UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549 FORM 10-Q (Mark One) xQUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934 For the Quarterly Period Ended June 30,
2004 OR o
TRANSITION REPORT PURSUANT
TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 Commission 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 200Brisbane, 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 Exchange 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;
  and
For the three and six
  months ended June 30, 2003, in this report.Therefore, when considering
financial information for 2003, you should rely only on Amendment No. 1, our
Form 10-Q for the three months ended March 31, 2004 and this report. Except as
expressly stated herein, this report speaks to the June 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 June 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

53Item
  4

Controls
  and Procedures

54Part II

Other InformationItem
  1

Legal
  Proceedings

55Item
  1A

Risk
  Factors

56Item
  2

Unregistered
  Sales of Equity Securities and Use of Proceeds

71Item
  3

Defaults
  Upon Senior Securities

71Item
  4

Submission
  of Matters to a Vote of Security Holders

71Item
  5

Other
  Information

72Item
  6

Exhibits

72Signatures

72Certifications

733

PART I  FINANCIAL
INFORMATION

Item 1. Financial Statements

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

June 30,
  2004

December 31,
  2003ASSETSCurrent assets:Cash and
cash equivalents

$
1,973

$
13,221Investment
securities


16,267


15,464Accounts
receivable


7,497


4,464Unbilled
accounts receivable


1,251


2,094Due from
related party





386Prepaid
expenses and other current assets


2,251


682Total
current assets


29,239


36,311Investment in affiliate





34,561Property and equipment


97,189


18,517Restricted cash


9,924


1,092Other assets


3,692


3,983Total
assets

$
140,044

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

$
5,138

$
4,908Accrued and
other current liabilities


7,791


4,155Derivative
liabilities


16,829


3,407Current
portion of obligation to related party





2,575Due to
related parties


5,719


210Total
current liabilities


35,477


15,255Non-current obligations


43,095


Obligation to related
  party, non-current





31,540Other liabilities


768


629Total
liabilities


79,340


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





5,818Minority interest in
  variable interest entity


25,733


Stockholders equity:Common
stock


253


250Additional
paid-in capital


205,442


184,032Deferred
stock compensation


(1,802
)

(242
)Accumulated
deficit


(172,529
)

(146,438
)Accumulated
other comprehensive income


3,607


3,620Total
stockholders equity


34,971


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

$
140,044

$
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
  June 30,

Six
  Months Ended
  June 30,2004

2003
  (Restated)

2004

2003
  (Restated)Revenues:Research
contracts and grants

$
11,109

$
3,861

$
15,054

$
6,350Related
party services





315





572Total
revenues


11,109


4,176


15,054


6,922Operating
expenses:Research
and development:Related
party





30


55


98Other


11,738


5,170


18,376


10,809Total
research and development


11,738


5,200


18,431


10,907General and
administrative


5,675


2,966


10,533


6,391Loss from
operations


(6,304
)

(3,990
)

(13,910
)

(10,376
)Other
income (expense):Investment
income and other


168


177


416


380Valuation
adjustments


(12,046
)

(1,197
)

(13,722
)

6,243Equity in
loss of affiliate





(201
)




(6,000
)Total
other income (expense)


(11,878
)

(1,221
)

(13,306
)

623Net loss
before minority interest


(18,182
)

(5,211
)

(27,216
)

(9,753
)Minority
interest in loss of subsidiary





92





255Minority
interest in loss of variable
  interest entity


584





1,125


Net
loss


(17,598
)

(5,119
)

(26,091
)

(9,498
)Charges
related to Series A preferred
  stock:Dividends





(46
)




(103
)Accretion
to redemption value





(602
)




(762
)Beneficial
conversion charges





(1,221
)




(1,446
)Net loss
applicable to common stockholders

$
(17,598
)
$
(6,988
)
$
(26,091
)
$
(11,809
)Basic and
diluted loss per share applicable
  to common stockholders

$
(0.70
)
$
(0.40
)
$
(1.04
)
$
(0.71
)Weighted
average shares used in computing
  basic and diluted loss per share applicable to common stockholders


25,221


17,358


25,135


16,606See accompanying notes to condensed
consolidated financial statements.

5

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

Six
  Months Ended
  June 30,2004

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

$
(26,091
)
$
(9,498
)Adjustments
to reconcile net loss to net cash used in operating
  activities:Minority
interest in loss of subsidiary





(255
)Minority
interest in loss of variable interest entity


(1,125
)

Depreciation and amortization


818


593Amortization of premiums and discounts on investment securities


145


(154
)Stock
compensation expense


846


349Valuation
adjustments


13,420


(6,243
)Equity in
loss of affiliate





6,000Changes in
assets and liabilities:Receivables


(2,457
)

(242
)Prepaid
expenses and other current assets


504


1,111Accounts
payable


39


478Accrued
and other current liabilities


3,146


(2,617
)Due to
related parties


(62
)

(703
)Other
liabilities


(50
)

51Net cash used
in operating activities


(10,867
)

(11,130
)Cash flows
from investing activities:Purchase of
investment securities


(9,132
)

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


7,237


11,390Purchase of
property and equipment


(20,759
)

(9,100
)Cash from
consolidation of variable interest entity


9,723


Deposits
and other


(117
)

42Change in
restricted cash


(177
)

(6
)Net cash used
in investing activities


(13,225
)

(2,288
)Cash flows
from financing activities:Stock
issued in private placements, net


2,965


11,685Proceeds
from non-current obligations


9,759


Payments on
non-current obligations


(1,169
)

Exercise of
employee stock options


546


630Employee
stock purchase plan


447


235Other


87


(598
)Net cash
provided by financing activities


12,635


11,952Effect of
exchange rate changes on cash


209


Decrease in
cash and cash equivalents


(11,248
)

(1,466
)Cash and
cash equivalents at beginning of period


13,221


9,360Cash and
cash equivalents at end of period

$
1,973

$
7,894Supplemental schedule of non cash investing and
  financing activities:Accrued
purchases of construction in progress

$
2,468

$
Accretion
to redemption value of Series A preferred stock





762Amortization of beneficial conversion feature of Series A preferred
  stock





1,446See accompanying notes to condensed
consolidated financial statements.

