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 SECURITIESEXCHANGE ACT OF 1934For the Quarterly Period Ended September
  30, 2004ORo
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIESEXCHANGE 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
  incorporation or organization)
(I.R.S. Employer Identification No.)1000 Marina Blvd., Suite 200
  Brisbane, California
94005(Address of Principal Administrative Offices)
(Zip Code) (650)
624-1000
(Registrants 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 Act).Yes o No
x The issuer has
one class of common stock with 33,106,523 shares outstanding as of December 29,
2006.    EXPLANATORY NOTE

On September 26, 2006, we
filed an amendment to our Annual Report on Form 10-K for the year ended
December 31, 2003 (Amendment No. 1) to restate our consolidated balance
sheets at December 31, 2003 and 2002, and the statements of operations and of
cash flows for each of the three years ended December 31, 2003, as well as the
related notes thereto. We have not amended our previously filed quarterly
reports on Form 10-Q for the interim periods for the year ended December 31,
2003 affected by this restatement. We have amended such financial information
as part of the following:


Amendment No. 1;
For the three months ended
  March 31, 2003 in our Form 10-Q for the three months ended March 31, 2004;
For the three and six
  months ended June 30, 2003 in our Form 10-Q for the three and six months
  ended June 30, 2004; and
For the three and nine
  months ended September 30, 2003, in this report.Therefore, when considering
financial information for 2003, you should rely only on Amendment No. 1, our
Form 10-Qs for the three months ended March 31 and June 30, 2004 and this
report. Except as expressly stated herein, this report speaks to the September
30, 2004 date of this report.

These condensed consolidated
financial statements are unaudited and should be read in conjunction with the
audited consolidated financial statements incorporated by reference in
Amendment No. 1. The condensed consolidated financial information as of
December 31, 2003 has been derived from audited consolidated financial
statements not included herein.

2

VaxGen, Inc.

Form 10-Q

For the Quarter Ended September 30, 2004

Table of Contents

PagePart I
Financial InformationItem 1
Financial Statements (unaudited):Condensed Consolidated Balance Sheets

4Condensed Consolidated Statements of
  Operations

5Condensed Consolidated Statements of Cash
  Flows

6Notes to Condensed Consolidated Financial
  Statements

7Item 2
Managements Discussion and Analysis of Financial Condition
and
  Results of Operations:Overview

37Critical Accounting Policies and Estimates

38Results of Operations

39Liquidity and Capital Resources

45Item 3
Quantitative and Qualitative Disclosures About Market
Risk

52Item 4
Controls and Procedures

53Part II
Other InformationItem 1
Legal Proceedings

54Item 1A
Risk Factors

55Item 2
Unregistered Sales of Equity Securities and Use of
Proceeds

69Item 3
Defaults Upon Senior Securities

69Item 4
Submission of Matters to a Vote of Security
Holders

69Item 5
Other Information

69Item 6
Exhibits

69Signatures

70Certifications

713

PART I  FINANCIAL
INFORMATION

Item 1. Financial Statements

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

September 30,
  2004

December 31,
  2003ASSETSCurrent assets:Cash and cash
equivalents

$
6,715

$
13,221Investment securities


9,146


15,464Accounts receivable


5,218


4,464Unbilled accounts
receivable


608


2,094Due from related
party





386Prepaid expenses and other
current assets


2,576


682Total current assets


24,263


36,311Investment in
affiliate





34,561Property and
equipment


108,155


18,517Restricted cash


1,274


1,092Other assets


3,723


3,983Total assets

$
137,415

$
94,464LIABILITIES,
  MINORITY INTEREST AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable

$
6,315

$
4,908Accrued and other current
liabilities


7,820


4,155Derivative
liabilities





3,407Current portion of obligation
to related party





2,575Due to related
parties


6,945


210Total current
liabilities


21,080


15,255Non-current
obligations


46,868


Obligation to related party,
non-current





31,540Other liabilities


809


629Total liabilities


68,757


47,424Commitments and contingencies
(Note 13)Minority interest in
subsidiary





5,818Minority interest in variable
interest entity


25,139


Stockholders
equity:Common stock


256


250Additional paid-in
capital


224,674


184,032Deferred stock
compensation


(1,716
)

(242
)Accumulated deficit


(183,361
)

(146,438
)Accumulated other comprehensive
income


3,666


3,620Total stockholders
equity


43,519


41,222Total liabilities, minority
interest and stockholders equity

$
137,415

$
94,464See accompanying notes to condensed
consolidated financial statements.

4

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

Three
  Months Ended
  September 30,

Nine
  Months Ended
  September 30,2004

2003
  (Restated)

2004

2003
  (Restated)Revenues:Research contracts and
grants

$
7,254

$
6,585

$
22,308

$
12,935Related party
services





333





905Total revenues


7,254


6,918


22,308


13,840Operating expenses:Research and
development:Related party





22


55


119Other


10,431


8,312


28,807


19,121Total research and
development


10,431


8,334


28,862


19,240General and
administrative


6,101


3,379


16,633


9,770Loss from operations


(9,278
)

(4,795
)

(23,187
)

(15,170
)Other income
(expense):Investment income and
other


88


48


503


427Valuation adjustments


(2,461
)

(3,544
)

(16,183
)

2,699Equity in loss of
affiliate





(510
)




(6,510
)Total other income
(expense)


(2,373
)

(4,006
)

(15,680
)

(3,384
)Net loss before minority
interest


(11,651
)

(8,801
)

(38,867
)

(18,554
)Minority interest in loss of
subsidiary





279





534Minority interest in loss of
variable
  interest entity


819





1,944


Loss before cumulative effect
of change in
  accounting principle


(10,832
)

(8,522
)

(36,923
)

(18,020
)Cumulative effect of change in
accounting
  principle





700





700Net loss


(10,832
)

(7,822
)

(36,923
)

(17,320
)Charges related to Series A
preferred
  stock:Dividends





(6
)




(109
)Accretion to redemption
value





(86
)




(848
)Beneficial conversion
charges





(177
)




(1,623
)Net loss applicable to common
stockholders

$
(10,832
)
$
(8,091
)
$
(36,923
)
$
(19,900
)Basic and diluted loss per
share applicable
  to common stockholders

$
(0.43
)
$
(0.40
)
$
(1.46
)
$
(1.11
)Weighted average shares used in
computing
  basic and diluted loss per share applicable to common stockholders


25,371


20,561


25,214


17,939See accompanying notes to condensed
consolidated financial statements.

5

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

Nine
  Months Ended
  September 30,2004

2003
  (Restated)Cash flows from operating
activities:Net loss

$
(36,923
)
$
(17,320
)Adjustments to reconcile net
loss to net cash used in operating
  activities:Minority interest in loss of
subsidiary





(534
)Minority interest in loss of
variable interest entity


(1,944
)

Depreciation and
amortization


1,271


857Amortization of premiums and
discounts on investment securities


232


(137
)Stock compensation
expense


1,394


508Valuation adjustments


15,402


(1,699
)Cumulative effect of change in
accounting principle





(700
)Equity in loss of
affiliate





6,510Changes in assets and
liabilities:Receivables


373


(1,581
)Prepaid expenses and other
current assets


105


(1,329
)Accounts payable


3


3,810Accrued and other current
liabilities


3,130


(2,775
)Due to related
parties


(210
)

(681
)Other liabilities


(71
)

57Net cash used in operating
activities


(17,238
)

(15,014
)Cash flows from investing
activities:Purchase of investment
securities


(15,975
)

(4,614
)Proceeds from sale and
maturities of investment securities


21,163


11,913Purchase of property and
equipment


(28,667
)

(12,169
)Cash from consolidation of
variable interest entity


9,723


Deposits and other


(399
)

(918
)Change in restricted
cash


8,481


(55
)Net cash used in investing
activities


(5,674
)

(5,843
)Cash flows from financing
activities:Stock issued in private
placements, net


2,965


11,685Proceeds from non-current
obligations


13,267


Payments on non-current
obligations


(1,169
)

Exercise of employee stock
options


575


693Employee stock purchase
plan


447


400Other


93


(598
)Net cash provided by financing
activities


16,178


12,180Effect of exchange rate changes on
cash


228


Decrease in cash and cash
equivalents


(6,506
)

(8,677
)Cash and cash equivalents at
beginning of period


13,221


9,360Cash and cash equivalents at
end of period

$
6,715

$
683Supplemental schedule of non
cash investing and
  financing activities:Accrued purchases of
construction in progress

$
5,652

$
Accretion to redemption value
of Series A preferred stock





848Amortization of beneficial
conversion feature of Series A preferred
  stock





1,623See accompanying notes to condensed
consolidated financial statements.

6

VaxGen, Inc.Notes to Condensed Consolidated Financial Statements

1. Description of Business and Basis of
Presentation

The unaudited
condensed consolidated financial statements of VaxGen, Inc. (VaxGen) and its
subsidiaries (collectively Company) included herein have been prepared by VaxGen
pursuant to the rules and regulations of the Securities and Exchange Commission
(SEC). The
condensed consolidated financial statements include the accounts of VaxGen, its
subsidiary, VaxGen-Celltrion,
Inc. (VCI) and effective January 1, 2004 a variable interest entity (VIE), Celltrion,
Inc. (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.

Certain
information or footnote disclosure normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America (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 condensed consolidated financial
information included herein. While VaxGen believes that the disclosures are
adequate to make the information not misleading, these condensed consolidated
financial statements should be read in conjunction with VaxGens audited financial
statements contained in its Annual Report on Form 10-K/A for the year ended
December 31, 2003 as filed with the SEC on September 26, 2006.

The results of
operations for the three and nine month periods ended September 30, 2004 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.

Nature
of Business Activities

VaxGen is a
biopharmaceutical company focused on the development, manufacture and
commercialization of biologic products for the prevention and treatment of
human infectious disease. The Company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
(AIDSVAX) intended to prevent human immunodeficiency virus (HIV). In 2002,
the Company broadened its product development portfolio to also include
biodefense vaccines. From inception through September 30, 2003, VaxGen was a
development stage enterprise and its financial statements during that period
were prepared in conformity with GAAP governing development stage enterprises.

The Company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 the Company may
not be able to raise additional capital, the risk that the Company may fail to
obtain any future government biodefense contracts, the risk that the Company
may fail to perform under any existing or future contracts and the risk that
the Company 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 (NIH) and related entities.

Delisting
from Nasdaq

As a result of the Companys
inability to timely file financial statements, the Company was delisted from
Nasdaq on August 9, 2004. Since that time, the Companys common stock has
traded over the counter, or OTC, and has been quoted on the Pink Sheets LLC as
VXGN.PK.

7

Basis
of Presentation and Changes in Accounting Principles

In July 2003,
the Company adopted FAS No. 150, Accounting
for Certain Financial Instruments with Characteristics of Both Liabilities and
Equity(FAS 150). FAS 150 establishes standards for classification
and measurement in the balance sheet of certain financial instruments with
characteristics of both liabilities and equity. It requires classification of a
financial instrument that is within its scope as a liability (or an asset in
some circumstances). Financial instruments within the scope of FAS 150 are
initially and subsequently measured at fair value. FAS 150 was effective for financial
instruments entered into or modified after May 31, 2003 and, otherwise was
effective at the beginning of the first interim period beginning after June 15,
2003.

Agreements
that consist of a written put option and a purchased call option constitute financial
instruments under FAS 150. VaxGen and Celltrion entered into such financial
instruments in 2002. In accordance with APB 29, VaxGen recorded the financial
instruments at fair value in 2002. There were no other-than-temporary declines
in value recorded; therefore, the carrying value was not adjusted until
VaxGens July 1, 2003 adoption of FAS 150. At that time, VaxGen determined the
financial instruments current fair value and, in accordance with FAS 150,
accounted for the $0.7 million change in fair value as a cumulative effect of a
change in accounting principle.

Interpretation No. 46, Consolidation
of Variable Interest Entities (FIN 46), was originally issued by
the Financial Accounting Standards Board (FASB) in January 2003 and was
revised in December 2003 (as revised, FIN 46R). FIN 46R clarifies the
application of Accounting Research Bulletin No. 51, Consolidated Financial Statements
(ARB 51), to certain VIEs in which equity investors do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support. If two or more related parties hold variable
interests in the same variable interest entity, and the aggregate variable
interest held by those parties would, if held by a single party, identify that
party as the primary beneficiary, then the party, within the related party
group, that is most closely associated with the variable interest entity is the
primary beneficiary. An enterprise is required to consolidate a VIE if it is
the primary beneficiary of the VIE. FIN 46R applies immediately to arrangements
created after January 31, 2003 and, with respect to arrangements created
before February 1, 2003, no later than the end of the first reporting
period after March 15, 2004.

In February
2002, Celltrion was formed by VaxGen together with Nexol Biotech Co., Ltd
(Nexol), Nexol Co., Ltd. (Nexol Co), Korea Tobacco & Ginseng Corp.
(KT&G) and J. Stephen & Company Ventures Ltd. (JS, collectively
Korean Investors) to build and operate a mammalian cell culture
biomanufacturing facility in Incheon, Republic of Korea, and to provide partial
funding for the construction of VCI, a manufacturing facility under VaxGen control
in South San Francisco, California.

During 2004, VaxGen adopted
the provisions of FIN 46R and determined that both Celltrion and VCI were VIEs
and that VaxGen is their primary beneficiary. Accordingly, in accordance with
FIN 46R, the unaudited condensed consolidated financial statements for the
three and nine months ended September 30, 2004 include the results of Celltrion
as a VIE. VCI has been consolidated by VaxGen since its inception in the third
quarter of 2002. As VaxGen and Celltrion are the only stockholders of VCI, the adoption
of FIN 46R eliminated the Companys accounting for Celltrions minority
interest in VCI. Prior to implementing the consolidation provisions within FIN
46R, VaxGen had reflected Celltrion in its financial statements using the
equity method.

The liabilities recognized
as a result of consolidating Celltrion do not represent additional claims on
VaxGens or VCIs assets. Rather, they represent claims against the specific
assets of Celltrion. Conversely, the assets recognized as a result of
consolidating Celltrion do not represent additional assets that could be used
to satisfy claims against VaxGens or VCIs assets. The general creditors of
VaxGen and VCI have no recourse to the general credit of Celltrion. The general
creditors of Celltrion have no recourse to the general credit of VaxGen and
VCI.

8

At September 30, 2004, the
following significant assets and liabilities of Celltrion are included in the
unaudited condensed consolidated balance sheet (in thousands):

September
  30, 2004Cash and cash equivalents

$
5,700Property and equipment


86,855Non-current obligations


46,868Net assets


73,008In addition, as a result of
the adoption of FIN 46R and the resulting consolidation of Celltrion, all
intercompany 2002 and 2003 transactions between VaxGen, VCI and Celltrion have
been eliminated as of January 1, 2004. Also, certain Celltrion transactions
have been adjusted to conform to VaxGens accounting policies as if Celltrion
had been consolidated from inception. As of January 1, 2004, the cumulative
effect of the change in accounting principle resulting from the consolidation
of Celltrion and the elimination of these transactions resulted in increased
additional paid-in capital of $17.6 million and increased deferred stock
compensation of $0.2 million.

The results of operations of
Celltrion included in the unaudited condensed consolidated statements of
operations were as follows (in thousands):

Three
  Months
  EndedSeptember 30,
  2004

Nine Months
  Ended
  September 30,2004Operating expenses:Research and
development

$
333

$
1,022General and
administrative


1,135


2,382Loss from operations


(1,468
)

(3,404
)Other income


69


327Minority interest


819


1,944Net loss

$
(580
)
$
(1,133
)2. Restatement

On
September 26, 2006, the Company filed an amendment to its Annual Report on Form
10-K for the year ended December 31, 2003 (Amendment No. 1) primarily to restate
its consolidated balance sheets at December 31, 2003 and 2002, and the results
of operations and of cash flows for each of the three years ended December 31,
2003, as well as the related notes thereto. The Company did not amend its
previously filed quarterly reports on Form 10-Q for the interim periods for the
year ended December 31, 2003 affected by this restatement.

The
Company amended such financial information as part of the following:


Amendment No. 1;
For the three months ended
  March 31, 2003 in Form 10-Q for the three months ended March 31, 2004;
For the three and six
  months ended June 30, 2003 in Form 10-Q for the three and six months ended
  June 30, 2004; and
For the three and nine
  months ended September 30, 2003, in this report.9

The following
condensed consolidated statements of operations and condensed consolidated
statement of cash flows reflect restatements for various adjustments that are
included in one or more of the categories below:


Revenue recognition.Revenues and certain
  expenses related to U.S. government cost-plus-fixed-fee contracts are
  recognized as services are performed. Previously, the Company recognized
  these revenues and expenses after completing contract milestones.
  Additionally, fees for services rendered by the Company for Celltrion, an
  equity method investee, are recognized as revenues. Previously, the Company
  accounted for a pro-rata portion of the fees as reductions to operating
  expenses based upon its percentage ownership interest in Celltrion.
Investments in affiliates. The non-cash
  investment in Celltrion is recorded at fair value and the Companys share of
  Celltrions net losses is reflected using the equity method of accounting.
  Translation adjustments resulting from changes in foreign currency exchange
  rates relating to Celltrion are reported as a component of other
  comprehensive income. In addition, the effects of Celltrions equity
  transactions are reflected in additional paid-in capital. Previously, the
  Company disclosed its non-cash investment in Celltrion in the notes to its
  consolidated financial statements, but did not record its initial investment
  in or activities relating to Celltrion in the consolidated balance sheets,
  statements of operations or statements of changes in stockholders equity. In
  addition, because the Company effectively controlled the operations of VCI,
  the consolidated financial statements now include the Companys accounts and
  those of VCI from its inception in June 2002 and reflect Celltrions minority
  interest ownership in VCI. Previously, the Company accounted for VCI under
  the equity method from June 2002 through the first quarter of 2003 after
  which it began to consolidate VCI. The Company also entered into financial
  instruments with Celltrion by which Celltrion provided the Company with a
  purchase option to purchase their ownership interest in VCI. The purchase
  option is included in other assets. Previously, the Company did not record an
  asset relating to the purchase option.
Series A Preferred Stock, warrants and derivatives.
  The Series A Preferred Stock includes certain embedded features that are
  accounted for as a separate embedded derivative liability which is maintained
  at its fair value. Previously, these features were not separated from the
  Series A Preferred Stock and therefore were not accounted for as derivatives.
  The resulting non-cash accretion to redemption charges relating to the Series
  A Preferred Stock are now larger than previously reported. In addition, the warrants
  issued in conjunction with the Series A Preferred Stock have been revalued to
  account for embedded features including potential premium cash redemptions
  and liquidated damages related to registration rights.
Stock-based compensation. Adjustments were
  made to reflect the recognition of certain non-cash stock-based compensation
  resulting from 2003 option grants issued to newly hired executives on their
  respective hire dates in accordance with their employment agreements, were
  not formally approved by the Companys Board of Directors until the next
  Board meeting following hire, which resulted in a different measurement date
  for the options than what had been previously used.
Timing issues. During the Reaudits, the
  Company identified transactions that were previously presented in incorrect
  fiscal periods. The adjustments the Company recorded principally represented
  reversals of prepaid expenses, accruals or reserves that were recorded in
  periods for which inadequate evidential support existed to maintain those
  balances. The restated financial statements reflect these transactions in the
  proper fiscal periods.
Reclassifications.
  The Company reclassified a number of items in the restated results for 2003.
  For example, certain overhead costs have been reclassified from general and
  administrative expense to research and development expense.10

CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS
(in thousands, except per share data)

Three Months Ended September 30, 2003Previously
  Reported

Adjustments

RestatedRevenues:Research contracts and
grants

$
5,612

$
973

$
6,585Related party
services


132


201


333Total revenues


5,744


1,174


6,918Operating expenses:Research and
development:Related party


249


(227
)

22Other


5,660


2,652


8,312Total research and
development


5,909


2,425


8,334General and
administrative


5,187


(1,808
)

3,379Loss from operations


(5,352
)

557


(4,795
)Other income
(expense):Investment income and
other


49


(1
)

48Valuation adjustments


(2,980
)

(564
)

(3,544
)Equity in loss of
affiliate





(510
)

(510
)Total other income
(expense)


(2,931
)

(1,075
)

(4,006
)Net loss before minority
interest


(8,283
)

(518
)

(8,801
)Minority interest in loss of
subsidiary


428


(149
)

279Loss before cumulative effect
of change in
  accounting principle


(7,855
)

(667
)

(8,522
)Cumulative effect of change in
accounting
  principle





700


700Net loss


(7,855
)

33


(7,822
)Charges related to Series A
preferred
  stock:Dividends


(6
)




(6
)Accretion to redemption
value


(29
)

(57
)

(86
)Beneficial conversion
charges


(288
)

111


(177
)Net loss applicable to common
stockholders

$
(8,178
)
$
87

$
(8,091
)Basic and diluted net loss per
share
  applicable to common stockholders

