|UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549FORM 10-Q


(Mark One)


|X|  QUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934


For the Quarterly
Period Ended June 30, 2003


OR


|_| TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934


Commission File
Number 0-26483


VaxGen, Inc.


(Exact name of
Registrant as Specified in its Charter)


Delaware(State or other
jurisdiction of incorporation or organization)


94-3236309(I.R.S. Employer
Identification Number)


1000 Marina Blvd.,
Suite 200Brisbane, California 94005 (Address of Principal
Administrative Offices) (Zip Code)


(650) 624-1000 (Registrants Telephone
Number, Including Area Code)


Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|


Indicate by check mark whether the
registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) Yes |X|
No |_|


The issuer has one class of common
stock with 20,479,472 shares outstanding as of August 1, 2003.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|VaxGen, Inc.


Form 10-Q


For the Quarter Ended
June 30, 2003


Table of Contents
|----------------------------------------------------------------------------------

|Part I  |  | Financial Information                                                                  |  | Page | 
|------- |  | -------------------------------------------------------------------------------------- |  | ---- | 
|Item 1  |  | Financial Statements (unaudited):                                                      | 
|        |  | Condensed Consolidated Balance Sheets                                                  |  | 2    | 
|        |  | Condensed Consolidated Statements of Operations                                        |  | 3    | 
|        |  | Condensed Consolidated Statements of Cash Flows                                        |  | 4    | 
|        |  | Notes to Condensed Consolidated Financial Statements                                   |  | 6    | 
|Item 2  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations: | 
|        |  | Overview                                                                               |  | 12   | 
|        |  | Results of Operations                                                                  |  | 15   | 
|        |  | Liquidity and Capital Resources                                                        |  | 16   | 
|        |  | Risk Factors                                                                           |  | 18   | 
|Item 3  |  | Quantitative and Qualitative Disclosures About Market Risk                             |  | 24   | 
|Item 4  |  | Controls and Procedures                                                                |  | 24   | 
|Part II |  | Other Information                                                                      | 
|Item 1  |  | Legal Proceedings                                                                      |  | 25   | 
|Item 6  |  | Exhibits and Reports on Form 8-K                                                       |  | 26   | 
|        |  | Signature                                                                              |  | 27   | 
|        |  | Certifications                                                                         |  |      | 

|
|

|PART I 
FINANCIAL INFORMATION


Item 1. Financial Statements


VaxGen, Inc. (A Development Stage
Enterprise) CONDENSED
CONDSOLIDATED BALANCE SHEETS (Unaudited)
|----------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                             | June 30,
2003 | December 31,
2002
|------------------------------------------------------------ | ------------- | -----------------
|ASSETS                                                       |               |                  
|Current assets:                                              |              
|Cash and cash equivalents                                    |               | $     7,894,000  
|Investment securities                                        |               | 6,705,000        
|Accounts receivable                                          |               | 516,000          
|Accounts receivable  related party                          |               | 392,000          
|Deferred costs                                               |               | 946,000          
|Prepaid expenses and other current assets                    |               | 494,000          
|                                                             |               |                  
|Total current assets                                         |               | 16,947,000       
|                                                            
|Property and equipment, net                                  |               | 13,541,000       
|Restricted cash                                              |               | 1,039,000        
|Investment in affiliate                                      |               |                 
|Employee loans receivable                                    |               | 135,000          
|Other assets                                                 |               | 400,000          
|                                                             |               |                  
|Total assets                                                 |               | $   32,062,000   
|                                                             |               |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                         |              
|Current liabilities:                                         |              
|Payable to Genentech                                         |               | $     1,670,000  
|Accounts payable                                             |               | 1,598,000        
|Accrued clinical trial expenses                              |               |                 
|Accrued liabilities                                          |               | 1,855,000        
|Deferred revenues                                            |               | 3,348,000        
|Current portion of long-term obligations                     |               | 7,000            
|                                                             |               |                  
|Total current liabilities                                    |               | 8,478,000        
|Minority interest of subsidiary                              |               | 5,759,000        
|Deferred rent                                                |               | 572,000          
|Redeemable convertible preferred stock, $0.01 par            |              
|value, 20,500 shares authorized:                             |              
|Series A 6% cumulative, $0.01 par value,                     |              
|585 and 3,800 shares issued and outstanding at June 30,      |              
|2003 and December 31, 2002, respectively (liquidation        |              
|preference of $585,000 and $3,800,000 at June 30,            |              
|2003 and December 31, 2002, respectively)                    |               | 540,000          
|Commitments and contingencies                                |              
|Stockholders equity:                                        |              
|Preferred stock, $0.01 par value, 19,979,500 shares          |              
|authorized; none issued or outstanding                       |               |                 
|Common stock, $0.01 par value, 40,000,000 shares authorized; |              
|20,479,472 and 15,777,064 shares issued and outstanding      |              
|at June 30, 2003 and December 31, 2002, respectively         |               | 204,000          
|Additional paid-in capital                                   |               | 172,785,000      
|Deferred stock compensation                                  |               | (29,000          
|Accumulated other comprehensive income                      |              
|unrealized gain on investment securities                     |               | 52,000           
|Deficit accumulated during the development stage             |               | (156,299,000     
|                                                             |               |                  
|Total stockholders equity                                   |               | 16,713,000       
|                                                             |               |                  
|Total liabilities and stockholders equity                   |               | $   32,062,000   
|                                                             |               |                  

|See accompanying notes
to condensed consolidated financial statements.


2
|--------------------------------------------------------------------------

|VaxGen, Inc. (A Development Stage
Enterprise)CONDENSED CONSOLIDATED STATEMENTS
OF OPERATIONS (Unaudited)
|--------------------------------------------------------------------------------------------------------

|                                       | Three months ended
June 30, | Six months ended
June 30, | Period from Inception
(November 27, 1995)
through June 30,
|-------------------------------------- | --------------------------- | ------------------------- | ----------------------------------------------------------
|
|Revenue:                               |                             |                           |                                                           
|Research grant and contract revenue    |                             | $   2,565,000             |                                                           
|Related party services revenue         |                             | 206,000                   |                                                           
|                                       |                             |                           |                                                           
|Total revenues                         |                             | 2,771,000                 |                                                           
|Operating expenses:                    |                            
|Research and development:              |                            
|Genentech charges                      |                             | 692,000                   |                                                           
|Other                                  |                             | 4,644,000                 |                                                           
|                                       |                             |                           |                                                           
|Total research and development         |                             | 5,336,000                 |                                                           
|General and administrative expenses    |                             | 4,616,000                 |                                                           
|                                       |                             |                           |                                                           
|Loss from operations                   |                             | (7,181,000                | )                                                         
|Other income (expense):                |                            
|Investment income                      |                             | 176,000                   |                                                           
|Interest expense                       |                             |                          |                                                           
|Equity in loss of affiliate            |                             |                          |                                                           
|                                       |                             |                           |                                                           
|Total other income, net                |                             | 176,000                   |                                                           
|                                       |                             |                           |                                                           
|Net loss before minority interest      |                             | (7,005,000                | )                                                         
|                                      
|Minority interest in subsidiary losses |                             | 500,000                   |                                                           
|                                       |                             |                           |                                                           
|Net loss                               |                             | (6,505,000                | )                                                         
|Charges related to convertible         |                            
|preferred stock:                       |                            
|Dividends                              |                             | (46,000                   | )                                                         
|Accretion to redemption value          |                             | (80,000                   | )                                                         
|Beneficial conversion charge           |                             | (893,000                  | )                                                         
|                                       |                             |                           |                                                           
|Net loss applicable to common          |                            
|stockholders                           |                             | $(7,524,000               | )                                                         
|                                       |                             |                           |                                                           
|Basic and diluted loss per share       |                            
|applicable to common                   |                            
|stockholders                           |                             | $         (0.43           | )                                                         
|Weighted average shares used in        |                            
|computing basic and diluted            |                            
|loss per share                         |                             | 17,358,000                |                                                           

|See accompanying notes
to condensed consolidated financial statements.



3
|---------------------------------------------------------------------------

|VaxGen, Inc. (A Development Stage
Enterprise) CONDENSED CONSOLIDATED STATEMENTS
OF CASH FLOWS (Unaudited)
|---------------------------------------------------------------------------------------------------------

|                                                                  | Six
      months ended June 30, | Period
      from
      Inception
      (November 27,
      1995) throughJune 30, 2003
|----------------------------------------------------------------- | ------------------------------- | --------------------------------------------------------------------------------------
|
|Net loss                                                          |                                 | $(13,160,000                                                                          
|Adjustments
      to reconcile net loss to net                    |                                
|cash used
      in operating activities:                          |                                
|Minority
      interest in subsidiary losses                      |                                 | (909,000                                                                              
|Depreciation
      and amortization                               |                                 | 593,000                                                                               
|Amortization
      of premiums and                                |                                
|discounts
      on investment securities                          |                                 | (51,000                                                                               
|Stock compensation
      expense                                  |                                 | 281,000                                                                               
|Bad debt
      reserve                                            |                                 |                                                                                      
|Warrants
      issued to consultants                              |                                 |                                                                                      
|Equity in
      loss of affiliate                                 |                                 |                                                                                      
|Changes
      in assets and liabilities:                          |                                
|Accounts
      receivable                                         |                                 | 834,000                                                                               
|Deferred
      costs                                              |                                 | 433,000                                                                               
|Prepaid
      expenses and other current assets                   |                                 | 1,271,000                                                                             
|Restricted
      cash                                             |                                 | (6,000                                                                                
|Employee
      loans receivable                                   |                                 |                                                                                      
|Other
      assets                                                |                                 | (16,000                                                                               
|Payable
      to Genentech                                        |                                 | (230,000                                                                              
|Deferred
      revenues                                           |                                 | 2,431,000                                                                             
|Deferred
      rent                                               |                                 | (34,000                                                                               
|Accounts
      payable, accrued liabilities                       |                                
|and
      other long-term obligations                             |                                 | (3,551,000                                                                            
|                                                                  |                                 |                                                                                       
|Net
      cash used in operating activities                       |                                 | (12,114,000                                                                           
|Cash flows
      from investing activities:                       |                                
|Purchase
      of investment securities                           |                                 | (4,614,000                                                                            
|Proceeds
      from sale and maturities of                        |                                
|investment
      securities                                       |                                 | 11,286,000                                                                            
|Purchase
      of property and equipment                          |                                 | (699,000                                                                              
|Long-term
      lease deposits                                    |                                 |                                                                                      
|Acquisition of affiliate,
      net of cash acquired              |                                 | (2,941,000                                                                            
|                                                                  |                                 |                                                                                       
|Net
      cash provided by (used in) investing activities         |                                 | 3,032,000                                                                             
|Cash
      flows from financing activities:                       |                                
|Proceeds
      from issuance of preferred stock                   |                                 |                                                                                      
|Payments
      under capital lease obligations                    |                                 | (8,000                                                                                
|Proceeds
      from issuance of common stock, net of issuance     |                                
|costs                                                             |                                 | 11,685,000                                                                            
|Return of
      capital on redeemable convertible preferred stock |                                 |                                                                                      
|Exercise
      of employee stock options                          |                                 | 633,000                                                                               
|Employee
      stock purchase plan                                |                                 | 235,000                                                                               
|Loans from
      Genentech                                        |                                 |                                                                                      
|Cash payment
      of dividends                                   |                                 | (18,000                                                                               
|                                                                  |                                 |                                                                                       
|Net
      cash provided by financing activities                   |                                 | 12,527,000                                                                            

|4
|-

|VaxGen, Inc. (A Development Stage
Enterprise) CONDENSED CONSOLIDATED STATEMENTS
OF CASH FLOWS(continued)
|--------------------------------------------------------------------------------------------------------

|                                                                 | Six
      months ended June 30, | Period
      from
      Inception
      (November 27,
      1995) throughJune 30, 2003
|---------------------------------------------------------------- | ------------------------------- | --------------------------------------------------------------------------------------
|
|Increase
      (decrease) in cash and cash equivalents           |                                 | 3,445,000                                                                             
|Cash and
      cash equivalents at beginning of period           |                                 | 4,449,000                                                                             
|                                                                 |                                 |                                                                                       
|Cash and
      cash equivalents at end of period                 |                                 | $7,894,000                                                                            
|                                                                 |                                 |                                                                                       
|Supplemental
      schedule of non cash                          |                                
|investing
      and financing activities:                        |                                
|Dividends
      paid/accrued to redeemable convertible preferred |                                
|stockholders
      through the issuance of common stock          |                                 | $     85,000                                                                          
|Accretion
      of redemption value of redeemable                |                                
|convertible
      preferred stock                                |                                 | 160,000                                                                               
|Recognition
      of beneficial conversion feature               |                                
|of
      redeemable convertible preferred stock                  |                                 | 893,000                                                                               
|Recognition
      of fair value of common stock warrants issued  |                                
|with
      redeemable convertible preferred stock                |                                 |                                                                                      
|Conversion
      of redeemable convertible preferred stock       |                                
|into
      common stock                                          |                                 | 3,299,000                                                                             
|Reclassification
      of unaccreted portion of financing costs  |                                
|and
      fair value of warrants from preferred stock to         |                                
|equity upon conversion                                           |                                 | 246,000                                                                               
|Equipment
      acquired through capital leases                  |                                 |                                                                                      
|Issuance
      of stock through conversion of                    |                                
|Genentech
      note payable                                     |                                 |                                                                                      
|Note receivable
      partially settled by                       |                                
|severance
      obligation                                       |                                 |                                                                                      

|See accompanying notes
to condensed consolidated financial statements.