6

VaxGen, Inc.Notes to Condensed
Consolidated Financial Statements1. 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 six month periods ended June 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.

7

Basis
of Presentation and 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 six months ended June 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.

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

June 30,
  2004Cash and cash equivalents

$
918Property and equipment


77,118Restricted cash


8,827Non-current obligations


43,095Net assets


73,325In 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.

8

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

Three
  Months
  Ended June 30,
  2004

Six Months
  Ended June 30,
  2004Operating expenses:Research and
development

$
338

$
689General and
administrative


717


1,247Loss from operations


(1,055
)

(1,936
)Other income


101


258Minority interest


584


1,125Net loss

$
(370
)
$
(553
)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; and
For the three and six
  months ended June 30, 2003, in this report.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.9


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 June 30, 2003Previously
  Reported

Adjustments

RestatedRevenues:Research
contracts and grants

$
2,565

$
1,296

$
3,861Related party
services


206


109


315Total
revenues


2,771


1,405


4,176Operating
  expenses:Research and
development:Related
party


692


(662
)

30Other


4,644


526


5,170Total
research and development


5,336


(136
)

5,200General and
administrative


4,010


(1,044
)

2,966Loss from
operations


(6,575
)

2,585


(3,990
)Other income
  (expense):Investment
income and other


176


1


177Valuation
adjustments


(1,024
)

(173
)

(1,197
)Equity in loss
of affiliate





(201
)

(201
)Total other
income (expense)


(848
)

(373
)

(1,221
)Net loss
before minority interest


(7,423
)

2,212


(5,211
)Minority interest in loss of subsidiary


168


(76
)

92Net
loss


(7,255
)

2,136


(5,119
)Charges
  related to Series A preferred stock:Dividends


(46
)




(46
)Accretion to
redemption value


(222
)

(380
)

(602
)Beneficial
conversion charges


(2,132
)

911


(1,221
)Net loss
applicable to common stockholders

$
(9,655
)
$
2,667

$
(6,988
)Basic and
  diluted net loss per share applicable to common stockholders

$
(0.56
)
$
0.16

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


17,358





17,35811

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

Six Months Ended June 30, 2003Previously
  Reported

Adjustments

RestatedRevenues:Research
contracts and grants

$
3,677

$
2,673

$
6,350Related party
services


307


265


572Total
revenues


3,984


2,938


6,922Operating
  expenses:Research and
development:Related
party


1,052


(954
)

98Other


8,309


2,500


10,809Total
research and development


9,361


1,546


10,907General and
administrative


8,465


(2,074
)

6,391Loss from
operations


(13,842
)

3,466


(10,376
)Other income
  (expense):Investment
income and other


379


1


380Valuation
adjustments


4,051


2,192


6,243Equity in loss
of affiliate





(6,000
)

(6,000
)Total other
income (expense)


4,430


(3,807
)

623Net loss
before minority interest


(9,412
)

(341
)

(9,753
)Minority
  interest in loss of subsidiary


584


(329
)

255Net
loss


(8,828
)

(670
)

(9,498
)Charges
  related to Series A preferred stock:Dividends


(103
)




(103
)Accretion to
redemption value


(302
)

(460
)

(762
)Beneficial
conversion charges


(2,459
)

1,013


(1,446
)Net loss
applicable to common stockholders

$
(11,692
)
$
(117
)
$
(11,809
)Basic and
  diluted net loss per share applicable to common stockholders

$
(0.70
)
$
(0.01
)
$
(0.71
)Weighted average shares used in
computing
  basic and diluted net loss per share applicable to common stockholders


16,606





16,606CONDENSED CONSOLIDATED STATEMENT OF CASH
FLOWS
(in thousands)

Six Months Ended June 30, 2003Previously
  Reported

Adjustments

RestatedCash
  provided by (used in):Operating
activities

$
(11,507
)
$
377

$
(11,130
)Investing
activities


2,425


(4,713
)

(2,288
)Financing
activities


12,527


(575
)

11,952Increase in
  cash and cash equivalents


3,445


(4,911
)

(1,466
)Cash and
  cash equivalents at beginning of period


4,449


4,911


9,360Cash and
  cash equivalents at end of period

$
7,894

$


$
7,89412

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 June 30, 2003Previously
  Reported

Adjustments

RestatedNet loss

$
(7,255
)
$
2,136

$
(5,119
)Other
  comprehensive income (loss):Translation
adjustment





1,552


1,552Unrealized
gain (loss)


(134
)

1


(133
)Total other
  comprehensive income (loss)


(134
)

1,553


1,419Comprehensive
  loss

$
(7,389
)
$
3,689

$
(3,700
)Six Months Ended June 30, 2003Previously
  Reported

Adjustments

RestatedNet loss

$
(8,828
)
$
(670
)
$
(9,498
)Other comprehensive
  loss:Translation
adjustment





(224
)

(224
)Unrealized
gain (loss)


(246
)




(246
)Total other
  comprehensive income (loss)


(246
)

(224
)

(470
)Comprehensive
  loss

$
(9,074
)
$
(894
)
$
(9,968
)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 June 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.

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.