$
(0.40
)
$


$
(0.40
)Weighted average shares used in
computing
  basic and diluted net loss per share applicable to common stockholders


20,561





20,56111

CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS
(in thousands, except per share data)

Nine Months Ended September 30, 2003Previously
  Reported

Adjustments

RestatedRevenues:Research contracts and
grants

$
9,289

$
3,646

$
12,935Related party
services


439


466


905Total revenues


9,728


4,112


13,840Operating expenses:Research and
development:Related party


1,301


(1,182
)

119Other


13,969


5,152


19,121Total research and
development


15,270


3,970


19,240General and
administrative


13,652


(3,882
)

9,770Loss from operations


(19,194
)

4,024


(15,170
)Other income
(expense):Investment income and
other


428


(1
)

427Valuation adjustments


1,071


1,628


2,699Equity in loss of
affiliate





(6,510
)

(6,510
)Total other income
(expense)


1,499


(4,883
)

(3,384
)Net loss before minority
interest


(17,695
)

(859
)

(18,554
)Minority interest in loss of
subsidiary


1,012


(478
)

534Loss before cumulative effect
of change in
  accounting principle


(16,683
)

(1,337
)

(18,020
)Cumulative effect of change in
accounting
  principle





700


700Net loss


(16,683
)

(637
)

(17,320
)Charges related to Series A
preferred
  stock:Dividends


(109
)




(109
)Accretion to redemption
value


(331
)

(517
)

(848
)Beneficial conversion
charges


(2,747
)

1,124


(1,623
)Net loss applicable to common
stockholders

$
(19,870
)
$
(30
)
$
(19,900
)Basic and diluted net loss per
share
  applicable to common stockholders

$
(1.11
)
$


$
(1.11
)Weighted average shares used in
computing
  basic and diluted net loss per share applicable to common stockholders


17,939





17,939CONDENSED CONSOLIDATED STATEMENT OF CASH
FLOWS
(in thousands)

Nine Months Ended September 30, 2003Previously
  Reported

Adjustments

RestatedCash provided by (used
in):Operating activities

$
(15,654
)
$
640

$
(15,014
)Investing activities


(869
)

(4,974
)

(5,843
)Financing activities


12,757


(577
)

12,180Increase in cash and cash
equivalents


(3,766
)

(4,911
)

(8,677
)Cash and cash equivalents at
beginning of
  period


4,449


4,911


9,360Cash and cash equivalents at
end of period

$
683

$


$
68312

The following
tables reflect restatements of other comprehensive loss for various adjustments
that are included in one or more of the categories discussed above (in
thousands):

Three
        Months Ended September 30, 2003Previously
        Reported
    
    Adjustments
    
    RestatedNet
        loss
    
    $
    (7,855
    )
    $
    33
    
    $
    (7,822
    )Other
        comprehensive income (loss):Translation
        adjustment
    
    
    
    
    
    1,203
    
    
    1,203Unrealized
        gain (loss)
    
    
    (21
    )
    
    
    
    
    (21
    )Total
        other comprehensive income (loss)
    
    
    (21
    )
    
    1,203
    
    
    1,182Comprehensive
        loss
    
    $
    (7,876
    )
    $
    1,236
    
    $
    (6,640
    )Nine
        Months Ended September 30, 2003Previously
        Reported
    
    Adjustments
    
    RestatedNet
        loss
    
    $
    (16,683
    )
    $
    (637
    )
    $
    (17,320
    )Other
        comprehensive loss:Translation
        adjustment
    
    
    
    
    
    979
    
    
    979Unrealized
        gain (loss)
    
    
    (267
    )
    
    
    
    
    (267
    )Total
        other comprehensive income (loss)
    
    
    (267
    )
    
    979
    
    
    712Comprehensive
        loss
    
    $
    (16,950
    )
    $
    342
    
    $
    (16,608
    )3. Summary of Significant Accounting Policies

Property
and Equipment

Property and
equipment are stated at cost, net of accumulated depreciation and amortization.
Construction in progress primarily represents costs incurred for the design,
construction and validation of the Companys manufacturing facilities in the
Republic of Korea and California. No depreciation is recognized for
construction in progress until the related assets are operational. At September
30, 2004, the Korean and California manufacturing facilities were not yet
operational and therefore, no depreciation had been recognized for these
facilities. Equipment, consisting of laboratory equipment, computers and other
office furniture and equipment, is depreciated using the straight-line method
over the assets estimated useful lives of five to six years. Leasehold
improvements and capital lease assets are amortized using the straight-line
method over the shorter of the assets estimated useful lives or the remaining
term of the lease.

Significant
additions and improvements are capitalized, while repairs and maintenance costs
are charged to expenses as incurred. Property and equipment purchased for
specific research and development projects with no alternative uses are
expensed. Interest incurred during construction of facilities is capitalized
and amortized over the life of the related asset. Interest capitalization
ceases when a project or construction activities are substantially completed.
Annual bank guarantee fees incurred during construction are also capitalized.
When assets are retired or otherwise disposed of, the cost and accumulated
depreciation or amortization are removed from the accounts and any resulting
gain or loss is reflected in operations in the period recognized.

13

Stock-Based
Compensation

The Company
accounts for stock-based compensation based on the provisions of Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees
(APB 25), which states that, for fixed plans, no compensation expense is
recorded for stock options or other stock-based awards to employees that are
granted with an exercise price equal to or above the fair value per share of
the common stock on the grant date. In the event that stock options are granted
with an exercise price below the fair value of the common stock at the grant
date, the difference between the fair value of the common stock and the
exercise price of the stock option is recorded as deferred compensation.
Deferred compensation is amortized to compensation expense using the
straight-line method over the vesting period of the stock option.

The Company
has adopted the disclosure requirements of Statement of Financial Accounting
Standards (FAS) No. 123, Accounting for Stock-Based Compensation
(FAS 123) and Statement of FAS No. 148, Accounting for Stock Based CompensationTransition
and Disclosurean Amendment of FASB Statement No. 123, which
requires compensation expense to be disclosed based on the fair value of the
options granted at the date of the grant.

Celltrion grants employees
stock options with approval by its Board of Directors and stockholders. Stock
options are granted to Celltrion employees upon completion of one year of
service. Shares under option vest 40% upon completion of the third year of
service from the grant date. The remainder vests 30% each for the fourth and
fifth year of service from the grant date. All Celltrion stock option grants
expire no later than 9 years from the date of grant, unless cancelled earlier
due to termination of employment or other events defined in the option
agreement, such as the holder assigning or pledging their stock options or
Celltrion being unable to comply with the exercise of the stock option due to
bankruptcy or liquidation. Celltrion option grants for 51,900 preferred shares,
104,300 preferred shares and 123,250 preferred shares were granted to employees
on March 24, 2004, February 22, 2003 and July 19, 2002, respectively. Celltrion
stock options outstanding at September 30, 2004 had a weighted-average exercise
price of 8,198 Korean Won ($7.12 equivalent). The Celltrion stock option
agreement has an anti-dilution provision that is triggered by the issuance of
new shares or warrants at prices which are lower than the options exercise
price. In May 2004, based upon these anti-dilution provisions, the exercise
price and number of shares granted for all outstanding options was changed due
to the issuance of new shares at prices lower than the exercise price. These
stock options are subject to variable accounting. Accordingly, subsequent
changes in the value of Celltrions stock will result in increases or decreases
in compensation expense until the options are exercised, cancelled or expire
unexercised.

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 as restated would have been
increased to the pro forma amounts indicated below (in thousands, except per share
data):

Three
  Months Ended
  September 30,

Nine
  Months Ended
  September 30,2004

2003(Restated)

2004

2003(Restated)Net loss applicable to common
stockholders
   as reported

$
(10,832
)
$
(8,091
)
$
(36,923
)
$
(19,900
)Add: Stock-based employee
compensation
  expense included in reported net loss, net of minority interest


192


40


408


159Less: Total stock-based employee
  compensation expense determined under fair value based method for all awards,
  net of minority interest


(1,784
)

(2,005
)

(5,746
)

(5,750
)Net loss applicable to common
stockholders
   pro forma

$
(12,424
)
$
(10,056
)
$
(42,261
)
$
(25,491
)Net loss per share applicable
to common
  stockholders  basic and diluted, as reported

$
(0.43
)
$
(0.40
)
$
(1.46
)
$
(1.11
)Net loss per share applicable
to common
  stockholders  basic and diluted, pro forma

$
(0.49
)
$
(0.49
)
$
(1.68
)
$
(1.42
)14

The value of
each option grant and Employee Stock Purchase Plan grant was estimated on the
date of grant using the Black-Scholes option pricing model with the following
weighted average assumptions (no expected dividends):

Three
  Months Ended
  September 30,

Nine
  Months Ended
  September 30,2004

2003

2004

2003VaxGen Stock Option PlansRisk-free
  .

3.61
%

2.27
%

3.77
%

2.30
%Expected
  life in years

5.0


4.0


5.0


4.0Volatility

102
%

106
%

100
%

105
%Celltrion Stock Option PlanRisk-free
  interest rate

4.88
%

n/a


4.88
%

n/aExpected
  life in years

6.0


n/a


6.0


n/aVolatility

71
%

n/a


72
%

n/aEmployee Stock Purchase PlanRisk-free
  interest rate

1.86
%

0.91
%

1.36
%

1.02
%Expected
  life in years

1.0


1.0


1.0


1.0Volatility

84
%

146
%

88
%

140
%New
Accounting Pronouncements

In
December 2004, the FASB issued FAS No. 153, Exchanges of
Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for
Nonmonetary Transactions (FAS 153). FAS 153 addresses the
measurement of exchanges of nonmonetary assets and redefines the scope of
transactions that should be measured based on the fair value of the assets
exchanged. The provisions in FAS 153 are effective for nonmonetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005, which
is effective with the Companys first quarter of fiscal 2006. The Company does
not expect adoption of FAS 153 will have a material impact on its consolidated
financial position, results of operations or cash flows.

In December 2004, the FASB
issued FAS No. 123(R), Share-Based Payment (FAS 123R) which is
a revision of FAS 123. Generally, the approach in FAS 123R is similar to the
approach described in FAS 123. However, FAS 123R requires all share-based
payments to employees, including grants of employee stock options, to be
recognized in the consolidated statement of operations based on their fair values.
Pro forma disclosure is no longer an alternative. The new rule applies to
option grants made after adoption as well as options that are not vested at the
date of adoption. FAS 123R must be adopted in annual periods beginning after
July 1, 2005. The Company plans to begin applying FAS 123R prospectively in the
first quarter of 2006. Additionally, in August 2005, the FASB issued FASB Staff
Position (FSP) FSP FAS 123R-1, Classification and Measurement of Freestanding
Financial Instruments Originally Issued in Exchange for Employee Services under
FASB Statement No. 123(R) (FSP1). In FSP1, the FASB decided to
defer the requirements in FAS 123 that make a freestanding financial instrument
subject to the recognition and measurement requirements of other GAAP when the
rights conveyed by the instrument are no longer dependent on the holder being
an employee. In October 2005, the FASB issued FSP FAS 123R-2, Practical
Accommodation to the Application of Grant Date as Defined in FASB Statement No.
123(R) (FSP2). In FSP2, the FASB is providing companies with a
practical accommodation when determining the grant date of an award that is
subject to the accounting provisions in FAS 123R. In November 2005, the
FASB issued FSP FAS 123R-3, Transition
Election Related to Accounting for the Tax Effects of Share-Based Payment
Awards(FSP3). FSP3 provides an elective alternative method that
establishes a computational component to arrive at the beginning balance of the
accumulated paid-in capital pool related to employee compensation and a
simplified method to determine the subsequent impact on the accumulated paid-in
capital pool of employee awards that are fully vested and outstanding upon the
adoption of FAS 123R. In February 2006, the FASB issued FSP FAS 123R-4, Classification of Options and Similar Instruments
Issued as Employee Compensation That Allow for Cash Settlement upon the
Occurrence of a Contingent Event (FSP4), which concludes that a
cash settlement feature that can be exercised only upon the occurrence of a
contingent event that is outside the employees control does not become a
liability until it becomes probable that the event will occur. An option or
similar instrument that is

15

classified as
equity, but subsequently becomes a liability because the contingent cash
settlement event is probable of occurring, shall be accounted for similar to
modification from an equity to liability award. To the extent that the
liability exceeds the amount previously recognized in equity, the excess is
recognized as compensation cost. The total recognized compensation cost for an
award with a contingent cash settlement feature shall at least equal the fair
value of the award at the grant date. FSP4 is applicable only for options or
similar instruments issued as part of employee compensation arrangements.   In October 2006, the FASB issued FSP FAS
123R-5, Amendment of FASB Staff Position FAS
123(R)-1 (FSP5), which addresses whether a modification of an
instrument in connection with an equity restructuring should be considered a
modification for purposes of applying FSP1. The provisions in FSP5 are
effective for the first reporting period beginning after October 10, 2006.
Also, in October 2006, the FASB issued FSP FAS 123R-6, Technical Corrections of FASB Statement No. 123
(revised 2004)(FSP6), which addresses certain technical
corrections of FAS 123R. The provisions in FSP6 are effective for the first
reporting period beginning after October 20, 2006.  The guidance in FSP1, FSP2, FSP3, FSP4, FSP5 and FSP6 will be
applied upon the Companys adoption of FAS 123R. The Company is currently
evaluating the impact of adopting the guidance in FAS 123R, FSP1, FSP2, FSP3,
FSP4, FSP5 and FSP6 on the Companys consolidated financial position, results
of operations and cash flows.

In March 2005,
the SEC published Staff Accounting Bulletin No. 107 (SAB 107). The
interpretations in this staff accounting bulletin express the views of the
staff regarding the interaction between FAS 123R and certain SEC rules and
regulations and provide the staffs views regarding the valuation of
share-based payment arrangements for public companies. In particular, SAB 107
provides guidance related to share-based payment transactions with
non-employees, the transition from nonpublic to public entity status, valuation
methods (including assumptions such as expected volatility and expected term),
the accounting for certain redeemable financial instruments issued under
share-based payment arrangements, the classification of compensation expense,
non-GAAP financial measures, first-time adoption of FAS 123R in an interim
period, capitalization of compensation cost related to share-based payment
arrangements, the accounting for income tax effects of share-based payment
arrangements upon adoption of FAS 123R, the modification of employee share
options prior to adoption of FAS 123R and disclosures in Managements
Discussion and Analysis subsequent to adoption of FAS 123R. The Company will
comply with SAB 107 upon its adoption of FAS 123R. The Company is currently
evaluating the impact of adopting SAB 107 on the Companys consolidated
financial position, results of operations and cash flows.

In March 2005, the FASB
issued FASB Interpretation No. 47, Accounting
for Conditional Asset Retirement Obligations (FIN 47). FIN 47
clarifies that a conditional asset retirement obligation, as used in FAS 143,
refers to a legal obligation to perform an asset retirement activity in which
the timing or method of the settlement are conditional on a future event that
may or may not be within the control of the entity. Accordingly, an entity is
required to recognize a liability for the fair value of a conditional asset
retirement obligation if the fair value can be reasonably estimated. FIN 47 is
effective no later than fiscal years ending after December 15, 2005. The
Company does not expect adoption of this interpretation will have a material
impact on its consolidated financial position, results of operations or cash
flows.

In
April 2005, the FASB issued FIN 46(R)-6, Determining the Variability to Be Considered in
Applying FASB Interpretation No. 46(R) (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 is currently evaluating
the impact of adopting FSP FIN 46R-6 on the Companys consolidated financial
position, results of operations and cash flows.

16

In May 2005,
the FASB issued FAS No. 154, Accounting
Changes and Error CorrectionsA replacement of APB Opinion No. 20 and FASB Statement
No. 3(FAS 154).   FAS 154 replaces APB Opinion No. 20,
Accounting Changes, and FAS No.
3, Reporting Accounting Changes in Interim
Financial Statements, and changes the requirements for the
accounting for, and reporting of, a change in accounting principles. FAS 154
applies to all voluntary changes in accounting principles and changes required
by an accounting pronouncement in the unusual instance that the pronouncement
does not include specific transition provisions. Under previous guidance, changes
in accounting principle were recognized as a cumulative effect in the net
income of the period of the change. FAS 154 requires retrospective application
of changes in accounting principle, limited to the direct effects of the
change, to prior periods financial statements, unless it is impracticable to
determine either the period-specific effects or the cumulative effect of the
change in accounting principle. Additionally, FAS 154 requires that a change in
depreciation, amortization or depletion method for long-lived, nonfinancial
assets be accounted for as a change in accounting estimate affected by a change
in accounting principle and that correction of errors in previously issued
financial statements should be termed a restatement. The provisions in FAS
154 are effective for accounting changes and correction of errors made in
fiscal years beginning after December 15, 2005, which is effective with the
Companys first quarter of fiscal 2006. The Company does not expect the
adoption of FAS 154 will have a material impact on its consolidated financial
position, results of operations or cash flows.

In June 2005, the FASB
issued FSP FAS 150-5, Issuers Accounting under FASB Statement No. 150 for
Freestanding Warrants and Other Similar Instruments on Shares that are
Redeemable(FAS 150-5). FAS 150-5 clarifies that freestanding
warrants and similar instruments on shares that are redeemable should be
accounted for as liabilities under FAS 150 regardless of the timing of the
redemption feature or price, even though the underlying shares may be
classified as equity. FAS 150-5 is effective for the first reporting period
beginning after September 30, 2005. Although the Company does have outstanding
warrants as of July 1, 2005, the shares issued upon exercise of the warrants
are not redeemable; consequently, the Company does not expect the adoption of
FAS 150-5 will have a material impact on its consolidated financial position,
results of operations or cash flows.

In July 2005, the FASB
issued FSP APB 18-1, Accounting by an
Investor for its Proportionate Share of Accumulated Other Comprehensive Income
of an Investee Accounted for under the Equity Method in Accordance with APB
Opinion No. 18 upon a Loss of Significant Influence(FSP APB
18-1), which provides guidance on how an investor should account for its
proportional share of an investees equity adjustments for other comprehensive
income (OCI) upon a loss of significant influence as detailed in paragraph
121 of FAS No. 130, Reporting Comprehensive Income(FAS 130).  APB Opinion No. 18, The Equity Method of
Accounting for Investments in
Common Stock (APB 18) requires a transaction of an equity method
investee of a capital nature be accounted for as if the investee was a
consolidated subsidiary, which requires the investor to record its
proportionate share of the investees adjustments for OCI as increases or
decreases to the investment account with corresponding adjustments in
equity.  FSP APB 18-1 requires that an
investors proportionate share of an investees equity adjustments for OCI
should be offset against the carrying value of the investment at the time
significant influence is lost and equity method accounting is no longer
appropriate. However, to the extent that the offset results in a carrying value
of the investment that is less than zero, an investor should (a) reduce the
carrying value of the investment to zero and (b) record the remaining balance
in income. The guidance in FSP APB 18-1 is effective for the Company on October
1, 2005. The Company is currently evaluating the impact of adopting FSP APB
18-1 on the Companys consolidated financial position, results of operations
and cash flows.

In September 2005, the
Emerging Issues Task Force (EITF) reached a consensus on Issue No. 05-7, Accounting for
Modifications to Conversion Options Embedded in Debt Instruments and Related
Issues (EITF 05-7). EITF 05-7 requires that a change in the fair
value of a conversion option brought about by modifying the debt agreement be
included in analyzing in accordance with EITF consensus on Issue No. 96-19, Debtors
Accounting for a Modification or Exchange of Debt Instruments(EITF
96-19), whether a debt instrument is considered extinguished.  Under EITF 96-19s requirements, an issuer
who modifies a debt instrument must compare the present value of the original
debt instruments cash flows to the present value of the cash flows of the
modified debt. If the present value of those cash flows varies by more than 10
percent, the modification is considered significant and extinguishments
accounting is applied to the original debt. If the change in the present value
of the cash flows is less than 10 percent, the debt is considered to be
modified and is subject to EITF 96-19s modification accounting. EITF 05-7
requires that in applying the 10 percent test the change in the fair value of
the conversion option be treated in the same manner as a current period cash
flow. EITF 05-7 also requires that, if a modification does not result in an
extinguishment, the change in fair value of the conversion option be accounted
for as an adjustment to interest expense over the remaining term of the debt.
The issuer should not recognize a beneficial conversion feature

17

(BCF) or reassess an existing BCF upon modification of the
conversion
option of a debt instrument that does not result in an extinguishment. EITF
05-7 is effective for modifications of debt instruments beginning in the first
interim or annual reporting period beginning after December 15, 2005. The
Company does not expect the adoption of EITF 05-7 to have material impact on
the Companys consolidated financial position, results of operations or cash
flows.

