UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR
  15(d) OF THE SECURITIES
  EXCHANGE ACT OF 1934 For the Quarterly Period Ended March 31, 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 200
  Brisbane, California

94005(Address of Principal Administrative Offices)

(Zip Code)(650) 624-1000
  (Registrants Telephone Number, Including Area Code) Indicate by
check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes o    No x Indicate by
check mark whether the registrant is a large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definition of accelerated filer and
large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one): Large
accelerated filer  o     Accelerated
filer  x     Non-accelerated
filer o Indicate by
check mark whether the registrant is a shell company (as defined in Rule 12b-2
of the 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 Amendment No. 1 and, for the three months ended March 31, 2003, in
this report. Therefore, when considering financial information for 2003, you
should rely only on Amendment No. 1 and this report. Except as expressly stated
herein, this report speaks to the March 31, 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 Three Months Ended March 31, 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

34Critical Accounting Policies and Estimates

35Results of Operations

36Liquidity and Capital Resources

39Item
  3

Quantitative and Qualitative Disclosures
  About Market Risk

46Item
  4

Controls
  and Procedures

48Part II

Other InformationItem
  1

Legal
  Proceedings

51Item
  1A

Risk
  Factors

52Item
  2

Unregistered
  Sales of Equity Securities and Use of Proceeds

67Item
  3

Defaults
  Upon Senior Securities

67Item
  4

Submission
  of Matters to a Vote of Security Holders

67Item
  5

Other
  Information

67Item
  6

Exhibits

67Signatures

68Certifications

703

PART I  FINANCIAL
INFORMATION

Item 1. Financial Statements

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

March 31,
  2004

December 31,
  2003ASSETSCurrent
assets:Cash and cash
equivalents

$
5,096

$
13,221Investment
securities


19,756


15,464Accounts
receivable


6,294


4,464Unbilled
accounts receivable


271


2,094Due from
related party





386Prepaid
expenses and other current assets


2,150


682Total current
assets


33,567


36,311Investment in
affiliate





34,561Property and
equipment


84,933


18,517Restricted cash


9,816


1,092Other assets


4,538


3,983Total
assets

$
132,854

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

$
3,356

$
4,908Accrued and
other current liabilities


5,470


4,155Derivative
liabilities


5,083


3,407Current
portion of obligation to related party





2,575Due to related
parties


2,600


210Current
portion of non-current obligations


1,185


Total current
liabilities


17,694


15,255Non-current
obligations


39,198


Obligation to related party,
non-current





31,540Other liabilities


716


629Total
liabilities


57,608


47,424Commitments and contingencies
(Note 11)Minority interest in
subsidiary





5,818Minority interest in variable
interest entity


23,893


Stockholders
equity:Common
stock


252


250Additional
paid-in capital


202,558


184,032Deferred stock
compensation


(522
)

(242
)Accumulated
deficit


(154,931
)

(146,438
)Accumulated
other comprehensive income


3,996


3,620Total
stockholders equity


51,353


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

$
132,854

$
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
  March 31,2004

2003
  (Restated)Revenues:Research
contracts and grants

$
3,945

$
2,489Related party
services





257Total
revenues


3,945


2,746Operating expenses:Research and
development:Related
party


55


68Other


6,638


5,640Total
research and development


6,693


5,708General and
administrative


4,858


3,425Loss from
operations


(7,606
)

(6,387
)Other income
(expense):Investment
income and other


248


204Valuation
adjustments


(1,676
)

7,440Equity in loss
of affiliate





(5,799
)Total other
income (expense)


(1,428
)

1,845Net loss
before minority interest


(9,034
)

(4,542
)Minority interest in loss of
subsidiary





163Minority interest in loss of
variable
  interest entity


541


Net
loss


(8,493
)

(4,379
)Charges related to Series A
preferred
  stock:Dividends





(57
)Accretion to
redemption value





(160
)Beneficial
conversion charges





(225
)Net loss
applicable to common stockholders

$
(8,493
)
$
(4,821
)Basic and diluted net loss per share applicable to common
  stockholders

$
(0.34
)
$
(0.30
)Weighted average shares used in
computing
  basic and diluted net loss per share applicable to common stockholders


25,048


15,846See accompanying notes to condensed
consolidated financial statements.

5

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

Three
  Months Ended
  March 31,2004

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

$
(8,493
)
$
(4,379
)Adjustments to
reconcile net loss to net cash used in operating
  activities:Minority
interest in loss of subsidiary





(163
)Minority
interest in loss of variable interest entity


(541
)

Depreciation
and amortization


338


283Amortization
of premiums and discounts on investment securities


64


(57
)Stock
compensation expense


339


79Valuation
adjustments


1,676


(7,440
)Equity in loss
of affiliate





5,799Changes in
assets and liabilities:Receivables


(142
)

(1,890
)Prepaid
expenses and other current assets


614


571Accounts
payable


(1,720
)

1,263Accrued and
other current liabilities


858


(136
)Due to
related parties


55


(733
)Other
liabilities


(15
)

25Net cash used in
operating activities


(6,967
)

(6,778
)Cash flows from investing
activities:Purchase of
investment securities


(7,165
)

(410
)Proceeds from
sale and maturities of investment securities


2,839


5,055Purchase of
property and equipment


(12,713
)

(4,061
)Cash from
consolidation of variable interest entity


9,723


Deposits and
other


(100
)

53Change in
restricted cash


(2
)

(2
)Net cash provided
by (used in) investing
  activities


(7,418
)

635Cash flows from financing
activities:Proceeds from
non-current obligations


5,581


Exercise of
employee stock options


217


631Employee stock
purchase plan


196


104Other


7


(580
)Net cash provided
by financing activities


6,001


155Effect of exchange
rate changes on cash


259


Decrease in cash and cash
equivalents


(8,125
)

(5,988
)Cash and cash equivalents at
beginning of period


13,221


9,360Cash and cash equivalents at
end of period

$
5,096

$
3,372Supplemental schedule of non
cash investing and
  financing activities:Accrued
purchases of construction in progress

$
(2,795
)
$
Accretion to
redemption value of Series A preferred stock





160Amortization
of beneficial conversion feature of Series A preferred
  stock





225See accompanying notes to condensed
consolidated financial statements.

6

VaxGen, Inc.Notes to Condensed Consolidated Financial Statements

1. Description of Business and Basis of
Presentation

The unaudited
condensed consolidated financial statements of VaxGen, Inc. (VaxGen) and its
subsidiaries (collectively Company) included herein have been prepared by
VaxGen pursuant to the rules and regulations of the Securities and Exchange
Commission (SEC). The condensed consolidated financial statements include the
accounts of VaxGen, its subsidiary, VaxGen-Celltrion, Inc. (VCI) and effective January 1, 2004 a
variable interest entity (VIE), Celltrion, Inc. (Celltrion), a
company developing and operating a mammalian cell culture biomanufacturing
facility in the Republic of Korea. All intercompany accounts and transactions
have been eliminated in consolidation.

Certain
information or footnote disclosure normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America (GAAP) have been condensed or omitted pursuant to
such rules and regulations. In the opinion of the Companys management, the accompanying
unaudited condensed consolidated financial statements contain all adjustments,
consisting only of normal recurring adjustments, considered necessary for a
fair statement of the condensed consolidated financial information included
herein. While VaxGen believes that the disclosures are adequate to make the
information not misleading, these condensed consolidated financial statements
should be read in conjunction with VaxGens audited financial statements
contained in its Annual Report on Form 10-K/A for the year ended December 31,
2003 as filed with the SEC on September 26, 2006.

The results of
operations for the three month period ended March 31, 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 months ended March 31, 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 March 31, 2004, the
following significant assets and liabilities of Celltrion are included in the
unaudited condensed consolidated balance sheet (in thousands):

March 31,
  2004Cash and cash equivalents

$
3,977Property and equipment


65,588Non-current obligations


39,198Net assets


72,370In 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
  March 31, 2004Operating expenses:Research and
development

$
351General and
administrative


530Loss from operations


(881
)Other income


157Minority interest


541Net loss

$
(183
)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 Amendment No. 1 and for the three months ended March 31, 2003, in this
report.

