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**UNITED STATES            SECURITIES AND EXCHANGE COMMISSION            WASHINGTON, D.C. 20549**

**FORM            10-Q**

(Mark            One)
|   |                                                                                                                                      |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------|
| **x**  | **QUARTERLY REPORT                        PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES                        EXCHANGE ACT OF 1934** |

**For the            Quarterly Period Ended March 31, 2006**

OR
|   |                                                                                                                                       |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------|
| **o**  | **TRANSITION REPORT                        PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES                        EXCHANGE ACT OF 1934** |

*Commission            File Number 0-26483*

**VaxGen,            Inc.**(Exact name of Registrant as Specified in its Charter)
|                                                                                                          |   |                                                        |
|---------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------|
| **Delaware**                                                                                                  |   | **94-3236309**                                              |
| (State or other                        jurisdiction of                        incorporation or organization)  |   | (I.R.S. Employer                        Identification No.) |
|                                                                                                          |   |                                                        |
| **349 Oyster Point                        Boulevard,                        South San Francisco, California** |   | **94080**                        (Zip Code)                 |
| (Address of Principal                        Executive Offices)                                               |   |                                                        |

**(650)            624-1000**(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether            the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of            the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter            period that the registrant was required to file such reports), and (2) has been subject            to such filing requirements for the past 90 days.

Yes o    No            x

Indicate by check mark whether            the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated            filer. See definition of “accelerated filer and large accelerated filer” in            Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer            o     Accelerated filer            x     Non-accelerated filer            o

Indicate by check mark whether            the registrant is a shell company (as defined in Rule 12b-2 of the Exchange            Act).

Yes o    No            x

The issuer has one class of            common stock with 33,106,523 shares outstanding as of June 29, 2007.

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**VaxGen,            Inc.**

**Form            10-Q**

**For the            Quarter Ended March 31, 2006**

**Table of            Contents**

|                           |   |                                                                                                                                      |                                                                        |   |     |
|--------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------|--------|----------|
|                           |   |                                                                                                                                      |                                                                        |   | **Page** |
|                           |   |                                                                                                                                      |                                                                        |   |          |
| Part                        I  |   | Financial                        Information                                                                                              |                                                                        |   |
| Item                        1  |   | Financial                        Statements (unaudited):                                                                                  |                                                                        |   |
|                           |   |                                                                                                                                      | Condensed                        Consolidated Balance Sheets                |   | 3        |
|                           |   |                                                                                                                                      | Condensed                        Consolidated Statements of Operations      |   | 4        |
|                           |   |                                                                                                                                      | Condensed                        Consolidated Statements of Cash Flows      |   | 5        |
|                           |   |                                                                                                                                      | Notes                        to Condensed Consolidated Financial Statements |   | 6        |
| Item                        2  |   | Management’s                        Discussion and Analysis of Financial Condition and Results of                        Operations |                                                                        |   |
|                           |   |                                                                                                                                      | Overview                                                                    |   | 16       |
|                           |   |                                                                                                                                      | Critical                        Accounting Policies and Estimates           |   | 18       |
|                           |   |                                                                                                                                      | Results                        of Operations                                |   | 18       |
|                           |   |                                                                                                                                      | Liquidity                        and Capital Resources                      |   | 21       |
| Item                        3  |   | Quantitative                        and Qualitative Disclosures About Market Risk                                                         |                                                                        | 25     |
| Item                        4  |   | Controls                        and Procedures                                                                                            |                                                                        | 26     |
|                           |   |                                                                                                                                      |                                                                        |   |     |
| Part                        II |   | Other                        Information                                                                                                  |                                                                        |   |
| Item                        1  |   | Legal                        Proceedings                                                                                                  |                                                                        | 28     |
| Item                        1A |   | Risk                        Factors                                                                                                       |                                                                        | 28     |
| Item                        2  |   | Unregistered                        Sales of Equity Securities and Use of Proceeds                                                        |                                                                        | 44     |
| Item                        3  |   | Defaults                        Upon Senior Securities                                                                                    |                                                                        | 44     |
| Item                        4  |   | Submission                        of Matters to a Vote of Security Holders                                                                |                                                                        | 44     |
| Item                        5  |   | Other                        Information                                                                                                  |                                                                        | 44     |
| Item                        6  |   | Exhibits                                                                                                                                  |                                                                        | 45     |
|                           |   |                                                                                                                                      |                                                                        |   |     |
|                           |   | Signatures                                                                                                                                |                                                                        | 45     |
|                           |   |                                                                                                                                      |                                                                        |   |     |
|                           |   | Certifications                                                                                                                            |                                                                        |   |

2

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**PART I —            FINANCIAL INFORMATION**

**Item 1.            Financial Statements**

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

|                                                                    |   |                                      |     |                                         |   |     |   |
|-------------------------------------------------------------------------|--------|-------------------------------------------|----------|----------------------------------------------|--------|----------|--------|
|                                                                    |   | **March 31,                        2006** |     | **December 31,                        2005** |   |
|                                                                    |   |                                           |     |                                              |   |
|                                                                    |
| **ASSETS**                                                              |   |                                      |     |                                         |   |     |   |
| Current                        assets:                                  |   |                                      |     |                                         |   |     |   |
| Cash and cash                        equivalents                        |   | $                                         | 10,209   |                                         | $      | 4,560    |   |
| Investment                        securities                            |   |                                      | 9,289    |                                         |   | 12,466   |   |
| Accounts                        receivable                              |   |                                      | 3,559    |                                         |   | 1,820    |   |
| Unbilled accounts                        receivable                     |   |                                      | 5,290    |                                         |   | 1,455    |   |
| Due from related                        party                           |   |                                      | 1,027    |                                         |   | 901      |   |
| Prepaid expenses and                        other current assets        |   |                                      | 1,639    |                                         |   | 4,638    |   |
|                                                                    |   |                                           |          |                                         |        |          |   |
| Total current                        assets                             |   |                                      | 31,013   |                                         |   | 25,840   |   |
| Investment in                        affiliate                          |   |                                      | 21,124   |                                         |   | 17,761   |   |
| Property and                        equipment                           |   |                                      | 32,237   |                                         |   | 32,275   |   |
| Restricted                        cash                                  |   |                                      | 3,300    |                                         |   | 3,278    |   |
| Other                        assets                                     |   |                                      | 2,566    |                                         |   | 2,679    |   |
|                                                                    |   |                                           |          |                                         |        |          |   |
| Total assets                                                            |   | $                                         | 90,240   |                                         | $      | 81,833   |   |
|                                                                    |   |                                           |          |                                         |        |          |   |
|                                                                    |
| **LIABILITIES AND                        STOCKHOLDERS’ EQUITY**   |   |                                      |     |                                         |   |     |   |
| Current                        liabilities:                             |   |                                      |     |                                         |   |     |   |
| Accounts                        payable                                 |   | $                                         | 6,749    |                                         | $      | 10,005   |   |
| Accrued and other                        current liabilities            |   |                                      | 7,982    |                                         |   | 11,272   |   |
| Derivative                        liability                             |   |                                      | 2,530    |                                         |   | 2,925    |   |
| Due to related                        party                             |   |                                      | 28       |                                         |   | —  |   |
|                                                                    |   |                                           |          |                                         |        |          |   |
| Total current                        liabilities                        |   |                                      | 17,289   |                                         |   | 24,202   |   |
| Convertible senior                        subordinated notes            |   |                                      | 30,055   |                                         |   | 29,967   |   |
| Deferred rent and                        other liabilities              |   |                                      | 3,687    |                                         |   | 3,519    |   |
|                                                                    |   |                                           |          |                                         |        |          |   |
| Total                        liabilities                                |   |                                      | 51,031   |                                         |   | 57,688   |   |
|                                                                    |   |                                           |          |                                         |        |          |   |
|                                                                    |
| Contingencies (Note                        11 and 13)                   |   |                                      |     |                                         |   |     |   |
|                                                                    |
| Stockholders’                        equity:                      |   |                                      |     |                                         |   |     |   |
| Common stock                                                            |   |                                      | 331      |                                         |   | 296      |   |
| Additional paid-in                        capital                       |   |                                      | 297,039  |                                         |   | 266,248  |   |
| Deferred stock                        compensation                      |   |                                      | —  |                                         |   | (348     | )      |
| Accumulated                        deficit                              |   |                                      | (264,924 | )                                            |   | (248,090 | )      |
| Accumulated other                        comprehensive income           |   |                                      | 6,763    |                                         |   | 6,039    |   |
|                                                                    |   |                                           |          |                                         |        |          |   |
| Total                        stockholders’ equity                 |   |                                      | 39,209   |                                         |   | 24,145   |   |
|                                                                    |   |                                           |          |                                         |        |          |   |
| Total liabilities and                        stockholders’ equity |   | $                                         | 90,240   |                                         | $      | 81,833   |   |
|                                                                    |   |                                           |          |                                         |        |          |   |

See accompanying            notes to condensed consolidated financial statements.

3

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

|                                                                                                  |   |                                                                           |    |     |   |    |   |
|-------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------|---------|----------|--------|---------|--------|
|                                                                                                  |   | **Three Months                        Ended                        March 31,** |    |
|                                                                                                  |   |                                                                                |         |          |        |         |   |
|                                                                                                  |   | **2006**                                                                       |    | **2005** |   |
|                                                                                                  |   |                                                                                |    |          |   |
| Revenues                                                                                              |   | $                                                                              | 6,304   |     | $      | 7,646   |   |
|                                                                                                  |   |                                                                                |         |     |        |         |   |
| Operating                        expenses:                                                            |   |                                                                           |    |     |   |    |   |
| Research and                        development                                                       |   |                                                                           | 14,176  |     |   | 15,502  |   |
| General and                        administrative                                                     |   |                                                                           | 6,646   |     |   | 7,127   |   |
|                                                                                                  |   |                                                                                |         |     |        |         |   |
| Total operating                        expenses                                                       |   |                                                                           | 20,822  |     |   | 22,629  |   |
|                                                                                                  |   |                                                                                |         |     |        |         |   |
| Loss from                        operations                                                           |   |                                                                           | (14,518 | )        |   | (14,983 | )      |
|                                                                                                  |   |                                                                                |         |     |        |         |   |
| Other income                        (expense):                                                        |   |                                                                           |    |     |   |    |   |
| Interest                        expense                                                               |   |                                                                           | (630    | )        |   | (126    | )      |
| Interest income and                        other                                                      |   |                                                                           | 267     |     |   | 52      |   |
| Valuation                        adjustments                                                          |   |                                                                           | 395     |     |   | — |   |
| Equity in loss of                        affiliate                                                    |   |                                                                           | (2,506  | )        |   | — |   |
| Gain on foreign                        currency transactions                                          |   |                                                                           | 158     |     |   | — |   |
|                                                                                                  |   |                                                                                |         |     |        |         |   |
| Total other expense,                        net                                                       |   |                                                                           | (2,316  | )        |   | (74     | )      |
|                                                                                                  |   |                                                                                |         |     |        |         |   |
| Net loss before                        minority interest                                              |   |                                                                           | (16,834 | )        |   | (15,057 | )      |
| Minority interest in                        loss of variable interest entity                          |   |                                                                           | — |     |   | 1,683   |   |
|                                                                                                  |   |                                                                                |         |     |        |         |   |
| Net loss                                                                                              |   | $                                                                              | (16,834 | )        | $      | (13,374 | )      |
|                                                                                                  |   |                                                                                |         |     |        |         |   |
| Basic and diluted                        net loss per share                                           |   | $                                                                              | (0.53   | )        | $      | (0.45   | )      |
|                                                                                                  |   |                                                                                |         |     |        |         |   |
| Weighted average                        shares used in computing basic and diluted net loss per share |   |                                                                           | 31,551  |     |   | 29,578  |   |
|                                                                                                  |   |                                                                                |         |     |        |         |   |

See accompanying            notes to condensed consolidated financial statements.

4

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

|                                                                                               |   |                                                                           |    |     |   |    |   |
|----------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------|---------|----------|--------|---------|--------|
|                                                                                               |   | **Three Months                        Ended                        March 31,** |    |
|                                                                                               |   |                                                                                |         |          |        |         |   |
|                                                                                               |   | **2006**                                                                       |    | **2005** |   |
|                                                                                               |   |                                                                                |    |          |   |
| Cash flows from                        operating activities:                                       |   |                                                                           |    |     |   |    |   |
| Net loss                                                                                           |   | $                                                                              | (16,834 | )        | $      | (13,374 | )      |
| Adjustments to                        reconcile net loss to net cash used in operating activities: |   |                                                                           |    |     |   |    |   |
| Gain on foreign                        currency transactions                                       |   |                                                                           | (158    | )        |   | — |   |
| Equity in loss of                        affiliate                                                 |   |                                                                           | 2,506   |     |   | — |   |
| Valuation                        adjustments                                                       |   |                                                                           | (395    | )        |   | — |   |
| Minority interest in                        loss of variable interest entity                       |   |                                                                           | — |     |   | (1,683  | )      |
|                                                                                               |
| Depreciation and                        amortization                                               |   |                                                                           | 1,578   |     |   | 1,065   |   |
| Stock-based                        compensation                                                    |   |                                                                           | 816     |     |   | 3,080   |   |
| Amortization of                        premiums and discounts on investment securities             |   |                                                                           | (4      | )        |   | 44      |   |
| Non-cash interest                        expense                                                   |   |                                                                           | 177     |     |   | — |   |
| Changes in assets and                        liabilities:                                          |   |                                                                           |    |     |   |    |   |
| Receivables                                                                                        |   |                                                                           | (5,574  | )        |   | (3,506  | )      |
| Prepaid expenses and                        other current assets                                   |   |                                                                           | 26      |     |   | (1,061  | )      |
| Accounts                        payable                                                            |   |                                                                           | (3,271  | )        |   | 1,040   |   |
| Accrued and other                        current liabilities                                       |   |                                                                           | (2,226  | )        |   | 2,723   |   |
| Due to/from related                        parties                                                 |   |                                                                           | (98     | )        |   | 80      |   |
| Deferred rent and other                        liabilities                                         |   |                                                                           | 888     |     |   | (35     | )      |
|                                                                                               |   |                                                                                |         |     |        |         |   |
| Net cash used in                        operating activities                                       |   |                                                                           | (22,569 | )        |   | (11,627 | )      |
|                                                                                               |   |                                                                                |         |     |        |         |   |
| Cash flows from                        investing activities:                                       |   |                                                                           |    |     |   |    |   |
| Purchase of property                        and equipment                                          |   |                                                                           | (1,540  | )        |   | (16,656 | )      |
| Proceeds from sale of                        investment in affiliate                               |   |                                                                           | 2,399   |     |   | — |   |
| Proceeds from sale and                        maturities of investment securities                  |   |                                                                           | 3,219   |     |   | 4,974   |   |
| Other                                                                                              |   |                                                                           | (22     | )        |   | (532    | )      |
|                                                                                               |   |                                                                                |         |     |        |         |   |
| Net cash provided by                        (used in) investing activities                         |   |                                                                           | 4,056   |     |   | (12,214 | )      |
|                                                                                               |   |                                                                                |         |     |        |         |   |
| Cash flows from                        financing activities:                                       |   |                                                                           |    |     |   |    |   |
| Proceeds from private                        placement, net                                        |   |                                                                           | 25,226  |     |   | 9,482   |   |
| Proceeds from                        non-current obligations                                       |   |                                                                           | — |     |   | 2,368   |   |
| Other                                                                                              |   |                                                                           | (1,064  | )        |   | — |   |
|                                                                                               |   |                                                                                |         |     |        |         |   |
| Net cash provided by                        financing activities                                   |   |                                                                           | 24,162  |     |   | 11,850  |   |
| Effect of exchange                        rate changes on cash and cash equivalents                |   |                                                                           | — |     |   | 181     |   |
|                                                                                               |   |                                                                                |         |     |        |         |   |
| Increase (decrease)                        in cash and cash equivalents                            |   |                                                                           | 5,649   |     |   | (11,810 | )      |
| Cash and cash                        equivalents at beginning of period                            |   |                                                                           | 4,560   |     |   | 20,698  |   |
|                                                                                               |   |                                                                                |         |     |        |         |   |
| Cash and cash                        equivalents at end of period                                  |   | $                                                                              | 10,209  |     | $      | 8,888   |   |
|                                                                                               |   |                                                                                |         |     |        |         |   |

See accompanying            notes to condensed consolidated financial statements.

5

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**VaxGen,            Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

|   |             |
|--------|------------------|
| **1.** | **Organization** |

*          Nature            of Business Activities*

VaxGen, Inc., or VaxGen, is a            biopharmaceutical company focused on the development, manufacture and commercialization            of biologic products for the prevention and treatment of human infectious disease.            VaxGen’s business strategy focuses on the development and commercialization of            biologic products to counter potential bioterrorism threats, principally vaccines for            the long-term prevention of anthrax and smallpox.

VaxGen was incorporated on            November 27, 1995 and was formed to develop a vaccine intended to prevent human            immunodeficiency virus. In 2002, VaxGen broadened its product development portfolio to            also include biodefense vaccines.

VaxGen’s activities            involve inherent risks. These risks include, but are not limited to, the possibility            that internal controls are not or will not be adequate to ensure timely and reliable            financial information, the risk that VaxGen may not be able to raise additional            capital, the risk that VaxGen may fail to obtain any future government biodefense            contracts, the risk that VaxGen may fail to perform under any existing or future            contracts and the risk that VaxGen may be unable to commercialize its vaccine product            candidates.

VaxGen’s principal source            of revenue is the U.S. government, principally the National Institutes of Health, or            NIH, and related entities.

*          Delisting            from the Nasdaq National Market*

As a result of VaxGen’s            inability to timely file financial statements, it was delisted effective August 9, 2004            from the Nasdaq National Market, now the Nasdaq Global Market, or Nasdaq. Since that            time, VaxGen’s common stock has traded over the counter, or OTC, and has been            quoted on the Pink Sheets LLC under the symbol, VXGN.PK.

*          Basis            of Presentation*

The unaudited condensed            consolidated financial statements of VaxGen and its subsidiaries, collectively referred            to as the Company, included herein have been prepared pursuant to the rules and            regulations of the Securities and Exchange Commission, or SEC. The unaudited condensed            consolidated financial statements include the accounts of VaxGen, its subsidiaries,            VaxGen-Celltrion, Inc., or VCI, and Celltrion, Inc., or Celltrion, a company developing            and operating a mammalian cell culture biomanufacturing facility in the Republic of            Korea. All intercompany accounts and transactions have been eliminated in            consolidation. The unaudited condensed consolidated financial statements include the            accounts of VaxGen and VCI and Celltrion from January 1, 2004 through June 30, 2005.            The condition for control of entities is the ownership of a majority voting interest or            the ability to otherwise exercise control over the entity.