13

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 June 30, 2004 had a weighted-average exercise price of 8,198 Korean Won ($7.09 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 would have been increased to the pro forma amounts indicated below (in thousands, except per share data):

Three Months Ended June 30,

Six Months Ended June 30,2003



20032004

(Restated)

2004

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

$
(17,598
)
$
(6,988
)
$
(26,091
)
$
(11,809
)Add: Stock-based employee compensation expense included in reported net loss, net of minority interest


147


51


216


119Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of minority interest


(2,246
)

(1,908
)

(3,962
)

(3,745
)Net loss applicable to common stockholders  pro forma

$
(19,697
)
$
(8,845
)
$
(29,837
)
$
(15,435
)Net loss per share applicable to common stockholders  basic and diluted, as reported

$
(0.70
)
$
(0.40
)
$
(1.04
)
$
(0.71
)Net loss per share applicable to common stockholders  basic and diluted, pro forma

$
(0.78
)
$
(0.51
)
$
(1.19
)
$
(0.93
)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 June 30,

Six Months Ended June 30,2004

2003

2004

2003VaxGen Stock Option PlansRisk-free interest rate

3.85
%

2.36
%

3.78
%

2.55
%Expected life in years

5.0


4.0


5.0


4.0Volatility

99
%

104
%

100
%

102
%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

1.70
%

1.06
%

1.36
%


1.10



%Expected life in years

1.0


1.0


1.0


1.0Volatility

78
%

141
%

88
%

135
%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

15

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 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 June 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.


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

18

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.


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

19

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, Employee Stock Purchase Plan and Series A Preferred Stock, 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.

June 30,2004

2003Potentially dilutive securities:Options to purchase common stock


4,536,116


3,052,874Warrants to purchase common stock


985,831


1,021,302Employee Stock Purchase Plan





279,262Series A Preferred Stock





203,833Total


5,521,947


4,557,2715. Balance Sheet Components


Restricted Cash


At June 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 June 30, 2004, Celltrion had restricted cash of 10,000 million Korean Won ($8.7 million equivalent) on deposit with its lending bank, representing a minimum deposit required to secure a loan.


Property and Equipment


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

June 30,2004

December 31,2003Construction in progress

$
79,019

$
14,347Land


13,010


Leasehold improvements


3,201


3,138Machinery, furniture and equipment


7,320


5,466Sub-total


102,550


22,951Less: accumulated depreciation and amortization


(5,361
)

(4,434
)Total

$
97,189

$
18,517Accrued and Other Current Liabilities


Accrued and other current liabilities at June 30, 2004 and December 31, 2003 included employment and severance benefit accruals of $2.3 million and $2.9 million, respectively.

20

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 June 30, 2004, the carrying amounts for land and construction in progress were 15,033 million Korean Won and 73,384 million Korean Won (equivalent to $13.0 million and $63.4 million), respectively. At June 30, 2004, Celltrion had unused commitments related to the Loan of 12,749 million Korean Won (equivalent to $11.0 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 June 30, 2004). Cash outlays for interest on borrowings related to this loan totaled $0.4 million and $0.8 million for the three and six months ended June 30, 2004, respectively.


The following is a summary of non-current obligations (in thousands, presented at June 30, 2004 exchange rates):

June 30, 2004Land purchase obligation


$
9,036Less: current portion



Non-current land purchase obligation



9,036Construction loan



33,969Sub-total



43,005Accrued long-term interest



90Non-current obligations


$
43,095In 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 $0.5million and $1.0 million was capitalized for the three and six months ended June 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 June 30, 2004 are as follows (in thousands, presented at June 30, 2004 exchange rates):

2004

$
2005


2,2592006


2,8312007


9,0522008


6,7942009 and beyond


22,069Total

$
43,00521

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 June 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 June 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 $25.7 million in the unaudited condensed consolidated balance sheet at June 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 $22.1 million at June 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 or Celltrion Warrants).


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 Celltrion Warrants granted were 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. 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 Celltrion Warrants was determined to be $25.5 million.

22

To determine the fair value of the Celltrion Warrants at the date of grant, Celltrion utilized the following assumptions:

Risk-free interest rate


4.88%Expected average life


0.72 yearExpected volatility


41.92%Expected dividend yield


0.00%The following is a summary of Celltrion Warrants outstanding at June 30, 2004:

Exercise Price

Term(in months)

SharesFirst Tranche, April 13, 2004

5,000 Korean Won($4.33 equivalent)

7.5

3,306,500Celltrion 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 June 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.

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. For the period from May 17, 2004 to June 30, 2004, the Company paid $0.3 million in cash penalty payments to the holders of the Series A Warrants. At June 30, 2004, the embedded derivative liability was valued at $11.1 million. Due to the quarterly revaluation of the embedded derivative liability, the Company recorded in the statements of operations other expense of $10.4 million and $0.3 million for the three months ended June 30, 2004 and 2003, respectively; and other expense of $10.5 million and other income of $1.1 million for the six months ended June 30, 2004 and 2003, respectively.

23

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 June 30,
2004, 1,405 million Korean Won (equivalent to $1.2 million) is included in
other non-current assets representing the remaining balance of advance payments
made to Daewoo. Additionally, Celltrion had outstanding construction accruals
due to Daewoo of $5.6 million as of June 30, 2004.  During the three and six months ended June 30, 2004, Celltrion
paid Daewoo $4.3 million and $13.6 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):

June 30,
  2004

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

$
43,325

$
38,546Research and other credit
carryforwards


7,502


5,345Deferred research
expenses


1,243


1,447Depreciation


2,314


1,818Accrued liabilities


827


540Other


(1,122
)

(669
)Total gross deferred tax
assets


54,089


47,027Less: Valuation
allowance


(54,089
)

(47,027
)Net deferred tax
assets

$


$
24

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

Three
        Months Ended
        June 30,
    
    Six
        Months EndedJune 30,2004
    
    2003(Restated)
    
    2004
    
    2003(Restated)Statutory
        rate
    
    
    34.0
    %
    
    34.0
    %
    
    34.0
    %
    
    34.0
    %Equity
        in loss of affiliate
    
    
    0.0
    
    
    (1.3
    )
    