5
|--------------------------------------------------------------------------

|VaxGen, Inc. (A Development Stage
Enterprise)


Notes to Condensed
Consolidated Financial Statements June 30, 2003 (Unaudited)


1. Basis of Presentation


The unaudited condensed consolidated
financial statements of VaxGen, Inc. (a development stage enterprise) (VaxGen,
We, or the Company) included herein have been prepared by VaxGen
pursuant to the rules and regulations of the Securities and Exchange Commission. Certain
information or footnote disclosure normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States of America
have been condensed or omitted pursuant to such rules and regulations. In the opinion of
VaxGens management, the accompanying unaudited condensed consolidated financial
statements contain all adjustments, consisting only of normal recurring adjustments,
necessary to present fairly the financial information included herein. While VaxGen
believes that the disclosures are adequate to make the information not misleading these
condensed consolidated financial statements should be read in conjunction with
VaxGens audited financial statements contained in its Annual Report on Form 10-K for
the year ended December 31, 2002. The results of operations for the three and six month
periods ended June 30, 2003, are not necessarily indicative of the operating results for
the full year.


The condensed consolidated financial
statements include the accounts of VaxGen and, in 2003, its consolidated subsidiary,
VaxGen-Celltrion, Inc (VCI), (see Note 6). VaxGen owns less than 100% of VCI;
therefore VaxGen records minority interest in the condensed consolidated financial
statements to account for the ownership interest of the minority owner. All significant
intercompany accounts and transactions have been eliminated in consolidation.


We have presented the condensed
consolidated financial statements on the basis of a going concern, which contemplates the
realization of assets and the satisfaction of liabilities in the normal course of
business. However, we may not be able to continue our operations because we have
experienced significant operating losses, which we expect, will continue, and have
insufficient sources of funding for our operations. In order for us to remain a going
concern we will require significant additional funding in the near term. We are exploring
opportunities to raise capital through equity offerings, strategic alliances and other
financing vehicles. However, there can be no assurance that any such additional financing
will be available to us on the terms that we deem acceptable, if at all. The financial
statements do not include any adjustments relating to the recoverability and
classification of liabilities that might be necessary should we be unable to continue as a
going concern. We expect the cash and cash equivalents at June 30, 2003, will be
sufficient to fund operations according to our current plan through the first quarter of
2004. External cash requirements are expected to be lower during the last half of 2003
because of anticipated revenues from our contract with the National Institutes of Health
(NIH) related to the development of an anthrax vaccine and other revenue
sources. Should managements plan not develop as anticipated, we will restrict
additional planned activities and operations, as necessary, to sustain operations and
conserve cash resources.



Use of estimates and
reclassifications



The preparation of financial
statements requires management to make estimates, assumptions and judgments that affect
the reported amounts of assets, liabilities, revenues and expenses, and related
disclosures of contingent assets and liabilities. On an on-going basis, management
evaluates its estimates, including those related to investments; bad debts; grant revenue
arrangements; restructuring; and litigation and other contingencies. VaxGen bases its
estimates on historical experience and on various other assumptions that are believed to
be reasonable under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from those estimates under
different assumptions or conditions.



VaxGen, prior to filing its financial
statements on Form 10-Q, publicly releases an unaudited condensed consolidated balance sheet and
statement of operations. Between the date of VaxGens earnings release and the filing
of its Form 10-Q, reclassifications and adjustments may be required. The condensed
consolidated statements of operations for the three and six month periods ended June 30,
2003 reflect adjustments to other income, net, minority interest in subsidiary losses, and
charges attributable to redeemable convertible preferred stock made subsequent to the
earnings release. The cumulative effect of these adjustments was a decrease in net loss
applicable to common stockholders, basic and diluted, for the three and six month periods
ended June 30, 2003 of $11,000 and $120,000 respectively. The effect of these adjustments
upon basic and diluted loss per share applicable to common stockholders for the three and
six month periods ended June 30, 2003 was $0.00 and $0.01 respectively.



Accounting for Asset
Retirement Obligations


On January 1, 2003, we adopted
Statement of Financial Accounting Standards No. 143, Accounting for Asset
Retirement Obligations (SFAS No. 143), which addresses financial
accounting and reporting for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. The standard applies to legal
obligations associated with the retirement of long-lived assets that result from the
acquisition, construction, development and/or normal use of the assets. SFAS No. 143
requires that the fair value of a liability for an asset retirement obligation be
recognized in the period in which it is incurred if a reasonable estimate of fair value
can be made. The fair value of the liability is added to the carrying amount of the
associated asset and this additional carrying amount is depreciated over the life of the
asset. The adoption of SFAS No. 143 did not have a material effect on our financial
condition or results of operations.
6
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|New accounting
pronouncements



In May 2003 the Financial Accounting
Standards Board released Statement of Financial Accounting Standards No. 150,
Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity (SFAS No. 150). This statement establishes
standards for how companies classify and measure certain financial instruments. SFAS No.
150 requires that companies classify financial instruments that fall within the scope of
the statement as liabilities. We plan to adopt SFAS No. 150 in the third quarter of 2003
and we anticipate that, as a result of our adoption of SFAS No. 150, we will classify our
redeemable convertible preferred stock as a liability.



2. Stock-Based
Compensation


We account for stock-based
compensation based on the provisions of Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB No. 25), which
states that, for fixed plans, no compensation expense is recorded for stock options or
other stock-based awards to employees that are granted with an exercise price equal to or
above the estimated fair value per share of our common stock on the grant date. In the
event that stock options are granted with an exercise price below the estimated fair value
of our common stock at the grant date, the difference between the fair value of our common
stock and the exercise price of the stock option is recorded as deferred compensation.
Deferred compensation is amortized to compensation expense over the vesting period of the
stock option. We have adopted the disclosure requirements of Statement of Financial
Accounting Standards No. 123, Accounting for Stock-Based Compensation
(SFAS No. 123) and Statement of Financial Accounting Standards No. 148,
Accounting for Stock Based CompensationTransition and Disclosurean
Amendment of FASB Statement No. 123 (SFAS No. 148), which require
compensation expense to be disclosed based on the fair value of the options granted at the
date of the grant. If we had accounted for our stock based compensation plans using a
fair-value-based method in accordance with SFAS No. 123, our net loss and net loss per
share would approximate the pro forma amounts indicated in the following table:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                          | Three months ended
June 30, | Six months ended
June 30,
|--------------------------------------------------------- | --------------------------- | -------------------------
|
|Net loss applicable to common stockholders  as reported  |                             | $(7,524,000              
|Add: Stock-based employee compensation expense            |                            
|included in reported net loss, net of related tax effects |                             | 143,000                  
|Less: Total stock-based employee compensation expense     |                            
|determined under fair value based method for all awards,  |                            
|net of related tax effects                                |                             | (1,582,000               
|                                                          |                             |                          
|Net loss applicable to common stockholders  pro forma    |                             | $(8,963,000              
|                                                          |                             |                          
|Loss per share  basic and diluted, as reported           |                             | $         (0.43          
|Loss per share  basic and diluted, pro forma             |                             | $         (0.52          

|3. Loss per Share


Basic loss per share is computed as
net loss applicable to common stockholders divided by the weighted average number of
shares of common stock outstanding for the period. Potential shares of common stock
include dilutive shares issuable upon the exercise of outstanding options to purchase
shares of common stock, warrants to purchase shares of common stock, and shares of our
Series A 6% cumulative convertible preferred stock, which are listed below assuming that
the shares of the convertible preferred stock converted into shares of our common stock.
For all periods presented, such potential shares of common stock were excluded from the
computation of diluted net loss per share, as their effect is antidilutive.


Potentially dilutive securities
include:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                  | June 30,
|--------------------------------- | --------
|
|Options to purchase common stock  |         
|Warrants to purchase common stock |         
|Convertible preferred stock       |         
|                                  |         
|Total                             |         
|                                  |         

|7
|-

|Weighted average exercise prices for excluded
options and warrants were $11.54 and $12.45 at June 30, 2003 and 2002, respectively.



4.  Redeemable
Convertible Preferred Stock Financing



The Company entered into a
Securities  Purchase Agreement dated as of May 23, 2001 with four investors,  whereby the
Company received  approximately  $20,000,000 in consideration for the sale of 20,000
shares of the Companys Series A 6%  Cumulative  Convertible  Preferred  Stock
 (Preferred  Stock) and the  issuance  of Common  Stock Purchase  Warrants  described
 below.  Expenses  relating  to the  transaction  were  approximately  $1,700,000,
resulting  in net proceeds of  approximately  $18,300,000.  These  proceeds  were used to
prepare the  Companys HIV/AIDS vaccine,  AIDSVAX, for  commercial-scale  manufacturing
as well as for the development of new adjuvants and for general  corporate  purposes.  As
of June 30,  2003,  585 shares of  Preferred  Stock were  outstanding, which are
convertible into 203,833 shares of common stock.



A summary of the significant terms
of the Preferred Stock financing are as follows:


Conversion


Each share of Preferred  Stock can
be converted  into common stock at the option of the holder at any time after issuance
 according to a conversion  ratio,  subject to adjustment for dilution or certain  equity
 adjustments. The initial  conversion  ratio is  determined by dividing the  liquidation
 value ($1,000 per share plus accrued dividends)  by the original  conversion  price of
$23.2185 per share then  multiplied by the number of shares to be converted.  During the
fourth  quarter of 2002,  one of the holders of Preferred  Stock  exercised a warrant,
which had the effect,  under the  anti-dilution  provisions  applicable to the Preferred
 Stock, of reducing the conversion  price of the  Preferred  Stock to  $14.133.  During
 the  fourth  quarter  of  2002,  two  investors converted a total of 16,200 shares of
Preferred  Stock in exchange for 1,172,436  shares of common stock,  which included
 shares  issued for accrued  but unpaid  dividends.  In the second  quarter of 2003,  the
Company  sold 1,742,160  newly issued shares of VaxGens common stock to a single
 institutional  investor at a price of $2.87 per share.  This  transaction had the
effect,  under the  anti-dilution  provisions  applicable to the Preferred Stock,  of
reducing the  conversion  price of the Preferred  Stock to $2.87.  During the second
quarter of 2003, three  investors  converted 3,215 shares in the aggregate of Preferred
 Stock in exchange for 1,149,758  shares of common stock, which included shares issued
for accrued but unpaid dividends.


The Company may also force  conversion of the
Preferred  Stock into common stock if the weighted  average price per share of our stock
for at least 20 out of 30 consecutive trading days equals or exceeds $24.73.


Redemption


In the event that there is no
earlier  conversion,  the Company must redeem the Preferred  Stock for cash on May 23,
2004,  at a redemption  price equal to $1,000 per share plus all accrued and unpaid
 dividends.  The Company may, within certain limits, pay up to 50% of such redemption
price in shares of the Companys common stock.