In September 2005, the EITF
reached a consensus on Issue No. 05-8, Income Tax Consequences of Issuing Convertible Debt
with a Beneficial Conversion Feature (EITF 05-8).  Under EITF 05-08, the issuance of
convertible debt with a BCF results in a temporary difference for purposes of
applying FAS No. 109, Accounting for Income Taxes. The deferred
taxes recognized for the temporary difference should be recorded as an
adjustment to paid-in capital. EITF 98-5, Accounting for Convertible Securities with Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios,
and EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments,
require that the nondetachable conversion feature of a convertible debt
security be accounted for separately if it is a BCF. A BCF is recognized and
measured by allocating to additional paid-in capital a portion of the proceeds
equal to the conversion features intrinsic value. A discount on the
convertible debt is recognized for the amount that is allocated to additional
paid-in capital. The debt discount is accreted from the date of issuance to the
stated redemption date of the convertible instrument or through the earliest
conversion date if the instrument does not have a stated redemption date. The
U.S. Federal Income Tax Code includes the entire amount of proceeds received at
issuance as the tax basis of the convertible debt security. EITF 05-8 should be
applied retrospectively to all instruments with a BCF accounted for under EITF
98-5 and EITF 00-27 for periods beginning after December 15, 2005. The Company
does not expect the adoption of EITF 05-8 to have material impact on the
Companys consolidated financial position, results of operations or cash flows.

In November
2005, the FASB issued FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments (FSP FAS
115-1 and FAS 124-1).  This FSP
nullifies certain requirements of EITF Issue No. 03-1 and supersedes EITF
Abstracts, Topic No. D-44, Recognition of Other-Than-Temporary Impairment upon
the Planned Sale of a Security Whose Cost Exceeds Fair Value. Based on the clarification provided in FSP FAS 115-1 and FAS
124-1, the amount of any other-than-temporary impairment that needs to be
recognized will continue to be dependent on market conditions, the occurrence
of certain events or changes in circumstances relative to an investee and an
entitys intent and ability to hold the impaired investment at the time of the
valuation.  FSP FAS 115-1 and FAS 124-1
are effective for reporting periods beginning after December 15, 2005.  The Company is evaluating the impact of
adopting the guidance in FSP FAS 115-1 and FAS 124-1on the Companys
consolidated financial position, results of operations and cash flows.

In February
2006, the FASB issued FAS No. 155, Accounting
for Certain Hybrid Financial Instruments (FAS 155), which amends
FAS 133 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 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) (EITF
06-3). EITF 06-03 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.

18

In July 2006,
the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxesan
interpretation of FASB Statement No. 109(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 is currently evaluating the impact of adopting FIN 48
on the Companys consolidated financial position, results of operations and
cash flows.

In September 2006, the FASB
issued FAS No. 157, Fair Value Measurement (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 (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 (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 (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 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 (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 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
Issue 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.

19

In December 2006, the FASB
issued FSP EITF 00-19-2, Accounting for Registration Payment Arrangements
(FSP 00-19-2) which addresses accounting for registration payment
arrangements. FSP 00-19-2 specifies that the contingent obligation to make
future payments or otherwise transfer consideration under a registration
payment arrangement, whether issued as a separate agreement or included as a
provision of a financial instrument or other agreement, should be separately recognized
and measured in accordance with FASB Statement No. 5, Accounting for Contingencies.
FSP 00-19-2 further clarifies that a financial instrument subject to a
registration payment arrangement should be accounted for in accordance with
other applicable generally accepted accounting principles without regard to the
contingent obligation to transfer consideration pursuant to the registration
payment arrangement. For registration payment arrangements and financial
instruments subject to those arrangements that were entered into prior to the
issuance of EITF 00-19-2, this guidance shall be effective for financial
statements issued for fiscal years beginning after December 15, 2006 and
interim periods within those fiscal years. Early adoption of FSP 00-19-2 for
interim or annual periods for which financial statements or interim reports
have not been issued is permitted. The Company began applying EITF 00-19-2 prospectively in the first
quarter of 2004.

4. Net Loss per Share

Basic net loss
per share is computed as net loss applicable to common stockholders divided by
the weighted average number of common shares outstanding for the period.  Potential common shares include dilutive
shares issuable upon the exercise of outstanding VaxGen stock options, warrants
and Employee Stock Purchase Plan, which are listed below.  For all periods presented, such potential
common shares were excluded from the computation of diluted net loss per share,
as their effect is antidilutive.

September 30,2004

2003Potentially
  dilutive securities:Options to
purchase common stock


4,559,895


3,758,058Warrants to
purchase common stock


1,845,620


985,159Employee Stock
Purchase Plan





197,759Total


6,405,515


4,940,9765. Balance Sheet
Components

Restricted
Cash

At September
30, 2004 and December 31, 2003, VaxGen had restricted cash of $1.1 million as
compensating balances to support outstanding letters of credit.  The letters of credit, which are renewed
annually, relate to VaxGens leases and utility services.  At September 30, 2004, Celltrion had
restricted cash of 200 million Korean Won ($0.2 million equivalent). At January
1, 2004, Celltrion maintained a restricted cash deposit of 10,000 million
Korean Won with its lending bank, representing a minimum deposit required to
secure a loan. The restriction on this restricted cash was lifted during
September 2004.

Property
and Equipment

The following
is a summary of property and equipment (in thousands):

September
  30, 
  2004

December
  31,
  2003Construction in
progress

$
89,200

$
14,347Land


13,060


Leasehold
improvements


3,228


3,138Machinery, furniture and
equipment


8,483


5,466Sub-total


113,971


22,951Less: accumulated depreciation
and
  amortization


(5,816
)

(4,434
)Total

$
108,155

$
18,51720

Accrued
and Other Current Liabilities

Accrued and
other current liabilities at September 30, 2004 and December 31, 2003 included
employment and severance benefit accruals of $2.5 million and $2.9 million,
respectively, and customer deposits of $1.4 million and zero, respectively.

6. Non-current
Obligations

In April 2002, Celltrion purchased land from Incheon Metropolitan City
for 14,501 million Korean Won (equivalent to $11.0 million)
(Land Purchase Agreement).  Of this amount, 13,051 million Korean Won
(equivalent to $9.9 million) was
financed through Incheon Metropolitan City over a period of 10 years.  Interest accrues at 4% annually and is
payable together with five principal payments, which are scheduled to be paid
every two years starting on April 1, 2004.
Interest is capitalized as part of construction in progress during
construction of the facility and other buildings.

In January 2003, Celltrion obtained secured long-term financing of
52,000 million Korean Won (equivalent to $44.2   million) with a nine-year term from a Korean bank (Loan).  Funds from
the Loan are to be used for
construction of the Incheon administration buildings and manufacturing
facility.  As construction progresses,
the bank funds 60% of the progress payments (up to 52,000 million Korean Won),
while Celltrion pays the remaining 40%.
Celltrions land and construction in progress represent collateral for
the outstanding Loan balance.  There are
no significant financial covenants in the Loan agreements.  As of September 30, 2004, the carrying
amounts for land and construction in progress were 15,033 million Korean Won
and 84,146 million Korean Won (equivalent to $13.1 million and $73.0 million), respectively.  At
September 30, 2004, Celltrion had unused commitments related to the Loan of
8,699 million Korean Won (equivalent to $7.6 million).
Only interest payments are due monthly for the first four years of the
Loan term, and principal and interest payments are due monthly for the
remaining five years of the Loan term.
Interest is adjusted quarterly, based on a 3-month Korean certificate of
deposit rate plus 1.5% (interest rate of 5.4% at September 30, 2004).  Cash outlays for interest on borrowings
related to this loan totaled $0.5 million and $1.3 million for the three and nine months ended
September 30, 2004, respectively.

The following is a U. S. dollar summary of non-current obligations (in
thousands, presented at September 30, 2004 exchange rates):

September 30,
  2004Land
  purchase obligation

$
9,070Less:
  current portion


Non-current
  land purchase obligation


9,070Construction
  loan


37,618Sub-total


46,688Accrued long-term interest


180Non-current obligations

$
46,868In addition, the Korean bank from which Celltrion obtained the Loan
guarantees Celltrions outstanding balance under the Land Purchase
Agreement.  As a result, Celltrion pays
the bank an annual guarantee fee of 1% of the outstanding land purchase
balance.

For all
non-current obligations, interest of $0.7 million and $1.7 million was capitalized for the three and nine
months ended September 30, 2004, respectively.
All capitalized interest is included in the cost basis of the buildings
during construction.  No significant
interest has been expensed by Celltrion since its inception.

Principal payments due for
current and non-current obligations as of September 30, 2004 are as follows (in
thousands, presented at September 30, 2004 exchange rates):

2004

$
2005


2,2672006


5,0152007


9,7912008


7,5232009
  and beyond


22,092Total

$
46,68821

7. Minority Interest in Variable
Interest Entity

In order to
build and operate the Incheon manufacturing facility, Celltrion received an
in-kind investment by VaxGen of cell culture technology and production support.  In 2002, Celltrion entered into a License
Agreement, an AIDSVAX Supply Agreement and a Consulting Agreement with
VaxGen.   In addition, at the inception
of Celltrion, VaxGen received 7.8 million shares of Celltrions common stock
valued at 6,224 Korean Won per share (equivalent to $4.71 per share).

During
2002, Celltrion sold 7,670,000 shares of preferred stock at a price of 5,000
Korean Won per share (equivalent to $3.78 per share), resulting in gross
proceeds of $29.0 million and sold 455,000 shares of preferred stock at a price
of 22,775 Korean Won per share (equivalent to $18.82 per share), resulting in
gross proceeds of $8.6 million. During 2003, Celltrion sold 390,000 shares of
preferred stock at a price of 22,348 Korean Won per share (equivalent to $18.78
per share), resulting in gross proceeds of $7.3 million. As of September 30,
2004, VaxGen owned 7.8 million shares of Celltrion common stock, representing a
46% voting interest.

Celltrions
preferred stock gives the preferred stockholders the right to 100% cumulative
dividends from potential profits from the production of AIDSVAX.  Preferred shares are required to convert
into Celltrion common shares at a ratio of 1:1 upon the cancellation of the
Supply Agreement between VaxGen and Celltrion or the thirteenth year of the
joint venture.  The Supply Agreement can
be cancelled by VaxGen with 30 days written notice or by either party in the
event of a material breach of the contract.

Under the Korean Commercial Code,
in order for a corporation to be able to pay dividends, it must have
distributable profits.  Celltrion did
not accrue any preferred stock dividends during the period from its inception
through September 30, 2004 as it incurred losses and did not have distributable
profits.  In the event that there are
distributable profits, holders of the preferred stock shall be entitled to a
dividend preference on a cumulative basis so that any preferred dividend not
paid in a given year will be forwarded to succeeding years as an outstanding
obligation of Celltrion until paid off. All Celltrion preferred and common
shares have equal voting rights.

As a result of consolidating
Celltrion, the Company has a minority interest balance of $25.1 million in the
unaudited condensed consolidated balance sheet at September 30, 2004, which
represents the equity interests of Celltrions preferred stockholders based on
voting interest. This amount is less than the carrying cost of the preferred
stockholders investment by $22.7 million at September 30, 2004 because
VaxGens investment in Celltrion was a non-monetary transaction which was
eliminated upon the consolidation of VaxGen and Celltrion.

8. Equity Transactions

Warrants
Issued By Celltrion

On
April 13, 2004, Celltrion granted warrants to all of its existing stockholders
to acquire a total of 4.0 million shares of its convertible preferred
stock.   The exercise price was 5,000
Korean Won ($4.38 equivalent) per preferred share.  The exercise period was April 13, 2004 to December 31, 2004 (First
Tranche).

Under
the terms of the First Tranche, if the then-existing stockholders of Celltrion
did not subscribe for all of the shares in the First Tranche (Unsubscribed
Shares), the Celltrion Board of Directors would dispose of the Unsubscribed
Shares as follows:  (a) stockholder JS
could purchase the same percent of the Unsubscribed Shares as JSs percentage
ownership in Celltrion as of April 13, 2004; and  (b) stockholders Nexol or Nexol Co would then be allowed to
subscribe for any remaining Unsubscribed Shares.   Under the terms of the First Tranche, stockholders were required
to notify Celltrion by May 30, 2004 stating that they would exercise their
Celltrion Warrants before the December 31, 2004 expiration date. Otherwise, the
First Tranche was forfeited and under the terms of the First Tranche, such
Unsubscribed Shares would be made available to the other stockholders for
purchase prior to December 31, 2004.  As
a result of the notices, all of the Unsubscribed Shares were allocated to Nexol
and Nexol Co.

On
July 14, 2004, Celltrion granted warrants to all of its existing stockholders
to acquire a total of 2.0 million shares, of its convertible preferred
stock.   The exercise price was 5,000
Korean Won ($4.34 equivalent) per preferred share.  The exercise period was January 1, 2005 to December 31, 2005
(Second Tranche).

22

On
July 14, 2004, VaxGen and the Korean Investors amended the JVA that formed
Celltrion (Amended JVA).  Pursuant to
the Amended JVA, Celltrions Board of Directors approved the First Tranche and
the Second Tranche (collectively, Celltrion Warrants).  Under the terms of the Second Tranche, if
the then-existing stockholders of Celltrion did not subscribe for all of the
shares in the Second Tranche, such Unsubscribed Shares would be sold to Nexol
or Nexol Co.  VaxGen, KT&G and JS
were given a priority right over Nexol to purchase the Unsubscribed
Shares.

In accordance with EITF
Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Companys Own Stock, Celltrion recorded the
Celltrion Warrants as a deemed dividend with offsetting charges to additional
paid-in capital for their fair value as determined using the Black-Scholes
Model. Using the Black-Scholes Model, the fair value of the First Tranche was
determined to be $25.5 million and the fair value of the Second Tranche was
determined to be $13.8 million.

To determine the fair value
of the Celltrion Warrants at the date of grant, Celltrion utilized the
following assumptions (no expected dividends):

First Tranche


Second TrancheRisk-free interest rate


4.88%


4.47%Expected average life


0.72 year


1.47 yearExpected volatility


41.92%


43.27%The following
is a summary of Celltrion
Warrants outstanding at September 30, 2004:

Exercise Price

Term
  (in months)

SharesFirst
  Tranche,
  April 13, 2004

5,000
  Korean Won
  ($4.34 equivalent)

7.5

3,306,500Second
  Tranche,
  July 14, 2004

5,000
  Korean Won
  ($4.34 equivalent)

17.5

2,000,000Celltrion
Preferred Stock

In May 2004,
Celltrion issued 693,500 shares of its convertible preferred stock under the
First Tranche at a price of 5,000 Korean Won ($4.28 equivalent) per share,
resulting in net proceeds of 3,447 million Korean Won($3.0 million equivalent). Daewoo
purchased 63,745 of these shares and another vendor purchased 16,083 shares.

Celltrions
preferred stock gives the preferred stockholders the right to 100 % cumulative
dividends from Celltrions potential profits from the production of
AIDSVAX.  Celltrion preferred shares are
convertible into Celltrion common shares at a ratio of 1:1, upon the earlier of
the cancellation of the Supply Agreement between VaxGen and Celltrion or the
thirteenth year of the JVA.  No
dividends were paid by Celltrion through September 30, 2004. The Supply
Agreement can be cancelled by VaxGen with 30 days written notice or by either
party in the event of a material breach of the contract that is
unresolved.  All Celltrion preferred and
common shares have equal voting rights.

Beneficial
Conversion Features

At
the date of issuance of the 2004 Celltrion preferred stock, Celltrion recorded
a BCF for the fair value of the underlying Celltrion common stock in excess of
the Celltrion preferred stock purchase price (equivalent to conversion price)
with the maximum ceiling of the cash proceeds received for the preferred stock
issuance.  Celltrion applied the
intrinsic value method in measuring the BCF in the conversion option in
accordance with EITF 00-27. The 10,252 million Korean Won ($9.0 million
equivalent) BCF is being amortized over the period from issuance to the 13th
year of the JVA.  Celltrions accounting
for its preferred stock and BCF is reflected as changes in the minority
interest in variable interest entity in the accompanying condensed consolidated
balance sheet.

23

9. Series A Warrants

The terms of
the 2001 Series A Mandatorily Redeemable Convertible Preferred Stock (Series A
Preferred Stock) and warrants (Series A Warrants) include registration
rights and put features not under the Companys control. These features are
considered to be an embedded derivative liability and the Company determined
the fair value of this derivative to be $3.9 million on the date of issuance.
The Company did not file its Quarterly Report on Form 10-Q for the quarter
ended March 31, 2004 by the extended filing deadline of May 17, 2004.  As a result, the Companys registration
statement on Form S-3 covering the resale of 655,078 shares of common stock
issuable upon exercise of the Series A Warrants was suspended.  Pursuant to the suspension of the
registration statement, the Series A Warrants became redeemable for cash at the
option of the Series A Warrant holders and the Company became liable for
monthly cash penalty payments to the Series A Warrant holders.  During the three and nine months ended
September 30, 2004, the Company paid $0.5 million and $0.8 million, respectively,
in cash penalty payments to the holders of the Series A Warrants.

On September
21, 2004, the Company completed transactions in which the Series A Warrants
were surrendered in exchange for two new series of warrants (Exchange
Warrants).  The Company issued to the
holders of the Series A Warrants, Exchange 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 Exchange 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 ($16.00 Warrants).  In connection with the exchange, the
agreements governing the Series A Warrants were terminated.  As a result of the surrender and exchange of
the Series A Warrants, the Company is no longer subject to monthly cash penalty
payments and the holders of the Exchange Warrants do not have cash redemption
rights related to the Exchange Warrants.

Multiple
features are embedded in the Companys Series A Preferred Stock and Series A
Warrants. These embedded derivatives have been valued using the Monte Carlo
fair value methodology. The Company completed the valuation of two put options
embedded in the Series A Preferred Stock, one put option embedded in the Series
A Warrants and the expected payment of liquidated damages to the Series A
Preferred Stock and Series A Warrant holders upon certain triggering events
described above. The Monte Carlo 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.

The key inputs
for the valuation analysis of these embedded derivatives at the date of the
exchange for the Exchange Warrants were volatility of 121% and a risk free
interest rate of 2.37%. The key inputs for the valuation analysis of the $0.01
per share Exchange Warrants were volatility of 90% and a risk free interest
rate of 1.80%. The key inputs for the valuation analysis of the $16.00 Exchange
Warrants were volatility of 109% and a risk free interest rate of 2.82%.

The valuation
of the embedded derivatives associated with the Series A Warrants at the date
of the exchange for the Exchange Warrants was $14.4 million and the valuation of
the Exchange Warrants was $18.8 million.
The $4.4 million difference in value is included as other expense in the
statement of operations for the three and nine months ended September 30, 2004
and the $18.8 million value of the Exchange Warrants was recorded as an
increase in additional paid-in capital.

Due to the
quarterly revaluation of the embedded derivative liability, the Company
recorded in the statements of operations other income of $1.7 million and other
expense of $0.8 million for the three months ended September 30, 2004 and 2003,
respectively; and other expense of $8.8 million and other income of $0.3
million for the nine months ended September 30, 2004 and 2003,
respectively.  At September 30, 2004, the
embedded derivative liability was valued at zero due to the issuance of the
Exchange Warrants and the conversion of all of the outstanding Series A
Preferred stock.

10. Related Party
Transactions

In December 2002, Celltrion
engaged Daewoo Engineering and Construction Co., Ltd. (Daewoo) to manage the
construction of the Incheon manufacturing facility and administration
buildings.  In January 2003, Daewoo
purchased 260,000 shares of Celltrions preferred stock at a price of 22,348
Korean Won per share (equivalent to $18.78 per share). At the time of this
purchase, Nexols and Celltrions Chief Executive Officer, who are the same
person, entered into a purchase agreement with Daewoo.  Per the terms of this purchase agreement,
upon the completion of the construction of Celltrions facility, Daewoo would
sell these shares to Nexol at the original purchase price.  Celltrions Chief Executive Officer
guaranteed this agreement.  At September
30, 2004, 1,007

24

million Korean
Won (equivalent to $0.9 million) is included in other non-current assets
representing the remaining balance of advance payments made to Daewoo.
Additionally, Celltrion had outstanding accounts payable due to Daewoo of $6.9
million as of September 30, 2004. During the three and nine months ended
September 30, 2004, Celltrion paid Daewoo $2.9 million $16.5 million,
respectively, related to the construction of the Incheon facilities. Celltrion
was not consolidated with VaxGen as of or during the year ended December 31,
2003.

11. Income Taxes

The Company has reported no
income tax benefits due to limitations on the recognition of deferred tax
assets for financial reporting purposes. Based on the weight of available
evidence, including cumulative losses since inception and expected future
losses, the Company has determined that it is more likely than not that the
entire deferred tax asset amount will not be realized and, therefore, a
valuation allowance has been provided on net deferred tax assets.

