UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 FORM 10-Q (Mark One) x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR
 15(d) OF THE SECURITIES
 EXCHANGE ACT OF 1934For the Quarterly Period Ended September
 30, 2007ORo
TRANSITION REPORT PURSUANT TO SECTION 13 OR
 15(d) OF THE SECURITIES
 EXCHANGE ACT OF 1934Commission File Number 0-26483VaxGen, Inc.(Exact name of Registrant as Specified in its
 Charter)  Delaware

94-3236309(State or other jurisdiction of

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

94080(Address of Principal Executive Offices)

(Zip Code)(650) 624-1000(Registrants Telephone Number, Including Area Code) Indicate by
check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes x          No
o 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 October 31,
2007.    VaxGen, Inc.

Form 10-Q

For the Quarter Ended September 30, 2007

Table of Contents
PagePart
 I

Financial
 InformationItem
 1

Financial
 Statements (unaudited):Condensed Consolidated Balance Sheets

3Condensed Consolidated Statements of
 Operations

4Condensed Consolidated Statements of Cash
 Flows

5Notes to Condensed Consolidated Financial
 Statements

6Item
 2

Managements
 Discussion and Analysis of Financial Condition and Results of OperationsOverview

13Critical Accounting Policies and Estimates

15Results of Operations

15Liquidity and Capital Resources

18Item
 3

Quantitative
 and Qualitative Disclosures About Market Risk

20Item
 4

Controls
 and Procedures

21Part
 II

Other
 InformationItem
 1

Legal
 Proceedings

26Item
 1A

Risk
 Factors

26Item
 2

Unregistered
 Sales of Equity Securities and Use of Proceeds

35Item
 3

Defaults
 Upon Senior Securities

35Item
 4

Submission
 of Matters to a Vote of Security Holders

35Item
 5

Other
 Information

35Item
 6

Exhibits

35Signatures

35Certifications2

PART
I  FINANCIAL INFORMATION

Item 1. Financial Statements

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

September 30,
 2007



December 31,2006ASSETSCurrent assets:Cash and cash
equivalents:Cash and commercial
paper


$
56,610



$
18,697Reverse repurchase
agreements








54,378Total cash and cash equivalents



56,610




73,075Investment securities



20,710




24,668Accounts receivable








516Unbilled accounts
receivable








7,164Prepaid expenses and other
current assets



2,078




2,828Total current assets



79,398




108,251Property and equipment



23,678




28,417Restricted cash



3,030




2,895Other assets



1,717




2,497Total assets


$
107,823



$
142,060LIABILITIES AND
STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable


$
2,363



$
4,660Accrued and other current
liabilities



2,604




5,610Derivative liability



4,377




8,220Total current
liabilities



9,344




18,490Convertible senior subordinated
notes



30,589




30,321Deferred rent and other
liabilities



4,656




4,188Total liabilities



44,589




52,999Contingencies (Note
12)Stockholders
equity:Common stock



331




331Additional paid-in
capital



301,111




299,226Accumulated deficit



(238,212
)



(210,498
)Accumulated other comprehensive
income



4




2Total stockholders
equity



63,234




89,061Total liabilities and
stockholders equity


$
107,823



$
142,060See accompanying notes to condensed
consolidated financial statements.

3

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

Three Months Ended
 September 30,



Nine Months Ended
 September 30,2007


2006



2007



2006Revenues


$
416



$
2,356



$
4,798



$
13,269Operating expenses:Research and
development



4,125




11,158




16,050




39,128General and
administrative



5,403




6,496




16,778




20,882Restructuring



1,092









5,374




Total operating
expenses



10,620




17,654




38,202




60,010Loss from operations



(10,204
)



(15,298
)



(33,404
)



(46,741
)Other income
(expense):Interest expense



(612
)



(613
)



(1,835
)



(1,857
)Interest income and
other



1,163




981




3,682




1,432Valuation adjustments



(201
)



(195
)



3,843




(1,658
)Equity in loss of
affiliate


















(5,290
)Gain on foreign currency
transactions


















4,678Gain on sale of investment in
affiliate


















61,198Total other income,
net



350




173




5,690




58,503Net income (loss)


$
(9,854
)


$
(15,125
)


$
(27,714
)


$
11,762Basic net income (loss) per
share


$
(0.30
)


$
(0.46
)


$
(0.84
)


$
0.36Diluted net income (loss) per
share


$
(0.30
)


$
(0.46
)


$
(0.84
)


$
0.36Weighted average shares used in
computing
 basic net income (loss) per share



33,107




33,107




33,107




32,594Shares used in computing diluted
net income
 (loss) per share



33,107




33,107




33,107




32,761See accompanying notes to condensed
consolidated financial statements.

4

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

Nine Months Ended
 September 30,2007



2006Cash flows from operating
activities:Net income
(loss)


$
(27,714
)


$
11,762Adjustments to
reconcile net income (loss)
 to net cash used in operating activities:Gain on sale of
investment in affiliate








(61,198
)Gain on foreign
currency transactions








(4,678
)Equity in loss
of affiliate








5,290Valuation
adjustments



(3,843
)



1,658Depreciation
and amortization



4,606




4,665Stock-based
compensation



1,885




2,434Amortization of
premiums and discounts on
 investment securities



(988
)



(27
)Non-cash
interest expense



535




532Changes in
assets and liabilities:Receivables



7,907




(5,502
)Prepaid
expenses and other current assets



891




(1,295
)Accounts
payable



(2,297
)



(5,796
)Accrued and
other current liabilities



(508
)



(7,029
)Other



620




1,612Net cash used in
operating activities



(18,906
)



(57,572
)Cash flows from investing
activities:Purchase of
property and equipment



(19
)



(2,316
)Proceeds (fees)
from sale of investment in
 affiliate, net



(2,441
)



76,472Proceeds from
sale and maturities of
 investment securities



51,074




12,532Purchases of
investment securities



(46,126
)



(11,237
)Other



(47
)



654Net cash provided
by (used in) investing activities



2,441




76,105Cash flows from financing
activities:Proceeds from
private placements, net








25,226Other








(177
)Net cash provided
by financing activities








25,049(Decrease) increase in cash and
cash
 equivalents



(16,465
)



43,582Cash and cash equivalents at
beginning of
 period



73,075




4,560Cash and cash equivalents at end
of period


$
56,610



$
48,142See accompanying notes to condensed
consolidated financial statements.

5

VaxGen, Inc.Notes to Condensed Consolidated Financial Statements

1.
OrganizationNature
of Business Activities

VaxGen, Inc.,
or VaxGen, is a biopharmaceutical company focused on the development,
manufacture and commercialization of biologic products for the prevention and
treatment of human infectious disease.

VaxGen was
incorporated on November 27, 1995. During 2002 through 2006, VaxGen
developed vaccines against inhalation anthrax and smallpox for the purpose of
biodefense. In December 2006, the Department of Health and Human
Services, or HHS,
terminated its contract with VaxGen related to the development and delivery of
a next-generation anthrax vaccine. Following
the HHS decision, VaxGen ceased actively developing its anthrax vaccine, scaled back its biodefense activities and
began pursuing strategic and other alternatives.

Through March
31, 2007, VaxGens principal source of revenue has been the U.S. government,
principally the National Institutes of Health, or NIH, and related entities. Since
April 1, 2007, VaxGens principal source of revenue has been Celltrion, Inc.,
or Celltrion, a company developing and operating a mammalian cell culture
biomanufacturing facility in the Republic of Korea.

VaxGens
activities involve inherent risks. These risks include, but are not limited to,
the possibility that internal controls are not or will not be adequate to
ensure timely and reliable financial information, the risk that VaxGen may not
be able to raise additional capital, the risk that VaxGen may fail to identify
a strategic option that is attractive and the risk that VaxGen may be unable to
commercialize any product candidates it may identify.

Delisting
from the Nasdaq National Market

As a result of
VaxGens inability to timely file financial statements with the Securities and
Exchange Commission, or SEC, it was delisted effective August 9, 2004 from the
Nasdaq National Market, now the Nasdaq Global Market, or Nasdaq. Since that
time, VaxGens common stock has traded over the counter, or OTC, and has been
quoted on the Pink Sheets LLC under the symbol, VXGN.PK. VaxGen became current
in its filing of reports with the SEC on October 4, 2007.

Basis
of Presentation

The unaudited
condensed consolidated financial statements of VaxGen and its subsidiaries,
collectively referred to as the Company, included herein have been prepared
pursuant to the rules and regulations of the SEC. All intercompany accounts and
transactions have been eliminated in consolidation.

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

The results of
operations for the nine month period ended September 30, 2007 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.

For the six
months ended June 30, 2006, VaxGens investment in Celltrion was accounted for
under the equity method. During 2006, VaxGen sold substantially all of
its Celltrion common stock. Accordingly, VaxGen no longer had the ability to
exercise significant influence over operating and financial policies of
Celltrion, and as of July 1, 2006, VaxGen accounted for its investment in
Celltrion under the cost method. At September 30, 2006, VaxGens
ownership interest in Celltrion was 8%. At December 31, 2006 and September 30, 2007, VaxGen held a nominal
ownership interest in Celltrion.

6

2.
Summary of Significant Accounting PoliciesThe Companys significant accounting policies are disclosed in the
Companys annual report of Form 10-K for the year ended December 31, 2006 and
have not changed significantly as of September 30, 2007, with the exception of
the following:

Accounting
Principles Recently Adopted

In July 2006,
the Financial Accounting Standards Board, or FASB, issued FIN 48, Accounting for Uncertainty in Income Taxesan
interpretation of FASB Statement No. 109, or FIN 48, which clarifies
the accounting for uncertainty in tax positions. FIN 48 requires that the
Company recognize in its financial statements the impact of a tax position if
that position is more likely than not of being sustained upon audit, based on
the technical merits of the position. FIN 48 is effective for fiscal years
beginning after December 15, 2006 which is the beginning of the Companys
fiscal 2007. The Companys unaudited consolidated financial statements
have not been materially impacted by the adoption of FIN 48 as of January 1,
2007. In May 2007, the FASB issued FSP No. FIN 48-1, Definition of
Settlement in FASB Interpretation No. 48,or FIN 48-1. FIN 48-1 provides guidance on how an enterprise should determine
whether a tax position is effectively settled for the purpose of recognizing
previously unrecognized tax benefits. The adoption of FIN 48-1 did not have a
material impact on the Companys consolidated financial position, results of
operations or cash flows. See Note 9, Income Taxes, for further details
of the impact of adoption.

In December 2006, the FASB
issued FASB Staff Position EITF 00-19-2, Accounting for Registration Payment Arrangements,
or FSP 00-19-2, which provides guidance on 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 is required to be applied to
reporting periods beginning after December 15, 2006. The Company adopted the
disclosure requirements of FSP 00-19-2 as of January 1, 2007. The Companys
previous accounting for registration payment arrangements in connection with
its 5 1/2% Convertible Senior Subordinated Notes, due April 1, 2010, or Notes,
as well as shares issued or issuable in private placements of its common stock,
or collectively Issuable Shares, was already in compliance with FSP 00-19-2.