Certain information or footnote            disclosure normally included in financial statements prepared in accordance with            generally accepted accounting principles in the United States of America, or GAAP, have            been condensed or omitted pursuant to such rules and regulations. In the opinion of the            Company’s management, the accompanying unaudited condensed consolidated financial            statements contain all adjustments, consisting only of normal recurring adjustments,            considered necessary for a fair statement of the unaudited condensed consolidated            financial information included herein. While VaxGen believes that the disclosures are            adequate to make the information not misleading, these unaudited condensed consolidated            financial statements should be read in conjunction with VaxGen’s audited            financial statements contained in its Annual Report on Form 10-K for the year ended            December 31, 2005.

The results of operations for            the three month period ended March 31, 2006 are not necessarily indicative of the            operating results for the full year. The preparation of financial statements in            conformity with GAAP requires management to make estimates, judgments and assumptions            that affect the reported amounts of assets, liabilities, revenues, expenses and related            disclosures. While management believes its estimates, judgments and assumptions are            reasonable, the inherent nature of estimates is that actual results will likely be            different from the estimates made.

In September 2005, VaxGen            entered into an agreement to sell 1.2 million of its shares in Celltrion to a group of            Korean investors. Nexol Co., LTD, or Nexol, purchased 250,000 of these shares.            Subsequent to this transaction, Nexol and its affiliates, collectively, became the            largest stockholder of Celltrion. Upon this reconsideration event, VaxGen was no longer            the primary beneficiary of Celltrion and, in accordance with Interpretation No. 46,            *Consolidation of Variable Interest Entities*, was originally issued by the            Financial Accounting Standards Board, or FASB, in January 2003 and was revised in            December 2003, referred to, as revised, as FIN 46R, Celltrion has been deconsolidated            from VaxGen effective July 1, 2005. From July 1, 2005 through March 31, 2006            VaxGen’s investment in Celltrion was accounted for under the equity method. At            March 31, 2006, VaxGen’s ownership interest in Celltrion was 22%.

6

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|   |                                                                  |
|--------|-----------------------------------------------------------------------|
| **2.** | **Summary of                        Significant Accounting Policies** |

The Company’s significant            accounting policies are disclosed in the Company’s annual report of Form 10-K for            the year ended December 31, 2005 and have not changed significantly as of March 31,            2006, with the exception of the following:

*          Stock-Based            Compensation*

In January 2006, the Company            adopted the fair value recognition provisions of Financial Accounting Standards, or            FAS, No. 123 (revised 2004*), Share-Based Payment*, or FAS 123R, which requires            the recognition of the fair value of stock-based compensation for all stock-based            payment awards, including grants of stock options made to the Company’s employees            and directors. Under the fair value recognition provision of FAS 123R, stock-based            compensation is measured at the grant date based on the fair value of the awards            expected to vest and is recognized as expense ratably over the requisite service period            of the award. The Company uses the Black-Scholes valuation model to measure the fair            value of its stock-based awards utilizing various assumptions with respect to stock            price volatility, forfeiture rates, risk-free interest rates and expected life. If any            of the assumptions used in the Black-Scholes model change significantly, stock-based            compensation may differ materially in the future from that recorded in the current            period.

The Company adopted FAS 123R            using the modified prospective method which requires the application of the accounting            standard as of January 1, 2006. The Company’s unaudited condensed            consolidated financial statements for the three months ended March 31, 2006 reflect the            impact of FAS 123R. In accordance with the modified prospective method, the financial            statements for prior periods have not been restated to reflect, and do not include, the            impact of FAS 123R. Upon the adoption of FAS 123R in January 2006, the deferred stock            compensation balance of $0.3 million was reclassified to additional paid-in-capital.            The Company adopted the short-cut method for calculating the beginning balance of the            additional paid in capital pool, or APIC Pool, related to the tax effects of employee            stock-based compensation, and to determine the subsequent impact on the APIC pool and            Statement of Cash Flows of the tax effects of employee stock-based compensation awards            that are outstanding upon adoption of FAS 123R. The Company has not recognized excess            tax benefits related to employee stock-based compensation and, therefore, does not            currently have an APIC Pool because the related deductions are embedded in the            Company’s net operating loss carryforwards.

Prior to January 1, 2006, the            Company accounted for stock-based compensation based upon the provisions of Accounting            Principles Board, or APB, Opinion No. 25, *Accounting for Stock Issued to            Employees*, or APB 25, and had adopted the disclosure-only provisions of FAS No.            123, *Accounting for Stock-Based Compensation* and FAS No. 148, *Accounting for            Stock-Based Compensation—Transition and Disclosure—an Amendment of FASB            Statement No. 123,* or FAS 123.

Had compensation cost for the            Company’s stock-based compensation plans been determined in a manner consistent            with the fair value approach described in FAS 123, the Company’s net loss and net            loss per share would have been increased to the pro forma amounts, estimated on the            date of grant using the Black-Scholes option pricing model, indicated below (in            thousands, except per share data):

|                                                                                                                                                                                  |   |                                                                                |   |    |   |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------|--------|---------|--------|--------|
|                                                                                                                                                                                  |   | **Three Months                        Ended                        March 31, 2005** |   |
|                                                                                                                                                                                  |   |                                                                                     |        |    |
| Net loss – as                        reported                                                                                                                                   |   |                                                                                | $      | (13,374 | )      |   |
| Add: Stock-based                        employee compensation expense included in reported net loss, net of                        minority interest                                  |   |                                                                                |   | 2,968   |   |   |
| Less: Total stock-based                        employee compensation expense determined under fair value based method for                        all awards, net of minority interest |   |                                                                                |   | (4,309  | )      |   |
|                                                                                                                                                                                  |   |                                                                                |        |         |   |   |
| Net loss – pro                        forma                                                                                                                                     |   |                                                                                | $      | (14,715 | )      |   |
|                                                                                                                                                                                  |   |                                                                                |        |         |   |   |
| Net loss per share                        – basic and diluted, as reported                                                                                                      |   |                                                                                | $      | (0.45   | )      |   |
| Net loss per share                        – basic and diluted, pro forma                                                                                                        |   |                                                                                | $      | (0.50   | )      |   |

During the three months ended            March 31, 2005, there were no stock options granted by VaxGen and there were no            enrollments in the Employee Stock Purchase Plan. See Note 8, Stock Options, for further            discussion regarding stock-based compensation.

*          New            Accounting Pronouncements*

In April 2005, the FASB issued            FASB Interpretation Number, or FIN, 46(R)-6, *Determining the Variability to Be            Considered in Applying FASB Interpretation No. 46(R)*, or FSP FIN 46R-6. FSP FIN            46R-6 addresses certain major implementation issues related to FIN 46(R). Specifically,            FSP FIN 46R-6 addresses how a reporting enterprise should determine the variability to            be considered in applying FIN 46R. The variability that is considered in applying FIN            46R affects the determination of (a) whether the entity is a variable interest entity            or VIE, (b) which interests are “variable interests” in the entity, and (c)            which party, if any, is the primary beneficiary of the VIE. That variability will            affect any calculation of expected losses and expected residual returns, if such a            calculation is necessary. The effective date and transition requirements prescribed by            FSP FIN 46R-6 are complex. For example, an enterprise is required to apply the guidance            in the FSP prospectively to all entities (including newly created entities) with which            that enterprise first becomes involved and to all entities previously required to be            analyzed under FIN 46R when a “reconsideration event” has occurred as            defined in FIN 46R beginning the first day of the first reporting period beginning            after June 15, 2006. Retrospective

7

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application is permitted but not            required; however, a company that chooses retrospective application must do so no later            than the end of the first annual reporting period ending after July 15, 2006. The            Company does not expect the adoption of FSP FIN 46R-6 will have a material impact on            its consolidated financial position, results of operations or cash flows.

In February 2006, the FASB            issued FAS No. 155, *Accounting for Certain Hybrid Financial Instruments*, or FAS            155, which amends FAS No. 133, *Accounting for Derivative Instruments and Hedging            Activities,* and FAS No. 140, *Accounting for Transfers and Servicing of Financial            Assets and Extinguishments of Liabilities*, and improves the financial reporting of            certain hybrid financial instruments by requiring more consistent accounting that            eliminates exemptions and provides a means to simplify the accounting for these            instruments. Specifically, FAS 155 allows financial instruments that have embedded            derivatives to be accounted for as a whole (eliminating the need to bifurcate the            derivative from its host) if the holder elects to account for the whole instrument on a            fair value basis. FAS 155 is effective for all financial instruments acquired or issued            after the beginning of an entity’s first fiscal year that begins after September            15, 2006. The Company does not expect the adoption of FAS 155 will have a material            impact on its consolidated financial position, results of operations or cash            flows.

In March 2006, the FASB Emerging            Issues Task Force, or EITF, reached a tentative consensus on Issue No. 06-3, *How            Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be            Presented in the Income Statement (That Is, Gross Versus Net Presentation)*, or EITF            06-3. EITF 06-3 addresses income statement classification and disclosure requirements            of externally-imposed taxes on revenue-producing transactions. EITF 06-3 is effective            for periods beginning after December 15, 2006. The Company does not expect the            implementation of EITF 06-3 to have a material impact on the Company’s            consolidated financial position, results of operations or cash flows.

In July 2006, the FASB issued            FIN 48, *Accounting for Uncertainty in Income Taxes—an interpretation of FASB            Statement No. 109*, or FIN 48, which clarifies the accounting for uncertainty in tax            positions. FIN 48 requires that the Company recognize in its financial statements the            impact of a tax position if that position is more likely than not of being sustained            upon audit, based on the technical merits of the position. FIN 48 is effective for            fiscal years beginning after December 15, 2006 which is the beginning of the            Company’s fiscal 2007. The Company does not expect the adoption of FIN 48 will            have a material impact on its consolidated financial position, results of operations or            cash flows.

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

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

In November 2006, the FASB            ratified EITF Issue No. 06-6, *Application of EITF Issue No. 05-7, ‘Accounting            for Modifications to Conversion Options Embedded in Debt Instruments and Related            Issues’*, or EITF 06-6. EITF 06-6 addresses the modification of a convertible            debt instrument that changes the fair value of an embedded conversion option and the            subsequent recognition of interest expense for the associated debt instrument when the            modification does not result in a debt extinguishment pursuant to EITF 96-19. The            consensus should be applied to modifications or exchanges of debt instruments occurring            in interim or annual periods beginning after November 29, 2006. The Company does not            expect the adoption of EITF 06-6 to have a material impact on its consolidated            financial position, results of operations or cash flows.

In November 2006, the FASB            ratified EITF Issue No. 06-7, *Issuer’s Accounting for a Previously Bifurcated            Conversion Option in a Convertible Debt Instrument When the Conversion Option No Longer            Meets the Bifurcation Criteria in FASB Statement No. 133, Accounting for Derivative            Instruments and Hedging Activities*, or EITF 06-7. At the time of issuance, an            embedded conversion option in a convertible debt instrument may be required to be            bifurcated from the debt instrument and accounted for separately by the issuer as a            derivative under FAS 133, based on the application of EITF Issue 00-19, *Accounting            for Derivative Financial Instruments Indexed to, and Potentially Settled in, a            Company’s Own Stock,* or EITF 00-19. Subsequent to the issuance of the            convertible debt, facts may change and cause the embedded conversion option to no            longer meet the conditions for separate accounting as a derivative

8

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instrument, such as when the            bifurcated instrument meets the conditions of EITF 00-19 to be classified in            stockholders’ equity. Under EITF 06-7, when an embedded conversion option            previously accounted for as a derivative under FAS 133 no longer meets the bifurcation            criteria under that standard, an issuer shall disclose a description of the principal            changes causing the embedded conversion option to no longer require bifurcation under            FAS 133 and the amount of the liability for the conversion option reclassified to            stockholders’ equity. EITF 06-7 should be applied to all previously bifurcated            conversion options in convertible debt instruments that no longer meet the bifurcation            criteria in FAS 133 in interim or annual periods beginning after December 15, 2006,            regardless of whether the debt instrument was entered into prior or subsequent to the            effective date of EITF 06-7. Earlier application of EITF 06-7 is permitted in periods            for which financial statements have not yet been issued. The Company does not expect            the adoption of EITF 06-7 to have a material impact on its consolidated financial            position, results of operations or cash flows.

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

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

|   |                                          |
|--------|-----------------------------------------------|
| **3.** | **Net Loss per                        Share** |

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

|                                                         |   |                                 |   |     |   |    |   |
|--------------------------------------------------------------|--------|--------------------------------------|--------|----------|--------|---------|--------|
|                                                         |   | **March                        31,** |   |
|                                                         |   |                                      |   |
|                                                         |   | **2006**                             |   | **2005** |   |
|                                                         |   |                                      |   |          |   |
| Options to purchase                        common stock      |   |                                 | 4,572  |     |   | 4,617   |   |
| Warrants to purchase                        common stock     |   |                                 | 1,659  |     |   | 959     |   |
| Convertible senior                        subordinated notes |   |                                 | 2,134  |     |   | — |   |
|                                                         |   |                                      |        |     |        |         |   |
| Total                                                        |   |                                 | 8,365  |     |   | 5,576   |   |
|                                                         |   |                                      |        |     |        |         |   |

|   |                                          |
|--------|-----------------------------------------------|
| **4.** | **Comprehensive                        Loss** |

Comprehensive loss combines net            loss and other comprehensive income (loss). Other comprehensive income (loss)            represents certain amounts that are reported as components of stockholders’            equity in the consolidated balance sheet, including foreign currency translation            adjustments and unrealized gains or losses on investment securities.

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

|                                                                      |   |                                                                           |    |     |   |    |   |
|---------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------|---------|----------|--------|---------|--------|
|                                                                      |   | **Three Months                        Ended                        March 31,** |    |
|                                                                      |   |                                                                                |         |          |        |         |   |
|                                                                      |   | **2006**                                                                       |    | **2005** |   |
|                                                                      |   |                                                                                |    |          |   |
| Net loss                                                                  |   | $                                                                              | (16,834 | )        | $      | (13,374 | )      |
| Foreign currency                        translation adjustments           |   |                                                                           | 686     |     |   | 8,938   |   |
| Unrealized gains                        (losses) on investment securities |   |                                                                           | 38      |     |   | (97     | )      |
|                                                                      |   |                                                                                |         |     |        |         |   |
| Comprehensive                        loss                                 |   | $                                                                              | (16,110 | )        | $      | (4,533  | )      |
|                                                                      |   |                                                                                |         |     |        |         |   |

|   |                                                             |
|--------|------------------------------------------------------------------|
| **5.** | **Accrued and Other                        Current Liabilities** |

On September 30, 2003, the            National Institute of Allergy and Infectious Diseases, or NIAID, awarded the Company a            second cost-plus contract valued at $80.3 million for the advanced development of the            Company’s anthrax vaccine candidate, or 2003 Anthrax Contract. In December 2004,            NIAID terminated, for its convenience, a portion of the 2003 Anthrax Contract and            redirected the funds earmarked for the terminated portion into other contract            milestones, leaving the total contract value unchanged. The portion of the

9

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contract which was terminated            included activities VaxGen had subcontracted to a fill/finish service provider. In            March 2006, VaxGen agreed to pay this fill/finish service provider $1.5 million for            costs relating to the termination of the subcontract, which are not reimbursable under            the terms of VaxGen’s contract with NIAID. The Company’s accrued and other            current liabilities consist of the following (in thousands):

|                                                            |   |                  |   |                                         |   |   |   |   |    |   |   |
|-----------------------------------------------------------------|--------|-----------------------|--------|----------------------------------------------|--------|--------|--------|--------|---------|--------|--------|
|                                                            |   | **March 31,****2006** |   | **December 31,                        2005** |   |
|                                                            |   |                       |   |                                              |   |
| Employment                        benefits                      |   |                  | $      | 2,995                                        |   |   |   | $      | 6,380   |   |   |
| Refund due to                        customer on canceled grant |   |                  |   | 1,134                                        |   |   |   |   | 1,134   |   |   |
| Cash                        overdraft                           |   |                  |   | 1,064                                        |   |   |   |   | — |   |   |
| Sub-contractor                        settlement                |   |                  |   | 950                                          |   |   |   |   | 1,530   |   |   |
| Clinical trial                        expenses                  |   |                  |   | 883                                          |   |   |   |   | 829     |   |   |
| Other                                                           |   |                  |   | 956                                          |   |   |   |   | 1,399   |   |   |
|                                                            |   |                  |        |                                              |   |   |   |        |         |   |   |
|                                                            |   |                  | $      | 7,982                                        |   |   |   | $      | 11,272  |   |   |
|                                                            |   |                  |        |                                              |   |   |   |        |         |   |   |

|   |                                                  |
|--------|-------------------------------------------------------|
| **6.** | **Related Party                        Transactions** |

VaxGen provides services to            assist Celltrion with their operations. VaxGen is paid for out-of-pocket expenses and            services rendered. VaxGen recognized $0.4 million of revenue from Celltrion during the            three months ended March 31, 2006. These services were considered to be inter-company            in 2005, while Celltrion was consolidated with VaxGen, and therefore were            eliminated.

In February 2006, Celltrion and            VaxGen entered into an agreement, or Agreement to Provide U.S. GAAP Financial            Information, whereby Celltrion agreed to use its best efforts to timely prepare annual            and quarterly financial statements in accordance with U.S. GAAP. Under the agreement,            VaxGen agreed to reimburse Celltrion for all invoiced costs of the independent            accountants relating to the preparation of U.S. GAAP financial statements as well as            all invoiced costs of audits and reviews performed by another independent registered            public accounting firm. In addition, VaxGen will compensate Celltrion for the cost of            internal resources utilized in support of these activities at a rate of 190% of the            employee’s hourly wage; such costs shall not exceed the U.S. dollar equivalent of            300 million Korean Won (equivalent to $0.3 million at the exchange rate on March 31,            2006) per year and shall be subject to VaxGen’s approval. During the three months            ended March 31, 2006, the Company incurred $0.6 million of expenses under these            agreements.

|   |                                              |
|--------|---------------------------------------------------|
| **7.** | **Common Stock                        Offerings** |

VaxGen completed the following            private placement of common stock during the three months ended March 31,            2006:

|                                     |   |                                                |   |                                               |   |       |   |                               |   |   |   |   |      |   |   |   |   |   |   |
|------------------------------------------|--------|-----------------------------------------------------|--------|----------------------------------------------------|--------|------------|--------|------------------------------------|--------|--------|--------|--------|-----------|--------|--------|--------|--------|--------|--------|
| **Date**                                 |   | **Sales Price****Per                        Share** |   | **Closing Price                        Per Share** |   | **Shares** |   | **Net Proceeds****(in thousands)** |   |
|                                          |   |                                                     |   |                                                    |   |            |   |                                    |   |
| February 10,                        2006 |   |                                                | $      | 7.70                                               |   |       |   | $                                  | 9.20   |   |   |   | 3,500,000 |   |   | $      | 25,226 |   |   |

Financing costs associated with            this private placement were $1.7 million. In connection with this financing, VaxGen            issued to the accredited institutional investors five-year warrants initially            exercisable to purchase 699,996 shares of common stock at an exercise price of $9.24            per share. If VaxGen does not file all of its delinquent periodic reports with the SEC            by September 30, 2006 the warrants will become exercisable for an additional 350,000            shares of common stock, at a price of $9.24 per share. If VaxGen does not file all of            its delinquent periodic reports with the SEC by January 31, 2007, the warrants will            become exercisable for an additional 350,000 shares of common stock, at a price of            $9.24 per share. See Note 13, Subsequent Events, for a further discussion regarding            warrants.