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


Revenue recognition.Revenues and certain
  expenses related to U.S. government cost-plus-fixed-fee contracts are
  recognized as services are performed. Previously, the Company recognized
  these revenues and expenses after completing contract milestones.
  Additionally, fees for services rendered by the Company for Celltrion, an
  equity method investee, are recognized as revenues. Previously, the Company
  accounted for a pro-rata portion of the fees as reductions to operating
  expenses based upon its percentage ownership interest in Celltrion.
Investments in affiliates. The non-cash
  investment in Celltrion is recorded at fair value and the Companys share of
  Celltrions net losses is reflected using the equity method of accounting. Translation
  adjustments resulting from changes in foreign currency exchange rates
  relating to Celltrion are reported as a component of other comprehensive
  income. In addition, the effects of Celltrions equity transactions are
  reflected in additional paid-in capital. Previously, the Company disclosed
  its non-cash investment in Celltrion in the notes to its consolidated
  financial statements, but did not record its initial investment in or
  activities relating to Celltrion in the consolidated balance sheets, statements
  of operations or statements of changes in stockholders equity. In addition,
  because the Company effectively controlled the operations of VCI, the
  consolidated financial statements now include the Companys accounts and
  those of VCI from its inception in June 2002 and reflect Celltrions minority
  interest ownership in VCI. Previously, the Company accounted for VCI under
  the equity method from June 2002 through the first quarter of 2003 after
  which it began to consolidate VCI. The Company also entered into financial
  instruments with Celltrion by which Celltrion provided the Company with a
  purchase option to purchase their ownership interest in VCI. The purchase
  option is included in other assets. Previously, the Company did not record an
  asset relating to the purchase option.
Series A Preferred Stock, warrants and derivatives.
  The Series A Preferred Stock includes certain embedded features that are
  accounted for as a separate embedded derivative liability which is maintained
  at its fair value. Previously, these features were not separated from the
  Series A Preferred Stock and therefore were not accounted for as derivatives.
  The resulting non-cash accretion to redemption charges relating to the Series
  A Preferred Stock are now larger than previously reported. In addition, the
  warrants issued in conjunction with the Series A Preferred Stock have been
  revalued to account for embedded features including potential premium cash
  redemptions and liquidated damages related to registration rights.9


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 STATEMENT OF
OPERATIONS
(in thousands, except per share data)

Three Months Ended March 31, 2003Previously
  Reported

Adjustments

RestatedRevenues:Research
contracts and grants

$
1,112

$
1,377

$
2,489Related party
services


101


156


257Total
revenues


1,213


1,533


2,746Operating expenses:Research and
development:Related
party


360


(292
)

68Other


3,665


1,975


5,640Total
research and development


4,025


1,683


5,708General and
administrative


3,909


(484
)

3,425Loss from
operations


(6,721
)

334


(6,387
)Other income
(expense):Investment
income and other


201


3


204Valuation
adjustments


5,075


2,365


7,440Equity in loss
of affiliate


(128
)

(5,671
)

(5,799
)Total other
income (expense)


5,148


(3,303
)

1,845Net loss
before minority interest


(1,573
)

(2,969
)

(4,542
)Minority interest in loss of
subsidiary





163


163Net
loss


(1,573
)

(2,806
)

(4,379
)Charges related to Series A
preferred
  stock:Dividends


(57
)




(57
)Accretion to
redemption value


(80
)

(80
)

(160
)Beneficial
conversion charges


(327
)

102


(225
)Net loss
applicable to common stockholders

$
(2,037
)
$
(2,784
)
$
(4,821
)Basic and diluted net loss per
share
  applicable to common stockholders

$
(0.13
)
$
(0.17
)
$
(0.30
)Weighted average shares used in
computing
  basic and diluted net loss per share applicable to common stockholders


15,846





15,846CONDENSED CONSOLIDATED STATEMENT OF CASH
FLOWS
(in thousands)

Three Months Ended March 31, 2003Previously
  Reported

Adjustments

RestatedCash provided by (used
in):Operating
activities

$
(6,321
)
$
(457
)
$
(6,778
)Investing
activities


2,411


(1,776
)

635Financing
activities


733


(578
)

155Increase in cash and cash
equivalents


(3,177
)

(2,811
)

(5,988
)Cash and cash equivalents at
beginning of
  period


4,449


4,911


9,360Cash and cash equivalents at
end of period

$
1,272

$
2,100

$
3,37211

The following
table reflects 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 March 31, 2003Previously
        Reported
    
    Adjustments
    
    RestatedNet
        loss
    
    $
    (1,573
    )
    $
    (2,806
    )
    $
    (4,379
    )Other
        comprehensive loss:Translation
        adjustment
    
    
    
    
    
    (1,776
    )
    
    (1,776
    )Unrealized
        loss
    
    
    (112
    )
    
    (1
    )
    
    (113
    )Total
        other comprehensive loss
    
    
    (112
    )
    
    (1,777
    )
    
    (1,889
    )Comprehensive
        loss
    
    $
    (1,685
    )
    $
    (4,583
    )
    $
    (6,268
    )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 March 31,
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.

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.

12

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 March 31, 2004 had a weighted-average exercise
price of 8,334 Korean Won ($7.27 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. No such
events occurred prior to March 31, 2004. 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
  March 31,2004

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

$
(8,493
)
$
(4,821
)Add: Stock-based employee
compensation
  expense included in reported net loss, net of minority interest


69


68Less: Total stock-based employee
  compensation expense determined under fair value based method for all awards,
  net of minority interest


(1,717
)

(1,837
)Net loss applicable to common
stockholders
   pro forma

$
(10,141
)
$
(6,590
)Net loss per share applicable
to common
  stockholders  basic and diluted, as reported

$
(0.34
)
$
(0.30
)Net loss per share applicable
to common
  stockholders  basic and diluted, pro forma

$
(0.40
)
$
(0.42
)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 
  March 31,2004



2003VaxGen Stock Option PlansRisk-free
  interest rate


3.08
%

2.63
%Expected
  life in years


5.0


4.0Volatility


101
%

101
%Celltrion Stock Option PlanRisk-free interest
  rate


4.88
%

n/aExpected
  life in years


6.0


n/aVolatility


73.1
%

n/aEmployee Stock Purchase PlanRisk-free
  interest rate


0.95
%

1.17
%Expected
  life in years


1.0


1.0Volatility


101
%

126
%13

New
Accounting Pronouncements

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

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

14

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.

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.

15

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 (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 05-8,
the issuance of convertible debt with a BCF results in a temporary difference
for purposes of applying FAS No. 109, Accounting
for Income Taxes. The deferred taxes recognized for the temporary
difference should be recorded as an adjustment to paid-in capital. EITF 98-5, Accounting for Convertible Securities with Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios, and
EITF 00-27, Application of Issue No. 98-05
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 BCF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.

16

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 06-3
addresses income statement classification and disclosure requirements of
externally-imposed taxes on revenue-producing transactions. EITF 06-3 is
effective for periods beginning after December 15, 2006. The Company does not
expect the implementation of EITF 06-3 to have a material impact on the
Companys consolidated financial position, results of operations or cash flows.

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

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

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

17

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 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.

18

For all
periods presented, such potential common shares were excluded from the
computation of diluted net loss per share, as their effect is antidilutive.

March 31,2004

2003Potentially dilutive securities:Options to
purchase common stock


3,754,834


3,079,229Warrants to
purchase common stock


1,021,250


943,407Employee Stock
Purchase Plan


81,505


334,502Series A
Preferred Stock





268,875Total


4,857,589


4,626,0135. Balance Sheet
Components

Restricted
Cash

At March 31,
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 March 31, 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):

March 31,
  2004

December
  31, 2003Construction
  in progress

$
66,897

$
14,347Land


13,112


Leasehold
  improvements


3,168


3,138Machinery,
  furniture and equipment


6,633


5,466Sub-total


89,810


22,951Less:
  accumulated depreciation and amortization


(4,877
)

(4,434
)Total

$
84,933

$
18,517Accrued
and Other Current Liabilities

Accrued and
other current liabilities at March 31, 2004 and December 31, 2003 included
employment and severance benefit accruals of $2.2 million and $2.9 million,
respectively.