Accounting
Principles Not Yet Adopted

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

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

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

3.
Net Income (Loss) per ShareBasic net income (loss) per
share is calculated based on net income (loss) and the weighted-average number
of shares of common stock outstanding during the reported period. Diluted net
income (loss) per share is calculated by increasing the weighted-average number
of common shares outstanding during the period- if not anti-dilutive- by the
number of additional shares of common stock that would have been outstanding if
the dilutive potential shares of common stock had been issued. The dilutive
effect of potential common stock (including outstanding stock options, common
stock warrants and convertible senior subordinated debt) is reflected in
diluted net income per share by application of the treasury stock method, which
includes consideration of share-based compensation as required by FAS 123R in
the three and nine months ended September 30, 2007.

7

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

Three Months Ended
 September 30,

Nine Months Ended
 September 30,2007

2006

2007

2006Weighted-average number of
common shares
 outstanding used in computing basic net income (loss) per share



33,107



33,107



33,107



32,594Dilutive potential common shares
used in
 computing diluted net income (loss) per share















167Total
weighted-average number of shares
 used in computing diluted net income (loss) per share



33,107



33,107



33,107



32,761Basic net loss
per share is computed as net income (loss) divided by the weighted average
number of common shares outstanding for the period. For all periods presented,
the following potential common shares were excluded from the computation of
diluted net income (loss) per share, as their effect was antidilutive (in
thousands):

Three Months Ended
 September 30,

Nine Months Ended
 September 30,2007

2006

2007

2006Options to purchase common
stock



5,552



4,399



5,552



3,604Warrants to purchase common
stock



2,320



2,009



2,320



2,009Convertible senior subordinated
notes



2,134



2,134



2,134



2,134Total



10,006



8,542



10,006



7,7474.
Comprehensive
 Income (Loss)Comprehensive
income (loss) combines net income (loss) and other comprehensive income (loss).
Other comprehensive income (loss) represents certain amounts that are reported
as components of stockholders equity in the consolidated balance sheet,
including foreign currency translation adjustments and unrealized gains or
losses on investment securities. The Companys comprehensive income (loss)
consists of the following (in thousands):

Three Months Ended
 September 30,

Nine Months Ended
 September 30,2007

2006

2007

2006Net income (loss)

$

(9,854
)
$

(15,125
)
$


(27,714
)
$


11,762Foreign currency translation
adjustments



















(3,326
)Unrealized gains on investment
securities




1




(6
)



2




67Comprehensive
income (loss)

$


(9,853
)
$


(15,131
)
$


(27,712
)
$


8,5035.
Accrued and Other Current LiabilitiesThe Companys
accrued and other current liabilities consist of the following (in thousands):

September 30,
 2007

December 31, 
 2006Employment
 benefits


$
620


$
2,049Restructuring




952




Income taxes



60




1,210Clinical
 trial expenses








931Interest



866




433Other



106




987$
2,604



$
5,6106.
Contract Changes and RestructuringAnthrax
Contract

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

8

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

On April 3, 2007,
the Company entered into a settlement agreement with HHS. In accordance with
the agreement, the parties terminated the remaining cost-plus contract related
to the development of a next-generation anthrax vaccine through a separate
contract modification. As part of the settlement agreement, NIAID paid the
Company $11.0 million. The settlement agreement also released both parties of
all liabilities associated with the Companys three government anthrax
contracts: the 2002 Anthrax Contract, the 2003 Anthrax Contract and the SNS
Contract. As part of the settlement agreement, the parties converted the
termination of the SNS Contract, which HHS terminated for default on December
19, 2006, to a termination for convenience and also terminated the 2003 Anthrax
Contract under a bilateral contract modification for the convenience of the
government on a no-cost basis. During the nine months ended September 30, 2007,
the Company recorded the $11.0 million settlement as a collection of $7.1
million of 2006 receivables and $3.9 million of 2007 receivables. The $3.9
million was recorded as revenue during the three months ended March 31, 2007
primarily for the reimbursement of restructuring costs incurred as a result of
the termination of the contracts.

Smallpox

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

Restructurings

In January
2007, the Company restructured operations to significantly reduce operating
costs and announced it was actively pursuing avenues to enhance stockholder
value through a strategic transaction. The Company incurred restructuring costs
associated with this plan of $2.6 million for employee termination benefits,
$0.1 million related to the acceleration of stock options and $1.0 million of
costs associated with the consolidation of its facilities in California. The
majority of these costs were recovered from the U.S. government as part of the
April 2007 settlement agreement. In May and September 2007, the Company further
reduced its workforce to decrease operating costs. Restructuring costs relating
to the May and September 2007 workforce reductions included employee
termination and benefit costs.

All
restructuring costs are expected to be paid by December 31, 2008. At September
30, 2007, $1.0 million of these costs were unpaid, included in accrued and
other current liabilities and include the following:

Balance
 as of
 December
 31,
 2006

Costs
 Incurred

Amounts
 Paid

Balance
 as of
 March 31,
 2007Workforce
 reduction

$


$
2,642

$
(2,070
)
$
572Consolidation
 of excess facilities and other





1,006


(746
)

260Total

$


$
3,648

$
(2,816
)
$
832Balance
 as of
 March 31,
 2007

Costs
 Incurred

Amounts
 Paid

Balance
 as of
 June 30,
 2007Workforce
 reduction

$
572

$
566

$
(695
)
$
443Consolidation
 of excess facilities and other


260





(260
)

Total

$
832

$
566

$
(955
)
$
443Balance
 as of
 June 30,
 2007

Costs
 Incurred

Amounts
 Paid

Balance
 as of
 Sep. 30,
 2007Workforce
 reduction

$
443

$
1,092

$
(583
)
$
9529

7.
Private Placement WarrantsIn February 2006,
VaxGen raised net proceeds of $25.2 million through a private placement to a
group of accredited institutional investors. In connection with this financing,
VaxGen issued to the investors five-year warrants initially exercisable to
purchase 699,996 shares of common stock at an exercise price of $9.24 per
share. Because VaxGen did not file all of its delinquent periodic reports with
the SEC by September 30, 2006, the warrants became exercisable for an
additional 349,994 shares of common stock, at a price of $9.24 per share.
Because VaxGen again did not file all of its delinquent periodic reports with
the SEC by January 31, 2007, the warrants became exercisable for an additional
349,994 shares of common stock, at a price of $9.24 per share.

8.
Executive Officer CompensationIn February
2007, the Board of Directors granted to executive officers options for
1,590,000 shares and implemented an option exchange program allowing executive
officers to exchange old options for 714,700 shares for new options for 178,675
shares. All of the options were granted effective February 12, 2007 with an
exercise price of $2.23 per share, the closing market price of one share of the
Companys common stock on that date. Each option will vest monthly on a
pro-rata basis over one to four years. The Board also approved two potential
retention bonus payments. During the three months ended September 30, 2007, the
aggregate first retention bonus payment of $0.3 million was made to the
executives who remained regular full-time employees in good standing through
June 30, 2007. Additionally, a second cash bonus payment of the same amount
will be made, conditioned upon certain terms, including that the executive
remain a regular full-time employee in good standing through the completion of
a strategic transaction.

9.
Income TaxesThe Company
accounts for income taxes using an asset and liability approach, which requires
the recognition of deferred income tax assets and liabilities for the expected
future tax consequences of events that have been recognized in the Companys
consolidated financial statements or tax returns. Deferred income tax assets
and liabilities are determined based upon the temporary differences between the
financial statement and tax bases of assets and liabilities using enacted tax
rates. A valuation allowance is provided on deferred tax assets if it is
determined that it is more likely than not that the asset will not be realized.

The Company
adopted FIN 48 on January 1, 2007 and in so doing, has analyzed filing
positions in all of the federal and state jurisdictions where it is required to
file income tax returns, as well as all open tax years in these jurisdictions.
The implementation of FIN 48 did not have a material impact on the condensed
consolidated financial statements and did not require an adjustment to
accumulated deficit. The Company has an unrecognized tax benefit of
approximately $1.2 million, which did not change significantly during the three
or nine months ended September 30, 2007. If recognized, there would be no
impact to the 2007 effective income tax rate due to the existence of the
valuation allowance. In addition, future changes to the unrecognized tax
benefits will have no impact on the effective tax rate to the extent that a
valuation allowance exists.

Under special
IRS rules, or Section 382 Limitation, cumulative stock purchases by material
shareholders exceeding 50% during a 3-year period can potentially limit a
companys future use of net operating losses, or NOLs. Under current tax rules,
any Section 382 Limitation is not expected to significantly impact the recorded
value or timing of utilization of the Companys NOLs.

The Companys
policy is to classify and accrue interest expense and penalties on income tax
underpayments (overpayments) as other expense in its condensed consolidated
statement of operations. The amount of unrecognized tax related interest
expense and penalties at January 1, 2007 was zero. The Company did not incur
any income tax related interest income, interest expense or penalties for the
three or nine months ended September 30, 2007.

As a result of significant changes to its financial
statements, the Company has amended its U.S. federal and state returns for the
tax years ended December 31, 2002 through 2005. These amendments will
have no impact on the effective tax rate due to the existence of the valuation
allowance. The Companys U.S. tax returns for 2002 and subsequent years remain
subject to examination by tax authorities. The Company is also subject to examination
in various state jurisdictions for 2002 and subsequent years.

10

10.
Stock-Based CompensationIn February
2007, the Board of Directors granted to executive officers options for
1,590,000 shares and implemented an option exchange program allowing executive
officers to exchange old options for 714,700 shares for new options for 178,675
shares. Options for 235,000 shares were also granted to members of the board of
directors. The options were granted with an exercise price of $2.23 per share,
the closing market price of one share of the Companys common stock. Option
shares will vest monthly on a pro-rata basis over one to four years.

The impact on
consolidated results of operations of recording stock-based compensation for
the three and nine months ended September 30, 2007 and 2006 was as follows (in
thousands):

Three Months Ended
 September 30,

Nine Months Ended
 September 30,2007

2006

2007

2006Research and
 development

$
162

$
407

$
883

$
1,627General and
 administrative


187


261


1,002


807Total stock-based
compensation

$
349

$
668

$
1,885

$
2,43411.
CelltrionVaxGen
provides services to assist Celltrion with its operations under a Technical
Support and Services Sub-Agreement. VaxGen is paid for out-of-pocket expenses
and services rendered. VaxGen recognized $0.2 million and $0.3 million of
revenue from Celltrion during the three months ended September 30, 2007 and
2006, respectively; and $0.7 million and $1.3 million of revenue from Celltrion
during the nine months ended September 30, 2007 and 2006, respectively.