As part of the February 2006            private placement and the November 2004 private placement, the Company agreed to file a            registration statement on Form S-1 no later than 30 days after the first day that the            Company becomes current with its reporting requirements under the Securities Exchange            Act of 1934, or Exchange Act. The registration statement will register for resale the            common stock issued in both transactions and the stock issuable upon exercise of the            warrants from the February 2006 transaction. The Company may be liable for liquidated            damages of 1% of the purchase price per month to holders of the shares and shares            issuable upon exercise of the warrants (a) if the registration statement is not filed            on or prior to 30 days of the Company becoming current in its reporting requirements;            (b) if the registration statement is not declared effective by the SEC on or prior to            120 days from filing; or (c) if the registration statement (after being declared            effective) ceases to be effective in a manner that violates such obligations. The            Company does not consider these liquidated damages to be probable or reasonably            estimable. Consequently, no reserves have been established for these            matters.

10

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|        |                                          |
|--------|-----------------------------------------------|
| **8.** | **Stock                        Options**      |
|   |                                          |
|   | *Vaxgen Stock                        Options* |

The Company has equity incentive            plans for its directors, officers and employees. The 1996 Stock Option Plan, or Plan,            has 4,750,000 shares of common stock reserved for issuance and a provision that            automatically increases this number by 3.5% of the issued and outstanding common stock            on the last trading day of the December immediately preceding each fiscal year through            January 2007. Options granted under the Plan may be designated as qualified or            nonqualified at the discretion of the Compensation Committee of the Board of Directors.            Generally, shares under option vest ratably over four years, beginning one year from            the date of grant; however, options can vest upon grant. Under the 1998 Director Stock            Option Plan, or Director Plan, new non-employee directors will receive an initial            option grant to acquire up to 30,000 shares at the fair market value of VaxGen’s            common stock on the grant date. Initial option grants vest over four years, with a            vesting schedule of one-forty-eighth (1/48th) of the shares vesting and            exercisable each month, beginning on the grant date, such that the option is completely            vested on the fourth anniversary of its grant date. All options expire no later than 10            years from the date of grant. Qualified stock options are exercisable at not less than            the fair market value of the stock at the date of grant and nonqualified stock options            are exercisable at prices determined at the discretion of the Board of Directors, but            not less than 85% of the fair market value of the stock at the date of            grant.

The following is a summary of            VaxGen’s stock option activity and related information for the years ended            December 31:

|                                                   |   |                                           |      |                                                                                                     |   |                                           |   |                                                                                                     |      |   |   |   |   |
|--------------------------------------------------------|--------|------------------------------------------------|-----------|----------------------------------------------------------------------------------------------------------|--------|------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------|-----------|--------|--------|--------|--------|
|                                                   |   | **2005**                                       |      | **2004**                                                                                                 |   |
|                                                   |   |                                                |      |                                                                                                          |   |
|                                                   |   | **Options                        Outstanding** |      | **Weighted                        Average                        Exercise                        Price** |   | **Options                        Outstanding** |   | **Weighted                        Average                        Exercise                        Price** |      |
|                                                   |   |                                                |      |                                                                                                          |   |                                                |   |                                                                                                          |      |
| Balance at beginning                        of year    |   |                                           | 4,634,671 |                                                                                                     | $      | 10.66                                          |   |                                                                                                     | 3,746,689 |   | $      | 10.37  |   |
| Granted                                                |   |                                           | —   |                                                                                                     |   | —                                        |   |                                                                                                     | 1,169,178 |   |   | 11.39  |   |
| Exercised                                              |   |                                           | —   |                                                                                                     |   | —                                        |   |                                                                                                     | (135,138  | )      |   | 7.57   |   |
| Forfeited                                              |   |                                           | (151,114  | )                                                                                                        |   | 11.14                                          |   |                                                                                                     | (146,058  | )      |   | 11.92  |   |
|                                                   |   |                                                |           |                                                                                                     |   |                                           |   |                                                                                                          |           |   |   |   |   |
| Balance at end of                        year          |   |                                           | 4,483,557 |                                                                                                     |   | 10.64                                          |   |                                                                                                     | 4,634,671 |   |   | 10.66  |   |
|                                                   |   |                                                |           |                                                                                                     |   |                                           |   |                                                                                                          |           |   |   |   |   |
| Options exercisable                        at year end |   |                                           | 3,685,372 |                                                                                                     |   | 10.91                                          |   |                                                                                                     | 2,734,164 |   |   | 11.41  |   |
|                                                   |   |                                                |           |                                                                                                     |   |                                           |   |                                                                                                          |           |   |   |   |   |

The following table summarizes            information about VaxGen’s stock options granted during the years ended December            31:

|                                                    |   |                                                                          |   |                                                                                                     |   |                                                                          |   |                                                                                                     |    |   |   |   |   |   |   |   |   |   |   |   |
|---------------------------------------------------------|--------|-------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------|---------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
|                                                    |   | **2005**                                                                      |   | **2004**                                                                                                 |   |
|                                                    |   |                                                                               |   |                                                                                                          |   |
| **Exercise price on                        grant date** |   | **Weighted                        Average Fair                        Value** |   | **Weighted                        Average                        Exercise                        Price** |   | **Weighted                        Average Fair                        Value** |   | **Weighted                        Average                        Exercise                        Price** |    |
|                                                         |   |                                                                               |   |                                                                                                          |   |                                                                               |   |                                                                                                          |    |
| Equals market                        price              |   |                                                                          | $      | —                                                                                                  |   |                                                                          |   | $                                                                                                        | — |   |   |   | $      | 9.27   |   |   |   | $      | 12.19  |   |
| Is below market                        price            |   |                                                                          |   | —                                                                                                  |   |                                                                          |   |                                                                                                     | — |   |   |   |   | 10.13  |   |   |   |   | 10.94  |   |

During the year ended December            31, 2005, no stock options were granted. During the year ended December 31, 2004,            745,500 options were granted at an exercise price below market price.

During the three months ended            March 31, 2006, the Company granted an option for 120,000 shares of VaxGen common stock            to a newly hired executive at an exercise price of $8.58 per share which was equal to            the fair market value on the date of grant. The fair value of this option on the date            of grant was $0.8 million. The option vests over four years with 25% of the shares            vesting on the one-year anniversary date and the remaining shares vesting in equal            monthly installments over the subsequent three years. At the time of the grant, neither            the options nor the shares of the common stock issuable upon exercise of the options            were registered under the Securities Act of 1933, or Securities Act. VaxGen granted            these options in a transaction exempt from the registration requirements of the            Securities Act by virtue of the exemption provided for in Section 4(2) of the Act. The            following is a summary of VaxGen’s stock option activity and related information            for the three months ended March 31, 2006:

|                                                         |   |                                           |      |                                                                                                     |   |                                                                                                                                                   |   |                                                  |   |   |   |      |   |
|--------------------------------------------------------------|--------|------------------------------------------------|-----------|----------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------|--------|--------|--------|-----------|--------|
|                                                         |   | **Options                        Outstanding** |      | **Weighted                        Average                        Exercise                        Price** |   | **Weighted                        Average                        Remaining                        Contractual                        Life (in years)** |   | **Aggregate Intrinsic                        Value*** |   |
|                                                         |   |                                                |      |                                                                                                          |   |                                                                                                                                                        |   |                                                       |   |
| Balance at January                        1, 2006            |   |                                           | 4,483,557 |                                                                                                     | $      | 10.64                                                                                                                                                  |   |                                                  |   |   |   |      |   |
| Granted                                                      |   |                                           | 120,000   |                                                                                                     |   | 8.58                                                                                                                                                   |   |                                                  |   |   |   |      |   |
| Forfeited                                                    |   |                                           | (31,504   | )                                                                                                        |   | 12.62                                                                                                                                                  |   |                                                  |   |   |   |      |   |
|                                                         |   |                                                |           |                                                                                                     |   |                                                                                                                                                   |   |                                                  |   |   |   |      |   |
| Balance at March 31,                        2006             |   |                                           | 4,572,053 |                                                                                                     |   | 10.57                                                                                                                                                  |   |                                                  | 2.4    |   | $      | 4,859,244 |   |
|                                                         |   |                                                |           |                                                                                                     |   |                                                                                                                                                   |   |                                                       |        |   |        |           |   |
| Options exercisable                        at March 31, 2006 |   |                                           | 3,816,418 |                                                                                                     |   | 10.82                                                                                                                                                  |   |                                                  | 2.4    |   | $      | 4,136,904 |   |
|                                                         |   |                                                |           |                                                                                                     |   |                                                                                                                                                   |   |                                                       |        |   |        |           |   |

|   |                                                                                                                                       |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------|
| *      | Based upon the                        closing price of the Company’s common stock of $8.80 on March 31,                        2006. |

11

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The aggregate intrinsic values            in the table above represent the total pretax intrinsic value (the difference between            the Company’s closing stock price on the last trading day of the three months            ended March 31, 2006 and the exercise price, multiplied by the number of in-the-money            options) that would have been received by the option holders had all option holders            exercised their options on March 31, 2006. This amount changes based upon the fair            market value of the Company’s common stock. The Company issues new shares upon            the exercise of options.

As of March 31, 2006, there was            approximately $3.6 million, net of expected forfeitures, of total unrecognized            stock-based compensation related to unvested arrangements granted under the            Company’s equity-based incentive plans. As of that date, this cost was expected            to be recognized over a weighted average period of 2.1 years. There were no options            exercised during the three months ended March 31, 2006 and 2005. The total fair value            of shares vested during the three months ended March 31, 2006 was $0.7            million.

|   |   |                                             |
|--------|--------|--------------------------------------------------|
|   |   | *Celltrion Stock                        Options* |

Celltrion grants employees stock            options subject to approval by its Board of Directors and stockholders. Celltrion            recorded $1.5 million as deferred compensation and additional paid-in capital for            option awards issued during 2004. Upon the deconsolidation of Celltrion in July 2005,            the $0.4 million remaining balance was reversed from additional paid-in capital and            deferred compensation.

|   |   |                                                   |
|--------|--------|--------------------------------------------------------|
|   |   | *Non-cash                        Compensation Expense* |

Non-cash compensation expense            for the three months ended March 31, 2006 and 2005 was $0.8 million and $3.1 million,            respectively. Such expense was primarily related to fair-value compensation of stock            options in 2006 as well as stock modifications. In 2005, the Board of Directors            authorized a modification to options held by employees who left the Company such that            the exercisability of the options were extended from 90 days following termination to            90 days following listing on a national securities exchange. In February 2006, the            Company further modified the period of exercisability from 90 days following listing on            a national securities exchange to 30 days following listing on a national securities            exchange. The Company recorded a non-cash expense for these modifications of $0.1            million during the three months ended March 31, 2006 and 2005. See Note 9, Employee            Stock Purchase Plan, for a further discussion regarding non-cash            compensation.

|   |   |                                                    |
|--------|--------|---------------------------------------------------------|
|   |   | *Impact of                        Adoption of FAS 123R* |

In January 2006, the Company            adopted the fair value recognition provision of FAS 123R, which requires the            recognition of the fair value of stock-based compensation expense for all stock-based            payment awards, including grants of stock options, made to the Company’s            employees and directors. Under the fair value recognition provision of FAS 123R,            stock-based compensation cost is estimated at the grant date based on the fair value of            the awards ultimately expected to vest and is recognized as expense ratably over the            requisite service period of the award. The Company uses the Black-Scholes valuation            model to estimate the fair value of its stock-based awards utilizing various            assumptions with respect to stock price volatility, forfeiture rates and expected life.            If any of the assumptions used in the Black-Scholes model change significantly,            stock-based compensation expense may differ materially in the future from that recorded            in the current period.

The Company uses various            subjective assumptions, including the following:

|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | *Expected                        Volatility*: The expected stock price volatility is based upon the                        Company’s historical volatility. The Company believes this method of                        computing volatility is more reflective and a better indicator of the                        expected future volatility, than using an average of a comparable market                        index or of a comparable company in the same industry. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   | • | *Expected Average                        Life*: The expected average life of the ten-year contractual term                        options granted in 2006 of 6.08 years is based upon application of the                        simplified method as promulgated in SEC Staff Accounting Bulletin No.                        107.                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   | • | *Risk-Free                        Interest Rate*: The risk-free rate for the expected term of stock                        options is based upon the rates for U.S. Treasury Bonds with terms equal to                        the options’ expected terms in effect at the time of                        grant.                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   | • | *Expected                        Dividend*: The Company has not paid and does not anticipate paying any                        dividends in the near future.                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   | • | *Estimated                        Pre-vesting Forfeitures*: When estimating forfeitures, the Company                        considers voluntary termination behaviors as well as trends of actual                        forfeitures of vested stock options.                                                                                                                                                                                                                    |

12

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The Company used the following            assumptions:

|                                               |   |                                                                                |                              |   |
|----------------------------------------------------|--------|-------------------------------------------------------------------------------------|-----------------------------------|--------|
|                                               |   | **Three Months                        Ended                        March 31, 2006** |                              |
|                                               |   |                                                                                     |                              |
| *VaxGen Stock                        Option Plans* |   |                                                                                |                              |   |
| Risk-free interest                        rate     |   |                                                                                | 4.9                               | %      |
| Expected average                        life       |   |                                                                                | 6.08                        years |   |
| Volatility                                         |   |                                                                                | 94                                | %      |

During periods following the            adoption of FAS 123R, the Company recorded stock-based compensation expense for awards            granted prior to, but not yet vested, as of December 31, 2005, using the fair value            method required for pro forma disclosure under FAS 123 in effect for expense            recognition purposes, adjusted for estimated forfeitures. The adoption had no effect on            cash flows.

The impact on consolidated            results of operations of recording stock-based compensation was as follows (in            thousands):

|                                                           |   |                                                                                |   |   |   |   |
|----------------------------------------------------------------|--------|-------------------------------------------------------------------------------------|--------|--------|--------|--------|
|                                                           |   | **Three Months                        Ended                        March 31, 2006** |   |
|                                                           |   |                                                                                     |   |
| Research and                        development                |   |                                                                                | $      | 572    |   |   |
| General and                        administrative              |   |                                                                                |   | 243    |   |   |
|                                                           |   |                                                                                |        |        |   |   |
| Effect on net                        income                    |   |                                                                                | $      | (815   | )      |   |
|                                                           |   |                                                                                |        |        |   |   |
| Effect on net income                        per share, basic   |   |                                                                                | $      | (0.03  | )      |   |
| Effect on net income                        per share, diluted |   |                                                                                | $      | (0.03  | )      |   |

|   |                                                    |
|--------|---------------------------------------------------------|
| **9.** | **Employee Stock                        Purchase Plan** |

The Company’s 2001            Employee Stock Purchase Plan, or ESPP, is implemented by a series of 24-month offering            periods, each referred to as an Offering Period and collectively referred to as            Offering Periods. Offering Periods were suspended effective July 1, 2004 as a result of            the Company’s delisting from Nasdaq. In March 2005, the Board of Directors            approved the extension of the Offering Period ending in March 2005 which resulted in a            modification of the terms of the underlying options. During the three months ended            March 31, 2005, the Company recorded $2.1 million in non-cash research and development            compensation expense and $0.7 million in non-cash general and administrative            compensation expense for this modification. In November 2005, the Company terminated            the ESPP.

|    |          |
|---------|---------------|
| **10.** | **Celltrion** |

VaxGen provided mammalian cell            culture technology and biologics production expertise as its 2002 investment in            Celltrion. VaxGen’s proportionate share of the investee’s undistributed            losses was recorded as equity in loss of affiliate through December 31, 2003. As a            result of the consolidation of VaxGen and Celltrion, from January 1, 2004 through June            30, 2005, this investment was eliminated in consolidation. Effective July 1, 2005, as a            result of the deconsolidation of Celltrion, VaxGen’s proportionate share of the            investee’s undistributed losses was again recorded as equity in loss of            affiliate.

Summarized selected financial            information used for the three months ended March 31, 2006 is as follows (in            thousands):

|                                        |   |     |    |   |
|---------------------------------------------|--------|----------|---------|--------|
|                                        |   | **2006** |    |
|                                        |   |          |    |
| Operating                        expenses   |   | $        | 10,918  |   |
|                                        |   |          |         |   |
| Loss from                        operations |   |     | (10,918 | )      |
| Other                        expense        |   |     | (1,275  | )      |
|                                        |   |          |         |   |
| Net loss                                    |   | $        | (12,193 | )      |
|                                        |   |          |         |   |

The results of operations of            Celltrion for the three months ended March 31, 2005 (while Celltrion was consolidated)            are as follows (in thousands):

|                                              |   |     |   |   |
|---------------------------------------------------|--------|----------|--------|--------|
|                                              |   | **2005** |   |
|                                              |   |          |   |
| Operating                        expenses:        |   |     |   |   |
| Research and                        development   |   | $        | 693    |   |
| General and                        administrative |   |     | 1,673  |   |
|                                              |   |          |        |   |
| Loss from                        operations       |   |     | (2,366 | )      |
| Other                        expense              |   |     | (202   | )      |
|                                              |   |          |        |   |
| Net loss                                          |   | $        | (2,568 | )      |
|                                              |   |          |        |   |

|    |              |
|---------|-------------------|
| **11.** | **Contingencies** |

Substantially all of            VaxGen’s revenue is derived from government contracts and grants. Future sales to            U.S. government agencies will depend, in part, on VaxGen’s ability to meet U.S.            government agency contract requirements. U.S. government contracts typically

13

----

contain unfavorable termination            provisions and are subject to audit and modification by the government at its sole            discretion. The U.S. government may terminate any of its contracts with VaxGen either            for its convenience or if VaxGen defaults by failing to perform in accordance with the            contract schedule and terms. If the U.S. government terminates any of its contracts,            the Company may be liable to sub-contractors, service providers or vendors for goods            and services that may no longer be reimbursable by the U.S. government.

|    |                                           |
|---------|------------------------------------------------|
| **12.** | **Segment                        Information** |

The Company’s segment            information has been prepared in accordance with FAS No. 131, *Disclosures about            Segments of an Enterprise and Related Information.* Prior to January 1, 2004 and            since July 1, 2005, the Company operated in one business segment. As a result of the            consolidation of Celltrion in 2004 and the deconsolidation of Celltrion in 2005, from            January 1, 2004 to June 30, 2005, the Company operated in two business segments.            Therefore, for the three months ended March 31, 2006 and 2005 the Company operated in            one segment and two segments, respectively. VaxGen’s business segment is the            development of vaccines that immunize against infectious disease and Celltrion’s            is mammalian cell culture biomanufacturing. Each segment has discrete financial            information and its own management structure. All of VaxGen’s operating assets            are located in the United States of America. At December 31, 2005 and March 31, 2006            VaxGen operated in one segment and therefore balance sheet segment information is not            presented below.