    0.0
    
    
    (21.5
    )Valuation
        adjustments
    
    
    (22.8
    )
    
    (8.0
    )
    
    (17.7
    )
    
    22.3Equity-based
        compensation expense
    
    
    (0.2
    )
    
    (0.6
    )
    
    (0.2
    )
    
    (0.7
    )Research
        and other credits
    
    
    4.6
    
    
    0.6
    
    
    6.1
    
    
    0.7Exemption
        for foreign ownership
    
    
    (1.4
    )
    
    
    
    
    (1.7
    )
    
    Change
        in foreign tax rates
    
    
    
    
    
    
    
    
    (0.2
    )
    
    Foreign
        tax rates less than statutory rate
    
    
    (0.7
    )
    
    
    
    
    (0.6
    )
    
    Other
    
    
    2.0
    
    
    (0.3
    )
    
    1.5
    
    
    (1.1
    )Change
        in valuation allowance
    
    
    (15.5
    )
    
    (24.4
    )
    
    (21.2
    )
    
    (33.7
    )Effective
        tax rate
    
    
    0.0
    %
    
    0.0
    %
    
    0.0
    %
    
    0.0
    %At June 30,
2004, VaxGen had U.S. federal and California net operating loss carryforwards
of $110 million and $88 million, respectively.
The U.S. federal and California net operating loss carryforwards expire
by from 2015 through 2024 and 2005 through 2014, respectively.  Additionally, as of June 30, 2004, VaxGen
has federal research credits, expiring from 2015 through 2024, of $3.6 million
and State of California research credits, carrying forward indefinitely, of
$2.8 million.  These carryforwards could
be subject to certain limitations in the event there is a change in control of
VaxGen.

As of June 30,
2004, Celltrion had net operating losses for Korean tax purposes of 5,760
million Korean Won (equivalent to $5.0 million).  The carryforwards expire from 2007 to 2009. Additionally,
Celltrion has various tax credit carryforwards, expiring from 2007 to 2010,
totaling 2,413 million Korean Won (equivalent to $2.1 million) at June 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 the Company 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.

25

The Companys
comprehensive loss consists of the following (in thousands):

Three Months EndedJune 30,

Six Months EndedJune 30,2004

2003
  (Restated)

2004

2003 
  (Restated)Net loss

$
(17,598
)
$
(5,119
)
$
(26,091
)
$
(9,498
)Other comprehensive income
(loss):Foreign
currency translation adjustments


(272
)

1,552


74


(224
)Unrealized
gains on available-for-sale securities


(117
)

(133
)

(87
)

(246
)Other comprehensive income
(loss)


(389
)

1,419


(13
)

(470
)Comprehensive loss

$
(17,987
)
$
(3,700
)
$
(26,104
)
$
(9,968
)The Companys
accumulated other comprehensive income balance consists of the following (in
thousands):

June 30,
  2004

December
  31,
  2003Foreign
  currency translation adjustments

$
3,687

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


(80
)

7Accumulated
  other comprehensive income

$
3,607

$
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.  Celltrion had an unused commitment related
to the letter of credit of $5.7 million as of June 30, 2004.

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.

26

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 June 30,
2004, the Company believed that it had strong defenses and intended to defend
these actions vigorously.  See
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 June
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.

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
June 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.

27

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

Three Months Ended June 30,

Six Months Ended June 30,Revenues

2004

2003

2004

2003VaxGen

$
11,241

$
4,176

$
15,321

$
6,922Celltrion





n/a





n/aEliminations


(132
)

n/a


(267
)

n/aTotal

$
11,109

$
4,176

$
15,054

$
6,922Three Months Ended June 30,

Six Months Ended June 30,Depreciation and Amortization

2004

2003

2004

2003VaxGen

$
442

$
310

$
746

$
593Celltrion


445


n/a


882


n/aEliminations


(407
)

n/a


(810
)

n/aTotal

$
480

$
310

$
818

$
593Three Months Ended June 30,

Six Months Ended June 30,Equity in Loss of Affiliate

2004

2003

2004

2003VaxGen (in Celltrion)

$
(780
)
$
(201
)
$
(1,432
)
$
(6,000
)Celltrion (in VCI)


(144
)

n/a


(527
)

n/aEliminations


924


n/a


1,959


n/aTotal

$


$
(201
)
$


$
(6,000
)Three Months Ended June 30,

Six Months Ended June 30,Net Loss

2004

2003

2004

2003VaxGen

$
(17,551
)
$
(5,119
)
$
(25,977
)
$
(9,498
)Celltrion


(1,643
)

n/a


(3,051
)

n/aEliminations


1,596


n/a


2,937


n/aTotal

$
(17,598
)
$
(5,119
)
$
(26,091
)
$
(9,498
)Property, Plant and Equipment,
  net

June 30,  2004

December 31, 2003VaxGen

$
20,071

$
18,517Celltrion


77,252


n/aEliminations


(134
)

n/aTotal

$
97,189

$
18,517Investment in Affiliate

June 30,  2004

December 31,2003VaxGen (in Celltrion)

$
33,129

$
34,561Celltrion (in VCI)


5,232


n/aEliminations


(38,361
)

n/aTotal

$


$
34,56128

Total
  Assets

June 30,
  2004

December
  31,
  2003VaxGen

$
85,956

$
94,464Celltrion


127,358


n/aEliminations


(73,270
)

n/aTotal

$
140,044

$
94,464Three Months Ended
  June 30,

Six Months Ended
  June 30,Purchases of Property and
  Equipment

2004

2003

2004

2003VaxGen

$
(1,169
)
$
(5,039
)
$
(2,300
)
$
(9,100
)Celltrion


(6,877
)

n/a


(18,459
)

n/aEliminations





n/a





n/aTotal

$
(8,046
)
$
(5,039
)
$
(20,759
)
$
(9,100
)16. Subsequent Events

Series
A Warrants

For the period
from July 1, 2004 to September 21, 2004, the Company paid $0.5 million 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.  The $0.01 per share Exchange Warrants were
exercised by the end of January 2005.
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.