6. Non-current
Obligations

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

In January 2003, Celltrion obtained secured long-term financing of
52,000 million Korean Won (equivalent to $44.2 million) with a nine-year term from a Korean bank
(Loan). Funds from the Loan are to be used for construction of the Incheon
administration buildings and manufacturing facility. As construction
progresses, the bank funds 60% of the progress payments (up to 52,000 million
Korean Won), while Celltrion pays the remaining 40%. Celltrions land and
construction in progress represent collateral for the outstanding Loan balance.
There are no significant financial covenants in the Loan agreements. As of
March 31, 2004, the carrying amounts for land and construction in progress were
15,033 million Korean Won and 59,463 million Korean Won (equivalent to $13.1
million and $51.8 million),
respectively. At March 31, 2004,
Celltrion had unused commitments related to the Loan of 17,605 million Korean
Won (equivalent to $15.4 million).
Only interest payments are due monthly for the first four years

19

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 5.7% at March 31, 2004). Cash outlays for interest on borrowings related to
this loan totaled $0.4 million for the three months ended March 31, 2004.

The following is a summary of non-current obligations (in
thousands, presented at March 31, 2004 exchange rates):

March 31,
  2004Land purchase obligation

$
10,292Less: current portion


(1,185
)Non-current land purchase obligation


9,107Construction loan


30,000Sub-total


39,107Accrued
  long-term interest


91Non-current
  obligations

$
39,198In 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 $0.5 million was capitalized for the three months ended March 31, 2004. 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 March 31, 2004 are
as follows (in thousands, presented at March 31, 2004 exchange rates):

2004

$
1,1852005


2006


3,2772007


6,0002008


8,2762009 and beyond


21,554Total

$
40,2927. 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 March 31, 2004, VaxGen owned 7.8 million shares of
Celltrion common stock, representing a 48% 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.

20

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 March 31, 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 $23.9
million in the unaudited condensed consolidated balance sheet at March 31,
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 $21.0 million at
March 31, 2004 because VaxGens investment in Celltrion was a non-monetary
transaction which was eliminated upon the consolidation of VaxGen and
Celltrion.

8. 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 March 31,
2004, 3,507 million Korean Won (equivalent to $3.1 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 $2.3 million as of March 31, 2004. During the three months
ended March 31, 2004, Celltrion paid Daewoo $9.3 million related to the
construction of the Incheon facilities. Celltrion was not consolidated with
VaxGen as of December 31, 2003.

9. 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):

March 31,
  2004

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

$
41,303

$
38,546Research and
other credit carryforwards


6,739


5,345Deferred
research expenses


1,345


1,447Depreciation


2,066


1,818Accrued
liabilities


614


540Other


(1,022
)

(669
)Total gross
deferred tax assets


51,045


47,027Less:
  Valuation allowance


(51,045
)

(47,027
)Net deferred
tax assets

$


$
21

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

Three Months Ended March 31,2004

2003(Restated)Statutory
rate


34.0
%

34.0
%Equity in loss
of affiliate


0.0


(45.0
)Valuation
adjustments


(7.0
)

57.8Equity-based
compensation expense


(0.3
)

(0.8
)Research and
other credits


9.4


0.7Exemption for
foreign ownership


(2.5
)

Change in
foreign tax rates


(0.8
)

Foreign tax
rates less than statutory rate


(0.2
)

Other


0.4
      

(2.0
)Change in
valuation allowance


(33.0
)

(44.7
)Effective tax
rate


0.0
%

0.0
%At March 31,
2004, VaxGen had U.S. federal and California net operating loss carryforwards
of $106 million and $82 million, respectively. The U.S. federal and California
net operating loss carryforwards expire from 2015 through 2024 and 2005 through
2014, respectively. Additionally, as of March 31, 2004, VaxGen has federal
research credits, expiring from 2015 through 2024, of $3.5 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 March
31, 2004, Celltrion had net operating losses for Korean tax purposes of 4,864
million Korean Won (equivalent to $4.2 million). The carryforwards expire from
2007 to 2009. Additionally, Celltrion has various tax credit carryforwards,
expiring from 2007 to 2010, totaling 1,559 million Korean Won (equivalent to
$1.4 million) at March 31, 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.

10. 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.

22

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

Three
  Months Ended March 31,2004

2003
  (Restated)Net loss

$
(8,493
)
$
(4,379
)Other
  comprehensive income (loss):Foreign
currency translation adjustments


346


(1,776
)Unrealized
gains on available-for-sale
  securities


30


(113
)Other
  comprehensive income (loss)


376


(1,889
)Comprehensive
  loss

$
(8,117
)
$
(6,268
)The Companys
accumulated other comprehensive income balance consists of the following (in
thousands):

March 31, 
  2004

December
  31, 
  2003Foreign
  currency translation adjustments

$
3,959

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


37


7Accumulated
  other comprehensive income

$
3,996

$
3,62011. 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 $6.3 million as of March
31, 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
14.

23

12. 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 March 31, 2004, the Company believed that it had strong
defenses and intended to defend these actions vigorously. See Subsequent Events
in Note 14.

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 March 31, 2004, the Company has provided $0.5
million for the settlement of these derivative actions. See Subsequent Events
in Note 14.

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.

13. 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
March 31, 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.

24

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

Three Months Ended March 31,Revenues

2004

2003VaxGen

$
4,080

$
2,746Celltrion





n/aEliminations


(135
)

n/aTotal

$
3,945

$
2,746Three Months Ended March 31,Depreciation and Amortization

2004

2003VaxGen

$
304

$
283Celltrion


437


n/aEliminations


(403
)

n/aTotal

$
338

$
283Three Months Ended March 31,Equity in Loss of Affiliate

2004

2003VaxGen (in
  Celltrion)

$
(652
)
$
(5,799
)Celltrion
  (in VCI)


(382
)

n/aEliminations


1,034


n/aTotal

$


$
(5,799
)Three Months Ended March 31,Net Loss

2004

2003VaxGen

$
(8,426
)
$
(4,379
)Celltrion


(1,408
)

n/aEliminations


1,341


n/aTotal

$
(8,493
)
$
(4,379
)Property,
  Plant and Equipment, net

March 31, 
  2004

December
  31, 
  2003VaxGen

$
19,344

$
18,517Celltrion


65,654


n/aEliminations


(65
)

n/aTotal

$
84,933

$
18,517Investment
  in Affiliate

March 31, 
  2004

December
  31, 
  2003VaxGen (in
  Celltrion)

$
33,909

$
34,561Celltrion
  (in VCI)


5,293


n/aEliminations


(39,202
)

n/aTotal

$


$
34,56125

Total
  Assets

March 31, 
  2004

December
  31, 2003VaxGen

$
87,125

$
94,464Celltrion


120,083


n/aEliminations


(74,354
)

n/aTotal

$
132,854

$
94,464Three Months Ended March 31,Purchases of Property and Equipment

2004

2003VaxGen

$
(1,131
)
$
(4,061
)Celltrion


(11,582
)

n/aEliminations





n/aTotal

$
(12,713
)
$
(4,061
)14. Subsequent Events

Series
A Warrants

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 Companys warrants, issued
in conjunction with the 2001 Series A Mandatorily Redeemable Convertible
Preferred Stock (Series A Preferred Stock), (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 September 21,
2004, the Company paid $0.8 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.

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.

26

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.

27

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.

28

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

March
        31,
        2004
    
    Increase
        
        due to Amendment
    
    Adjusted
        Payments2004
    
    $
    2,079
    
    $
    
    
    $
    2,0792005
    
    
    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
    
    $
    10,779
    
    $
    35,895
    
    $
    46,674Resolution
of Class Action Suit and Derivative Suit

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

The Company
also 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 May 26,
2004, at the 2004 Annual Meeting of Stockholders, the stockholders of the Company
approved an increase in the number of shares authorized for issuance under the
VaxGen 2001 Employee Stock Purchase Plan from 0.6 million to 1.0 million
shares.

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.

29

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.

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 in 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 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.