The tax
effects of temporary differences and carryforwards that give rise to deferred
tax assets are as follows (in thousands):

September 30,
  2004

December 31,
  2003Deferred tax
  assets:Net operating
loss carryforwards

$
46,585

$
38,546Research and
other credit carryforwards


8,492


5,345Deferred
research expenses


1,142


1,447Depreciation


2,560


1,818Accrued
liabilities


735


540Other


(1,500
)

(669
)Total gross
deferred tax assets


58,014


47,027Less:
  Valuation allowance


(58,014
)

(47,027
)Net deferred
tax assets

$


$
The differences between the
U.S. statutory tax rate and the Companys effective tax rate are as follows:

Three
        Months Ended
        September 30,
    
    Nine
        Months Ended
        September 30,2004
    
    2003(Restated)
    
    2004
    
    2003(Restated)Statutory
        rate
    
    
    34.0
    %
    
    34.0
    %
    
    34.0
    %
    
    34.0
    %Equity
        in loss of affiliate
    
    
    0.0
    
    
    (2.2
    )
    
    0.0
    
    
    (12.8
    )Valuation
        adjustments
    
    
    (11.2
    )
    
    (15.4
    )
    
    (15.8
    )
    
    5.3Equity-based
        compensation expense
    
    
    (0.4
    )
    
    (0.5
    )
    
    (0.3
    )
    
    (0.6
    )Research
        and other credits
    
    
    7.5
    
    
    0.4
    
    
    6.5
    
    
    0.5Exemption
        for foreign ownership
    
    
    (0.6
    )
    
    
    
    
    (1.4
    )
    
    Change
        in foreign tax rates
    
    
    
    
    
    
    
    
    (0.2
    )
    
    Foreign
        tax rates less than statutory rate
    
    
    (0.1
    )
    
    
    
    
    (0.4
    )
    
    Other
    
    
    1.9
    
    
    (0.2
    )
    
    1.7
    
    
    (0.7
    )Change
        in valuation allowance
    
    
    (31.1
    )
    
    (16.1
    )
    
    (24.1
    )
    
    (25.7
    )Effective
        tax rate
    
    
    0.0
    %
    
    0.0
    %
    
    0.0
    %
    
    0.0
    %At September
30, 2004, VaxGen had U.S. federal and California net operating loss
carryforwards of $118 million and $97 million, respectively. The U.S. federal
and California net operating loss carryforwards expire from 2015 through 2024
and from 2005 through 2014, respectively. Additionally, as of September 30,
2004, VaxGen has federal research credits, expiring from 2015 through 2024, of
$3.7 million and State of California research credits, carrying forward indefinitely,
of $3.0 million. These carryforwards could be subject to certain limitations in
the event there is a change in control of VaxGen.

25

As of
September 30, 2004, Celltrion had net operating losses for Korean tax purposes
of 6,821 million Korean Won (equivalent to $5.9 million). The carryforwards
expire from 2007 to 2009. Additionally, Celltrion has various tax credit
carryforwards, expiring from 2007 to 2010, totaling 3,266 million Korean Won
(equivalent to $2.8 million) at September 30, 2004. These carryforwards could
be subject to certain limitations in the event there is a change in control of
Celltrion. Celltrion is exempt from paying the annual property tax on 100% of
the share of its building and land related to foreign investment through 2007
and 50% of the share of foreign investment for three years thereafter. In
addition, Celltrion will receive tax holidays related to the share of income
tax related to foreign investment, once it begins earning income or 5 years
after Celltrion was granted the tax holiday, whichever occurs first. The tax
holiday will equal 100% of VaxGens foreign investment share of Celltrions
income taxes from 2002 through 2009, and 50% of the foreign investment share
for three years thereafter. Benefits received based upon foreign investment
shares are subject to change based upon subsequent changes in the foreign
investment as a percentage of total ownership.

12. Comprehensive
Loss

Comprehensive
loss combines net 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 loss consists of the following (in thousands):

Three
        Months Ended
        September 30,
    
    Nine
        Months Ended
        September 30,2004
    
    2003(Restated)
    
    2004
    
    2003(Restated)Net
        loss
    
    $
    (10,832
    )
    $
    (7,822
    )
    $
    (36,923
    )
    $
    (17,320
    )Other
        comprehensive income (loss):Foreign
        currency translation adjustments
    
    
    10
    
    
    1,203
    
    
    84
    
    
    979Unrealized
        gains on available-for-sale securities
    
    
    49
    
    
    (21
    )
    
    (38
    )
    
    (267
    )Other
        comprehensive income (loss)
    
    
    59
    
    
    1,182
    
    
    46
    
    
    712Comprehensive
        loss
    
    $
    (10,773
    )
    $
    (6,640
    )
    $
    (36,877
    )
    $
    (16,608
    )The Companys
accumulated other comprehensive income balance consists of the following (in
thousands):

September
  30, 
  2004

December
  31, 2003Foreign
  currency translation adjustments

$
3,697

$
3,613Unrealized
  gains on available-for-sale securities


(31
)

7Accumulated
  other comprehensive income

$
3,666

$
3,62013. Commitments and
Contingencies

In December
2002, Celltrion entered into an engineering, procurement and construction
agreement (Construction Agreement) with Daewoo pursuant to which Daewoo
agreed to engineer and construct Celltrions Incheon facility. The cost under
the Construction Agreement is estimated to be 47,400 million Korean Won plus
25.7 million Swiss francs, which in the aggregate was the equivalent of $56.8
million in December 2002, subject to certain exceptions for change orders and
changed circumstances such as force majeure and changes in law. Celltrion may
terminate the Construction Agreement and pay only for services rendered.
Amounts due under the Construction Agreement are paid by Celltrion based on
monthly invoicing and achievement of specified milestone events.

In July 2003, Celltrion
obtained a letter of credit amounting to $7.0 million for the construction of
facilities from the National Agricultural Cooperative Federation. During the
three months ended September 30, 2004, this letter of credit was reduced to
$5.0 million. Celltrion had an unused commitment related to the letter of
credit of $3.7 million as of September 30, 2004.

26

In January
2004, Celltrion entered into a consulting agreement with a third party for
business development services (Consulting Agreement) totaling $1.0 million.
Thirty percent of the fee is due upon the successful execution of a Letter of
Intent with a prospective biopharmaceutical client. An additional 30% of the
fee is payable within one month following the successful execution of a
definitive agreement with the biopharmaceutical client, and the remaining 40%
of the fee is payable within two months following the successful execution of
such an agreement.

Substantially
all of the Companys revenue is derived from government contracts and grants.
Future sales to U.S. government agencies will depend, in part, on the Company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 the Company either for its
convenience or if the Company 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 the U.S. government for damages or to
sub-contractors, service providers or vendors for goods and services that may
no longer be reimbursable by the U.S. government. See Subsequent Events in Note
16.

14. Legal Proceedings

On
March 17, 2003, a civil complaint for violation of Sections 10(b) and 20(a) of
the Securities Exchange Act of 1934 was filed in the United States District
Court for the Northern District of California, entitled Janice Whitkens v.
VaxGen, Inc., et al., Civil Action No. C03-1129 JSW. Named, as defendants are
VaxGen, Inc., Chief Executive Officer Lance K. Gordon and former President Donald
P. Francis. The plaintiff seeks to represent a class of persons who purchased
the Companys securities between August 6, 2002 and February 26, 2003, and
alleges that the defendants misled investors about the progress of certain
clinical trials and the Companys future manufacturing and marketing plans.
Following the filing of the Whitkens complaint, several additional class action
complaints were filed in the same court, each making identical or similar
allegations against the same defendants. As of September 30, 2004, the Company
believed that it had strong defenses and intended to defend these actions
vigorously. See Resolution of Class Action Suit and Derivative Suitin Subsequent
Events in Note 16.

On or about
March 21, 2003, two separate but virtually identical shareholder derivative
actions were filed in California Superior Court for San Mateo County entitled
Rhodes v. Allen, et al. civil action No. CIV 430087, and MacDonald v. Allen, et
al., civil action No. CIV 430088. A consolidated complaint was filed in June
2003. Named as defendants in the action are VaxGen directors Lance K. Gordon,
Randall L-W. Caudill, and William D. Young, and former VaxGen directors Donald
P. Francis, Phillip W. Berman, David W. Beier, and Stephen C. Francis (Company
Directors). Also named as defendants are Paul Allen and Vulcan Ventures, Inc.
(Vulcan Defendants). The allegations of the consolidated complaint
(Derivative Lawsuit) are similar to those contained in the class action,
although unlike the class action, in the Derivative Lawsuit the plaintiff
purports to seek recovery on behalf of VaxGen, rather than from VaxGen.
Plaintiffs allege as well that the Vulcan Defendants sold shares of the
Companys stock while in possession of material non-public information about
the Company. Plaintiffs, purportedly suing on behalf of VaxGen, assert claims
against all defendants for breach of fiduciary duty, mismanagement, waste and
unjust enrichment and against the Vulcan Defendants for breach of fiduciary
duty and insider trading. As of September 30, 2004, the Company has provided
$0.5 million for the settlement of these derivative actions. See Subsequent
Events in Note 16.

The Company is
subject to a wide variety of laws and regulations relating to land use and
development and to environmental compliance and permitting obligations,
including those related to the use, storage, discharge, emission and disposal
of hazardous materials. Certain claims, suits and complaints in the ordinary
course of business are pending or may arise. While there can be no assurance as
to the ultimate outcome of any litigation involving the Company, the Company
does not believe any pending legal proceeding will result in a judgment or
settlement that would have a material adverse effect on the Companys
consolidated financial position, results of operations or cash flows.

27

15. Segment
Information

The Companys
segment information has been prepared in accordance with FAS No. 131, Disclosures
about Segments of an Enterprise and Related Information. Accounting
policies of the segments are the same. Upon consolidation, all intercompany
accounts and transactions are eliminated. Prior to January 1, 2004, the Company
operated in one business segment. As a result of the consolidation of
Celltrion, effective January 1, 2004, the Company operates in two business
segments. VaxGen operates in one business segment, the development of vaccines
that immunize against infectious disease, and Celltrion operates in another,
mammalian cell culture biomanufacturing. Each segment has discrete financial
information and its own management structure.

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, the
National Institutes of Health and related entities. From its inception through
September 30, 2004, Celltrion had not been operational or earned any revenues.
All of VaxGens operating assets are located in the United States of America.
Celltrions operating assets are located in the Republic of Korea.

Information
regarding the segments is stated below (in thousands):

Three Months Ended 
  September 30,

Nine Months Ended
  September 30,Revenues

2004

2003

2004

2003VaxGen

$
7,346

$
6,918

$
22,666

$
13,840Celltrion





n/a





n/aEliminations


(92
)

n/a


(358
)

n/aTotal

$
7,254

$
6,918

$
22,308

$
13,840Three Months Ended 
  September 30,

Nine Months Ended
  September 30,Depreciation and Amortization

2004

2003

2004

2003VaxGen

$
404

$
264

$
1,150

$
857Celltrion


456


n/a


1,338


n/aEliminations


(407
)

n/a


(1,217
)

n/aTotal

$
453

$
264

$
1,271

$
857Three Months Ended 
  September 30,

Nine Months Ended
  September 30,Equity in Loss of Affiliate

2004

2003

2004

2003VaxGen (in Celltrion)

$
(191
)
$
510

$
(1,623
)
$
(6,510
)Celltrion (in VCI)


(130
)

n/a


(657
)

n/aEliminations


321


n/a


2,280


n/aTotal

$


$
510

$


$
(6,510
)Three Months Ended 
  September 30,

Nine Months Ended
  September 30,Net Loss

2004

2003

2004

2003VaxGen

$
(11,333
)
$
(7,822
)
$
(37,310
)
$
(17,320
)Celltrion


(713
)

n/a


(3,764
)

n/aEliminations


1,214


n/a


4,151


n/aTotal

$
(10,832
)
$
(7,822
)
$
(36,923
)
$
(17,320
)28

Property, Plant and Equipment, net

September
  30, 
  2004

December
  31,
  2003VaxGen

$
21,299

$
18,517Celltrion


87,001


n/aEliminations


(145
)

n/aTotal

$
108,155

$
18,517Investment in Affiliate

September
  30, 
  2004

December
  31,
  2003VaxGen (in Celltrion)

$
32,938

$
34,561Celltrion (in VCI)


5,190


n/aEliminations


(38,128
)

n/aTotal

$


$
34,561Total Assets

September
  30, 
  2004

December
  31,
  2003VaxGen

$
76,362

$
94,464Celltrion


132,798


n/aEliminations


(71,745
)

n/aTotal

$
137,415

$
94,464Three Months Ended 
  September 30,

Nine Months Ended 
  September 30,Purchases of Property and
  Equipment

2004

2003

2004

2003VaxGen

$
(1,632
)
$
(3,069
)
$
(3,932
)
$
(12,169
)Celltrion


(6,276
)

n/a


(24,735
)

n/aEliminations





n/a





n/aTotal

$
(7,908
)
$
(3,069
)
$
(28,667
)
$
(12,169
)16. Subsequent Events

SNS
Contract

In November
2004, the Office of Public Health Emergency and Preparedness (OPHEP) awarded
VaxGen a contract valued at $877.5 million to provide 75 million doses of
rPA102 to the U.S. governments Strategic National Stockpile (SNS) for civilian defense (SNS
Contract). The SNS Contract
called for VaxGen to provide 25 million doses of its rPA anthrax vaccine to the
SNS within two years of the award and a total of 75 million doses within three
years.

In November
2006, VaxGen received a clinical hold notification from the FDA that postponed
the initiation of the second Phase 2 trial for its investigational anthrax
vaccine, rPA102. In December 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.

29

Under the
terms of the SNS Contract, and as is typical in government contracting, HHS
reserved its right to hold VaxGen liable for any excess costs of procuring an
anthrax vaccine. HHS has given VaxGen no indication of whether it will exercise
this right. According to the Federal Acquisition Regulation, the government
could be entitled to recover excess costs if HHS procured the same or similar
anthrax vaccine from another contractor; however, the Company does not believe
such an amount is estimable. VaxGen is actively exploring its strategic and
legal alternatives. VaxGen has the right to appeal the termination and any
government claim for excess costs associated with the procurement of an
alternative anthrax vaccine.

Restructuring

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 and costs associated with consolidation of its facilities in
California. Estimated costs of the related termination benefits are $3.0
million to $3.5 million; estimated facilities-related costs are $0.7 million to
$1.2 million.

Equity
Financings

In
November 2004, VaxGen raised net proceeds of $37.5 million through the private
placement of 3 million shares of common stock at $13.25 per share to a group of
accredited institutional investors. In February 2006, VaxGen raised net
proceeds of $25.3 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. In connection with the February 2006 financing, VaxGen also issued
to the investors five-year warrants initially exercisable to purchase 700,000
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 January 31, 2007, the warrants became
exercisable for an additional 700,000 shares of common stock, at a price of
$9.24 per share.

As
part of the November 2004 and February 2006 private placements, 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 Exchange Act of 1934. The registration for resale applies to the
common stock issued in both transactions as well as 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.

Exchange
Warrants

The
$0.01 per share Exchange Warrants were exercised by the end of January 2005. In December 2006, the Company entered into
an addendum (Addendum) with the holders of the $16.00 Warrants under which
the term of these warrants was extended by three additional years. The $16.00
Warrants, as amended, will expire September 21, 2010 instead of September 21,
2007. No other terms of the $16.00 Warrants were amended. In connection with
entering into the Addendum, the Company received releases from the holders of
the $16.00 Warrants regarding potential claims related to these warrants.

30

Convertible
Senior Subordinated Notes

In
April 2005, the Company raised aggregate net proceeds of $31.5 million through
a private placement of 5-1/2% Convertible Senior Subordinated Notes (Notes)
due April 1, 2010. The Notes require semi-annual payments of interest in cash
at a rate of 5-1/2%; convert, at the option of the holder, into the Companys
common stock at an initial conversion price of $14.76 per share subject to
adjustment; convert, at the Companys option, into common stock if the
Companys common stock reaches a price of $22.14 per share; will be
provisionally redeemable at the Companys option for a redemption price of 100% of the principal amount of the Notes
to be redeemed, plus accrued and unpaid interest, plus an interest make-whole
payment, under certain circumstances, including among others, that the closing
price of the Companys common stock has exceeded $22.14 per share, subject to
adjustment, for at least 20 trading days within a period of 30 consecutive
trading days; and constitute senior subordinated obligations of the Company.
The Company, at its own option, may redeem the Notes for face value plus
accrued interest and an interest make-whole payment. If there shall have
occurred on or prior to the stated maturity of the Notes a change in control,
the holders of the Notes may require the Company to repurchase the Notes and
pay a make-whole premium to the holders of the Notes.

Obligation
to Register Shares

Pursuant to the Notes, the
Company has agreed to register the shares issuable upon conversion of the Notes
for resale under the Securities Act of 1933, as amended (Securities Act). The
Company has agreed to file with the SEC a registration statement (Registration
Statement) with respect to these shares no later than thirty days following
(Filing Date) the first date it becomes current in its reporting requirements
under the Securities and Exchange Act of 1934 and to use its best efforts to
cause the Registration Statement to become effective on or before the date that
is the earlier of (1) in the event of no review by the SEC no later than
90 days after the Filing Date, (2) in the event of a review by the SEC, no
later than 120 days after the Filing Date (the earlier of (1) and (2),
Required Effective Date).

The Company will be liable
for liquidated damages under the following circumstances (Defaults):


if the Registration
  Statement is not filed on or before the Filing Date;
if the Registration
  Statement is not declared effective by the SEC on or prior to the Required
  Effective Date; or
if the Registration
  Statement (after its effectiveness date) ceases to be effective in certain
  circumstances.In the event
of a Default, the Company shall pay as liquidated damages, for each 30-day
period of a Default, an amount in cash equal to 1% of the principal amount of
the Notes until the applicable failure has been cured. The liquidated damages
payable under the Stock Purchase Agreement will apply on a pro rata basis for
any portion of a 30-day period of a Default.

Amended
Facilities Lease

Between
February 2004 and February 2005, VaxGen amended its lease agreement to expand
its office space by approximately 20,000 square feet. On April 14, 2005, VaxGen
entered into an amended lease agreement to secure space to support the
production of its recombinant anthrax vaccine candidate as well as its other
programs. This space, which totals 105,000 square feet, will be used for
manufacturing, quality assurance, quality control, research and development and
other functions. The amended lease replaces VaxGens previous sublease for
approximately 50,000 square feet and previous leases of approximately 20,000
square feet. It also provides an additional 35,000 square feet of new space.
This lease terminates in December 2016; however, VaxGen has options to renew
the lease for two additional five-year periods. In connection with the amended
lease agreement, an amended letter of credit in the amount of $2.4 million was
issued to the lessors. The letter of credit is collateralized by a certificate
of deposit held by the bank that issued the letter of credit. In addition, the
amended lease agreement provides for up to $2.2 million in reimbursements for
the costs of certain tenant improvements. VaxGen billed for and received the
full $2.2 million in reimbursements.

31

Per the terms
of the amended lease agreement, VaxGens future minimum annual payments under
operating lease obligations will increase as follows:

September
        30,
        2004
    
    Increase
        
        due to 
        Amendment
    
    Adjusted
        Payments2004
    
    $
    725
    
    $
    
    
    $
    7252005
    
    
    2,847
    
    
    425
    
    
    3,2722006
    
    
    2,687
    
    
    1,185
    
    
    3,8722007
    
    
    1,930
    
    
    1,296
    
    
    3,2262008
    
    
    1,236
    
    
    1,554
    
    
    2,7902009
        and beyond
    
    
    
    
    
    31,435
    
    
    31,435Total
    
    $
    9,425
    
    $
    35,895
    
    $
    45,320Resolution
of Class Action Suit and Derivative Suit

In
May 2005, the United States District Court for the Northern District of
California dismissed with prejudice the class action lawsuit (No. C03-01129
JSW) filed against the Company in March 2003.

The Company
settled the shareholders derivative lawsuit that had been filed following the
February 2003 announcement by the Company of clinical trial results relating to
its AIDSVAX product. Under the terms of the settlement, the Company paid $0.5
million to the derivative plaintiffs to cover attorneys fees and agreed to
make certain changes in its disclosure practices and procedures. The court
approved the settlement in September 2005.

2003
Anthrax Contract

In December 2004, NIAID
notified the Company of its intent to terminate, for its convenience, a portion
of the 2003 Anthrax Contract and redirect 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 the Company had subcontracted to a fill/finish service provider. In
March 2006, the Company agreed to pay this service provider $1.5 million for
costs relating to the termination of the subcontract, which are not
reimbursable under the terms of the Companys contract with NIAID.

In 2006, the
Company completed the manufacturing scale-up and one Phase 2 trial and process
validation in connection with the 2003 Anthrax Contract.

Other

On August 8,
2005, at a special meeting of stockholders, the stockholders of the Company
approved an amendment to the Companys Amended and Restated Certificate of
Incorporation to increase the authorized number of shares of common stock from
40 million shares to 65 million shares.