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.

29

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.

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.

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.

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:

June
        30,2004
    
    Increasedue to
        Amendment
    
    AdjustedPayments2004
    
    $
    1,402
    
    $
    
    
    $
    1,4022005
    
    
    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
    
    $
    10,102
    
    $
    35,895
    
    $
    45,997Resolution
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. C03-1129 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
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 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 which was for 47,400 million Korean Won plus 25.7 million Swiss
francs.

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 June 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 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.

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.

Celltrion
Stock, Options and Warrants

On
July 14, 2004, Celltrion granted warrants to all of its existing stockholders
to acquire 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). 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, 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.  However, they each 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 June 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 per
share ($7.49 equivalent) and 7,047
Korean Won per share ($7.20
equivalent), 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,

35

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 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).

Restricted
Cash

In
September 2004, Celltrion was released from the requirement to maintain a
10,000 million Korean Won ($8.8 million
equivalent) deposit to secure a loan for the construction of Celltrions
facility.

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.

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.

37

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 June 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 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. 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 the 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 June 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 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.

38

RESULTS
OF OPERATIONS

Comparison of Fiscal Quarters Ended June 30,
2004 and 2003

Revenues

Three
  Months Ended
  June 30,

Percent
  change
  2004/2003

Six Months Ended
  June 30,

Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003
  (Restated)(in thousands)




(in thousands)Research
  contracts and grants

$
11,109

$
3,861

188
%

$
15,054

$
6,350

137
%Related
  party services





315

(100
%)





572

(100
%)Total
  revenues

$
11,109

$
4,176

166
%

$
15,054

$
6,922

117
%Total revenues
increased by $6.9 million to $11.1 million in the three months ended June 30,
2004 over the comparable period in 2003 due primarily to an increase in
activities related to our NIAID Contracts partially offset by a substantial
decrease in revenues from AIDSVAXrelated activities and a decrease in related
party services and consisted principally of:


Contract
  revenues of $10.1 million recognized on our NIAID Contracts primarily reflecting work
  performed under the 2003 Anthrax Contract;
Grant
  revenues of $0.8 million from SAIC-Frederick, Inc. to complete certain
  residual activities related to the completion of the AIDSVAX clinical trials;
  and
Grant
  revenues of $0.2 million from two NIAID-funded SBIR grants.Revenues in
  the three months ended June 30, 2003 primarily consisted of:
Contract
  revenues of $3.4 million recognized on the completion of work performed under
  the 2002 Anthrax Contract;
Grant
  revenues of $0.5 million from two NIAID-funded SBIR grants; 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 $8.1 million to $15.1 million in the six months ended
  June 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 $13.7 million recognized on our NIAID Contracts primarily
  reflecting work performed under the 2003 Anthrax Contract;
Grant
  revenues of $0.9 million from SAIC-Frederick, Inc. to complete certain
  residual activities related to the completion of the AIDSVAX clinical trials;
  and
Grant
  revenues of $0.5 million from two NIAID-funded SBIR grants.Revenues in
  the six months ended June 30, 2003 primarily consisted of:
Contract
  revenues of $5.7 million recognized on work performed under the 2002 Anthrax
  Contract;
Grant
  revenues of $0.6 million from two NIAID-funded SBIR grants; and
Related
  party services revenues of $0.6 million earned as part of a consulting
  agreement with Celltrion.Celltrion did
not earn any revenues during these periods.

39

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
  June 30,



Six Months Ended
  June 30,Percent



Percent2004

2003(Restated)

change
  2004/2003

2004

2003(Restated)

change
  2004/2003(in thousands)



(in thousands)Related
  party

$


$
30

(100
%)


$
55

$
98

(44
%)Other


11,738


5,170

127
%



18,376


10,809

70
%Total
  research and development

$
11,738

$
5,200

126
%


$
18,431

$
10,907

69
%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
  June 30,

Percent
  change
  2004/2003

Six Months Ended
  June 30,

Percent
  change
  2004/20032004

2003(Restated)

2004


2003(Restated)(in thousands)




(in thousands)Direct
  Costs:NIAID
Contracts

$
6,845

$
1,813

277
%

$
8,869

$
2,955

200
%AIDSVAX


187


1,399

(87
%)


378


3,035

(88
%)Smallpox


754


228

231
%


1,295


418

210
%VCI


721


170

323
%


1,904


561

239
%Total direct
costs


8,507


3,610

136
%


12,446


6,969

79
%Indirect and
  other costs


3,231


1,590

103
%


5,985


3,938

52
%Research and
development expenses

$
11,738

$
5,200

126
%

$
18,431

$
10,907

69
%The increase
of $6.5 million in research and development expenses in the three months ended
June 30, 2004 over the comparable period in 2003 was primarily due to:


Indirect
  research and development costs, which increased by $1.6 million, consisting
  primarily of:-
Other
  development costs, which increased by $0.9 million due to expanded
  operations;-
Celltrions
  research and development expenses in the three months ended June 30, 2004
  were $0.4 million; prior to January 1, 2004, Celltrions operations were not
  included in our consolidated results; and-
Increased
  facilities overhead costs of $0.3 million due to the expansion of the VCI
  facility.
Clinical
  trial expenses, which decreased by $1.1 million as the AIDSVAX Phase 3
  clinical trials were completed in 2003 and expenses relating to those trials
  in 2004 were minimal.40


