements as well as all invoiced costs of
audits and reviews performed by another independent registered public
accounting firm. In addition, VaxGen will compensate Celltrion for the cost of
internal resources utilized in support of these activities at a rate of 190% of
the employees hourly wage; such costs shall not exceed the U.S. dollar
equivalent of 300 million Korean Won (equivalent to $0.3 million at the
exchange rate on June 30, 2006) per year and shall be subject to VaxGens
approval. During the three and six months ended June 30, 2006, the Company
incurred $0.8 million and $1.4 million of expenses under these agreements.

7.
Common
 Stock OfferingsVaxGen completed the
following private placement of common stock during the six months ended June
30, 2006:

Date

Sales Price
 Per Share

Closing Price
 Per Share

Shares

Net Proceeds(in thousands)February 10, 2006


$
7.70



$
9.20




3,500,000



$
25,226Financing
costs associated with this private placement were $1.7 million. In connection
with this financing, VaxGen issued to the accredited institutional investors
five-year warrants initially exercisable to purchase 699,996 shares of common
stock at an exercise price of $9.24 per share. If VaxGen does not file all of
its delinquent periodic reports with the SEC by September 30, 2006 the warrants
will become exercisable for an additional 350,000 shares of common stock, at a
price of $9.24 per share. If VaxGen does not file all of its delinquent
periodic reports with the SEC by January 31, 2007, the warrants will become
exercisable for an additional 350,000 shares of common stock, at a price of
$9.24 per share. See Note 13, Subsequent Events, for a further discussion
regarding warrants.

As part of the
February 2006 private placement and the November 2004 private placement, the
Company agreed to file a registration statement on Form S-1 no later than 30
days after the first day that the Company becomes current with its reporting
requirements under the Securities Exchange Act of 1934, or Exchange Act. The
registration statement will register for resale the common stock issued in both
transactions and the stock issuable upon exercise of the warrants from the
February 2006 transaction. The Company may be liable for liquidated damages of
1% of the purchase price per month to holders of the shares and shares issuable
upon exercise of the warrants (a) if the registration statement is not filed on
or prior to 30 days of the Company becoming current in its reporting
requirements; (b) if the registration statement is not declared effective by
the SEC on or prior to 120 days from filing; or (c) if the registration
statement (after being declared effective) ceases to be effective in a manner
that violates such obligations. The Company does not consider these
liquidated damages to be probable or reasonably estimable. Consequently, no
reserves have been established for these matters.

8.
Stock OptionsVaxgen
Stock Options

The Company
has equity incentive plans for its directors, officers and employees. The 1996
Stock Option Plan, or Plan, has 4,750,000 shares of common stock reserved for
issuance and a provision that automatically increases this number by 3.5% of
the issued and outstanding common stock on the last trading day of the December
immediately preceding each fiscal year through January 2007. Options granted
under the Plan may be designated as qualified or nonqualified at the discretion
of the Compensation Committee of the Board of Directors. Generally, shares
under option vest ratably over four years, beginning one year from the date of
grant; however, options can vest upon grant. Under the 1998 Director Stock
Option Plan, or Director Plan, new non-employee directors will receive an
initial option grant to acquire up to 30,000 shares at the fair market value of
VaxGens common stock on the grant date. Initial option grants vest over four
years, with a vesting schedule of one-forty-eighth (1/48th) of the
shares vesting and exercisable each month, beginning on the grant date, such
that the option is completely vested on the fourth anniversary of its grant
date. All options expire no later than 10 years from the date of grant.
Qualified stock options are exercisable at not less than the fair market value
of the stock at the date of grant and nonqualified stock options are
exercisable at prices determined at the discretion of the Board of Directors,
but not less than 85% of the fair market value of the stock at the date of
grant.

11

The following
is a summary of VaxGens stock option activity and related information for the
years ended December 31:

2005

2004Options
 Outstanding

Weighted
 Average
 Exercise
 Price

Options
 Outstanding

Weighted
 Average
 Exercise
 PriceBalance at beginning of
year


4,634,671


$
10.66



3,746,689


$
10.37Granted










1,169,178



11.39Exercised










(135,138
)


7.57Forfeited


(151,114
)


11.14



(146,058
)


11.92Balance at end
of year


4,483,557



10.64



4,634,671



10.66Options exercisable at year
end


3,685,372



10.91



2,734,164



11.41The following
table summarizes information about VaxGens stock options granted during the
years ended December 31:

2005

2004Exercise price on grant date

Weighted
 Average Fair
 Value

Weighted
 Average
 Exercise
 Price

Weighted
 Average Fair
 Value

Weighted
 Average
 Exercise
 PriceEquals market price


$




$




$
9.27



$
12.19Is below market price













10.13




10.94During the
year ended December 31, 2005, no stock options were granted. During the year
ended December 31, 2004, 745,500 options were granted at an exercise price
below market price.

During the six
months ended June 30, 2006, the Company granted an option for 120,000 shares of
VaxGen common stock to a newly hired executive at an exercise price of $8.58
per share which was equal to the fair market value on the date of grant. The
fair value of this option on the date of grant was $0.8 million. The option
vests over four years with 25% of the shares vesting on the one-year
anniversary date and the remaining shares vesting in equal monthly
installments over the subsequent three years. At the time of the grant, neither the options
nor the shares of the common stock issuable upon exercise of the options were
registered under the Securities Act of 1933, or Securities Act. VaxGen granted
these options in a transaction exempt from the registration requirements of the
Securities Act by virtue of the exemption provided for in Section 4(2) of the
Act. The following is a summary of VaxGens stock option activity and
related information for the six months ended June 30, 2006:

Options
 Outstanding

Weighted
 Average
 Exercise
 Price

Weighted
 Average
 RemainingContractualLife (in years)

Aggregate Intrinsic ValueBalance at
 January 1, 2006


4,483,557


$
10.64Granted


120,000



8.58Forfeited


(83,187
)


10.22Balance at June
30, 2006


4,520,370



10.59



2.1


$
276,215Options
 exercisable at June 30, 2006


3,926,093



10.75



2.1


$
257,188* Based upon the closing price of the Companys common stock of $4.88
on June 30, 2006.

The aggregate intrinsic values in the table above represent the total
pretax intrinsic value (the difference between the Companys closing stock
price on the last trading day of the three months ended June 30, 2006 and the
exercise price, multiplied by the number of in-the-money options) that would
have been received by the option holders had all option holders exercised their
options on June 30, 2006. This amount changes based upon the fair market value
of the Companys common stock. The Company issues new shares upon the exercise
of options.

As of June 30, 2006, there was approximately $3.0 million, net of
expected forfeitures, of total unrecognized stock-based compensation related to unvested arrangements granted under the
Companys equity-based incentive plans. As of that date, this cost was expected
to be recognized over a weighted average period of 2.1 years. There were no
options exercised during the six months ended June 30, 2006 and 2005. The total
fair value of shares vested during the six months ended June 30, 2006 was $1.4
million.

Celltrion
Stock Options

Celltrion
grants employees stock options subject to approval by its Board of Directors
and stockholders. Celltrion recorded $1.5 million as deferred compensation and
additional paid-in capital for option awards issued during 2004. Upon the
deconsolidation of Celltrion in July 2005, the $0.4 million remaining balance
was reversed from additional paid-in capital and deferred compensation.

12

Non-cash
Compensation Expense

Non-cash
compensation expense for the three and six months ended June 30, 2006 was $1.0
million and $1.8 million, respectively. Non-cash compensation expense for the
three and six months ended June 30, 2005 was $0.8 million and $3.9 million,
respectively. Such expense was primarily related to fair-value compensation of
stock options in 2006 as well as stock modifications. In 2005, the Board of
Directors authorized a modification to options held by employees who left the
Company such that the exercisability of the options were extended from 90 days
following termination to 90 days following listing on a national securities
exchange. In February 2006, the Company further modified the period of exercisability
from 90 days following listing on a national securities exchange to 30 days
following listing on a national securities exchange. The Company recorded a
non-cash expense for these modifications of $0.2 million and $0.3 million
during the three and six months ended June 30, 2006, respectively. The Company
recorded a non-cash expense for these modifications of $0.1 million during the
three and six months ended June 30, 2005. See Note 9, Employee Stock Purchase
Plan, for a further discussion regarding non-cash compensation.

Impact
of Adoption of FAS 123R

In January
2006, the Company adopted the fair value recognition provision of FAS 123R,
which requires the recognition of the fair value of stock-based compensation
expense for all stock-based payment awards, including grants of stock options,
made to the Companys employees and directors. Under the fair value recognition
provision of FAS 123R, stock-based compensation cost is estimated at the grant
date based on the fair value of the awards ultimately expected to vest and is
recognized as expense ratably over the requisite service period of the award.
The Company uses the Black-Scholes valuation model to estimate the fair value
of its stock-based awards utilizing various assumptions with respect to stock
price volatility, forfeiture rates and expected life. If any of the assumptions
used in the Black-Scholes model change significantly, stock-based compensation
expense may differ materially in the future from that recorded in the current
period.

The Company
uses various subjective assumptions, including the following:


Expected Volatility:
 The expected stock price volatility is based upon the Companys historical
 volatility. The Company believes this method of computing volatility is more
 reflective and a better indicator of the expected future volatility, than
 using an average of a comparable market index or of a comparable company in
 the same industry.
Expected Average Life:
 The expected average life of the ten-year contractual term options granted in
 2006 of 6.08 years is based upon application of the simplified method as
 promulgated in SEC Staff Accounting Bulletin No. 107.
Risk-Free Interest Rate:
 The risk-free rate for the expected term of stock options is based upon the
 rates for U.S. Treasury Bonds with terms equal to the options expected terms
 in effect at the time of grant.
Expected Dividend:
 The Company has not paid and does not anticipate paying any dividends in the
 near future.
Estimated Pre-vesting Forfeitures:
 When estimating forfeitures, the Company considers voluntary termination
 behaviors as well as trends of actual forfeitures of vested stock options.The Company
used the following assumptions:

Six Months Ended
June 30, 2006VaxGen Stock Option
PlansRisk-free interest
rate


4.9
%Expected average life


6.08 yearsVolatility


94
%During periods
following the adoption of FAS 123R, the Company recorded stock-based
compensation expense for awards granted prior to, but not yet vested, as of
December 31, 2005, using the fair value method required for pro forma
disclosure under FAS 123 in effect for expense recognition purposes, adjusted
for estimated forfeitures. The adoption had no effect on cash flows.

The impact on
consolidated results of operations of recording stock-based compensation for
the three and six months ended June 30, 2006 was as follows (in thousands,
except per share data):

Three Months Ended 
 June 30, 2006

Six Months Ended June 30, 2006Research and
development


$
647



$
1,220General and
administrative



303




546Effect on net
income


$
(950
)


$
(1,766
)Effect on net income per share,
basic


$
(0.03
)


$
(0.05
)Effect on net income per share,
diluted


$
(0.03
)


$
(0.05
)13

9.
Employee Stock Purchase PlanThe Companys
2001 ESPP is implemented by a series of 24-month offering periods, each
referred to as an Offering Period and collectively referred to as Offering Periods.
Offering Periods were suspended effective July 1, 2004 as a result of the
Companys delisting from Nasdaq. The Board of Directors approved the extension
of the Offering Periods ended in March 2005 and June 2005 which resulted in a
modification of the terms. During the three months ended June 30, 2005, the
Company recorded $0.1 million in non-cash research and development compensation
expense and zero in non-cash general and administrative compensation expense
for this modification. During the six months ended June 30, 2005, the Company
recorded $2.2 million in non-cash research and development compensation expense
and $0.7 million in non-cash general and administrative compensation expense
for this modification. In November 2005, the Company terminated the ESPP.

10.
CelltrionVaxGen provided mammalian
cell culture technology and biologics production expertise as its 2002
investment in Celltrion. VaxGens
proportionate share of the investees undistributed losses was recorded as
equity in loss of affiliate through December 31, 2003. As a result of the
consolidation of VaxGen and Celltrion, from January 1, 2004 through June 30,
2005, this investment was eliminated in consolidation. Effective July 1, 2005,
as a result of the deconsolidation of Celltrion, VaxGens proportionate share
of the investees undistributed losses was again recorded as equity in loss of
affiliate.

During June
2006, VaxGen received gross proceeds of $79.0 million from the sale of 3.6
million shares of its Celltrion common stock to Nexol and its affiliates. The
Companys basis in the 3.6 million shares sold in June 2006 was $11.8 million.
VaxGen recognized $4.9 million of expenses associated with this sale, resulting
in a net gain on the sale of investment in affiliate of $61.2 million. VaxGen
also provided the buyers with the right through the end of 2006 to purchase
VaxGens 2.2 million remaining shares of Celltrion common stock at a price of
22,000 Korean Won, or Option. If exercised in its entirety, the Option could
result in potential gross proceeds of $51.0 million (translated at June 30,
2006). The Company used the Black-Scholes valuation model to measure the fair
value of the Option utilizing various assumptions with respect to stock price
volatility and risk-free interest rates. VaxGen determined the fair value of
this Option to be $1.1 million and accordingly deferred this amount of the June
2006 gain in accrued and other current liabilities until the exercise or
expiration of the Option.

The unaudited
condensed consolidated financial statements include the accounts of VaxGen and
Celltrion from January 1, 2004 through June 30, 2005. From July 1, 2005 through
June 30, 2006, VaxGens investment in Celltrion was accounted for under the
equity method.

Summarized selected financial
information used for the three and six months ended June 30, 2006 is as follows
(in thousands):

Three Months

Six MonthsOperating expenses


$
12,035



$
22,953Loss from operations



(12,035
)



(22,953
)Other expense



(1,550
)



(2,825
)Net
loss


$
(13,585
)


$
(25,778
)The results of operations of
Celltrion for the three and six months ended June 30, 2005 (while Celltrion was
consolidated) are as follows (in thousands):

Three Months

Six MonthsOperating expenses:Research and
development


$
918



$
1,611General and
administrative



2,266




3,939Loss from operations



(3,184
)



(5,550
)Other expense



(346
)



(547
)Net
loss


$
(3,530
)


$
(6,097
)11.
ContingenciesSubstantially all of VaxGens
revenue is derived from government contracts and grants. Future sales to U.S.
government agencies will depend, in part, on VaxGens ability to meet U.S.
government agency contract requirements. U.S. government contracts typically
contain unfavorable termination provisions and are subject to audit and
modification by the government at its sole discretion. The U.S. government may
terminate any of its contracts with VaxGen either for its convenience or if
VaxGen defaults by failing to perform in accordance with the contract schedule
and terms. If the U.S. government terminates any of its contracts, the Company
may be liable to sub-contractors, service providers or vendors for goods and
services that may no longer be reimbursable by the U.S. government.

14

12.
Segment InformationThe Companys
segment information has been prepared in accordance with FAS No. 131, Disclosures about Segments of an Enterprise and
Related Information. Prior to January 1, 2004 and since July 1,
2005, the Company operated in one business segment. As a result of the
consolidation of Celltrion in 2004 and the deconsolidation of Celltrion in
2005, from January 1, 2004 to June 30, 2005, the Company operated in two
business segments. Therefore, for the three months ended June 30, 2006 and
2005, the Company operated in one segment and two segments, respectively; and
for the six months ended June 30, 2006 and 2005, the Company operated in one
segment and two segments, respectively. VaxGens business segment is the
development of vaccines that immunize against infectious disease and
Celltrions is mammalian cell culture biomanufacturing. Each segment has
discrete financial information and its own management structure. All of
VaxGens operating assets are located in the United States of America. At
December 31, 2005 and June 30, 2006 VaxGen operated in one segment and
therefore balance sheet segment information is not presented below.