Substantially all of            VaxGen’s revenue is derived from federal government contracts and grants,            primarily from the U.S. Department of Health and Human Services, or HHS, the NIH and            related entities. From its inception through its deconsolidation from VaxGen as of July            1, 2005, Celltrion had not earned any revenues.

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

|         |   |                                                                           |   |     |   |    |   |
|--------------|--------|--------------------------------------------------------------------------------|--------|----------|--------|---------|--------|
|         |   | **Three Months                        Ended                        March 31,** |   |
|         |   |                                                                                |   |
| **Revenues** |   | **2006**                                                                       |   | **2005** |   |
|         |   |                                                                                |   |          |   |
| VaxGen       |   | $                                                                              | 6,304  |     | $      | 7,685   |   |
| Celltrion    |   |                                                                           | n/a    |     |   | — |   |
| Eliminations |   |                                                                           | n/a    |     |   | (39     | )      |
|         |   |                                                                                |   |          |   |
| Total        |   | $                                                                              | 6,304  |     | $      | 7,646   |   |
|         |   |                                                                                |   |          |   |

|                                                     |   |                                                                           |   |     |   |   |   |
|----------------------------------------------------------|--------|--------------------------------------------------------------------------------|--------|----------|--------|--------|--------|
|                                                     |   | **Three Months                        Ended                        March 31,** |   |
|                                                     |   |                                                                                |   |
| **Depreciation and                        Amortization** |   | **2006**                                                                       |   | **2005** |   |
|                                                     |   |                                                                                |   |          |   |
| VaxGen                                                   |   | $                                                                              | 1,578  |     | $      | 880    |   |
| Celltrion                                                |   |                                                                           | n/a    |     |   | 644    |   |
| Eliminations                                             |   |                                                                           | n/a    |     |   | (459   | )      |
|                                                     |   |                                                                                |   |          |   |
| Total                                                    |   | $                                                                              | 1,578  |     | $      | 1,065  |   |
|                                                     |   |                                                                                |   |          |   |

|                                        |   |                                                                           |     |   |     |    |   |
|---------------------------------------------|--------|--------------------------------------------------------------------------------|----------|--------|----------|---------|--------|
|                                        |   | **Three Months                        Ended                        March 31,** |     |
|                                        |   |                                                                                |     |
| **Interest                        Expense** |   |                                                                           | **2006** |   | **2005** |
|                                        |   |                                                                                |     |        |     |
| VaxGen                                      |   | $                                                                              | 630      |   | $        | — |   |
| Celltrion                                   |   |                                                                           | n/a      |   |     | 126     |   |
|                                        |   |                                                                                |     |        |     |
| Total                                       |   | $                                                                              | 630      |   | $        | 126     |   |
|                                        |   |                                                                                |     |        |     |

|                                                   |   |                                                                           |   |     |   |    |   |
|--------------------------------------------------------|--------|--------------------------------------------------------------------------------|--------|----------|--------|---------|--------|
|                                                   |   | **Three Months                        Ended                        March 31,** |   |
|                                                   |   |                                                                                |   |
| **Equity in Loss of                        Affiliate** |   | **2006**                                                                       |   | **2005** |   |
|                                                   |   |                                                                                |   |          |   |
| VaxGen (in                        Celltrion)           |   | $                                                                              | (2,506 | )        | $      | (885    | )      |
| Eliminations                                           |   |                                                                           | n/a    |     |   | 885     |   |
|                                                   |   |                                                                                |   |          |   |
| Total                                                  |   | $                                                                              | (2,506 | )        | $      | — |   |
|                                                   |   |                                                                                |   |          |   |

|                                |   |                                                                           |    |     |   |    |   |
|-------------------------------------|--------|--------------------------------------------------------------------------------|---------|----------|--------|---------|--------|
|                                |   | **Three Months                        Ended                        March 31,** |    |
|                                |   |                                                                                |    |
| **Net                        Loss** |   | **2006**                                                                       |    | **2005** |   |
|                                |   |                                                                                |    |          |   |
| VaxGen                              |   | $                                                                              | (16,834 | )        | $      | (13,335 | )      |
| Celltrion                           |   |                                                                           | n/a     |     |   | (2,951  | )      |
| Eliminations                        |   |                                                                           | n/a     |     |   | 2,912   |   |
|                                |   |                                                                                |    |          |   |
| Total                               |   | $                                                                              | (16,834 | )        | $      | (13,374 | )      |
|                                |   |                                                                                |    |          |   |

|                                                           |   |                                                                           |   |     |   |    |   |
|----------------------------------------------------------------|--------|--------------------------------------------------------------------------------|--------|----------|--------|---------|--------|
|                                                           |   | **Three Months                        Ended                        March 31,** |   |
|                                                           |   |                                                                                |   |
| **Purchases of                        Property and Equipment** |   | **2006**                                                                       |   | **2005** |   |
|                                                           |   |                                                                                |   |          |   |
| VaxGen                                                         |   | $                                                                              | (1,540 | )        | $      | (2,200  | )      |
| Celltrion                                                      |   |                                                                           | n/a    |     |   | (14,456 | )      |
|                                                           |   |                                                                                |   |          |   |
| Total                                                          |   | $                                                                              | (1,540 | )        | $      | (16,656 | )      |
|                                                           |   |                                                                                |   |          |   |

14

----

|    |                                         |
|---------|----------------------------------------------|
| **13.** | **Subsequent                        Events** |

*          Strategic            National Stockpile Contract*

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

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

In April 2007, the Company            entered into a settlement agreement with HHS. In accordance with the agreement, the            parties terminated the remaining cost-plus contract related to the development of a            next-generation anthrax vaccine through a separate contract modification. As part of            the settlement agreement, NIAID paid the Company $11.0 million. The settlement            agreement also released both parties of all liabilities associated with the            Company’s three anthrax government contracts: the 2002 Anthrax Contract, the 2003            Anthrax Contract and the SNS Contract. As part of the settlement agreement, the parties            converted the termination of the SNS Contract, which HHS terminated for default on            December 19, 2006, to a termination for convenience and also, terminated the 2003            Anthrax Contract under a bilateral contract modification for the convenience of the            government on a no-cost basis, effective April 3, 2007.

*          Restructurings*

In January 2007, the Company            restructured operations to significantly reduce operating costs and announced it is            actively pursuing avenues to enhance stockholder value through a strategic transaction.            The Company incurred restructuring costs associated with this plan, including employee            termination benefits of $2.9 million and costs associated with consolidation of its            facilities in California of $1.0 million. The majority of these costs were recovered            from the U.S. government as part of the April 2007 settlement agreement.

In May 2007, the Company reduced            its workforce to further reduce operating costs. Restructuring costs included employee            termination and benefit costs. Estimated costs of the restructuring are $0.6            million.

*          Agreements            between VaxGen and Celltrion*

During June and December 2006,            VaxGen received aggregate gross proceeds of $130.3 million from the sale of most of its            Celltrion common stock to Nexol and affiliates of Nexol. As a result, as of June 30,            2006, VaxGen was no longer entitled to hold two seats on Celltrion’s Board of            Directors or appoint a Representative Director. Accordingly, VaxGen no longer had the            ability to exercise significant influence over operating and financial policies of            Celltrion, and as of July 1, 2006, VaxGen’s investment in Celltrion will be            accounted for under the cost method in accordance with APB 29. In September 2006, the            joint venture agreement between VaxGen and the Korean Investors was terminated and the            Korean Investors entered into a Celltrion shareholders’ agreement. In November            2006, Celltrion’s stockholders approved the appointment of their non-VaxGen            Co-CEO as the sole CEO of Celltrion.

In            March 2007, Celltrion and VaxGen amended the Technical Support and Services            Sub-Agreement as well as the Agreement to Provide U.S. GAAP Financial Information to            reflect a reduction in overhead rate on services performed from 90% to 40%.

*          Smallpox*

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

*          $16.00            Warrants*

On September 21, 2004, the Company            completed a transaction in which warrants to purchase common stock issued in 2001 in            connection with its Series A Preferred Stock financing, or Series A Warrants, were            surrendered in exchange for two new series of warrants. The Company issued to the            holders of the Series A Warrants, warrants to purchase a total of 1,146,388 shares of            common

15

----

stock, exercisable until September            21, 2005, at an exercise price of $0.01 per share, and warrants to purchase a total of            655,078 shares of common stock, exercisable until September 21, 2007, at an exercise            price of $16.00 per share, or $16.00 Warrants. In December 2006, VaxGen entered into an            addendum, or Addendum, with the holders of the $16.00 Warrants under which the term was            extended by three additional years. The $16.00 Warrants, as amended, will expire            September 21, 2010. No other terms of the $16.00 Warrants were amended. In connection            with entering into the Addendum, VaxGen received releases from the holders of the            $16.00 Warrants regarding potential claims related to these warrants.

*          Private            Placement Warrants*

In February 2006, VaxGen raised net            proceeds of $25.2 million through a private placement to a group of accredited            institutional investors. In connection with this financing, VaxGen issued to the            investors five-year warrants initially exercisable to purchase 699,996 shares of common            stock at an exercise price of $9.24 per share. Because VaxGen did not file all of its            delinquent periodic reports with the SEC by September 30, 2006, the warrants became            exercisable for an additional 350,000 shares of common stock, at a price of $9.24 per            share. Because VaxGen again did not file all of its delinquent periodic reports with            the SEC by January 31, 2007, the warrants became exercisable for an additional 350,000            shares of common stock, at a price of $9.24 per share.

*          Executive            Officer Compensation*

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

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

***Special**Note**Regarding**Forward*-*Looking**Statements***

This discussion and analysis            should be read in conjunction with our Annual Report on Form 10-K for the year ended            December 31, 2005, and our unaudited condensed consolidated financial statements and            related notes thereto appearing in Item 1 of this Quarterly Report on Form 10-Q. In            addition to the other information contained or incorporated by reference in this            Quarterly Report on Form 10-Q, you should carefully consider the risk factors described            in Part II – Item 1A herein when evaluating an investment in our common stock.            This Quarterly Report includes “forward-looking statements” within the            meaning of Section 27A of the Securities Act, and Section 21E of the Securities            Exchange Act of 1934, or Exchange Act. All statements other than statements of            historical fact are “forward-looking statements” for purposes of these            provisions, including any statements of the plans and objectives of management for            future operations, any statements regarding future operations, any statements            concerning proposed new products or services, any statements regarding pending or            future mergers or acquisitions, any statements regarding future economic conditions or            performance, and any statement of assumptions underlying any of the foregoing. In some            cases, forward-looking statements can be identified by the use of terminology such as            “may,” “will,” “expects,” “plans,”            “anticipates,” “estimates,” “potential” or            “continue” or the negative thereof or other comparable            terminology.

There can be no assurance that            such expectations or any of the forward-looking statements will prove to be correct,            and actual results could differ materially from those projected or assumed in the            forward-looking statements. Our forward-looking statements are subject to inherent            risks and uncertainties including, but not limited to, the risk factors set forth in            this Quarterly Report. Factors that could cause or contribute to such differences            include, but are not limited to, our limited cash resources, our ability to finance our            research, our significant corporate and SEC-related expenses and limited revenue to            offset these expenses, availability of appropriate prospective acquisitions or            investment opportunities, litigation and the risks discussed in our other SEC filings.            All forward-looking statements and reasons why results may differ included in this            Quarterly Report are made as of the date hereof, and we assume no obligation to update            any such forward-looking statement or reason why actual results might differ. When used            in the report, unless otherwise indicated, “we,” “our” and            “us” refers to VaxGen.

**OVERVIEW**

We are a biopharmaceutical            company focused on the development, manufacture and commercialization of biologic            products for the prevention and treatment of human infectious disease. Our business            strategy focuses on the development and commercialization of biologic products to            counter potential bioterrorism threats, principally vaccines against inhalation anthrax            and smallpox. We were incorporated in 1995 and formed to complete the development of an            investigational recombinant protein vaccine intended to prevent

16

----

infection by human            immunodeficiency virus. In 2002, we broadened our product development portfolio to also            include biodefense vaccines.

On August 6, 2004, we announced            that we had received notification from Nasdaq that our stock would discontinue trading            on Nasdaq effective August 9, 2004. This action followed our appeal to Nasdaq for a            listing extension after not meeting the stated time requirements to file Quarterly            Reports on Form 10-Q for the quarters ended March 31 and June 30, 2004, respectively.            We intend to apply for relisting on Nasdaq or listing on another exchange upon filing            our remaining, outstanding and delinquent reports. Our common stock is currently quoted            on the OTC Pink Sheets under the symbol VXGN.PK.

In February 2006, we raised net            proceeds of $25.2 million through a private placement to a group of accredited            institutional investors.

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

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

**Celltrion**

Prior to implementing the            consolidation provisions within Interpretation No. 46, *Consolidation of Variable            Interest Entities – an interpretation of ARB No. 51*, was originally issued by            the Financial Accounting Standards Board, or FASB, in January 2003 and was revised in            December 2003, referred to, as revised, as FIN 46R, on January 1, 2004, we had            reflected our investment in Celltrion, Inc., or Celltrion, in our consolidated            financial statements using the equity method. In September 2005, we entered into            agreements to sell 1.2 million of our shares in Celltrion to a group of Korean            investors and raise $15.1 million in gross proceeds. Nexol Co., Ltd, or Nexol,            purchased 250,000 of these shares. Subsequent to this transaction, Nexol and its            affiliates, collectively, became the largest stockholder of Celltrion. Upon this            reconsideration event, we were no longer the primary beneficiary of Celltrion and, in            accordance with FIN 46R, Celltrion was deconsolidated from VaxGen. From July 1, 2005            through March 31, 2006 our investment in Celltrion was accounted for under the equity            method. At March 31, 2006, our ownership interest in Celltrion was 22%.

Celltrion is a development stage            bio-manufacturing company incorporated on February 26, 2002 and since that date its            principal activities have consisted of design and construction of a manufacturing            facility in Incheon, Republic of Korea, and partially funding the construction of our            U.S. biopharmaceutical manufacturing facility, as well as raising capital and            recruiting scientific and management personnel.

**Subsequent            Events**

During 2006, we received gross            proceeds of $130.3 million from the sale of substantially all of our Celltrion common            stock to Nexol and affiliates of Nexol.

In December 2006, HHS terminated            for default the SNS Contract. In April 2007, we entered into a settlement agreement            with HHS, in which HHS modified the SNS Contract from a termination for default to a            termination for convenience. The settlement agreement also released both parties of all            liabilities associated with our three anthrax government contracts. We also mutually            terminated the 2003 Anthrax Contract for the convenience of the government.

In January and May 2007, we            restructured operations to significantly reduce operating costs and announced we were            actively pursuing avenues to enhance stockholder value through a strategic            transaction.

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

17

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In February 2007, the Board of            Directors granted to executive officers options for 1,590,000 shares and implemented an            option exchange program allowing executive officers to exchange old options for 714,700            shares for new options for 178,675 shares. The Board also approved two potential            retention bonus payments.

See Subsequent Events in Note 13 to            the unaudited condensed consolidated financial statements for more information            regarding events occurring after March 31, 2006.

**CRITICAL            ACCOUNTING POLICIES AND ESTIMATES**

Reference should be made to Item            7, Management’s Discussion and Analysis of Financial Condition and Results of            Operations, in our Annual Report on Form 10-K for the fiscal year ended December 31,            2005, filed with the SEC on May 30, 2007, for a description of our critical accounting            policies. There have been no significant changes to our policies since we filed that            report other than our adoption of FAS No. 123 (revised 2004*), Share-Based            Payment*, or FAS 123R

*          Stock-based            Compensation Expense*

Effective January 1, 2006, we            adopted the fair value recognition provisions of FAS 123R, using the modified            prospective transition method, and therefore have not restated prior periods’            results. Under this method we recognize compensation expense for all stock-based            payments granted after January 1, 2006, and prior to but not yet vested as of            January 1, 2006, in accordance with FAS 123R. Under the fair value            recognition provisions of FAS 123R, we recognize stock-based compensation net of            an estimated forfeiture rate and only recognize compensation cost for those shares            expected to vest on a straight-line basis over the requisite service period of the            award. Prior to FAS 123R adoption, we accounted for stock-based payments under APB            25 and accordingly, recognized compensation expense for options that were granted at an            exercise price below their deemed fair market value and for modifications to            options.

Determining the appropriate fair            value model and calculating the fair value of stock-based payment awards require the            input of various highly-subjective assumptions, including the expected life of the            stock-based payment awards, our stock price volatility and the expected forfeiture rate            of our options. Management determined the expected stock price volatility assumption            based upon the Company’s historical volatility. We believe this method of            computing volatility is more reflective and a better indicator of the expected future            volatility, than using an average of a comparable market index or of a comparable            company in the same industry. The expected term of options granted was derived from the            short-cut method described in SEC’s SAB No. 107. The risk-free rate for the            expected term of the option is based on the U.S. Treasury yield curve in effect at the            time of grant. The assumptions used in calculating the fair value of stock-based            payment awards represent management’s best estimates, but these estimates involve            inherent uncertainties and the application of management judgment. As a result, if            factors change and we use different assumptions, our stock-based compensation expense            could be materially different in the future. In addition, we are required to estimate            the expected forfeiture rate and only recognize expense for those shares expected to            vest. If our actual forfeiture rate is materially different from our estimate, the            stock-based compensation expense could be significantly different from what we have            recorded in the current period. See Note 2 and 8 to the Condensed Consolidated            Financial Statements for a further discussion on stock-based compensation.

**RESULTS OF            OPERATIONS**

**Comparison of Fiscal Quarters            Ended March 31, 2006 and 2005**

|     |   |                                                                           |              |                                                                       |   |              |   |   |   |   |
|----------|--------|--------------------------------------------------------------------------------|-------------------|----------------------------------------------------------------------------|--------|-------------------|--------|--------|--------|--------|
|     |   | **Three Months                        Ended                        March 31,** |              | **Percent                        change                        2006/2005** |   |              |
|     |   |                                                                                |              |                                                                       |   |
|     |   | **2006**                                                                       |              | **2005**                                                                   |   |              |   |
|     |   |                                                                                |                   |                                                                       |        |                   |   |        |   |   |
|     |   | **(in                        thousands)**                                      |              |                                                                       |   |              |
| Revenues |   | $                                                                              |   6,304 |                                                                       | $      |   7,646 |   | (18%)  |   |   |

Revenues in the three months            ended March 31, 2006 and 2005 were primarily from our Anthrax Contracts principally            reflecting work performed for NIAID. In 2006, NIAID-related activities decreased from            the comparable period in the prior year as our efforts shifted from work done under the            Anthrax Contracts to work under the SNS Contract. Related party services revenues were            earned as part of a consulting services agreement with Celltrion to provide technical            assistance related to the design, engineering and construction of Celltrion’s            manufacturing facility. VaxGen recognized $0.4 million of revenue from Celltrion during            the three months ended March 31, 2006. These services were considered to be            inter-company in 2005, while Celltrion was consolidated with VaxGen, and therefore were            eliminated. The amounts earned vary with the level of services required. Celltrion did            not earn any revenues during these periods.