Direct costs
  associated with our NIAID Contracts, which increased by $5.0 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;
Direct costs
  associated with our smallpox program, consisting primarily of labor costs,
  which increased by $0.5 million; and
Direct costs
  associated with supporting VCI, which increased by $0.5 million due to the
  expansion of the facility.The increase
of $7.5 million in research and development expenses in the six months ended
June 30, 2004 over the comparable period in 2003 was primarily due to:


Direct costs
  associated with our NIAID Contracts, which increased by $5.9 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 $2.6 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 $2.0 million, consisting
  primarily of:-
Other
  development costs, which increased by $1.0 million due to expanded
  operations;-
Celltrions
  research and development expenses in the six months ended June 30, 2004 were
  $0.7 million; prior to January 1, 2004, Celltrions operations were not
  included in our consolidated results; and-
Facilities
  overhead costs, which increased by $0.3 million.
Direct costs
  associated with supporting VCI, which increased by $1.3 million due to the
  expansion of the facility; and
Direct costs
  associated with our smallpox program, consisting primarily of labor costs,
  which increased by $0.9 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
  June 30,

Percent
  change
  2004/2003

Six Months Ended
  June 30,

Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003
  (Restated)(in thousands)




(in thousands)General and administrative
expenses

$
5,675

$
2,966

91%

$
10,533

$
6,391

65%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 June 30, 2004 over the comparable period of 2003 was primarily due to:


Professional
  services, which increased by $1.0 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);
Celltrions
  general and administrative expenses in the three months ended June 30, 2004 were
  $0.8 million; prior to January 1, 2004, Celltrions operations were not
  included in our consolidated results;
Personnel
  costs, which increased $0.7 million due to increased headcount to support our
  expanding operations;
Other
  miscellaneous expenses, which increased by $0.1 million; and
Recruiting
  fees, which increased by $0.1 million for certain senior management
  positions.The increase
of $4.1 million in general and administrative expenses in the six months ended
June 30, 2004 over the comparable period of 2003 was primarily due to:


Professional
  services, which increased by $1.1 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);
Celltrions
  general and administrative expenses in the six months ended June 30, 2004
  were $1.3 million; prior to January 1, 2004, Celltrion operations were not
  included in our consolidated results;
Personnel
  costs, which increased $0.9 million due to increased headcount to support our
  expanding operations;
During the
  six months ended June 30, 2004, we provided $0.5 million for the settlement
  of derivative lawsuits;
Recruiting
  fees, which increased by $0.2 million for certain senior management
  positions; and
Other
  miscellaneous expenses, which increased by $0.1 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
  June 30,

Percent
  change
  2004/2003

Six Months Ended
  June 30,

Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003
  (Restated)(in thousands)




(in thousands)Investment income

$
168

$
177


(5
%)
$
416

$
380


9
%Valuation adjustments


(12,046
)

(1,197
)

906
%

(13,722
)

6,243


(320
%)Equity in loss of
affiliate





(201
)
(100
%)




(6,000
)

(100
%)Other income
(expense)

$
(11,878
)
$
(1,221
)

873
%
$
(13,306
)
$
623


** Calculation
not meaningful

The increase
in other expense of $10.7 million in the three months ended June 30, 2004 from
the comparable period in 2003 was primarily due to:


Mark-to-market
  valuation adjustments related to the our derivatives, which were other
  expense of $12.0 million in the three months ended June 30, 2004 and $1.2
  million in the comparable period in 2003 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 $0.2 million in 2003 compared to zero in 2004
  as a result of the consolidation of Celltrion effective as of January 1,
  2004.The change to
other expense of $13.3 million in the six months ended June 30, 2004 from other
income of $0.6 million in the comparable period in 2003 was primarily due to:


Mark-to-market
  valuation adjustments related to the our derivatives, which were other
  expense of $13.7 million in the six months ended June 30, 2004 and other
  income of $6.2 million in the comparable period in 2003 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 $6.0 million in 2003 compared to zero in 2004
  as a result of the consolidation of Celltrion effective as of January 1,
  2004.We expect
future mark-to-market adjustments relating to the valuation of derivatives will
fluctuate, as the valuation calculation is sensitive to, and directly related
to, the likelihood of derivative instrument triggering events occurring and the
market price of our common stock on any given measurement date. 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.

43

Minority
interest in loss of subsidiary

Three Months Ended
  June 30,

Percent
  change
  2004/2003

Six Months Ended
  June 30,

Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003
  (Restated)(in thousands)




(in thousands)Minority interest in loss of
subsidiary

$


$
92

(100%)

$ 

$ 255

(100%)Minority interest in loss of subsidiary for the three months and six
months ended June 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 in the consolidation
of VaxGen, VCI and Celltrion.

Minority
interest in loss of variable interest entity

Three
  Months Ended
  June 30,

Percent
  change
  2004/2003

Six Months Ended
  June 30,

Percent
  change
  2004/20032004

2003


2004

2003(in thousands)




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

$
584

$


*

$
1,125

$


** Calculation
not meaningful

Minority interest in loss of variable interest entity for the three
months and six months ended June 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.

Charges
related to Series A preferred stock

Three
  Months Ended
  June 30,

Percent
  change
  2004/2003
Six Months Ended
  June 30,

Percent
  change
  2004/20032004

2003
  (Restated)


2004

2003
  (Restated)(in thousands)




(in thousands)Charges related to Series A
preferred stock

$


$
(1,869
)
(100%)

$


$
(2,311
)
(100%)There were no
charges related to Series A preferred stock for the three or six months ended
June 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 June 30:Cash, cash equivalents and
investment
  securities

$
18,240

$
14,599Working capital
(deficit)


(6,238
)

7,317Six
  months ended June 30:Cash provided by (used
in):Operating
activities


(10,867
)

(11,130
)Investing
activities


(13,225
)

(2,288
)Financing
activities


12,635


11,952Effect of
exchange rate changes on cash


209


Capital expenditures (included
in investing
  activities above)


(20,759
)