Substantially all of VaxGens
revenue is derived from federal government contracts and grants, primarily from
the U.S. Department of Health and Human Services, or HHS, the NIH and related
entities. From its inception through its deconsolidation from VaxGen as of July
1, 2005, Celltrion has not earned any revenues. Information regarding the
segments is stated below (in thousands):

Three Months Ended
 June 30,

Six Months Ended
 June 30,Revenues

2006

2005

2006

2005VaxGen


$
4,607



$
10,069



$
10,912



$
17,754Eliminations



n/a




(88
)



n/a




(127
)Total


$
4,607



$
9,981



$
10,912



$
17,627Three Months Ended
 June 30,

Six Months Ended
 June 30,Depreciation and Amortization

2006

2005

2006

2005VaxGen


$
1,499



$
982



$
3,077



$
1,862Celltrion



n/a




887




n/a




1,538Eliminations



n/a




(465
)



n/a




(931
)Total


$
1,499



$
1,404



$
3,077



$
2,469Three Months Ended
 June 30,

Six Months Ended
 June 30,Interest Expense

2006

2005

2006

2005VaxGen


$
614



$
590



$
1,244



$
590Celltrion



n/a




398




n/a




524Total


$
614



$
988



$
1,244



$
1,114Three Months Ended
 June 30,

Six Months Ended
 June 30,Equity in Loss of Affiliate

2006

2005

2006

2005VaxGen (in
 Celltrion)


$
(2,784
)


$
(1,141
)


$
(5,290
)


$
(2,026
)Eliminations



n/a




1,141




n/a




2,026Total


$
(2,784
)


$




$
(5,290
)


$
Three Months Ended
 June 30,

Six Months Ended
 June 30,Net Income (Loss)

2006

2005

2006

2005VaxGen


$
43,721



$
(15,280
)


$
26,887



$
(28,615
)Celltrion



n/a




28,568




n/a




25,617Eliminations



n/a




(28,619
)



n/a




(25,707
)Total


$
43,721



$
(15,331
)


$
26,887



$
(28,705
)Three Months Ended
 June 30,

Six Months Ended
 June 30,Purchases of Property and Equipment

2006

2005

2006

2005VaxGen


$
(520
)


$
(4,094
)


$
(2,060
)


$
(6,294
)Celltrion



n/a




(8,010
)



n/a




(22,466
)Eliminations



n/a









n/a




Total


$
(520
)


$
(12,104
)


$
(2,060
)


$
(28,760
)15

13.
Subsequent EventsStrategic
National Stockpile Contract

In September
2002, the Company was awarded a $20.9 million cost-plus contract, or 2002
Anthrax Contract, from the NIAID to develop a new anthrax vaccine candidate and
to create a feasibility plan for how the Company would manufacture an emergency
stockpile of 25 million doses of the vaccine. On September 30, 2003, NIAID
awarded the Company a second cost-plus contract valued at $80.3 million for the
advanced development of the Companys anthrax vaccine candidate.

In November 2004, the
Company was awarded a contract for $877.5 million to provide 75 million doses
of its recombinant anthrax vaccine to the U.S. government Strategic National
Stockpile, or SNS, for civilian defense, or SNS Contract. In November
2006, VaxGen received a clinical hold notification from the Food and Drug
Administration that postponed the initiation of the second Phase 2 trial for
its investigational anthrax vaccine, rPA102. On December 19, 2006, HHS
terminated for default the SNS Contract. HHS based the decision on its
determination that VaxGen failed to successfully cure the condition
endangering performance and failed to meet a milestone imposed by HHS that
required VaxGen to initiate a clinical trial of the vaccine candidate by
December 18, 2006.

In April 2007,
the Company entered into a settlement agreement with HHS. In accordance with
the agreement, the parties terminated the remaining cost-plus contract related
to the development of a next-generation anthrax vaccine through a separate
contract modification. As part of the settlement agreement, NIAID paid the
Company $11.0 million. The settlement agreement also released both parties of
all liabilities associated with the Companys three anthrax government
contracts: the 2002 Anthrax Contract, the 2003 Anthrax Contract and the SNS
Contract. As part of the settlement agreement, the parties converted the
termination of the SNS Contract, which HHS terminated for default on December
19, 2006, to a termination for convenience and also, terminated the 2003
Anthrax Contract under a bilateral contract modification for the convenience of
the government on a no-cost basis, effective April 3, 2007.

Restructurings

In January
2007, the Company restructured operations to significantly reduce operating
costs and announced it is actively pursuing avenues to enhance stockholder
value through a strategic transaction. The Company incurred restructuring costs
associated with this plan, including employee termination benefits of $2.9
million and costs associated with consolidation of its facilities in California
of $1.0 million. The majority of these costs were recovered from the U.S.
government as part of the 2007 settlement agreement.

In May 2007,
the Company reduced its workforce to further reduce operating costs.
Restructuring costs included employee termination and benefit costs. Estimated
costs of the restructuring are $0.6 million.

Agreements
between VaxGen and Celltrion

In September
2006, the joint venture agreement between VaxGen and the Korean Investors was
terminated and the Korean Investors entered into a Celltrion shareholders
agreement. In November 2006, Celltrions stockholders approved the appointment
of their non-VaxGen Co-CEO as the sole CEO of Celltrion. In December 2006,
VaxGen received gross proceeds of $51.3 million from the sale of its remaining
Celltrion common stock to Nexol and its affiliates under the Option.

In March 2007,
Celltrion and VaxGen amended the Technical Support and Services Sub-Agreement
as well as the Agreement to Provide U.S. GAAP Financial Information to reflect
a reduction in overhead rate on services performed from 90% to 40%.

$16.00
Warrants

On September
21, 2004, the Company completed a transaction in which warrants to purchase
common stock issued in 2001 in connection with its Series A Preferred Stock
financing, or Series A Warrants, were surrendered in exchange for two new
series of warrants. The Company issued to the holders of the Series A Warrants,
warrants to purchase a total of 1,146,388 shares of common stock, exercisable
until September 21, 2005, at an exercise price of $0.01 per share, and warrants
to purchase a total of 655,078 shares of common stock, exercisable until
September 21, 2007, at an exercise price of $16.00 per share, or $16.00
Warrants. In December 2006, VaxGen entered into an addendum, or Addendum, with
the holders of the $16.00 Warrants under which the term was extended by three
additional years. The $16.00 Warrants, as amended, will expire September 21,
2010. No other terms of the $16.00 Warrants were amended. In connection with
entering into the Addendum, VaxGen received releases from the holders of the
$16.00 Warrants regarding potential claims related to these warrants.

16

Private
Placement Warrants

In February
2006, VaxGen raised net proceeds of $25.2 million through a private placement
to a group of accredited institutional investors. In connection with this
financing, VaxGen issued to the investors five-year warrants initially exercisable
to purchase 699,996 shares of common stock at an exercise price of $9.24 per
share. Because VaxGen did not file all of its delinquent periodic reports with
the SEC by September 30, 2006, the warrants became exercisable for an
additional 350,000 shares of common stock, at a price of $9.24 per share.
Because VaxGen again did not file all of its delinquent periodic reports with
the SEC by January 31, 2007, the warrants became exercisable for an additional
350,000 shares of common stock, at a price of $9.24 per share.

Smallpox

In June 2007,
the Company and the Chemo-Sero-Therapeutic Research Institute of Japan,
or Kaketsuken, terminated by mutual consent their agreement to
co-develop a next-generation, attenuated smallpox vaccine, LC16m8, for use in
the United States and elsewhere. Under the terms of the termination agreement,
VaxGen will transfer to Kaketsuken or its designee all reports, data and
materials and all intellectual property rights that relate to conducting
non-clinical and clinical development of LC16m8 in the U.S. In return,
Kaketsuken has released VaxGen from ongoing development obligations.

Executive
Officer Compensation

In February 2007, the Board
of Directors granted to executive officers options for 1,590,000 shares and
implemented an option exchange program allowing executive officers to exchange
old options for 714,700 shares for new options for 178,675 shares. All of the
options were granted effective February 12, 2007 with an exercise price of
$2.23, the closing market price of one share of the Companys common stock on
that date. Each will vest monthly on a pro-rata basis over one to four years.
The Board also approved two potential retention bonus payments. The aggregate
first retention bonus payment of $0.3 million was made to the executives during
the three months ended September 30, 2007. Additionally, a second cash bonus
payment of the same amount will be made, conditioned upon the executive
remaining a regular full-time employee in good standing through the completion
of a strategic transaction and other terms.

ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

Special
Note Regarding Forward-Looking Statements

This
discussion and analysis should be read in conjunction with our Annual Report on
Form 10-K for the year ended December 31, 2005, and our unaudited condensed
consolidated financial statements and related notes thereto appearing in Item 1
of this Quarterly Report on Form 10-Q. In addition to the other information
contained or incorporated by reference in this Quarterly Report on Form 10-Q,
you should carefully consider the risk factors described in Part II  Item 1A
herein when evaluating an investment in our common stock. This Quarterly Report
includes forward-looking statements within the meaning of Section 27A of the
Securities Act, and Section 21E of the Securities Exchange Act of 1934, or
Exchange Act. All statements other than statements of historical fact are
forward-looking statements for purposes of these provisions, including any
statements of the plans and objectives of management for future operations, any
statements regarding future operations, any statements concerning proposed new
products or services, any statements regarding pending or future mergers or
acquisitions, any statements regarding future economic conditions or
performance, and any statement of assumptions underlying any of the foregoing.
In some cases, forward-looking statements can be identified by the use of
terminology such as may, will, expects, plans, anticipates,
estimates, potential or continue or the negative thereof or other
comparable terminology.

There can be
no assurance that such expectations or any of the forward-looking statements
will prove to be correct, and actual results could differ materially from those
projected or assumed in the forward-looking statements. Our forward-looking
statements are subject to inherent risks and uncertainties including, but not
limited to, the risk factors set forth in this Quarterly Report. Factors that
could cause or contribute to such differences include, but are not limited to,
our limited cash resources, our ability to finance our research, our
significant corporate and SEC-related expenses and limited revenue to offset
these expenses, availability of appropriate prospective acquisitions or
investment opportunities, litigation and the risks discussed in our other SEC
filings. All forward-looking statements and reasons why results may differ
included in this Quarterly Report are made as of the date hereof, and we assume
no obligation to update any such forward-looking statement or reason why actual
results might differ. When used in the report, unless otherwise indicated,
we, our and us refers to VaxGen.

OVERVIEW

We are a
biopharmaceutical company focused on the development, manufacture and
commercialization of biologic products for the prevention and treatment of
human infectious disease. Our business strategy focuses on the development and
commercialization of biologic products to counter potential bioterrorism
threats, principally vaccines against inhalation anthrax and smallpox. We were

17

incorporated
in 1995 and formed to complete the development of an investigational
recombinant protein vaccine intended to prevent infection by HIV. In 2002, we
broadened our product development portfolio to also include biodefense
vaccines.

On August 6,
2004, we announced that we had received notification from Nasdaq that our stock
would discontinue trading on Nasdaq effective August 9, 2004. This action
followed our appeal to Nasdaq for a listing extension after not meeting the
stated time requirements to file Quarterly Reports on Form 10-Q for the
quarters ended March 31 and June 30, 2004, respectively. We intend to apply for
relisting on Nasdaq or listing on another exchange upon filing our remaining,
outstanding and delinquent reports. Our common stock is currently quoted on the
OTC Pink Sheets under the symbol VXGN.PK.

In February
2006, we raised net proceeds of $25.2 million through a private placement to a
group of accredited institutional investors.

In September
2002, we were awarded a $20.9 million cost-plus contract, or 2002 Anthrax
Contract, from the National Institute of Allergy and Infectious Diseases, or
NIAID, to develop a new anthrax vaccine candidate and to create a feasibility
plan for how we would manufacture an emergency stockpile of 25 million doses of
the vaccine. On September 30, 2003, NIAID awarded us a second cost-plus
contract, or 2003 Anthrax Contract, valued at $80.3 million for the advanced
development of our anthrax vaccine candidate, collectively referred to as the
Anthrax Contracts.

In November 2004, we were
awarded a contract for $877.5 million to provide 75 million doses of our
recombinant anthrax vaccine to the U.S. government Strategic National
Stockpile, or SNS, for civilian defense, or SNS Contract. In November
2006, we received a clinical hold notification from the Food and Drug
Administration that postponed the initiation of the second Phase 2 trial for
our investigational anthrax vaccine, rPA102. On December 19, 2006, the U.S.
Department of Health and Human Services, or HHS, terminated for default the SNS
Contract. HHS based the decision on its determination that we failed to
successfully cure the condition endangering performance and failed to meet a
milestone imposed by HHS that required us to initiate a clinical trial of the
vaccine candidate by December 18, 2006. Following the HHS decision, we ceased actively developing rPA102, scaled back our biodefense
activities and
are actively pursuing strategic and other alternatives.

Celltrion

Prior to
implementing the consolidation provisions within Interpretation No. 46, Consolidation
of Variable Interest Entities - an
interpretation of ARB No. 51, was originally issued by the
Financial Accounting Standards Board, or FASB, in January 2003 and was revised
in December 2003, referred to, as revised, as FIN 46R, on January 1, 2004, we
had reflected our investment in Celltrion, Inc., or Celltrion, in our
consolidated financial statements using the equity method. In September 2005,
we entered into agreements to sell 1.2 million of our shares in Celltrion to a
group of Korean investors and raise $15.1 million in gross proceeds. Nexol Co.,
Ltd, or Nexol, purchased 250,000 of these shares. Subsequent to this
transaction, Nexol and its affiliates, collectively, became the largest
stockholder of Celltrion. Upon this reconsideration event, we were no longer
the primary beneficiary of Celltrion and, in accordance with FIN 46R, Celltrion
was deconsolidated from VaxGen. From July 1, 2005 through June 30, 2006 our
investment in Celltrion was accounted for under the equity method.

In June 2006,
we entered into agreements to sell and option our remaining Celltrion common
stock to Nexol and its affiliates. We received gross proceeds of $79.0 million
from the sale of 3.6 million shares of our Celltrion common stock. We
recognized $4.9 million of expenses associated with this sale, resulting in a
net gain on the sale of investment in affiliate of $61.2 million. As a result
of these agreements, we were no longer entitled to hold two seats on
Celltrions Board of Directors or appoint an executive officer. Accordingly, we
no longer had the ability to exercise significant influence over operating and
financial policies of Celltrion, and as of July 1, 2006, we will account for
our investment in Celltrion under the cost method. At June 30, 2006, our
ownership interest in Celltrion was 8%.

Celltrion is a
development stage bio-manufacturing company incorporated on February 26, 2002
and since that date its principal activities have consisted of design and
construction of a manufacturing facility in Incheon, Republic of Korea, and
partially funding the construction of our U.S. biopharmaceutical manufacturing
facility, as well as raising capital and recruiting scientific and management
personnel.

Subsequent Events

In December
2006, we received gross proceeds of $51.3 million from the sale of
substantially all of our Celltrion common stock to Nexol and its affiliates.

In December
2006, HHS terminated for default the SNS Contract. In April 2007, we entered
into a settlement agreement with HHS, in which HHS modified the SNS Contract
from a termination for default to a termination for convenience. The settlement
agreement also released both parties of all liabilities associated with our
three anthrax government contracts. We also mutually terminated the 2003
Anthrax Contract for the convenience of the government.

In January and
May 2007, we restructured operations to significantly reduce operating costs
and announced we were actively pursuing avenues to enhance stockholder value
through a strategic transaction.

18

In June 2007,
the Company and the Chemo-Sero-Therapeutic Research Institute of Japan, or
Kaketsuken, terminated by mutual consent their agreement to co-develop a
next-generation, attenuated smallpox vaccine, LC16m8, for use in the United
States and elsewhere. Under the terms of the termination agreement, VaxGen will
transfer to Kaketsuken or its designee all reports, data and materials and all
intellectual property rights that relate to conducting non-clinical and
clinical development of LC16m8 in the U.S. In return, Kaketsuken has released
VaxGen from ongoing development obligations.

In February
2007, the Board of Directors granted to executive officers options for
1,590,000 shares and implemented an option exchange program allowing executive
officers to exchange old options for 714,700 shares for new options for 178,675
shares. The Board also approved two potential retention bonus payments.

See Note 13,
Subsequent Events, to the unaudited condensed consolidated financial statements
for more information regarding events occurring after June 30, 2006.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Reference
should be made to Item 7, Managements Discussion and Analysis of Financial
Condition and Results of Operations, in our Annual Report on Form 10-K for the
fiscal year ended December 31, 2005, filed with the SEC on May 30, 2007, for a
description of our critical accounting policies. There have been no significant
changes to our policies since we filed that report other than our adoption of
FAS No. 123 (revised 2004), Share-Based
Payment, or FAS 123R.

Stock-based
Compensation Expense

Effective January 1, 2006,
we adopted the fair value recognition provisions of FAS 123R, using the
modified prospective transition method, and therefore have not restated prior
periods results. Under this method we recognize compensation expense for all
stock-based payments granted after January 1, 2006, and prior to but not yet
vested as of January 1, 2006, in accordance with FAS 123R. Under the fair value
recognition provisions of FAS 123R, we recognize stock-based compensation net
of an estimated forfeiture rate and only recognize compensation cost for those
shares expected to vest on a straight-line basis over the requisite service
period of the award. Prior to FAS 123R adoption, we accounted for stock-based
payments under APB 25 and accordingly, recognized compensation expense for
options that were granted at an exercise price below their deemed fair market
value and for modifications to options.