The Company  accounts for the
 difference  between the carrying  amount of  redeemable  preferred  stock and the
redemption  amount by increasing the carrying  amount for periodic  accretion,  so that
the carrying amount will equal the redemption  amount at the scheduled  redemption  date.
 The accretion of the  redemption  value of the Preferred Stock for the six months ended
June 30, 2003 and 2002 was $406,000 and $867,000, respectively.


Dividends


Each share of  Preferred  Stock is
entitled to receive  annual  dividends  of 6% payable on June 30 and December 31,
 beginning  on December  31,  2001.  If not paid within five days of either  such date,
 the  dividend  will accumulate  and  compound.  Payment may be made in cash or in shares
of common  stock at the  Companys  option. Payment on  December  31,  2001 was made in
65,253  shares of common  stock.  During  2002,  payment was made in 114,300  shares of
common  stock,  along with an  additional  26,182  shares of common stock that were paid
upon conversion  for  accrued  but unpaid  dividends.  During the first six months of
2003,  payment was made in cash for  $18,000  along with 29,549  shares of common  stock
that were paid upon  conversion  for accrued but unpaid dividends.  Net loss  applicable
 to  common  stockholders  for the six  months  ended  June  30,  2003 and 2002 included
non-cash charges of $85,000 and $603,000, respectively, for Preferred Stock dividends.


Voting


Each share of Preferred  Stock has
voting  rights equal to the number of shares of common stock into which it is convertible
 on the  record  date of the  vote,  provided  that, for  voting  purposes,  in no event
 shall the conversion price be deemed to be less than $19.824 per share.
8
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Liquidation


In the event of liquidation,
 dissolution or winding up of the Company,  either  voluntary or involuntary,  each
holder of shares of  Preferred  Stock will be entitled to  receive,  out of the assets of
the Company  available for  distribution to  stockholders  and prior to any  distribution
to holders of common stock,  $1,000 per share plus accrued dividends.


Common Stock Purchase Warrants



In connection  with the Preferred
 Stock  financing,  the Company  issued  Common Stock  Purchase  Warrants (the
Warrants)  initially for the purchase of 297,177 shares of common stock to the
Preferred Stock investors.  The Warrants,  which  expire on May 23,  2006,  originally
 had an exercise  price of $25.2375  per share;  however, effective  as of June 5, 2003,
 the  exercise  price was  automatically  adjusted  to $12.324  per share and the number
of shares  issuable on exercise of the warrants  increased to 608,568,  in  accordance
 with the terms of the Warrants.


The Company  valued the Warrants at
$11.80 per share,  resulting in a total value of  approximately  $3,500,000. This amount
was  accounted for as a reduction in the carrying  value of the Preferred  Stock until
the scheduled redemption  of the  Preferred  Stock,  and an  increase  to  additional
 paid-in-capital.  The fair value of the Warrants was calculated  using the
 Black-Scholes  model.  The discount is being amortized over three years, and
accordingly,  net  loss to  common  stockholders  for the six  months  ended  June 30,
 2003 and 2002  reflected non-cash  charges of $160,000 and $867,000  respectively.  As a
result of the  conversions of Preferred Stock in the second  quarter of 2003,  the
Company  recorded the  pro-rata  share of the  unaccreted  portion of the fair value
 assigned  to the  Warrants  as a charge to equity  upon  conversion.  The  charge to
equity  amounted  to $246,000.



Effect of Beneficial Conversion
Feature


The Companys  Preferred Stock was
issued with a beneficial  conversion  feature,  which was valued at $734,000. The
beneficial  conversion amount has been accounted for as an increase in additional
 paid-in capital and as an in-substance  dividend  to the  preferred  stockholders,
 which  increases  the net loss  applicable  to  common stockholders.


As noted  above,  one of the holders
of Preferred  Stock  exercised a warrant,  which had the effect,  under the anti-dilution
 provisions  applicable to the Preferred  Stock, of reducing the conversion price of the
Preferred Stock to $14.133.  The reduction in conversion  price  resulted in an
additional  553,044 shares of common stock issuable upon  conversion.  The  incremental
 shares issuable upon conversion were accounted for as a contingent beneficial
 conversion  feature in  accordance  with EITF No. 00-27,  Application  of Issue No.
98-5 to Certain Convertible  Instruments.  The  contingent  beneficial  conversion
 feature  was  measured by  multiplying  the incremental  shares by the fair value of the
 Companys  common  stock on the  commitment  date of May 23, 2001. The fair value of the
 Companys  common stock on the  commitment  date was $20.00 per share.  Accordingly,
 the Company recorded a contingent  beneficial  conversion feature in the amount of
$11,061,000 in the fourth quarter of  2002.  The  contingent  beneficial  conversion
 feature  was  treated  as a  deemed  dividend  to  preferred stockholders.


In connection  with a private
 placement  financing  which closed in the second  quarter of 2003 the  conversion price
of the Preferred Stock was further reduced,  from $14.133 to $2.87.  This further
 reduction in conversion price resulted in an additional  1,055,298  shares of common
stock  issuable upon  conversion.  The  incremental shares issuable upon conversion were
accounted for as a contingent  beneficial  conversion  feature as described above.
 Accordingly,  the Company recorded a contingent  beneficial conversion feature in the
amount of $893,000 in the second quarter of 2003. The contingent  beneficial  conversion
 feature was treated as a deemed  dividend to preferred stockholders.


5. Anthrax Contract



In September 2002, the Company was
awarded a contract from the National Institute of Allergy and Infectious Diseases
(NIAID) to develop a new anthrax vaccine candidate and to create a feasibility plan to
manufacture an emergency stockpile of 25 million doses of the vaccine. The current period
of performance of the contract is from September 30, 2002 through December 31, 2003.
Under the initial phase of the NIAID contract, the Company expects to be awarded, upon satisfaction
of certain milestones, approximately $16,200,000. During the six months ended June 30,
2003, the Company recognized a total of $2,558,000 in revenue related to the completion
of the first and second contractual milestones. The Company will recognize revenue based
on the completion of future milestones, which have been specified by NIAID. Revenues and
costs (not to exceed revenues) associated with milestones which have not been
substantiated through objective evidence of completion from NIAID, will be deferred on
the balance sheet. At June 30, 2003, the Company had $946,000 of deferred costs and $3,348,000 of
deferred revenues related to this contract.



6. Celltrion Joint
Venture



In February 2002, the Company and a
group of South Korean investors formed a joint venture, named Celltrion, which intends to
raise up to approximately $122,000,000, consisting of up to approximately $92,000,000 in
cash and an in-kind investment of mammalian cell culture technology and know-how valued
at $30,000,000, to build and operate a manufacturing facility in Incheon, South Korea.
9
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|As of June 30, 2003, the South
Korean investors had contributed approximately $43,750,000 in cash to Celltrion of the
$50,000,000 in cash that the joint venture agreement between Celltrion and the Company
requires to have been funded by the end of August 2002, and secured a $40,000,000 loan
with a Korean bank. As a result of the in-kind investment of mammalian cell culture
technology and know-how, the Company currently has a 47.8% interest in Celltrion,
although if funding is completed as intended, our interest will be approximately 44%. In
the event that AIDSVAX is ultimately licensed for commercial use and the Incheon facility
is validated and licensed to produce AIDSVAX, Celltrion would produce bulk material that
will be sold to the Company. Celltrion may also be used to manufacture other products
that VaxGen may develop in the future or products from third parties. The Company accounts for its
investment in Celltrion using the equity method of accounting. The Company does not own a majority
of the voting its nor will it be the primary beneficiary of the Joint Venture.


Under the terms of the joint venture
agreement, Celltrion is obligated to invest $7,000,000 to capitalize a new corporation,
VaxGen-Celltrion, Inc. (VCI), and Celltrion will initially be the sole shareholder of
VCI, receiving seven million shares of common stock in exchange for its $7,000,000
capital contribution. The funding of the $7,000,000 capital contribution was completed in
December 2002. The capitalization of VCI has been used to design and construct the
manufacturing facility adjacent to VaxGens research facility in South San Francisco,
California. The Company plans to use this facility to manufacture its anthrax vaccine if
it is awarded a U.S. Government contract to produce an emergency stockpile of the
vaccine. The Company will supervise the design and construction of this manufacturing
facility and is responsible for all costs relating to capital expenditures, validation,
operation and licensure of the facility in excess of the original $7,000,000 contribution
by Celltrion.  For every dollar expended by the Company in connection with capital
expenditures, validation, operation and licensure of the facility in excess of the
original $7,000,000 contribution by Celltrion, VCI will issue to the Company one share of
VCI common stock.


Through the first quarter of 2003,
the Company accounted for its investment in VCI using the equity method of accounting.  As a
result of the Company's ongoing investment in VCI, its ownership percentage of VCI increased to
approximately 45% as of June 30, 2003.  During the quarter ended June 30, 2003, the
Company, as a result of its increasing direct ownership interest in the equity of VCI,
combined with its primary beneficiary status, determined that the financial position and
results of operations of VCI are required to be consolidated with the financial
statements of the Company.  Accordingly, the condensed consolidated financial statements
as of and for the three and six months ended June 30, 2003 reflect the consolidated
results of VaxGen and VCI, effective from January 1, 2003 going forward.  All material
intercompany balances and transactions have been eliminated in consolidation.



7. Related Party
Transactions


As of June 30, 2003, the Company had loans
outstanding to two executive officers in the amount of $135,000. In May 2002, an
executive received a non-interest bearing loan in the amount of $80,000. The loan per the
executives employment agreement will be forgiven at the rate of 25% per year for each of
the first four full years of the executives employment with the Company. In August 2000,
an executive received a non-interest bearing loan in the amount of $55,000. Both loans
were made to assist in the purchase of residences in connection with employment-related
relocations.


8. Comprehensive Loss
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                 | Three months ended
June 30, | Six months ended
June 30,
|-------------------------------- | --------------------------- | -------------------------
|
|Net loss                         |                             | $(6,505,000              
|Net unrealized gains (losses) on |                            
|investment securities            |                             | (134,000                 
|                                 |                             |                          
|Comprehensive loss               |                             | $(6,639,000              
|                                 |                             |                          

|10
|--

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



This discussion and analysis should
be read in conjunction with our condensed consolidated financial statements and related
notes thereto appearing in Item 1 of this report. In addition to historical information,
this report contains forward-looking statements within the meaning of the
federal securities laws. These forward-looking statements include without limitation
projections as to the timing or amount of future revenues or expenses, statements
regarding our expectations and beliefs about our ability to raise additional capital to
finance our operations, forecasts regarding the length of time current cash resources will
enable us to continue our operations in the absence of additional financing, the timing of
completion and announcement of the results of our Thai Phase III clinical trial of
AIDSVAX, the timing and progress of completion of our anthrax, smallpox or HIV/AIDS
vaccine candidates, the timing and amount of any government awards relating to an anthrax
vaccine, our ability to obtain additional financing from private sources, from
governmental agencies or from philanthropic organizations to continue to develop AIDSVAX
and Celltrions ability to complete construction of its manufacturing facilities and
its ability to manufacture biopharmaceutical products. Reference should be made to the
section of this report entitled Risk Factors, and to our Annual Report on Form
10-K, filed with the Securities and Exchange Commission on March 31, 2003 under the
heading Business, for a more detailed description of such factors. Readers are
cautioned not to place undue reliance on these forward-looking statements, which speak
only as of the date of this report. We do not undertake and specifically decline any
obligation to update or to publicly announce the results of any revisions to these
forward-looking statements to reflect future events or developments.



CRITICAL ACCOUNTING
POLICIES AND ESTIMATES


Our discussion and analysis of our
operating results and financial condition is based upon our condensed consolidated
financial statements, which have been prepared in accordance with accounting principles
generally accepted in the United States of America. The preparation of the financial
statements requires us to make estimates, judgments, and assumptions that affect the
reported amounts of assets, liabilities, revenues and expenses. While we believe our
estimates, judgments, and assumptions are reasonable, the inherent nature of estimates is
that actual results will likely be different from the estimates made.


We believe the following critical
accounting policy affects the most significant judgments and estimates used in the
preparation of our consolidated financial statements.