30

Celltrion
Agreements

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

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

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

Financing
for Facility Construction and Expansion

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

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

31

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

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

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

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

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

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

Celltrion
Stock, Options and Warrants

On
April 13, 2004 and July 14, 2004, Celltrion granted warrants to all of its
existing stockholders to acquire 4.0 million and 2.0 million shares,
respectively, of its convertible preferred stock. The exercise price was 5,000
Korean Won ($4.34 equivalent) per preferred share. The exercise period was
April 13, 2004 to December 31, 2004 for the April 13, 2004 warrants (First
Tranche) and January 1, 2005 to December 31, 2005 for the July 14, 2004
warrants (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 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 Warrants before the December 31, 2004 expiration
date. Otherwise, the 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.
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 March 31, 2005 (Extended
First Tranche).

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 May 2004,
Celltrion issued 693,500 shares of its 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.

32

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 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 ($7.20
equivalent) per share, respectively.
These grants and the stock option grants issued in 2002, 2003 and 2004 contain
an anti-dilution provision. Accordingly, in 2005 and 2006, all Celltrion stock option grants
exercise prices and the number of shares granted were modified, per the terms
of the original stock option agreements.

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

In May 2005,
Celltrion issued 2,872,840 shares of common stock to existing stockholders in a
proportionate stock dividend.

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

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

33

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.

34

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
March 31, 2004, we owned 48% 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 14 to the unaudited condensed financial statements for more
information regarding events occurring after March 31, 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.

35

RESULTS OF OPERATIONS

Comparison of Fiscal Quarters Ended March 31,
2004 and 2003

Revenues

Three months ended
  March 31,Percent
  change
  2004/20032004

2003
  (Restated)(in thousands)Research
  contracts and grants

$
3,945

$
2,489



58
%Related
  party services





257


(100
%)Total
  revenues

$
3, 945

$
2,746



44
%Total revenues
increased by $1.2 million to $3.9 million in the three months ended March 31,
2004 over the comparable period in 2003 due primarily to an increase in
activities related to our NIAID Contracts slightly offset by a decrease in
related party services and consisted principally of:


Contract revenues of $3.7
million recognized on our NIAID Contracts primarily reflecting work performed under
  the 2003 Anthrax Contract;
Grant revenues of $0.2 million
from two
  NIAID-funded SBIR grants; and
Grant revenues of $0.1 million
from
  SAIC-Frederick, Inc. to complete certain residual activities related to the
  completion of the AIDSVAX clinical trials.Revenues for the three months
ended March
  31, 2003 primarily consisted of:
Contract revenues of $2.3
million
  recognized on work performed under the 2002 Anthrax Contract;
Related party services revenues
of $0.3
  million earned as part of a consulting agreement with Celltrion; and
Grant revenues of $0.2 million
from two
  NIAID-funded SBIR grants.Celltrion did
not earn any revenues during these periods.

Revenues
earned in one period are not indicative of revenues to be earned in future
periods. We expect future years revenues to be progressively less, as efforts
shift from work done under the advanced development contracts to work under the
SNS contract, from which no revenues are 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
  March 31,Percent
  change
  2004/20032004

2003
  (Restated)(in thousands)Related
  party

$
55

$
68


(19
%)Other


6,638


5,640



18
%Total
  research and development

$
6,693

$
5,708



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

36

The following
table details research and development expenses by major project:

Three months ended
  March 31,

Percent
  change
  2004/20032004

2003
  (Restated)(in thousands)Direct Costs:NIAID
Contracts

$
2,024

$
1,142



77
%AIDSVAX


191


1,636



(88
%)Smallpox


541


190



185
%VCI


1,183


391



202
%Total direct
costs


3,939


3,359



17
%Indirect and other
costs


2,754


2,349



17
%Research and development
expenses

$
6,693

$
5,708



17
%The increase
of $1.0 million in research and development expenses in the three months ended
March 31, 2004 over the comparable period in 2003 was primarily due to:


Clinical trial expenses, which
decreased by
  $1.5 million as the AIDSVAX Phase 3 clinical trials were completed in 2003
  and expenses relating to those trials in 2004 were minimal;
Direct costs associated with
our NIAID
  Contracts, which increased by $0.9 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;
Direct costs associated with
supporting
  VCI, which increased by $0.8 million due to the expansion of the facility;
Direct costs associated with
our smallpox
  program, consisting primarily of labor costs, which increased by $0.4 million;
  and
Indirect research and
development expenses,
  which increased by $0.4 million, consisting primarily of:-
Celltrions
  research and development expenses in the three months ended March 31, 2004
  were $0.3 million; prior to January 1, 2004, Celltrions operations were not
  included in our consolidated results; and-
Other
  development costs, which increased by $0.1 million due to expanded
  operations.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.

37

General
and administrative expenses

Three months ended
  March 31,Percent
  change 
  2004/20032004

2003
  (Restated)(in thousands)General and
administrative expenses

$
4,858

$
3,425

42%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 $1.4 million in general and administrative expenses in the three months
ended March 31, 2004 over the comparable period of 2003 was primarily due to:


Celltrions general and
administrative
  expenses in the three months ended March 31, 2004 were $0.5 million; prior to
  January 1, 2004, Celltrions operations were not included in our consolidated
  results;
During the three months ended
March 31,
  2004, we provided $0.5 million for the settlement of derivative lawsuits;
Professional services, which
increased by
  $0.3 million principally reflecting higher fees for accounting and auditing
  services and other professional fees and expenses associated with our efforts
  to comply with various reporting and regulatory requirements; and
Recruiting fees, which
increased by $0.1
  million principally for certain senior management positions.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.

Other
income (expense)

Three Months Ended
  March 31,

Percent
  change
  2004/20032004

2003
  (Restated)(in thousands)Investment
  income

$
248

$
204



22
%Valuation
  adjustments


(1,676
)

7,440


(123
%)Equity in
  loss of affiliate





(5,799
)

(100
%)Other income
  (expense)

$
(1,428
)
$
1,845


(177
%)The change to
other expense of $1.4 million in the three months ended March 31, 2004 from
other income of $1.8 million in the comparable period in 2003 was primarily due
to:


Mark-to-market valuation
adjustments
  related to the our derivatives, which changed primarily due to changes in the
  fair value of our common stock; and
Our share of Celltrions
losses, which were
  $5.8 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 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

38

expense in
2005 due to increased borrowings to finance its construction activities and the
completion of certain phases of its construction activities for which interest
was previously capitalized.

Minority
interest in loss of subsidiary

Three Months Ended
  March 31,

Percent
  change
  2004/20032004

2003
  (Restated)(in thousands)Minority
  interest in loss of subsidiary

$


$
163

(100%)Minority
interest in loss of subsidiary for the three months ended March 31, 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
  March 31,

Percent
  change
  2004/20032004

2003(in thousands)Minority
  interest in loss of variable interest entity

$
541

$



** Calculation
not meaningful

Minority
interest in loss of variable interest entity for the three months ended March
31, 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
  March 31,

Percent
  change
  2004/20032004

2003
  (Restated)(in thousands)Charges
  related to Series A preferred stock

$


$
(442
)
(100%)There were no
charges related to Series A preferred stock for the three months ended March
31, 2004 as all outstanding shares of Series A Preferred Stock were converted
into common stock by December 31, 2003.

LIQUIDITY AND CAPITAL RESOURCES

2004

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

$
24,852

$
12,244Working capital


15,873


5,154Three months ended March
31:Cash provided by (used
in):Operating
activities


(6,967
)

(6,778
)Investing
activities


(7,418
)

635Financing
activities


6,001


155Effect of
exchange rate changes on cash


259


Capital expenditures (included
in investing
  activities above)


(12,713
)

(4,061
)39

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 March 31, 2004, we
had $15.4 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 March 31, 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 $7.0 million and $6.8 million for the three months ended March
31, 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 $1.7
  million and income of $7.4 million in the three months ended March 31, 2004,
  and 2003, respectively, reflecting changes in the fair value of outstanding
  derivatives. These changes in fair value primarily resulted from the changes
  in the fair value of our common stock during those periods and the 2003
  conversion of the outstanding Series A Preferred Stock associated with the
  derivatives; and
  Non-cash charges for our
  equity in loss of affiliate of $5.8 million for our share of Celltrions net
  losses for the three months ended March 31, 2003. Due to the consolidation of
  Celltrion in 2004 there was no similar charge in the same period of 2004.Net cash provided by (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 three months ended March 31, 2004 were made in
connection with the expansion of the Korean manufacturing facility ($11.6
million) and research and development laboratories and leasehold improvements
associated with the California manufacturing facility and office facilities
($1.1 million). Capital expenditures in the three months ended March 31, 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 $5.8 million to $6.0 million in 2004 from $0.2
million in 2003 and primarily consisted of the proceeds from Celltrions
construction borrowings.