Determining the appropriate
fair value model and calculating the fair value of stock-based payment awards
require the input of various highly-subjective assumptions, including the
expected life of the stock-based payment awards, our stock price volatility and
the expected forfeiture rate of our options. Management determined the expected
stock price volatility assumption based upon the Companys historical
volatility. We believe this method of computing volatility is more reflective
and a better indicator of the expected future volatility, than using an average
of a comparable market index or of a comparable company in the same industry.
The expected term of options granted was derived from the short-cut method
described in SECs SAB No. 107. The risk-free rate for the expected term of the
option is based on the U.S. Treasury yield curve in effect at the time of
grant. The assumptions used in calculating the fair value of stock-based
payment awards represent managements best estimates, but these estimates
involve inherent uncertainties and the application of management judgment. As a
result, if factors change and we use different assumptions, our stock-based
compensation expense could be materially different in the future. In addition,
we are required to estimate the expected forfeiture rate and only recognize
expense for those shares expected to vest. If our actual forfeiture rate is
materially different from our estimate, the stock-based compensation expense
could be significantly different from what we have recorded in the current
period. See Note 2 and 8 to the Condensed Consolidated Financial Statements for
a further discussion on stock-based compensation.

RESULTS OF OPERATIONS

Comparison of Fiscal
Quarters and Six Months Ended June 30, 2006 and 2005

RevenuesThree Months Ended
 June 30,

Percent
 change
 2006/2005

Six Months Ended
 June 30,

Percent
 change
 2006/20052006

2005



2006

2005(in thousands)



(in thousands)Revenues


$
4,607



$
9,981


(54
)%


$
10,912



$
17,627


(38
)%Revenues in
the three and six months ended June 30, 2006 and 2005 were primarily from our
Anthrax Contracts principally reflecting work performed for NIAID. In 2006,
NIAID-related activities decreased from the comparable period in the prior year
as our efforts shifted from work done under the Anthrax Contracts to work under
the SNS Contract. Related party services revenues were earned as part of a
consulting services agreement with Celltrion to provide technical assistance
related to the design, engineering and construction of Celltrions
manufacturing facility. VaxGen recognized $0.6 million and $1.0 million of
revenue from Celltrion during the three and six months ended June 30, 2006.
These services were considered to be inter-company in 2005, while Celltrion was
consolidated with VaxGen, and therefore were eliminated. The amounts earned
vary with the level of services required. Celltrion did not earn any revenues
during these periods.

19

Revenues
earned in one period are not indicative of revenues to be earned in future
periods. We expect future quarters revenues to be progressively less, as
efforts shift from work done under the Anthrax Contracts to work under the SNS
Contract or otherwise unfunded by NAIAD.

Research
and development expenses

Three Months Ended
  June 30,

Percent
  change
  2006/2005

Six Months Ended
  June 30,

Percent
  change
  2006/20052006

2005


2006

2005(in thousands)




(in thousands)Research and development
  expenses

$
13,794

$
18,004


(23)%

$
27,970

$
33,506


(17)%Research expenses include
costs associated with research and testing of our product candidates and
include the costs of internal personnel, outside contractors, allocated
overhead and laboratory supplies. Product development expenses include costs of
preclinical development and conducting clinical trials, costs of internal
personnel, drug supply costs, research fees charged by outside contractors,
allocated overhead and co-development costs.

The decrease
of $4.2 million in research and development expenses in the three months ended
June 30, 2006 over the comparable period in 2005 was primarily due to:


Outside
  consultant expenses, which decreased by $1.2 million primarily due to reduced
  activities related to our Anthrax Contracts since June 30, 2005;
Costs for
  materials and supplies, which decreased by $0.9 million primarily associated
  with reduced activities related to our Anthrax Contracts;
Celltrions
  research and development expenses, which decreased by $0.9 million because
  effective July 1, 2005 Celltrions operating expenses were not included in
  our consolidated results;
Clinical
  expenses, which decreased by $0.6 million primarily associated with reduced
  activities related to our Anthrax Contracts; and
Facility
  expenses, which decreased by $0.6 million primarily associated with reduced
  activities related to our Anthrax Contracts.The decrease
of $5.5 million in research and development expenses in the six months ended
June 30, 2006 over the comparable period in 2005 was primarily due to:


Costs for
  materials and supplies, which decreased by $3.1 million primarily associated
  with reduced activities related to our Anthrax Contracts;
Celltrions
  research and development expenses, which decreased by $1.6 million because
  effective July 1, 2005 Celltrions operating expenses were not included in
  our consolidated results;
Stock-based
  compensation charges, which decreased by $1.2 million. In 2006, we recorded
  $0.9 million due to the adoption of FAS 123R and $0.3 million in other
  non-cash compensation related to stock option modifications. In 2005, we
  recorded $2.2 million due to the modification of offering periods under our
  employee stock purchase plan, or ESPP, and $0.2 million in other non-cash
  compensation;
Facility
  expenses, which decreased by $0.8 million primarily associated with reduced
  activities related to our Anthrax Contracts;
Clinical
  expenses, which decreased by $0.6 million primarily associated with reduced
  activities related to our Anthrax Contracts;
Outside
  consultant expenses, which decreased by $0.4 million primarily due to
  additional operational assistance required since June 30, 2005; and
Allocations
  from general and administrative expense for facilities and other overhead
  costs, which increased by $2.2 million due to changes in the relative
  headcounts by department.The process of
conducting preclinical studies and clinical trials necessary to obtain the U.S.
Food and Drug Administration, or FDA, approval is costly and time consuming.
The probability of success for each product candidate and clinical trial may be
affected by a variety of factors, including, among others, the quality of
product candidate early clinical data, investment in the program, competition,
manufacturing capabilities and commercial viability. As a result of the uncertainties
discussed above, the uncertainty associated with clinical trial enrollments and
the risks inherent in the development process, we are unable to determine the
duration

20

and completion
costs of current or future clinical stages of our product candidates.
Development timelines, probability of success and development costs vary
widely. While we are primarily focused on developing our anthrax product
candidate, we anticipate that we will make determinations as to which
additional programs to pursue and how much funding to direct to each program on
an ongoing basis in response to the scientific and clinical success of each
product candidate, as well as an ongoing assessment as to each product
candidates commercial potential.

We expect
quarterly research and development expenses to decrease substantially during
the remainder of 2006 as our efforts shift from work done under the Anthrax
Contracts to work under the SNS Contract.

General
and administrative expenses

Three Months Ended
  June 30,

Percent
  change
  2006/2005

Six Months Ended
  June 30,

Percent
  change
  2006/20052006

2005


2006

2005(in thousands)




(in thousands)General and
  administrative expenses

$
7,740

$
8,985


(14)%

$
14,387

$
16,112


(11)%General and
administrative expenses consist primarily of compensation costs, occupancy
costs including depreciation expense, fees for accounting, legal and other
professional services and other general corporate expenses.

The decrease
of $1.2 million in general and administrative expenses in the three months
ended June 30, 2006 over the comparable period of 2005 was primarily due to:


Celltrions
  general and administrative expenses, which decreased by $2.3 million due to
  Celltrions operating expenses not being included in our consolidated results
  effective July 1, 2005;
Overhead
  costs allocated to research and development, which increased by $0.8 million
  in 2006 (reducing general and administrative expenses) resulting from changes
  in the relative headcounts by department; and
Professional
  fees, which increased by $1.9 million due to audit and other fees and
  expenses associated with our efforts to comply with various reporting and
  regulatory requirements including the Sarbanes-Oxley Act of 2002.The decrease
  of $1.7 million in general and administrative expenses in the six months
  ended June 30, 2006 over the comparable period of 2005 was primarily due to:
Celltrions
  general and administrative expenses, which decreased by $3.9 million due to
  Celltrions operating expenses not being included in our consolidated results
  effective July 1, 2005;
Overhead
  costs allocated to research and development, which increased by $2.2 million
  in 2006 (reducing general and administrative expenses) resulting from changes
  in the relative headcounts by department;
Occupancy
  costs, principally, rent and security services, which increased by $0.7 million
  due to our amended lease in April 2005 to secure space to support the
  production of our recombinant anthrax vaccine candidate as well as our other
  programs;
Depreciation
  expense, which increased by $0.9 million due to expanded operations since
  June 30, 2005 and the implementation of our enterprise resource planning
  system; and
Professional
  fees, which increased by $2.8 million due to audit and other fees and
  expenses associated with our efforts to comply with various reporting and
  regulatory requirements including the Sarbanes-Oxley Act of 2002.We expect that
quarterly general and administrative expenses will be lower than the
corresponding periods in 2005 during the remainder of 2006, but will continue
to reflect the significant resources required to support our public reporting
requirements.

Other
income (expense)

Three Months Ended
  June 30,

Six Months Ended
  June 30,2006

2005

2006

2005(in thousands)

(in thousands)Interest
  expense

$
(614
)
$
(988
)
$
(1,244
)
$
(1,114
)Interest
  income and other


187


415


453


467Valuation
  adjustments


(1,858
)

(176
)

(1,463
)

(176
)Equity in
  loss of affiliate


(2,784
)




(5,290
)

Gain on
  foreign currency transactions


4,519





4,678


Gain on sale
  of investment in affiliate


61,198





61,198


Other income (expense)

$
60,648

$
(749
)
$
58,332

$
(823
)21

The increase
in other income of $61.4 million in the three months ended June 30, 2006 from
the comparable period in 2005 was primarily due to:


Gain on sale
  of investment resulting from our June 2006 sale of 3.6 million of our
  Celltrion common stock to Nexol and its affiliates for gross proceeds of
  $79.0 million, net of $11.8 million in basis, $4.9 million in expenses and
  the deferral of $1.1 million related to the option sold along with the
  shares;
Realized
  foreign currency gains increased primarily due to the collection of the June
  2006 proceeds from the sale of Celltrion common stock;
Effective
  July 1, 2005, we recognize our share of Celltrions losses under the equity
  method. For the three months ended June 30, 2005, Celltrion was consolidated
  with VaxGen;
In 2006 and
  2005, 5 1/2% interest on the $31.5 million of our Convertible Senior
  Subordinated Notes, due April 1, 2010, or Notes, was recorded, whereas in
  2005 there was also $0.3 million of interest expense on Celltrions debt;
Expenses for
  mark-to-market adjustments related to the valuation of our outstanding
  derivatives on our Notes, changed primarily due to changes in the likelihood
  of a change in control potentially triggering the redemption option related
  to the Notes; and
Interest
  income and other decreased primarily due to lower overall cash, cash
  equivalent and investment balances due to the cash flow used in operating
  activities, primarily for our operating losses.The increase
  in other income of $59.2 million in the six months ended June 30, 2006 from
  the comparable period in 2005 was primarily due to:
Gain on sale
  of investment resulting from our June 2006 sale of 3.6 million of our
  Celltrion common stock to Nexol and its affiliates for gross proceeds of
  $79.0 million, net of $11.8 million in basis, $4.9 million in expenses and
  $1.1 million related to the option sold along with the shares;
Realized
  foreign currency gains increased primarily due to the collection of the 2005
  and 2006 proceeds from the sale of Celltrion common stock;
Effective
  July 1, 2005, we recognize our share of Celltrions losses under the equity
  method. For the six months ended June 30, 2005, Celltrion was consolidated
  with VaxGen;
In 2006 and
  2005, interest on our Notes was recorded, whereas in 2005 there was also $0.5
  million of interest expense on Celltrions debt; and
Expenses for
  mark-to-market adjustments related to the valuation of our outstanding
  derivatives on our Notes changed primarily due to changes in the likelihood
  of a change in control potentially triggering the redemption option related
  to the Notes.We anticipate
future investment income will fluctuate and will be primarily driven by our
future cash, cash equivalent and investment balances. Valuation adjustments
will continue to be impacted by changes in our common stock price, our
volatility and our expectations relative to a change in control. No changes in
our debt levels are anticipated and therefore quarterly interest expense is
expected to remain at the three months ended June 30, 2006 level throughout
2006. As a result of the sale of Celltrion common stock in June 2006, our
accounting treatment for the remaining investment in Celltrion will be recorded
under the cost method; accordingly, we will no longer have further equity in
loss of affiliate charges. In addition, if the option to purchase our remaining
Celltrion shares is exercised prior to 2007, we would expect a significant gain
from the sale and from the resulting foreign currency transaction.

Minority
interest in loss of variable interest entity

Three Months Ended
  June 30,

Six Months Ended
  June 30,2006

2005

2006

2005(in thousands)

(in thousands)Minority interest
  in loss of variable interest entity

$


$
2,426

$


$
4,109Minority
interest in loss of variable interest entity for the three and six months ended
June 30, 2005 reflects the interests of Celltrions other stockholders in the
net loss of Celltrion. For the three and six months ended June 30, 2006,
Celltrion was not consolidated with VaxGen.

See Note 12,
Segment Information, included in the notes to the unaudited condensed
consolidated financial statements in Part I  Item 1 of this report for segment
information.

22

LIQUIDITY AND CAPITAL RESOURCES

2006

2005(in thousands)As of June
  30:Cash, cash
  equivalents and investment securities

$
82,285

$
36,339Working
  capital


69,946


6,351Six months ended June 30:Cash
  provided by (used in):Operating activities

$
(32,223
)
$
(27,525
)Investing activities


86,287


(25,766
)Financing activities


22,861


49,618Effect of exchange rate changes on cash and
  cash equivalents





125Capital expenditures
  (included in investing activities above)


(2,060
)

(28,760
)Our primary
financing requirements are for funding our day-to-day working capital
requirements and capital equipment expenditures related to the manufacturing
facilities in California. Through June 30, 2006, we financed our operations
primarily through sales of our common stock, the issuance of Series A Preferred
Stock, the issuance of the Notes, sales of our Celltrion common stock as well
as through revenues from research contracts and grants. From time-to-time, as
part of our investment strategy, we enter into reverse repurchase agreements to
increase our return on investments and improve our liquidity. Reverse
repurchase agreements involve a purchase of securities and an agreement to
resell the same securities at a later date at an agreed-upon price. The primary
risk associated with short-term collateralized borrowings is that the
counterparty might be unable to perform under the terms of the contract. Our
exposure is limited, however, because we generally invest in overnight
agreements.

In April 2005,
we raised aggregate net proceeds of $29.7 million through a private placement
of $31.5 million of Notes due April 1, 2010. The Notes require us to make
semi-annual payments of interest in cash at a rate of 5 1/2%, due April 1 and
October 1. If a change in control occurs, as defined in the indenture, on or
prior to the stated maturity of the Notes, the holders of the Notes may require
under certain circumstances us to repurchase the Notes and pay a make-whole
premium to the holders of the Notes. If the
stock price on the effective date of redemption is less than $12.30 per share,
no make-whole premium will be paid. If the holders request such a
repurchase, we or our successor entity, may choose to pay in cash, common stock
or a combination of cash and common stock.

In September
2005, we entered into agreements to sell 1.2 million of our shares in Celltrion
to a group of Korean investors and raise $15.1 million in gross proceeds. Nexol
purchased 250,000 of these shares. Subsequent to this transaction, Nexol and
its affiliates, collectively, became the largest stockholder of Celltrion. Upon
this reconsideration event, we were no longer the primary beneficiary of
Celltrion and, in accordance with FIN 46R, Celltrion was deconsolidated from
VaxGen. From July 1, 2005 through June 30, 2006 our investment in Celltrion was
accounted for under the equity method. In June 2006, we entered into
agreements to sell and option our remaining Celltrion common stock to Nexol and
its affiliates. We received gross proceeds of $79.0 million from the
sale of 3.6 million shares of our Celltrion common stock. We recognized $4.9
million of expenses associated with this sale. As a result of these agreements, we were no longer entitled to hold two
seats on Celltrions Board of Directors or appoint a Representative Director.
Accordingly, we no longer had the ability to exercise significant influence
over operating and financial policies of Celltrion, and as of July 1, 2006, we
will account for our investment in Celltrion under the cost method. At
June 30, 2006, our ownership interest in Celltrion was 8%. See Note 13,
Subsequent Events, for a further discussion regarding financings.

Our future
capital requirements will depend on several factors, including:


Our ability
  to negotiate government contracts or grants, particularly our ability to win
  contracts to continue to develop or to sell our vaccine candidates;
The timing
  of collection of accounts receivable from our government contracts and
  grants;
Progress of
  internal research and development projects;
Levels and
  timing of capital expenditures on the manufacturing facilities in the
  Republic of Korea and California; and
Our ability
  to identify and exploit business development opportunities.23

Net cash used
in operating activities of $32.2 million and $27.5 million for the six months
ended June 30, 2006 and 2005, respectively, was primarily attributable to our
operating losses although the effect of non-cash charges upon operating
activities was significant in both periods and included:


Equity in
  loss of affiliate of $5.3 million and zero for the six months ended June 30,
  2006 and 2005, respectively. Effective July 1, 2005, we recognize our share
  of Celltrions losses under the equity method. For the six months ended June
  30, 2005, Celltrion was consolidated with VaxGen;
Realized
  foreign currency gains of $4.7 million and zero for the six months ended June
  30, 2006 and 2005, respectively. Realized foreign currency gains increased
  primarily due to the collection of the 2005 and 2006 proceeds from the sale
  of Celltrion shares;
Stock-based
  compensation expense of $1.8 million in 2006 and $3.9 million in 2005. The decrease
  from 2005 is primarily the result of modifications to the Companys employee
  stock purchase plan in 2005;
Valuation
  adjustments of $1.5 million and $0.2 million in the six months ended June 30,
  2006 and 2005, respectively, reflecting changes in the fair value of
  outstanding derivatives from our debt; and
Depreciation
  and amortization of $3.1 million and $2.5 million for the six months ended
  June 30, 2006, and 2005, respectively. The increase from 2005 is primarily
  the result of depreciation on manufacturing equipment leasehold improvements
  placed into service since June 30, 2005.The $61.2
million gain on the 2006 sale of 3.6 million shares of our investment in
Celltrion was removed from operating activities and the net proceeds received
are reflected in investing activities.