In February
2006, Celltrion and VaxGen entered into an agreement, or Agreement to Provide
U.S. GAAP Financial Information, whereby Celltrion agreed to use its best
efforts to timely prepare annual and quarterly financial statements in
accordance with U.S. GAAP. Under the agreement, VaxGen agreed to reimburse
Celltrion for all invoiced costs of its independent accountants relating to the
preparation of U.S. GAAP financial statements as well as all invoiced costs of
audits and reviews performed by another independent registered public
accounting firm. In addition, VaxGen agreed to compensate Celltrion for the
cost of internal resources utilized in support of these activities at a rate of
190% of the employees hourly wage; such costs shall not exceed the U.S. dollar
equivalent of 300 million Korean Won (equivalent to $0.3 million at the
exchange rate on September 30, 2007) per year and shall be subject to VaxGens
approval. In March 2007, Celltrion and VaxGen amended the Technical Support and
Services Sub-Agreement as well as the Agreement to Provide U.S. GAAP Financial
Information to reflect a reduction in overhead rate on services performed from
90% to 40%. During the three and nine months ended September 30, 2007, the
Company incurred zero and $1.2 million of expenses under these agreements,
respectively. During the three and nine months ended September 30, 2006, the
Company incurred $0.5 million and $1.9 million of expenses under these
agreements, respectively.

VaxGen
provided mammalian cell culture technology and biologics production expertise
as its 2002 investment in Celltrion. VaxGens proportionate share of the
investees undistributed losses was recorded as equity in loss of affiliate
through July 1, 2006. Summarized selected financial information for the six
months ended June 30, 2006, while the Companys investment in Celltrion was
accounted for under the equity method, was as follows (in thousands):

Operating
 expenses

$
22,953Loss from
 operations


(22,953
)Other
 expense


(2,825
)Net
loss

$
(25,778
)In 2007, the
Company paid the final $2.4 million in fees due from the 2006 sale of substantially
all of its remaining Celltrion common stock.

12.
ContingenciesIf an
executive officers employment with VaxGen is terminated without cause, or the
executive resigns due to good reasons, as defined in their employment
agreements, the executive would be entitled to receive as severance 12 months
of their base salary and all of their outstanding unvested stock options would
be accelerated and become immediately exercisable. If this occurs within 13
months of a change of control, as defined in their agreements, the executive
will also be eligible to receive a bonus payment equal to up to 30 percent of
his salary on a prorated basis. As of September 30, 2007, the aggregate salary
and bonus obligations under these circumstances would be $1.5 million.

11

On October 5,
2007, or Filing Date, the Company filed with the SEC a registration statement,
or Registration Statement, under the Securities Exchange Act of 1933, as
amended, or Securities Act, with respect to the Issuable Shares. The Company
has agreed 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) is referred to as the Required
Effective Date.

In the event
of a default, the Company is required to 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 purchase price of the 2006 private placement until the applicable
failure has been cured. The Company considers the likelihood of becoming
obligated for such liquidated damages to be remote and accordingly no provision
for their payment has been recorded. Should the Company become obligated to
make payment of these liquidated damages, it could have a material adverse
effect on its financial position and results of operations, particularly if the
Company becomes obligated to make a payment in full for all liquidated damages
potentially due and payable under these agreements.

The Companys
obligation to maintain the effectiveness of the Registration Statement ends
upon the earlier to occur of (i) two years from the date of effectiveness of
the Registration Statement, (ii) the date when all holders of Issuable Shares
are eligible to sell such securities under Rule 144(k) promulgated under the
Securities Act, (iii) the date when all securities registered under the Registration
Statement have been sold and (iv) the date when all securities registered under
the Registration Statement cease to be outstanding. The Company estimates that
the maximum monthly amount of consideration that the Company could be required
to pay as liquidated damages under these registration payment obligations is
$0.3 million.

13.
Segment InformationSince July 1,
2005, the Company has operated in one business segment, the development of
vaccines that immunize against infectious disease. All of VaxGens operating
assets are located in the United States of America. Substantially all of
VaxGens revenue has been derived from federal government contracts and grants,
primarily from HHS, NIH and related entities.

14.
Subsequent EventOn October 11, 2007, the
Company amended its lease agreement, dated October 26, 1998, or Lease
Amendment. The Lease Amendment calls for the Company to relinquish occupancy of
one of its two buildings subject to the lease, effective March 1, 2008. The
Lease Amendment will reduce the Companys lease obligations by $12 million over
the remaining lease term, which runs through December 31, 2016. The Company
paid a surrender fee to the landlord of $0.1 million. Under the Lease
Amendment, the amount of the $2.35 million letter of credit delivered by the
Company in favor of the landlord will be reduced by $0.95 million, with further
reductions over the remaining term of the lease upon the achievement of
financial benchmarks by the Company.

12

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

Special
Note Regarding Forward-Looking Statements

This
discussion and analysis should be read in conjunction with our Annual Report on
Form 10-K for the year ended December 31, 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 of 1933, or Securities Act, and Section 21E of the Securities
Exchange Act of 1934, or Exchange Act. All statements other than statements of
historical fact are forward-looking statements for purposes of these
provisions, including any statements of the plans and objectives of management
for future operations, any statements regarding future operations, any
statements concerning proposed new products or services, any statements
regarding pending or future mergers or acquisitions, any statements regarding
future economic conditions or performance, and any statement of assumptions
underlying any of the foregoing. In some cases, forward-looking statements can
be identified by the use of terminology such as may, will, expects, plans,
anticipates, estimates, potential or continue or the negative thereof
or other comparable terminology.

There can be
no assurance that such expectations or any of the forward-looking statements
will prove to be correct, and actual results could differ materially from those
projected or assumed in the forward-looking statements. Our forward-looking
statements are subject to inherent risks and uncertainties including, but not
limited to, the risk factors set forth in this Quarterly Report. Factors that
could cause or contribute to such differences include, but are not limited to,
our limited cash resources, our ability to finance our research, our
significant corporate and Securities and Exchange Commission, or 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. We were incorporated in 1995 and formed to complete
the development of an investigational recombinant protein vaccine intended to
prevent infection by human immunodeficiency virus. In 2002, we broadened our
product development portfolio to also include biodefense vaccines.

On August 6,
2004, we announced that we had received notification from Nasdaq that our stock
would discontinue trading on Nasdaq effective August 9, 2004. This action
followed our appeal to Nasdaq for a listing extension after not meeting the
stated time requirements to file Quarterly Reports on Form 10-Q for the
quarters ended March 31 and June 30, 2004, respectively. We became current
again in our filing of reports with the SEC on October 4, 2007. Our common
stock is currently quoted on the OTC Pink Sheets under the symbol VXGN.PK.

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

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

In December
2006, we announced the termination of the SNS Contract by HHS. As a result, we
implemented a reduction in force, or RIF, in January 2007. The cash outflow of
the January RIF was $2.8 million and $0.5 million during the three months ended
March 31, 2007 and June 30, 2007, respectively, and $0.3 million thereafter.
Beginning in April 2007, wage savings per month were $0.7 million and $0.2
million, respectively, for Research and Development, or R&D, and General
and Administrative, or G&A. In addition, we did not renew an office space
lease that expired at the end of May 2007. This lease, coupled with utilities
and maintenance, reduced future expenses by $0.2 million per month.

13

In May 2007,
we further reduced our workforce to decrease operating costs. The cash outflow
of this RIF was $0.4 million during the three months ended June 30, 2007 and
$0.2 million thereafter. This RIF mostly impacted R&D. Beginning in July
2007, additional wage savings were $0.1 million per month. The RIFs in January
2007 and May 2007 have reduced our cash disbursements by approximately $1.2
million to $1.4 million per month since June 30, 2007. We do not expect these
savings to be materially offset by any anticipated increases in other expenses.

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

In September
2007, we further reduced our workforce to decrease operating costs.
Restructuring costs included employee termination and benefit costs. Estimated
costs of the restructuring are $1.1 million. The cash outflow of this RIF was
$0.3 million during the three months ended September 30, 2007 and is expected
to be $0.6 million and $0.2 million during the three months ended December 31,
2007 and thereafter, respectively. Beginning in October 2007, additional
expected wage savings are $0.3 million per month. We do not expect these
savings to be materially offset by any anticipated increases in other expenses.

On October 11,
2007, we amended our lease agreement, dated October 26, 1998, or Lease
Amendment. The Lease Amendment calls for us to relinquish occupancy of one of
our two buildings subject to the lease, effective March 1, 2008. The Lease
Amendment will reduce our lease obligations by $12 million over the remaining
lease term, which runs through December 31, 2016. We paid a surrender fee to
the landlord of $0.1 million. Under the Lease Amendment, the amount of the
$2.35 million letter of credit we delivered in favor of the landlord will be
reduced by $0.95 million, with further reductions over the remaining term of
the lease upon our achievement of financial benchmarks.

Celltrion

For the six
months ended June 30, 2006, our investment in Celltrion, Inc., or Celltrion, a
company developing and operating a mammalian cell culture biomanufacturing
facility in the Republic of Korea, was accounted for under the equity method.
At June 30, 2006, our ownership interest in Celltrion was 8%. During June and
December 2006, we received gross proceeds of $130.3 million from the sale of
substantially all of our Celltrion common stock. At December 31, 2006 and
September 30, 2007, we held a nominal ownership interest in Celltrion.

14

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Reference
should be made to Item 7, Managements Discussion and Analysis of Financial
Condition and Results of Operations, in our Annual Report on Form 10-K for the
fiscal year ended December 31, 2006, filed with the SEC in August 2007, for a
description of our critical accounting policies. There have been no significant
changes to our policies since we filed that report other than our adoption of FIN
48, Accounting for Uncertainty in Income
Taxesan interpretation of FASB Statement No. 109, or FIN 48 and FSP No. FIN 48-1, Definition of Settlement
in FASB Interpretation No. 48,or
FIN 48-1.

Effective
January 1, 2007, we adopted FIN 48 and FIN 48-1; see Note 9. We have filed
tax returns with positions that may be challenged by the tax authorities. These
positions relate to, among others, deductibility of certain expenses, expenses
included in our research and development tax credit computations, as well as
other matters. Although the outcome of tax audits is uncertain, in managements
opinion, adequate provisions for income taxes have been made for potential
liabilities resulting from such matters. We regularly assess the tax positions
for such matters and include reserves for those differences in position. The
reserves are utilized or reversed once the statute of limitations has expired
and/or at the conclusion of the tax examination. We believe that the ultimate
outcome of these matters will not have a material impact on our financial
position, financial operations or liquidity.

In December
2006, the FASB issued FASB Staff Position EITF 00-19-2, Accounting for Registration Payment
Arrangements, or FSP 00-19-2, which provides guidance on 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
is required to be applied to reporting periods beginning after December 15,
2006. We adopted FSP 00-19-2 as of January 1, 2007. Our previous accounting for
registration payment arrangements in connection with our 5 1/2% Convertible
Senior Subordinated Notes, due April 1, 2010, or Notes, as well as shares
issued or issuable in private placements of our common stock, or collectively
Issuable Shares, was already in compliance with FSP 00-19-2.