Revenues earned in one period            are not indicative of revenues to be earned in future periods. We expect future            quarters’ revenues to be progressively less, as efforts shift from work done            under the Anthrax Contracts to work under the SNS Contract or otherwise unfunded by            NAIAD.

18

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|                                                     |   |                                                                           |   |                                                                       |   |   |   |   |   |
|----------------------------------------------------------|--------|--------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------|--------|--------|--------|--------|--------|
|                                                     |   | **Three Months                        Ended                        March 31,** |   | **Percent                        change                        2006/2005** |   |
|                                                     |   |                                                                                |   |                                                                       |
|                                                     |   | **2006**                                                                       |   | **2005**                                                                   |   |   |
|                                                     |   |                                                                                |   |                                                                            |   |        |   |
|                                                     |   | **(in                        thousands)**                                      |   |                                                                       |   |
| Research and                        development expenses |   | $  14,176                                                            |   | $  15,502                                                        |   | (9%)   |   |

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

The decrease of $1.3 million in            research and development expenses in the three months ended March 31, 2006 over the            comparable period in 2005 was primarily due to:

|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                       |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | Costs for materials                        and supplies, which decreased by $2.3 million primarily associated with                        reduced activities related to our Anthrax Contracts;                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   | • | Non-cash                        compensation charges, which decreased by $1.7 million. In 2006, we recorded                        $0.5 million due to the adoption of FAS 123R. In 2005, we recorded $2.1                        million due to the modification of offering periods under our employee                        stock purchase plan and $0.1 million in other modification                        charges; |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   | • | Celltrion’s                        research and development expenses, which decreased by $0.7 million because                        effective July 1, 2005 Celltrion’s operating expenses were not                        included in our consolidated results;                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   | • | Outside consultant                        expenses, which increased by $0.8 million primarily due to additional                        operational assistance required since March 31, 2005;                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   | • | Labor and related                        expenses, which increased by $1.2 million primarily due to additional                        headcount since March 31, 2005; and                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   | • | Allocations from                        general and administrative expense for facilities and other overhead costs,                        which increased by $1.4 million due to increased operations since March 31,                        2005.                                                                                                                                                                        |

The process of conducting            preclinical studies and clinical trials necessary to obtain Food and Drug            Administration, or FDA, approval is costly and time consuming. The probability of            success for each product candidate and clinical trial may be affected by a variety of            factors, including, among others, the quality of product candidate early clinical data,            investment in the program, competition, manufacturing capabilities and commercial            viability. As a result of the uncertainties discussed above, the uncertainty associated            with clinical trial enrollments and the risks inherent in the development process, we            are unable to determine the duration and completion costs of current or future clinical            stages of our product candidates. Development timelines, probability of success and            development costs vary widely. While we are primarily focused on developing our anthrax            product candidate, we anticipate that we will make determinations as to which            additional programs to pursue and how much funding to direct to each program on an            ongoing basis in response to the scientific and clinical success of each product            candidate, as well as an ongoing assessment as to each product candidate’s            commercial potential.

We expect quarterly research and            development expenses to decrease substantially during the remainder of 2006 as our            efforts shift from work done under the Anthrax Contracts to work under the SNS            Contract.

*          General            and administrative expenses*

|                                                       |   |                                                                           |   |                                                                       |   |   |   |   |   |
|------------------------------------------------------------|--------|--------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------|--------|--------|--------|--------|--------|
|                                                       |   | **Three Months                        Ended                        March 31,** |   | **Percent                        change                        2006/2005** |   |
|                                                       |   |                                                                                |   |                                                                       |
|                                                       |   | **2006**                                                                       |   | **2005**                                                                   |   |   |
|                                                       |   |                                                                                |        |                                                                       |        |        |   |        |   |
|                                                       |   | **(in                        thousands)**                                      |   |                                                                       |   |
| General and                        administrative expenses |   | $  6,646                                                             |   | $  7,127                                                         |   | (7%)   |   |

The decrease of $0.5 million in            general and administrative expenses in the three months ended March 31, 2006 over the            comparable period of 2005 was primarily due to:

|   |   |                                                                                                                                                                                                                                                                           |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | Celltrion’s                        general and administrative expenses, which decreased by $1.7 million                        because effective July 1, 2005 Celltrion’s operating expenses were                        not included in our consolidated results; |
|   |   |                                                                                                                                                                                                                                                                           |
|   | • | Allocations to                        research and development expense for facilities and other overhead costs,                        which increased by $1.4 million (reducing general and administrative                        expenses);                                  |

19

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|   |   |                                                                                                                                                                                                                                                                                          |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | Facilities overhead                        costs, which increased by $0.9 million due to increased space and other                        costs incurred to support operations; and                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                          |
|   | • | Professional                        services, which increased by $1.7 million principally reflecting services                        consisting of consulting and legal fees associated with our efforts to                        comply with various reporting and regulatory requirements. |

We expect that quarterly general            and administrative expenses will be lower than the corresponding periods in 2005 during            the remainder of 2006, but will continue to reflect the significant resources required            to support our public reporting requirements.

*          Other            income (expense)*

|                                                         |   |                                                                           |         |     |   |    |   |
|--------------------------------------------------------------|--------|--------------------------------------------------------------------------------|--------------|----------|--------|---------|--------|
|                                                         |   | **Three Months                        Ended                        March 31,** |         |
|                                                         |   |                                                                                |         |
|                                                         |   | **2006**                                                                       |         | **2005** |   |
|                                                         |   |                                                                                |              |     |        |         |   |
|                                                         |   | **(in                        thousands)**                                      |         |
| Interest                        expense                      |   | $                                                                              | (630         | )        | $      | (126    | )      |
| Interest income and                        other             |   |                                                                           | 267          |     |   | 52      |   |
| Valuation                        adjustments                 |   |                                                                           | 395          |     |   | — |   |
| Equity in loss of                        affiliate           |   |                                                                           | (2,506       | )        |   | — |   |
| Gain on foreign                        currency transactions |   |                                                                           | 158          |     |   | — |   |
|                                                         |   |                                                                                |              |     |        |         |   |
| Other expense,                        net                    |   | $                                                                              |  (2,316 | )        | $      | (74     | )      |
|                                                         |   |                                                                                |              |     |        |         |   |

The increase in other expense            was primarily due to:

|   |   |                                                                                                                                                                                                                                                                                                                                                                 |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | Effective July 1,                        2005, we recognize our share of Celltrion’s losses under the equity                        method. For the three months ended March 31, 2005, Celltrion was                        consolidated with VaxGen;                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                 |
|   | • | In 2006, interest on                        our 5 1/2% Convertible Senior Subordinated Notes, due April 1, 2010, or                        Notes, was recorded, whereas in 2005, VaxGen did not have debt outstanding                        through March 31. In 2005, there was $0.1 million of interest expense on                        Celltrion’s debt; |
|   |   |                                                                                                                                                                                                                                                                                                                                                                 |
|   | • | Expenses for                        mark-to-market adjustments related to the valuation of our outstanding                        derivatives on our Notes, changed primarily due to changes in the                        likelihood of a change in control potentially triggering the redemption                        option related to the Notes;               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                 |
|   | • | Interest income and                        other increased primarily due to the increased cash, cash equivalent and                        investment balances from financing activities, primarily the private                        placement which occurred in February 2006; and                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                 |
|   | • | Realized foreign                        currency gains increased primarily due to the 2006 collection of the                        remaining proceeds from the 2005 sale of some of our Celltrion common                        stock.                                                                                                                              |

We anticipate future investment            income will fluctuate and will be primarily driven by our future cash, cash equivalent            and investment balances. Valuation adjustments will continue to be impacted by changes            in our common stock price, our volatility and our expectations relative to a change in            control. No changes in our debt levels are anticipated and therefore quarterly interest            expense is expected to remain at the three months ended March 31, 2006 level throughout            2006.

*          Minority            interest in loss of variable interest entity*

|                                                                         |   |                                                                           |   |               |   |   |   |
|------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------|--------|--------------------|--------|--------|--------|
|                                                                         |   | **Three Months                        Ended                        March 31,** |   |
|                                                                         |   |                                                                                |   |
|                                                                         |   | **2006**                                                                       |   | **2005**           |   |
|                                                                         |   |                                                                                |   |                    |   |
|                                                                         |   | **(in                        thousands)**                                      |   |
| Minority interest in                        loss of variable interest entity |   | $  —                                                           |   | $  1,683 |   |

Minority interest in loss of            variable interest entity for the three months ended March 31, 2005 reflects the            interests of Celltrion’s other stockholders in the net loss of Celltrion. For the            three months ended March 31, 2006, Celltrion was not consolidated with            VaxGen.

See Note 12, Segment            Information, included in the notes to the unaudited condensed consolidated financial            statements in Part I – Item 1 of this report for segment information.

20

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**LIQUIDITY            AND CAPITAL RESOURCES**

|                                                                                 |   |                                      |    |     |   |    |   |
|--------------------------------------------------------------------------------------|--------|-------------------------------------------|---------|----------|--------|---------|--------|
|                                                                                 |   | **2006**                                  |    | **2005** |   |
|                                                                                 |   |                                           |    |          |   |
|                                                                                 |   | **(in                        thousands)** |    |
| **As of March                        31:**                                           |   |                                      |    |     |   |    |   |
| Cash, cash                        equivalents and investment securities              |   | $                                         | 19,498  |     | $      | 29,165  |   |
| Working                        capital                                               |   |                                      | 13,724  |     |   | 8,414   |   |
|                                                                                 |   |                                      |    |     |   |    |   |
| **Three months                        ended March 31:**                              |   |                                      |    |     |   |    |   |
| Cash provided by                        (used in):                                   |   |                                      |    |     |   |    |   |
| Operating                        activities                                          |   | $                                         | (22,569 | )        | $      | (11,627 | )      |
| Investing                        activities                                          |   |                                      | 4,056   |     |   | (12,214 | )      |
| Financing                        activities                                          |   |                                      | 24,162  |     |   | 11,850  |   |
| Effect of exchange rate                        changes on cash and cash equivalents  |   |                                      | — |     |   | 181     |   |
| Capital expenditures                        (included in investing activities above) |   |                                      | (1,540  | )        |   | (16,656 | )      |

Our primary financing            requirements as of March 31, 2006 were the funding of our operations and expenditures            related to our manufacturing facility in California. Through March 31, 2006, we            financed our operations primarily through sales of our common stock, the issuance of            Series A Preferred Stock, the issuance of the Notes, sales of our Celltrion common            stock as well as through revenues from research contracts and grants. From            time-to-time, as part of our investment strategy, we enter into reverse repurchase            agreements to increase our return on investments and improve our liquidity. Reverse            repurchase agreements involve a purchase of securities and an agreement to resell the            same securities at a later date at an agreed-upon price. The primary risk associated            with short-term collateralized borrowings is that the counterparty might be unable to            perform under the terms of the contract. Our exposure is limited, however, because we            generally invest in overnight agreements.

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

In September 2005, we entered            into agreements to sell 1.2 million of our shares in Celltrion to a group of Korean            investors and raise $15.1 million in gross proceeds. Nexol purchased 250,000 of these            shares. Subsequent to this transaction, Nexol and its affiliates, collectively, became            the largest stockholder of Celltrion. Upon this reconsideration event, we were no            longer the primary beneficiary of Celltrion and, in accordance with FIN 46R, Celltrion            was deconsolidated from VaxGen. From July 1, 2005 through March 31, 2006 our investment            in Celltrion was accounted for under the equity method. At March 31, 2006, our            ownership interest in Celltrion was 22%. See Note 13, Subsequent Events, for a further            discussion regarding financings.

Our future capital requirements            will depend on several factors, including:

|   |   |                                                                                                                                                                                                                              |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | Our ability to                        negotiate government contracts or grants, particularly our ability to win                        contracts to continue to develop or to sell our product                        candidates; |
|   |   |                                                                                                                                                                                                                              |
|   | • | The timing of                        collection of accounts receivable from our government contracts and                        grants;                                                                                           |
|   |   |                                                                                                                                                                                                                              |
|   | • | Progress of internal                        research and development projects;                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                              |
|   | • | Levels and timing of                        capital expenditures on the manufacturing facilities in California;                        and                                                                                        |
|   |   |                                                                                                                                                                                                                              |
|   | • | Our ability to                        identify and exploit business development opportunities.                                                                                                                                    |

Net cash used in operating            activities of $22.6 million and $11.6 million for the three months ended March 31, 2006            and 2005, respectively, was primarily attributable to our operating losses although the            effect of non-cash charges upon net cash used in operating activities was significant            in both periods and included:

|   |   |                                                                                                                                                                                                                                                                                                                                       |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | Stock-based                        compensation expense of $0.8 million in 2006 and $3.1 million in 2005. The                        decrease from 2005 is primarily the result of modifications to the                        Company’s employee stock purchase plan in 2005;                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                       |
|   | • | Minority interest                        for the non-VaxGen share in the losses of Celltrion of zero in 2006 and                        $1.7 million in 2005. The decrease from 2005 is the result of the                        deconsolidation of Celltrion effective July 1, 2005;                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                       |
|   | • | Valuation                        adjustments of $0.4 million and zero in 2006 and 2005, respectively,                        reflecting changes in the fair value of outstanding derivatives. At March                        31, 2006, we had a derivative liability associated with the Notes. As a                        result of the |

21

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|                                                                                         |   |                                                                                                                                                                                                                                                                                                                                                                                   |
|----------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                         |   | conversion of the                        outstanding Series A Preferred Stock and the exchange of the associated                        warrants, no derivatives were outstanding during the three months ended                        March 31, 2005; and                                                                                                                             |
|                                                                                         |   |                                                                                                                                                                                                                                                                                                                                                                                   |
|                                                                                         | • | Depreciation and                        amortization of $1.6 million and $1.1 million, respectively. The increase                        primarily reflects the California manufacturing facility’s                        commencement of operations during late 2005.                                                                                                          |
|                                                                                         |   |                                                                                                                                                                                                                                                                                                                                                                                   |
| Cash used in                        operating activities was also affected by the following: |
|                                                                                         |   |                                                                                                                                                                                                                                                                                                                                                                                   |
|                                                                                         | • | Accrued and other                        current liabilities, which decreased by $2.2 million in 2006, increased by                        $2.7 million in 2005 primarily due to the $3.2 million payment during the                        three months ended March 31, 2006 of an ESPP Bonus accrual from December                        31, 2005 and the timing of other payments; |
|                                                                                         |   |                                                                                                                                                                                                                                                                                                                                                                                   |
|                                                                                         | • | Accounts payable,                        which decreased by $3.3 million in 2006, increased by $1.0 million in 2005                        primarily due to the timing of payments and the reduced level of operating                        activities at March 31, 2006; and                                                                                                         |
|                                                                                         |   |                                                                                                                                                                                                                                                                                                                                                                                   |
|                                                                                         | • | Receivables, which                        increased by $5.6 million in 2006 and by $3.5 million in 2005 primarily due                        to the timing of payments received from the U.S. government.                                                                                                                                                                              |

Net cash used in investing            activities consisted primarily of activities relating to the purchase and sale of            investment securities as well as capital expenditures. Capital expenditures in the            three months ended March 31, 2006 and 2005 were made in connection with the expansion            of the Korean manufacturing facility (zero and $14.5 million, respectively) and            research and development laboratories and leasehold improvements associated with the            California manufacturing and office facilities ($0.5 million and $1.7 million,            respectively). In addition, during the three months ended March 31, 2006 and 2005 we            purchased $1.0 million and $0.5 million, respectively, of software related to the            implementation of a new enterprise resource planning system. We collected the final            $2.4 million in cash due from the late 2005 sale of some of our Celltrion common stock            during the three months ended March 31, 2006. We expect minimal capital expenditures            during the remainder of 2006 because the Californian manufacturing facilities are now            substantially complete and Celltrion is no longer consolidated.

Net cash provided by our            financing activities increased to $24.2 million in the three months ended March 31,            2006 from $11.9 million in the comparable period in 2005. In February 2006, we raised            net proceeds of $25.2 million through a private placement of 3,500,000 shares of our            common stock at $7.70 per share at a discount to the $9.20 per share closing price. In            March 2005, Celltrion issued 1,949,700 shares of preferred stock at a price of 5,000            Korean Won ($4.99 equivalent) per share, resulting in proceeds of 9,749 million Korean            Won ($9.5 million equivalent). In January 2003, Celltrion obtained collaterized            long-term financing of 52,000 million Korean Won (equivalent to $44.2 million) with a            nine-year term from a Korean bank, or Loan. Funds from the Loan, $2.4 million in the            three months ended March 31, 2005, were used for construction of the Incheon            administration buildings and manufacturing facility.

At March 31, 2006, $19.5            million, or 22%, of our assets consisted of cash, cash equivalents and investment            securities. Working capital was $13.7 million at March 31, 2006, compared to $8.4            million at March 31, 2005. This $5.3 million increase in working capital is due            primarily to the following:

|   |   |                                                                                                                                                                                                                                                                                                                                                                               |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | Due to related                        parties, which decreased by $12.4 million primarily as a result of the                        deconsolidation of Celltrion effective July 1, 2005;                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                               |
|   | • | Partially offset by                        derivative liabilities, which increased by $2.5 million as a result the                        Notes and the resulting put option derivative, compared to no derivatives                        outstanding as of March 31, 2005;                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                               |
|   | • | Accrued and other                        current liabilities, which decreased by $4.9 million primarily due to the                        timing of payments; and                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                               |
|   | • | Cash, cash                        equivalents and investment securities, which decreased by $9.7 million                        primarily due to our operating losses for the twelve months ended March 31,                        2006 partially offset by the private placement in February 2006 and the                        2005 sale of some of our Celltrion common stock. |

We continually review            alternatives to obtain additional financing and to increase revenues by procuring            future contracts to supply anthrax and smallpox vaccines to the U.S. government and            other potential customers. Some of our alternatives to obtain additional financing            include the sale of our common stock, obtaining additional debt and the sale of some or            all of our investment in Celltrion. There can be no assurances that we will be            successful in these efforts. The reaudit of our financial statements for the three            years ended December 31, 2003, the resulting restatement of periodic reports previously            filed with the SEC, the lapsing of our resale registration statements, the extended            period while we have not been current in our SEC reporting and the delisting of our            common stock will likely have an adverse impact on whether financing will be available            or the terms of that financing. See Subsequent Events in Note 13 for further discussion            on additional financings.