In September
2005, the Compensation Committee of the Companys Board of Directors approved a
contingent bonus program for employees participating in the Companys
employee stock purchase plan (ESPP). Under this program, a bonus would
be payable to ESPP participants in the event the ESPP was
terminated by the Company. In November 2005, the Company terminated the
ESPP and the bonus therefore became payable. Payment of this bonus was
contingent upon the successful completion of a financing subsequent to the
termination of the ESPP and was available only to individuals who were
employees of the Company at the time of the bonus payment. Accordingly, in
November 2005, the Company recorded an expense of $3.2 million for the
estimated cost of this bonus program. In the first quarter of 2006, the Company
paid employees in satisfaction of this bonus program.

Agreements
between VaxGen and Celltrion

The Celltrion joint venture
agreement (JVA) was amended by VaxGen and the Korean Investors (Revised
JVA) on December 30, 2004. Under the terms of the Revised JVA, Celltrion is
managed by a Board of Directors comprised of six individuals. VaxGen and Nexol
both hold two seats on the Celltrion Board and are entitled to appoint a senior
executive officer (Representative Director) of Celltrion. VaxGen may continue
to hold these two seats on the Board and appoint a Representative Director so
long as it retains 66-2/3% of its initial shareholdings in Celltrion. The laws
of the Republic of Korea govern the Revised JVA.

32

On December 30, 2004, VaxGen
and the Korean Investors also executed a Termination Agreement, which provided
for the termination of the Supply Agreement, the License Agreement and the
Sub-License Agreement. Celltrion has the right to continue to use certain
technology previously transferred to it by VaxGen and may purchase future
technical support and certain services from VaxGen under a Technical Support
and Services Agreement, which was also executed on December 30, 2004.

In addition, per the terms
of the Revised JVA and as a result of termination of the Supply Agreement, all
outstanding Celltrion preferred stock converted into Celltrion common stock;
however, since there were insufficient shares of authorized Celltrion common
stock available at the time, the conversion did not become effective until 2005
when Celltrions stockholders approved an increase in the number of authorized
shares. No dividends were paid to the holders of Celltrion preferred stock.

Also on December 30, 2004,
VaxGen and the Korean Investors executed the Surrender Agreement. This
agreement, which was amended on March 7, 2005, provides for the return to
Celltrion of two million shares of Celltrion common stock held by VaxGen and
281,005 shares held by one of the Korean Investors. This agreement was approved
by Celltrions stockholders in March 2005 and became effective in May 2005.

In addition, and also on
December 30, 2004, VaxGen exercised its right to acquire all of Celltrions
shares of VCI for $7.7 million, making VaxGen the sole stockholder in VCI.

VaxGen and Celltrion entered
into a Technical Support and Services Sub-Agreement (Sub-Agreement) effective
in June 2005. The Sub-Agreement provides for VaxGen to assist Celltrion with
services required under the Bristol-Myers Squibb Company agreement discussed
below. Under the Sub-Agreement, VaxGen will be paid for out-of-pocket expenses
and services rendered.

In July 2005, VaxGen
participated in a round of fund-raising with the Korean Investors and Celltrion
and purchased from Celltrion 239,068 shares of common stock for $1.2 million.

In September 2005, VaxGen
entered into an agreement to raise $15.1 million in gross proceeds through the
sale of 1.2 million of its shares in Celltrion to a group of Korean investors.
In 2005, VaxGen received $12.4 million of the gross proceeds from the
transaction. VaxGen received the remaining proceeds in the first quarter of
2006. Nexol Co purchased 250,000 of these shares. Subsequent to this
transaction, Nexol and its related parties became the largest stockholder of Celltrion.
As a result, as of September 2005, VaxGen was no longer the primary beneficiary
of Celltrion and, in accordance with FIN 46R, Celltrion will be deconsolidated
from VaxGen; and, thereafter, VaxGens investment in Celltrion will be
accounted for under the equity method.

In February 2006, VaxGen and
Celltrion entered into an agreement 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 the independent auditors. 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 300 million Korean Won ($0.3 million equivalent)
per year and shall be subject to approval in advance by VaxGen.

During 2006,
VaxGen received gross proceeds of $130 million from the sale of most of its
Celltrion common stock to Nexol and affiliates of Nexol. As a result, as of
June 2006, VaxGen was no longer entitled to hold two seats on Celltrions Board
of Directors or appoint a Representative Director. In September 2006, the
Revised JVA 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.
Accordingly, VaxGen no longer had the ability to exercise significant influence
over operating and financial policies of Celltrion, and as of November 2006,
VaxGens investment in Celltrion will be accounted for under the cost method in
accordance with APB 29. As of December 31, 2006, VaxGens remaining shares of
Celltrion common stock represent less than a 1% ownership interest and VaxGen
no longer has a representative on the Celltrion Board of Directors.

33

Celltrion
Agreements

In June 2005, Celltrion
entered into several agreements to manufacture biologic products being developed
by Bristol-Myers Squibb Company (BMS). Technology transfer activities began
immediately upon the execution of the BMS agreements. Production of product,
which will be manufactured according to U.S. cGMP standards, is expected to
utilize a significant portion of Celltrions 50,000 liters of bioreactor
capacity and began in 2006. In July 2006, Celltrion entered into a Supply
Agreement with BMS. Construction on the new facility, which is adjacent to the
current facility, commenced in July 2006. The new facility will have 60,000
liters of bioreactor capacity.

In July 2005, Celltrion and
Aphton Corporations wholly-owned subsidiary (Igeneon) signed a licensing and
commercialization agreement and a product development and manufacturing
agreement related to the manufacturing, marketing and distribution of Igeneons
clinical product candidate IGN311. Under the agreements, Igeneon granted
Celltrion a license to commercialize IGN311 in certain Asian countries,
including Japan. In return, Igeneon will receive from Celltrion milestone
payments totaling $6.0 million. In addition, Celltrion will provide development
and manufacturing services related to the optimization and upscaling of IGN311
and will produce material for further clinical development.

In April 2006, Celltrion
entered into several agreements with A&G Pharmaceutical, Inc. (A&G)
to manufacture and supply clinical and commercial material of GP88Ab as well as
to develop and commercialize a partner for GP88Ab. Under the agreements, A&G
granted or will grant to Celltrion a first right of negotiation to manufacture
and supply the clinical materials for Phase 3 clinical trials as well as the
commercial materials. Also, A&G granted Celltrion an exclusive license and
sublicense to develop and have developed, make, use, offer for sale, sell and
have sold products in the certain territory and additionally the right to give
a sublicense to third parties with the approval of A&G. In return, A&G
will receive from Celltrion milestone payments totaling $2.0 million upon
completion of various phases to reach the Phase 2 clinical trials. In
consideration for the commercialization license, Celltrion shall pay to A&G
a royalty equal to a certain percentage of the net sales of Celltrion.
Separately, on July 14, 2006, Celltrion purchased 769,230 shares of A&G
common stock for $2.0 million.

Financing
for Facility Construction and Expansion

In October
2005, Celltrion issued a one-year bond for 20,000 million Korean Won
($19.2 million equivalent) to Shinhan Bank at a variable interest rate, equal
to the 91-day CD rate plus 2.05%. Subsequent to the issuance of the bond,
Celltrion entered into an interest rate swap agreement with the bank at a fixed
interest rate of 6.63%.

During 2005
and 2006, Celltrion modified the construction design and work scope for the
production of generic and specific products in its construction agreement with
Daewoo. As a result of this modification, the total construction cost increased
to 67,551 million Korean Won plus 26.9 million Swiss francs (equivalent to
$93.1 million) from the original construction agreement in January 2003.

In February 2006, Celltrion entered into a Land Purchase Agreement with
Incheon Metropolitan City at a stated price of 24,700 million Korean
Won ($25.5 million equivalent) and
made an advance principal payment of 2,470 million Korean
Won ($2.5 million equivalent). In
March 2006, Celltrion and Incheon Metropolitan City entered into an amended
agreement, which reduced the original discount received and increased the
stated price of the land to 32,931 million Korean Won ($33.9
million equivalent). As a result, Celltrion made an additional advance payment
of 823 million Korean
Won ($0.8 million equivalent).
Celltrion is obligated to pay for the land in five annual installments of 5,928
million Korean Won ($6.1 million equivalent), plus interest at
4.0%, beginning in March 2007.

In June 2006,
Celltrion obtained collateralized long-term financing of
20,000 million Korean Won (equivalent to $21.1 million at the exchange
rate on September 30, 2006) and $20.8 million from Woori Bank and Shinhan
Bank, respectively, to be used for construction of a second manufacturing
facility adjacent to the current facility. In addition, Celltrion
entered into an interest rate swap
agreement with Shinhan Bank in order to hedge the variable interest rate. Celltrion also entered into a currency
swap agreement with Shinhan Bank to convert the U.S.
dollar-denominated borrowing into Korean Won-denominated borrowing.

In September
2006, Celltrion obtained additional U.S. dollar-denominated collateralized
long-term financing of $3.8 million from Shinhan Bank to be used for
construction of a second manufacturing facility adjacent to the current
facility. In addition, Celltrion entered into an interest rate swap agreement
with Shinhan Bank in order to hedge the variable interest rate.

34

Celltrion
also entered into a currency swap agreement with Shinhan Bank to convert the
U.S. dollar-denominated borrowing into Korean Won-denominated borrowing.

In October 2006, Celltrion
borrowed 20,000 million Korean Won ($21.0 million equivalent) from Shinhan Bank
with a variable interest rate and a maturity of two-years. In connection to the
borrowing, Celltrion entered into an interest rate swap agreement with Shinhan
Bank in order to hedge the exposure to the variable interest rate.

In November 2006, Celltrion
issued a collateralized three-year bond for 20,000 million Korean Won ($21.4
million equivalent) to Woori Bank at a variable interest rate, equal to the
banks 91-day CD rate plus 1.4% (aggregate rate of 6.1% in November 2006).

In December 2006, Celltrion
entered into a land purchase agreement for 783 million Korean Won ($0.8 million
equivalent) which is required to be paid within 6 months.

In December 2006, Celltrion
obtained short-term borrowing amounting to 10,000 million Korean Won ($10.8
million equivalent) from Woori Bank. Celltrion also obtained a commitment for a
letter of credit of $10.0 million from Shinhan Bank in December 2006 and $20.0
million from Woori Bank in November and December 2006.

In December 2006, Celltrion
obtained additional collateralized long-term financing of $2.0 million from
Shinhan Bank. In addition, in connection to the financing, Celltrion entered
into a currency swap agreement with Shinhan Bank in order to hedge the exposure
to foreign currency.

Celltrion
Stock, Options and Warrants

Under
the terms of the Second Tranche, the then-existing stockholders of Celltrion
agreed on December 30, 2004 that they would not exercise their right to the
Unsubscribed Shares in the Second Tranche provided that Nexol or Nexol Co
purchased all of the Unsubscribed Shares in the First Tranche.

In December
2004, Celltrion issued 1,356,800 shares of its preferred stock under the First
Tranche at a price of 5,000 Korean Won ($4.56 equivalent) per share, resulting
in net proceeds of 6,751 million Korean Won ($6.2 million equivalent). On December
30, 2004, Celltrions Board of Directors agreed to extend Nexol and Nexol Co.s
Warrant expiration date from December 31, 2004 to September 30, 2005 (Extended
First Tranche).

On March 29,
2005 and March 24,
2006, Celltrion awarded stock option grants to employees for 302,900 and 267,950, common shares, respectively, at
exercise prices of 7,675 Korean Won ($7.49
equivalent) per share and 7,047 Korean
Won ($7.20 equivalent) per share,
respectively. These grants and the stock option grants issued in 2002, 2003 and 2004 contain an anti-dilution provision. Accordingly,
in 2005
and 2006, all Celltrion stock
option grants exercise prices and the number of shares granted were modified,
per the terms of the original stock option agreements.

In March 2005,
Celltrion issued 1,949,700 shares under the First Tranche at a price of 5,000
Korean Won ($4.99
equivalent) per share, resulting in proceeds of 9,749 million Korean Won ($9.7 million equivalent). This sale
completed Nexol and Nexol Cos purchases under their Warrants and remaining
Unsubscribed Shares in the First Tranche. In March 2005, Celltrion also converted all 12,515,000 preferred shares
(including the 1,949,700 shares) into common stock upon approval at their stockholders
meeting. A BCF of 9,749 million Korean
Won ($9.7 million equivalent) was recognized as a deemed dividend in
March 2005 associated with the exercise of the Warrant and the conversion of
the preferred stock.

In May 2005, Celltrion
issued 2,872,840 shares of common stock to existing stockholders in a
proportionate stock dividend. In July 2005, Celltrion sold 3
million shares of its common stock to the existing stockholders and others at a
price of 5,000 Korean Won ($4.80
equivalent) per share, resulting in proceeds of 15,000 million Korean Won ($14.4
million equivalent). Celltrions non-VaxGen Co-CEO and his affiliates purchased an
aggregate of 711,837 of these shares, two members of Celltrions Board of
Directors purchased an aggregate of 756,321 of these shares, VaxGen purchased
239,068 shares, employees purchased an aggregate of 20,230 shares and two
vendors purchased an aggregate of 24,554 shares.

In August
2005, Celltrion issued 1,986,301 shares of its common stock under the Second
Tranche at a price of 5,000 Korean Won ($4.92 equivalent) per share, resulting
in proceeds of 9,932 million Korean Won ($9.8 million equivalent). A BCF of
9,932 million Korean Won ($9.8
million equivalent) was recognized as a deemed dividend in

35

August 2005
associated with the exercise of the Warrant and the immediate conversion of the
preferred stock on the exercise date. Also in August 2005, Celltrion issued 33,924
shares of its common stock to JS at a price of 22,500 Korean Won ($22.16
equivalent) per share, resulting in
proceeds of 763 million Korean Won ($0.8 million equivalent). Celltrions stockholder holding the
reallocation Warrants allowed the following parties to purchase a portion of
its reallocation shares, consistent with the terms of the reallocation
Warrants: a member of Celltrions Board of Directors purchased 79,149 of these
shares, an employee purchased 924 shares and a vendor purchased 8,041 shares.
Prior to becoming a member of Celltrions Board of Directors, this individual
purchased 158,298 shares of Celltrions preferred stock in 2004 under the First
Tranche at a price of 5,000 Korean Won ($4.92
equivalent) per share.

In August
2005, Nexol purchased 260,000 shares of Celltrions common stock from Daewoo.

In September 2005, Nexol Co purchased all of the outstanding common shares
of JS. In October 2005, JS became an affiliate of Nexol. In connection with its
acquisition by Nexol, its name was changed to Nexol Venture Capital Co., Ltd.

In January
2006, Celltrion issued 1,136,360 shares of its common stock to institutional
investors at a price of 22,000 Korean Won ($22.28 equivalent) per share, resulting in proceeds of
25,000 million Korean Won ($25.3
million equivalent).

36

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/A for the year ended December 31, 2003, filed on September
26, 2006, 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 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
incorporated in 1995 and formed to complete the development of an investigational recombinant protein
vaccine (AIDSVAX) intended
to prevent infection by human immunodeficiency virus (HIV). In 2002, we
broadened our product development portfolio to also include biodefense
vaccines. From inception through September 30, 2003, we were a development
stage enterprise and our financial statements during that period were prepared
in conformity with GAAP governing development stage enterprises.

On August 6,
2004, we announced that we had received notification from the Nasdaq Panel 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. The Nasdaq Panels
decision to delist our stock was based on our filing delinquency and our
determination that previously filed financial statements for the years ended
December 31, 2003, 2002 and 2001 should not be relied upon.

37

Celltrion

During 2004,
we adopted the provisions of Financial Accounting Standards Board
Interpretation No. 46, Consolidation of Variable Interest Entities(as
revised, FIN 46R), and determined that Celltrion, Inc. (Celltrion), our
equity method investee as of the date of adoption, constituted a variable
interest entity (VIE) and that we are its primary beneficiary. Accordingly, in
accordance with FIN 46R, our consolidated financial statements in this report
include the accounts of our VIE effective January 1, 2004, as if Celltrion has
been consolidated since its inception.

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.

As a part of the initial
capitalization of Celltrion, we made an in-kind contribution to Celltrion of
the license and sub-license of certain cell culture technology used for the
manufacture of pharmaceutical products.
We received 7.8 million shares of Celltrions common stock for this
contribution, representing approximately
half of the then outstanding shares. In March 2002, we entered into a
Supply Agreement, a License Agreement and a Sub-License Agreement with
Celltrion. At September 30,
2004, we owned 46% of Celltrion and were the largest stockholder.

Celltrions development
activities involve inherent risks. These risks include, among others,
dependence on key personnel and the ongoing need to finance its operations
prior to commencement of manufacturing operations. Successful future operations
will depend on Celltrions ability to secure contract manufacturing agreements
for biopharmaceutical products. In addition, Celltrion is dependent on us to
provide certain technical support.

Subsequent Events

On September 26, 2006, we filed our amended
Annual Report on Form 10-K/A for the years ended December 31, 2003, 2002 and
2001 with the SEC. We intend to apply for relisting on Nasdaq or American Stock
Exchange upon filing our remaining delinquent reports. Our common stock is
currently quoted on the OTC Pink Sheets as VXGN.PK.

In
January 2007, we restructured operations to significantly reduce operating
costs and announced we were actively pursuing avenues to enhance stockholder
value through a strategic transaction. As a result of the restructuring, our
monthly net cash expenditures will be reduced to approximately $3.0 million. We
expect to incur restructuring costs associated with this plan, including
employee termination benefits and costs associated with consolidation of our
California facilities. Estimated costs of the related termination benefits are
approximately $3.0 million to $3.5 million; estimated facilities-related costs
are approximately $0.7 million to $1.2 million.

See Subsequent
Events in Note 16 to the unaudited condensed financial statements for more
information regarding events occurring after September 30, 2004.

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/A for
the fiscal year ended December 31, 2003, filed with the SEC on September 26,
2006, for a description of our critical accounting policies. The following
policy on Variable Interest Entities reflects an additional critical accounting
policy that was not included in our Form 10-K/A for 2003 because Celltrion was
not being consolidated prior to the adoption of FIN 46R during 2004. There have
been no other significant changes to our policies since we filed that report.

Consolidation
of Variable Interest Entities

In
January 2003, the FASB issued FIN 46. The FASB issued a revised FIN 46
(FIN 46R) in December 2003 which modifies and clarifies various aspects of
the original interpretations. Variable interest entities are entities
controlled by another entity through means other than voting rights. FIN 46R
provides guidance on determining whether and how a business enterprise should
consolidate a variable interest entity. As a result of the adoption of FIN 46R
and the resulting consolidation of Celltrion, all intercompany 2002 and 2003
transactions between VaxGen, VCI and Celltrion have been eliminated as of
January 1, 2004. Also, certain Celltrion transactions have been adjusted to
conform to VaxGens accounting policies as if Celltrion had been consolidated
from inception. As of January 1, 2004, the cumulative effect of the change in
accounting principle resulting from the consolidation of

38

Celltrion and
the elimination of these transactions resulted in increased additional paid-in
capital of $17.6 million and an increase in deferred stock compensation of $0.2
million.

RESULTS
OF OPERATIONS

Comparison of Fiscal Quarters Ended September
30, 2004 and 2003

Revenues

Three
  Months Ended
  September 30,




Nine Months Ended
  September 30,Percent
  change
  2004/2003



Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003(Restated)(in thousands)



(in thousands)Research
  contracts and grants

$
7,254

$
6,585

10
%

$
22,308

$
12,935

72
%Related
  party services





333


(100
%)







905

(100
%)Total
  revenues

$
7,254

$
6,918


5
%



$
22,308

$
13,840

61
%Total revenues
increased by $0.3 million to $7.3 million in the three months ended September
30, 2004 over the comparable period in 2003 as revenues recognized on our NIAID
Contracts increased modestly and were partially offset by a decrease in
revenues from AIDSVAXrelated activities and a decrease in related party
services and consisted principally of:


Contract
  revenues of $7.0 million recognized on our NIAID Contracts primarily
  reflecting work performed under the 2003 Anthrax Contract and the 2002
  Contract;
Grant
  revenues of $0.2 million from two NIAID-funded SBIR grants; and
Grant
  revenues of $0.1 million from SAIC-Frederick, Inc. to complete certain
  residual activities related to the completion of the AIDSVAX clinical trials.Revenues in
  the three months ended September 30, 2003 primarily consisted of:
Contract
  revenues of $6.0 million recognized on work performed under the 2002 Anthrax
  Contract;
Grant
  revenues of $0.3 million from two NIAID-funded SBIR grants;
Revenues of
  $0.3 million from the Walter Reed Army Institute of Research (WRAIR) under
  a new 2003 grant; and
Related
  party services revenues of $0.3 million earned as part of a consulting
  agreement with Celltrion.Celltrion
  did not earn any revenues during these periods.Total
  revenues increased by $8.5 million to $22.3 million in the nine months ended
  September 30, 2004 over the comparable period in 2003 due primarily to an
  increase in activities related to our NIAID Contracts offset by a decrease in
  revenues from AIDSVAXrelated activities and a decrease in related party
  services and consisted principally of:
Contract
  revenues of $20.7 million recognized on our NIAID Contracts primarily
  reflecting work performed under the 2003 Anthrax Contract;
Grant
  revenues of $1.0 million from SAIC-Frederick, Inc. to complete certain
  residual activities related to the completion of the AIDSVAX clinical trials;
  and
Grant
  revenues of $0.6 million from two NIAID-funded SBIR grants.Revenues in
  the nine months ended September 30, 2003 primarily consisted of:
Contract
  revenues of $11.7 million recognized on work performed under the 2002 Anthrax
  Contract;
Grant
  revenues of $0.9 million from two NIAID-funded SBIR grants;39


Revenues of
  $0.3 million from the Walter Reed Army Institute of Research (WRAIR) under
  a new 2003 grant; and
Related
  party services revenues of $0.9 million earned as part of a consulting
  agreement with Celltrion.Celltrion did
not earn any revenues during these periods.