RESULTS OF OPERATIONS

Comparison of Fiscal Quarters and Nine Months
Ended September 30, 2007 and 2006

Revenues

Three Months Ended
 September 30,

Percent
 change2007/2006

Nine Months Ended
 September 30,

Percent
 change2007/20062007

2006


2007

2006(in thousands)



(in thousands)Revenues

$
416

$
2,356

(82)%

$
4,798

$
13,269

(64)%Revenues prior
to March 31, 2007 were primarily from our Anthrax Contracts principally
reflecting work performed for NIAID and the reimbursement of restructuring
costs incurred as a result of the termination of the Anthrax Contracts in
December 2006. In 2007, NIAID-related activities decreased from the comparable
period in the prior year as our work on the Anthrax contract ended in December
2006 and revenue for the three months ended March 31, 2007 was primarily
related to the governments reimbursement of our January 2007 restructuring
costs incurred as a result of the termination of the contracts. Services
revenues were also earned as part of a consulting services agreement with
Celltrion to provide technical assistance related to the design, engineering
and construction of Celltrions manufacturing facility. VaxGen recognized $0.2
million and $0.3 million of revenue from Celltrion during the three months
ended September 30, 2007 and 2006, respectively; and $0.7 million and $1.3
million of revenue from Celltrion during the nine months ended September 30,
2007 and 2006, respectively. The amounts earned vary with the level of services
required. VaxGen also recognized $0.2 million of revenue from the sale of
miscellaneous manufacturing by-products during the three months ended September
30, 2007.

Revenues
earned in one period are not indicative of revenues to be earned in future
periods. Following the HHS decision, we ceased actively developing our anthrax
vaccine, scaled back our biodefense activities and are actively pursuing
strategic and other alternatives; therefore, we expect revenues for the three
months ended December 31, 2007 to primarily include revenues from Celltrion,
which are not expected to be significant.

Research
and development expenses

Three Months Ended
 September 30,

Percent
 change2007/2006

Nine Months Ended
 September 30,

Percent
 change2007/20062007

2006



2007

2006(in thousands)




(in thousands)Research and
 development expenses

$
4,125

$
11,158

(63)%

$
16,050

$
39,128

(59)%15

Research
expenses, which are currently general facility maintenance in nature, include
the costs of internal personnel, outside contractors, allocated overhead and
laboratory supplies. The decrease in research and development expenses in the
three months ended September 30, 2007 over the comparable period in 2006 was
primarily due to:


Facilities
 and other overhead costs, including allocations from general and
 administrative expense, which decreased by $4.6 million due to changes in the
 relative headcounts by department and reduced spending;
Outside
 consultant expenses, which decreased by $1.4 million primarily due to reduced
 activities related to our Anthrax Contracts; and
Labor and
 benefits, which decreased by $1.0 million primarily associated with the
 reductions in force in January and May 2007 as a result of overall reductions
 in activities related to our Anthrax Contracts.The decrease
in research and development expenses in the nine months ended September 30,
2007 over the comparable period in 2006 was primarily due to:


Labor and
 benefits, which decreased by $8.6 million primarily associated with the
 reductions in force in January and May 2007 as a result of overall reductions
 in activities related to our Anthrax Contracts;
Facilities
 and other overhead costs, including allocations from general and
 administrative expense, which decreased by $8.4 million due to changes in the
 relative headcounts by department and reduced spending; and
Outside
 consultant expenses, which decreased by $6.1 million primarily due to reduced
 activities related to our Anthrax Contracts.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. Development timelines, probability of success and
development costs vary widely. While we are currently not actively developing
any product candidates, we anticipate that we will make determinations as to
which new 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 future
product candidates.

We expect
quarterly research and development expenses to decrease during the three months
ended December 31, 2007 because following the HHS decision we ceased actively
developing our anthrax vaccine, scaled back our biodefense activities and are
actively pursuing strategic and other alternatives.

General
and administrative expenses

Three Months Ended
 September 30,

Percent
 change2007/2006

Nine Months Ended
 September 30,

Percent
 change2007/20062007

2006



2007

2006(in thousands)




(in thousands)General and
 administrative expenses

$
5,403

$
6,496

(17)%

$
16,778

$
20,882

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

The decrease
in general and administrative expenses in the three months ended September 30,
2007 over the comparable period of 2006 was primarily due to:


Labor and
 benefits, which decreased by $1.3 million primarily associated with the
 reductions in force in January and May 2007;
Professional
 fees, which increased by $0.6 million due to audit and legal fees and
 expenses associated with our efforts to comply with various reporting and
 regulatory requirements including the Sarbanes-Oxley Act of 2002; and
Outside
 consultant expenses, which decreased by $0.6 million primarily due to reduced
 activities associated with the reaudit of our prior year financial
 statements.The decrease
in general and administrative expenses in the nine months ended September 30,
2007 over the comparable period of 2006 was primarily due to:


Labor and
 benefits, which decreased by $4.0 million primarily associated with the
 reductions in force in January and May 2007;16

Outside
 consultant expenses, which decreased by $1.8 million primarily due to reduced
 activities associated with the reaudit of our prior year financial
 statements;
Professional
 fees, which increased by $0.9 million due to audit and legal fees and
 expenses associated with our efforts to comply with various reporting and
 regulatory requirements including the Sarbanes-Oxley Act of 2002; and
Facilities
 and other overhead costs, net of allocations to research and development
 expense, which increased by $0.8 million due to changes in the relative
 headcounts by department.We expect
quarterly general and administrative expenses to decrease during the three
months ended December 31, 2007 because following the HHS decision we scaled
back activities and are actively pursuing strategic and other alternatives.

Restructuring
expenses

Three Months Ended
 September 30,

Nine Months Ended
 September 30,2007

2006

2007

2006(in thousands)

(in thousands)Restructuring

$
1,092

$


$
5,374

$
During
January, May and September 2007, we reduced our workforce to reduce operating
costs. Restructuring costs include $4.4 million for employee termination
benefits and $1.0 million for costs associated with consolidation of our
facilities in California.

Other
income (expense)

Three Months Ended
 September 30,

Nine Months Ended
 September 30,2007

2006

2007

2006(in thousands)

(in thousands)Interest
 expense

$
(612
)
$
(613
)
$
(1,835
)
$
(1,857
)Interest
 income and other


1,163


981


3,682


1,432Valuation
 adjustments


(201
)

(195
)

3,843


(1,658
)Equity in
 loss of affiliate











(5,290
)Gain on
 foreign currency transactions











4,678Gain on sale
 of investment in affiliate











61,198Other income,
net

$
350

$
173

$
5,690

$
58,503The decrease
in other income for the three and nine months ended September 30, 2007 from the
comparable period in 2006 was primarily due to:


Interest
 income and other increased due to greater overall cash, cash equivalent and
 investment balances primarily due to the sale of substantially all of our
 Celltrion common stock in June 2006 and December 2006, partially offset by
 our operating losses;
Expenses for
 mark-to-market adjustments related to the valuation of our outstanding
 derivatives on our 5 1/2% Convertible Senior Subordinated Notes, due April 1,
 2010, or Notes, changed primarily due to changes in the likelihood of a
 change in control potentially triggering the redemption option related to the
 Notes;
For the
 three and six months ended June 30, 2006, we recognized our share of
 Celltrions losses under the equity method. We sold substantially all of our
 ownership interest in Celltrion during 2006 and accordingly, effective July
 1, 2006, no longer account for it under the equity method;
Realized
 foreign currency gains in 2006 were primarily due to the collection of the
 June 2006 proceeds from the sale of Celltrion common stock; and
Gain on sale
 of investment in affiliate resulting from our June 2006 sale of 3.6 million
 of our Celltrion common stock for gross proceeds of $79.0 million, net of
 $11.8 million in basis, $4.9 million in expenses and the deferral of $1.1
 million related to an option sold along with the shares.We anticipate
future investment income will fluctuate and will be primarily driven by our
future cash, cash equivalent and investment balances. Valuation adjustments
will continue to be impacted by changes in our common stock price, our
volatility and our expectations relative to a change in control. No changes in
our debt levels are anticipated and therefore quarterly interest expense is
expected to remain at the three months ended September 30, 2007 level throughout
2007.

As noted in
Note 13, Segment Information, included in the notes to the unaudited condensed
consolidated financial statements in Part I  Item 1 of this report, we have
only one segment.

17

LIQUIDITY AND CAPITAL RESOURCES

2007

2006(in thousands)As of September 30:Cash, cash
 equivalents and investment securities

$
77,320

$
59,403Working
 capital


70,054


57,625Nine Months ended September 30:Cash
 provided by (used in):Operating
activities

$
(18,906
)
$
(57,572
)Investing
activities


2,441


76,105Financing
activities





25,049Our primary
financing requirements as of September 30, 2007 are the funding of our reduced
levels of facility maintenance and general administration because following the
HHS decision we ceased actively developing rPA102, scaled back our biodefense
activities and are actively pursuing strategic and other alternatives. Through
December 31, 2006, we financed our operations primarily through sales of our
common stock, the issuance of Series A Preferred Stock, the issuance of the
Notes, sales of our Celltrion common stock as well as through revenues from
research contracts and grants.

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

During the
year ended December 31, 2006, we received gross proceeds of $130.3 million from
the sale of substantially all of our Celltrion common stock. The Companys
basis in the shares sold in 2006 was $19.0 million. The Company incurred $7.3
million in fees and related expenses associated with the sale of this stock,
resulting in a gain of $104.0 million. At December 31, 2006 and September 30,
2007, we held a nominal ownership interest in Celltrion.

As a result of
the termination of our SNS Contract, we implemented a RIF in January 2007. The cash
outflow of the January RIF was $2.8 million and $0.5 million during the three
months ended March 31, 2007 and June 30, 2007, respectively, and $0.3 million
thereafter. Beginning in April 2007, wage savings per month were $0.7 million
and $0.2 million, respectively, for R&D and G&A. In addition, we did
not renew an office space lease that expired at the end of May 2007. This
lease, coupled with utilities and maintenance, reduced future expenses by $0.2
million per month.

In May 2007,
we reduced our workforce to further lower operating costs. The cash outflow of
this RIF was $0.4 million during the three months ended June 30, 2007 and $0.2
million thereafter. This RIF mostly impacted R&D. Beginning in July 2007,
additional wage savings were $0.1 million per month. The RIFs in January 2007
and May 2007 have reduced our cash disbursements by approximately $1.2 million
to $1.4 million per month since June 30, 2007. We do not expect these savings
to be materially offset by any anticipated increases in other expenses.

In September
2007, we further reduced our workforce to decrease operating costs.
Restructuring costs included employee termination and benefit costs. Estimated
costs of the restructuring are $1.1 million. The cash outflow of this RIF was
$0.3 million during the three months ended September 30, 2007 and is expected
to be $0.6 million and $0.2 million during the three months ended December 31,
2007 and thereafter, respectively. Beginning in October 2007, additional
expected wage savings are $0.3 million per month. We do not expect these
savings to be materially offset by any anticipated increases in other expenses.