**Off-Balance Sheet            Arrangements**

As of March 31, 2006, we did not            have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC            Regulation S-K.

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**Recent Accounting            Pronouncements**

In April 2005, the FASB issued            FIN 46(R)-6, *Determining the Variability to Be Considered in Applying FASB            Interpretation No. 46(R)*, or FSP FIN 46R-6. FSP FIN 46R-6 addresses certain major            implementation issues related to FIN 46(R). Specifically, FSP FIN 46R-6 addresses how a            reporting enterprise should determine the variability to be considered in applying FIN            46R. The variability that is considered in applying FIN 46R affects the determination            of (a) whether the entity is a variable interest entity or VIE, (b) which interests are            “variable interests” in the entity, and (c) which party, if any, is the            primary beneficiary of the VIE. That variability will affect any calculation of            expected losses and expected residual returns, if such a calculation is necessary. The            effective date and transition requirements prescribed by FSP FIN 46R-6 are complex. For            example, an enterprise is required to apply the guidance in the FSP prospectively to            all entities (including newly created entities) with which that enterprise first            becomes involved and to all entities previously required to be analyzed under FIN 46R            when a “reconsideration event” has occurred as defined in FIN 46R beginning            the first day of the first reporting period beginning after June 15, 2006.            Retrospective application is permitted but not required; however, a company that            chooses retrospective application must do so no later than the end of the first annual            reporting period ending after July 15, 2006. We do not expect the adoption of FAS 155            will have a material impact on our consolidated financial position, results of            operations or cash flows.

In February 2006, the FASB            issued FAS No. 155, *Accounting for Certain Hybrid Financial Instruments*, or FAS            155, which amends FAS No. 133, *Accounting for Derivative Instruments and Hedging            Activities* and FAS No. 140, *Accounting for Transfers and Servicing of Financial            Assets and Extinguishments of Liabilities*, and improves the financial reporting of            certain hybrid financial instruments by requiring more consistent accounting that            eliminates exemptions and provides a means to simplify the accounting for these            instruments. Specifically, FAS 155 allows financial instruments that have embedded            derivatives to be accounted for as a whole (eliminating the need to bifurcate the            derivative from its host) if the holder elects to account for the whole instrument on a            fair value basis. FAS 155 is effective for all financial instruments acquired or issued            after the beginning of an entity’s first fiscal year that begins after September            15, 2006. We do not expect the adoption of FIN 46(R)-6 will have a material impact on            our consolidated financial position, results of operations or cash flows.

In March 2006, the EITF reached            a tentative consensus on Issue No. 06-3, *How Sales Taxes Collected from Customers            and Remitted to Governmental Authorities Should Be Presented in the Income Statement            (That Is, Gross Versus Net Presentation),* or EITF 06-3. EITF 06-3 addresses income            statement classification and disclosure requirements of externally-imposed taxes on            revenue-producing transactions. EITF 06-3 is effective for periods beginning after            December 15, 2006. We do not expect the implementation of EITF 06-3 to have a material            impact on our consolidated financial position, results of operations or cash            flows.

In July 2006, the FASB issued            Interpretation No. 48, *Accounting for Uncertainty in Income Taxes—an            interpretation of FASB Statement No. 109*, or FIN 48, which clarifies the accounting            for uncertainty in tax positions. FIN 48 requires that we recognize in our financial            statements the impact of a tax position if that position is more likely than not of            being sustained upon audit, based on the technical merits of the position. FIN 48 is            effective for fiscal years beginning after December 15, 2006 which is the beginning of            our fiscal 2007. We do not expect the adoption of FIN 48 will have a material impact on            our consolidated financial position, results of operations or cash flows.

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

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

In November 2006, the FASB            ratified EITF Issue No. 06-6, *Application of EITF Issue No. 05-7, ‘Accounting            for Modifications to Conversion Options Embedded in Debt Instruments and Related            Issues’*, or EITF 06-6. EITF 06-6 addresses the modification of a convertible            debt instrument that changes the fair value of an embedded conversion option and the            subsequent recognition of interest expense for the associated debt instrument when the            modification does not result in a debt extinguishment pursuant to EITF            96-19.

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The consensus should be applied            to modifications or exchanges of debt instruments occurring in interim or annual            periods beginning after November 29, 2006. We do not expect the adoption of EITF 06-6            to have a material impact on our consolidated financial position, results of operations            or cash flows.

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

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

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

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**ITEM 3.            QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

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

*          Interest            Rate Risk*

We are exposed to market rate            changes by debt securities included in our investment portfolio. By policy, we invest            in debt instruments of the U.S. government, federal agencies and high-quality corporate            issuers, limit the amount of credit exposure to any one issuer, and limit duration by            restricting the term. Investments in both fixed rate and floating rate instruments            carry a degree of interest rate risk. Fixed rate securities may have their fair market            value adversely affected due to a rise in interest rates, while floating rate            securities may produce less income than expected if interest rates fall. Due in part to            these factors, our future investment income may decrease due to changes in interest            rates or due to losses we may suffer when securities decline in market value. At March            31, 2006, we held available-for-sale securities in the principal amount of $9.3            million. If market interest rates were to increase immediately and uniformly by 10%            from levels at March 31, 2006, the fair value of our portfolio would decline by an            immaterial amount, and would not have a significant effect on our operations or cash            flows. Our exposure to losses as a result of interest rate changes is managed through            investing in a portfolio of securities with a weighted-average maturity of one year or            less.

*          Indebtedness*

At March 31, 2006, our            outstanding non-current liabilities include $31.5 million of our Notes due April            1, 2010 which we sold in a private placement in April 2005. As the Notes bear interest            at a fixed rate, our interest expense under the Notes would not be affected by interest            rate changes. As of March 31, 2006, we did not invest in derivative financial            instruments, interest rate swaps or other investments that alter interest rate            exposure.

*          Foreign            Currency Risk*

Our exposure to foreign currency            exchange rates is related primarily to our investment in Celltrion. Our investment in            this international business is subject to risks, including, but not limited to,            differing economic conditions, changes in political climate, differing tax structures,            other regulations and restrictions and foreign exchange rate volatility when compared            to the United States dollar. Accordingly, our future results could be materially            affected by changes in these or other factors. As exchange rates vary, our share in            Celltrion’s results, when translated, may vary from expectations and could            adversely impact overall profitability. If market foreign currency exchange rates were            to change the impact would be reflected in the balance of our investment in Celltrion            and in accumulated other comprehensive income. Such a change would not have a            significant effect on our operations or cash flows. As of March 31, 2006, we did not            invest in derivative financial instruments, currency swaps or other investments that            alter foreign currency exposure.

*          Derivative            Valuation Risk*

The terms of our Notes include            put features not under our control. These features are considered to be an embedded            derivative liability and we determined the fair value of this derivative to be $1.8            million on the date of issuance. Due to the quarterly revaluation of the embedded            derivative liability, we recorded in our statements of operations other income of $0.4            million for the three months ended March 31, 2006. At March 31, 2006, the embedded            derivative liability was valued at $2.5 million. We determine the fair value of the            derivative liabilities using the Monte Carlo Simulation methodology. This methodology            allows flexibility in incorporating various assumptions such as probabilities of            certain triggering events. The valuations are based on the information available as of            the various valuation dates. Factors affecting the amount of these liabilities include            expectations regarding triggering events, the market value of our common stock, the            estimated volatility of our common stock, our market capitalization, the risk free            interest rate and other assumptions. The inputs for the valuation analysis of the            derivatives include the probabilities of certain triggering events, which we believed            to be unlikely as of March 31, 2006. A change in this probability and or a change in            the market value of our common stock could have a significant impact on the results of            our operations; however, there would not be any impact on our cash flows.

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**ITEM 4.            CONTROLS AND PROCEDURES**

***Disclosure Controls and            Procedures***

As required by Rule 13a-15(b)            under the Securities Exchange Act of 1934, as amended, we carried out an evaluation,            under the supervision and with the participation of our management, including our Chief            Executive Officer and Chief Financial Officer, of the effectiveness of the design and            operation of our disclosure controls and procedures as of the end of the period covered            by this report. Disclosure controls and procedures are designed to ensure that the            information required to be disclosed in our reports which we file or submit under the            Securities Exchange Act of 1934 is (i) accumulated and communicated to our management            (including the Chief Executive Officer and Chief Financial Officer) as appropriate to            allow timely decisions regarding required disclosures, and (ii) recorded, processed,            summarized and reported within the time periods specified in the SEC’s rules and            forms. Based upon the material weaknesses in our internal control over financial            reporting as described below, our Chief Executive Officer and Chief Financial Officer            have concluded that our disclosure controls and procedures were not effective as of the            end of the period covered by this report.

A material weakness is a control            deficiency, or combination of control deficiencies, that results in more than a remote            likelihood that a material misstatement of the annual or interim financial statements            will not be prevented or detected.

In conjunction with our most            recent evaluation of disclosure controls and procedures, improved focus on the            evaluation and reporting of deficiencies and progress made with respect to the            formulation of our remediation plans, we have enhanced our description of certain            previously reported material weaknesses in our internal control over financial            reporting as described below:

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 1)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | We did not maintain                        an effective control environment, specifically, the following material                        weaknesses were identified within the control environment:                                              |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | a)                                                                                                                                                                                                                                               | We did not maintain                        an effective control environment based on criteria established in                        *Internal Control-Integrated Framework* issued by the Committee of                        Sponsoring Organizations of the Treadway Commission, or COSO. Specifically,                        the financial reporting organization structure was not adequate to support                        the size, complexity or activities of the Company. In addition, certain                        finance positions were staffed with individuals who did not possess the                        level of accounting knowledge, experience and training in the application                        of GAAP commensurate with our financial reporting requirements.                                                                                                                                                                                                                                                                                                                                                                          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | b)                                                                                                                                                                                                                                               | We did not maintain                        effective financial reporting processes, including sufficient formalized                        and consistent finance and accounting polices and procedures; nor did we                        prevent or detect instances of non-compliance with certain such policies                        and procedures that do exist. Specifically, we lacked formalized reporting                        policies and procedures.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | c)                                                                                                                                                                                                                                               | We did not maintain                        effective monitoring controls and related segregation of duties over                        automated and manual transactions processes. Specifically, we failed to                        implement processes to ensure periodic monitoring of our existing internal                        control activities over financial reporting to identify and assess                        significant risk that may impact financial statements and related                        disclosures. Additionally, inadequate segregation of duties led to untimely                        identification and resolution of accounting and discourse matters and                        failure to perform timely and effective supervision and reviews.                                                                                                                                                                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| The above control                        deficiencies resulted in audit adjustments to our 2006 interim and annual                        consolidated financial statements. These control deficiencies affect                        substantially all financial statement accounts, which could result in a                        material misstatement to our interim or annual consolidated financial                        statements that would not be prevented or detected. |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | The material                        weakness in our control environment contributed to the existence of the                        following control deficiencies, each of which is considered to be a                        material weakness: |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | a)                                                                                                                                                                                                                                               | We did not maintain                        effective controls over our process to ensure the complete, accurate and                        timely preparation and review of our consolidated financial statements in                        accordance with GAAP. Specifically, we did not have effective controls over                        the process for identifying, accumulating and reviewing all required                        supporting information to ensure the completeness, accuracy and timely                        preparation and review of our consolidated financial statements and                        disclosures. This control deficiency resulted in audit adjustments to our                        fiscal 2006 interim and annual consolidated financial statements.                        Additionally, this control deficiency could result in a misstatement of                        substantially all financial statement accounts that would result in a                        material misstatement to our interim or annual consolidated financial                        statements that would not be prevented or detected. |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | b)                                                                                                                                                                                                                                               | We did not maintain                        effective controls to ensure that journal entries, both recurring and                        non-recurring, were consistently reviewed and approved in a timely manner                        to ensure the validity, completeness and accuracy of recorded entries. This                        control deficiency resulted in audit adjustments to our fiscal 2006 interim                        and annual consolidated financial statements. Additionally, this control                        deficiency could result in a misstatement of substantially all financial                        statement accounts that would result in a material misstatement to our                        interim or annual consolidated financial statements that would not be                        prevented or detected.                                                                                                                                                                                                                                                                                                           |

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|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | c)     | We did not maintain                        effective controls over the procurement process. Specifically, effective                        controls were not in place to ensure the appropriate controls over the                        approval of new vendors, authorization of purchase orders, including                        categorization of appropriate expense line items, the receipt of goods and                        the approval and authorization of vendor payments. This control deficiency                        could result in a misstatement of current liabilities and operating                        expenses that would result in a material misstatement to our interim or                        annual consolidated financial statements that would not be prevented or                        detected.                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   | d)     | We did not maintain                        effective controls over the completeness and accuracy of certain revenue                        and expense accruals. Specifically, we failed to identify, analyze and                        review certain accruals at period end relating to certain accounts                        receivable, accounts payable, accrued liabilities, revenue and other direct                        expenses to ensure that they were accurately, completely and properly                        recorded. This control deficiency resulted in audit adjustments to our                        fiscal 2006 interim and annual consolidated financial statements.                        Additionally, this control deficiency could result in a misstatement of the                        aforementioned accounts that would result in a material misstatement to our                        interim or annual consolidated financial statements that would not be                        prevented or detected.                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   | e)     | We did not maintain                        effective controls over the existence, completeness and valuation of fixed                        assets and related depreciation expense. Specifically, effective controls                        were not designed and in place to ensure that fixed asset additions and                        disposals were recorded, as well as, the periodic physical verification of                        fixed assets. This control deficiency resulted in audit adjustments to our                        fiscal 2006 interim and annual consolidated financial statements.                        Additionally, this control deficiency could result in a misstatement of                        fixed assets and depreciation expense that would result in a material                        misstatement to our interim or annual consolidated financial statements                        that would not be prevented or detected.                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   | f)     | We did not maintain                        effective controls over spreadsheets. Specifically, we did not maintain                        effective controls over the completeness, accuracy and validity of                        spreadsheets used in our financial reporting process to maintain effective                        version control and ensure that access was restricted to appropriate                        personnel, and that unauthorized modification of the data or formulas                        within spreadsheets was prevented. This control deficiency resulted in                        audit adjustments to our fiscal 2006 interim and annual consolidated                        financial statements. Additionally, this control deficiency could result in                        a misstatement of substantially all financial statement accounts that would                        result in a material misstatement to our interim or annual consolidated                        financial statements that would not be prevented or detected. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   | g)     | We did not design                        and maintain effective controls over the completeness, accuracy and                        valuation of our payroll and payroll expense. Specifically, we did not                        design and maintain effective controls over the administration of employee                        data or controls to provide reasonable assurance regarding the proper                        authorization of non-recurring payroll changes. This control deficiency                        could result in a misstatement of the aforementioned accounts that would                        result in a material misstatement to our interim or annual consolidated                        financial statements that would not be prevented or detected.                                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   | h)     | We did not design                        and maintain effective controls over the completeness, accuracy, existence                        and valuation of our research grant and contract revenue accounts.                        Specifically, we did not design and maintain effective controls to provide                        reasonable assurance that indirect and provisional rates used to calculate                        manufacturing overhead and technical overhead were complete and accurate.                        This control deficiency resulted in audit adjustments to our fiscal 2006                        interim and annual consolidated financial statements. Additionally, this                        control deficiency could result in a misstatement of the aforementioned                        accounts that would result in a material misstatement to our interim or                        annual consolidated financial statements that would not be prevented or                        detected.                                            |

As described in Item 9A of our            Annual Report on Form 10-K for the year ended December 31, 2005, which we refer to as            our 2005 10-K, our management has established a plan for remediation of the material            weaknesses in our internal control over financial reporting.

The certifications of our            principal executive officer and principal financial officer required in accordance with            Section 302 of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this            Quarterly Report on Form 10-Q. The disclosures set forth in this Item 4 contain            information concerning the evaluation of our disclosure controls and procedures and            changes in internal control over financial reporting, referred to in the            certifications. Those certifications should be read in conjunction with this Item 4 for            a complete understanding of the matters covered by the certifications.

Our management undertook and            completed reconciliations, analyses, reviews and control procedures in addition to            those historically completed to confirm that this Quarterly Report fairly presents in            all material aspects our financial position, results of operations and cash flows as            of, and for the period presented in accordance with U.S. generally accepted accounting            principles.

***Changes in Internal            Control over Financial Reporting***

There has been no change in            internal control over financial reporting in the fiscal quarter ended March 31, 2006,            that has materially affected, or is reasonably likely to materially affect, our            internal control over financial reporting. We continue to develop a

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remediation plan to address the            material weaknesses in our internal control over financial reporting. The development            of our remediation plan is described Item 9A of our 2005 10-K. We expect that the            implementation of this plan will extend throughout 2007.

***Inherent Limitations on            Effectiveness of Controls***

Our management, including the            Chief Executive Officer and Chief Financial Officer, does not expect that our            disclosure controls and procedures or our internal control over financial reporting            will prevent all error and all fraud. A control system, no matter how well designed and            operated, can provide only reasonable, not absolute, assurance that the objectives of            the control system are met. Because of the inherent limitations in all control systems,            no evaluation of controls can provide absolute assurance that all control issues and            instances of fraud, if any, within the Company have been detected.

**PART II            OTHER INFORMATION**

**ITEM 1.            LEGAL PROCEEDINGS**

None.

**ITEM 1A.            RISK FACTORS**

You should carefully consider            the following risk factors as well as other information in our filings under the            Exchange Act before making any investment decisions regarding our common stock. The            risks and uncertainties described herein are not the only ones we face. Additional            risks and uncertainties that we do not know or that we currently deem immaterial may            also impair our business, financial condition, operating results and prospects. If            events corresponding to any of these risks actually occur, they could materially            adversely affect our business, financial condition, operating results or prospects. In            that case, the trading price of our common stock could decline. When used in this            report, unless otherwise indicated, “we,” “our” and            “us” refers to VaxGen. Risk factors which have materially changed since our            2005 10-K are marked with an “*”.

**We do not have current            financial statements, and therefore you are not able to evaluate our current financial            condition or operating history and results.***

We have had to restate certain            historical financial statements and have engaged our new independent registered public            accounting firm to reaudit those financial statements. In July 2004, we announced that            we were reauditing and restating our financial statements for the fiscal years ended            December 31, 2003 and 2002 because we determined that we should recognize revenue from            certain government contracts as costs were incurred, instead of after completing            contract milestones. In October 2004, we announced that we would also be reauditing and            restating our financial statements for the fiscal year ended December 31, 2001. In            connection with the restatement of our financial statements for the fiscal year ended            December 31, 2001, we also made adjustments to our balance sheet as of December 31,            2000. In July 2005, we concluded that our historical accounting for our 2002 investment            in Celltrion was also not in conformity with generally accepted accounting principles            in the United States of America, or U.S. GAAP and was, therefore, inappropriate. Our            2002 and 2003 restated financial statements reflect the recording of our investment in            Celltrion at fair value and the recognition of our share of Celltrion’s net            losses using the equity method of accounting. This process has taken additional time to            complete and has delayed the completion of the reaudit and restatement of our financial            statements.