Revenues
earned in one period are not indicative of revenues to be earned in future
periods. We expect future years revenues to be progressively less, as efforts
shift from work done under the advanced development contracts to work under the
SNS contract, from which no revenues will be earned until shipments commence.
Related party services revenues for 2004 were eliminated due to the
consolidation of Celltrion.

Research
and development expenses

Three
  Months Ended
  September 30,




Nine Months Ended
  September 30,Percent
  change
  2004/2003



Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003(Restated)(in thousands)




(in thousands)Related
  party

$


$
22


(100
%)



$
55

$
119

(54
%)Other


10,431


8,312


25
%




28,807


19,121

51
%Total
  research and development

$
10,431

$
8,334


25
%



$
28,862

$
19,240

50
%Research
expenses include costs associated with research and testing of our product
candidates prior to reaching the development stage 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 following
table details research and development expenses by major project:

Three Months Ended
  September 30,




Nine Months Ended
  September 30,Percent
  change
  2004/2003



Percent
  change
  2004/20032004

2003(Restated)


2004

2003
  (Restated)(in thousands)




(in thousands)Direct Costs:NIAID
Contracts

$
4,964

$
3,999


24
%

$
13,834

$
6,954

99
%AIDSVAX


197


941


(79
%)



576


3,976

(86
%)Smallpox


858


520


65
%


2,154


937

130
%VCI


1,381


776


78
%



3,284


1,337

146
%Total direct
costs


7,400


6,236


19
%



19,848


13,204

50
%Indirect and other
costs


3,031


2,098


44
%



9,014


6,036

49
%Research and development
expenses

$
10,431

$
8,334


25
%


$
28,862

$
19,240

50
%The increase
of $2.1 million in research and development expenses in the three months ended
September 30, 2004 over the comparable period in 2003 was primarily due to:


Direct costs
  associated with our NIAID Contracts, which increased by $1.0 million
  primarily due to increased development work associated with the 2003 Anthrax
  Contract, relative to substantial work on the 2002 Anthrax Contract in the
  comparable period in 2003;
Indirect
  research and development costs, which increased by $0.9 million, consisting
  primarily of:40

-
Other
  development costs, which increased by $0.4 million due to expanded
  operations;-
Celltrions
  research and development expenses in the three months ended September 30,
  2004 were $0.3 million; prior to January 1, 2004, Celltrions operations were
  not included in our consolidated results; and-
Increased
  facilities overhead costs of $0.2 million due to the expansion of the VCI
  facility.
Direct costs
  associated with supporting VCI, which increased by $0.6 million due to the
  expansion of the facility;
Clinical
  trial expenses, which decreased by $0.7 million as the AIDSVAX Phase 3
  clinical trials were completed in 2003 and expenses relating to those trials
  in 2004 were minimal; and
Direct costs
  associated with our smallpox program, consisting primarily of labor costs,
  which increased by $0.3 million.The increase
  of $9.6 million in research and development expenses in the nine months ended
  September 30, 2004 over the comparable period in 2003 was primarily due to:
Direct costs
  associated with our NIAID Contracts, which increased by $6.9 million
  primarily due to increased development work associated with the 2003 Anthrax
  Contract, relative to work on the 2002 Anthrax Contract in the comparable
  period in 2003;
Clinical
  trial expenses, which decreased by $3.4 million as the AIDSVAX Phase 3
  clinical trials were completed in 2003 and expenses relating to those trials
  in 2004 were minimal;
Indirect
  research and development costs, which increased by $3.0 million, consisting
  primarily of:
Other
  development costs, which increased by $1.4 million due to expanded
  operations;
Celltrions
  research and development expenses in the nine months ended September 30, 2004
  were $1.0 million; prior to January 1, 2004, Celltrions operations were not
  included in our consolidated results; and
Increased
  facilities overhead costs of $0.6 million.
Direct costs
  associated with supporting VCI, which increased by $1.9 million due to
  expansion of the VCI facility; and
Direct costs
  associated with our smallpox program, consisting primarily of labor costs,
  which increased by $1.2 million.The
process of conducting preclinical studies and clinical trials necessary to
obtain 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 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 anticipate developing additional product
candidates internally and we intend to consider in-licensing product
candidates, which will increase our research and development expenses in future
periods.

We expect
research and development expenses, including those of Celltrion, to increase
substantially during the remainder of 2004 and in 2005 as we advance
development of our product candidates and expand Celltrions manufacturing
facilities.

41

General
and administrative expenses

Three
  Months Ended
  September 30,




Nine Months Ended
  September 30,Percent
  change
  2004/2003



Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003
  (Restated)(in thousands)




(in thousands)General and
  administrative expenses

$
6,101

$
3,379


81
%


$
16,633

$
9,770


70%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 increase
of $2.7 million in general and administrative expenses in the three months
ended September 30, 2004 over the comparable period of 2003 was primarily due
to:


Personnel
  costs, which increased $0.9 million due to increased headcount to support our
  expanding operations;
Celltrions
  general and administrative expenses in the three months ended September 30,
  2004 were $1.1 million; prior to January 1, 2004, Celltrion operations were
  not included in our consolidated results;
Professional
  services, which increased by $0.5 million principally reflecting higher fees
  for accounting and auditing services and other professional fees associated
  with the beginning of new audits and the restatement of our prior years
  financial statements by our new auditors in April 2004, other fees and
  expenses associated with our efforts to comply with various reporting and
  regulatory requirements including the Sarbanes-Oxley Act of 2002 (SOX); and
Recruiting
  fees, which increased by $0.2 million for certain senior management
  positions.The increase
  of $6.9 million in general and administrative expenses in the nine months
  ended September 30, 2004 over the comparable period of 2003 was primarily due
  to:
Celltrions
  general and administrative expenses in the nine months ended September 30,
  2004 were $2.4 million; prior to January 1, 2004, Celltrion operations were
  not included in our consolidated results;
Professional
  services, which increased by $1.5 million principally reflecting higher fees
  for accounting and auditing services and other professional fees associated
  with the beginning of new audits and the restatement of our prior years
  financial statements by our new auditors in April 2004, other fees and
  expenses associated with our efforts to comply with various reporting and
  regulatory requirements including the Sarbanes-Oxley Act of 2002 (SOX);
Personnel
  costs, which increased $1.7 million due to increased headcount to support our
  expanding operations;
During the
  nine months ended September 30, 2004, we provided $0.5 million for the
  settlement of derivative lawsuits;
Recruiting
  fees, which increased by $0.4 million for certain senior management
  positions; and
Other
  miscellaneous expenses, which increased by $0.4 million.We expect that general and
administrative expenses, including those of Celltrion, will exceed historical
levels during the remainder of 2004 and in 2005 and will reflect substantial
additional resources required to support our increased research and development
activities, operations and public reporting requirements.

42

Other
income (expense)

Three
  Months Ended
  September 30,



Nine Months Ended
  September 30,Percent
  change
  2004/2003



Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003
  (Restated)(in thousands)



(in thousands)Investment income

$
88

$
48



83
%

$
503

$
427



18
%Valuation adjustments


(2,461
)

(3,544
)


(31
%)


(16,183
)

2,699

(700
%)Equity in loss of
affiliate





(510
)
(100
%)





(6,510
)
(100
%)Other income
(expense)

$
(2,373
)
$
(4,006
)
(41
%)

$
(15,680
)
$
(3,384
)

363
%The decrease
in other expense of $1.6 million in the three months ended September 30, 2004
from the comparable period in 2003 was primarily due to:


Mark-to-market
  valuation adjustments related to the our derivatives, which decreased by $1.1
  million primarily due to changes in the fair value of our common stock; and
Our share of
  Celltrions losses, which were $0.5 million in 2003 compared to zero in 2004
  as a result of the consolidation of Celltrion effective as of January 1,
  2004.The increase
in other expense of $12.3 million in the nine months ended September 30, 2004
from the comparable period in 2003 was primarily due to:


Mark-to-market
  valuation adjustments related to the our derivatives, which changed to other
  expense of $16.2 million from other income of $2.7 million primarily due to
  the May 2004 suspension of our SEC registration statement which caused the
  Series A Warrants to become redeemable for cash at the option of the Series A
  Warrant holders and due to changes in the fair value of our common stock; and
Our share of
  Celltrions losses, which were $6.5 million in 2003 compared to zero in 2004
  as a result of the consolidation of Celltrion effective as of January 1,
  2004.We do not
expect future mark-to-market adjustments relating to the valuation of our
derivatives because as of September 30, 2004 all of the underlying instruments
were converted or exchanged for new instruments that do not include derivative
features. Also, we anticipate future investment income will fluctuate and will
be primarily driven by our future cash, cash equivalents and investments
balances. In addition, we anticipate a significant increase in Celltrions
interest expense in 2005 due to increased borrowings to finance its
construction activities and the completion of certain phases of its
construction activities for which interest was previously capitalized.

Minority
interest in loss of subsidiary

Three
  Months Ended
  September 30,



Nine Months Ended
  September 30,Percent
  change
  2004/2003



Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003
  (Restated)(in thousands)



(in thousands)Minority interest in loss of
subsidiary

$


$
279


(100
%)

$


$
534



(100
%)Minority
interest in loss of subsidiary for the three months and nine months ended
September 30, 2003 reflects Celltrions share of the net loss of VCI. As of
January 1, 2004, Celltrion was included in our consolidated results and
accordingly, its share in the losses of VCI was eliminated.

43

Minority
interest in loss of variable interest entity

Three
  Months Ended
  September 30,



Nine Months Ended
  September 30,Percent
  change
  2004/2003



Percent
  change
  2004/20032004

2003


2004

2003(in thousands)



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

$
819

$



*

$
1,944

$



** Calculation not
meaningfulMinority
interest in loss of variable interest entity for the three months and nine
months ended September 30, 2004 reflects the interests of Celltrions other
stockholders in the net loss of Celltrion. Prior to January 1, 2004, Celltrion
was not included in our consolidated results and accordingly, the other
stockholders share of Celltrions losses was not reflected in our consolidated
results.

Cumulative
effect of change in accounting principle

Three
  Months Ended
  September 30,



Nine Months Ended
  September 30,Percent
  change
  2004/2003



Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003
  (Restated)(in thousands)



(in thousands)Cumulative effect of change in
accounting
  principle

$


$
700



(100
%)

$


$
700



(100
%)Cumulative
effect of change in accounting principle for the three months and nine months
ended December 31, 2003 relates to our adoption of Financial Accounting
Standard No. 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity(FAS
150). From the inception of VCI in 2002 to our adoption of FAS 150, the fair
value of the VCI Purchase Option increased by $0.7 million. This increase was
accounted for in accordance with FAS 150 as a cumulative effect of change in
accounting principle.

Charges
related to Series A preferred stock

Three
  Months Ended
  September 30,



Nine Months Ended
  September 30,Percent
  change
  2004/2003



Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003
  (Restated)(in thousands)



(in thousands)Charges related to Series A
preferred stock

$


$
(269
)


(100
%)

$


$
(2,580
)


(100
%)There were no
charges related to Series A preferred stock for the three or nine months ended
September 30, 2004 as all outstanding shares of Series A Preferred Stock were
converted into common stock by December 31, 2003.

44

LIQUIDITY AND CAPITAL RESOURCES

2004

2003(Restated)(in thousands)As of September
30:Cash, cash equivalents and
investment
  securities

$
15,861

$
6,828Working capital
(deficit)


3,183


(3,728
)Nine months ended September
30:Cash provided by (used
in):Operating
activities


(17,238
)

(15,014
)Investing
activities


(5,674
)

(5,843
)Financing
activities


16,178


12,180Effect of
exchange rate changes on cash


228


Capital expenditures (included
in investing
  activities above)


(28,667
)

(12,169
)Our primary
financing requirements are for funding our day-to-day working capital
requirements and capital equipment expenditures related to the manufacturing
facilities in the Republic of Korea and California. As of September 30, 2004,
we had $7.6 million in unused commitments to fund construction of the
facilities in the Republic of Korea. The liabilities recognized as a result of
consolidating Celltrion do not represent additional claims on VaxGens or VCIs
assets. Rather, they represent claims against the specific assets of Celltrion.
Conversely, the assets recognized as a result of consolidating Celltrion do not
represent additional assets that could be used to satisfy claims against
VaxGens or VCIs assets. The general creditors of VaxGen and VCI have no
recourse to the general credit of Celltrion. The general creditors of Celltrion
have no recourse to the general credit of VaxGen and VCI.

Through September 30, 2004,
we financed our operations primarily through sales of our common stock, sales
of Celltrion preferred stock, the issuance of Series A Preferred Stock as well
as through revenues from research contracts and grants and debt to finance the
purchase of land and construction of facilities in the Republic of Korea. 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.Net cash used in operating
activities of $17.2 million and $15.0 million for the nine months ended
September 30, 2004 and 2003, respectively, was primarily attributable to our
net losses although the effect of non-cash charges upon net cash used in
operating activities was significant in both 2003 and 2004. For example,


A non-cash expense of
  $15.4 million and income of $1.7 million in the nine months ended September
  30, 2004 and 2003, respectively, reflecting changes in the fair value of
  outstanding warrants and derivatives. These changes in fair value primarily
  resulted from the May 2004 suspension of our SEC registration statement which
  caused the Series A Warrants to become redeemable for cash at the option of
  the Series A Warrant holders and due to changes in the fair value of our
  common stock;
Non-cash charges for our
  equity in loss of affiliate of $6.5 million for our share of Celltrions net
  losses for the nine months ended September 30, 2003. Due to the consolidation
  of Celltrion in 2004 there was no similar charge in the same period of 2004;45


Non-cash charges for stock
  compensation of $1.4 million and $0.5 million for the nine months ended September
  30, 2004, and 2003, respectively. The increase in these charges in 2004
  reflects $0.7 million from the consolidation of Celltrion; and
Non-cash charges for
  depreciation and amortization of $1.3 million and $0.9 million for the nine
  months ended September 30, 2004, and 2003, respectively.Net cash used in investing
activities consisted primarily of activities relating to the purchase and sale
of investment securities as well as capital expenditures. Capital expenditures
in the nine months ended September 30, 2004 were made in connection with the
expansion of the Korean manufacturing facility ($24.7 million) and research and
development laboratories and leasehold improvements associated with the
California manufacturing facility and office facilities ($3.9 million). Capital
expenditures in the nine months ended September 30, 2003 were made in
connection with the expansion of research and development laboratories and
leasehold improvements associated with the California manufacturing facility and
office facilities. We expect capital expenditures during the remainder of 2004
to increase substantially due to the ongoing expansion of the Korean and
Californian manufacturing facilities.

Net cash provided by our financing activities
increased $4.0 million to $16.2 million in 2004 from $12.2 million in 2003 and
primarily consisted of the proceeds from private placements and construction
borrowings by Celltrion.

At September 30, 2004, $15.9
million, or 12%, of our assets consisted of cash, cash equivalents and
short-term investments. We had working capital of $3.2 million at September 30,
2004, compared to a working capital deficit of $3.7 million at September 30,
2003. This $6.9 million increase in working capital is primarily due to our
derivative liabilities which decreased to zero at September 30, 2004 from $6.2
million in fair value at September 30, 2003 as a result of the exchange of the
Series A Warrants and the conversion of the Series A Preferred Stock.

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 cancellation of
the SNS Contract, the reaudit of our financial statements for the three years
ended December 31, 2003, the resulting restatement of reports previously filed
with the Securities and Exchange Commission, the lapsing of our registration
statements and the delisting of our common stock may have an adverse
impact on whether financing will be available or that it will be available on
terms that we will accept. See Subsequent Events in Note 16.

As a result of the adoption
of FIN 46R and the resulting consolidation of Celltrion, the following
significant intercompany balances included in the Companys consolidated
balance sheet at December 31, 2003 have been eliminated as of September 30,
2004 (in thousands):

December 31,
  2003Due from related party


$
386Investment in affiliate



34,561Other assets (1)



3,600Current portion of
  obligation to related party



2,575Obligation to related
  party, non-current



31,540(1) An amount of $0.4
million included in the reported balance of $4.0 million of other assets at
December 31, 2003 is not related to the consolidation of Celltrion.

46

Contractual Obligations

In June 2004,
the Company engaged a sub-contractor to provide component materials for the
NIAID project. The remaining commitment as of September 30, 2004 was for $5.8
million. If NIAID terminates the related parts of its contracts with the
Company, the Company may have a financial liability to this sub-contractor and
such amounts, if any, may not be reimbursable by NIAID. There were no other
material changes in our contractual obligations during the nine months ended
September 30, 2004.

The following
table summarizes our significant contractual obligations at September 30, 2004,
and the effect such obligations are expected to have on our liquidity and cash
flows in future periods.

Total
    
    2004
    
    2005-06
    
    2007-08
    
    2009
        and
        beyond(in
        thousands)Operating
        lease obligations (1)
    
    $
    9,425
    
    $
    725
    
    $
    5,534
    
    $
    3,166
    
    $
    Celltrion
        obligations (2)
    
    
    57,852
    
    
    2,218
    
    
    11,437
    
    
    20,181
    
    
    24,016Purchase
        obligations (3)
    
    
    281
    
    
    81
    
    
    50
    
    
    20
    
    
    130Total
        contractual obligations
    
    $
    67,558
    
    $
    3,024
    
    $
    17,021
    
    $
    23,367
    
    $
    24,146(1) Operating
lease obligations include office and laboratory facilities under non-cancelable
operating leases.

(2) Celltrion
obligations reflect principal and interest payments due on Celltrions
construction loans and land financing as translated on September 30, 2004.

(3) Purchase obligations include service
agreements, contracts related to manufacturing and research operations and
license agreements.

Off-Balance Sheet Arrangements

As of
September 30, 2004, 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 December 2004, the
FASB issued FAS No. 153, Exchangesof Nonmonetary Assets, an amendment of APB Opinion
No. 29, Accounting for Nonmonetary Transactions (FAS
153). FAS 153 addresses the measurement of exchanges of nonmonetary assets and
redefines the scope of transactions that should be measured based on the fair
value of the assets exchanged. The provisions in FAS 153 are effective for
nonmonetary asset exchanges occurring in fiscal periods beginning after
June 15, 2005, which is effective with our first quarter of fiscal 2006.
We do not expect adoption of FAS 153 will have a material impact on our
consolidated financial position, results of operations or cash flows.