Cash used in
operating activities was also affected by the following:


Accrued and
  other current liabilities, which increased by $0.2 million in 2006 and by
  $5.3 million in 2005 primarily due to the timing of payments and the reduced
  level of operating activities at June 30, 2006;
Accounts
  payable, which decreased by $0.3 million in 2006, increased by $2.3 million
  in 2005 primarily due to the timing of payments and the reduced level of
  operating activities at June 30, 2006; and
Receivables,
  which increased by $5.6 million in 2006 and by $9.7 million in 2005 primarily
  due to reduced revenues earned from the U.S. government and the timing of
  payments received.Net cash
provided by investing activities consisted primarily of the $76.5 million in
net proceeds from the sale of our Celltrion common stock net of activities
relating to the purchase and sale of investment securities as well as capital
expenditures. Capital expenditures in the six months ended June 30, 2006 and
2005 were made in connection with the expansion of the Korean manufacturing
facility (zero and $22.4 million, respectively) and research and development
laboratories and leasehold improvements associated with the California manufacturing
facility and office facilities ($0.7 million and $4.8 million, respectively).
In addition, during the six months ended June 30, 2006 and 2005 we purchased
$1.4 million and $1.5 million of software related to the implementation of a
new enterprise resource planning system. We expect minimal capital expenditures
during the remainder of 2006 because the California manufacturing facilities
are now substantially complete and Celltrion is no longer consolidated.

Net cash
provided by our financing activities decreased to $22.9 million in the six
months ended June 30, 2006 from $49.6 million in the comparable period in 2005.
In February 2006, we raised net proceeds of $25.2 million through a private
placement of 3,500,000 shares of our common stock at $7.70 per share at a
discount to the $9.20 per share closing price. In April 2005, we raised net
proceeds of $29.7 million through a private placement of the Notes due April 1,
2010. In March 2005, Celltrion issued 1,949,700 shares of preferred stock at a
price of 5,000 Korean Won ($4.99 equivalent) per share, resulting in proceeds
of 9,749 million Korean Won ($9.5 million equivalent). In January 2003,
Celltrion obtained collaterized long-term financing of 52,000 million Korean
Won (equivalent to $44.2 million) with a nine-year term from a Korean bank, or
Loan. Funds from the Loan, $10.5 million in the six months ended June 30, 2005,
were used for construction of the Incheon administration buildings and
manufacturing facility.

At June 30,
2006, $82.3 million, or 59%, of our assets consisted of cash, cash equivalents
and investment securities. We had working capital of $69.9 million at June 30,
2006, compared to $6.4 million at June 30, 2005. This $63.5 million increase in
working capital is primarily due to the following:


Cash, cash
  equivalents and investment securities, which increased by $45.9 million
  primarily as a result of the June 2006 sale of 3.6 million shares of
  Celltrion common stock, net of operating losses;
Due to
  related parties, which decreased by $12.8 million primarily as a result of
  the deconsolidation of Celltrion effective July 1, 2005;24


Current
  obligations, which decreased by $7.2 million primarily as a result of the
  deconsolidation of Celltrion effective July 1, 2005;
Receivables,
  which decreased by $5.4 million primarily due to reduced revenues earned from
  the U.S. government; and
Accrued and
  other current liabilities, which decreased by $5.5 million primarily due to
  the timing of payments.We continually
review alternatives to obtain additional financing and to increase revenues by
procuring future contracts to supply anthrax and smallpox vaccines to the U.S.
government and other potential customers. Some of our alternatives to obtain
additional financing include the sale of our common stock, obtaining additional
debt and the sale of some or all of our investment in Celltrion. There can be
no assurances that we will be successful in these efforts. The reaudit of our
financial statements for the three years ended December 31, 2003, the resulting
restatement of periodic reports previously filed with the SEC, the lapsing of
our resale registration statements, the extended period while we have not been
current in our SEC reporting and the delisting of our common stock will likely
have an adverse impact on whether financing will be available or the terms of
that financing. See Subsequent Events in Note 13 for further discussion on
additional financings.

Off-Balance Sheet Arrangements

As of June 30,
2006, we did not have any off-balance sheet arrangements as defined in Item
303(a)(4)(ii) of SEC Regulation S-K.

Recent Accounting Pronouncements

In April 2005,
the FASB issued FIN 46(R)-6, Determining the
Variability to Be Considered in Applying FASB Interpretation No. 46(R),
or FSP FIN 46R-6. FSP FIN 46R-6 addresses certain major implementation issues
related to FIN 46(R). Specifically, FSP FIN 46R-6 addresses how a reporting
enterprise should determine the variability to be considered in applying FIN
46R. The variability that is considered in applying FIN 46R affects the
determination of (a) whether the entity is a variable interest entity or VIE,
(b) which interests are variable interests in the entity, and (c) which
party, if any, is the primary beneficiary of the VIE. That variability will
affect any calculation of expected losses and expected residual returns, if
such a calculation is necessary. The effective date and transition requirements
prescribed by FSP FIN 46R-6 are complex. For example, an enterprise is required
to apply the guidance in the FSP prospectively to all entities (including newly
created entities) with which that enterprise first becomes involved and to all
entities previously required to be analyzed under FIN 46R when a
reconsideration event has occurred as defined in FIN 46R beginning the first
day of the first reporting period beginning after June 15, 2006. Retrospective
application is permitted but not required; however, a company that chooses
retrospective application must do so no later than the end of the first annual
reporting period ending after July 15, 2006. We do not expect the adoption of
FAS 155 will have a material impact on our consolidated financial position,
results of operations or cash flows.

In February
2006, the FASB issued FAS No. 155, Accounting
for Certain Hybrid Financial Instruments, or FAS 155, which amends
FAS No. 133, Accounting for Derivative
Instruments and Hedging Activities and FAS No. 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities, and improves the
financial reporting of certain hybrid financial instruments by requiring more
consistent accounting that eliminates exemptions and provides a means to
simplify the accounting for these instruments. Specifically, FAS 155 allows
financial instruments that have embedded derivatives to be accounted for as a
whole (eliminating the need to bifurcate the derivative from its host) if the
holder elects to account for the whole instrument on a fair value basis. FAS
155 is effective for all financial instruments acquired or issued after the
beginning of an entitys first fiscal year that begins after September 15,
2006. We do not expect the adoption of FAS 155 will have a material impact on
our consolidated financial position, results of operations or cash flows.

In March 2006,
the EITF reached a tentative consensus on Issue No. 06-3, How Sales Taxes Collected from
Customers and Remitted to Governmental Authorities Should Be Presented in the
Income Statement (That Is, Gross Versus Net Presentation), or EITF
06-3. EITF 06-3 addresses income statement classification and disclosure
requirements of externally-imposed taxes on revenue-producing transactions.
EITF 06-3 is effective for periods beginning after December 15, 2006. We do not
expect the implementation of EITF 06-3 to have a material impact on our
consolidated financial position, results of operations or cash flows.

In July 2006,
the FASB issued Interpretation No. 48, Accounting
for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109,
or FIN 48, which clarifies the accounting for uncertainty in tax positions. FIN
48 requires that we recognize in our financial statements the impact of a tax
position if that position is more likely than not of being sustained upon
audit, based on the technical merits of the position. FIN 48 is effective for
fiscal years beginning after December 15, 2006 which is the beginning of our
fiscal 2007. We do not expect the adoption of FIN 48 will have a material
impact on our consolidated financial position, results of operations or cash
flows.

In September
2006, the FASB issued FAS No. 157, Fair
Value Measurement, or FAS 157. FAS 157 defines fair value,
establishes a framework for measuring fair value and expands disclosures about
fair value measurements. FAS 157 is effective for financial statements issued
for fiscal years beginning after November 15, 2007 and interim periods within
those fiscal years. We are evaluating the impact of adopting FAS 157 on our
consolidated financial position, results of operations and cash flows.

25

In September
2006, the SEC published Staff Accounting Bulletin Topic 1N, Financial
Statements  Considering the Effects of Prior Year Misstatements When
Quantifying Misstatements in Current Year Financial Statements, or
SAB 108. SAB 108 addresses how a company should quantify the effect of an error
on the financial statements. The SEC staff concludes in SAB 108 that a dual
approach should be used to compute the amount of a misstatement. Specifically,
the amount should be computed using both the rollover (current year income
statement perspective) and iron curtain (year-end balance sheet perspective)
methods. SAB 108 does not address how to evaluate materiality, that is, how to
assess the quantitative and qualitative effects of a misstatement on the
financial statements. The SEC staffs views on evaluating the materiality of an
error are covered in SAB Topic 1M, Financial Statements  Materiality, or SAB
99. Companies that will need to change their method for computing the amount of
an error must adopt the dual approach for fiscal years ending after November
15, 2006, which is effective with our year ended December 31, 2006. A change in
the method of quantifying errors represents a change in accounting policy.
Accordingly, if the use of the dual approach results in a larger, material
misstatement, we will have to adjust its financial statements. Under FAS 154,
changes in accounting policy generally are accounted for using retrospective
application; however, SAB 108 permits public companies to report the cumulative
effect of the new policy as an adjustment to opening retained earnings. We do
not expect the adoption of SAB 108 to have a material impact on our
consolidated financial position, results of operations or cash flows.

In November
2006, the FASB ratified EITF Issue No. 06-6, Application
of EITF Issue No. 05-7, Accounting for Modifications to Conversion Options
Embedded in Debt Instruments and Related Issues, or EITF 06-6. EITF
06-6 addresses the modification of a convertible debt instrument that changes
the fair value of an embedded conversion option and the subsequent recognition
of interest expense for the associated debt instrument when the modification
does not result in a debt extinguishment pursuant to EITF 96-19. The
consensus should be applied to modifications or exchanges of debt instruments
occurring in interim or annual periods beginning after November 29, 2006. We
do not expect the adoption of EITF 06-6 to have a material impact on our consolidated
financial position, results of operations or cash flows.

In November
2006, the FASB ratified EITF Issue No. 06-7, Issuers Accounting for a Previously
Bifurcated Conversion Option in a Convertible Debt Instrument When the
Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities,
or EITF 06-7. At the time of issuance, an embedded conversion option in a
convertible debt instrument may be required to be bifurcated from the debt
instrument and accounted for separately by the issuer as a derivative under FAS
133, based on the application of EITF Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Companys Own Stock, or EITF 00-19.
Subsequent to the issuance of the convertible debt, facts may change and cause
the embedded conversion option to no longer meet the conditions for separate
accounting as a derivative instrument, such as when the bifurcated instrument meets
the conditions of EITF 00-19 to be classified in stockholders equity. Under
EITF 06-7, when an embedded conversion option previously accounted for as a
derivative under FAS 133 no longer meets the bifurcation criteria under that
standard, an issuer shall disclose a description of the principal changes
causing the embedded conversion option to no longer require bifurcation under
FAS 133 and the amount of the liability for the conversion option reclassified
to stockholders equity. EITF 06-7 should be applied to all previously
bifurcated conversion options in convertible debt instruments that no longer
meet the bifurcation criteria in FAS 133 in interim or annual periods beginning
after December 15, 2006, regardless of whether the debt instrument was entered
into prior or subsequent to the effective date of EITF 06-7. Earlier
application of EITF 06-7 is permitted in periods for which financial statements
have not yet been issued. We do not expect the adoption of EITF 06-7 to have a
material impact on our consolidated financial position, results of operations
or cash flows.

In February
2007, the FASB issued FAS No. 159, The Fair
Value Option for Financial Assets and Financial Liabilities - Including an
Amendment of FASB Statement No. 115, or FAS 159, which permits all
entities to choose to measure eligible items, including many financial
instruments, at fair value at specified election dates. A business entity will
report unrealized gains and losses on items for which the fair value option has
been elected in earnings at each subsequent reporting date. The fair value
option: (a) may be applied instrument by instrument, with a few exceptions,
such as investments otherwise accounted for by the equity method; (b) is
irrevocable (unless a new election date occurs); and (c) is applied only to
entire instruments and not to portions of instruments. Most of the provisions
in FAS 159 are elective; however, the amendment to FAS No. 115, Accounting for Certain Investments in Debt and Equity
Securities,applies to all entities with available-for-sale and
trading securities. FAS 159 is effective for fiscal years beginning after
November 15, 2007. We are evaluating the impact of adopting FAS 159 on our
consolidated financial position, results of operations and cash flows.

In June 2007, the EITF
published Issue No. 07-3, Accounting for Nonrefundable Advance Payments for
Goods or Services to Be Used in Future Research and Development Activities,
or EITF 07-3. The EITF
reached a consensus that these payments made by an entity to third parties
should be deferred and capitalized. Such amounts should be recognized as an
expense as the related goods are delivered or the related services are
performed. Entities should report the effects of applying this Issue as a
change in accounting principle through a cumulative-effect adjustment to
retained earnings as of the beginning of the year of adoption. EITF 07-3 is
effective beginning on January 1, 2008. Earlier application is not
permitted. We do not expect that adoption of this new Standard will have a
material effect on our financial position or results of operations.

26

ITEM 3. QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK

Our operations
and cash flows are subject to fluctuations due to changes in interest rates in
our investment portfolio of debt securities and to foreign currency exchange
rates.

Interest
Rate Risk

We are exposed
to market rate changes by debt securities included in our investment portfolio.
By policy, we invest in debt instruments of the U.S. government, federal
agencies and high-quality corporate issuers, limit the amount of credit
exposure to any one issuer, and limit duration by restricting the term.
Investments in both fixed rate and floating rate instruments carry a degree of
interest rate risk. Fixed rate securities may have their fair market value
adversely affected due to a rise in interest rates, while floating rate
securities may produce less income than expected if interest rates fall. Due in
part to these factors, our future investment income may decrease due to changes
in interest rates or due to losses we may suffer when securities decline in
market value. At June 30, 2006, we held available-for-sale securities in the
principal amount of $0.8 million. If market interest rates were to increase
immediately and uniformly by 10% from levels at June 30, 2006, the fair value
of our portfolio would decline by an immaterial amount, and would not have a
significant effect on our operations or cash flows. Our exposure to losses as a
result of interest rate changes is managed through investing in a portfolio of
securities with a weighted-average maturity of one year or less.

Indebtedness

At June 30,
2006, our outstanding non-current liabilities include $31.5 million of our
Notes due April 1, 2010 which we sold in a private placement in April
2005. As the Notes bear interest at a fixed rate, our interest expense under
the Notes would not be affected by interest rate changes. As of June 30, 2006,
we did not invest in derivative financial instruments, interest rate swaps or
other investments that alter interest rate exposure.

Foreign
Currency Risk

Our exposure
to foreign currency exchange rates is related primarily to our investment in
Celltrion. Our investment in this international business is subject to risks,
including, but not limited to, differing economic conditions, changes in
political climate, differing tax structures, other regulations and restrictions
and foreign exchange rate volatility when compared to the United States dollar.
Accordingly, our future results could be materially affected by changes in
these or other factors. As exchange rates vary, our share in Celltrions
results, when translated, may vary from expectations and could adversely impact
overall profitability. If market foreign currency exchange rates were to change
the impact would be reflected in the balance of our investment in Celltrion and
in accumulated other comprehensive income. Such a change would not have a significant
effect on our operations or cash flows. As of June 30, 2006, we did not invest
in derivative financial instruments, currency swaps or other investments that
alter foreign currency exposure.