Revenue Recognition


We recognize revenue when all of the
following conditions have occurred:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Persuasive
evidence of an arrangement exists;
| | - | ---------------------------------------------

| |  | Delivery
has occurred or services have been rendered;
| | - | -----------------------------------------------------

| |  | The
price is fixed and determinable; and
| | - | ----------------------------------------

| |  | Collectibility
is reasonably assured.
| | - | -------------------------------------

|Our fees are typically considered to be
fixed or determinable at the inception of an arrangement and are negotiated at the outset
of an arrangement and are generally based on specific services or products to be
delivered. In the event payment terms are provided that differ significantly from our
standard business practices and collectibility is not reasonably assured, the fees are
deemed to not be fixed or determinable and revenue is recognized as the fees are paid.



In addition, we adopted the guidance
provided by the SEC, which addresses the proper recognition of service revenue based upon
output measures. We believe that this is the appropriate treatment of our contract with
the NIH to develop a new anthrax vaccine. Under this arrangement we deferred revenues and
expenses on our balance sheet until we are able to provide objective evidence that we have
attained the specified milestones established by the NIH. Costs are deferred only to the
extent of expected revenues. At June 30, 2003, we had $946,000 of deferred costs and
$3,348,000 of deferred revenues related to this agreement.



Investment in Celltrion
and VCI


We account for our investment in
Celltrion using the equity method of accounting. We do not own a majority of the voting
stock nor will we be the primary beneficiary of the joint venture. Since the historical
cost of the non-monetary assets that we contributed is zero, there is no investment in
Celltrion recorded on our balance sheet. Additionally, because we have no further funding
obligation to Celltrion we will not pick up equity in earnings (loss) of Celltrion until
such time that losses previously not recognized have been recovered.



Through the first quarter of 2003, we
accounted for our investment in VCI using the equity method of accounting. As a result of
our ongoing investment in VCI, our ownership percentage of VCI increased to approximately
45% as of June 30, 2003. During the quarter ended June 30, 2003, the Company, as a result
of its increasing direct ownership interest in the equity of VCI, combined with its
primary beneficiary status, determined that the financial position and results of
operations of VCI are required to be consolidated with the financial statements of the
Company. Accordingly, the condensed consolidated financial statements as of and for the
three and six months ended June 30, 2003 reflect the consolidated results of VaxGen and
VCI, effective from January 1, 2003 going forward. All material intercompany balances and
transactions have been eliminated in consolidation.
11
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Valuation of Long-Lived
Assets


The carrying value of long-lived
assets is reviewed on a regular basis for the existence of facts or circumstances both
internally and externally that may suggest impairment. Specific potential indicators of
impairment include:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
significant decrease in the fair value of an asset;
| | - | -----------------------------------------------------

| |  | a
significant change in the extent or manner in which an asset is used or a significant
physical          change in an asset;
| | - | -----------------------------------------------------------------------------------------------------------------------------

| |  | a
significant adverse change in legal factors or in the business climate that affects the
value of an          asset;
| | - | ---------------------------------------------------------------------------------------------------------------------

| |  | a
adverse action or assessment by the U.S. Food and Drug Administration or another
regulator; and
| | - | -------------------------------------------------------------------------------------------------

| |  | an
accumulation of costs significantly in excess of the amount originally expected to
acquire or          construct an asset.
| | - | -----------------------------------------------------------------------------------------------------------------------------

|When we determine that the carrying
value of intangible assets or long-lived assets are not recoverable based upon the
existence of one or more of the above indicators of impairment, we may be required to
record impairment charges for these assets that have not been previously recorded.


OVERVIEW


In November 1995, VaxGen was formed
to continue development of AIDSVAX, a preventive vaccine candidate against HIV/AIDS. At
that time, Genentech, Inc. (Genentech) licensed to us the technology necessary
for completing development and commercialization of AIDSVAX under a license agreement. As
of August 1, 2003, Genentech owned approximately 7% of our outstanding common stock.


Until 2002, our work was focused on
developing and testing AIDSVAX. We have since broadened our operations with the formation
of Celltrion and the initiation of programs to develop preventive vaccines against anthrax
and smallpox.


We have developed two formulations of
AIDSVAX, which focus on the predominant HIV subtype in North America, Europe, the
Caribbean, and Australia (subtype B) and the predominant HIV subtype in Southeast Asia and
East Asia (subtype E). We have commenced two Phase III clinical trials, one in North
America and Europe to determine the efficacy AIDSVAX B/B and one in Thailand, to determine
the efficacy of AIDSVAX B/E.



In October 1999, we completed the
initial inoculation and enrollment of over 5,400 trial volunteers for the North
American/European Phase III clinical trial, which was conducted in 59 clinical centers and
completed the clinical trial as planned in December 2002. On February 24, 2003, we
announced that the study did not show a statistically significant reduction of HIV within
the study population as a whole, which was the primary endpoint of the trial. Although we
intend to continue analyzing data from this trial and to complete a second Phase III trial
in Thailand, any additional development of AIDSVAX will depend on whether we obtain
funding from sources such as governmental agencies and philanthropic organizations.
Beginning in April 2003, NIAID and the Centers for Disease Control and Prevention
(CDC) have been supporting a series of meetings with us to examine data from
the trial to independently determine if any further government supported research and
development are warranted. We cannot be certain whether or when we will obtain additional
funding to continue to develop AIDSVAX.


In August 2000, we completed the
initial inoculation and enrollment of over 2,500 volunteers for the Thai Phase III
clinical trial, which is being conducted in 17 clinical centers in Bangkok. We completed
the fieldwork for this trial during the second quarter of 2003 and expect to announce
clinical results during the fourth quarter of 2003. We will not know the results from the
clinical trial until we unblind the data immediately prior to public announcement. As
occurred with our North American/European trial, the Thai trial may fail to achieve its
primary endpoint. If the trial fails to achieve its primary endpoint, we may discontinue
developing AIDSVAX. The U.S. Food and Drug Administration (FDA) has designated
our HIV/AIDS vaccine candidates Fast Track Products for the prevention of HIV infection.
The Fast Track designation could enable more rapid regulatory review of AIDSVAX if and
when we submit a Biologics License Application (BLA). We are required under
our license with Genetech to submit a BLA for AIDSVAX by May 2006. If we fail to do so or
otherwise are unable to extend this date, Genentech may terminate our license agreement or
convert the license to a non-exclusive license.



In February 2002, we and a group of
South Korean investors announced the formation of a joint venture, called Celltrion, to
build and operate a manufacturing facility in Incheon, South Korea. As our part of the
investment in the joint venture, we are providing mammalian cell culture technology and
biologics production expertise. Celltrion contributed funds to a subsidiary for the
purpose of funding the first $7,000,000 of construction cost for a smaller manufacturing
facility adjacent to our research facility in South San Francisco, California. This
smaller facility was originally intended to support the licensure and commercial launch of
AIDSVAX, if the North American and European clinical trial was successful, but is also
designed to support the manufacture of other biopharmaceutical products, including our
anthrax vaccine candidate or products from third parties. In the event that AIDSVAX is
proven successful and the Incheon facility is validated and licensed to produce AIDSVAX,
Celltrion would produce bulk material that will be sold to us. However, in the event that
we abandon the development of AIDSVAX, we believe the Incheon facility could be used to
manufacture other biopharmaceutical products, in which we would share in the profits based
on our percentage ownership. After all rounds of financing are complete, our fully-diluted
ownership of the joint venture will be approximately 44%. Although we have no further
funding obligation to Celltrion, we are responsible for certain future costs related to
capital expenditures, validation, operation and licensure of the manufacturing facility in
South San Francisco, California in excess of Celltrions original $7,000,000
investment. At the end of each calendar year, VCI will issue to us one share of VCI common
stock for every dollar expended by us in connection with capital expenditures, validation,
operation and licensure of the facility in excess of the original $7,000,000 contribution
by Celltrion. To date, our investment in VCI is $5,662,000.
12
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|In September 2002, we were awarded a
contract from NIAID to develop a new anthrax vaccine candidate and to create a feasibility
plan to manufacture an emergency stockpile of 25 million doses of the vaccine. The current
period of performance of the contract is from September 30, 2002 through December 31,
2003. The goal of the government contract is to develop a modern vaccine that proves to be
safe in humans, efficacious in animal challenge studies and requires no more than three
injections. Under the initial phase of the NIAID contract, we expect to be awarded, upon
satisfaction of certain milestones, approximately $16,200,000 to advance the development
of a vaccine candidate initially developed by the USAMRIID. If results from the Phase I
clinical trial are positive, NIAID may elect, at least 60 days prior to December 31, 2003,
to extend the contract. If the contract were to be extended, we would be eligible for an
additional contract award of approximately $15,000,000 beginning in late 2003 and running
through 2007 as a continuation of the current contract to support a Phase II clinical
trial. Performance under the current contract may position us to be awarded additional
contracts expected to be awarded in 2003 to advance the product development of an anthrax
vaccine; conduct a large-scale Phase II clinical trial; and manufacture an emergency
stockpile of anthrax vaccine under an Investigational New Drug Application
(IND). Our current business plan is highly dependent on our ability to win
these additional contracts, and we cannot be certain whether we will be awarded any
additional contracts or the timing of any such awards. If we fail to obtain the next
contract to advance the development of our vaccine, we may be unable to raise additional
funds to continue development of our other product candidates and fund operations.



Also in September 2002, we were
awarded a $1,000,000 task order to provide AIDSVAX under a supply contract to develop HIV
vaccines for a forthcoming Phase III trial in Thailand funded by the NIH and conducted by
the Walter Reed Army Institute of Research (WRAIR). The majority of the
contract award will be earned in 2003. There were two government options that, when
exercised, would increase the contract award to a total of $3,300,000. In February 2003,
NIAID exercised the first option to take delivery of the first two-thirds of the vaccine
supply. In April 2003, NIAID exercised their second option for the remaining balance. The
start date of the clinical trial has been delayed due to matters outside of our control,
but is now currently scheduled to begin enrolling volunteers during the fourth quarter of
2003 and will combine our AIDSVAX B/E vaccine with ALVAC, an HIV vaccine candidate being
developed by Aventis Pasteur.



In December 2002, we announced that
we and Chemo-Sero-Therapeutic Research Institute (Kaketsuken) of Kumamoto,
Japan, entered into initial agreement that allows us to begin development of
Kaketsukens attenuated smallpox vaccine, LC16-Kaketsuken, for use in the United
States, subject to approval by the FDA. We believe, that the vaccine, which was licensed
in Japan in 1980, will have a better safety profile, yet be equally effective, compared to
smallpox vaccines available in the United States or elsewhere. We are currently in
negotiations with Kaketsuken to define the specific commercial terms of our relationship
and our rights to sell any commercialized vaccine.



Since inception, our research and
development expenses have been applied to two product development projects: AIDSVAX B/B
and AIDSVAX B/E, our HIV vaccine candidates, and a program to develop a new anthrax
vaccine for the United States government.


As of June 30, 2003 we have incurred
total costs of $84,655,000 in research and development of AIDSVAX since we began
operations in late 1995. For the six months ended June 30, 2003, we incurred costs of
$2,821,000 towards the research and development of AIDSVAX. The most significant research
and development costs incurred for the development of AIDSVAX include: the costs to
conduct the Phase III clinical trials, the cost of the clinical materials, the costs
associated with the laboratory activities required to support the trials, the advanced
development of our manufacturing process, the establishment of a regulatory and quality
systems group to support the possible licensure of the products, and the costs to refine
the manufacturing process of the vaccine. In 2003, we expect the development cost for
AIDSVAX will be approximately $3,900,000. The costs are primarily associated with the
conclusion of the Thai Phase III clinical trial.



The anthrax vaccine project began
during the fourth quarter of 2002 when the NIH awarded us a cost reimbursement contract to
develop a new vaccine to prevent anthrax infection. As of June 30, 2003, we have incurred
total costs of $3,191,000 towards this project, of which $946,000 has been deferred along
with the related revenue until the milestones that are required have been met. We expect
to incur additional costs related to this project of approximately $4,200,000 during 2003,
of which we expect to receive reimbursement for all our direct expenses, coverage for a
certain part of our overhead and general and administrative expenses and a fixed profit
amount.


In February 2003, we received
official notification from NIAID indicating that we met the program requirements
stipulated under the first milestone of the anthrax vaccine development contract.
Milestone 1 required us to produce the pilot lot of the anthrax vaccine clinical material
amongst other associated activities. In June 2003, we received official notification from
NIAID indicating that we met the program requirements stipulated under the second
milestone of the anthrax vaccine development contract. Along with Milestones 1 and 2, we
continue to perform, in parallel, against the other milestones required under the contract
with NIAID. To date, we have performed within budget and on schedule. However, we cannot
guarantee that we will continue to do so.