In December 2004, the FASB issued Statement of Financial Accounting
Standards (FAS) No. 123(R), Share-Based Payment (FAS 123R) which is a
revision of FAS No. 123, Accounting for
Stock-Based Compensation(FAS 123). Generally, the approach in FAS 123R is similar to the
approach described in FAS 123. However, FAS 123R requires all share-based
payments to employees, including grants of employee stock options, to be
recognized in the consolidated statement of operations based on their fair
values. Pro forma disclosure is no longer an alternative. The new rule applies to option
grants made after adoption as well as options that are not vested at the date
of adoption. FAS 123R must be adopted in annual periods beginning after July 1,
2005. We began applying FAS 123R prospectively in the first quarter of 2006.
Additionally, in August 2005, the FASB issued FASB Staff Position (FSP) FSP
FAS 123R-1, Classification and Measurement
of Freestanding Financial Instruments Originally Issued in Exchange for
Employee Services under FASB Statement No. 123(R)(FSP1). In FSP1,
the FASB decided to defer the requirements in FAS 123 that make a freestanding
financial instrument subject to the recognition and measurement requirements of
other GAAP when the rights conveyed by the instrument are no longer dependent
on the holder being an employee. In October 2005, the FASB issued FSP FAS
123R-2, Practical Accommodation to the
Application of Grant Date as Defined in FASB Statement No. 123(R)(FSP2).
In FSP2, the FASB is providing companies with a practical accommodation when
determining the grant date of an award that

47

is subject to the accounting provisions in
FAS 123R. In November 2005, the FASB issued FSP FAS 123R-3, Transition Election Related to Accounting for the Tax
Effects of Share-Based Payment Awards(FSP3). FSP3 provides an
elective alternative method that establishes a computational component to
arrive at the beginning balance of the accumulated paid-in capital pool related
to employee compensation and a simplified method to determine the subsequent
impact on the accumulated paid-in capital pool of employee awards that are
fully vested and outstanding upon the adoption of FAS 123R. In February 2006,
the FASB issued FSP FAS 123R-4, Classification
of Options and Similar Instruments Issued as Employee Compensation That Allow
for Cash Settlement upon the Occurrence of a Contingent Event
(FSP4), which concludes that a cash settlement feature that can be exercised
only upon the occurrence of a contingent event that is outside the employees
control does not become a liability until it becomes probable that the event
will occur. An option or similar instrument that is classified as equity, but
subsequently becomes a liability because the contingent cash settlement event
is probable of occurring, shall be accounted for similar to modification from
an equity to liability award. To the extent that the liability exceeds the
amount previously recognized in equity, the excess is recognized as
compensation cost. The total recognized compensation cost for an award with a
contingent cash settlement feature shall at least equal the fair value of the
award at the grant date. FSP4 is applicable only for options or similar
instruments issued as part of employee compensation arrangements. In October
2006, the FASB issued FSP FAS 123R-5, Amendment of FASB Staff Position FAS 123(R)-1
(FSP5), which addresses whether a modification of an instrument in connection
with an equity restructuring should be considered a modification for purposes
of applying FSP1. The provisions in FSP5 are effective for the first reporting
period beginning after October 10, 2006. Also, in October 2006, the FASB issued
FSP FAS 123R-6, Technical Corrections of
FASB Statement No. 123 (revised 2004)(FSP6), which addresses
certain technical corrections of FAS 123R. The provisions in FSP6 are effective
for the first reporting period beginning after October 20, 2006. The guidance
in FSP1, FSP2, FSP3, FSP4, FSP5 and FSP6 will be applied upon our adoption of
FAS 123R. We are currently evaluating the impact of adopting the guidance in
FAS 123R, FSP1, FSP2, FSP3, FSP4, FSP5 and FSP6 on our consolidated financial
position, results of operations and cash flows.

In March 2005,
the SEC published Staff Accounting Bulletin No. 107 (SAB 107). The
interpretations in this staff accounting bulletin express the views of the staff
regarding the interaction between FAS 123R and certain SEC rules and
regulations and provide the staffs views regarding the valuation of
share-based payment arrangements for public companies. In particular, SAB 107
provides guidance related to share-based payment transactions with
non-employees, the transition from nonpublic to public entity status, valuation
methods (including assumptions such as expected volatility and expected term),
the accounting for certain redeemable financial instruments issued under
share-based payment arrangements, the classification of compensation expense,
non-GAAP financial measures, first-time adoption of FAS 123R in an interim
period, capitalization of compensation cost related to share-based payment
arrangements, the accounting for income tax effects of share-based payment
arrangements upon adoption of FAS 123R, the modification of employee share
options prior to adoption of FAS 123R and disclosures in Managements
Discussion and Analysis subsequent to adoption of FAS 123R. We will comply with
SAB 107 upon our adoption of FAS 123R. We are currently evaluating the impact
of adopting SAB 107 on our consolidated financial position, results of
operations and cash flows.

In March 2005,
the FASB issued FASB Interpretation No. 47, Accounting for Conditional Asset
Retirement Obligations (FIN 47). FIN 47 clarifies that a
conditional asset retirement obligation, as used in FAS 143, refers to a legal
obligation to perform an asset retirement activity in which the timing or
method of the settlement are conditional on a future event that may or may not
be within the control of the entity. Accordingly, an entity is required to
recognize a liability for the fair value of a conditional asset retirement
obligation if the fair value can be reasonably estimated. FIN 47 is effective
no later than fiscal years ending after December 15, 2005. We do not
expect the adoption of FIN 47 will have a material impact on our consolidated
financial position, results of operations or cash flows.

In April 2005, the FASB issued FIN 46(R)-6, Determining
the Variability to Be Considered in Applying FASB Interpretation No. 46(R)
(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

48

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 are currently evaluating the impact of
adopting FSP FIN 46R-6 on our consolidated financial position, results of
operations and cash flows.

In
May 2005, the FASB issued FAS No. 154, Accounting
Changes and Error CorrectionsA replacement of APB Opinion No. 20 and FASB
Statement No. 3(FAS
154). FAS 154 replaces APB Opinion No. 20, Accounting Changes, and FAS No. 3, Reporting Accounting Changes in
Interim Financial
Statements, and changes the requirements for the accounting for, and
reporting of, a change in accounting principles. FAS 154 applies to all
voluntary changes in accounting principles and changes required by an
accounting pronouncement in the unusual instance that the pronouncement does
not include specific transition provisions. Under previous guidance, changes in
accounting principle were recognized as a cumulative effect in the net income
of the period of the change. FAS 154 requires retrospective application of
changes in accounting principle, limited to the direct effects of the change,
to prior periods financial statements, unless it is impracticable to determine
either the period-specific effects or the cumulative effect of the change in
accounting principle. Additionally, FAS 154 requires that a change in
depreciation, amortization or depletion method for long-lived, nonfinancial
assets be accounted for as a change in accounting estimate affected by a change
in accounting principle and that correction of errors in previously issued
financial statements should be termed a restatement. The provisions in
FAS 154 are effective for accounting changes and correction of errors made
in fiscal years beginning after December 15, 2005, which is effective with
our first quarter of fiscal 2006. We are currently evaluating the impact of
adopting FAS 154 on our consolidated financial position, results of operations
and cash flows.

In
June 2005, the FASB issued FSP FAS 150-5, Issuers Accounting under FASB Statement
No. 150 for Freestanding Warrants and Other Similar Instruments on Shares
that are Redeemable(FAS 150-5). FAS 150-5 clarifies that
freestanding warrants and similar instruments on shares that are redeemable
should be accounted for as liabilities under FAS 150 regardless of the timing
of the redemption feature or price, even though the underlying shares may be
classified as equity. FAS 150-5 is effective for the first reporting period
beginning after September 30, 2005. Although we had outstanding warrants as of
July 1, 2005, the shares issued upon exercise of the warrants are not
redeemable; consequently, we do not expect the adoption of FAS 150-5 will have
a material impact on our consolidated financial position, results of operations
or cash flows.

In July 2005,
the FASB issued FSP APB 18-1, Accounting by
an Investor for its Proportionate Share of Accumulated Other Comprehensive
Income of an Investee Accounted for under the Equity Method in Accordance with
APB Opinion No. 18 upon a Loss of Significant Influence(FSP APB
18-1), which provides guidance on how an investor should account for its
proportional share of an investees equity adjustments for other comprehensive
income (OCI) upon a loss of significant influence as detailed in paragraph
121 of FAS No. 130, Reporting Comprehensive Income(FAS
130). APB Opinion No. 18, The Equity Method
of Accounting for Investments in Common Stock (APB 18) requires a
transaction of an equity method investee of a capital nature be accounted for
as if the investee was a consolidated subsidiary, which requires the investor
to record its proportionate share of the investees adjustments for OCI as
increases or decreases to the investment account with corresponding adjustments
in equity. FSP APB 18-1 requires that an investors proportionate share of an
investees equity adjustments for OCI should be offset against the carrying
value of the investment at the time significant influence is lost and equity
method accounting is no longer appropriate. However, to the extent that the
offset results in a carrying value of the investment that is less than zero, an
investor should (a) reduce the carrying value of the investment to zero and (b)
record the remaining balance in income. The guidance in FSP APB 18-1 is
effective for us on October 1, 2005. We are currently evaluating the impact of
adopting FSP APB 18-1 on our consolidated financial position, results of
operations and cash flows.

In September
2005, the EITF reached a consensus on Issue No. 05-7, Accounting for Modifications to
Conversion Options Embedded in Debt Instruments and Related Issues
(EITF 05-7). EITF 05-7 requires that a change in the fair value of a conversion
option brought about by modifying the debt agreement be included in analyzing
in accordance with EITF consensus on Issue No. 96-19, Debtors Accounting for a Modification
or Exchange of Debt Instruments(EITF 96-19), whether a debt
instrument is considered extinguished. Under EITF 96-19s requirements, an
issuer who modifies a debt instrument must compare the present value of the
original debt instruments cash flows to the present value of the cash flows of
the modified debt. If the present value of those cash flows varies by more than
10 percent, the modification is considered significant and extinguishments
accounting is

49

applied to the
original debt. If the change in the present value of the cash flows is less
than 10 percent, the debt is considered to be modified and is subject to EITF
96-19s modification accounting. EITF 05-7 requires that in applying the 10
percent test the change in the fair value of the conversion option be treated
in the same manner as a current period cash flow. EITF 05-7 also requires that,
if a modification does not result in an extinguishment, the change in fair
value of the conversion option be accounted for as an adjustment to interest
expense over the remaining term of the debt. The issuer should not recognize a
beneficial conversion feature (BCF) or reassess an existing BCF upon
modification of the conversion option of a debt instrument that does not result
in an extinguishment. EITF 05-7 is effective for modifications of debt
instruments beginning in the first interim or annual reporting period beginning
after December 15, 2005. We do not expect the adoption of EITF 05-7 to have
material impact on our consolidated financial position, results of operations
or cash flows.

In September
2005, the EITF reached a consensus on Issue No. 05-8, Income Tax Consequences of Issuing
Convertible Debt with a Beneficial Conversion Feature (EITF 05-8).
Under EITF 05-8, the issuance of convertible debt with a BCF results in a
temporary difference for purposes of applying FAS No. 109, Accounting for Income Taxes.
The deferred taxes recognized for the temporary difference should be recorded
as an adjustment to paid-in capital. EITF 98-5, Accounting for Convertible Securities
with Beneficial Conversion Features or Contingently Adjustable Conversion
Ratios, and EITF 00-27, Application of Issue No. 98-5 to Certain Convertible
Instruments, require that the nondetachable conversion feature of a
convertible debt security be accounted for separately if it is a BCF. A BCF is
recognized and measured by allocating to additional paid-in capital a portion
of the proceeds equal to the conversion features intrinsic value. A discount
on the convertible debt is recognized for the amount that is allocated to
additional paid-in capital. The debt discount is accreted from the date of
issuance to the stated redemption date of the convertible instrument or through
the earliest conversion date if the instrument does not have a stated
redemption date. The U.S. Federal Income Tax Code includes the entire amount of
proceeds received at issuance as the tax basis of the convertible debt
security. EITF 05-8 should be applied retrospectively to all instruments with a
BCF accounted for under EITF 98-5 and EITF 00-27 for periods beginning after
December 15, 2005. We do not expect the adoption of EITF 05-8 to have material
impact on our consolidated financial position, results of operations or cash
flows.

In November
2005, the FASB issued FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments (FSP FAS
115-1 and FAS 124-1). This FSP nullifies certain requirements of EITF Issue
No. 03-01 and supersedes EITF Abstracts, Topic No. D-44, Recognition
of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose
Cost Exceeds Fair Value.Based on the clarification provided in FSP
FAS 115-1 and FAS 124-1, the amount of any other-than-temporary impairment that
needs to be recognized will continue to be dependent on market conditions, the
occurrence of certain events or changes in circumstances relative to an
investee and an entitys intent and ability to hold the impaired investment at
the time of the valuation. FSP FAS 115-1 and FAS 124-1 are effective for
reporting periods beginning after December 15, 2005. We are evaluating the
impact of adopting the guidance in FSP FAS 115-1 and FAS 124-1on our
consolidated financial position, results of operations and cash flows.



In February 2006, the FASB issued FAS No. 155,
Accounting for Certain Hybrid Financial Instruments (FAS 155), which amends FAS No. 133, Accounting for Derivative Instruments and Hedging
Activities(FAS 133) 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) (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.

50

In July 2006, the FASB issued
Interpretation No. 48, Accounting for Uncertainty in Income Taxesan
interpretation of FASB Statement No. 109(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
are currently evaluating the impact of adopting FIN 48 on our consolidated
financial position, results of operations and cash flows.

In September 2006, the FASB
issued FAS No. 157, Fair Value Measurement (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.

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 (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 (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 (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 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 (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 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 Issue 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.

51

In December 2006, the FASB issued
FSP EITF 00-19-2, Accounting for Registration Payment Arrangements (FSP
00-19-2) which addresses accounting for registration payment arrangements. FSP
00-19-2 specifies that the contingent obligation to make future payments or
otherwise transfer consideration under a registration payment arrangement,
whether issued as a separate agreement or included as a provision of a
financial instrument or other agreement, should be separately recognized and
measured in accordance with FASB Statement No. 5, Accounting for Contingencies.
FSP 00-19-2 further clarifies that a financial instrument subject to a
registration payment arrangement should be accounted for in accordance with
other applicable generally accepted accounting principles without regard to the
contingent obligation to transfer consideration pursuant to the registration
payment arrangement. For registration payment arrangements and financial
instruments subject to those arrangements that were entered into prior to the issuance
of EITF 00-19-2, this guidance shall be effective for financial statements
issued for fiscal years beginning after December 15, 2006 and interim periods
within those fiscal years. Early adoption of FSP 00-19-2 for interim or annual
periods for which financial statements or interim reports have not been issued
is permitted. We began applying EITF 00-19-2 prospectively in the first quarter
of 2004.

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 September 30,
2004, we held available-for-sale securities in the principal amount of $9.1
million. If market interest rates were to increase immediately and uniformly by
10% from levels at September 30, 2004, 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

In January 2003, Celltrion obtained collateralized long-term financing of
52,000 million Korean Won ($44.2 million equivalent) with a nine-year term from a Korean bank
(Loan). Funds from the Loan are to be used for construction of the
administration buildings and manufacturing facility. As construction
progresses, the bank funds 60% of the progress payments (up to 52,000 million
Korean Won), while Celltrion pays the remaining 40%. Celltrions land and
construction in progress represent collateral for the outstanding Loan balance.
Only interest payments are due monthly for the first four years of the Loan
term, and principal and interest payments are due monthly for the remaining
five years of the Loan term. Interest is adjusted quarterly, based on a 3-month
Korean certificate of deposit rate plus 1.5% (an aggregate rate of 5.4% at
September 30, 2004). If market interest rates were to increase
immediately and uniformly by 10% from levels at September 30, 2004, the
increase in interest payments due under the Loan would increase by an
immaterial amount, and would not have a significant effect on our operations or
cash flows. At September 30, 2004,
Celltrion owed 43,301 million Korean Won ($37.6 million equivalent) related to the Loan.

As of September 30, 2004, we did not
invest in derivative financial instruments, interest rate swaps or other
investments that alter interest rate exposure.

52

Foreign
Currency Risk

Our exposure to foreign currency
exchange rates is related primarily to our investment in Celltrion. Our
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. We
are also affected by exchange rate fluctuations as the financial statements of
our foreign subsidiary are translated from Korean Won into the United States
dollar in consolidation. As exchange rates vary, these results, when
translated, may vary from expectations and could adversely impact overall
profitability. If market foreign currency exchange rates were to change
immediately and uniformly by 10% from levels at September 30, 2004, the change
would not have a significant effect on our operations or cash flows. As of September 30, 2004, we did not invest
in derivative financial instruments, currency swaps or other investments that
alter foreign currency exposure.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and
Procedures

As required by SEC Rule 13a-15(e)
and 15d-15(e), 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 this evaluation
and identification of the material weaknesses in internal control over
financial reporting as disclosed in Item 4 of our Form 10-Q for the quarter
ended March 31, 2004, our Chief Executive Officer and Chief Financial Officer
have concluded that our disclosure controls and procedures were not effective
as of the end of the period covered by this report.

Changes in Internal Control over
Financial Reporting

There have been no changes to the
Companys internal control over financial reporting during the quarter ended
September 30, 2004 that have materially affected, or are reasonably likely to
materially affect, the Companys internal control over financial reporting.

Remediation Efforts

The Audit Committee has taken an
active role in overseeing managements implementation of the remedial measures
described below. By implementing these remedial measures, management intends to
improve our internal control over financial reporting and to avoid material
misstatements in consolidated financial statements prepared for external
purposes, in the future. Our management is working under the supervision of the
Audit Committee to identify and implement additional corrective actions, where
required, to improve the effectiveness of our internal control over financial
reporting, including the enhancement of systems and procedures.

We have implemented or are
implementing the following measures, which have materially affected, or are
reasonably likely to materially affect our internal control over financial
reporting:


The hiring of key additional accounting and financial
  reporting staff (although we have experienced difficulty in attracting and
  retaining such staff);
The engagement of expert consultants specializing in
  accounting and financial reporting to augment our accounting staff;53


The acquisition of accounting and financial reporting
  research tools for the use of both our staff and our expert consultants;
The initiation of an ongoing and comprehensive review of
  financial controls and procedures to address the issues identified above and
  to bring us into compliance with the requirements of the Sarbanes-Oxley Act
  with respect to internal controls and procedures;
The selection and implementation of an Enterprise Resource
  Planning (ERP) software program designed to automate and systematize
  internal control over financial reporting; and
The engagement of the services of an independent internal
  controls consultant to document, test and develop current and expanded
  internal controls and procedures.Management believes that, through
implementation of the measures noted above, we have begun to address the
conditions identified above as material weaknesses. We are monitoring the
effectiveness of these measures, and of our internal control over financial
reporting on an ongoing basis. We will take further action, as appropriate, to
strengthen our internal control over financial reporting to the greatest extent
reasonable and possible.

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.

PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On March 17, 2003, a civil complaint for violation of Sections
10(b) and 20(a) of the Securities Exchange Act of 1934 was filed in the United
States District Court for the Northern District of California, entitled Janice
Whitkens v. VaxGen, Inc., et al., Civil Action No. C03-1129 JSW. Named, as
defendants are VaxGen, Inc., Chief Executive Officer Lance K. Gordon and former
President Donald P. Francis. The plaintiff seeks to represent a class of
persons who purchased our securities between August 6, 2002 and February 26,
2003, and alleges that the defendants misled investors about the progress of
certain clinical trials and our future manufacturing and marketing plans.
Following the filing of the Whitkens complaint, several additional class action
complaints were filed in the same court, each making identical or similar
allegations against the same defendants. See Subsequent Events in Note 16 to
the unaudited condensed financial statements.

On or about March 21, 2003, two separate but virtually identical
shareholder derivative actions were filed in California Superior Court for San
Mateo County entitled Rhodes v. Allen, et al. civil action No. CIV 430087, and
MacDonald v. Allen, et al., civil action No. CIV 430088. A consolidated
complaint was filed in June 2003. Named as defendants in the action are VaxGen
directors Lance K. Gordon, Randall L-W. Caudill, and William D. Young, and former
VaxGen directors Donald P. Francis, Phillip W. Berman, David W. Beier, and
Stephen C. Francis (Company Directors). Also named as defendants are Paul
Allen and Vulcan Ventures, Inc. (Vulcan Defendants). The allegations of the
consolidated complaint (Derivative Lawsuit) are similar to those contained in
the class action, although unlike the class action, in the Derivative Lawsuit
the plaintiff purports to seek recovery on behalf of VaxGen, rather than from
VaxGen. Plaintiffs allege as well that the Vulcan Defendants sold shares of our
stock while in possession of material non-public information about the Company.
Plaintiffs, purportedly suing on behalf of VaxGen, assert claims against all
defendants for breach of fiduciary duty, mismanagement, waste and unjust
enrichment and against the Vulcan Defendants for breach of fiduciary duty and
insider trading. As of September 30, 2004, we have provided $0.5 million for
the settlement of these derivative actions. See Subsequent Events in Note 16 to
the unaudited condensed financial statements.

54

ITEM 1A. RISK FACTORS

For the nine months ended September 30, 2004, there has been no
significant change to the identified risk factors filed in our Annual Report on
Form 10-K/A filed with the Securities and Exchange Commission on September 26,
2006, other than the addition of risk factors associated with our newly
consolidated VIE, Celltrion, and the removal of Risks Related to the Issuance of Series
A 6% Cumulative Redeemable Convertible Preferred Stock (Series A Preferred
Stock) and Warrants because the Series A Preferred Stock and
associated warrants are no longer outstanding as of September 30, 2004.

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 presently 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 the report, unless otherwise indicated, we, our and us
refers to VaxGen.

Risks Relating to Our Business


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 are in the process of restating
certain historical financial statements and 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 are 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.


Effective January 1, 2004, we are
required to consolidate Celltrions financial statements into our own. Celltrion
maintains its records in accordance with Korean accounting principles; however, we require
financial statements that are prepared in accordance with GAAP and which have been audited
in conformity with U.S. Auditing Standards. Celltrions internal controls over
financial reporting may not be sufficient to enable them to report their interim GAAP
financial results to us on a timely basis. In addition, their independent registered
public accounting firm could conclude that Celltrions internal controls over
financial reporting are not sufficient to enable the registered public accounting firm to
complete their required annual audit of Celltrions GAAP financial statements in a
timely fashion, if at all.