At March 31, 2004, $24.9
million, or 19%, of our assets consisted of cash, cash equivalents and
short-term investments. Working capital was $15.9 million at March 31, 2004,
compared to working capital of $5.2 million at March 31, 2003. This $10.7
million increase in working capital is due, in large part, to the following:


  Investment securities
  increased $10.9 million due to three rounds of financing after March 31,
  2003;
  Cash increased by $4.0 million
  related to the consolidation of Celltrion in 2004; and
  Derivative liabilities
  increased by $3.9 million in fair value as a result of an increased
  likelihood of potential payments being due under the registration rights
  agreement associated with the Series A warrants.40

We continually
review alternatives to obtain additional financing and to increase revenues by
procuring future contracts to supply anthrax and smallpox vaccines to the U.S.
government and other potential customers. Some of our alternatives to obtain
additional financing include the sale of our common stock, obtaining additional
debt and the sale of some or all of our investment in Celltrion. There can be
no assurances that we will be successful in these efforts. The cancellation of
the SNS Contract, the reaudit of our financial statements for the three years
ended December 31, 2003, the resulting restatement of reports previously filed
with the Securities and Exchange Commission, the lapsing of our registration
statements and the delisting of our common stock may have an adverse
impact on whether financing will be available or that it will be available on
terms that we will accept. See Subsequent Events in Note 14.

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 March 31, 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.

Contractual Obligations

The following
table summarizes our significant contractual obligations at March 31, 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)
    
    $
    10,779
    
    $
    2,079
    
    $
    5,534
    
    $
    3,166
    
    $
    Celltrion
        obligations (2)
    
    
    50,289
    
    
    3,071
    
    
    6,858
    
    
    16,999
    
    
    23,361Purchase
        obligations (3)
    
    
    444
    
    
    244
    
    
    50
    
    
    20
    
    
    130Total
        contractual obligations
    
    $
    61,512
    
    $
    5,394
    
    $
    12,442
    
    $
    20,185
    
    $
    23,491(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 March 31, 2004.(3)
  Purchase
  obligations include service agreements, contracts related to manufacturing
  and research operations and license agreements.Off-Balance Sheet Arrangements

As of March
31, 2004, we did not have any off-balance sheet arrangements as defined in Item
303(a)(4)(ii) of SEC Regulation S-K.

41

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

42

share-based
payment arrangements, the classification of compensation expense, non-GAAP
financial measures, first-time adoption of FAS 123R in an interim period,
capitalization of compensation cost related to share-based payment
arrangements, the accounting for income tax effects of share-based payment
arrangements upon adoption of FAS 123R, the modification of employee share
options prior to adoption of FAS 123R and disclosures in Managements
Discussion and Analysis subsequent to adoption of FAS 123R. We will comply with
SAB 107 upon our adoption of FAS 123R. We are currently evaluating the impact of
adopting SAB 107 on our consolidated financial position, results of operations
and cash flows.

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

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

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

In
June 2005, the FASB issued FSP FAS 150-5, Issuers Accounting under FASB
Statement No. 150 for Freestanding Warrants and Other Similar Instruments
on Shares that are Redeemable (FAS 150-5). FAS 150-5 clarifies that
freestanding warrants and similar instruments on shares that are redeemable
should be accounted for as liabilities under FAS 150 regardless of the timing
of the redemption feature or price, even though the underlying shares may be
classified as equity. FAS 150-5 is effective for the first reporting period
beginning after 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.

43

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

44

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.

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

45

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

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

ITEM 3. QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK

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

Interest
Rate Risk

We are exposed
to market rate changes by debt securities included in our investment portfolio.
By policy, we invest in debt instruments of the U.S. government, federal
agencies and high-quality corporate issuers, limit the amount of credit
exposure to any one issuer, and limit duration by restricting the term.
Investments in both fixed rate and floating rate instruments carry a degree of
interest rate risk. Fixed rate securities may have their fair market value
adversely affected due to a rise in interest rates, while floating rate
securities may produce less income than expected if interest rates fall. Due in
part to these factors, our future investment income may decrease due to changes
in interest rates or due to losses we may suffer when securities decline in
market value. At March 31, 2004, we held available-for-sale securities in the
principal amount of $19.8 million. If market interest rates were to increase
immediately and uniformly by 10% from levels at March 31, 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.

46

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 5.7% at
March 31, 2004). At March 31, 2004, Celltrion owed 34,395 million Korean Won ($30.0
million equivalent) related to the
Loan. If market interest rates were to increase immediately and
uniformly by 10% from levels at March 31, 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 March 31,
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 March 31, 2004, the change
would not have a significant effect on our operations or cash flows. As of
March 31, 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 $0.1 million and other income of $1.5 million for the three
months ended March 31, 2004 and 2003, respectively. At March 31, 2004, the
embedded derivative liability was valued at $0.7 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 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 very
unlikely as of March 31, 2004. Had our assessment of these probabilities been
that the triggering events were likely to occur, the fair value of this derivative
at March 31, 2004 could have been as high as $8 to $12 million. For a
discussion of events in May and September of 2004, see Subsequent Events in
Note 14 to the condensed consolidated financial statements.

47

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

In connection
with our preparation of the restated consolidated financial statements for the
years ended December 31, 2003, 2002 and 2001 and in connection with the
preparation of our quarterly consolidated financial information, control
deficiencies were identified that existed in the design or operation of our
internal control over financial reporting that we consider to be material
weaknesses in the effectiveness of our internal control over financial
reporting as of March 31, 2004.

A material
weakness is a control deficiency, or combination of control deficiencies, that
results in more than a remote likelihood that a material misstatement of the
annual or interim financial statements will not be prevented or detected. We
consider the following control deficiencies that existed in the design or
operation of our internal control over financial reporting to be material
weaknesses in the effectiveness of our internal control over financial
reporting:

1.
  We did not
  maintain an effective control environment based on criteria established in
  Internal Control  Integrated Framework issued by the Committee of
  Sponsoring Organizations of the Treadway Commission. Specifically, the
  financial reporting organizational structure was not adequate to support the
  size, complexity or activities of the Company. In addition, certain key
  finance positions were staffed with individuals who did not possess the level
  of accounting knowledge, experience and training in the application of GAAP
  commensurate with the Companys financial reporting requirements. This
  control deficiency resulted in the restatement of the Companys 2001, 2002
  and 2003 annual consolidated financial statements and audit adjustments to
  the Companys 2004 interim and annual consolidated financial statements.
  Additionally, this control deficiency affects substantially all financial
  statement accounts that could result in a material misstatement to the
  Companys interim or annual consolidated financial statements that would not
  be prevented or detected. Accordingly, management has determined that this
  control deficiency constitutes a material weakness.2.
  We did not
  maintain effective segregation of duties over automated and manual
  transaction processes. Specifically, inadequate segregation of duties led to
  the untimely identification and resolution of accounting and disclosure
  matters and failure to perform timely and effective supervision and reviews.
  This control deficiency resulted in the restatement of the Companys 2001,
  2002 and 2003 annual consolidated financial statements and audit adjustments
  to the Companys 2004 interim and annual consolidated financial statements.
  Additionally, this control deficiency could result in a misstatement of
  substantially all financial statement accounts that would result in a
  material misstatement to the Companys interim or annual consolidated
  financial statements that would not be prevented or detected. Accordingly,
  management has determined that this control deficiency constitutes a material
  weakness.The material weaknesses
described above contributed to the existence of the material weaknesses
discussed in items 3 through 9 below.