We cannot reasonably estimate the
nature, timing and the ultimate cost of completing product development projects due to the
numerous risks and uncertainties associated with developing vaccines, including:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | intense
and changing governmental regulation, both foreign and domestic, and social and political
considerations with respect to drug development, particularly bio-terrorism and AIDS
research;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
fact that the anthrax and smallpox vaccine projects are in the very early stages of
development and that we have only limited experience in developing vaccines and products
other than AIDSVAX;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
uncertainty of future pre-clinical and clinical study results and the uncertainty of the
timing of enrolling volunteers in vaccine trials, particularly in large scale clinical
vaccine trials enrolling numerous volunteers in multiple cities and in various countries;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
possibility of delays in the collection of clinical trial data;
| | - | -------------------------------------------------------------------

|13
|--

| |  | the
uncertainty related to our manufacturing facilities, which are either in an early stage
of          construction or have not yet been validated; and
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | various
risks related to our reliance on third parties, including Genentech, Celltrion and
government          entities.
| | - | ------------------------------------------------------------------------------------------------------------------------

|See the section entitled Risk
Factors for a more detailed discussion of these risks and uncertainties.

14
|------------------------------------------------------------------------------------------------------------

|RESULTS OF OPERATIONS



Since inception, we have generated
$5,902,000 in research grant and contract revenue from a contract from NIAID to develop a
new anthrax vaccine, grants from the NIH for research and development of HIV vaccines,
funds received through a collaborative agreement with BBI Biotech Research Laboratories,
Inc. and from service agreement fees from our manufacturing joint venture.



Six months ended June 30, 2003
compared to the six months ended June 30, 2002


Revenue


Research grant and contract revenue
increased from $238,000 for the six months ended June 30, 2002 to $3,677,000 for the six
months ended June 30, 2003. The revenue for the six months ended June 30, 2003 primarily
consisted of contract revenue with NIAID related to the completion of the first and second
milestones in the development of a new anthrax vaccine which amounted to approximately
$2,558,000; funds received as reimbursements under a collaborative agreement with BBI
Biotech which amounted to approximately $424,000; two Small Business Innovation Research
(SBIR) grants that are funded by NIAID which amounted to approximately
$656,000; and revenue related to WRAIR which amounted to approximately $39,000. Related
party service fee revenue of $307,000 was earned as part of a service agreement with the
Celltrion joint venture. Revenue earned in one period is not indicative of revenue to be
earned in future periods. We expect research grant and contract revenue to increase in the
foreseeable future if we are successful in pursuing our current and anticipated future
contracts. We expect related party service revenue to remain at approximately current
levels for the foreseeable future.



Research and development
expenses



Research and development expenses increased 5%, from $8,956,000 for the six
months ended June 30, 2002 to $9,361,000 for the six months ended June 30, 2003.
The net increase was due primarily to personnel costs which rose in the first
six months of 2003 by $1,900,000 reflecting expenses required to staff a
regulatory and quality services organization as well as the staffing necessary
to develop, validate and operate a manufacturing facility. In addition, expenses
relating to the anthrax vaccine project, principally for subcontractor costs,
increased by $854,000. These increased expenses were partially offset by a
reduction in clinical trial expenses of $2,100,000 in 2003 due to the completion
of the North American and European AIDSVAX trial. We expect research and
development expenses to increase for the foreseeable future if we are able to
advance the product candidates we have under development and if we are able to
raise necessary funds to support such programs.



General and
administrative expenses


General and administrative expenses
increased 49%, from $6,069,000 for the six months ended June 30, 2002 to $9,071,000 for
the six months ended June 30, 2003. Of this increase, approximately $1,459,000 was due to
expenses relating to the operation of the South San Francisco manufacturing facility with
most of the remaining increase due to higher spending for occupancy and insurance costs.
During the third quarter of 2002, we entered into a sublease agreement to occupy an
additional 50,000 square feet of space to establish a manufacturing facility and the
laboratory facilities needed to support a manufacturing operation. In addition, insurance
premium cost, mainly in the product liability and directors and officers liability
programs, increased due to current market conditions in the insurance industry. We expect
general and administrative expenses will be maintained at similar levels but will be
adjusted according to the level of our research and development activity and planned
operations.


Total other income, net


Other income, net, consisting
primarily of investment income, decreased 67%, from $1,159,000 for the six months ended
June 30, 2002 to $379,000 for the six months ended June 30, 2003. The decrease in
investment income of $780,000 was primarily attributable to lower average balances of
cash, cash equivalents and investment securities, along with lower yields.



Minority interest in
subsidiary losses



Minority interest in subsidiary losses was
$909,000 for the six months ended June 30, 2003 reflecting Celltrions share of the
net loss of VCI during that period.



Three months ended June 30, 2003
compared to the three months ended June 30, 2002


Revenue


Research grant and contract revenue increased
from $220,000 for the three months ended June 30, 2002 to $2,565,000 for the three months
ended June 30, 2003. The revenue for the three months ended June 30, 2003 primarily
consisted of contract revenue with NIAID related to the completion of the second milestone
in the development of a new anthrax vaccine which amounted to approximately $1,892,000;
funds received as reimbursements under a collaborative agreement with BBI Biotech which
amounted to approximately $202,000; two SBIR grants that are funded by NIAID which
amounted to approximately $447,000; and revenue related to WRAIR which amounted to
approximately $24,000. Related party service fee revenue of $206,000 was earned as part of
a service agreement with the Celltrion joint venture. Revenue earned in one period is not
indicative of revenue to be earned in future periods. We expect research grant and
contract revenue to increase in the foreseeable future if we are successful in pursuing
our current and anticipated future contracts. We expect related party service revenue to
remain at approximately current levels for the foreseeable future.

15
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|Research and development
expenses


Research and development expenses
increased 24%, from $4,299,000 for the three months ended June 30, 2002 to $5,336,000 for
the three months ended June 30, 2003. The net increase was due primarily to personnel
costs which rose in the first six months of 2003 by $865,000 due to salary and benefits
expenses required to staff a regulatory and quality services organization expenses for
staffing necessary to develop, validate and operate a manufacturing facility. Expenses
for the anthrax vaccine project, principally for subcontractor costs, increased by
$1,162,000 in 2003. These increased expenses were partially offset by a reduction in
clinical trial expenses of $754,000 in 2003 due to the completion of the North American
and European AIDSVAX trial. We expect research and development expenses to increase for
the foreseeable future if we are able to advance the product candidates we have under
development and if we are able to raise necessary funds to support such programs.



General and
administrative expenses



General and administrative expenses
increased 47%, from $3,141,000 for the three months ended June 30, 2002 to $4,616,000 for
the three months ended June 30, 2003. Of this increase, approximately $913,000 was due to
expenses relating to the operation of the South San Francisco manufacturing facility with
most of the remaining increase due to higher spending for occupancy, personnel and
insurance costs. During the third quarter of 2002, we entered into a sublease agreement to
occupy an additional 50,000 square feet of space to establish a manufacturing facility and
the laboratory facilities needed to support a manufacturing operation. Compensation costs
increased due to the hiring of additional staff required to support the expanding
infrastructure of our operations. In addition, insurance premium cost, mainly in the
product liability and directors and officers liability programs, increased due to current
market conditions in the insurance industry. We expect general and administrative expenses
will be maintained at similar levels but will be adjusted according to the level of our
research and development activity and planned operations.



Total other income, net


Other income, net, consisting
primarily of investment income, decreased 68%, from $557,000 for the three months ended
June 30, 2002 to $176,000 for the three months ended June 30, 2003. The decrease in
investment income of $381,000 was primarily attributable to lower average balances of
cash, cash equivalents and investment securities, along with lower yields.



Minority interest in
subsidiary losses


Minority interest in subsidiary losses was
$500,000 for the three months ended June 30, 2003 reflecting Celltrions share of the
net loss of VCI during that period.


LIQUIDITY AND CAPITAL
RESOURCES


Our primary financing requirements
are for (i) capital equipment expenditures related to the manufacturing facility in South
San Francisco, California; (ii) funding our day-to-day working capital requirements; and
(iii) research and development costs.



Cash, cash equivalents and investment
securities were $14,599,000 and our working capital position was $8,469,000 at June 30,
2003. We have financed our operations since inception primarily through capital provided
by Genentech, sales of our common stock, an issuance of convertible preferred stock,
research grant and contract revenues and related party services revenues. Genentech has no
obligation to provide us future funding.


We completed our initial public
offering in July 1999, in which we sold 3,565,000 shares of common stock resulting in net
proceeds to us of approximately $41,959,000. Since our initial public offering, we have
raised aggregate net proceeds of $35,784,500 in three private placements of common stock,
including net proceeds of $24,100,000 through the sale of 2,174,000 shares of common stock
to Vulcan Ventures, Inc. in December 1999, net proceeds of $5,000,000 through the sale of
1,742,160 newly-issued shares of common stock to a single institutional investor in May
2003 at $2.87 per share and net proceeds of $6,684,500 through the sale of 1,591,307
newly-issued shares of common stock to a single institutional investor in June 2003 at
$4.3989 per share. In addition, on May 23, 2001, we completed a preferred stock financing
through which four investors paid us an aggregate of approximately $20,000,000 in
consideration for 20,000 shares of our Series A Preferred Stock at a price of $1,000 per
share, convertible into shares of our common stock, at an initial conversion price of
$23.2185 per share. In the event that there is no earlier conversion, we must redeem the
Series A Preferred Stock for cash on May 23, 2004, at a redemption price equal to $1,000
per share plus all accrued and unpaid dividends. We may within certain limits, pay up to
50% of such redemption price in shares of our common stock. Expenses relating to the
transaction were approximately $1,700,000, resulting in net proceeds to us of
approximately $18,300,000. The proceeds from the Series A Preferred Stock financing were
used to prepare the Companys HIV/AIDS vaccine, AIDSVAX, for commercial-scale
manufacturing as well as for the development of new adjuvants and for general corporate
purposes. As of June 30, 2003, 585 shares of Series A Preferred Stock remained
outstanding, which are convertible into 203,833 shares of common stock.

16
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|In connection with the preferred
stock financing, we issued warrants for the purchase of 297,177 shares of our common stock
to our preferred stock investors. The warrants, which expire on May 23, 2006, originally
had an exercise price of $25.2375 per share; however effective as of June 5, 2003, the
exercise price was automatically adjusted to $12.324 per share and the number of shares
issuable on exercise of the warrants increased to 608,568, in accordance to the terms of
the warrants. Any future financing at a price below $2.87 would cause a further adjustment
in the number of shares issuable upon exercise and the exercise price.


Since our inception, investing
activities, other than purchases and sales of investment securities, have consisted
entirely of equipment acquisitions and leasehold improvements. From inception through June
30, 2003, our gross investment in equipment and leasehold improvements was $7,120,000. The
increase in equipment and leasehold improvements has been primarily due to the development
of our research and development laboratories, our manufacturing facility and in the
establishment of office facilities. Net cash used in operating activities for the six
months ended June 30, 2003 was $12,114,000, primarily representing expenditures for
research and development costs and general and administrative expenses in excess of
revenues from grants and contracts as compared to $12,161,000 for the six months ended
June 30, 2002.



In 2001, we finalized a collaborative
agreement with BBI Biotech, which is being funded by NIAID, to obtain and store clinical
specimens from our North American/European Phase III clinical trial of AIDSVAX. The
project is being funded under a contract, which NIAID awarded BBI Biotech for seven years.
Under a subcontract with BBI Biotech, we anticipated receiving approximately
$1,730,000 to support the sample collection. We recognized $424,000 and $0 from this
collaborative agreement for the six months ended June 30, 2003 and 2002, respectively. We
have completed this project and we do not anticipate further revenue recognition relating
to this collaborative agreement.