(9,100
)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 June 30, 2004, we had
$11.0 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 June 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 $10.9 million and $11.1 million for the six months ended June 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
  $13.4 million and income of $6.2 million in the six months ended June 30,
  2004 and 2003, respectively, reflecting changes in the fair value of
  outstanding 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 $6.0 million for our share of Celltrions net
  losses for the six months ended June 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
  depreciation and amortization of $0.8 million and $0.6 million for the six
  months ended June 30, 2004, and 2003, respectively; and
Non-cash charges for stock
  compensation of $0.8 million and $0.3 million for the six months ended June
  30, 2004, and 2003, respectively. The increase in these charges in 2004 reflects
  $0.5 million from the consolidation of Celltrion.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 six months ended June 30, 2004 were made in connection with the
expansion of the Korean manufacturing facility ($18.5 million) and research and
development laboratories and leasehold improvements associated with the
California manufacturing facility and office facilities ($2.3 million). Capital
expenditures in the six months ended June 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 used in investing activities in
2004 also included $9.7 million from the consolidation of Celltrion as a
variable interest entity effective January 1, 2004.

Net cash
provided by our financing activities increased $0.7 million to $12.6 million in
2004 from $11.9 million in 2003 and primarily consisted of the proceeds from
private placements and from Celltrions construction borrowings.

At June 30, 2004, $18.2
million, or 13%, of our assets consisted of cash, cash equivalents and
short-term investments. We had a working capital deficit of $6.2 million at
June 30, 2004, compared to working capital of $7.3 million at June 30, 2003.
This $13.5 million decrease in working capital is primarily due to our
derivative liabilities which increased by $14.4 million in fair value as a
result of 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.

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.
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 June 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,
we engaged a sub-contractor to provide component materials for the NIAID
project. The total commitment was for $6.8 million. If NIAID terminates the
related parts of its contracts with us, we may have a financial liability to
this sub-contractor and such amounts, if any, may not be reimbursable by NIAID.
There were no other significant changes in our contractual obligations during
the six months ended June 30, 2004.

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

Payments
        Due by PeriodTotal
    
    2004
    
    2005-06
    
    2007-08
    
    2009
        and
        beyond(in
        thousands)Operating
        lease obligations (1)
    
    $
    10,102
    
    $
    1,402
    
    $
    5,534
    
    $
    3,166
    
    $
    Celltrion
        obligations (2)
    
    
    53,623
    
    
    2,043
    
    
    8,947
    
    
    18,642
    
    
    23,991Purchase
        obligations (3)
    
    
    362
    
    
    162
    
    
    50
    
    
    20
    
    
    130Total
        contractual obligations
    
    $
    64,087
    
    $
    3,607
    
    $
    14,531
    
    $
    21,828
    
    $
    24,121(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 June 30, 2004.(3)
Purchase
  obligations include service agreements, contracts related to manufacturing
  and research operations and license agreements.Off-Balance Sheet Arrangements

As of June 30, 2004, we did not
have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC
Regulation S-K.

47
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 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,

48

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 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.

49

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 June 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
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
05-08, 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

50

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. 03-1 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. 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.

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.

51

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.
The Company does not expect the adoption of EITF 06-7 to have a material impact
on its consolidated financial position, results of operations or cash flows.

In 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.

52

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK

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

Interest
Rate Risk

We are exposed to market rate
changes by debt securities included in our investment portfolio. By policy, we
invest in debt instruments of the U.S. government, federal agencies and
high-quality corporate issuers, limit the amount of credit exposure to any one
issuer, and limit duration by restricting the term. Investments in both fixed
rate and floating rate instruments carry a degree of interest rate risk. Fixed
rate securities may have their fair market value adversely affected due to a
rise in interest rates, while floating rate securities may produce less income
than expected if interest rates fall. Due in part to these factors, our future
investment income may decrease due to changes in interest rates or due to
losses we may suffer when securities decline in market value. At June 30, 2004,
we held available-for-sale securities in the principal amount of $16.3 million.
If market interest rates were to increase immediately and uniformly by 10% from
levels at June 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 June
30, 2004). At June 30, 2004, Celltrion owed 39,251 million Korean Won ($34.0
million equivalent) related to the
Loan. If market interest rates were to increase immediately and
uniformly by 10% from levels at June 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. As of June 30,
2004, we did not invest in derivative financial instruments, interest rate
swaps or other investments that alter interest rate exposure.

Foreign
Currency Risk

Our exposure to foreign currency exchange rates is related primarily to
our investment in Celltrion. Our 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 June 30, 2004, the
change would not have a significant effect on our operations or cash flows. As of June 30, 2004, we did not invest in
derivative financial instruments, currency swaps or other investments that
alter foreign currency exposure.

Derivative
Valuation Risk

The terms of our 2001 Series A Preferred Stock offering include
registration rights and put features not under our control. These features are
considered to be an embedded derivative liability and we determined the fair
value of this derivative to be $3.9 million on the date of issuance. Due to the
quarterly revaluation of the embedded derivative liability, we recorded in our
statements of operations other expense of $10.4 million and $0.3 million for
the three

53

months ended June 30, 2004 and 2003, respectively; and other expense of
$10.5 million and other income of $1.1 million for the six months ended June
30, 2004 and 2003, respectively. At June 30, 2004, the embedded derivative
liability was valued at $11.1 million. We determine the fair value of the
derivative liabilities using the Monte Carlo Simulation methodology. This
methodology allows flexibility in incorporating various assumptions such as
probabilities of certain triggering events. The valuations are based on the
information available as of the various valuation dates. Factors affecting the
amount of these liabilities include expectations regarding triggering events,
the market value of our common stock, the estimated volatility of our common
stock, our market capitalization, the risk free interest rate and other
assumptions.