Net cash used
in operating activities of $18.9 million and $57.6 million for the nine months
ended September 30, 2007 and 2006, respectively, was primarily attributable to
our operating losses although the effect of non-cash items upon operating
activities was significant in both periods and included:


During the
 nine months ended September 30, 2006, we recognized our share of Celltrions
 losses under the equity method. We sold substantially all of our ownership
 interest in Celltrion during 2006 and accordingly effective July 1, 2006 no
 longer account for it under the equity method;
Stock-based
 compensation expense of $1.9 million in 2007 and $2.4 million in 2006. Both
 periods primarily reflect charges from the fair value of stock options; and
Valuation
 gain of $3.9 million in 2007 and valuation loss of $1.7 million in 2006,
 respectively, reflecting changes in the fair value of outstanding derivatives
 from the Notes.18

The $61.2
million gain on the 2006 sale of 3.6 million shares of our investment in
Celltrion was removed from operating activities and the net proceeds received
are reflected in investing activities.

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


Prepaid
 expenses and other current assets, which decreased by $0.9 million in 2007
 and increased by $1.3 million in 2006 primarily due to the timing of payments
 and the reduced level of operating activities;
Accounts
 payable, which decreased by $2.3 million in 2007 and by $5.8 million in 2006
 primarily due to the timing of payments and the reduced level of operating
 activities;
Accrued and
 other current liabilities, which decreased by $0.5 million in 2007 and by
 $7.0 million in 2006 primarily due to the timing of payments and the reduced
 level of operating activities; and
Receivables,
 which decreased by $7.9 million in 2007 and increased by $5.5 million in 2006
 primarily due to reduced revenues earned from the U.S. government and the
 timing of payments received.Net cash
provided by investing activities during the nine months ended September 30,
2006 consisted primarily of the $76.5 million in net proceeds from the 2006
sale of our Celltrion common stock net of activities relating to the purchase
and sale of investment securities as well as capital expenditures. Capital
expenditures in the nine months ended September 30, 2007 were minimal. During
2006, capital expenditures of $0.8 million were made in connection with the
expansion of the research and development laboratories and leasehold
improvements associated with the California manufacturing facility and office
facilities. In addition, during the nine months ended September 30, 2006 we
purchased $1.5 million of software related to the implementation of a new
enterprise resource planning system. We expect minimal capital expenditures
during the remainder of 2007 because the California manufacturing facilities are
now substantially complete. Net cash provided by investing activities also
includes net purchases and sales of securities. During the nine months ended
September 30, 2007, we paid the final $2.4 million in fees due from the 2006
sale of substantially all of our remaining Celltrion common stock.

Net cash
provided by our financing activities in the nine months ended September 30,
2006 was from our collection of net proceeds of $25.2 million through a private
placement of 3.5 million shares of our common stock at $7.70 per share at a
discount to the $9.20 per share closing price together with warrants to
purchase up to 1.4 million shares of common stock at a price of $9.24 per
share.

At September
30, 2007, $77.3 million, or 72%, of our assets consisted of cash, cash
equivalents and investment securities. We had working capital of $70.1 million
at September 30, 2007, compared to $57.6 million at September 30, 2006. This
increase in working capital is primarily due to the net proceeds from the 2006
sale of our Celltrion common stock and the following:


Receivables,
 which decreased by $8.8 million primarily due to reduced revenues earned from
 the U.S. government and the collection of amounts due from them;
Accounts
 payable, which decreased by $1.9 million primarily as a result of reduced
 operations; and
Accrued and
 other current liabilities, which decreased by $2.6 million primarily due to
 the timing of payments and as a result of reduced operations.We believe
that our existing cash, cash equivalents and investment securities will be
sufficient to cover our working capital needs, capital expenditures, debt
obligations and commitments through at least December 31, 2008. Our future
capital requirements will depend upon our ability to identify and exploit
business development opportunities including actively pursuing avenues to
enhance stockholder value through a strategic transaction.

Off-Balance Sheet Arrangements

As of September 30, 2007, we
did not have any off-balance sheet arrangements as defined in Item
303(a)(4)(ii) of SEC Regulation S-K.

19

Recent Accounting Pronouncements

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

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

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

ITEM 3. QUANTITATIVE AND
QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest
Rate Risk

We are exposed
to market rate changes by debt securities included in our investment portfolio.
By policy, we invest in debt instruments of the U.S. government, federal
agencies and high-quality corporate issuers, limit the amount of credit
exposure to any one issuer, and limit duration by restricting the term.
Investments in both fixed rate and floating rate instruments carry a degree of
interest rate risk. Fixed rate securities may have their fair market value
adversely affected due to a rise in interest rates, while floating rate
securities may produce less income than expected if interest rates fall. Due in
part to these factors, our future investment income may decrease due to changes
in interest rates or due to losses we may suffer when securities decline in
market value. At September 30, 2007, we held available-for-sale securities in
the principal amount of $20.7 million. If market interest rates were to
increase immediately and uniformly by 10% from levels at September 30, 2007,
the fair value of our portfolio would decline by an immaterial amount, and would
not have a significant effect on our operations or cash flows. Our exposure to
losses as a result of interest rate changes is managed through investing in a
portfolio of securities with a weighted-average maturity of one year or less.

Indebtedness

At September
30, 2007, our outstanding non-current liabilities include $31.5 million of our
Notes due April 1, 2010 which we sold in a private placement in April
2005. As the Notes bear interest at a fixed rate, our interest expense under
the Notes would not be affected by interest rate changes. As of September 30,
2007, we did not invest in derivative financial instruments, interest rate
swaps or other investments that alter interest rate exposure.

Derivative
Valuation Risk

The terms of
our Notes include put features not under our control. These features are
considered to be an embedded derivative liability and we determined the fair
value of this derivative to be $1.8 million on the date of issuance. Due to the
quarterly revaluation of the embedded derivative liability, we recorded in our
statements of operations other expense of $0.2 million and income of $3.8
million for the three and nine months ended September 30, 2007, respectively.
At September 30, 2007, the embedded derivative liability was valued at $4.4
million. We determine the fair value of the derivative liabilities using the
Monte Carlo Simulation methodology. This methodology allows flexibility in
incorporating various assumptions such as probabilities of certain triggering
events. The valuations are based on the information available as of the various
valuation dates. Factors affecting the amount of these liabilities include
expectations regarding triggering events, the market value of our common stock,
the estimated volatility of our common stock, our market capitalization, the
risk free interest rate and other assumptions. A change in probability of a
triggering event and or a change in the market value of our common stock could
have a significant impact on the results of our operations; however, there
would not be any impact on our cash flows.

20

ITEM 4. CONTROLS AND
PROCEDURES

Background

As described
in Item 9A of our Annual Report on Form 10-K for the year ended December 31,
2006, which we refer to as our 2006 10-K, we identified material weaknesses
which are listed below under the heading Material Weaknesses Reported in 2006.A material weakness is a control
deficiency
in our internal control over financial reporting, or ICFR, or a combination of control deficiencies
in ICFR, such that there is a reasonable possibility that a material
misstatement of the annual or interim financial statements will not be
prevented or detected on a timely basis. We have implemented, and will continue to implement and
evaluate remediation measures and improvements to the overall design of our
control environment, as described below, to address the material weaknesses in
our ICFR. We believe the remediation
measures described below have strengthened our ICFR. As we are able to evaluate
the effectiveness of these remedial measures over a sufficient period of time,
we would expect that the remaining material weaknesses identified in section IV
below would be remediated.

This report is presented in the following sections:

I.
Managements ConclusionII.
Materials Weaknesses Reported in 2006III.
Remediation of Material
  Weaknesses Reported in 2006IV.
Ongoing Remediation
  InitiativesV.
Other InformationI. Managements Conclusion

As required by Rule 13a-15(b) under the Securities Exchange Act of
1934, as amended, or Exchange Act, 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 Exchange Act 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 Securities and Exchange Commission, or SEC, rules
and forms. Based upon the material weaknesses in our ICFR as described below,
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. The certifications of our principal executive
officer and principal financial officer required in accordance with Section 302
of the Sarbanes-Oxley Act of 2002, or SOX, are attached as exhibits to this
Quarterly Report on Form 10-Q. The disclosures set forth in this Item 4 contain
information concerning the evaluation of our disclosure controls and procedures
and changes in ICFR, referred to in the certifications. Those certifications
should be read in conjunction with this Item 4 for a complete understanding of
the matters covered by the certifications.

II. Material
Weaknesses Reported in 2006

As described in Item 9A of our 2006 10-K, we previously identified the
following material weaknesses:

1)
We did not maintain an effective control environment, specifically,
  the following material weaknesses were identified within the control
  environment:a)
We did not maintain an effective control environment based on
  criteria established in Internal Control-Integrated Framework
  issued by the
  Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Specifically, the financial reporting
  organization structure was not adequate to support the size, complexity or
  activities of the Company. In addition, certain finance positions were
  staffed with individuals who did not possess the level of accounting
  knowledge, experience and training in the application of generally
  accepted accounting principles in the United States of America, or GAAP, commensurate with our financial reporting
  requirements.b)
We did not maintain effective financial reporting processes,
  including sufficient formalized and consistent finance and accounting polices
  and procedures; nor did we prevent or detect instances of non-compliance with
  existing policies and procedures that do exist. Specifically, we lacked
  formalized reporting policies and procedures.c)
We did not maintain effective monitoring controls and related
  segregation of duties over automated and manual transactions processes.
  Specifically, we failed to implement processes to ensure periodic monitoring
  of our existing internal control activities over financial reporting to
  identify and assess significant risk that may impact financial statements and
  related disclosures. Additionally, inadequate segregation of duties led to
  untimely identification and resolution of accounting and disclosure matters
  and failure to perform timely and effective supervision and reviews.21