From January 1, 2004 to June 30,            2005, we were required to consolidate Celltrion’s financial statements into our            own. From July 1, 2005 to March 31, 2006, we were required to account for our            investment in Celltrion under the equity method. Celltrion maintains its records in            accordance with Korean accounting principles; however, we require financial statements            that are prepared in accordance with U.S. GAAP and which have been audited in            conformity with U.S. Auditing Standards. Celltrion maintains its records in accordance            with Korean accounting principles; however, we require financial statements that are            prepared in accordance with U.S. GAAP and which have been audited in conformity with            U.S. Auditing Standards. Celltrion’s internal control over financial reporting            may be insufficient to enable them to report their interim U.S. GAAP financial results            to us on a timely basis.

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

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

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

**We are currently ineligible            to register securities with the SEC, and we may never regain compliance.**

Until we have filed current            financial statements and made all the necessary filings with the SEC pursuant to            Sections 13 and 15(d) of the Exchange Act, we will not be able to register any            securities for re-sale. Until we are able to register securities with the SEC for            resale, any purchasers who purchase our common stock or other securities directly from            us will have to rely on an exemption from the federal and state securities laws in            order to resell their securities. We cannot estimate when, if ever, we will have filed            outstanding periodic reports and regained compliance with Sections 13 and 15(d) of the            Exchange Act.

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

We believe we need to correct            deficiencies in our internal controls and procedures for financial reporting. These            deficiencies include inadequate controls and procedures relating to revenue recognition            for government contracts, account reconciliations, segregation of duties, journal            entries, accounting for investments in affiliates, accounting for equity securities and            derivatives, accounting for stock-based compensation, cut-off procedures and depth of            accounting knowledge.

Failure to address these            deficiencies in a timely manner might increase the risk of future financial reporting            misstatements and may prevent us from being able to meet our filing deadlines. Under            the supervision of our Audit Committee, we are continuing the process of identifying            and implementing corrective actions where required to improve the design and            effectiveness of our internal controls, including the enhancement of systems and            procedures. Significant additional resources will be required to establish and maintain            appropriate controls and procedures and to prepare the required financial and other            information during this process.

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

|   |   |                                                                                                                                                                        |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | faulty human                        judgment and simple errors, omissions or mistakes;                                                                                      |
|   |   |                                                                                                                                                                        |
|   | • | collusion of two or                        more people;                                                                                                                     |
|   |   |                                                                                                                                                                        |
|   | • | inappropriate                        management override of procedures; and                                                                                                 |
|   |   |                                                                                                                                                                        |
|   | • | the risk that                        enhanced controls and procedures may still not be adequate to assure timely                        and reliable financial information. |

If we fail to have effective            internal controls and procedures for financial reporting in place, we could be unable            to provide timely and reliable financial information. Additionally, if we fail to have            effective internal controls and procedures for financial reporting in place, it could            adversely affect our financial reporting requirements under our government            contracts.

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

In February 2006, we raised net            proceeds of $25.2 million through a private placement to a group of accredited            institutional investors. We will, however, need to raise substantial additional capital            in order to satisfy the requirements under the SNS Contract for acceptance of our            anthrax vaccine and to continue operations. We may attempt to raise these funds through            equity or debt financings, collaborative arrangements with corporate partners or from            other sources, including the sale of all or a portion of our interest in Celltrion. The            reaudit of our financial statements for the three years ended December 31, 2003, the            resulting restatement of periodic reports previously filed with the SEC, the lapsing of            our resale registration statements, the extended period while we have not been current            in our SEC reporting and the delisting of our common stock will likely have an adverse            impact on whether financing will be available or the terms of that            financing.

If additional funds are raised            through the issuance of preferred equity or debt securities, these securities could            have rights, preferences and privileges senior or otherwise superior to those of our            common shares, and debt financings will likely involve covenants restricting our            business activities. Any sale of additional equity or convertible debt securities will            be dilutive to existing stockholders.

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We cannot guarantee you that            additional funds will be available on acceptable terms, or at all. If we are unable to            raise additional capital when necessary, we may be required to relinquish our rights to            certain key technologies, vaccine candidates or marketing territories under the terms            of certain of our collaborative agreements. Furthermore, if we are unable to raise            additional capital when necessary, we may be unable to perform under our existing            contracts, we may default on our contracts, our contracts may be terminated and we may            not be able to secure new contracts.

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

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

**If we fail to meet our            obligations under the Notes, our payment obligations may be accelerated.**

In April 2005, we raised gross            proceeds of $31.5 million through a private placement of Notes due April 1, 2010. The            Notes have the following features:

|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | require semi-annual                        payment of interest in cash at a rate of 5 1/2%;                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|   | • | convert, at the                        option of the holder, into shares of our common stock at an initial                        conversion price of approximately $14.76 per share subject to                        adjustment;                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|   | • | will be                        provisionally redeemable at our option in cash upon the occurrence of                        certain circumstances, including among others, that the closing price of                        VaxGen common stock exceeds approximately $22.14 per share subject to                        adjustment, for at least 20 trading days within a period of 30 consecutive                        trading days;                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|   | • | if a change in                        control, as defined in our indentures, occurs on or prior to the stated                        maturity of the Notes, the holders of the Notes may require us to                        repurchase the Notes and pay a make-whole premium to the holders of the                        Notes. If the holders request such a repurchase, we or the successor                        entity, may choose to pay in cash, common stock or a combination of cash                        and common stock; and |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|   | • | constitute senior                        subordinated obligations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |

Under the terms of the Notes, if            certain events occur, including, without limitation, our failure to pay any installment            of principal or interest due under the Notes, then the holders may, among other things,            elect to accelerate our obligations under the Notes and declare the outstanding            principal balance of the Notes and accrued but unpaid interest thereon immediately due            and payable. In the event that the holders declare the Notes immediately due and            payable or seek to foreclose on any of our assets, it would have a material adverse            effect on our financial position and we may not have sufficient cash to satisfy our            obligation.

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

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

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

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

**We may fail to meet the            requirements, as stated in our contract, for acceptance of our anthrax vaccine into the            SNS of the U.S. government, which could cause us to suffer losses and the contract to            be terminated.**

The U.S. government has            undertaken commitments to acquire improved countermeasures against bioterrorism,            including the stockpiling of vaccines for anthrax and smallpox. On November 4, 2004, we            were awarded the SNS Contract to supply the U.S. government with up to 75 million doses            of our anthrax vaccine candidate over five years. If we fail to meet the requirements            of the SNS Contract or otherwise breach the contract, the government could terminate            the SNS Contract. For example, we estimate that we will be prepared to deliver            validated drug product in the fourth quarter of 2006, rather than during the first half            of 2006 as originally planned. If the U.S. government does not agree to amend the SNS            Contract schedules, we will not be able to meet the schedule set forth in the SNS            Contract and the U.S. government may terminate the contract for default and seek its            excess re-procurement costs.

We are communicating with HHS            regarding a potential modification to our SNS Contract. We currently anticipate that            this potential modification will establish a new schedule for delivery of the vaccine            into the SNS stockpile to accommodate certain delays in the development of the vaccine            and additional requirements by HHS. Because the potential modification and its content            are still under discussion, we cannot assure that the modification will be issued by            HHS in our favor, if at all. If HHS does not approve the modification, we will not be            able to perform the first delivery under the SNS Contract, in which event HHS may            declare us in default under the SNS contract. Additionally, HHS may require additional            data prior to accepting delivery of a validated recombinant anthrax vaccine, which            could delay delivery of the vaccine. Due to the evolving nature of biodefense product            procurement by HHS and the risks and uncertainties associated with pharmaceutical            product development, we cannot be certain of the timing of deliveries or that the            vaccine can be delivered.

In addition, the SNS Contract is            primarily a fixed-price contract and, if we do not perform efficiently, we could suffer            losses under the contract. In accordance with its standard contracting terms, the U.S.            government may terminate the SNS Contract at its convenience at any time. We need to            substantially increase our employee base to fulfill certain requirements under the SNS            Contract, and are in the process of doing so. However, there is no guarantee that we            will be able to find and hire additional suitable employees or that we will be able to            integrate them into our operations properly so as to enable us to fulfill the            requirements of the SNS Contract. Any failure to adequately staff our operations will            have a material adverse effect on our business.

**The government’s            determination to award future contracts to us may be challenged by an interested party,            such as another bidder, at the Government Accountability Office or in federal            court.**

The laws and regulations            governing the procurement of goods and services by the U.S. government provide            procedures by which other bidders and other interested parties may challenge the award            of a government contract. Such protests could be filed even if there are not any valid            legal grounds on which to base the protest. If any such protests are filed, the            government agency may decide to suspend our performance under the contract while such            protests are being considered by the Government Accountability Office or the applicable            federal court, thus potentially delaying delivery of goods and services and payment. In            addition, we may be forced to expend considerable funds to defend the award. If a            protest is successful, the government may be ordered to terminate our contract for its            convenience and resolicit bids. The government could even be directed to award the            contract to one of the other bidders.

**The U.S. Congress may            instigate an inquiry into the award of the SNS Contract to us which could adversely            impact our business.**

At least two Senate offices,            including that of Senator Charles Grassley, have made inquiries about the award of the            SNS Contract. Senator Charles Grassley, Chairman of the U.S. Senate Finance Committee,            sent a letter to HHS on January 28, 2005 requesting information about the SNS Contract            and its award to us. The letter alleges that HHS may have acted prematurely in awarding            the SNS Contract to us. There can be no assurance that the U.S. Senate Finance            Committee or other Congressional committees or members of Congress will not pursue an            inquiry into the SNS Contract. Such an inquiry, if it were initiated, could include            public hearings that could lead to negative publicity, a change to the SNS Contract,            and an adverse effect on the value of our common stock. In addition, our competitors            may attempt to create negative perceptions about VaxGen among members of Congress or            the public that could encourage such inquiries. A formal U.S. Congressional inquiry            would distract management, require significant human and financial resources to defend,            could harm our reputation and could ultimately lead to audit or modification of            contract terms or provisions of the SNS Contract by the U.S. government at its sole            discretion, all of which may adversely impact our business.

**The award of the SNS Contract            does not mean there will be any future contracts awarded.**

The award of one government            contract does not secure or increase the likelihood of the award of future contracts.            By law, the U.S. government must seek competitive offers when procuring goods and            services. In addition, if we do not perform in accordance with the

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terms of the SNS Contract, we            may receive a poor performance report, which would be considered by the U.S. government            in making any future awards, thus making it more difficult for us to win the award of            such future contracts. Accordingly, we cannot be certain that we will be awarded any            future government contracts, including any contract to supply an additional government            stockpile of anthrax vaccine. It is possible that future awards to provide the U.S.            government with emergency stockpiles of anthrax vaccine will be granted solely to            another supplier. If the U.S. government makes significant future contract awards for            the supply of its emergency stockpile to our competitors, such as Emergent BioDefense            Operations Lansing Inc., or Emergent, formerly BioPort Corp, our business will be            harmed and it is unlikely that we will be able to ultimately commercialize that            particular vaccine. In addition, the determination of when and whether a product is            ready for large scale purchase and potential use will be made by the Office of Public            Health Emergency Preparedness in consultation with other governmental agencies            including the FDA and the Centers for Disease Control. President Bush has proposed, and            Congress is considering, measures to accelerate the development of biodefense products            through the National Institutes of Health, or NIH, funding, the review process by the            FDA and the final government procurement contracting authority. While this may help            speed the approval of our vaccine candidates, it may also encourage competitors to            develop their own vaccine candidates. If competitive vaccine candidates gain approval,            we could face severe competition, which could harm our business.

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

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

**We may encounter difficulties            managing the changes in our operations, which could adversely affect our            business.**

We have experienced a period of            rapid change in our business as a result of increased emphasis on biodefense            opportunities. In addition, we expect to experience substantial changes in 2006 in            manufacturing, quality systems, clinical and regulatory functions associated with the            completion of the Anthrax Contracts and the shifting of our focus to the SNS Contract.            This change in our business has strained and may continue to strain our administrative,            financial and operational functions. We will need to, among other things, expand our            staff and improve our systems and procedures to manage and maintain an adequate system            of internal controls. Furthermore, we made substantial capital expenditures in order to            fulfill certain obligations under the SNS Contract. We plan additional capital            expenditures in this regard, but at substantially lower levels than what we have            already made. These additional capital expenditures will be primarily for redundancy,            safety and corporate expansion. If we are unable to manage the changes of our business            effectively, we may be unable to perform under our existing contracts or obtain future            government contracts, both of which would harm our results of operations and financial            condition.

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

We have entered into contracts            with NIAID and HHS and a license agreement with the U.S. Army Medical Research            Institute of Infectious Diseases, or USAMRIID, which are U.S. government agencies.            Substantially all of our revenue is derived from government contracts and grants. In            contracting with government agencies, we are subject to various U.S. government agency            contract requirements. Future sales to U.S. government agencies will depend, in part,            on our ability to meet U.S. government agency contract requirements, which we cannot be            certain of satisfying.

U.S. government contracts            typically contain termination provisions unfavorable to the non-governmental party, and            are subject to audit and modification by the government at its sole discretion, which            subjects us to additional risks.

These risks include the ability            of the U.S. government to unilaterally:

|   |   |                                                                                                                                                                                                                                                            |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | suspend or prevent                        us for a set period of time from receiving new government contracts or                        extending existing contracts based on violations or suspected violations of                        laws or regulations; |
|   |   |                                                                                                                                                                                                                                                            |
|   | • | terminate our                        existing government contracts;                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                            |
|   | • | reduce the scope and                        value of our existing government contracts;                                                                                                                                                                         |

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|   |   |                                                                                                                                       |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | audit and object to                        our contract-related costs and fees, including allocated indirect                        costs; |
|   |   |                                                                                                                                       |
|   | • | control and                        potentially prohibit the export of our products; and                                                    |
|   |   |                                                                                                                                       |
|   | • | change certain                        terms, conditions and requirements of our contracts.                                                 |

The U.S. government may            terminate any of its contracts with us either for its convenience or if we default by            failing to perform in accordance with the contract schedule and terms. Termination for            convenience provisions generally enable us to recover only our costs incurred or            committed, and settlement expenses and profit on the work completed prior to            termination. Termination for default provisions do not permit these recoveries and make            us liable for excess costs incurred by the U.S. government in procuring undelivered            items from another source. In addition, the U.S. government could bring criminal and            civil charges against us based on intentional or unintentional violations of the            representations and certifications that we have made in all our government            contracts.

As a U.S. government contractor,            we are required to comply with applicable laws, regulations and standards relating to            our accounting practices and are subject to periodic audits and reviews. As part of any            such audit or review, the U.S. government may review the adequacy of, and our            compliance with, our internal control systems and policies, including those relating to            our purchasing, property, estimating, compensation and management information systems.            Based on the results of its audits, the U.S. government may adjust our contract-related            costs and fees, including allocated indirect costs. In addition, if an audit or review            uncovers any improper or illegal activity, we may be subject to civil and criminal            penalties and administrative sanctions, including termination of our contracts,            forfeiture of profits, suspension of payments, fines and suspension or prohibition from            doing business with the U.S. government.

We could also suffer serious            harm to our reputation if allegations of impropriety were made against us. Although            adjustments arising from government audits and reviews have not seriously harmed our            business in the past, future audits and reviews could cause adverse effects. In            addition, under U.S. government purchasing regulations, some of our costs, including            most financing costs, amortization of intangible assets, portions of our research and            development costs, and some marketing expenses, may not be reimbursable or allowed            under our contracts. Our NIAID Contracts and part of our SNS Contract contain            cost-reimbursement terms and provisions. All of the costs that we incur under our NIH            cost-reimbursement contracts will be subject to audit by the U.S. government, and the            U.S. government will also determine the final indirect cost rate that we may charge.            These audits could result in claims by the U.S. government for any unallowable or            unallocable costs that we charged, or excess indirect costs, and for penalties that may            be imposed for claiming unallowable costs.

In the future, if we must comply            with some or all of the U.S. government-specific cost accounting standards, it is            possible that we will need to expend substantial resources to modify our accounting            processes and procedures. Further, as a U.S. government contractor, we are subject to            an increased risk of investigations, criminal prosecution, civil fraud, whistleblower            lawsuits and other legal actions and liabilities to which purely private sector            companies are not.

In addition, with respect to the            technology we received from USAMRIID, our license agreement with USAMRIID provides that            USAMRIID reserves the right to require us and our affiliates to grant a nonexclusive,            partially exclusive, or exclusive sublicense in any field of use to a responsible            applicant, upon terms that are reasonable under the circumstances and under applicable            law, to fulfill public health or safety needs. While we would be given an opportunity            to appeal such a decision, the government’s exercise of such rights could give            our competitors an opportunity to exploit the licensed patents and thereby undermine            our competitive position. In addition, the license agreement requires us to manufacture            products licensed under the agreement in the United States, which will result in less            flexibility in commercializing our products.

**Our fixed price and cost plus            contracts may commit us to unfavorable terms.**

We provide our products and            services primarily through fixed-price and cost-plus contracts. In a fixed-price            contract, we must fully absorb our cost overruns, notwithstanding the difficulty of            estimating costs that are related to performance in accordance with contract            specifications. The failure to anticipate technical problems, estimate costs accurately            or control costs during performance of a fixed-price contract may reduce the            profitability of a fixed-price contract or cause a loss. In a cost-plus contract, we            are allowed to recover our approved costs, plus a fee, which may be fixed or variable            depending on the contract arrangement. The total price on a cost-plus contract is based            primarily on allowable costs incurred, but generally is subject to contract funding            limitations. U.S. government regulations require us to notify our customer of any cost            overruns or under runs on a cost-plus contract. If we incur costs in excess of the            funding limitation in the contract, we may not be able to recover those cost            overruns.

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

We license our anthrax vaccine            candidate from USAMRIID and we license our smallpox vaccine candidate from Kaketsuken.            Each of these license agreements requires that we perform certain obligations,            including diligence obligations. If we fail to comply with our

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obligations under these            agreements in a timely fashion, our licensors could terminate our rights to develop and            commercialize our anthrax and smallpox vaccine candidates, which would seriously harm            our business and prospects. These agreements may also require us to indemnify our            licensors for various liabilities that may arise from the development and            commercialization (including manufacture) of our vaccine candidates, whether or not the            reason for the liability is within our control.