Derivative
Valuation Risk

The terms of
our Notes include put features not under our control. These features are
considered to be an embedded derivative liability and we determined the fair
value of this derivative to be $1.8 million on the date of issuance. Due to the
quarterly revaluation of the embedded derivative liability, we recorded in our
statements of operations other expense of $1.9 million and $1.5 million for the
three and six months ended June 30, 2006, respectively. At June 30, 2006, the
embedded derivative liability was valued at $4.4 million. We determine the fair
value of the derivative liabilities using the Monte Carlo Simulation
methodology. This methodology allows flexibility in incorporating various
assumptions such as probabilities of certain triggering events. The valuations
are based on the information available as of the various valuation dates. Factors affecting the amount of these
liabilities include expectations regarding triggering events, the market value
of our common stock, the estimated volatility of our common stock, our market
capitalization, the risk free interest rate and other assumptions. The inputs
for the valuation analysis of the derivatives include the probabilities of
certain triggering events, which we believed to be unlikely as of June 30,
2006. A change in this probability and or a change in the market value of our
common stock could have a significant impact on the results of our operations;
however, there would not be any impact on our cash flows.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

As required by Rule 13a-15(b) under the Securities Exchange Act of
1934, as amended, we carried out an evaluation, under the supervision and with
the participation of our management, including our Chief Executive Officer and
Chief Financial Officer, of the effectiveness of the design and operation of
our disclosure controls and procedures as of the end of the period covered by
this report. Disclosure controls and procedures are designed to ensure that the
information required to be disclosed in our reports which we file or submit
under the Securities Exchange Act of 1934 is (i) accumulated and communicated
to our management (including the Chief Executive Officer and Chief Financial
Officer) as appropriate to allow timely decisions regarding required
disclosures, and (ii) recorded, processed, summarized and reported within the
time periods specified in the SECs rules and forms. Based upon the material
weaknesses in our internal control over financial reporting as described below,
our Chief Executive Officer and Chief Financial

27

Officer have concluded that our disclosure controls and procedures were
not effective as of the end of the period covered by this report.

A material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be
prevented or detected.

We previously identified the following material weaknesses:

1)
We did not maintain an effective control environment, specifically,
  the following material weaknesses were identified within the control
  environment:a)
We did not maintain an effective control environment based on
  criteria established in Internal Control-Integrated Framework
  issued by the
  Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Specifically, the financial reporting
  organization structure was not adequate to support the size, complexity or
  activities of the Company. In addition, certain finance positions were
  staffed with individuals who did not possess the level of accounting
  knowledge, experience and training in the application of GAAP commensurate
  with our financial reporting requirements.b)
We did not maintain effective financial reporting processes,
  including sufficient formalized and consistent finance and accounting polices
  and procedures; nor did we prevent or detect instances of non-compliance with
  certain such policies and procedures that do exist. Specifically, we lacked
  formalized reporting policies and procedures.c)
We did not maintain effective monitoring controls and related
  segregation of duties over automated and manual transactions processes.
  Specifically, we failed to implement processes to ensure periodic monitoring
  of our existing internal control activities over financial reporting to
  identify and assess significant risk that may impact financial statements and
  related disclosures. Additionally, inadequate segregation of duties led to
  untimely identification and resolution of accounting and discourse matters
  and failure to perform timely and effective supervision and reviews.The above control deficiencies resulted in audit adjustments to our
2006 interim and annual consolidated financial statements. These control
deficiencies affect substantially all financial statement accounts, which could
result in a material misstatement to our interim or annual consolidated
financial statements that would not be prevented or detected.

2)
The material weakness in our control
  environment contributed to the existence of the following control
  deficiencies, each of which is considered to be a material weakness:a)
We did not
  maintain effective controls over our process to ensure the complete, accurate
  and timely preparation and review of our consolidated financial statements in
  accordance with GAAP. Specifically, we did not have effective controls over the process
  for identifying, accumulating and reviewing all required supporting
  information to ensure the completeness, accuracy and timely preparation and
  review of our consolidated financial statements and disclosures. This control
  deficiency resulted in audit adjustments to our fiscal 2006 interim and
  annual consolidated financial statements. Additionally, this control deficiency
  could result in a misstatement of substantially all financial statement
  accounts that would result in a material misstatement to our interim or
  annual consolidated financial statements that would not be prevented or
  detected.b)
We did not maintain effective controls to ensure that journal
  entries, both recurring and non-recurring, were consistently reviewed and
  approved in a timely manner to ensure the validity, completeness and accuracy
  of recorded entries. This control deficiency resulted in audit adjustments to
  our fiscal 2006 interim and annual consolidated financial statements.
  Additionally, this control deficiency could result in a misstatement of
  substantially all financial statement accounts that would result in a
  material misstatement to our interim or annual consolidated financial
  statements that would not be prevented or detected.c)
We did not maintain effective controls over
  the procurement process. Specifically, effective controls were not in place
  to ensure the appropriate controls over the approval of new vendors,
  authorization of purchase orders, including categorization of appropriate
  expense line items, the receipt of goods and the approval and authorization
  of vendor payments. This control deficiency could result in a misstatement of current
  liabilities and operating expenses that would result in a material
  misstatement to our interim or annual consolidated financial statements that
  would not be prevented or detected.d)
We did not
  maintain effective controls over the completeness and accuracy of certain
  revenue and expense accruals. Specifically, we failed to identify, analyze
  and review certain accruals at period end relating to certain accounts
  receivable, accounts payable, accrued liabilities, revenue and other direct
  expenses to ensure that they were accurately, completely and properly
  recorded. This control deficiency resulted in audit adjustments to our fiscal
  2006 interim and annual consolidated financial statements. Additionally, this
  control deficiency could result in a misstatement of the aforementioned
  accounts that would result in a material misstatement to our interim or
  annual consolidated financial statements that would not be prevented or
  detected.28

e)
We did not
 maintain effective controls over the existence, completeness and valuation of
 fixed assets and related depreciation expense. Specifically, effective
 controls were not designed and in place to ensure that fixed asset additions
 and disposals were recorded, as well as, the periodic physical verification
 of fixed assets. This control
 deficiency resulted in audit adjustments to our fiscal 2006 interim and
 annual consolidated financial statements.
 Additionally, this control deficiency could result in a misstatement
 of fixed assets and depreciation expense that would result in a material
 misstatement to our interim or annual consolidated financial statements that
 would not be prevented or detected.f)
We did not
 maintain effective controls over spreadsheets. Specifically, we did not
 maintain effective controls over the completeness, accuracy and validity of
 spreadsheets used in our financial reporting process to maintain effective
 version control and ensure that access was restricted to appropriate
 personnel, and that unauthorized modification of the data or formulas within
 spreadsheets was prevented. This
 control deficiency resulted in audit adjustments to our fiscal 2006 interim
 and annual consolidated financial statements. Additionally, this control deficiency could result in a
 misstatement of substantially all financial statement accounts that would
 result in a material misstatement to our interim or annual consolidated
 financial statements that would not be prevented or detected.g)
We did not
 design and maintain effective controls over the completeness, accuracy and
 valuation of our payroll and payroll expense. Specifically, we did not design
 and maintain effective controls over the administration of employee data or
 controls to provide reasonable assurance regarding the proper authorization
 of non-recurring payroll changes.
 This control deficiency could result in a misstatement of the
 aforementioned accounts that would result in a material misstatement to our
 interim or annual consolidated financial statements that would not be
 prevented or detected.h)
We did not
 design and maintain effective controls over the completeness, accuracy,
 existence and valuation of our research grant and contract revenue
 accounts. Specifically, we did not
 design and maintain effective controls to provide reasonable assurance that
 indirect and provisional rates used to calculate manufacturing overhead and
 technical overhead were complete and accurate. This control deficiency
 resulted in audit adjustments to our fiscal 2006 interim and annual
 consolidated financial statements.
 Additionally, this control deficiency could result in a misstatement
 of the aforementioned accounts that would result in a material misstatement
 to our interim or annual consolidated financial statements that would not be
 prevented or detected.As described
in Item 9A of our Annual Report on Form 10-K for the year ended December 31,
2005, which we refer to as our 2005 10-K, our management has established a plan
for remediation of the material weaknesses in our internal control over
financial reporting.

The
certifications of our principal executive officer and principal financial
officer required in accordance with Section 302 of the Sarbanes-Oxley Act of
2002 are attached as exhibits to this Quarterly Report on Form 10-Q. The
disclosures set forth in this Item 4 contain information concerning the
evaluation of our disclosure controls and procedures and changes in internal
control over financial reporting, referred to in the certifications. Those
certifications should be read in conjunction with this Item 4 for a complete
understanding of the matters covered by the certifications.

Our management
undertook and completed reconciliations, analyses, reviews and control procedures
in addition to those historically completed to confirm that this Quarterly
Report fairly presents in all material aspects our financial position, results
of operations and cash flows as of, and for the period presented in accordance
with U.S. generally accepted accounting principles.

Changes
in Internal Control over Financial Reporting

During the
second quarter of 2006, we instituted a new enterprise resource planning
system, primarily used for automated general ledger and accounts payable
transactions. Our internal control over
financial reporting has been altered accordingly for this change in accounting
system. There have been no other
significant changes in our internal control over financial reporting during the
three months ended June 30, 2006. We
continue to develop our control procedures surrounding the implementation of
our new accounting system and we continue to develop a remediation plan to
address our previously disclosed material weaknesses in our internal control
over financial reporting. The development of our remediation plan is described
Item 9A of our 2005 10-K. We expect that the implementation of this plan will
extend throughout 2007.

Inherent
Limitations on Effectiveness of Controls

Our
management, including the Chief Executive Officer and Chief Financial Officer,
does not expect that our disclosure controls and procedures or our internal
control over financial reporting will prevent all error and all fraud. A
control system, no matter how well designed and operated, can provide only
reasonable, not absolute, assurance that the objectives of the control system
are met. Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, within the Company have been detected.

29

PART II

OTHER
INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None.

ITEM 1A. RISK FACTORS

You should
carefully consider the following risk factors as well as other information in
our filings under the Exchange Act before making any investment decisions
regarding our common stock. The risks and uncertainties described herein are
not the only ones we face. Additional risks and uncertainties that we do not
know or that we currently deem immaterial may also impair our business,
financial condition, operating results and prospects. If events corresponding
to any of these risks actually occur, they could materially adversely affect
our business, financial condition, operating results or prospects. In that
case, the trading price of our common stock could decline. When used in this
report, unless otherwise indicated, we, our and us refers to VaxGen. Risk
factors which have materially changed since our 2005 10-K are marked with an
*.

We do not have current financial statements,
and therefore you are not able to evaluate our current financial condition or
operating history and results.*

We have had to
restate certain historical financial statements and have engaged our new
independent registered public accounting firm to reaudit those financial
statements. In July 2004, we announced that we were reauditing and restating
our financial statements for the fiscal years ended December 31, 2003 and 2002
because we determined that we should recognize revenue from certain government
contracts as costs were incurred, instead of after completing contract
milestones. In October 2004, we announced that we would also be reauditing and
restating our financial statements for the fiscal year ended December 31, 2001.
In connection with the restatement of our financial statements for the fiscal
year ended December 31, 2001, we also made adjustments to our balance sheet as
of December 31, 2000. In July 2005, we
concluded that our historical accounting for our 2002 investment in Celltrion was
also not in conformity with generally accepted accounting principles in the
United States of America, or U.S. GAAP, and was, therefore, inappropriate. Our
2002 and 2003 restated financial statements reflect the recording of our
investment in Celltrion at fair value and the recognition of our share of
Celltrions net losses using the equity method of accounting. This process has
taken additional time to complete and has delayed the completion of the reaudit
and restatement of our financial statements.

From January
1, 2004 to June 30, 2005, we were required to consolidate Celltrions financial
statements into our own. From July 1, 2005 to June 30, 2006, we were required
to account for our investment in Celltrion under the equity method. Celltrion
maintains its records in accordance with Korean accounting principles; however,
we require financial statements that are prepared in accordance with U.S. GAAP
and which have been audited in conformity with U.S. Auditing Standards.
Celltrion maintains its records in accordance with Korean accounting
principles; however, we require financial statements that are prepared in
accordance with U.S. GAAP and which have been audited in conformity with U.S.
Auditing Standards. Celltrions internal control over financial reporting may
be insufficient to enable them to report their interim U.S. GAAP financial
results to us on a timely basis.

We are not currently listed on a national
exchange, including the Nasdaq Global Market or Nasdaq SmallCap Market, and
cannot assure you we will ever be listed.

As a result of
our failure to timely file periodic reports, we were delisted from Nasdaq, and
our common stock is not currently listed on any other national stock exchange.
Until we complete all necessary filings with the SEC pursuant to Sections 13
and 15(d) of the Exchange Act, we will not be able to apply for our common
stock to be listed on a national exchange. We do not know when, if ever, this
will be completed, and thus, whether our common stock will ever be listed. In
addition, we cannot be certain that Nasdaq will approve our stock for relisting
or that another exchange will approve our stock for listing. In order to be
eligible for relisting or listing, we must meet Nasdaqs or anther exchanges
initial listing criteria, and we believe we will need to be in compliance with
Sections 13 and 15(d) of the Exchange Act. Our common stock is currently quoted
on the Pink Sheets, LLC.

We are currently ineligible to register
securities with the SEC, and we may never regain compliance.

Until we have
filed current financial statements and made all the necessary filings with the
SEC pursuant to Sections 13 and 15(d) of the Exchange Act, we will not be able
to register any securities for re-sale. Until we are able to register
securities with the SEC for resale, any purchasers who purchase our common
stock or other securities directly from us will have to rely on an exemption
from the federal and state securities laws in order to resell their securities.
We cannot estimate when, if ever, we will have filed outstanding periodic
reports and regained compliance with Sections 13 and 15(d) of the Exchange Act.

Our internal controls may be insufficient to
ensure timely and reliable financial information.

We believe we
need to correct deficiencies in our internal controls and procedures for
financial reporting. These deficiencies include inadequate controls and
procedures relating to revenue recognition for government contracts, account
reconciliations, segregation of

30

duties,
journal entries, accounting for investments in affiliates, accounting for
equity securities and derivatives, accounting for stock-based compensation,
cut-off procedures and depth of accounting knowledge.

Failure to
address these deficiencies in a timely manner might increase the risk of future
financial reporting misstatements and may prevent us from being able to meet
our filing deadlines. Under the supervision of our Audit Committee, we are
continuing the process of identifying and implementing corrective actions where
required to improve the design and effectiveness of our internal controls,
including the enhancement of systems and procedures. Significant additional
resources will be required to establish and maintain appropriate controls and
procedures and to prepare the required financial and other information during
this process.

Even after
corrective actions are implemented, the effectiveness of our controls and
procedures may be limited by a variety of risks including:


faulty human
 judgment and simple errors, omissions or mistakes;
collusion of
 two or more people;
inappropriate
 management override of procedures; and
the risk
 that enhanced controls and procedures may still not be adequate to assure
 timely and reliable financial information.If we fail to
have effective internal controls and procedures for financial reporting in
place, we could be unable to provide timely and reliable financial information.
Additionally, if we fail to have effective internal controls and procedures for
financial reporting in place, it could adversely affect our financial reporting
requirements under our government contracts.

We will need to raise additional capital, and
any inability to raise required funds could harm our business.*

In February
2006, we raised net proceeds of $25.2 million through a private placement to a
group of accredited institutional investors. In June 2006, we received gross
proceeds of $79.0 million from the sale of 3.6 million shares of our Celltrion
common stock. We also provided the buyers
with the right through the end of 2006 to purchase our 2.2 million remaining
shares of Celltrion common stock at a price of 22,000 Korean Won, or Option. If
exercised in its entirety, the Option could result in potential gross proceeds
of $51.0 million (translated at June 30, 2006). We will, however, still need to raise substantial additional
capital in order to satisfy the requirements under the SNS Contract for
acceptance of our anthrax vaccine and to continue operations. We may attempt to
raise these funds through equity or debt financings, collaborative arrangements
with corporate partners or from other sources, including the sale of all or a
portion of our interest in Celltrion. The reaudit of our financial statements
for the three years ended December 31, 2003, the resulting restatement of
periodic reports previously filed with the SEC, the lapsing of our resale
registration statements, the extended period while we have not been current in
our SEC reporting and the delisting of our common stock will likely have an
adverse impact on whether financing will be available or the terms of that
financing.

If additional
funds are raised through the issuance of preferred equity or debt securities,
these securities could have rights, preferences and privileges senior or
otherwise superior to those of our common shares, and debt financings will
likely involve covenants restricting our business activities. Any sale of
additional equity or convertible debt securities will be dilutive to existing
stockholders. We cannot guarantee you that additional funds will be available
on acceptable terms, or at all. If we are unable to raise additional capital
when necessary, we may be required to relinquish our rights to certain key
technologies, vaccine candidates or marketing territories under the terms of
certain of our collaborative agreements. Furthermore, if we are unable to raise
additional capital when necessary, we may be unable to perform under our
existing contracts, we may default on our contracts, our contracts may be
terminated and we may not be able to secure new contracts.

Our operating results may be adversely
impacted by recently adopted changes in accounting for stock options.*

The Financial
Accounting Standards Board issued Statement of Financial Accounting Standards
No. 123(R), Share-Based
Payment, or FAS 123R, in December 2004, FAS123R, which we
implemented effective January 1, 2006, requires all share-based payments to
employees, including grants of employee stock options, to be recognized in the
statement of operations based on their fair values. The future impact of
adoption of FAS 123R cannot be predicted at this time because it will depend on
levels of share-based payments granted in the future. We use the Black-Scholes
option pricing model allowed under FAS 123R.