3.
  We did not maintain
  effective controls over the accounting for revenue related to government
  contracts. Specifically, our controls over revenue were not adequate to
  ensure that all revenue transactions were completely and accurately recorded
  in the interim and annual consolidated financial statements which impacted
  revenue, deferred revenue and deferred costs. In particular, the following
  revenue control deficiencies are, in aggregate, considered a material
  weakness: (i) failure to properly recognize revenue for governmental
  contracts under cost-plus-fixed-fee arrangements; (ii) failure to properly apply
  cut-off procedures over billable expenses and the timing of revenue
  recognition; and (iii) failure to properly review the invoiced reimbursement
  costs. These control deficiencies resulted in the restatement of the
  Companys 2002 and 2003 annual consolidated financial statements and audit
  adjustments to the Companys 2004 interim and annual consolidated financial
  statements. Additionally, these control deficiencies could result in a
  misstatement of revenue, deferred revenue and deferred costs that would result
  in a material misstatement to the Companys interim or annual consolidated
  financial statements that would not be prevented or detected. Accordingly,
  management has determined that these control deficiencies in aggregate
  constitute a material weakness.4.
  We did not maintain
  effective controls over the completeness and accuracy of account
  reconciliations. Specifically, account reconciliations and supporting
  schedules were not consistently documented, reviewed and approved in a timely
  manner. This control deficiency resulted in the restatement of the Companys
  2001, 2002 and 2003 annual consolidated financial statements and audit
  adjustments to the Companys 2004 interim and annual consolidated financial
  statements. Additionally, this control deficiency could result in a
  misstatement of substantially all financial statement accounts that would
  result in a material misstatement to the Companys48

interim or annual
  consolidated financial statements that would not be prevented or detected.
  Accordingly, management has determined that this control deficiency
  constitutes a material weakness.5.
  We did not maintain
  effective controls to ensure that journal entries, both recurring and
  non-recurring, were consistently reviewed and approved in a timely manner to
  ensure the validity, completeness and accuracy of recorded entries. This
  control deficiency resulted in the restatement of the Companys 2001, 2002
  and 2003 annual consolidated financial statements and audit adjustments to
  the Companys 2004 interim and annual consolidated financial statements.
  Additionally, this control deficiency could result in a misstatement of
  substantially all financial statement accounts that would result in a
  material misstatement to the Companys interim or annual consolidated
  financial statements that would not be prevented or detected. Accordingly,
  management has determined that this control deficiency constitutes a material
  weakness.6.
  We did not maintain
  effective controls over the completeness and accuracy of accounting for
  investments in affiliates. Specifically, the Companys accounting for their
  investments in Celltrion, Inc. and VaxGen-Celltrion, Inc. were not in
  accordance with GAAP. This control deficiency resulted in the restatement of
  the Companys 2002 and 2003 annual consolidated financial statements and
  audit adjustments to the Companys 2004 interim and annual consolidated
  financial statements. Additionally, this control deficiency could result in a
  misstatement of investments, current and long-term liabilities and
  stockholders equity that would result in a material misstatement to the
  Companys interim or annual consolidated financial statements that would not
  be prevented or detected. Accordingly, management has determined that this
  control deficiency constitutes a material weakness.7.
  We did not maintain
  effective controls over the completeness and accuracy of accounting for
  issuance of preferred stock, warrants and embedded derivatives. Specifically,
  the Companys accounting for their Series A redeemable convertible preferred
  stock, along with the common stock warrants and other embedded derivatives
  were not in accordance with GAAP. This control deficiency resulted in the
  restatement of the Companys 2001, 2002 and 2003 annual consolidated
  financial statements and audit adjustments to the Companys 2004 interim and
  annual consolidated financial statements. Additionally, this control
  deficiency could result in a misstatement of current and long-term
  liabilities, stockholders equity and non-operating expenses that would
  result in a material misstatement to the Companys interim or annual
  consolidated financial statements that would not be prevented or detected.
  Accordingly, management has determined that this control deficiency
  constitutes a material weakness.8.
  We did not maintain
  effective controls over the completeness and accuracy of accounting for
  awards under our various stock compensation plans. Specifically, the timing
  of authorization for issuances of and modifications to stock compensation arrangements
  were not communicated to the appropriate accounting personnel responsible to
  accurately and timely account for these transactions in the Companys
  consolidated financial statements. This control deficiency resulted in the
  restatement of the Companys 2001, 2002 and 2003 annual consolidated
  financial statements and audit adjustments to the Companys 2004 interim and
  annual consolidated financial statements. Additionally, this control
  deficiency could result in a misstatement of deferred stock compensation and
  the related stock compensation expense that would result in a material
  misstatement to the Companys interim or annual consolidated financial
  statements that would not be prevented or detected. Accordingly, management
  has determined that this control deficiency constitutes a material weakness.9.
  We did not maintain
  effective controls to ensure that operating expenses were recorded in the
  appropriate period. Specifically, the Companys controls over completeness
  and accuracy for operating expenses were insufficient to ensure clinical
  trial expenses, consulting fees and other operating expenses were completely
  and accurately recorded in the proper periods. This control deficiency
  resulted in the restatement of the Companys 2001, 2002 and 2003 annual
  consolidated financial statements and audit adjustments to the Companys 2004
  interim and annual consolidated financial statements. Additionally, this
  control deficiency could result in a misstatement of accrued expenses and the
  related operating expenses that would result in a material misstatement to
  the Companys interim or annual consolidated financial statements that would
  not be prevented or detected. Accordingly, management has determined that
  this control deficiency constitutes a material weakness.49

These material weaknesses
resulted in the restatement of the 2003, 2002 and 2001 consolidated financial
statements and in material adjustments to our quarterly balances during 2004.
Additionally, these control deficiencies could result in misstatements of our
financial statement accounts and disclosures that would result in a material
misstatement to the annual or interim consolidated financial statements that
would not be prevented or detected.

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 review and
due to the material weaknesses described above, 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 March 31, 2004 that have materially affected, or are reasonably likely to
materially affect, the Companys internal control over financial reporting.

Remediation
Efforts

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

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

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

50

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 14 to the unaudited
condensed financial statements.

On
or about March 21, 2003, two separate but virtually identical shareholder
derivative actions were filed in California Superior Court for San Mateo County
entitled Rhodes v. Allen, et al. civil action No. CIV 430087, and MacDonald v.
Allen, et al., civil action No. CIV 430088. A consolidated complaint was filed
in June 2003. Named as defendants in the action are VaxGen directors Lance K.
Gordon, Randall L-W. Caudill, and William D. Young, and former VaxGen directors
Donald P. Francis, Phillip W. Berman, David W. Beier, and Stephen C. Francis
(Company Directors). Also named as defendants are Paul Allen and Vulcan
Ventures, Inc. (Vulcan Defendants). The allegations of the consolidated
complaint (Derivative Lawsuit) are similar to those contained in the class
action, although unlike the class action, in the Derivative Lawsuit the
plaintiff purports to seek recovery on behalf of VaxGen, rather than from
VaxGen. Plaintiffs allege as well that the Vulcan Defendants sold shares of our
stock while in possession of material non-public information about the Company.
Plaintiffs, purportedly suing on behalf of VaxGen, assert claims against all
defendants for breach of fiduciary duty, mismanagement, waste and unjust
enrichment and against the Vulcan Defendants for breach of fiduciary duty and
insider trading. As of March 31, 2004, we have provided $0.5 million for the
settlement of these derivative actions. See Subsequent Events in Note 14 to the
unaudited condensed financial statements.

51

ITEM 1A. RISK FACTORS

For
the three months ended March 31, 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
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 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.

52

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

We will
require additional funds to continue operations and may attempt to raise these
funds through equity or debt financings, collaborative arrangements with
corporate partners or from other sources. Any equity financings will be
dilutive to existing stockholders, and any debt financings will likely involve
covenants restricting our business activities. We cannot guarantee you that
additional funds will be available on acceptable terms, or at all. If we are
unable to raise additional capital when necessary, we may be required to
relinquish our rights to certain key technologies, drug candidates or marketing
territories under the terms of certain of our collaborative agreements.