Also in 2001, we were awarded an SBIR
grant from the NIH to continue the development of a vaccine designed to prevent infection
by HIV subtype C, the most widespread form of the virus, which is predominantly found in
Africa, China and India. The SBIR Fast Track grant provides up to $1,131,000 for the
development program. We recognized revenue relating to this grant of approximately
$199,000 and 238,000 for the six months ended June 30, 2003 and 2002, respectively. The
NIH grant will allow us to create and conduct laboratory tests of a subtype C vaccine that
could be used alone in Southern Africa and India, or it could be combined with a vaccine
against the B and E subtypes for other regions of the world, such as China, where all
three subtypes are in circulation. We have completed this project and we do not anticipate
further revenue recognition relating to this grant.



In February 2002, we and a group of
South Korean investors formed a joint venture, named Celltrion, which intends to raise up
to approximately $122,000,000, consisting of up to approximately $92,000,000 in cash and
an in-kind investment of mammalian cell culture technology and know-how valued at
$30,000,000, to build and operate a manufacturing facility in Incheon, South Korea. The
joint venture also funded a capital contribution of $7,000,000 towards construction of a
smaller manufacturing facility in South San Francisco. Both facilities will be designed
for commercial manufacture of biopharmaceutical products, including AIDSVAX if eventually
licensed, our Anthrax vaccine candidate, or other products for third parties made through
mammalian-cell fermentation.


As part of our investment in the
joint venture, we provided mammalian cell culture technology and biologics production
expertise. We currently are Celltrions single-largest stockholder. Although we have
no further funding obligation to Celltrion, we are responsible for any additional capital
equipment costs in excess of $7,000,000 and certain costs related to capital expenditures,
validation, operation and licensure of the manufacturing facility in South San Francisco,
California. The South Korean investors will provide the funding necessary to design and
construct both facilities and to validate and operate the Incheon facility. After all
planned rounds of financing are completed, our fully diluted ownership will be
approximately 44%. As of June 30, 2003, the South Korean investors had contributed to
Celltrion approximately $43,750,000 of the $50,000,000 in cash required under joint
venture agreement between us and Celltrion, and secured a $40,000,000 loan with a Korean
bank. As a result, we currently have a 47.8% interest in the joint venture.



Under the initial phase of the NIAID
contract to develop a new anthrax vaccine, we expect an award, upon satisfaction of
certain milestones, of approximately $16,200,000 to advance the development of a vaccine
candidate initially developed by the USAMRIID. During the first quarter of 2003, we
recognized a total of $667,000 in revenue related to the completion of the first
contractual milestone. In the second quarter of 2003, we recognized a total of $1,892,000
in revenue related to the completion of the second contractual milestone. We will
recognize revenue based on the completion of future milestones, which have been specified
by NIAID. Revenues and costs (not to exceed revenues) associated with milestones which
have not been substantiated through objective evidence from NAID, will be deferred on our
balance sheet. As of July 2003, we had received payments of approximately $6,639,000 from
NIAID since the award date for this contract.



Also in September 2002, we were
initially awarded a $1,000,000 task order to supply AIDSVAX B/E under an existing general
contract to develop HIV vaccines for a forthcoming Phase III trial in Thailand funded by
NIAID and conducted by WRAIR. There were two contract options that, when exercised, would
increase the total contract award to $3,300,000. In February 2003, NIAID exercised the
first option to take delivery of the first two-thirds of the vaccine supply. In April
2003, NIAID exercised their second option for the remaining balance. The majority of the
contract award will be earned in 2003 when the supply is transferred to WRAIR.


In October 2002, the NIH awarded us
an SBIR grant to characterize the sequences of the viruses responsible for recent HIV
infections. The viruses are being sequenced from blood specimens obtained from volunteers
who became infected during their participation in our North American/European Phase III
clinical trial and is intended to help identify Subtype B virus variants that should be
included in future vaccine formulations. The grant award for the first phase of the grant
was $210,000. We recognized approximately $108,000 in grant revenue relating to the first
phase of the award for the six months ended June 30, 2003. We were awarded a grant for the
second phase of the grant in June 2003, for a total of $2,003,000. We recognized
approximately $348,000 in grant revenue relating to the second phase of the award for the
six months ended June 30, 2003.
17
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|We believe that our existing cash and
cash equivalents and investment securities, together with investment income, the funds
from our existing government contracts and grants, will enable us to meet our forecasted
expenditures through the first quarter of 2004. However, we will need to raise additional
funds to support our product development programs, other business opportunities and our
general operations. Our future capital requirements are also dependent on several other
factors, including:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
progress of other internal research and development projects;
| | - | -----------------------------------------------------------------

| |  | the
timing and ability to negotiate government contracts or grants, particularly our ability
to win          additional contracts to develop our anthrax vaccine candidate;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
ability to attract and negotiate business development opportunities;
| | - | ------------------------------------------------------------------------

| |  | the
timing of collection of accounts receivable from our government contracts and grants; and
| | - | ---------------------------------------------------------------------------------------------

| |  | the
timing of revenue, from our vaccine candidates.
| | - | ---------------------------------------------------

|We cannot assure you that we will be
able to raise funds when needed, or that such funds will be available on satisfactory
terms. If we are unable to raise additional capital, we will have to curtail or cease
operations. We will restrict additional planned activities and operations, as necessary,
to sustain operations and conserve cash resources.


RISK FACTORS


You should carefully consider the
following risk factors, in addition to the other information set forth in this Quarterly
Report on Form 10-Q, before making any investment decisions regarding our common stock.
Each of these risk factors could adversely affect our business, operating results and
stock price.


Risks Relating to our
Business



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


As of June 30, 2003, we had
$14,599,000 of cash and cash equivalents and investment securities. We believe that our
existing cash and cash equivalents and investment securities, together with investment
income and funds primarily from existing government contracts and grants, will enable us
to meet our forecasted expenditures through the first quarter of 2004, but our existing
capital resources will not be sufficient to commercialize AIDSVAX. In addition, we have
based this estimate on assumptions that may prove to be wrong. In addition, our
independent accountants have expressed doubt about our ability to continue as a going
concern. Even if we are technically able to successfully develop AIDSVAX in light of our
recent clinical trials, we expect additional development efforts and clinical trials will
add several years to the development timeline and result in substantial additional
expense. We are unable to fund these efforts with our current financial resources. In
addition, unless we receive the next government contract to advance development of our
anthrax vaccine, we will need to obtain additional funding to support our vaccine
candidates as well as to continue operations past the first quarter of 2004. We do not
know if additional financing will be available, at all or on acceptable terms. Any
additional equity financing will be dilutive to existing stockholders, and debt financing,
if available, may involve restrictive covenants. Collaborative arrangements will require
us to relinquish our rights to certain technologies drug candidates or marketing
territories. If we fail to raise sufficient funds, we would have to curtail or cease
operations.


We depend on the award of
government contracts, which involve the coordination of several government agencies, for
the development of our anthrax vaccine. The process of procuring government contracts is
lengthy and uncertain. If we fail to obtain future contracts to pursue advanced
development of our anthrax vaccine, or provide an emergency stockpile, we may not be able
to commercialize the product and we may be unable to raise additional funds to continue
operations.


We have entered into a contract with
the NIH to develop an anthrax vaccine. The contract requires us to provide a plan for how
we could manufacture an emergency stockpile of at least 25 million doses. However, the
contracts for advanced development and the emergency stockpile are each subject to
separate awards, which we must compete for. The process of obtaining government contracts
is lengthy and uncertain, and we cannot be certain that we would be awarded these
contracts. Our current business plan is highly dependent on obtaining these additional
contracts. If we fail to win these awards, we may be unable to raise additional funds to
continue our operations beyond the first quarter of 2004.


In addition, the federal government
has undertaken multiple commitments to help secure improved countermeasures against
bio-terrorism, including those, which might arise from the illegal use of smallpox and
anthrax. The determination of when and whether a product is ready for use and large scale
purchase will be made by a combination of authoritative organizations, including the FDA,
the NIH, the CDC, and the Department of Homeland Security. In addition, President Bush has
proposed and Congress is actively considering measures to speed up the review of
countermeasure products by the NIH, the review process by the FDA and the final government
procurement contracting authority. Although project BioShield was passed by the House of
Representatives in July 2003 by a vote of 421 to 2, we cannot predict the timing of
enactment of pending legislation nor can we predict the decisions that will be made in the
future by various government agencies.
18
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|Clinical development is a long,
expensive and uncertain process, and delay or failure can occur at any stage of our
clinical trials. We may not succeed in our efforts to develop AIDSVAX based on our
preliminary results and not meeting the primary endpoint of the Phase III clinical trial.


We must provide the FDA and foreign
regulatory authorities with clinical data that demonstrate the safety and statistically
significant efficacy of our product candidates before they can be approved for commercial
sale. Clinical development is a long, expensive and uncertain process, and delay or
failure can occur at any stage of our clinical trials. AIDSVAX is our most advanced
product candidate. Earlier this year we announced data from the first of two Phase III
clinical trials for AIDSVAX, in which we failed to meet the primary endpoint of the trial,
but did observe some evidence of efficacy in certain racial subgroups. We will need to
modify the vaccine in order to continue developing it for use in a broad population. In
addition, we believe that we will have to conduct additional clinical trials of AIDSVAX in
order to obtain approval from the FDA either in a broad patient population or in any
particular subgroups. These development efforts and subsequent clinical trials are lengthy
and expensive, and the outcome is uncertain. Even with modifications, we may discover that
AIDSVAX fails to protect individuals from contracting HIV. If we are unable to
successfully develop AIDSVAX, we will be unable to generate revenue from this product
opportunity, and our stock price is likely to decline.


We have limited
experience in developing other types of vaccines and products, such as smallpox and
anthrax vaccines, and may be unable to develop other vaccines and products, which
could adversely affect our abilityto execute our business strategy, our business and
our financial condition.


Part of our business strategy is to
develop biologic products for the prevention and treatment of human infectious diseases.
In September 2002, we were awarded a contract from NIAID to develop a new anthrax vaccine
and to create a feasibility plan to manufacture an emergency stockpile of 25 million
doses. In December 2002, we entered into agreements with Kaketsuken to initiate
development of Kaketsukens attenuated smallpox vaccine for use in the United States.
We have only limited experience in developing other types of vaccines and products, so we
may not be able to develop either an effective anthrax vaccine or a smallpox vaccine for
use in the United States or receive the appropriate regulatory approvals to distribute
either vaccine candidate in the U.S. If these development efforts fail, it could adversely
affect our ability to execute our business strategy, our business and our financial
condition.


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


Completion of our clinical trials,
and announcement of results of the trials could be delayed for a variety of reasons,
including:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | lower-than-anticipated
retention rate of volunteers in the trials;
| | - | ------------------------------------------------------------------

| |  | serious
adverse events related to the vaccine candidates;
| | - | ---------------------------------------------------------

| |  | our
principal third-party investigators may not perform our clinical trials on our
anticipated          schedules or consistent with our clinical trial protocols, or
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | different
interpretations of our preclinical and clinical data, which could lead initially to
         inconclusive results.
| | - | ----------------------------------------------------------------------------------------------------------------------------

|Our development costs will increase
if we have material delays in our clinical trial or if we need to perform more or larger
clinical trials than planned. If the delays are significant, our financial results and the
commercial prospects for our products and product candidates will be harmed, and our
prospects for profitability will be impaired. Furthermore, our inability to complete our
clinical trials in a timely manner could jeopardize our ability to obtain regulatory
approval.