If we fail to meet our obligations under the
Notes, our payment obligations may be accelerated.

In April 2005,
we raised gross proceeds of $31.5 million through a private placement of Notes
due April 1, 2010. The Notes have the following features:

31


require
 semi-annual payment of interest in cash at a rate of 5 1/2%;
convert, at
 the option of the holder, into shares of our common stock at an initial
 conversion price of approximately $14.76 per share subject to adjustment;
will be
 provisionally redeemable at our option in cash upon the occurrence of certain
 circumstances, including among others, that the closing price of VaxGen
 common stock exceeds approximately $22.14 per share subject to adjustment,
 for at least 20 trading days within a period of 30 consecutive trading days;
if a change
 in control, as defined in our indentures, occurs on or prior to the stated
 maturity of the Notes, the holders of the Notes may require us to repurchase
 the Notes and pay a make-whole premium to the holders of the Notes. If the holders request such a repurchase,
 we or the successor entity, may choose to pay in cash, common stock or a
 combination of cash and common stock; and
constitute
 senior subordinated obligations.Under the
terms of the Notes, if certain events occur, including, without limitation, our
failure to pay any installment of principal or interest due under the Notes,
then the holders may, among other things, elect to accelerate our obligations
under the Notes and declare the outstanding principal balance of the Notes and
accrued but unpaid interest thereon immediately due and payable. In the event
that the holders declare the Notes immediately due and payable or seek to
foreclose on any of our assets, it would have a material adverse effect on our
financial position and we may not have sufficient cash to satisfy our
obligation.

Our indebtedness could adversely affect our
financial health, limit our cash flow available to invest in the ongoing
requirements of our business and adversely affect the price of our common
stock.

Our existing
indebtedness consists of $31.5 million in Notes. This indebtedness, and any
future indebtedness we may incur, could have important consequences, including
the following:


making it
 more difficult for us to satisfy our financial and payment obligations, or to
 refinance maturing indebtedness;
making us
 more vulnerable to a downturn in the economy or our business;
limiting our
 ability to obtain additional financing in the future for working capital,
 capital expenditures, acquisitions and other general corporate purposes;
requiring
 application of a significant portion of our cash flow from operations to the
 payment of debt service costs, which would reduce the funds available to us
 for our operations;
limiting our
 flexibility in planning for, or reacting to, changes in our industry,
 business and markets; and
placing us
 at a competitive disadvantage to the extent we are more highly leveraged than
 some of our competitors.We may incur
significant additional indebtedness in the future to fund our continued
operations or future acquisitions. To the extent new debt is added to our
current debt levels, the substantial leverage risks described above would
increase. We may be required to
repurchase the Notes if certain change in control events occur.

We may fail to meet the requirements, as
stated in our contract, for acceptance of our anthrax vaccine into the SNS of
the U.S. government, which could cause us to suffer losses and the contract to
be terminated.

The U.S.
government has undertaken commitments to acquire improved countermeasures
against bioterrorism, including the stockpiling of vaccines for anthrax and
smallpox. On November 4, 2004, we were awarded the SNS Contract to supply the
U.S. government with up to 75 million doses of our anthrax vaccine candidate
over five years. If we fail to meet the requirements of the SNS Contract or
otherwise breach the contract, the government could terminate the SNS Contract.
For example, we estimate that we will be prepared to deliver validated drug
product in the fourth quarter of 2006, rather than during the first half of
2006 as originally planned. If the U.S. government does not agree to amend the
SNS Contract schedules, we will not be able to meet the schedule set forth in
the SNS Contract and the U.S. government may terminate the contract for default
and seek its excess re-procurement costs.

We are
communicating with HHS regarding a potential modification to our SNS Contract.
We currently anticipate that this potential modification will establish a new
schedule for delivery of the vaccine into the SNS stockpile to accommodate
certain delays in the development of the vaccine and additional requirements by
HHS. Because the potential modification and its content are still under

32

discussion, we
cannot assure that the modification will be issued by HHS in our favor, if at
all. If HHS does not approve the modification, we will not be able to perform
the first delivery under the SNS Contract, in which event HHS may declare us in
default under the SNS contract. Additionally, HHS may require additional data
prior to accepting delivery of a validated recombinant anthrax vaccine, which
could delay delivery of the vaccine. Due to the evolving nature of biodefense
product procurement by HHS and the risks and uncertainties associated with
pharmaceutical product development, we cannot be certain of the timing of
deliveries or that the vaccine can be delivered.

In addition,
the SNS Contract is primarily a fixed-price contract and, if we do not perform
efficiently, we could suffer losses under the contract. In accordance with its
standard contracting terms, the U.S. government may terminate the SNS Contract
at its convenience at any time. We need to substantially increase our employee
base to fulfill certain requirements under the SNS Contract, and are in the
process of doing so. However, there is no guarantee that we will be able to
find and hire additional suitable employees or that we will be able to
integrate them into our operations properly so as to enable us to fulfill the
requirements of the SNS Contract. Any failure to adequately staff our
operations will have a material adverse effect on our business.

The governments determination to award
future contracts to us may be challenged by an interested party, such as
another bidder, at the Government Accountability Office or in federal court.

The laws and
regulations governing the procurement of goods and services by the U.S.
government provide procedures by which other bidders and other interested
parties may challenge the award of a government contract. Such protests could
be filed even if there are not any valid legal grounds on which to base the
protest. If any such protests are filed, the government agency may decide to
suspend our performance under the contract while such protests are being
considered by the Government Accountability Office or the applicable federal
court, thus potentially delaying delivery of goods and services and payment. In
addition, we may be forced to expend considerable funds to defend the award. If
a protest is successful, the government may be ordered to terminate our
contract for its convenience and resolicit bids. The government could even be
directed to award the contract to one of the other bidders.

The U.S. Congress may instigate an
inquiry into the award of the SNS Contract to us which could adversely impact
our business.

At least two
Senate offices, including that of Senator Charles Grassley, have made inquiries
about the award of the SNS Contract. Senator Charles Grassley, Chairman of the
U.S. Senate Finance Committee, sent a letter to HHS on January 28, 2005
requesting information about the SNS Contract and its award to us. The letter
alleges that HHS may have acted prematurely in awarding the SNS Contract to us.
There can be no assurance that the U.S. Senate Finance Committee or other
Congressional committees or members of Congress will not pursue an inquiry into
the SNS Contract. Such an inquiry, if it were initiated, could include public
hearings that could lead to negative publicity, a change to the SNS Contract,
and an adverse effect on the value of our common stock. In addition, our
competitors may attempt to create negative perceptions about VaxGen among
members of Congress or the public that could encourage such inquiries. A formal
U.S. Congressional inquiry would distract management, require significant human
and financial resources to defend, could harm our reputation and could
ultimately lead to audit or modification of contract terms or provisions of the
SNS Contract by the U.S. government at its sole discretion, all of which may
adversely impact our business.

The award of the SNS Contract does not mean
there will be any future contracts awarded.

The award of
one government contract does not secure or increase the likelihood of the award
of future contracts. By law, the U.S. government must seek competitive offers
when procuring goods and services. In addition, if we do not perform in
accordance with the terms of the SNS Contract, we may receive a poor
performance report, which would be considered by the U.S. government in making
any future awards, thus making it more difficult for us to win the award of
such future contracts. Accordingly, we cannot be certain that we will be
awarded any future government contracts, including any contract to supply an
additional government stockpile of anthrax vaccine. It is possible that future
awards to provide the U.S. government with emergency stockpiles of anthrax
vaccine will be granted solely to another supplier. If the U.S. government
makes significant future contract awards for the supply of its emergency
stockpile to our competitors, such as Emergent BioDefense Operations Lansing
Inc., or Emergent, formerly BioPort Corp, our business will be harmed and it is
unlikely that we will be able to ultimately commercialize that particular
vaccine. In addition, the determination of when and whether a product is ready
for large scale purchase and potential use will be made by the Office of Public
Health Emergency Preparedness in consultation with other governmental agencies
including the FDA and the Centers for Disease Control. President Bush has
proposed, and Congress is considering, measures to accelerate the development
of biodefense products through the National Institutes of Health, or NIH,
funding, the review process by the FDA and the final government procurement
contracting authority. While this may help speed the approval of our vaccine
candidates, it may also encourage competitors to develop their own vaccine
candidates. If competitive vaccine candidates gain approval, we could face
severe competition, which could harm our business.

33

If the U.S. government fails to continue funding
our anthrax vaccine candidate development efforts or fails to purchase
sufficient quantities of any future biodefense vaccine candidate, we may be
unable to generate sufficient revenues to continue operations.

We have
received funding from the U.S. government for the development of our anthrax
vaccine candidate. Changes in government budgets and agendas may result in
future funding being decreased and de-prioritized, and government contracts
typically contain provisions that permit cancellation in the event that funds
are unavailable to the governmental agency. Furthermore, we cannot be certain
of the timing of any future funding, and substantial delays or cancellations of
funding could also result from protests or challenges from third parties or for
other reasons. If the U.S. government fails to continue to adequately fund our
research and development programs, we may be unable to generate sufficient
revenues to continue operations. Similarly, if we develop an anthrax vaccine
candidate that is approved by the FDA, but the U.S. government does not place
sufficient orders for this product, our future business will be harmed.

We may encounter difficulties managing the
change and growth of our operations, which could adversely affect our business.

We have experienced
a period of rapid change in our business as a result of increased emphasis on
biodefense opportunities. In addition, we expect to experience substantial
changes in 2006 in manufacturing, quality systems, clinical and regulatory
functions associated with the completion of the Anthrax Contracts and the
shifting of our focus to the SNS Contract. This change in our business has
strained and may continue to strain our administrative, financial and
operational functions. We will need to, among other things, expand our staff
and improve our systems and procedures to manage and maintain an adequate
system of internal controls. Furthermore, we made substantial capital
expenditures in order to fulfill certain obligations under the SNS Contract. We
plan additional capital expenditures in this regard, but at substantially lower
levels than what we have already made. These additional capital expenditures
will be primarily for redundancy, safety and corporate expansion. If we are
unable to manage the changes of our business effectively, we may be unable to
perform under our existing contracts or obtain future government contracts,
both of which would harm our results of operations and financial condition.

U.S. government agencies have special
contracting requirements, which create additional risks.

We have
entered into contracts with NIAID and HHS and a license agreement with the U.S.
Army Medical Research Institute of Infectious Diseases, or USAMRIID, which are
U.S. government agencies. Substantially all of our revenue is derived from
government contracts and grants. In contracting with government agencies, we
are subject to various U.S. government agency contract requirements. Future
sales to U.S. government agencies will depend, in part, on our ability to meet U.S.
government agency contract requirements, which we cannot be certain of
satisfying.

U.S.
government contracts typically contain termination provisions unfavorable to
the non-governmental party, and are subject to audit and modification by the
government at its sole discretion, which subjects us to additional risks.

These risks
include the ability of the U.S. government to unilaterally:


suspend or
 prevent us for a set period of time from receiving new government contracts
 or extending existing contracts based on violations or suspected violations
 of laws or regulations;
terminate
 our existing government contracts;
reduce the
 scope and value of our existing government contracts;
audit and
 object to our contract-related costs and fees, including allocated indirect
 costs;
control and
 potentially prohibit the export of our products; and
change
 certain terms, conditions and requirements of our contracts.The U.S.
government may terminate any of its contracts with us either for its
convenience or if we default by failing to perform in accordance with the
contract schedule and terms. Termination for convenience provisions generally
enable us to recover only our costs incurred or committed, and settlement
expenses and profit on the work completed prior to termination. Termination for
default provisions do not permit these recoveries and make us liable for excess
costs incurred by the U.S. government in procuring undelivered items from
another source. In addition, the U.S. government could bring criminal and civil
charges against us based on intentional or unintentional violations of the
representations and certifications that we have made in all our government
contracts.

34

As a U.S.
government contractor, we are required to comply with applicable laws,
regulations and standards relating to our accounting practices and are subject
to periodic audits and reviews. As part of any such audit or review, the U.S.
government may review the adequacy of, and our compliance with, our internal
control systems and policies, including those relating to our purchasing,
property, estimating, compensation and management information systems. Based on
the results of its audits, the U.S. government may adjust our contract-related
costs and fees, including allocated indirect costs. In addition, if an audit or
review uncovers any improper or illegal activity, we may be subject to civil
and criminal penalties and administrative sanctions, including termination of
our contracts, forfeiture of profits, suspension of payments, fines and
suspension or prohibition from doing business with the U.S. government.

We could also
suffer serious harm to our reputation if allegations of impropriety were made
against us. Although adjustments arising from government audits and reviews
have not seriously harmed our business in the past, future audits and reviews
could cause adverse effects. In addition, under U.S. government purchasing
regulations, some of our costs, including most financing costs, amortization of
intangible assets, portions of our research and development costs, and some
marketing expenses, may not be reimbursable or allowed under our contracts. Our
NIAID Contracts and part of our SNS Contract contain cost-reimbursement terms
and provisions. All of the costs that we incur under our NIH cost-reimbursement
contracts will be subject to audit by the U.S. government, and the U.S.
government will also determine the final indirect cost rate that we may charge.
These audits could result in claims by the U.S. government for any unallowable
or unallocable costs that we charged, or excess indirect costs, and for
penalties that may be imposed for claiming unallowable costs.

In the future,
if we must comply with some or all of the U.S. government-specific cost
accounting standards, it is possible that we will need to expend substantial
resources to modify our accounting processes and procedures. Further, as a U.S.
government contractor, we are subject to an increased risk of investigations,
criminal prosecution, civil fraud, whistleblower lawsuits and other legal
actions and liabilities to which purely private sector companies are not.

In addition,
with respect to the technology we received from USAMRIID, our license agreement
with USAMRIID provides that USAMRIID reserves the right to require us and our
affiliates to grant a nonexclusive, partially exclusive, or exclusive
sublicense in any field of use to a responsible applicant, upon terms that are
reasonable under the circumstances and under applicable law, to fulfill public
health or safety needs. While we would be given an opportunity to appeal such a
decision, the governments exercise of such rights could give our competitors
an opportunity to exploit the licensed patents and thereby undermine our competitive
position. In addition, the license agreement requires us to manufacture
products licensed under the agreement in the United States, which will result
in less flexibility in commercializing our products.

Our fixed price and cost plus contracts may
commit us to unfavorable terms.

We provide our
products and services primarily through fixed-price and cost-plus contracts. In
a fixed-price contract, we must fully absorb our cost overruns, notwithstanding
the difficulty of estimating costs that are related to performance in
accordance with contract specifications. The failure to anticipate technical
problems, estimate costs accurately or control costs during performance of a
fixed-price contract may reduce the profitability of a fixed-price contract or
cause a loss. In a cost-plus contract, we are allowed to recover our approved
costs, plus a fee, which may be fixed or variable depending on the contract
arrangement. The total price on a cost-plus contract is based primarily on
allowable costs incurred, but generally is subject to contract funding
limitations. U.S. government regulations require us to notify our customer of
any cost overruns or under runs on a cost-plus contract. If we incur costs in
excess of the funding limitation in the contract, we may not be able to recover
those cost overruns.

We license our vaccine candidates from third
parties. If we fail to perform our obligations under these license agreements,
we could lose our ability to develop and commercialize our vaccine candidates.

We license our
anthrax vaccine candidate from USAMRIID and we license our smallpox vaccine
candidate from Kaketsuken. Each of these license agreements requires that we
perform certain obligations, including diligence obligations. If we fail to
comply with our obligations under these agreements in a timely fashion, our
licensors could terminate our rights to develop and commercialize our anthrax
and smallpox vaccine candidates, which would seriously harm our business and
prospects. These agreements may also require us to indemnify our licensors for
various liabilities that may arise from the development and commercialization
(including manufacture) of our vaccine candidates, whether or not the reason
for the liability is within our control.

Our license agreement with Kaketsuken for our
smallpox vaccine candidate may restrict our ability to develop and
commercialize other smallpox vaccine products.

For a period
of five years after the termination of our LC16m8 Agreement with Kaketsuken for
our smallpox vaccine candidate, we may not, without Kaketsukens prior written
consent, file for or obtain regulatory approval, sell and/or otherwise deal in
any product having a similar activity to LC16m8. During the term of the LC16m8
Agreement, we may not, without the prior written consent of Kaketsuken,
develop, sell, commercialize and/or otherwise deal in any products which may
compete with or adversely affect LC16m8. These restrictions will be waived if
the LC16m8 Agreement is terminated due to Kaketsukens uncured material breach
of

35

the LC16m8
Agreement or the FDA determines that LC16m8 is not approvable in the United
States. These restrictions may adversely affect our ability to pursue
attractive business opportunities.