The above control deficiencies resulted in audit adjustments to our
  2006 interim and annual consolidated financial statements. These control
  deficiencies affect substantially all financial statement accounts, which
  could result in a material misstatement to our interim or annual consolidated
  financial statements that would not be prevented or detected.2)
The material weaknesses in our control environment contributed to the
  existence of the following control deficiencies, each of which was considered
  to be a material weakness:a)
We did not
  maintain effective controls over our process to ensure the complete, accurate
  and timely preparation and review of our consolidated financial statements in
  accordance with GAAP. Specifically, we did not have effective controls over the process
  for identifying, accumulating and reviewing all required supporting
  information to ensure the completeness, accuracy and timely preparation and
  review of our consolidated financial statements and disclosures. This control
  deficiency resulted in audit adjustments to our 2006 interim and annual
  consolidated financial statements. Additionally, this control deficiency
  could result in a misstatement of substantially all financial statement
  accounts that would result in a material misstatement to our interim or
  annual consolidated financial statements that would not be prevented or
  detected.b)
We did not maintain effective controls to ensure that journal
  entries, both recurring and non-recurring, were consistently reviewed and
  approved in a timely manner to ensure the validity, completeness and accuracy
  of recorded entries. This control deficiency resulted in audit adjustments to
  our 2006 interim and annual consolidated financial statements. Additionally,
  this control deficiency could result in a misstatement of substantially all
  financial statement accounts that would result in a material misstatement to
  our interim or annual consolidated financial statements that would not be
  prevented or detected.c)
We did not maintain effective controls over the procurement process.
  Specifically, effective controls were not in place over the approval of new
  vendors, authorization of purchase orders, including categorization of
  appropriate expense line items, the receipt of goods and the approval and
  authorization of vendor payments. This control deficiency could result in a
  misstatement of current liabilities and operating expenses that would result
  in a material misstatement to our interim or annual consolidated financial
  statements that would not be prevented or detected.d)
We did not maintain effective controls over the completeness and
  accuracy of certain revenue and expense accruals. Specifically, we failed to
  identify, analyze and review certain accruals at period end relating to
  certain accounts receivable, accounts payable, accrued liabilities, revenue
  and other direct expenses to ensure that they were accurately, completely and
  properly recorded. This control deficiency resulted in audit adjustments to
  our 2006 interim and consolidated financial statements. Additionally, this
  control deficiency could result in a misstatement of the aforementioned
  accounts that would result in a material misstatement to our interim or
  annual consolidated financial statements that would not be prevented or
  detected.e)
We did not maintain effective controls over the existence,
  completeness and valuation of fixed assets and related depreciation expense.
  Specifically, effective controls were not designed and in place to ensure
  that fixed asset additions and disposals were recorded, as well as, the
  periodic physical verification of fixed assets. This control deficiency
  resulted in audit adjustments to our 2006 interim and annual consolidated
  financial statements. Additionally, this control deficiency could result in a
  misstatement of fixed assets and depreciation expense that would result in a
  material misstatement to our interim or annual consolidated financial
  statements that would not be prevented or detected.f)
We did not maintain effective controls over spreadsheets.
  Specifically, we did not maintain effective controls over the completeness,
  accuracy and validity of spreadsheets used in our financial reporting process
  to maintain effective version control and ensure that access was restricted
  to appropriate personnel, and that unauthorized modification of the data or
  formulas within spreadsheets was prevented. This control deficiency resulted
  in audit adjustments to our 2006 interim and annual consolidated financial
  statements. Additionally, this control deficiency could result in a
  misstatement of substantially all financial statement accounts that would
  result in a material misstatement to our interim or annual consolidated
  financial statements that would not be prevented or detected.g)
We did not design and maintain effective controls over the
  completeness, accuracy and valuation of our payroll and payroll expense.
  Specifically, we did not design and maintain effective controls over the
  administration of employee data or controls to provide reasonable assurance
  regarding the proper authorization of non-recurring payroll changes. This
  control deficiency could result in a misstatement of the aforementioned
  accounts that would result in a material misstatement to our interim or
  annual consolidated financial statements that would not be prevented or
  detected.We have made certain changes
and are in the process of making additional changes and improvements to the
overall design of our control environment to address the material weaknesses in
ICFR described above. The Audit Committee has reviewed
and approved managements remediation plans for establishing and maintaining
adequate ICFR. Management reports on its progress on implementing improvements
to the Audit Committee at least quarterly.

22

During 2007, we have
implemented remediation measures as described below under section III
Remediation of Material Weaknesses Reported in 2006 and have implemented and
plan to continue to implement, the specific initiatives described below under
section IV Ongoing Remediation Initiatives. In addition, management and
financial consultants undertook and completed reconciliations, analyses and
detailed reviews of the financial statements and supporting documentation in
addition to those historically completed to confirm that this Quarterly Report
fairly presents in all material aspects our financial position, results of
operations and cash flows as of, and for the periods presented in accordance
with GAAP.

III. Remediation of Material Weaknesses Reported in 2006

As of September 30, 2007, we
believe we have effectively remediated the following material weaknesses in
ICFR that were included in Managements Report on Internal Control over
Financial Reporting in Item 9A of our 2006 10-K (the numerical and
alphabetical references correspond to section II above):

a)
We did not maintain an effective control environment based
  on criteria established in Internal Control-Integrated Framework issued by
  COSO We
  implemented control processes to address and remediate the material weakness
  reported in 2006 related to our organizational structure. The Chief Financial
  Officer, with assistance from his senior financial staff and outside
  consultants, has reviewed and will continue to review and adapt the overall
  design of our financial reporting organizational structure, including the
  roles and responsibilities of each functional group within the Company, to
  ensure that we have a sufficient compliment of personnel with knowledge, experience
  and training in the application of GAAP commensurate with our financial
  reporting requirements. Our activities to address and remediate the material
  weakness in this area included:i)
Retaining the services of
  outside consultants with relevant accounting experience, skills and knowledge
  in the application of GAAP, working under the supervision and direction of
  our management, to supplement our existing finance personnel. In addition, we
  retained well-qualified consultants to fill open senior financial compliance
  and internal audit positions. We plan to continue to supplement our staff
  with accounting, compliance and internal audit personnel, with relevant
  accounting experience, skills and knowledge in the application of GAAP and
  SOX, as required.ii)
Hiring an experienced Vice
  President of Finance in December 2006 who was subsequently replaced by an
  experienced consultant in September 2007, whose
  responsibilities include overseeing the corporate accounting and SEC external
  financial reporting functions.iii)
Sending accounting staff
  for relevant financial and accounting training as deemed necessary and
  continuing to evaluate and execute on any needs for continuing education.iv)
Completing job performance
  evaluations and determining areas for ongoing performance improvement and
  staff training needs.c)
We did not maintain effective controls over
  the procurement process.i)
Senior level
  managers verify that invoices are properly coded and supported, and that
  services or goods are received prior to payment.ii)
An approved
  vendor change request form is utilized to initiate any new vendors or update
  existing vendor information. In conjunction with remedial efforts under 1c
  above, system privileges were analyzed and modified to ensure proper
  segregation exists relating to vendor creation or modification. In
  conjunction with the monthly open purchase order review (2d above), vendors
  without an open purchase order are automatically closed in the financial
  system.iii)
We utilize
  the accounting systems purchase order routing feature to ensure all
  purchases are properly authorized. Additionally, the accounting system
  requires goods or services to be flagged as received and three or two-way
  matched prior to releasing an invoice for payment.iv)
A review of
  all purchase orders without an approved purchase requisition is performed
  monthly to ensure proper approval.v)
All checks
  over a specified dollar limit are signed by two members of management and all
  check registers are properly approved.vi)
All wire
  transfers are approved on our online banking system by executive management.vii)
Check
  signing and wire transfer authorization privileges are properly segregated.e)
We did not maintain effective controls over the existence,
  completeness and valuation of fixed assets and related depreciation expense.i.
All journal
  entries associated with fixed asset additions, disposals or related
  depreciation are properly completed, supported and approved by senior
  management.23

ii.
A quarterly
  roll-forward of fixed asset additions, disposals and related depreciation
  expenses is prepared and reconciled to the general ledger fixed
  asset accounts to ensure completeness and accuracy of the recorded fixed
  assets. The fixed asset reconciliations are reviewed and approved by senior
  management.iii.
Fixed assets
  are physically verified on an annual basis, such that all assets greater than
  a specified dollar limit are physically counted every two years. The last
  physical count of all assets with a net book value greater than a specified
  dollar limit was performed in September 2007. The physical count procedures
  and results are reviewed and approved by senior financial management and the
  Chief Financial Officer.g)
We did not design and maintain effective
  controls over the completeness, accuracy and valuation of our payroll and
  payroll expense.i.
All employee
  changes are documented in an approved personnel action request form.ii.
Changes in
  salary and bonus payouts are approved by the Chief Executive Officer and the
  Chief Financial Officer.iii.
All employee
  data and salary changes are reconciled quarterly to data in the employee
  master file within our accounting system as well as our payroll database to
  ensure accuracy and validity.iv.
A monthly
  and quarterly reconciliation of the payroll per the service provider is
  reconciled to the general ledger payroll accounts to ensure completeness and
  accuracy of processing. These reconciliations are reviewed and approved by
  senior management.IV. Ongoing Remediation Initiatives

To remediate the material weaknesses related to the control environment
and certain process controls, we have begun implementing new and enhanced
internal controls in a number of areas designed to remediate the material
weaknesses identified and to strengthen our ICFR. To the extent that these
measures have been implemented, they have yet to operate for a sufficient
period of time. These measures include the following (the numerical and alphabetical references
correspond to section II above):

1b)
We did not maintain effective financial
  reporting processes, including sufficient formalized and consistent finance
  and accounting polices and procedures; nor did we prevent or detect instances
  of non-compliance with certain such policies and procedures that do exist.i.
A training
  program was developed and implemented in August 2007 to ensure employees
  understand the importance of ICFR.ii.
Our
  financial policies and procedures were reviewed for completeness, accuracy
  and adequacy and updated as necessary. Financial personnel were provided with
  the policies and procedures and instructed to comply with the updated
  policies and procedures in the performance of their duties.iii.
A quarterly
  communication and certification plan was implemented to ensure internal
  controls over financial reporting are updated, as appropriate.iv.
A quarterly
  certification program was implemented to monitor employees compliance with
  financial policies and procedures.v.
The Chief
  Financial Officer and Board of Directors reviews monthly and quarterly cash
  projections and actual results, prepared by senior finance management, to
  monitor the cash resources and expenditures of the Company.1c)
We did not maintain effective monitoring
  controls and related segregation of duties over automated and manual
  transaction processes.i.
All system
  access privileges were analyzed and changes made as appropriate to ensure
  proper segregation exists within the accounting system.ii.
All required
  system changes were documented and properly approved by the most senior
  person in the affected department as well as by Information Technology staff.iii.
An analysis
  of manual procedures was performed in September 2007 and continues to be
  monitored. Appropriate changes were made to duties and responsibilities to
  strengthen the effectiveness of our segregation of duties within the
  accounting and finance department. Training was provided to finance team
  members on their new duties to ensure proper understanding and application.24

2a)
We did not maintain effective controls over
  our process to ensure the complete, accurate and timely preparation and
  review of our consolidated financial statements in accordance with GAAP.i.
We have retained and intend to continue to retain the services of
  outside consultants with relevant accounting experience, skills and knowledge
  in the application of GAAP, working under the supervision and direction of
  our management, to supplement our existing corporate accounting and financial
  reporting personnel.ii.
Management
  and financial consultants review support for financial results and financial
  statement disclosures.iii.
Checklists
  are completed to ensure preparation and review procedures related to our
  external SEC financial reporting processes are properly completed and
  documented.2b)
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.i.
Journal
  entries are reviewed for proper coding and supporting documentation and
  approved by appropriate levels of management in a timely manner.ii.
Approved
  journal entries are reconciled against posted journal entries to ensure
  completeness and accuracy.2d)
We did not maintain effective controls over
  the completeness and accuracy of certain revenue and expense accruals.i.
Appropriate
  finance staff review and approve the monthly accrual listings to ensure
  completeness and accuracy.ii.
The monthly
  accrued paid time off reconciliation is reviewed and approved by senior
  management.iii.
Vendor
  invoices are reviewed and approved to ensure they are recorded or accrued in
  the proper period.2f)
We did not maintain effective controls over
  spreadsheets.i.
During
  August 2007, a checklist of all spreadsheets was prepared and the
  spreadsheets were reviewed and analyzed to determine the level of controls
  necessary based upon the spreadsheets use and complexity.ii.
Access
  controls and back-up procedures have been implemented over all high and
  moderate risk spreadsheets.iii.
The formulas
  within high and moderate risk spreadsheets are checked annually to ensure the
  accuracy of the information generated by the spreadsheets. This check was
  last performed during August 2007.V. Other Information

Changes
in Internal Control over Financial Reporting

The
discussion above under section III, Remediation
of Material Weaknesses Reported in 2006,and under section IV, Ongoing Remediation
Initiatives, includes a description of the material changes to our
ICFR during 2007 that materially affected, or are reasonably likely to
materially affect, our ICFR.