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

The U.S.
government has undertaken commitments to help secure improved countermeasures
against bioterrorism, including the stockpiling of vaccines for anthrax and
smallpox. On September 30, 2003, VaxGen and Avecia were awarded
cost-reimbursement plus fixed fee contracts to advance development of their
respective anthrax vaccines and to each supply an inventory of three million
doses of their anthrax vaccines to the U.S. government. These contracts have
estimated values of $80.3 million and $71.3 million, respectively. Under the
then current version of Project BioShield, the U.S. government expected to
purchase a total of 60 million doses of an rPA anthrax vaccine over a 10-year
period. On March 11, 2004, the government issued a request for proposal, which
increased the size of the intended stockpile from 60 million doses to 75 million
doses. The process of obtaining government contracts is lengthy and uncertain
and we must compete for each contract. Moreover, the award of one government
contract does not necessarily secure the award of future contracts covering the
same vaccine. Accordingly, we cannot be certain that we will be awarded any
future contracts to supply a government stockpile of anthrax vaccine. It is
possible that future awards to provide the U.S. government with emergency
stockpiles of anthrax vaccine will be granted solely to Avecia or another
supplier. If the U.S. government makes significant future contract awards for
the supply of its emergency stockpile to our competitors, such as Avecia, our
business will be harmed and it is unlikely that we will be able to ultimately
commercialize that particular vaccine.

In addition,
the determination of when and whether a product is ready for large scale
purchase and potential use will be made by the government through consultation
with a number of governmental agencies, including the FDA, the NIH, the CDC and
the Department of Homeland Security. President Bush has proposed, and Congress
is considering, measures to accelerate the development of biodefense products
through NIH funding, the review process by the FDA and the final government
procurement contracting authority. While this may help speed the approval of
our vaccine candidates, it may also encourage competitors to develop their own
vaccine candidates. In its March 11, 2004 RFP regarding procurement of a 75
million-dose stockpile, the government identified the OSPHEP within HHS as the
procurement authority. If competitive vaccine candidates gain approval, we
could face severe competition, which could harm our business. Furthermore,
while Project BioShield was passed by the House of Representatives, we cannot
be certain that this legislation will be enacted into law or, if it is enacted
into law, predict the timing of its enactment, nor can we predict the decisions
that will be made in the future by various government agencies.

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

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

53

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

We have entered
into contracts with NIAID and a license agreement with USAMRIID, which are U.S.
government agencies. Substantially all of our revenue is derived from
government contracts and grants. In contracting with government agencies, we
are subject to various U.S. government agency contract requirements. Future
sales to U.S. government agencies will depend, in part, on our ability to meet
U.S. government agency contract requirements, certain of which we may not be
able to satisfy.

U.S.
government contracts typically contain unfavorable termination provisions and
are subject to audit and modification by the government at its sole discretion,
which subjects us to additional risks. These risks include the ability of the
U.S. government to unilaterally:

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

As a U.S.
government contractor, we are required to comply with applicable laws,
regulations and standards relating to our accounting practices and are subject
to periodic audits and reviews. As part of any such audit or review, the U.S.
government may review the adequacy of, and our compliance with, our internal
control systems and policies, including those relating to our purchasing,
property, estimating, compensation and management information systems. Based on
the results of its audits, the U.S. government may adjust our contract-related
costs and fees, including allocated indirect costs. In addition, if an audit or
review uncovers any improper or illegal activity, we may be subject to civil
and criminal penalties and administrative sanctions, including termination of
our contracts, forfeiture of profits, suspension of payments, fines and
suspension or prohibition from doing business with the U.S. government. We
could also suffer serious harm to our reputation if allegations of impropriety
were made against us. Although adjustments arising from government audits and
reviews have not seriously harmed our business in the past, future audits and
reviews could cause adverse effects. In addition, under U.S. government purchasing
regulations, some of our costs, including most financing costs, amortization of
intangible assets, portions of our research and development costs, and some
marketing expenses, may not be reimbursable or allowed under our contracts.
Further, as a U.S. government contractor, we are subject to an increased risk
of investigations, criminal prosecution, civil fraud, whistleblower lawsuits
and other legal actions and liabilities to which purely private sector
companies are not.

In addition,
the license agreement provides that USAMRIID reserves the right to require us
and our affiliates to grant a nonexclusive, partially exclusive, or exclusive
sublicense in any field of use to a responsible applicant, upon terms that are
reasonable under the circumstances and under applicable law, to fulfill public
health or safety needs.

54

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

We license our
anthrax vaccine candidate from USAMRIID and we license our smallpox vaccine
candidate from Kaketsuken. Each of these license agreements requires that we
perform certain obligations. If we fail to comply with our obligations under
these agreements in a timely fashion, our licensors could terminate our rights
to develop and commercialize our anthrax and smallpox vaccine candidates, which
would adversely affect our business and prospects.

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

For a period
of five years after the termination of the LC16m8 Agreement, we may not,
without Kaketsukens prior written consent, file for or obtain regulatory
approval, sell and or otherwise deal in any product potentially in competition
with LC16m8. During the term of the LC16m8 Agreement, we may not, without the
prior written consent of Kaketsuken, develop, sell, commercialize and/or otherwise
deal in any products which may compete with LC16m8. These restrictions will be
waived if the LC16m8 Agreement is terminated due to Kaketsukens uncured
material breach of the LC16m8 Agreement or the FDA determines that LC16m8 is
not approvable in the United States. These restrictions may adversely affect
our ability to pursue attractive business opportunities.

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

We rely on
suppliers to provide us with the necessary materials to produce our vaccine
candidates. Any significant delays in obtaining any of these materials from our
suppliers could cause us to fail to perform under our contracts, which may
cause us to be in breach under those contracts and cause those contracts to be
terminated. We cannot assure you that we will not face shortages from one or
more of these subcontractors in the future.

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

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

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

We have
experienced a period of rapid change in our business as a result of increased
emphasis on biodefense opportunities. In addition, we expect to experience
growth in manufacturing, clinical and regulatory functions associated with our
biodefense business. This change and growth in our business has strained and
may continue to strain our administrative, financial and operational functions.
We will need to expand our staff and improve our systems and procedures to
manage our expected growth and to maintain an adequate system of internal
controls. If we are unable to manage the change and growth of our business
effectively, we may be unable to obtain future government contracts and our
results of operations and financial condition will be adversely affected.

55

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

To develop
vaccine candidates, we must provide the FDA and foreign regulatory authorities
with clinical data that demonstrate adequate safety and immune response.
Because humans are not normally exposed to anthrax or smallpox, statistically
significant effectiveness of our biodefense product candidates cannot be
demonstrated in humans, but instead must be demonstrated, in part, by utilizing
animal models before they can be approved for commercial sale. Vaccine
development to show adequate evidence of effectiveness in animal models and safety
and immune response in humans is a long, expensive and uncertain process, and
delay or failure can occur at any stage of our animal studies or clinical
trials. Any delay or significant adverse clinical events arising during any of
our clinical trials could force us to abandon a vaccine candidate altogether or
to conduct additional clinical trials in order to obtain approval from the FDA
or foreign regulatory bodies. These development efforts and clinical trials are
lengthy and expensive, and the outcome is uncertain. If we are unable to
successfully develop our vaccine candidates, our revenues will suffer, and our
stock price is likely to decline.

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

Our business
prospects will depend on our ability to complete patient enrollment in clinical
trials, to obtain satisfactory results, to obtain required regulatory approvals
and to successfully commercialize our vaccine candidates. Completion of our
clinical trials, announcement of results of the trials and our ability to
obtain regulatory approvals could be delayed for a variety of reasons,
including:

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

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

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

56

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

We are
developing product candidates based upon current governmental policies
regulating these vaccines. For instance, we intend to pursue FDA approval of
our anthrax and smallpox vaccine candidates under requirements published by the
FDA in 2002 that allow the FDA to approve certain vaccines used to reduce or
prevent the toxicity of chemical, biological, radiological or nuclear
substances based on human clinical data to demonstrate safety and immune
response, and evidence of effectiveness derived from appropriate animal studies
and any additional supporting data. Our business is subject to substantial risk
because these policies may change suddenly and unpredictably and in ways that
could impair our ability to obtain regulatory approval of these products, and
we cannot guarantee that the FDA will approve our anthrax and smallpox
vaccines.