Our suppliers may fail to provide, or may be
delayed in providing, us with the necessary materials to produce our vaccine
candidates.

We rely on
suppliers to provide us with the necessary materials to produce our vaccine
candidates. Any significant delays in obtaining any of these materials from our
suppliers or other failure by our suppliers to perform as agreed may cause us
to fail to perform under our contracts, which may cause us to be in breach
under those contracts and cause those contracts to be terminated. We cannot
assure you that we will not face shortages from one or more of these suppliers
in the future. In particular, depending on both our and Kaketsukens supply
needs for LC16m8, we may be unable to obtain adequate bulk vaccine material
from Kaketsuken. We cannot ensure that if a shortage of LC16m8 bulk material
occurs, the bulk manufacturing technology will be transferred to us on terms
favorable to us or at all.

Our subcontractors may fail to perform, or
may be delayed in performing, certain tasks related to our ability to provide
our vaccine candidates to the government under our contracts.

We rely on
suppliers to provide us with the necessary materials to produce our vaccine
candidates. Any significant delays in obtaining any of these materials from our
suppliers or other failure by our suppliers to perform as agreed may cause us
to fail to perform under our contracts, which may cause us to be in breach
under those contracts and cause those contracts to be terminated. We cannot
assure you that we will not face shortages from one or more of these suppliers
in the future. In particular, depending on both our and Kaketsukens supply
needs for LC16m8, we may be unable to obtain adequate bulk vaccine material
from Kaketsuken. We cannot ensure that if a shortage of LC16m8 bulk material
occurs the bulk manufacturing technology will be transferred to us at terms
favorable to us or at all.

We have only a limited operating history and
we expect to continue to generate operating losses.

To date, we
have engaged primarily in research, development and clinical testing. Since our
inception in 1995, we have not been profitable from operations, and we cannot
be certain that we will ever achieve or sustain operating profitability. We
have a large accumulated deficit. Developing our product candidates will
require significant additional research and development, including non-clinical
testing and clinical trials, as well as regulatory approval. We expect these
activities, together with our general and administrative expenses, to result in
operating losses for the foreseeable future. Our ability to achieve operating
profitability will depend, in part, on our ability to procure future contracts
to supply the anthrax and smallpox vaccines to the U.S. government, to
successfully complete development of our proposed products, to obtain required
regulatory approvals and to manufacture and market our products directly or
through business partners. We cannot assure you that we will be able to
accomplish any of these objectives.

Vaccine development is a long, expensive and
uncertain process and the approval requirements for vaccines used to fight
bioterrorism are still evolving. If we are unable to successfully develop and
test our vaccine candidates in accordance with these requirements, our business
will suffer.

We are subject
to rigorous and extensive regulation by the FDA and comparable foreign
regulatory authorities. In the United States, our vaccine candidates for
anthrax and smallpox are regulated by the FDA as biological drug products,
known as Biologics. In order to obtain approval from the FDA to market our
vaccine candidates, other than to the SNS under the terms of our SNS Contract,
we will be required to submit to the FDA a Biologics License Application, or
BLA, which must include both preclinical and clinical trial data as prescribed
by the FDAs current regulatory criteria for vaccines such as our product
candidates, as well as extensive data regarding the manufacturing procedures
and processes for the vaccine candidates. Ordinarily, the FDA requires a
sponsor to support a BLA application with substantial evidence of the products
safety and effectiveness in treating the targeted indication based on data
derived from adequate and well-controlled clinical trials, including Phase 3
efficacy trials conducted in patients with the disease or condition being
targeted. Because humans are not normally exposed to anthrax or smallpox,
statistically significant effectiveness of our biodefense product candidates
cannot be demonstrated in humans, but instead must be demonstrated, in part, by
utilizing animal models before they can be approved for marketing.

Specifically,
we intend to pursue FDA approval of our anthrax and smallpox vaccine candidates
under requirements published by the FDA in 2002 that allow the FDA to approve
certain vaccines used to reduce or prevent the toxicity of chemical,
biological, radiological or nuclear substances based on human clinical data to
demonstrate safety and immune response, and evidence of effectiveness derived
from appropriate non-clinical studies and any additional supporting data. We
cannot predict whether we will obtain regulatory approval for any of our
product candidates pursuant to these provisions, or at all. We may fail to
obtain approval from the FDA or foreign regulatory authorities, or experience
delays in obtaining such approvals, due to varying interpretations of data or
failure to satisfy current safety, efficacy, and quality control requirements.
Until we receive FDA approval, we will not receive certain payments under the
SNS contract. Further, our business is subject to substantial risk because the
FDAs current policies governing biodefense vaccines may change suddenly and
unpredictably and in ways that could impair our ability to obtain regulatory

36

approval of
these products. We cannot guarantee that the FDA will approve our anthrax and
smallpox vaccine candidates on a timely basis or at all.

Delays in successfully completing our
clinical trials could jeopardize our ability to obtain regulatory approval or
market our vaccine candidates on a timely basis.

Our business
prospects will depend on our ability to complete patient enrollment in clinical
trials, to obtain satisfactory results, to obtain required regulatory approvals
and to successfully commercialize our vaccine candidates. Vaccine development
to show adequate evidence of effectiveness in animal models and safety and
immune response in humans is a long, expensive and uncertain process, and delay
or failure can occur at any stage of our non-clinical studies or clinical
trials. Any delay or significant adverse clinical events arising during any of
our clinical trials could force us to abandon a vaccine candidate altogether or
to conduct additional clinical trials in order to obtain approval from the FDA
or foreign regulatory bodies. These development efforts and clinical trials are
lengthy and expensive, and the outcome is uncertain. Completion of our clinical
trials, announcement of results of the trials and our ability to obtain
regulatory approvals could be delayed for a variety of reasons, including:


slower-than-anticipated
 enrollment of volunteers in the trials;
lower-than-anticipated
 recruitment or retention rate of volunteers in the trials;
serious
 adverse events related to the vaccine candidates;
unsatisfactory
 results of any clinical trial;
the failure
 of our principal third-party investigators to perform our clinical trials on
 our anticipated schedules; or
different
 interpretations of our preclinical and clinical data, which could initially
 lead to inconclusive results.Our
development costs will increase if we have material delays in any clinical
trial or if we need to perform more or larger clinical trials than planned. If
the delays are significant, or if any of our vaccine candidates do not prove to
be safe or effective or do not receive required regulatory approvals, our
financial results and the commercial prospects for our product candidates will
be harmed. Furthermore, our inability to complete our clinical trials in a timely
manner could jeopardize our ability to obtain regulatory approval.

The independent clinical investigators that
we rely upon to conduct our clinical trials may not be diligent, careful or
timely, and may make mistakes in the conduct of our clinical trials.

We depend on
independent clinical investigators to conduct our clinical trials. The
investigators are not our employees, and we cannot control the amount or timing
of resources that they devote to our vaccine development programs. If
independent investigators fail to devote sufficient time and resources to our
vaccine development programs, or if their performance is substandard or fails
to comply with the protocol and applicable laws and regulatory standards, FDA
approval of our vaccine candidates may be delayed or prevented. These
independent investigators may also have relationships with other commercial
entities, some of which may compete with us. If these independent investigators
assist our competitors at our expense, it could harm our competitive position.

If we fail to comply with extensive
regulations enforced by domestic and foreign regulatory authorities both before
and after we obtain approval of our vaccine candidates, the commercialization
of our product candidates could be prevented, delayed or suspended.

Vaccine
candidates are subject to extensive government regulations related to
development, testing, manufacturing and commercialization in the United States
and other countries. Our vaccine candidates are in the preclinical and clinical
stages of development and have not received required regulatory approval from
the FDA to be commercially marketed and sold in the United States. With the
exception of LC16m8, which is approved and sold in Japan, our vaccine
candidates have not received required regulatory approval from foreign
regulatory agencies to be commercially marketed and sold. The process of
obtaining and complying with FDA, other governmental and foreign regulatory
approvals and regulations is costly, time consuming, uncertain and subject to
unanticipated delays. Despite the time and expense exerted, regulatory approval
is never guaranteed.

We also are
subject to the following regulatory risks and obligations, among others;


the FDA or
 foreign regulators may refuse to approve an application if they believe that
 applicable regulatory criteria are not satisfied;
the FDA or
 foreign regulators may require additional testing for safety and
 effectiveness;37


the FDA or
 foreign regulators may interpret data from non-clinical testing and clinical
 trials in different ways than we interpret them;
if
 regulatory approval of a product is granted, the approval may be limited to
 specific indications or limited with respect to its distribution. In
 addition, many foreign countries control pricing and coverage under their
 respective national social security systems;
the FDA or
 foreign regulators may not approve our manufacturing processes or
 manufacturing facilities;
the FDA or
 foreign regulators may change their approval policies or adopt new
 regulations;
even if
 regulatory approval for any product is obtained, the marketing license will
 be subject to continual review, and newly discovered or developed safety or
 effectiveness data may result in suspension or revocation of the marketing
 license;
if
 regulatory approval of the vaccine candidate is granted, the marketing of
 that vaccine would be subject to adverse event reporting requirements and a
 general prohibition against promoting products for unapproved or off-label
 uses; and
in some
 foreign countries, we may be subject to official release requirements that
 require each batch of the vaccine we produce to be officially released by
 regulatory authorities prior to its distribution by us.Failure to
comply with the regulatory requirements of the FDA and other applicable foreign
regulatory bodies may subject us to administrative or judicially imposed
sanctions, including:


warning
 letters;
civil
 penalties;
criminal penalties;
injunctions;
product
 seizure or detention, including any products that we manufacture under the
 SNS Contract;
product
 recalls;
total or
 partial suspension of production; and
suspension
 or revocation of the marketing license.We and our subcontractors are subject to
ongoing regulatory review and periodic inspection and approval of manufacturing
procedures and operations, including compliance with cGMP regulations.

The
manufacturing methods, equipment and processes used by us and our
subcontractors must comply with the FDAs current Good Manufacturing Practices,
or cGMP, regulations. The cGMP requirements govern, among other things,
recordkeeping, production processes and controls, personnel and quality control.
The FDA must approve the facilities used to manufacture our products before
they can be used to commercially manufacture our vaccine products or commence
deliveries under the SNS Contract, and these facilities are subject to ongoing
and periodic inspections. If we or our subcontractors fail to comply with cGMP
requirements, or fail to pass a pre-approval inspection of our manufacturing
facility in connection with the SNS Contract, we may not receive regulatory
approval, and we would be subject to possible judicial or administrative
sanctions. In addition, preparing a manufacturing facility for commercial
manufacturing may involve unanticipated delays and the costs of complying with
the cGMP regulations may be significant. Any material changes we make to our
manufacturing processes after we obtain approval of a product may require
approval by the FDA, state or foreign regulatory authorities.

Our product development efforts may not yield
marketable products due to results of studies or trials, failure to achieve
regulatory approvals or market acceptance, proprietary rights of others or
manufacturing issues.

Our success
depends on our ability to successfully develop and obtain regulatory approval
to market new biopharmaceutical products. Development of a product requires
substantial technical, financial and human resources. Our potential products
may appear to be promising at various stages of development yet fail to reach
the market for a number of reasons, including:

38


the lack of
 adequate quality or sufficient prevention benefit, or unacceptable safety
 during preclinical studies or clinical trials;
their
 failure to receive necessary regulatory approvals;
the
 existence of proprietary rights of third parties; or
the
 inability to develop manufacturing methods that are efficient, cost-effective
 and capable of meeting stringent regulatory standards.Political or social factors may delay or
impair our ability to market our vaccine products.

Products
developed to treat diseases caused by or to combat the threat of bioterrorism
will be subject to changing political and social environments. The political
and social responses to bioterrorism have been highly charged and
unpredictable. Political or social pressures may delay or cause resistance to
bringing our products to market or limit pricing of our products, which would
harm our business.

We may fail to protect our intellectual
property or may infringe on the intellectual property rights of others, either
of which could harm our business.

If we are
unable to protect our intellectual property, we may be unable to prevent other
companies from using our technology in competitive products. If we infringe on
the intellectual property rights of others, we may be prevented from developing
or marketing our product candidates. We rely on patent and other intellectual
property protection to prevent our competitors from manufacturing and marketing
our product candidates. Given the rights retained and licenses granted to the
U.S. government with regard to our anthrax vaccine candidate, to the extent
that the U.S. government or foreign governments or organizations procuring
vaccines through treaties or agreements with the U.S. government constitute the
primary market for any of our products, the licenses granted by the U.S.
government may not provide us with a competitive advantage.

In addition,
under our U.S. government contracts, we have a duty to disclose each invention
that we conceive or reduce to practice in performing the agreement, and if we
wish to retain title to such invention, we must affirmatively elect to do so.
If we fail to strictly follow these disclosure requirements, the U.S.
government could take title to such inventions and preclude us from using them.
For each invention to which we retain title, the U.S. government has both a
worldwide, irrevocable, royalty-free license to practice or have practiced such
invention on behalf of the U.S. government, and certain march-in rights
pursuant to which the U.S. government could require us to license the invention
that we own to third parties, including our competitors.

Our
technology, including technology licensed from Kaketsuken and USAMRIID, or
technology that we may license in the future, if any, will be protected from
unauthorized use by others only to the extent that it is covered by valid and
enforceable patents, or effectively maintained as trade secrets and exclusively
licensed to us. The patent positions of pharmaceutical and biotechnology companies
can be highly uncertain and involve complex legal and factual questions.
Accordingly, we cannot predict the scope and breadth of patent claims that may
be afforded to other companies patents. In addition, we could incur
substantial costs in litigation if we are required to defend against patent
suits brought by third parties, or if we initiate these suits, even in such
instances in which the outcome is favorable to us.

The degree of
future protection for our proprietary rights is uncertain, and we cannot ensure
that:


others will
 not independently develop similar or alternative technologies or duplicate
 any of our technologies;
any patents
 issued to us or licensed from Kaketsuken or USAMRIID or other parties, or
 that we may license in the future, if any, will provide a basis for
 commercially viable products or will provide us with any competitive
 advantages or will not be challenged by third parties;
we or any of
 our current or future licensors will adequately protect trade secrets;
we will
 develop additional proprietary technologies that are patentable; or the
 patents of others will not have a material adverse effect on our business.We cannot be
certain that patents issued to us in the future, if any, or patents that we have
licensed from Kaketsuken and USAMRIID, or that we may license in the future, if
any, will be enforceable and afford protection against competitors. In this
regard, the U.S. government has the right to use, for or on behalf of the U.S.
government, any technologies developed by us under our U.S. government
contracts and we cannot prohibit third parties, including our competitors, from
using those technologies in providing products and services to the U.S.
government. Accordingly, under our license agreement with USAMRIID granting us
an exclusive

39

license to
commercialize the anthrax vaccine, the U.S. government retains a license for
any federal government agency to practice USAMRIIDs anthrax-related
inventions, by or on behalf of the government, thereby allowing the use of the
inventions in support of government contracts with other parties, including our
competitors.

Moreover, we
could lose the USAMRIID license if the U.S. government terminates the license
if we or any of our sublicensees:


fail to
 diligently develop a vaccine product in accordance with the development plan
 described in the agreement;
materially
 breach the agreement;
make a
 materially false statement (or fail to provide required information) in a
 plan or report required under the agreement;
fail to make
 payments required under the agreement; or
file for
 bankruptcy.In addition,
we cannot assure you that our operations or technology will not infringe
intellectual property rights of others. The United States Patent and Trademark
Office keeps United States patent applications confidential while the
applications are pending. As a result, we cannot determine which inventions
third parties claim in pending patent applications that they have filed. We may
need to engage in litigation to defend or enforce our patent and license rights
or to determine the scope and validity of the proprietary rights of others. If
we infringe the intellectual property of others, there can be no assurance that
we would be able to obtain licenses to use the technology on commercially
reasonable terms or at all. Failure to obtain licenses could force us to cease
development or sale of a product candidate.

We face competition from several companies
with greater financial, personnel and research and development resources than
ours.

Our
competitors are developing vaccine candidates for anthrax and smallpox, which
could compete with the vaccine candidates we are developing. Our commercial
opportunities will be reduced or eliminated if our competitors develop and
market products for any of the diseases that we target that:


are more
 effective;
have fewer
 or less severe adverse side effects;
are more
 adaptable to various modes of dosing;
are easier
 to administer; or
are less
 expensive than the products or product candidates we are developing.Even if we are
successful in developing effective vaccine products, and obtain FDA and other
regulatory approvals necessary for commercializing them, our products may not
compete effectively with other successful products. Researchers are continually
learning more about diseases, which may lead to new technologies for treatment.
Our competitors may succeed in developing and marketing products either that
are more effective than those that we may develop, alone or with our
collaborators, making our products obsolete, or that are marketed before any
products we develop are marketed.