If we do not receive adequate timely
financial reporting from Celltrion, we could be delinquent in our filings required under
Section 13 of the Exchange Act and we might not be able to maintain or file registration
statements relating to shares of our common stock. If we are relisted and are unable to
timely file periodic reports, we could again be delisted from Nasdaq. In addition,
Celltrions failure to achieve and maintain an effective internal control environment
for GAAP periodic financial reporting may also cause our investors to lose confidence in
our filed financial statements, which could have a material adverse effect on the market
price of our common stock.


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


As a result of our failure to have
current financial statements for the fiscal years ended December 31, 2003, 2002 and 2001,
we have been delisted from the Nasdaq, and our common stock is not currently listed on any
national stock exchange or on Nasdaq or the Nasdaq SmallCap Market. 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 re-listed on Nasdaq or for our common
stock to be listed on a national exchange or the Nasdaq SmallCap Market. 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. In order to be eligible for relisting we must meet Nasdaq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 traded on the Pink Sheets, LLC.


We are currently not eligible to
register securities with the SEC, and 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, completed the restatement of our 2001
through 2003 financial statements, filed amended and outstanding reports and regained
compliance with Sections 13 and 15(d) of the Exchange Act.

Our
internal controls may not be sufficient to ensure timely and reliable financial
information.

In response to a letter the Audit
Committee of the Board of Directors received from our independent auditors
regarding material weaknesses in the effectiveness of our internal controls, we
believe we need to correct deficiencies in our internal controls and procedures
for financial reporting. These deficiencies include insufficient staffing,
inadequate controls and procedures relating to revenue recognition for
government contracts, account reconciliations, segregation of duties, journal
entries 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
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.

55

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

We will require additional funds to
continue operations and may attempt to raise these funds through equity or debt
financings, collaborative arrangements with corporate partners or from other
sources. Any equity financings will be dilutive to existing stockholders, and
any debt financings will likely involve covenants restricting our business
activities. 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, drug candidates or marketing territories under the terms of
certain of our collaborative agreements.

We
may fail to obtain contracts to supply the Strategic National Stockpiles of
anthrax and smallpox vaccines to the U.S. government, and we may be unable to
commercialize our vaccine candidates.

The U.S. government has undertaken
commitments to help secure improved countermeasures against bioterrorism,
including the stockpiling of vaccines for anthrax and smallpox. On September
30, 2003, VaxGen and Avecia were awarded cost-reimbursement plus fixed fee
contracts to advance development of their respective anthrax vaccines and to
each supply an inventory of three million doses of their anthrax vaccines to
the U.S. government. These contracts have estimated values of $80.3 million and
$71.3 million, respectively. Under the then current version of Project
BioShield, the U.S. government expected to purchase a total of 60 million doses
of an rPA anthrax vaccine over a 10-year period. On March 11, 2004, the
government issued a request for proposal, which increased the size of the
intended stockpile from 60 million doses to 75 million doses. The process of
obtaining government contracts is lengthy and uncertain and we must compete for
each contract. Moreover, the award of one government contract does not
necessarily secure the award of future contracts covering the same vaccine.
Accordingly, we cannot be certain that we will be awarded any future contracts
to supply a 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 Avecia or another supplier. If the U.S.
government makes significant future contract awards for the supply of its
emergency stockpile to our competitors, such as Avecia, 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 government through consultation with a number of governmental
agencies, including the FDA, the NIH, the CDC and the Department of Homeland
Security. President Bush has proposed, and Congress is considering, measures to
accelerate the development of biodefense products through 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. In its
March 11, 2004 RFP regarding procurement of a 75 million-dose stockpile, the
government identified the OSPHEP within HHS as the procurement authority. If
competitive vaccine candidates gain approval, we could face severe competition,
which could harm our business. Furthermore, while Project BioShield was passed
by the House of Representatives, we cannot be certain that this legislation
will be enacted into law or, if it is enacted into law, predict the timing of
its enactment, nor can we predict the decisions that will be made in the future
by various government agencies.

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 result from protests
or challenges from third parties. 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.

56

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

We have entered into contracts with
NIAID and a license agreement with 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, certain of which we may not be able to satisfy.

U.S. government contracts typically
contain unfavorable termination provisions 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 contracts or extending
  existing contracts based on violations or suspected violations of laws or
  regulations;
terminate our
  existing contracts;
reduce the scope
  and value of our existing 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 and conditions in 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.

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.
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, the license agreement
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.

57

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. 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
adversely affect our business and prospects.

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 the LC16m8 Agreement, we may not, without Kaketsukens prior
written consent, file for or obtain regulatory approval, sell and or otherwise
deal in any product potentially in competition with 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 LC16m8. These restrictions will be waived if the LC16m8
Agreement is terminated due to Kaketsukens uncured material breach of 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 could 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 subcontractors in
the future.

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

To date, we have engaged primarily
in research, development and clinical testing. Since our inception in 1995, we
have not been profitable, and we cannot be certain that we will ever achieve or
sustain profitability. 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
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.

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 growth in manufacturing,
clinical and regulatory functions associated with our biodefense business. This
change and growth in our business has strained and may continue to strain our
administrative, financial and operational functions. We will need to expand our
staff and improve our systems and procedures to manage our expected growth and
to maintain an adequate system of internal controls. If we are unable to manage
the change and growth of our business effectively, we may be unable to obtain
future government contracts and our results of operations and financial
condition will be adversely affected.

58

Vaccine
development is a long, expensive and uncertain process, and delay or failure
can occur at any stage of our clinical trials.

To develop vaccine candidates, we
must provide the FDA and foreign regulatory authorities with clinical data that
demonstrate adequate safety and immune response. 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 commercial sale. 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 animal 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. If we are unable to successfully
develop our vaccine candidates, our revenues will suffer, and our stock price
is likely to decline.

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. 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 pre-clinical 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, it may delay FDA approval of our vaccine
candidates. 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.

59

The
approval requirements for vaccines used to fight bioterrorism are still
evolving, and we cannot be certain that any vaccines we develop, if effective,
would meet these requirements.

We are developing product
candidates based upon current governmental policies regulating these vaccines.
For instance, 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 animal studies and any additional
supporting data. Our business is subject to substantial risk because these
policies may change suddenly and unpredictably and in ways that could impair
our ability to obtain regulatory approval of these products, and we cannot
guarantee that the FDA will approve our anthrax and smallpox vaccines.

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

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 pre-clinical and clinical stages of development and have
not received required regulatory approval from the FDA to be commercially
marketed and sold. With the exception of LC16m8, which was licensed 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 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.
The FDA or foreign
  regulators may interpret data from pre-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.
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.60


We will be subject to continual regulatory review and periodic
  inspection and approval of manufacturing modifications, including compliance
  with cGMP regulations.Failure to
comply with these or other 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;
product recalls;
total or partial suspension of production; and
suspension or revocation of the marketing license.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. We expect that a significant portion
of the research that we will conduct will involve new and unproven
technologies. Development of a product requires substantial technical,
financial and human resources even if the product is not successfully
completed.

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 the:


lack of adequate quality or sufficient prevention benefit, or
  unacceptable safety during pre-clinical studies or clinical trials;
failure to receive necessary regulatory approvals;
existence of proprietary rights of third parties; or
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.

61

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. Our technology, including technology licensed from
Genentech and USAMRIID, or 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.
The patent positions of pharmaceutical and biotechnology companies can be
highly uncertain and involve complex legal and factual questions. No consistent
policy regarding the breadth of claims allowed in biotechnology patents has
emerged to date. 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.

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 Genentech, 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 Genentech, 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 license to commercialize the anthrax vaccine, the U.S.
government retains a license for any federal government agency to practice and
have practiced 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. In addition, we cannot
assure you that our operations or technology will not infringe intellectual
property 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.

Our South Korean manufacturing joint venture
may not be successful.

Celltrion has
not yet completed its full capitalization and we have not completed the
transfer of our technology to Celltrion. Two of the existing investors in
Celltrion have failed to meet a total of $6.3 million in funding obligations.
Celltrion will be unable to validate and operate the manufacturing facility in
the Republic of Korea if Celltrion is unable to secure or raise the necessary
funding or does not receive the necessary technology for the manufacture of
mammalian cell culture or other biopharmaceutical products.

Even if Celltrion
successfully completes the construction of its South Korean manufacturing
facility, we cannot be certain that the facility will pass domestic or foreign
regulatory approvals or be able to manufacture mammalian cell culture products
in commercial quantities on a cost-effective basis or at all. In addition, as
of September 30, 2004, Celltrion has not secured any agreements under which
products would be produced at this facility, and it is uncertain

62

whether there
will be sufficient demand for mammalian cell culture biomanufacturing to make
this facility profitable.

In addition,
the political, social and economic situation in the Republic of Korea, and the
stability of the Korean peninsula as a whole, may not provide an environment in
which Celltrion would be able to manufacture products cost-efficiently or at
all. The Korean government may impose regulations or restrictions that would
make it difficult, impractical or impossible, whether economically, legally or
otherwise, for Celltrion to conduct its business there. Celltrions
manufacturing operations may expose our business to numerous risks inherent in
international operations including:


foreign currency controls;
currency fluctuations;
trade restrictions or changes in tariffs;
the difficulties associated with staffing and managing international
  operations;
generally longer receivables collection periods;
potentially limited protection for intellectual property rights;
potentially adverse taxes; and
international conflict and war.If Celltrion
is unable to manufacture mammalian cell culture products, or if it becomes
commercially impractical for Celltrion to manufacture such products, we may not
gain financial or other benefit from the joint venture.

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 better tolerated;
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, or that are marketed before any products we develop are marketed.

63

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. For instance,
Avecia, in collaboration with Baxter Healthcare Corp. and the United Kingdoms
Defense Science and Technology Laboratory, was recently awarded a $71.3 million
cost reimbursement plus fixed fee contract by NIAID to make three million doses
of an anthrax vaccine for the U.S. government. Many of the organizations
competing with us, including Avecia, 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.

VaxGens
corporate and manufacturing facilities are primarily located in the San
Francisco Bay area. In addition to office and research facilities, through our
ownership position in both Celltrion and VCI, we have a significant investment
in VCIs biomanufacturing facilities in California, which contain sensitive and
expensive bioreactor equipment. The San Francisco Bay area is 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 VaxGen
maintains general business insurance against fires and some general business
interruptions, there can be no assurance that the amount of coverage will be
adequate in any particular case.

Celltrions manufacturing facilities are
located in the Republic of Korea. These
facilities are susceptible to damage from earthquakes and other natural
disasters, such as fires, floods and similar events.Although Celltrion maintains 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.

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 with these
groups, 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.

64

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

Our research
and development involves the controlled use of hazardous materials, chemicals
and viruses. We are subject to federal, state, local and foreign laws governing
the use, manufacture, storage, handling and disposal of such materials.
Although we believe that our safety procedures for the use, manufacture, storage,
handling and disposal of such materials comply with the standards prescribed by
federal, state, local and foreign regulations, 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 would be significant and any
adverse determination may result in liabilities in excess of our insurance
coverage. We currently have product liability insurance in the amount of $25.0
million for our anthrax program including the supply of three million doses of
anthrax vaccine to NIAID, as well as separate product liability coverage in the
amount of $25.0 million for our smallpox and AIDSVAX programs. 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 evolving, and we cannot be
certain that any such protections will apply to our vaccines or products.

Legislation
relating to medical products used to fight bioterrorism is evolving, and may
enable the U.S. government to release and use certain medical products prior to
such products obtaining FDA or other regulatory approval. According to the
terms of one proposed bill, upon a declaration of emergency, the U.S.
government may authorize the introduction and use of a qualified medical
product prior to such medical product obtaining FDA regulatory approval. Further,
such proposed legislation provides that the United States government may elect
to purchase and stockpile quantities of vaccines or products prior to receipt
of regulatory approval to fight bioterrorism. Legislation limiting or
restricting liability for the use of such vaccines is evolving, and we cannot
be certain that any such protections will apply to the vaccines or products
developed by us. If the legislation does not provide sufficient protection, and
we are not able to obtain these protections by contract, we may become subject
to product liability suits and other third party claims if vaccines or products
developed by us 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 we or our
employees 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.

65

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 products. If we lose the services of any key members of
senior management or scientific staff and we are unable to recruit qualified
replacements where we deem it necessary, we may be unable to achieve our
business objectives.

We currently do not have an internal
marketing and sales force and may rely on third parties for the sales or
marketing of some or all of our vaccines if they are successfully developed.
Our dependence on third parties may delay or impair our ability to generate
revenues, or adversely affect our profitability.

We lack any
sales or marketing history, and as of present do not have plans on developing
internally such capability, other than for sales directly to the U.S.
government and certain foreign governments. We intend to rely on third parties
for the sales and marketing of our products to entities other than the U.S. and
foreign governments. Our lack of sales and marketing personnel and distribution
relationships may impair our ability to generate revenues.

We license AIDSVAX from Genentech and our
license agreement may be terminated under certain circumstances.

From inception
through mid-2003, VaxGen was focused on research and development of a vaccine
for HIV infection (AIDSVAX), which we licensed from Genentech. This license
agreement, as amended effective as of May 1, 2002, permits Genentech to
terminate the agreement, or terminate the exclusivity of our license, if we:


fail to use due diligence in developing, seeking regulatory approval
  for, marketing or commercializing products covered by the agreement;
fail to file a BLA for AIDSVAX with the FDA prior to May 1, 2006; or
breach the license agreement and fail to cure the breach within the
  time period provided in the agreement.If Genentech
were to terminate our license agreement, we would not be able to develop or
market AIDSVAX.

Under the
Genentech license agreement, Genentech has retained title to the licensed
patents and patent applications and other licensed technology previously owned
by Genentech, while we will retain title to any improvements developed by us.

Other Risks

We are involved in litigation concerning the
results of our AIDSVAX Phase III clinical trial.

Since the
announcement of the results of the North American/European Phase III clinical
trial for AIDSVAX, we have been named in several securities class action
lawsuits and a shareholder derivative lawsuit relating to how those results
were disclosed. We are engaged in defending against these class actions, which,
if decided against us, could adversely affect our financial position. The
derivative action is purportedly being brought on our behalf, but we are
subject to certain obligations to indemnify the individual defendants in
connection with their defense of the claims asserted against them. Furthermore,
these actions are not likely to be resolved in less than a year. The costs
incurred in connection with these lawsuits could be significant and may not be
covered by our insurance policies. These lawsuits could also result in
continued diversion of our time and attention away from business operations,
which could harm our business.

66

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

Our board of
directors has the authority to establish the designation of 19,979,500
additional 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. The
issuance and conversion of any such preferred stock would further dilute the
percentage ownership of our stockholders.

Our stock price may be volatile, and an
investment in our stock could decline in value.

The trading
price of our common stock has been and is likely to continue to be extremely
volatile. Our stock price could be subject to wide fluctuations in response to
a variety of factors, including the following:


failure to win future government 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 our manufacturing
  facilities in South Korea;
changes in financial estimates by securities analysts;
rumors about our business prospects, product development efforts or
  clinical trials;
if our stock is delisted or not quoted on an approved stock exchange
  or the Nasdaq National Market or Small Cap Market for five consecutive days;
  or
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;
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 National 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.

67

Fluctuations in
foreign exchange rates may adversely affect our financial position and results
of operations.

The operations
of Celltrion expose us to currency fluctuations and exchange rate risks.
Celltrion, which is incorporated in the Republic of Korea, records its
transactions in Korean Won. Celltrions results, however, are reflected in our
consolidated financial statements in U.S. dollars. Therefore, our reported results
are exposed to fluctuations in the exchange rates between the U.S. dollar and
the Korean Won. During a period in which the U.S. dollar weakens against the
Korean Won, our reported consolidated net losses will increase because our
share of Celltrions net losses in Korean Won will translate into relatively
more U.S. dollars. In addition, Celltrions purchases of engineering and
construction services in Swiss francs are translated into Korean Won at the
time of payment.

The assets and
liabilities of Celltrion that are denominated in foreign currencies are
reflected in their balance sheet in Korean Won and translated at the spot rate
at the balance sheet date. The operating expenses of Celltrion that are
denominated in foreign currencies are reflected in their statement of
operations in Korean Won and translated at the average exchange rates for the
reporting period. The resulting foreign currency translation adjustments are
recorded in our stockholders equity as accumulated other comprehensive income or
loss.

We have, in
the past, not protected ourselves from the potential negative effects of
exchange rate fluctuations resulting from Celltrions operations. We do not
expect to enter into such hedging transactions or other forms of currency
protection in the form of forward exchange contracts, options or similar
agreements. Accordingly, changes in exchange rates will cause fluctuations in
our net loss and stockholders equity. These
factors could increase our net losses and could have a material adverse effect
on our financial condition and results of operations.

On an ongoing basis, we are required to have
current GAAP financial statements for Celltrion and until we receive this
information, we may not be able to evaluate our financial condition or operating
results on a timely basis.

Effective January 1, 2004, we are required to consolidate Celltrions
financial statements into our own. Celltrion maintains its records in
accordance with Korean accounting principles; however, we require financial
statements that are prepared in accordance with GAAP and which have been
audited in conformity with U.S. Auditing Standards. Celltrions
internal controls over financial reporting may not be sufficient to enable them
to report their interim GAAP financial results to us on a timely basis. In
addition, their independent auditors could conclude that Celltrions internal
controls over financial reporting are not sufficient to enable the auditors to
complete their required annual audit of Celltrions GAAP financial statements
in a timely fashion, if at all.

If we do not receive adequate timely financial reporting from
Celltrion, we could be delinquent in our filings required under Section 13 of
the Exchange Act and we might not be able to maintain or file registration statements relating to shares of our common stock.
If we are relisted and are unable to timely file periodic reports on account of
Celltrion, we could again be delisted from Nasdaq. In addition, Celltrions
failure to achieve and maintain
an effective internal control environment for GAAP periodic financial reporting
may also cause our investors to lose confidence in our filed financial statements, which could have
a material adverse effect on the market
price of our common stock.

Celltrion
subcontractors may fail to perform, or may be delayed in performing, certain
tasks related to the construction of the Incheon manufacturing facility.

Celltrion relies on subcontractors to perform certain tasks related to
the construction of their manufacturing facility.Any significant delays in performing these tasks by
subcontractors, or a failure to perform them in compliance with applicable
governmental regulations, could cause Celltrion to fail to complete their
facility in a timely manner, if at all, which may cause them to be in breach
under their customer contracts and cause those contracts to be terminated.We cannot assure you that one or more of these
subcontractors will
not be delayed in performing, or fail to perform their obligations under these
contracts in compliance with applicable legal requirements.

68

Celltrions suppliers may fail to provide, or
may be delayed in providing, Celltrion with the necessary materials to produce
their products.

When Celltrion begins production at their
manufacturing facility, they will be relying on suppliers to provide them with
the necessary materials to produce their products. Any significant delays in obtaining
any of these materials from suppliers or other failure by suppliers to
perform as agreed may cause
Celltrion to fail to perform under their contracts, which may cause Celltrion
to be in breach under those contracts and cause those contracts to be
terminated.We cannot
assure you that Celltrion will not face shortages from one or more of these
suppliers in the future. We cannot ensure that if a shortage of
materials occurs, that Celltrion will be able to obtain suppliers that will
agree to provide them to us at terms favorable to us or at all.


ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDSNone.ITEM 3.
DEFAULTS UPON SENIOR SECURITIESNone.ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSNone.ITEM 5.
OTHER INFORMATIONNone.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.

Filed Herewith10.58

Amendment,
  dated July 14, 2004, to Joint Venture Agreement between VaxGen and certain
  investors, dated February 25, 2002.









X10.59

Warrant
  Exchange Agreement, by and between VaxGen and CD Investment Partners, Ltd,
  dated September 21, 2004.

8-K

000-26483

9-24-04

10.5210.60

Warrant
  Exchange Agreement by and between VaxGen and Societe Generale, Kepler
  Capital, LLC, Cheyenne LLC and Prism Capital 5, L.P., dated September 21,
  2004.

8-K

000-26483

9-24-04

10.5310.61

Employment
  Agreement between VaxGen and Dr. Kathrin Jansen, dated September 30, 2004. +

8-K

000-26483

10-21-04

10.5631.1

Certification of Chief Executive
Officer









X31.2

Certification of Chief Financial
Officer









X32.1

Section 1350 Certification









X69

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:February
  6, 2007

By: /s/ James P. PanekJames P. PanekChief Executive Officer
  (Principal Executive Officer)Dated:February
  6, 2007
By: /s/ Matthew J. PfefferMatthew J. PfefferChief Financial Officer
  (Principal Financial Officer)70