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 ICFR 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.

25

PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None.

ITEM 1A. RISK FACTORS

You should
carefully consider the following risk factors as well as other information in
our filings under the Exchange Act before making any investment decisions
regarding our common stock. The risks and uncertainties described herein are
not the only ones we face. Additional risks and uncertainties that we do not
know or that we currently deem immaterial may also impair our business,
financial condition, operating results and prospects. If events corresponding
to any of these risks actually occur, they could materially adversely affect
our business, financial condition, operating results or prospects. In that
case, the trading price of our common stock could decline. When used in this
report, unless otherwise indicated, we, our and us refers to VaxGen. Risk
factors which have materially changed since our 2006 10-K are marked with an
*.

We are not currently listed on a national
exchange and cannot assure you we will ever be listed.

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

Our business to date has been largely
dependent on the success of rPA102, which was the subject the SNS Contract that
was terminated in December 2006. Although we ceased active development of
rPA102 and have reduced our workforce, we may be unable to successfully manage
our remaining resources, including available cash, while we seek to identify
and complete a strategic transaction.

We
discontinued clinical development of rPA102 after HHS terminated our SNS
Contract. In addition, in June 2007 we terminated our contract with Kaketsuken
to develop a smallpox vaccine. We had previously devoted substantially all of
our research, development and clinical efforts and financial resources toward
the development of rPA, and we have no product candidates in clinical or
preclinical development. In connection with the termination of our clinical
development of rPA102, we announced restructuring activities, including
significant workforce reductions. During the three quarter periods ended
September 30, 2007, we incurred charges associated with our restructuring
activities of approximately $5.4 million, which includes employee severance
costs of $4.4 million and facilities-related and other expenses of $1.0
million. As a result of the termination of our SNS Contract, we are evaluating
strategic alternatives and have retained Lazard Ltd. to act as our advisor in
this process. We cannot predict whether we be able to identify an appropriate
strategic alternative which will either provide us with a pipeline or return
value to our shareholders on a timely basis or at all. We also cannot predict
whether any such transaction would be consummated on favorable terms, and
anticipate that such transaction may require us to incur significant additional
costs.

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 rebuild
our product candidate pipeline.

Our prior
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, merging or in-licensing.

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.26

If our competitors
successfully enter into partnering or license agreements or we are unable to
reach agreement on license or partnering agreements on terms acceptable to us,
we may then be precluded from pursuing those specific opportunities. Since each
of these opportunities is unique, we may not be able to find a substitute. In
addition, if we are unable to manage successfully any acquisitions, joint
ventures and other collaboration opportunities, we may be limited in our
ability to develop new products and therefore to continue to expand our product
pipeline.

If we fail to cause our registration
statement to be declared effective in accordance with agreements we have made
in connection with the 2006 private placement of our common stock, or to remain
effective, we may be subject to liquidated damages or liability for breach of
contract. *

In February
2006, we raised gross proceeds of $26.95 million through a private placement of
our common stock and warrants exercisable for common stock. We agreed to
register under the Securities Act the shares of our common stock sold in this
transaction, and the shares of common stock issuable upon exercise of the
warrants. On October 5, 2007, we filed a registration statement for these
shares. We agreed to use our best efforts to cause the registration statement
to become effective in no event later than 120 days after the filing of such
registration statement. We have also made other customary agreements regarding
such registrations, including matters relating to indemnification, maintenance
of the registration statement, payment of expenses and compliance with state
blue sky laws. We may be liable for liquidated damages to each holder of
shares sold in the private placement if the registration statement is not
declared effective by the SEC on or prior to 120 days from filing; or if the
registration statement (after being declared effective) ceases to be effective
in a manner that violates such agreements. In this case, we may be required to
pay liquidated damages. Should we become obligated to make payment of these
liquidated damages, it could have a material adverse effect on our financial
position and our results of operations, particularly if we become obligated to
make a payment in full for all liquidated damages potentially due and payable
under these agreements.

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

We believe we
need to correct deficiencies in our internal controls and procedures for
financial reporting. Because of the material weaknesses described in Item 9A of
our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 and
Item 4 of this Quarterly Report, management has concluded that we did not
maintain effective internal control over financial reporting as of December 31,
2006, March 31, 2007, June 30, 2007 or September 30, 2007, based on the Internal ControlIntegrated Frameworkissued
by the Committee of Sponsoring Organizations of the Treadway Commission.

Failure to
address the identified 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 with the SEC. 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 control over financial reporting, including the enhancement of
systems and procedures. Significant additional resources will be required to
establish and maintain appropriate controls and procedures and to prepare the
required financial and other information during this process.

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

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

We may need to raise additional capital to
support our operations and in order to continue as a going concern if we
successfully complete a strategic transaction. *

Absent a
strategic transaction, we believe that our existing cash, cash equivalents and
securities available-for-sale as of September 30, 2007 will be sufficient to
meet our projected operating requirements through at least December 31, 2008.
In addition to our workforce reductions and the termination of our rPA102 and
smallpox development activities, we have announced that we are exploring
strategic alternatives. We may not successfully identify or implement any of
these alternatives, and even if we determine to pursue one or more of these
alternatives, we may be unable to do so on acceptable financial terms. Our
restructuring measures implemented to date and any proposed strategic
alternatives may disappoint investors and further depress the price of our
common stock and the value of an investment in our common stock thereby
limiting our ability to raise additional funds.

We will
require substantial funds to conduct development activities if we acquire
additional products or companies or consummate certain strategic transactions.
Our ability to conduct the required development activities related to any new
product candidates will be

27

significantly
limited if we are unable to obtain the necessary capital. We may seek to raise
additional funds through the sale of equity or debt to meet our working capital
and capital expenditure needs. We do not know, however, whether additional
financing will be available when needed, or whether it will be available on
favorable terms or at all. Failure to obtain adequate financing also may
adversely affect our ability to operate as a going concern.

As a result of the reductions in our
workforce that we announced in January, May and September 2007, we may not be
successful in retaining key employees and in attracting qualified new employees
as required in the future. If we are unable to retain our management,
scientific staff and scientific advisors or to attract additional qualified
personnel, our ability to rebuild our business will be seriously jeopardized. *

In January
2007, we implemented a restructuring resulting in the reduction of our
workforce by approximately 51%. In May 2007, we announced the discontinuation
of any further development activities with respect to rPA102 and a corporate
restructuring plan that included a reduction in our workforce to fewer than 70
employees. In September 2007, we further reduced our workforce to fewer than 30
employees. Competition among biotechnology companies for qualified employees is
intense, and the ability to retain and attract qualified individuals is
critical to our success. We may experience further reductions in force due to
voluntary employee resignations and a diminished ability to recruit new
employees. We may be unable to attract or retain key personnel on acceptable
terms, if at all.

If we fail to
meet our obligations under the 5 1/2% Convertible Senior Subordinated Notes due
2010, or Notes, our payment obligations may be accelerated.

The Notes have
the following features:

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

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

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


making it
 more difficult for us to satisfy our financial and payment obligations, or to
 refinance maturing indebtedness;
making us
 more vulnerable to a downturn in the economy or our business;
limiting our
 ability to obtain additional financing in the future for working capital,
 capital expenditures, acquisitions and other general corporate purposes;
requiring
 application of a significant portion of our cash flow from operations to the
 payment of debt service costs, which would reduce the funds available to us
 for our operations;
limiting our
 flexibility in planning for, or reacting to, changes in our industry,
 business and markets; and
placing us
 at a competitive disadvantage to the extent we are more highly leveraged than
 some of our competitors.28

We may incur
significant additional indebtedness in the future to fund our continued
operations or future acquisitions. To the extent new debt is added to our
current debt levels, the substantial leverage risks described above would
increase. We may be required to repurchase the Notes if certain
change-in-control events occur.

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

To date, we
have engaged primarily in research, development and clinical testing. Since our
inception in 1995, our operations have not been profitable, and we cannot be
certain that we will ever achieve or sustain operating profitability. At
September 30, 2007, we had an accumulated deficit of $238 million. Developing
any future 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.

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

We are subject
to rigorous and extensive regulation by the FDA and comparable foreign
regulatory authorities for any product candidates we may develop. In the United
States, our potential product candidates would likely be regulated by the FDA
as biological drug products, known as Biologics. In order to obtain approval
from the FDA to market our product candidates, we will be required to submit to
the FDA a Biologics License Application, or BLA, which must include both
preclinical and clinical trial data as prescribed by the FDAs current
regulatory criteria, as well as extensive data regarding the manufacturing
procedures and processes for the product candidates. Ordinarily, the FDA
requires a sponsor to support a BLA application with substantial evidence of
the products safety and effectiveness in treating the targeted indication
based on data derived from adequate and well-controlled clinical trials,
including Phase 3 efficacy trials conducted in patients with the disease or
condition being targeted.

We cannot
predict whether we will obtain regulatory approval for any product candidates
pursuant to these provisions. We may fail to obtain approval from the FDA or
foreign regulatory authorities, or experience delays in obtaining such
approvals, due to varying interpretations of data or failure to satisfy current
safety, efficacy and quality control requirements. Further, our business is
subject to substantial risk because the FDAs current policies may change
suddenly and unpredictably and in ways that could impair our ability to obtain
regulatory approval of product candidates. We cannot guarantee that the FDA
will approve product candidates on a timely basis or at all.

Delays in successfully completing any
clinical trials we may conduct could jeopardize our ability to obtain
regulatory approval or market our potential product candidates on a timely
basis.