Our
competitors include fully integrated pharmaceutical companies and biotechnology
companies that currently have drug and target discovery efforts, as well as
universities and public and private research institutions. Many of the
organizations competing with us may have substantially greater capital
resources, larger research and development staffs and facilities, greater
experience in drug development and in obtaining regulatory approvals, and
greater marketing capabilities than we do.

Natural disasters, including earthquakes, may
damage our facilities.

Our corporate
and manufacturing facilities are primarily located in California. Our
facilities in California are in close proximity to known earthquake fault
zones. As a result, our corporate, research and manufacturing facilities are
susceptible to damage from earthquakes and other natural disasters, such as
fires, floods and similar events. Although we maintain general business
insurance against fires and some general business interruptions, there can be
no assurance that the scope or amount of coverage will be adequate in any
particular case.

40

If we fail to manage successfully any company
or product acquisitions, joint ventures or in-licensed product candidates, we
may be limited in our ability to develop our product candidates and to continue
to expand our product candidate pipeline.

Our current
vaccine product development programs were initiated through in-licensing or
collaborative arrangements. These collaborations include licensing proprietary
technology from, and other relationships with, biotechnology companies and
government research institutes and organizations. As part of our business
strategy, we intend to continue to expand our product pipeline and capabilities
through company or product acquisitions, in-licensing or joint venture
arrangements.

Any such
activities will be accompanied by certain risks including:


exposure to
 unknown liabilities of acquired companies;
higher than
 anticipated acquisition costs and expenses;
the
 difficulty and expense of integrating operations and personnel of acquired
 companies;
disruption
 of our ongoing business;
diversion of
 managements time and attention; and
possible
 dilution to stockholders.If our
competitors successfully enter into partnering or license agreements or we are
unable to reach agreement on license or partnering agreements on terms
acceptable to us, we may then be precluded from pursuing those specific
opportunities. Since each of these opportunities is unique, we may not be able
to find a substitute. In addition, if we are unable to manage successfully any
acquisitions, joint ventures and other collaboration opportunities, we may be
limited in our ability to develop new products and therefore to continue to
expand our product pipeline.

Our use of
hazardous materials and chemicals require us to comply with regulatory
requirements and exposes us to potential liabilities.

Our research
and development involves the controlled use of hazardous materials and
chemicals. We are subject to federal, state, local and foreign laws governing
the use, manufacture, storage, handling and disposal of such materials. We
cannot eliminate the risk of accidental contamination or injury from these
materials. In the event of such an accident, we could be held liable for
significant damages or fines. These damages could exceed our resources and any
applicable insurance coverage. In addition, we may be required to incur
significant costs to comply with regulatory requirements in the future.

We may become subject to product liability
claims, which could reduce demand for our product candidates or result in
damages that exceed our insurance coverage.

We face an
inherent risk of exposure to product liability suits in connection with
vaccines being tested in human clinical trials or sold commercially. We may
become subject to a product liability suit if any vaccine we develop causes
injury, or if vaccinated individuals subsequently become infected or otherwise
suffer adverse effects from our vaccines or products. Regardless of merit or
eventual outcome, product liability claims may result in decreased demand for a
vaccine or product, injury to our reputation, withdrawal of clinical trial
volunteers and loss of revenues.

If a product
liability claim is brought against us, the cost of defending the claim could be
significant and any adverse determination could result in liabilities in excess
of our insurance coverage. We currently have product liability insurance,
including clinical trial liability, in the amount of $25.0 million for our
anthrax and smallpox programs. Additionally, we are applying for
indemnification under the Support Anti-terrorism by Fostering Effective
Technologies Act of 2002 which preempts and modifies tort laws so as to limit
the claims and damages potentially faced by companies who provide certain qualified
anti-terrorism products. However, we cannot be certain that our current
insurance can be maintained, or that additional insurance coverage could be
obtained on acceptable terms, if at all.

Legislation limiting or restricting liability
for medical products used to fight bioterrorism is new, and we cannot be
certain that any such protections will apply to our vaccines or products.

The Public
Readiness and Emergency Preparedness Act, or Public Readiness Act, was signed
into law December 2005 and creates general immunity for manufacturers of
countermeasures, including security countermeasures (as defined in Section
319F-2(c)(1)(B)), when the Secretary of HHS issues a declaration for their
manufacture, administration or use. The declaration is meant to provide

41

general
immunity from all claims under state or federal law for loss arising out of the
administration or use of a covered countermeasure. Manufacturers are exempt
from this protection in cases of willful misconduct.

Upon a
declaration by the Secretary of HHS, a compensation fund is created to provide
timely, uniform, and adequate compensation to eligible individuals for covered
injuries directly caused by the administration or use of a covered
countermeasure. The covered injuries to which the program applies are
defined as serious physical injuries or death. Individuals are permitted to
bring a willful misconduct action against a manufacturer only after they have
exhausted their remedies under the compensation program. However, a willful misconduct
action could be brought against us if an individual(s) exhausted their remedies
under the compensation program and thereby expose us to liability.

We may become
subject to standard product liability suits and other third party claims if
vaccines or products developed by us and which fall outside of the Public
Readiness Act cause injury or if vaccinated individuals subsequently become
infected or otherwise suffer adverse effects from such vaccines or products.

We may be subject to claims that our employees
or we have wrongfully used or disclosed alleged trade secrets of their former
employers.

As is
commonplace in the biotechnology industry, we employ individuals who were
previously employed at other biotechnology or pharmaceutical companies, including
our competitors or potential competitors. Although no claims against us are
currently pending, we may be subject to claims that these employees, or we,
have inadvertently or otherwise used or disclosed trade secrets or other
proprietary information of their former employers. Litigation may be necessary
to defend against these claims. Even if we are successful in defending against
these claims, litigation could result in substantial costs and be a distraction
to management.

Failure to hire and retain key management
employees could adversely affect our ability to obtain financing, develop our
products, conduct clinical trials or execute our business strategy.

We are highly
dependent on our senior management and scientific staff. These individuals have
played a critical role in raising capital, negotiating business development
opportunities, developing the vaccine candidates, conducting clinical trials
and manufacturing product candidates. We face intense competition for qualified
personnel, and the existence of non-competition agreements between prospective
employees and their former employers may prevent us from hiring those
individuals or subject us to suit from their former employers. We do not
maintain non-compete agreements with any of our employees. If we lose the
services of any key members of our senior management or scientific staff,
temporarily or permanently, and we are unable to recruit qualified replacements
where we deem it necessary, we may be unable to achieve our business
objectives.

Our stockholders
could experience substantial dilution as result of the issuance of additional
shares of common or preferred stock.

Our Board of
Directors has the authority to establish the designation of up to 20,000,000
shares of preferred stock that are convertible into common stock without any
action by our stockholders, and to fix the rights, preferences, privileges and
restrictions, including voting rights, of such shares. In February 2006, we
raised net proceeds of $25.2 million through a private placement of 3.5 million
shares of common stock at $7.70 per share to a group of accredited
institutional investors. We also issued to the investors five-year warrants
initially exercisable to purchase 699,996 shares of common stock at an exercise
price of $9.24 per share. Because we did not file all of our delinquent
periodic reports with the SEC by January 31, 2007, the warrants became
exercisable for an additional 700,000 shares of common stock, at a price of
$9.24 per share. We may raise additional funds through public or private
offerings of our preferred stock or our common stock, or through issuance of
debt securities that are convertible into shares of our common stock. The
issuance of additional shares of our common stock, or conversion of preferred
stock or debt securities into shares of common stock, would further dilute the
percentage ownership of our stockholders.

Shares of our common stock eligible for
future sale may adversely affect the market for our common stock.

After we have
filed all of our outstanding periodic reports with the SEC, if at all, from
time to time, certain of our stockholders may be eligible to sell all or some
of their shares of our common stock by means of effective resale registration
statements. We agreed to register for resale under the Securities Act the
shares of our common stock issuable upon conversion of the Notes and the shares
of our common stock issued in private placements of our common stock in
November 2004 and February 2006. We have agreed to file registration statements
for these shares within 30 days following the first date we become current in
our reporting requirements under the Exchange Act and to use our best efforts
to cause the registration statements to become effective in no event later than
120 days after the filing of these registration statements. In addition,
pursuant to Rule 144 generally, a stockholder (or stockholders whose shares are
aggregated) who has satisfied a one year holding period may, under certain
circumstances, sell within any three month period a number of securities which
does not exceed the greater of 1% of the then outstanding shares of common
stock or the average weekly trading volume of the class during the four
calendar weeks prior to such sale. Rule 144 also permits, under certain circumstances,
the sale of securities, without any limitation, by our stockholders that are
non-affiliates that have satisfied a two year

42

holding
period, such as certain of those stockholders who purchased shares of our
common stock in our November 2004 private placement. Any substantial sale of
our common stock effective resale registration statements or pursuant to Rule
144 or pursuant to any resale prospectus may have material adverse effect on
the market price of our securities.

Our stock price is likely to be volatile.

Currently, our
common stock is traded over the counter, or OTC, and is quoted on the OTC Pink
Sheets LLC. Stocks traded OTC typically are subject to greater volatility than
stocks traded on stock exchanges, such as the Nasdaq Global Market or the
Nasdaq Capital Market, due to the fact that OTC trading volumes are generally
significantly less than on stock exchanges. This lower volume may allow a
relatively few number of stock trades to greatly affect the stock price. As
such, the trading price of our common stock has been and is likely to continue
to be extremely volatile. For example, between August 9, 2004 and June 30,
2006, the closing price of our common stock, as quoted on the Pink Sheets, has
ranged from a high of $18.55 per share to a low of $3.38 per share.

Our stock
price could continue to be subject to wide fluctuations in response to a
variety of factors, including the following:


timing and
 consistency of filing financial statements;
failure to
 win future government contracts or the termination of our existing contracts
 and government activities relating to contracts for anthrax or smallpox
 vaccines;
adverse
 results or delays in clinical trials;
delays in
 our product development efforts;
real or
 perceived safety issues with any of our vaccine candidates;
failure to
 obtain or maintain required regulatory approvals;
delays in
 completion and/or validation of manufacturing activities relating to our
 partially owned facilities in the Republic of Korea;
changes in
 financial estimates by securities analysts and our failure to meet or exceed
 such estimates;
rumors about
 our business prospects, product development efforts or the progress, timing
 and completion of our clinical trials;
new products
 or services offered by us or our competitors or announcements relating to
 product developments by our competitors;
issuances of
 debt or equity securities;
actual or
 expected sales by our stockholders of substantial amounts of our common
 stock, including shares issued upon exercise of outstanding options and
 warrants; and
other events
 or factors, many of which are beyond our control.In addition,
the stock market in general, and the Nasdaq Global Market and biotechnology
companies in particular, have experienced extreme price and volume fluctuations
that have often been unrelated or disproportionate to the operating performance
of these companies. Broad market and industry factors may negatively affect the
market price of our common stock, regardless of actual operating performance.
In the past, following periods of volatility in the market price of a companys
securities, securities class action litigation has often been instituted
against companies. If we face securities litigation in the future, even if
meritless or unsuccessful, it would result in substantial costs and a diversion
of management attention and resources, which could have a material adverse
effect on our business.

We could experience equipment, raw material,
manufacturing, quality control or other production problems, especially in
periods of increasing volume.

There can be
no assurance that we will be able to meet our projected manufacturing capacity.
We have made and intend to continue to make significant capital expenditures to
expand our manufacturing capacity. However, since customer demand is difficult
to predict,

43

we may be
unable to ramp up our production quickly enough to timely fill new customer
orders. This could cause us to lose new business and possibly existing
business. In addition, if we overestimate customer demand, we could incur
significant costs from creating excess capacity. We may experience
manufacturing complications associated with increasing our manufacturing
capacity, including the adequate production capacity to meet order requirements
and delivery schedules. We may also experience difficulties implementing new
manufacturing processes or outsourcing some of our manufacturing. The addition
of fixed overhead costs increases our breakeven point and results in lower
profit margins unless compensated for by increased product sales. When
purchasing raw materials for our anticipated demand, we take into consideration
the order-to-delivery lead times of vendors and the economic purchase order
quantity for such raw materials. If we over-estimate customer demand, excess
raw material inventory can result, which would have an adverse effect on our
results of operations.

Failure of any portion of our infrastructure
at our California manufacturing facility could have a material adverse effect
on our business.

We are highly
dependent on our wholly owned manufacturing infrastructure in California to
achieve our business objectives. If we experience a problem that impairs our
manufacturing infrastructure, such as a computer virus, intentional disruption
of information technology systems by a third party, a work stoppage, terrorist
attack or manufacturing failure, the resulting disruptions could impede our
ability to book or process orders, manufacture and ship in a timely manner or
otherwise carry on our business in the ordinary course. Any such events could
cause us to lose significant customers or net sales and could require us to
incur significant expense to eliminate these problems and address related
security concerns.

We have no history of paying dividends on our
common stock.

We have never
paid cash dividends on our common stock and do not anticipate paying any cash
dividends on our common stock in the foreseeable future. We plan to retain any
future earnings to finance our growth. If we decide to pay dividends to the
holders of our common stock, such dividends may not be paid on a timely basis.

Our charter documents and Delaware law may
discourage an acquisition of VaxGen.

Provisions of
our certificate of incorporation, by-laws, and Delaware law could make it more
difficult for a third party to acquire us, even if doing so would be beneficial
to our stockholders. We may issue shares of preferred stock in the future without
stockholder approval and upon such terms as our board of directors may
determine. Our issuance of this preferred stock could have the effect of making
it more difficult for a third party to acquire, or of discouraging a third
party from acquiring, a majority of our outstanding stock. Our charter and
by-laws also provide that special stockholders meetings may be called only by
our Chairman of the board of directors, by our Secretary at the written request
of the chairman or by our board of directors, with the result that any
third-party takeover not supported by the board of directors could be subject
to significant delays and difficulties.

If we fail to cause a registration statement
to be declared effective in accordance with the timetable set forth in the
Notes, or in accordance with agreements we have made in connection with private
placements of our common stock, we will be subject to liquidated damages or
liability for breach of contract.

We agreed to
register under the Securities Act shares of our common stock issuable upon
conversion of the Notes, as well as shares issued or issuable in private
placements of our common stock. We have agreed to file registration statements
for these shares within 30 days following the first date we become current in
our reporting requirements under the Exchange Act, and to use our best efforts
to cause the registration statements to become effective in no event later than
120 days after the filing of such registration statements. We have also made
other customary agreements regarding such registrations, including matters
relating to indemnification, maintenance of the registration statements,
payment of expenses and compliance with state blue sky laws. We may be liable
for liquidated damages to each Note holder and purchaser in the private
placements (a) if the registration statements are not filed on or prior to 30
days of becoming current in our reporting requirements; (b) if the registration
statements are not declared effective by the SEC on or prior to 120 days from
filing; or (c) if the registration statements (after being declared effective)
cease to be effective in a manner that violates such agreements, collectively
referred to as a Registration Default. In the event of a Registration Default,
we may be required to pay liquidated damages. Should we become obligated to
make payment of these liquidated damages, it could have a material adverse
effect on our financial position and our results of operations, particularly if
we become obligated to make a payment in full for all liquidated damages
potentially due and payable under these agreements.

ITEM 2. UNREGISTERED SALES OF EQUITY
SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

44

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

45

ITEM 6. EXHIBITS

(a)
Exhibits required by Item 601 of Regulation S-K:

The following
exhibits are filed as part of this report:

(Note: Management contracts and compensatory
plans or arrangements are identified with a + in the following list.)

Incorporated by ReferenceExhibit
 No.

Exhibit

Form

File No.

Filing Date

Exhibit
 No.

FiledHerewith10.1

Modification #01 to
 Contract No. HHS0100200500001C, between the Department of Health and Human
 Services, Office of Research and Development Coordination and Office of
 Public Health Emergency Preparedness and VaxGen, Inc., dated May 5, 2006.*

8-K

0-26483

5-11-06

10.110.2

Share Purchase Agreement,
 between Nexol Co., Ltd., Nexol Biotech Co., Ltd., Nexol Venture Capital Co.,
 Ltd. and VaxGen, Inc., dated June 28, 2006.

8-K

0-26483

7-06-06

10.131.1

Certification of Chief Executive
Officer









X31.2

Certification of Principal Financial
Officer









X32.1

Section 1350 Certification









X* Confidential
treatment requested. The redacted portions have been separately filed with the
SEC as required by Rule 406 of Regulation C.

Signatures

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

VaxGen, Inc.Dated:August 29, 2007
By: /s/ James P. PanekJames P.
 PanekChief Executive Officer(Principal Executive Officer)Dated:August 29, 2007
By: /s/ Matthew J. PfefferMatthew J.
 PfefferChief Financial Officer(Principal Financial Officer)46