The inputs for the valuation analysis of the derivatives embedded in
the Series A Warrants include the probabilities of certain triggering events,
which we believed to be likely as of June 30, 2004. We did not file our
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, our registration
statement on Form S-3 covering the resale of 655,078 shares of common stock
issuable upon exercise of our warrants, issued in conjunction with the Series A
Preferred Stock 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 we became liable for monthly cash penalty
payments to the Series A Warrant holders. For the period from May 17, 2004 to
June 30, 2004, we paid $0.3 million in cash penalty payments to the holders of
the Series A Warrants. For a discussion of events in September of 2004, see
Subsequent Events in Note 16 to the condensed consolidated financial
statements.

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 June 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.

54

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;
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

55

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 June
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.

ITEM 1A. RISK FACTORS

For the six months ended June 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 Risks
Related to the Issuance of Series A 6% Cumulative Redeemable Convertible
Preferred Stock (Series A Preferred Stock) and Warrants which are
discussed below.

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 Related to the
Issuance of Series A 6% Cumulative Redeemable Convertible Preferred Stock
(Series A Preferred Stock) and Warrants

We
may be obligated to redeem the common stock issued on exercise of the warrants
and/or the warrants at a premium to the purchase or exercise price.

On May 23, 2001, we completed a
private placement in which we issued 20,000 shares of our Series A Preferred
Stock and warrants, or the Series A Warrants, to purchase common stock for
aggregate proceeds of $20.0 million. As of June 30, 2004, there were no shares
of Series A Preferred Stock outstanding; however, there remain Series A
Warrants to purchase 655,078 shares of common stock outstanding. As of June 30,
2004, only one share of common stock had been issued upon the exercise of
Series A Warrants. The terms of the Series A Warrants give the holders a
contractual right to require us to redeem all of the common stock issued upon
exercise of the Series A Warrants or the Series A Warrants at a 20% premium to
the gain that holders may receive upon conversion of the Series A Warrants
under certain circumstances including:


if we breach certain of our obligations under the purchase agreements
  between us and the holders;
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
if we are insolvent or certain actions are taken as part of a
  bankruptcy proceeding.We 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,
our registration statement on Form S-3 covering the resale of 655,078 shares of
common stock issuable upon exercise of our warrants, issued in conjunction with
the Series A Preferred Stock 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 we became liable for monthly cash penalty
payments to the Series A Warrant holders. For the period from May 17, 2004 to
June 30, 2004, we paid $0.3 million in cash penalty payments to the holders of
the Series A Warrants. For a discussion of events in September of 2004, see
Subsequent Events in Note 16 to the condensed consolidated financial
statements.

Continued penalty payments or the
redemption of the Series A Warrants would require the expenditure of a
significant amount of cash and, consequently, could harm our business.

56

If
our warrant holders elect to have their warrants assumed by a potential
acquirer of VaxGen, the acquirer could be deterred from completing the
acquisition.

Holders of the Series A Warrants
can elect to have their Series A Warrants remain outstanding after an
acquisition of VaxGen and to have the acquirer assume all of our obligations to
the holder. The ability of the holders of the Series A Warrants to force an
acquirer to assume the Series A Warrants could deter a potential acquirer from
completing an acquisition of VaxGen.

Risks Relating to Our
Business

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.

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.

57

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.

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.

58

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.

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.

59

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.

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

60

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.

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.

61

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.
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;62


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.

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.

63

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
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 June 30, 2004, Celltrion has not secured any agreements
under which products would be produced at this facility, and it is uncertain
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.

64

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.

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

65

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.

66

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.

67

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.

68

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.

69

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.

70

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
HOLDERSOn May 26, at the 2004
Annual Meeting of Stockholders, the stockholders of the Company were asked to
vote on the following items:

1.
To elect
  five directors, Lance K. Gordon, Franklin Berger, Randall L-W. Caudill,
  Michel Greco and William D. Young to serve until the Companys 2005 Annual
  Meeting of Stockholders or until their earlier retirement, resignation or
  removal;2.
To approve
  the amendment to the Companys 2001 Employee Stock Purchase Plan (the
  Plan), to increase the aggregate number of shares of Common Stock
  authorized for issuance under the Plan by 400,000 shares;3.
To approve
  the amendment and restatement of the Companys Bylaws; and4.
To ratify
  the appointment of PricewaterhouseCoopers LLP as the Companys independent
  auditors for the fiscal year ending December 31, 2004.The results of the matters
presented at the annual meeting, were as follows:

1.
Lance K. Gordon, Franklin
  Berger, Randall L-W. Caudill, Michel Greco and William D. Young were elected
  as directors of the Company to serve until the 2005 Annual Meeting of
  Stockholders as follows:Name

For

WithheldLance K. Gordon


22,966,423


80,590Franklin Berger


22,954,288


92,725Randall L-W. Caudill


22,589,311


457,702Michel Greco


22,968,838


78,175William D. Young


20,142,740


2,904,2732.
The approval of the
  amendment to the Plan, to increase the aggregate number of shares of Common
  Stock authorized for issuance under the Plan by 400,000 shares was approved
  as follows:For

Against

Abstain9,346,365


313,641


37,21871

3.
The approval of the
  amendment and restatement of the Companys Bylaws was approved as follows:For

Against

Abstain20,022,425


2,972,174


52,4144.
The ratification of
  PricewaterhouseCoopers LLP as the Companys independent auditors for the 2004
  fiscal year was approved as follows:For

Against

Abstain22,982,922


41,673


22,418ITEM 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 
  Herewith3.4

Amended and
  Restated Bylaws, dated as of May 26, 2004.









X10.57

Executive
  Employment Agreement between VaxGen and James M. Cunha, dated May 20, 2004. +

8-K

000-26483

6-06-05

10.231.1

Certification of Chief Executive
Officer









X31.2

Certification of Chief Financial
Officer









X32.1

Section 1350 Certification









XSignatures

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)72