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


Vaccine candidates are subject to
extensive government regulations related to development, clinical trials, manufacturing
and commercialization. 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. It also subjects us to the following risks and
obligations, among others.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
FDA or foreign regulators may refuse to approve an application if they believe that
applicable regulatory criteria are not satisfied.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------

| |  | The
FDA or foreign regulators may require additional testing for safety and efficacy.
| | - | -------------------------------------------------------------------------------------

| |  | If
regulatory approval of a product is granted, the approval may be limited to specific
indications or limited with respect to its distribution; for example, the FDA may approve
the licenses for only high-risk populations.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The
FDA or foreign regulators may not approve our manufacturing processes or manufacturing
facilities, or may require additional clinical studies to establish the safety, purity
and potency of our product candidates.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Even
if United States regulatory approval for any product is obtained, the license will be
subject to continual review, and newly discovered or developed safety or efficacy data
may result in 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 the FDAs general
prohibition against promoting products for unapproved or off-label uses.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | We
will be subject to continual regulatory review and periodic inspection and approval of
manufacturing modifications, including compliance with the FDAs cGMPs regulations.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|If the government fails
to continue funding or purchasing products we manufacture, our business will be harmed.
19
|------------------------------------------------------------------------------------------------------------------

|We have received funding from the
U.S. government for the development of an anthrax vaccine. Changes in government budgets
and agendas may result in future funding to be decreased and de-prioritized. Furthermore,
we cannot be certain of the timing of any future funding. The failure of the U.S.
government to continue to fund our research and development programs would harm our
business. Similarly, if we develop any anthrax vaccine candidate that is approved by the
FDA, the U.S. government is likely to be our largest customer for this product. The
failure of the U.S. government to place sufficient orders for this product or to place
orders on a timely basis would be harmful to our future business. Even if the U.S.
government were to become a customer, we would be subject to additional governmental
contract requirements, and future sales would depend, in part, on our ability to meet
those requirements, certain of which may be onerous or even impossible for us to satisfy


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


The approval requirements of vaccines
used to fight bio-terrorism are still evolving, and we cannot be certain that any vaccines
we develop, if effective, would meet the approval requirements of regulatory authorities.
We are developing products based upon current policies regulating these vaccines. Our
business is subject to substantial risk because these policies may change quickly and
unpredictably and in ways that could impair our ability to obtain regulatory approval of
these products.


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


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


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

| |  | lack
of sufficient prevention benefit or unacceptable safety during preclinical studies or
clinical          trials;
| | - | --------------------------------------------------------------------------------------------------------------------

| |  | failure
to receive necessary regulatory approvals;
| | - | --------------------------------------------------

| |  | existence
of proprietary rights of third parties; and
| | - | -----------------------------------------------------

| |  | inability
to develop manufacturing methods that are efficient, cost-effective and capable of
meeting stringent regulatory standards.
| | - | ------------------------------------------------------------------------------------------------------------------------------------

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


Several of our competitors have
announced that they are trying to develop an HIV vaccine and are planning, conducting or
have completed Phase I or Phase II clinical trials. In addition, several of these
companies are developing new drug therapies and other treatments that may mitigate the
impact of the disease. Our competitors are also developing vaccine candidates for anthrax
and smallpox, which would compete with the vaccine candidates we are developing. Our
commercial opportunities will be reduced or eliminated if our competitors develop and
market products for any of the diseases that we target that are:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | more
effective;
| | - | ---------------

| |  | have
fewer or less severe adverse side effects;
| | - | -----------------------------------------------

| |  | are
easier to administer; or
| | - | ----------------------------

| |  | are
less expensive than the products or product candidates we are developing.
| | - | -----------------------------------------------------------------------------

|Even if we are successful in
developing effective drugs, obtaining FDA and other required regulatory approvals and
commercializing them, our products may not compete effectively with these products or
other successful products. Researchers are continually learning more about diseases, which
may lead to new technologies for treatment. Our competitors may succeed in developing and
marketing products either that are more effective than those that we may develop, alone or
with our collaborators, or that are marketed before any products we develop are marketed.


Our competitors include fully
integrated pharmaceutical companies and biotechnology companies that currently have drug
and target discovery efforts, as well as universities and public and private research
institutions. Many of the organizations competing with us 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.


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



To date, we have engaged primarily in
research, development and clinical testing. At June 30, 2003, we had an accumulated
deficit of approximately $156,299,000. We expect to incur substantial losses in the
future.

20
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our South Korean
manufacturing joint venture may not be successful.


In February 2002, we entered into a
joint venture, Celltrion, with a group of South Korean investors for the purpose of
building and operating a manufacturing facility in Incheon, South Korea, and a smaller
manufacturing facility in South San Francisco. We have not yet completed the full
capitalization of, or the transfer of all technology to, Celltrion. Celltrion will be
unable to complete its capitalization and unable to build a manufacturing facility in
South Korea, if Celltrion is unable to secure or raise the necessary funding or does not
receive the necessary technology for the manufacture of AIDSVAX or other biopharmaceutical
products.


Even if Celltrion successfully builds
its manufacturing facilities, we cannot be certain that the facilities will pass domestic
or foreign regulatory approvals or be able to manufacture the vaccine candidates we are
developing or third parties products in commercial quantities, on a cost-effective
basis or at all.


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

| |  | foreign
currency controls;
| | - | --------------------------

| |  | currency
fluctuations;
| | - | ----------------------

| |  | trade
restrictions or changes in tariffs;
| | - | -----------------------------------------

| |  | the
difficulties associated with staffing and managing international operations;
| | - | --------------------------------------------------------------------------------

| |  | generally
longer receivables collection periods;
| | - | ------------------------------------------------

| |  | potentially
limited protection for intellectual property rights;
| | - | ----------------------------------------------------------------

| |  | potentially
adverse taxes; and
| | - | ------------------------------

| |  | international
conflict and war.
| | - | -------------------------------

|If Celltrion is unable to manufacture
AIDSVAX or other vaccines or products, or if it becomes commercially impractical for
Celltrion to manufacture those products, we may not recoup the cost of our investment, and
our business and results of operations will suffer.


Our use of hazardous
materials, chemicals and viruses exposes us to potential liabilities.


Our research and development involves
the controlled use of hazardous materials, chemicals, and viruses. Although we believe
that our safety procedures for handling and disposing of such materials comply with the
standards prescribed by state and federal regulations, we cannot completely 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.


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



We face an inherent risk of exposure
to product liability suits in connection with vaccines being tested in human clinical
trials or sold commercially. We may become subject to a product liability suit if any
vaccine we develop causes injury, or if vaccinated individuals subsequently become
infected or otherwise suffer adverse effects from our vaccines or products. Regardless of
merit or eventual outcome, product liability claims may result in decreased demand for a
vaccine or product, injury to our reputation, withdrawal of clinical trial volunteers and
loss of revenues. If a product liability claim is brought against us, the cost of
defending the claim would be significant and any adverse determination may result in
liabilities in excess of our insurance coverage. We currently have product liability
insurance in the amount of $25,000,000. However, we cannot be certain that our current
insurance can be maintained, or that additional insurance coverage could be obtained, on
acceptable terms, if at all.



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


Legislation relating to medical
products used to fight bio-terrorism is evolving, and may enable the United States
government to release and use certain medical products prior to such products obtaining
FDA or other regulatory approval. According to the terms of one proposed bill, upon a
declaration of emergency, the United States government may authorize the introduction and
use of a qualified medical product (possibly the anthrax vaccine, currently under
development with government funding, and the smallpox vaccine) prior to either such
medical product obtaining FDA regulatory approval. Further, such proposed legislation
provides that the United States government may elect to purchase and stockpile quantities
of vaccines or products prior to receipt of regulatory approval to fight bio-terrorism.
Legislation limiting or restricting liability for the use of such vaccines is evolving,
and we cannot be certain that any such protections will apply to the vaccines or products
developed by us. If the legislation does not provide sufficient protection, and we are not
able to obtain these protections by contract, we may become subject to product liability
suits and other third party claims if vaccines or products developed by us cause injury,
or if vaccinated individuals subsequently become infected or otherwise suffer adverse
effects from such vaccines or products. We currently have product liability insurance in
the amount of $25,000,000. However, we cannot be certain that our current insurance will
cover such claims, or that adequate insurance coverage can be obtained.


Political or social
factors may delay or reduce revenues by delaying or impairing our ability to market AIDSVAX
or any other vaccine or product.

21
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Products developed for use in
addressing the HIV/AIDS epidemic have been, and will continue to be, subject to competing
and changing political and social pressures. Similarly products developed to treat or
combat the threat of bio-terrorism will be subject to changing political and social
environments. The political and social responses to the HIV/AIDS epidemic and to
bio-terrorism have been highly charged and unpredictable. Political or social pressures
may delay or cause resistance to bringing our products to market or limit pricing of our
products, which would harm our business.


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



We are highly dependent on our senior
management and scientific staff, particularly Lance Gordon, Ph.D., our Chief Executive
Officer, Donald Francis, M.D., D.Sc., our President, and Phillip Berman, Ph.D., our Senior
Vice President, Research & Development. These individuals have played a critical role
in raising financing, negotiating business development opportunities, developing the
vaccine and conducting clinical trials. If we lose the services of any key members of
senior management and scientific staff and we are unable to recruit replacements where we
deem it necessary, we may be unable to achieve our business objectives.



Failure to protect our
intellectual property or infringing on the intellectual property rights of others could harm
our business and cause our stock price to fall.


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 the intellectual property rights of
others, we may be prevented from developing or marketing AIDSVAX or other products. We
rely on patent and other intellectual property protection to prevent our competitors from
manufacturing and marketing AIDSVAX and other products. Our technology, including
technology licensed from Genentech, 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. As a result, our success depends on our ability and
Genentechs ability, to:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | obtain
patents;
| | - | ---------------

| |  | protect
trade secrets;
| | - | ----------------------

| |  | operate
without infringing upon the proprietary rights of others; and
| | - | ---------------------------------------------------------------------

| |  | prevent
others from infringing on our proprietary rights.
| | - | ---------------------------------------------------------

|We cannot be certain that our patents
or patents that we license from Genentech will be enforceable and afford protection
against competitors. We cannot assure you that our operations or technology will not
infringe intellectual property rights of others. If we infringe the intellectual property
of others, there can be no assurance that we would be able to obtain licenses to use the
technology on commercially reasonable terms or at all.


Risks Relating to Our
Relationship with Genentech and Our Relationships with other Third Parties


We intend to rely on third
parties for the production, sales or marketing of our vaccines if they are successfully
developed. Our dependence on third parties may delay or impair our ability to generate
revenues, or adversely affect our profitability.


Since inception we have been
primarily focused on research and development of AIDSVAX. We lack any sales or marketing
history, and as of present do not have plans on developing internally such capability. We
intend to rely on third parties for the sales and marketing of our products. Our lack of
sales and marketing personnel and distribution relationships may impair our ability to
generate revenues. We are also entirely dependent on third parties to produce AIDSVAX. To
date, we have relied on Genentech for this purpose. Genentech currently has an exclusive
option to manufacture AIDSVAX, although they have consented to our participation in
Celltrion, our South Korean manufacturing joint venture. Our license agreement with
Genentech does not specify the price we will be required to pay Genentech to manufacture
AIDSVAX. Genentech is not able to assure us that it will have adequate manufacturing
capacity to produce AIDSVAX for us on a commercial scale.


Our license agreement with Genentech,
as amended effective as of May 1, 2002, permits Genentech to terminate the agreement, or
terminate the exclusivity of our license, if we:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | fail
to use due diligence in developing, seeking regulatory approval for, marketing or
commercializing products covered by the agreement;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------

| |  | fail
to file the first market approval application for AIDSVAX with the FDA prior to May 1,
2004; provided, that this date may be extended to May 1, 2006 if our Phase III clinical
trials do not meet all of their primary endpoints; or
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | breach
the license agreement and fail to cure the breach within the time period provided in the
agreement.
| | - | ----------------------------------------------------------------------------------------------------------

|If Genentech were to terminate our
license agreement, we would not be able to develop or market AIDSVAX.


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


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

22
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|On May 23, 2001 we completed a
private placement in which we issued 20,000 shares of our Series A Preferred Stock and
warrants to purchase common stock for aggregate proceeds of $20,000,000. As of June 30,
2003, there were 585 shares of Series A Preferred Stock and warrants to purchase 608,658
shares of common stock outstanding. The terms of our Series A Preferred Stock, and the
warrants, give the holders the right to require us to redeem all of the outstanding Series
A Preferred Stock, common stock issued on exercise of the warrants, and/or the warrants,
under certain circumstances, including:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | on
May 23, 2004, with respect to the Series A Preferred Stock;
| | - | --------------------------------------------------------------

| |  | at
a 15% premium upon a change of control; and
| | - | ----------------------------------------------

| |  | at
a 20% premium if we breach certain of our obligations under the purchase agreements, if
our stock is delisted or not quoted on an approved stock exchange or the Nasdaq National
Market or Small Cap Market for 5 consecutive days or if we are insolvent or certain
actions are taken as part of a bankruptcy proceeding.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our redemption of the Series A
Preferred Stock, common stock issued on conversion of the Series A Preferred Stock or on
exercise of the warrants, and/or the warrants, if any of these circumstances were to
happen they would require the expenditure of a significant amount of cash that could
substantially exceed the proceeds that we received in the private placement.