If we resume
development of any potential product candidates, our business prospects may
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 product candidates. Product development to show
adequate evidence of effectiveness in animal models and safety and immune
response in humans is a long, expensive and uncertain process, and delay or
failure can occur at any stage of our non-clinical studies or clinical trials.
Any delay or significant adverse clinical events arising during any of our
clinical trials could force us to abandon a product candidate altogether or to
conduct additional clinical trials in order to obtain approval from the FDA or
other regulatory body. These development efforts and clinical trials are
lengthy and expensive, and the outcome is uncertain. Completion of any clinical
trials we may commence, 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 product candidates;
unsatisfactory
 results of any clinical trial;
the failure
 of our principal third-party investigators to perform our clinical trials on
 our anticipated schedules; or
different
 interpretations of our preclinical and clinical data, which could initially
 lead to inconclusive results.Our
development costs will increase if we have material delays in any clinical
trial or if we need to perform more or larger clinical trials than planned. If
the delays are significant, or if any of our product 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.

29

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

Product
candidates are subject to extensive government regulations related to
development, testing, manufacturing and commercialization in the United States
and other countries. Our potential product candidates have not received
required regulatory approval from the FDA to be commercially marketed and sold in
the United States. Our future product candidates have not received required
regulatory approval from foreign regulatory agencies to be commercially
marketed and sold. The process of obtaining and complying with FDA, other
governmental and foreign regulatory approvals and regulations is costly, time
consuming, uncertain and subject to unanticipated delays. Despite the time and
expense exerted, regulatory approval is never guaranteed.

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

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

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

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

30

Our future 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 acquire, develop and obtain regulatory
approval to market new biopharmaceutical products. Development of a product
requires substantial technical, financial and human resources. Our potential
products may appear to be promising at various stages of development yet fail
to reach the market for a number of reasons, including:

the lack of
adequate quality or sufficient prevention benefit, or unacceptable safety during
preclinical studies or clinical trials;
their
failure to receive necessary regulatory approvals;
the
existence of proprietary rights of third parties; or
the
inability to develop manufacturing methods that are efficient, cost-effective
and capable of meeting stringent regulatory standards.We may fail to protect our intellectual
property or may infringe on the intellectual property rights of others, either
of which could harm our business.

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

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

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

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


others will
 not independently develop similar or alternative technologies or duplicate
 any of our technologies;
any patents
 issued to us or licensed from the U.S. Army Medical Research Institute of
 Infectious Diseases, or USAMRIID, or other parties, or that we may license in
 the future, if any, will provide a basis for commercially viable products or
 will provide us with any competitive advantages or will not be challenged by
 third parties;
we or any of
 our current or future licensors will adequately protect trade secrets; or
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 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
USAMRIIDs anthrax-related inventions, by or on behalf of the government,
thereby allowing the use of the inventions in support of government contracts
with other parties, including our competitors.

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


fail to
 diligently develop a vaccine product in accordance with the development plan
 described in the agreement;
materially
 breach the agreement;
make a materially
 false statement (or fail to provide required information) in a plan or report
 required under the agreement;
fail to make
 payments required under the agreement; or
file for
 bankruptcy.31

In addition,
we cannot assure you that our operations or technology will not infringe
intellectual property rights of others. The United States Patent and Trademark
Office keeps United States patent applications confidential while the
applications are pending. As a result, we cannot determine which inventions
third parties claim in pending patent applications that they have filed. We may
need to engage in litigation to defend or enforce our patent and license rights
or to determine the scope and validity of the proprietary rights of others. If
we infringe the intellectual property of others, there can be no assurance that
we would be able to obtain licenses to use the technology on commercially
reasonable terms or at all. Failure to obtain licenses could force us to cease
development or sale of a product candidate.

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

Our
competitors are developing product candidates which could compete with those we
may develop in the future. Our commercial opportunities will be reduced or
eliminated if our competitors develop and market products for any of the
diseases that we target that:

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

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

Natural disasters, including earthquakes, may
damage our facilities.

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

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

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

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

We face an
inherent risk of exposure to product liability suits in connection with product
candidates tested in human clinical trials or sold commercially. We may become
subject to a product liability suit if any product candidate we develop causes
injury, or if individuals subsequently become infected or otherwise suffer
adverse effects from our product candidates. If a product liability claim is
brought against us, the cost of defending the claim could be significant and
any adverse determination could result in liabilities in excess of our
insurance coverage. We maintained product liability insurance, including
clinical trial liability, in the amount of $10.0 million for our programs up
until March 2007, when the programs were suspended. We have an extended
reporting period for claims that may arise under this coverage. We cannot be
certain that additional insurance coverage, if required, could be obtained on
acceptable terms, if at all.

32

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

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

We are not compliant with Section 404 under
the Sarbanes-Oxley Act of 2002.

Section 404
under the Sarbanes-Oxley Act of 2002 requires that we perform an assessment of
our internal control over financial reporting, and engage our independent
registered public accounting firm to perform an audit of our internal control
over financial reporting. We were required to complete the assessment as to the
adequacy of our internal control reporting as of December 31, 2006, 2005 and
2004.

Although we
completed our assessments in 2006 and 2005, given our focus on completing and
filing our financial statements for those years, we did not have sufficient
time nor did we provide sufficient time to our independent registered public
accounting firm to complete our and their 2004 respective responsibilities
before December 31, 2004. Our independent registered public accounting firm concluded
that we failed to complete the required 2004 assessment as to the effectiveness
of our internal control over financial reporting, and they were unable to
complete their required audit of internal control over financial reporting.
Accordingly, they disclaimed an opinion as to the effectiveness of our internal
control over financial reporting for 2004.

We do not
believe that the SEC has provided guidance as to the effect of such a
disclaimer. Having received such a disclaimer, our Annual Report on Form 10-K
for the year ended December 31, 2004, may be deemed to be deficient by the SEC.
If our 2004 10-K were deemed to be deficient, the SEC may conclude that we are
in violation of Sections 13 and 15(d) of the Exchange Act.

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

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

Risks
Related to our Common Stock

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

Our Board of
Directors has the authority to establish the designation of almost 20,000,000
shares of preferred stock that are convertible into common stock without any
action by our stockholders, and to fix the rights, preferences, privileges and
restrictions, including voting rights, of such shares. In February 2006, we
raised net proceeds of $25.2 million through a private placement of 3.5 million
shares of common stock at $7.70 per share to a group of accredited
institutional investors. We also issued to the investors five-year warrants
initially exercisable to purchase 699,996 shares of common stock at an exercise
price of $9.24 per share. Because we did not file all of our delinquent
periodic reports with the SEC by January 31, 2007, the warrants became
exercisable for an additional 699,988 shares of common stock, at a price of
$9.24 per share. We may raise additional funds through public or private
offerings of our preferred stock or our common stock, or through issuance of
debt securities that are convertible into shares of our common stock. The
issuance of additional shares of our common stock, or conversion of preferred
stock or debt securities into shares of common stock, would further dilute the
percentage ownership of our stockholders.

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

Shares of our
common stock issued in a private placement February 2006 are being registered
for resale under a registration statement filed with the SEC. In addition,
pursuant to Rule 144, generally, a stockholder (or stockholders whose shares
are aggregated) who has satisfied a one year holding period may, under certain
circumstances, sell within any three month period a number of securities which
does not exceed the greater of 1% of the then outstanding shares of common
stock or the average weekly trading volume of the class during the four calendar
weeks prior to such sale. Rule 144 also permits, under certain circumstances,
the sale of securities, without any limitation, by our stockholders that are
non-affiliates that have satisfied a two year holding period, such as certain
of those stockholders who purchased shares of our common stock in our November
2004 private placement or Notes convertible into shares of our common stock in
our 2005 private placement of the Notes. Any substantial sale of our common
stock under effective resale registration statements or pursuant to Rule 144 or
pursuant to any resale prospectus may have a material adverse effect on the
market price of our securities.

33

Our stock price is likely to be volatile. *

Currently, our
common stock is traded OTC and is quoted on the OTC Pink Sheets LLC. Stocks
traded OTC typically are subject to greater volatility than stocks traded on
stock exchanges, such as the Nasdaq Global Market or the Nasdaq Capital Market,
due to the fact that OTC trading volumes are generally significantly less than
on stock exchanges. This lower volume may allow a relatively few number of
stock trades to greatly affect the stock price. The trading price of our common
stock has been and is likely to continue to be extremely volatile. For example,
between August 9, 2004 and September 30, 2007, the closing price of our common
stock, as quoted on the Pink Sheets, has ranged from a high of $18.55 per share
to a low of $1.24 per share.

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


timing and
 consistency of filing financial statements;
announcements
 or speculation about any strategic transactions we may enter into;
failure to
 win future government contracts and government activities relating to prior
 contracts;
adverse
 results or delays in clinical trials;
delays in
 our product development efforts;
real or
 perceived safety issues with any of our product candidates;
failure to
 obtain or maintain required regulatory approvals;
changes in
 financial estimates by securities analysts and our failure to meet or exceed
 such estimates;
rumors about
 our business prospects, product development efforts or the progress, timing
 and completion of our clinical trials;
new products
 or services offered by us or our competitors or announcements relating to
 product developments by our competitors;
issuances of
 debt or equity securities;
issuances of
 securities or the expectation of the issuance of securities as part of a
 merger or other strategic transaction;
actual or
 expected sales by our stockholders of substantial amounts of our common
 stock, including shares issued upon exercise of outstanding options and
 warrants; and
other events
 or factors, many of which are beyond our control.In addition,
the stock market in general and biotechnology companies in particular, have
experienced extreme price and volume fluctuations that have often been unrelated
or disproportionate to the operating performance of these companies. Broad
market and industry factors may negatively affect the market price of our
common stock, regardless of actual operating performance. In the past,
following periods of volatility in the market price of a companys securities,
securities class action litigation has often been instituted against companies.
If we face securities litigation in the future, even if it is without merit or
unsuccessful, it would result in substantial costs and a diversion of
management attention and resources, which could have a material adverse effect
on our business.

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

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

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

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

34

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDSNone.ITEM 3. DEFAULTS UPON SENIOR SECURITIESNone.ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSNone.ITEM 5. OTHER INFORMATIONNone.ITEM 6. EXHIBITS(a)
Exhibits required by Item 601 of Regulation S-K:

The following exhibits are
filed as part of this report:

Incorporated by ReferenceExhibit
 No.

Exhibit

Form

File No.

Filing Date

Exhibit
 No.

FiledHerewith10.1

VaxGen, Inc. Severance Benefit Plan, dated August 1, 2007

8-K

0-26483

August 7, 2007

10.131.1

Certification of Chief Executive
Officer

10-Q







X31.2

Certification of Principal Financial
Officer

10-Q







X32.1

Section 1350 Certification

10-Q







XSignatures

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

VaxGen, Inc.Dated:November 8, 2007
By: /s/ James P. PanekJames P.
 PanekChief Executive Officer(Principal Executive Officer)Dated:November 8, 2007
By: /s/ Matthew J. PfefferMatthew J.
 PfefferChief Financial Officer(Principal Financial Officer)35