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

Vaccine
candidates are subject to extensive government regulations related to
development, testing, manufacturing and commercialization in the United States
and other countries. Our vaccine candidates are in the pre-clinical and
clinical stages of development and have not received required regulatory
approval from the FDA to be commercially marketed and sold. With the exception
of LC16m8, which is 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.57


  We
  will be subject to continual regulatory review and periodic inspection and
  approval of manufacturing modifications, including compliance with cGMP
  regulations.Failure to
comply with these or other regulatory requirements of the FDA and other applicable
foreign regulatory bodies may subject us to administrative or judicially
imposed sanctions, including:


  warning
  letters;
  civil
  penalties;
  criminal
  penalties;
  injunctions;
  product
  seizure or detention;
  product
  recalls;
  total
  or partial suspension of production; and
  suspension
  or revocation of the marketing license.Our product development efforts may not yield
marketable products due to results of studies or trials, failure to achieve
regulatory approvals or market acceptance, proprietary rights of others or
manufacturing issues.

Our success
depends on our ability to successfully develop and obtain regulatory approval
to market new biopharmaceutical products. We expect that a significant portion
of the research that we will conduct will involve new and unproven
technologies. Development of a product requires substantial technical,
financial and human resources even if the product is not successfully
completed.

Our potential
products may appear to be promising at various stages of development yet fail
to reach the market for a number of reasons, including the:

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

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

58

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

If we are
unable to protect our intellectual property, we may be unable to prevent other
companies from using our technology in competitive products. If we infringe on
the intellectual property rights of others, we may be prevented from developing
or marketing our product candidates. We rely on patent and other intellectual
property protection to prevent our competitors from manufacturing and marketing
our product candidates. Our technology, including technology licensed from
Genentech and USAMRIID, or that we may license in the future, if any, will be
protected from unauthorized use by others only to the extent that it is covered
by valid and enforceable patents or effectively maintained as trade secrets.
The patent positions of pharmaceutical and biotechnology companies can be
highly uncertain and involve complex legal and factual questions. No consistent
policy regarding the breadth of claims allowed in biotechnology patents has
emerged to date. Accordingly, we cannot predict the scope and breadth of patent
claims that may be afforded to other companies patents. In addition, we could
incur substantial costs in litigation if we are required to defend against
patent suits brought by third parties, or if we initiate these suits.

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


  others
  will not independently develop similar or alternative technologies or
  duplicate any of our technologies;
  any
  patents issued to us or licensed from Genentech, USAMRIID or other parties,
  or that we may license in the future, if any, will provide a basis for
  commercially viable products or will provide us with any competitive
  advantages or will not be challenged by third parties;
  we
  or any of our current or future licensors will adequately protect trade
  secrets;
  we
  will develop additional proprietary technologies that are patentable; or
  the
  patents of others will not have a material adverse effect on our business.We cannot be
certain that patents issued to us in the future, if any, or patents that we
have licensed from Genentech, Kaketsuken and USAMRIID, or that we may license
in the future, if any, will be enforceable and afford protection against
competitors. In this regard, the U.S. government has the right to use, for or
on behalf of the U.S. government, any technologies developed by us under our
U.S. government contracts and we cannot prohibit third parties, including our
competitors, from using those technologies in providing products and services
to the U.S. government. Accordingly, under our license agreement with USAMRIID
granting us an exclusive license to commercialize the anthrax vaccine, the U.S.
government retains a license for any federal government agency to practice and
have practiced USAMRIIDs anthrax-related inventions, by or on behalf of the
government, thereby allowing the use of the inventions in support of government
contracts with other parties, including our competitors. In addition, we cannot
assure you that our operations or technology will not infringe intellectual
property rights of others. If we infringe the intellectual property of others,
there can be no assurance that we would be able to obtain licenses to use the
technology on commercially reasonable terms or at all.

Our South Korean manufacturing joint venture
may not be successful.

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

Even if Celltrion
successfully completes the construction of its South Korean manufacturing
facility, we cannot be certain that the facility will pass domestic or foreign
regulatory approvals or be able to manufacture mammalian cell culture products
in commercial quantities on a cost-effective basis or at all. In addition, as
of March 31, 2004, Celltrion has not secured any agreements under which
products would be produced at this facility, and it is uncertain

59

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

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

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

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

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

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

60

Our
competitors include fully integrated pharmaceutical companies and biotechnology
companies that currently have drug and target discovery efforts, as well as
universities and public and private research institutions. For instance,
Avecia, in collaboration with Baxter Healthcare Corp. and the United Kingdoms
Defense Science and Technology Laboratory, was recently awarded a $71.3 million
cost reimbursement plus fixed fee contract by NIAID to make three million doses
of an anthrax vaccine for the U.S. government. Many of the organizations
competing with us, including Avecia, may have substantially greater capital
resources, larger research and development staffs and facilities, greater
experience in drug development and in obtaining regulatory approvals, and
greater marketing capabilities than we do.

Natural disasters, including earthquakes, may
damage our facilities.

VaxGens
corporate and manufacturing facilities are primarily located in the San
Francisco Bay area. In addition to office and research facilities, through our
ownership position in both Celltrion and VCI, we have a significant investment
in VCIs biomanufacturing facilities in California, which contain sensitive and
expensive bioreactor equipment. The San Francisco Bay area is in close proximity
to known earthquake fault zones. As a result, our corporate, research and
manufacturing facilities are susceptible to damage from earthquakes and other
natural disasters, such as fires, floods and similar events. Although VaxGen
maintains general business insurance against fires and some general business
interruptions, there can be no assurance that the amount of coverage will be
adequate in any particular case.

Celltrions
manufacturing facilities are located in the Republic of Korea.These
facilities are susceptible to damage from earthquakes and other natural
disasters, such as fires, floods and similar events. Although
Celltrion maintains general business insurance against fires and some general
business interruptions, there can be no assurance that the scope or amount of
coverage will be adequate in any particular case.

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

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

Any such
activities will be accompanied by certain risks including:

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

61

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.

62

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.

63

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 March 31, 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 March 31, 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.If any of
these circumstances were to occur, our redemption of the common stock issued on
exercise of the Series A Warrants, and/or the Series A Warrants, would require
the expenditure of a significant amount of cash and, consequently, could harm
our business.

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.

Other Risks

We are involved in litigation concerning the
results of our AIDSVAX Phase 3 clinical trial.

Since the
announcement of the results of the North American/European Phase 3 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.

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 20 million
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.

64

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.

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.

65

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.

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.

66

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

ITEM 3.       DEFAULTS UPON SENIOR SECURITIES

None.

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

None.

ITEM 5.       OTHER INFORMATION

None.

ITEM 6.       EXHIBITS

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

The following
exhibits are filed as part of this report:

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

Incorporated
  by ReferenceExhibit 
  No.
  
  Exhibit
  
  Form
  
  File No.
  
  Filing Date
  
  Exhibit No.
  
  Filed Herewith10.53
  
  Transition
  and separation agreement between VaxGen and Phillip W. Berman dated as of
  February 13, 2004. + *
  
  
  
  
  
  
  
  
  
  X10.54
  
  Transition
  and separation agreement between VaxGen and Donald P. Francis dated as of
  February 13, 2004. + *
  
  
  
  
  
  
  
  
  
  X10.55
  
  Transition
  and separation agreement between VaxGen and William Heyward dated as of
  February 13, 2004. + *
  
  
  
  
  
  
  
  
  
  X10.56
  
  Transition
  and separation agreement between VaxGen and Carter A. Lee dated as of
  February 13, 2004. + *
  
  
  
  
  
  
  
  
  
  X31.1
  
  Certification of Chief Executive
Officer
  
  
  
  
  
  
  
  
  
  X31.2
  
  Certification of Chief Financial
Officer
  
  
  
  
  
  
  
  
  
  X32.1
  
  Section 1350
Certification
  
  
  
  
  
  
  
  
  
  X* Confidential treatment
requested. The redacted portions have been separately filed with the SEC as
required by Rule 406 of Regulation C.

67

Signatures

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

VaxGen, Inc.Dated:February
  6, 2007
  
  By: /s/ James P. PanekJames P. PanekChief Executive
  Officer(Principal Executive Officer)Dated:February
  6, 2007
  
  By: /s/ Matthew
          J. PfefferMatthew J. PfefferChief Financial
  Officer
  (Principal Financial Officer)68