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


Our board of directors has the
authority to establish the designation of 19,979,500 additional shares of preferred stock
that are convertible into common stock without any action by our stockholders, and to fix
the rights, preferences, privileges and restrictions, including voting rights, of such
shares. The issuance and conversion of any such preferred stock would further dilute the
percentage ownership of our stockholders.


If the holders of the
Series A Preferred Stock and the warrants elect to have the Series A Preferred Stockand
the warrants assumed by a potential acquirer of VaxGen, or redeemed by VaxGen, the
acquirer could be deterred from completing the acquisition.


The Series A Preferred Stock and the
warrants permit the holders to elect to have their shares of Series A Preferred Stock and
the warrants remain outstanding after an acquisition of VaxGen and to have the acquirer
assume all of our obligations to the holder. The Series A Preferred Stock also permits the
holders of Series A Preferred Stock to require us to repurchase the Series A Preferred
Stock, at a premium, in connection with an acquisition. The ability to force an acquirer
to assume the Series A Preferred Stock and the warrants, and the ability to force us to
repurchase the Series A Preferred Stock at a premium, in the event of a merger could deter
a potential acquirer from completing an acquisition of VaxGen.


We may be required to
obtain the consent of the holders of Series A Preferred Stock before taking corporate actions,
which could harm our business.


Our certificate of incorporation
requires us to obtain the consent of the holders of the Series A Preferred Stock before we
may issue securities that have senior or equal rights as the Series A Preferred Stock or
incur unsecured indebtedness for borrowed money, or take other actions with respect to the
Series A Preferred Stock or securities that have fewer rights than the Series A Preferred
Stock. We are also required to obtain the consent of the holders of the Series A Preferred
Stock before we amend or modify our certificate of incorporation or bylaws to change any
of the rights of the Series A Preferred Stockholders. While these obligations may deter a
potential acquirer from completing a transaction with us, they may also prevent us from
taking corporate actions that would be beneficial to us and our stockholders.


Other Risks


If we are unable to
maintain our Nasdaq National Market listing, it could have a material adverse impact on our
stock price, the market for our stock and our ability to raise capital


Our common stock trades on The Nasdaq
National Market. In order to continue trading on The Nasdaq National Market, we must
satisfy the continued listing requirements for that market. While we are presently in
compliance with the continued listing requirements, we may not be able to maintain
compliance with them.


Under The Nasdaq National Market
continued listing requirements, the minimum net tangible asset requirement was replaced
with a minimum stockholders equity requirement of $10,000,000 and, if a company does
not have $10,000,000 of stockholders equity, it is required, among other things, to
maintain a minimum bid price of $1.00. If we fail to comply with this or the other
applicable continued listing requirements that became effective on November 1, 2002,
our common stock may be delisted from The Nasdaq National Market.



At June 30, 2003, our
stockholders equity was $16,713,000 and our closing stock price on August 1, 2003
was $4.24. A delisting of our common stock from The Nasdaq National Market would
materially reduce the liquidity of our common stock and result in a corresponding material
reduction in the price of our common stock. In addition, any such delisting would
materially adversely affect our ability to raise capital through alternative financing
sources on terms acceptable to us, or at all, which could materially harm our business.



If we are delisted from the Nasdaq
National Market, we will also face a variety of legal consequences that will likely
negatively affect our business including, without limitation, the following:
23
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | we
may lose our exemption from the provisions of Section 2115 of the California
Corporations Code, which imposes aspects of California corporate law on certain
non-California corporations operating within California. As a result, (1) our
stockholders would be entitled to cumulative voting, and (2) we would be subject to
more stringent stockholder approval requirements and more stockholder-favorable dissenters rights
in connection with certain strategic transactions;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
state securities law exemptions available to us would be more limited and, as a result,
future issuances of our securities may require time-consuming and costly registration
statements and qualifications; and
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | due
to the application of different securities law exemptions and provisions, we may be
required to amend our stock option and stock purchase plans and comply with
time-consuming and costly administrative procedures.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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


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

| |  | adverse
results or delays in clinical trials;
| | - | ---------------------------------------------

| |  | delays
in our product development efforts;
| | - | ------------------------------------------

| |  | failure
to win future government contracts for anthrax or smallpox;
| | - | -------------------------------------------------------------------

| |  | real
or perceived safety issues with any of our vaccine candidates;
| | - | -------------------------------------------------------------------

| |  | delays
in completion of our manufacturing facilities in South Korea and the U.S.;
| | - | ---------------------------------------------------------------------------------

| |  | changes
in financial estimates by securities analysts;
| | - | ------------------------------------------------------

| |  | rumors
about our business prospects, product development efforts or 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;
| | - | ---------------------------------------

| |  | sales
by our stockholders of substantial amounts of our common stock, including shares issued
upon exercise of outstanding options and warrants and conversion of the Series A
Preferred Stock; and
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | other
events or factors, many of which are beyond our control.
| | - | --------------------------------------------------------------

|In addition, the stock market in
general, and The Nasdaq National Market and biotechnology companies in particular, have
experienced extreme price and volume fluctuations that have often been unrelated or
disproportionate to the operating performance of these companies. Broad market and
industry factors may negatively affect the market price of our common stock, regardless of
actual operating performance. In the past, following periods of volatility in the market
price of a companys securities, securities class action litigation has often been
instituted against companies. This type of litigation, if instituted, could result in
substantial costs and a diversion of managements attention and resources, which
would harm our business.


ITEM 3. QUANTITATIVE AND
QUALITATIVE DISCLOSURES ABOUT MARKET RISK


Our exposure to market rate changes
is related primarily to our debt securities included in our investment portfolio. We do
not have any derivative financial instruments. 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, limit duration by restricting the term, and hold
investments to maturity except under rare circumstances. 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 impacted due to a rise in interest rates, while
floating rate securities may produce less income than expected if interest rates fall. Due
in part to these factors, our future investment income may decrease due to changes in
interest rates or due to losses we may suffer when securities decline in market value. At
June 30, 2003, we held government debt instruments and corporate obligations in the
principal amount of $6,705,000. If market interest rates were to increase immediately and
uniformly by 10% from levels at June 30, 2003, the fair value of our portfolio would
decline by an immaterial amount. Our exposure to losses as a result of interest rate
changes is managed through investing primarily in securities that mature in a period of
one year or less.



We have exposure to foreign exchange
rate risk primarily related to our conducting clinical trials in Thailand. Thailand is
currently considered an emerging economy. A material increase in the value of
Thailands currency against the U.S. Dollar could cause an increase in our expenses.
The majority of our contracts associated with conducting clinical trials in Thailand are
priced in Baht. For the six months ended June 30, 2003, we have incurred no foreign
exchange gains or losses.



ITEM 4. CONTROLS AND
PROCEDURES



Our
chief executive officer and principal financial officer are responsible for establishing
and maintaining disclosure controls and procedures, as such term is defined under Rule
13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended
(the Exchange Act). Based on their ongoing evaluation of the effectiveness of
the Companys disclosure controls and procedures, our chief executive officer and
principal financial officer concluded that our disclosure controls and procedures are
effective.


There were no significant changes
(including corrective actions with regard to significant deficiencies or material
weaknesses) in our internal controls over financial reporting in the fiscal quarter ended
June 30, 2003.
24
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART II  OTHER
INFORMATION


ITEM 1. LEGAL PROCEEDINGS


On March 17, 2003 a civil complaint
for violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 was filed
in the United States District Court for the Northern District of California, entitled
Janice Whitkens v. VaxGen, Inc., et al., Civil Action No. C03-1129 JSW. Named, as
defendants are VaxGen, Inc., Chief Executive Officer Lance K. Gordon and President Donald
P. Francis, M.D. The plaintiff seeks to represent a class of persons who purchased the
Companys securities between August 6, 2002 and February 26, 2003, and alleges that
the defendants misled investors about the progress of certain clinical trials and the
Companys future manufacturing and marketing plans. Management believes the Company
has strong defenses and intends to defend the action vigorously.



Following the filing of the Whitkens
complaint, several additional class action complaints were filed in the same court, each
making identical or similar allegations against the same defendants. These cases have been
consolidated with the Whitkens case into a single action. Management believes the
Company has strong defenses and intends to defend the action vigorously.


On or about March 21, 2003, two
separate but virtually identical shareholder derivative actions were filed in California
Superior Court for San Mateo County entitled Rhodes v. Allen, et al. Civil Action
No. CIV 430087, and MacDonald v. Allen, et al., Civil Action No. CIV 430088. These
cases have been consolidatd into a single action. Named as defendants in the consolidated
action are Company directors Lance K. Gordon, Donald P. Francis. M.D., Phillip W. Berman,
David W. Beier, Randall L-W. Caudill, Stephen C. Francis and William D. Young. Also named
as defendants are Paul Allen and Vulcan Ventures, Inc. The allegations of the consolidated
complaint mirror those contained in the class action, and plaintiffs allege as well that
Mr. Allen and Vulcan Ventures sold shares of the Companys stock while in possession
of material non-public information about the Company. Plaintiffs, purportedly suing on
behalf of the Company, assert claims against all defendants for breach of fiduciary duty,
abuse of control, mismanagement, waste and unjust enrichment, and against Mr. Allen and
Vulcan Ventures for breach of fiduciary duty and insider trading. Management believes the
Company has strong defenses and intends to defend the action vigorously.

25
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ITEM 6. EXHIBITS AND
REPORTS ON FORM 8-K


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


The following exhibits are filed as
part of this report:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|     | Incorporated by Reference | 
|---- | ------------------------- | 
|
|3.1  |                           | 
|     |                           | 
|3.2  |                           | 
|     |                           | 
|3.3  |                           | 
|4.1  |                           | 
|     |                           | 
|4.2  |                           | 
|     |                           | 
|     |                           | 
|4.3  |                           | 
|     |                           | 
|     |                           | 
|4.4  |                           | 
|     |                           | 
|     |                           | 
|4.5  |                           | 
|     |                           | 
|31.1 |                           | 
|     |                           | 
|31.2 |                           | 
|     |                           | 
|32.1 |                           | 
|     |                           | 

|(b)              Reports
on Form 8-K:


A current report on Form 8-K, dated
May 13, 2003, was filed with the Securities and Exchange Commission, reporting under Item
7 the press release announcing our first quarter financial results.


A current report on Form 8-K, dated
May 20, 2003, was filed with the Securities and Exchange Commission, reporting under Item
5 that on May 19, 2003, we commenced the offering of 1,742,160 shares of our common stock
at $2.87 per share pursuant to our Form S-3 shelf registration statement and that on May
20, 2003, we issued a press release announcing that we had raised $5,000,000, through the
sale of 1,742,160 shares of our common stock to a single institutional investor.


A current report on Form 8-K, dated
May 28, 2003, was filed with the Securities and Exchange Commission, reporting under Item
5 that we announced the U.S. Food and Drug Administration has cleared the Investigational
New Drug application for our anthrax vaccine candidate.


A current report on Form 8-K, dated
June 6, 2003, was filed with the Securities and Exchange Commission, reporting under Item
5 that we commenced the offering of 1,591,307 shares of our common stock at $4.3989 per
share pursuant to our Form S-3 shelf registration statement.


A current report on Form 8-K, dated
June 9, 2003, was filed with the Securities and Exchange Commission, reporting under Item
5 that we raised $7,000,000 through the sale of 1,591,307 newly issued shares of common
stock to a single institutional investor.


A current report on Form 8-K, dated
June 11, 2003, was filed with the Securities and Exchange Commission, reporting under Item
5 that we were awarded a phase 2 Small Business Innovation Research grant from the
National Institute of Allergy and Infectious Diseases, a part of the U.S. National
Institutes of Health, to identify novel antigens for potential use in future HIV vaccine
candidates.


A current report on Form 8-K, dated
June 24, 2003, was filed with the Securities and Exchange Commission, reporting under Item
5 that we opened our new biopharmaceutical manufacturing facility in South San Francisco,
California.
26
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Signatures


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


VaxGen, Inc.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Dated: August 14, 2003 | By: /s/ Carter A. LeeCarter A. LeeSenior
Vice PresidentFinance & Administration(Principal Financial Officer) |  | 
|---------------------- | ---------------------------------------------------------------------------------------------------------------------- |  | 

|27
|--