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

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

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

We rely on suppliers to provide            us with the necessary materials to produce our vaccine candidates. Any significant            delays in obtaining any of these materials from our suppliers or other failure by our            suppliers to perform as agreed may cause us to fail to perform under our contracts,            which may cause us to be in breach under those contracts and cause those contracts to            be terminated. We cannot assure you that we will not face shortages from one or more of            these suppliers in the future. In particular, depending on both our and            Kaketsuken’s supply needs for LC16m8, we may be unable to obtain adequate bulk            vaccine material from Kaketsuken. We cannot ensure that if a shortage of LC16m8 bulk            material occurs, the bulk manufacturing technology will be transferred to us on terms            favorable to us or at all.

**Our subcontractors may fail            to perform, or may be delayed in performing, certain tasks related to our ability to            provide our vaccine candidates to the government under our contracts.**

We rely on suppliers to provide            us with the necessary materials to produce our vaccine candidates. Any significant            delays in obtaining any of these materials from our suppliers or other failure by our            suppliers to perform as agreed may cause us to fail to perform under our contracts,            which may cause us to be in breach under those contracts and cause those contracts to            be terminated. We cannot assure you that we will not face shortages from one or more of            these suppliers in the future. In particular, depending on both our and            Kaketsuken’s supply needs for LC16m8, we may be unable to obtain adequate bulk            vaccine material from Kaketsuken. We cannot ensure that if a shortage of LC16m8 bulk            material occurs the bulk manufacturing technology will be transferred to us at terms            favorable to us or at all.

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

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

**Vaccine development is a            long, expensive and uncertain process and the approval requirements for vaccines used            to fight bioterrorism are still evolving. If we are unable to successfully develop and            test our vaccine candidates in accordance with these requirements, our business will            suffer.**

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

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condition being targeted.            Because humans are not normally exposed to anthrax or smallpox, statistically            significant effectiveness of our biodefense product candidates cannot be demonstrated            in humans, but instead must be demonstrated, in part, by utilizing animal models before            they can be approved for marketing.

Specifically, we intend to            pursue FDA approval of our anthrax and smallpox vaccine candidates under requirements            published by the FDA in 2002 that allow the FDA to approve certain vaccines used to            reduce or prevent the toxicity of chemical, biological, radiological or nuclear            substances based on human clinical data to demonstrate safety and immune response, and            evidence of effectiveness derived from appropriate non-clinical studies and any            additional supporting data. We cannot predict whether we will obtain regulatory            approval for any of our product candidates pursuant to these provisions, or at all. We            may fail to obtain approval from the FDA or foreign regulatory authorities, or            experience delays in obtaining such approvals, due to varying interpretations of data            or failure to satisfy current safety, efficacy, and quality control requirements. Until            we receive FDA approval, we will not receive certain payments under the SNS contract.            Further, our business is subject to substantial risk because the FDA’s current            policies governing biodefense vaccines may change suddenly and unpredictably and in            ways that could impair our ability to obtain regulatory approval of these products. We            cannot guarantee that the FDA will approve our anthrax and smallpox vaccine candidates            on a timely basis or at all.

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

Our business prospects will            depend on our ability to complete patient enrollment in clinical trials, to obtain            satisfactory results, to obtain required regulatory approvals and to successfully            commercialize our vaccine candidates. Vaccine development to show adequate evidence of            effectiveness in animal models and safety and immune response in humans is a long,            expensive and uncertain process, and delay or failure can occur at any stage of our            non-clinical studies or clinical trials. Any delay or significant adverse clinical            events arising during any of our clinical trials could force us to abandon a vaccine            candidate altogether or to conduct additional clinical trials in order to obtain            approval from the FDA or foreign regulatory bodies. These development efforts and            clinical trials are lengthy and expensive, and the outcome is uncertain. Completion of            our clinical trials, announcement of results of the trials and our ability to obtain            regulatory approvals could be delayed for a variety of reasons, including:

|   |   |                                                                                                                                                                 |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | slower-than-anticipated                        enrollment of volunteers in the trials;                                                                               |
|   |   |                                                                                                                                                                 |
|   | • | lower-than-anticipated                        recruitment or retention rate of volunteers in the trials;                                                             |
|   |   |                                                                                                                                                                 |
|   | • | serious adverse                        events related to the vaccine candidates;                                                                                     |
|   |   |                                                                                                                                                                 |
|   | • | unsatisfactory                        results of any clinical trial;                                                                                                 |
|   |   |                                                                                                                                                                 |
|   | • | the failure of our                        principal third-party investigators to perform our clinical trials on our                        anticipated schedules; or |
|   |   |                                                                                                                                                                 |
|   | • | different                        interpretations of our preclinical and clinical data, which could initially                        lead to inconclusive results.    |

Our development costs will            increase if we have material delays in any clinical trial or if we need to perform more            or larger clinical trials than planned. If the delays are significant, or if any of our            vaccine candidates do not prove to be safe or effective or do not receive required            regulatory approvals, our financial results and the commercial prospects for our            product candidates will be harmed. Furthermore, our inability to complete our clinical            trials in a timely manner could jeopardize our ability to obtain regulatory            approval.

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

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

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

Vaccine candidates are subject            to extensive government regulations related to development, testing, manufacturing and            commercialization in the United States and other countries. Our vaccine candidates are            in the preclinical and clinical stages of development and have not received required            regulatory approval from the FDA to be commercially marketed and sold in the United            States. With the exception of LC16m8, which is approved and sold in Japan, our vaccine            candidates have not received required regulatory approval from foreign regulatory            agencies to be commercially marketed and sold. The process of obtaining and complying            with FDA, other governmental and foreign regulatory approvals and regulations is            costly, time consuming, uncertain and subject to unanticipated delays. Despite the time            and expense exerted, regulatory approval is never guaranteed.

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

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

Failure to comply with the            regulatory requirements of the FDA and other applicable foreign regulatory bodies may            subject us to administrative or judicially imposed sanctions, including:

|   |   |                                                                                                                                           |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | warning                        letters;                                                                                                        |
|   |   |                                                                                                                                           |
|   | • | civil                        penalties;                                                                                                        |
|   |   |                                                                                                                                           |
|   | • | criminal                        penalties;                                                                                                     |
|   |   |                                                                                                                                           |
|   | • | injunctions;                                                                                                                                   |
|   |   |                                                                                                                                           |
|   | • | product seizure or                        detention, including any products that we manufacture under the SNS                        Contract; |
|   |   |                                                                                                                                           |
|   | • | product                        recalls;                                                                                                        |
|   |   |                                                                                                                                           |
|   | • | total or partial                        suspension of production; and                                                                          |
|   |   |                                                                                                                                           |
|   | • | suspension or                        revocation of the marketing license.                                                                      |

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**We and our subcontractors are            subject to ongoing regulatory review and periodic inspection and approval of            manufacturing procedures and operations, including compliance with cGMP            regulations.**

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

**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. Development of a product requires substantial technical,            financial and human resources. Our potential products may appear to be promising at            various stages of development yet fail to reach the market for a number of reasons,            including:

|   |   |                                                                                                                                                                                   |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | the lack of adequate                        quality or sufficient prevention benefit, or unacceptable safety during                        preclinical studies or clinical trials;     |
|   |   |                                                                                                                                                                                   |
|   | • | their failure to                        receive necessary regulatory approvals;                                                                                                        |
|   |   |                                                                                                                                                                                   |
|   | • | the existence of                        proprietary rights of third parties; or                                                                                                        |
|   |   |                                                                                                                                                                                   |
|   | • | the inability to                        develop manufacturing methods that are efficient, cost-effective and                        capable of meeting stringent regulatory standards. |

**Political or social factors            may delay or impair our ability to market our vaccine products.**

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

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

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

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

Our technology, including            technology licensed from Kaketsuken and USAMRIID, or technology that we may license in            the future, if any, will be protected from unauthorized use by others only to the            extent that it is covered by valid and enforceable patents, or effectively maintained            as trade secrets and exclusively licensed to us. The patent positions of pharmaceutical            and biotechnology companies can be highly uncertain and involve complex legal and            factual questions. Accordingly, we cannot predict the scope and breadth of patent            claims that may be afforded to other companies’ patents. In addition, we could            incur substantial costs in litigation if

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we are required to defend            against patent suits brought by third parties, or if we initiate these suits, even in            such instances in which the outcome is favorable to us.

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

|   |   |                                                                                                                                                                                                                                                                                                                                                                              |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | others will not                        independently develop similar or alternative technologies or duplicate any                        of our technologies;                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                              |
|   | • | any patents issued                        to us or licensed from Kaketsuken or USAMRIID or other parties, or that we                        may license in the future, if any, will provide a basis for commercially                        viable products or will provide us with any competitive advantages or will                        not be challenged by third parties; |
|   |   |                                                                                                                                                                                                                                                                                                                                                                              |
|   | • | we or any of our                        current or future licensors will adequately protect trade                        secrets;                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                              |
|   | • | we will develop                        additional proprietary technologies that are patentable; or the patents of                        others will not have a material adverse effect on our business.                                                                                                                                                                          |

We cannot be certain that            patents issued to us in the future, if any, or patents that we have licensed from            Kaketsuken and USAMRIID, or that we may license in the future, if any, will be            enforceable and afford protection against competitors. In this regard, the U.S.            government has the right to use, for or on behalf of the U.S. government, any            technologies developed by us under our U.S. government contracts and we cannot prohibit            third parties, including our competitors, from using those technologies in providing            products and services to the U.S. government. Accordingly, under our license agreement            with USAMRIID granting us an exclusive license to commercialize the anthrax vaccine,            the U.S. government retains a license for any federal government agency to practice            USAMRIID’s anthrax-related inventions, by or on behalf of the government, thereby            allowing the use of the inventions in support of government contracts with other            parties, including our competitors.

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

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

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

**Our Korean manufacturing            joint venture may not be successful.**

We cannot be certain that            Celltrion, the manufacturing facility located in the Republic of Korea in which we are            a joint venture participant, will pass domestic or foreign regulatory approvals or be            able to manufacture mammalian cell culture products in commercial quantities on a            cost-effective basis or at all. In addition, it is uncertain whether Celltrion will be            able to effectively manage the facility for mammalian cell culture biomanufacturing and            to make this facility profitable. Furthermore, the political, social and economic            situation in the Republic of Korea, and the stability of the Korean peninsula as a            whole, may not provide an environment in which Celltrion would be able to manufacture            products cost-effectively or at all. The government of the Republic of Korea may impose            regulations or restrictions that would make it difficult, impractical or impossible,            whether economically, legally or otherwise, for Celltrion to conduct its business            there.

If Celltrion is unable to            manufacture mammalian cell culture products, or if it becomes commercially impractical            for Celltrion to manufacture such products, we may not realize a financial or other            benefit from our investment.

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

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

|   |   |                                                                                                 |
|--------|--------|------------------------------------------------------------------------------------------------------|
|   | • | are more                        effective;                                                           |
|   |   |                                                                                                 |
|   | • | have fewer or less                        severe adverse side effects;                               |
|   |   |                                                                                                 |
|   | • | are more adaptable                        to various modes of dosing;                                |
|   |   |                                                                                                 |
|   | • | are easier to                        administer; or                                                  |
|   |   |                                                                                                 |
|   | • | are less expensive                        than the products or product candidates we are developing. |

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

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

**Natural disasters, including            earthquakes, may damage our facilities.**

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

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

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

Any such activities will be            accompanied by certain risks including:

|   |   |                                                                                                                                    |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------|
|   | • | exposure to unknown                        liabilities of acquired companies;                                                           |
|   |   |                                                                                                                                    |
|   | • | higher than                        anticipated acquisition costs and expenses;                                                          |
|   |   |                                                                                                                                    |
|   | • | the difficulty and                        expense of integrating operations and personnel of acquired                        companies; |
|   |   |                                                                                                                                    |
|   | • | disruption of our                        ongoing business;                                                                              |
|   |   |                                                                                                                                    |
|   | • | diversion of                        management’s time and attention; and                                                          |
|   |   |                                                                                                                                    |
|   | • | possible dilution to                        stockholders.                                                                               |

If our competitors successfully            enter into partnering or license agreements or we are unable to reach agreement on            license or partnering agreements on terms acceptable to us, we may then be precluded            from pursuing those specific opportunities. Since each of

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these opportunities is unique,            we may not be able to find a substitute. In addition, if we are unable to manage            successfully any acquisitions, joint ventures and other collaboration opportunities, we            may be limited in our ability to develop new products and therefore to continue to            expand our product pipeline.

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

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

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

We face an inherent risk of            exposure to product liability suits in connection with vaccines being tested in human            clinical trials or sold commercially. We may become subject to a product liability suit            if any vaccine we develop causes injury, or if vaccinated individuals subsequently            become infected or otherwise suffer adverse effects from our vaccines or products.            Regardless of merit or eventual outcome, product liability claims may result in            decreased demand for a vaccine or product, injury to our reputation, withdrawal of            clinical trial volunteers and loss of revenues.

If a product liability claim is            brought against us, the cost of defending the claim could be significant and any            adverse determination could result in liabilities in excess of our insurance coverage.            We currently have product liability insurance, including clinical trial liability, in            the amount of $25.0 million for our anthrax and smallpox programs. Additionally, we are            applying for indemnification under the Support Anti-terrorism by Fostering Effective            Technologies Act of 2002, which preempts and modifies tort laws so as to limit the            claims and damages potentially faced by companies who provide certain            “qualified” anti-terrorism products. However, we cannot be certain that our            current insurance can be maintained, or that additional insurance coverage could be            obtained on acceptable terms, if at all.

**Legislation limiting or            restricting liability for medical products used to fight bioterrorism is new, and we            cannot be certain that any such protections will apply to our vaccines or            products.**

The Public Readiness and            Emergency Preparedness Act, or Public Readiness Act, was signed into law December 2005            and creates general immunity for manufacturers of countermeasures, including security            countermeasures (as defined in Section 319F-2(c)(1)(B)), when the Secretary of HHS            issues a declaration for their manufacture, administration or use. The declaration is            meant to provide general immunity from all claims under state or federal law for loss            arising out of the administration or use of a covered countermeasure. Manufacturers are            exempt from this protection in cases of willful misconduct.

Upon a declaration by the            Secretary of HHS, a compensation fund is created to provide “timely, uniform, and            adequate compensation to eligible individuals for covered injuries directly caused by            the administration or use of a covered countermeasure”. The “covered            injuries” to which the program applies are defined as serious physical injuries            or death. Individuals are permitted to bring a willful misconduct action against a            manufacturer only after they have exhausted their remedies under the compensation            program. However, a willful misconduct action could be brought against us if an            individual(s) exhausted their remedies under the compensation program and thereby            expose us to liability.

We may become subject to            standard product liability suits and other third party claims if vaccines or products            developed by us and which fall outside of the Public Readiness Act cause injury or if            vaccinated individuals subsequently become infected or otherwise suffer adverse effects            from such vaccines or products.

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

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

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

We are highly dependent on our            senior management and scientific staff. These individuals have played a critical role            in raising capital, negotiating business development opportunities, developing the            vaccine candidates, conducting clinical trials and manufacturing product candidates. We            face intense competition for qualified personnel, and the existence of non-competition            agreements between prospective employees and their former employers may prevent us from            hiring those individuals or subject us to suit from their former employers. We do not            maintain non-compete agreements with any of our employees. If we lose the services of            any key members of our senior management or scientific staff, temporarily or            permanently, and we are unable to recruit qualified replacements where we deem it            necessary, we may be unable to achieve our business objectives.

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

Our Board of Directors has the            authority to establish the designation of up to 20,000,000 shares of preferred stock            that are convertible into common stock without any action by our stockholders, and to            fix the rights, preferences, privileges and restrictions, including voting rights, of            such shares. In February 2006, we raised net proceeds of $25.2 million through a            private placement of 3.5 million shares of common stock at $7.70 per share to a group            of accredited institutional investors. We also issued to the investors five-year            warrants initially exercisable to purchase 699,996 shares of common stock at an            exercise price of $9.24 per share. Because we did not file all of our delinquent            periodic reports with the SEC by January 31, 2007, the warrants became exercisable for            an additional 700,000 shares of common stock, at a price of $9.24 per share. We may            raise additional funds through public or private offerings of our preferred stock or            our common stock, or through issuance of debt securities that are convertible into            shares of our common stock. The issuance of additional shares of our common stock, or            conversion of preferred stock or debt securities into shares of common stock, would            further dilute the percentage ownership of our stockholders.

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

After we have filed all of our            outstanding periodic reports with the SEC, if at all, from time to time, certain of our            stockholders may be eligible to sell all or some of their shares of our common stock by            means of effective resale registration statements. We agreed to register for resale            under the Securities Act the shares of our common stock issuable upon conversion of the            Notes and the shares of our common stock issued in private placements of our common            stock in November 2004 and February 2006. We have agreed to file registration            statements for these shares within 30 days following the first date we become current            in our reporting requirements under the Exchange Act and to use our best efforts to            cause the registration statements to become effective in no event later than 120 days            after the filing of these registration statements. In addition, pursuant to Rule 144            generally, a stockholder (or stockholders whose shares are aggregated) who has            satisfied a one year holding period may, under certain circumstances, sell within any            three month period a number of securities which does not exceed the greater of 1% of            the then outstanding shares of common stock or the average weekly trading volume of the            class during the four calendar weeks prior to such sale. Rule 144 also permits, under            certain circumstances, the sale of securities, without any limitation, by our            stockholders that are non-affiliates that have satisfied a two year holding period,            such as certain of those stockholders who purchased shares of our common stock in our            November 2004 private placement. Any substantial sale of our common stock effective            resale registration statements or pursuant to Rule 144 or pursuant to any resale            prospectus may have material adverse effect on the market price of our            securities.

**Our stock price is likely to            be volatile.**

Currently, our common stock is            traded over the counter, or OTC, and is quoted on the OTC Pink Sheets LLC. Stocks            traded OTC typically are subject to greater volatility than stocks traded on stock            exchanges, such as the Nasdaq Global Market or the Nasdaq Capital Market, due to the            fact that OTC trading volumes are generally significantly less than on stock exchanges.            This lower volume may allow a relatively few number of stock trades to greatly affect            the stock price. As such, the trading price of our common stock has been and is likely            to continue to be extremely volatile. For example, between August 9, 2004 and March 31,            2006, the closing price of our common stock, as quoted on the Pink Sheets, has ranged            from a high of $18.55 per share to a low of $6.67 per share.

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

|   |   |                                                                                                                                                                                                                                           |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | timing and                        consistency of filing financial statements;                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                           |
|   | • | failure to win                        future government contracts or the termination of our existing contracts                        and government activities relating to contracts for anthrax or smallpox                        vaccines; |
|   |   |                                                                                                                                                                                                                                           |
|   | • | adverse results or                        delays in clinical trials;                                                                                                                                                                           |

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|   |   |                                                                                                                                                                                                                                         |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | delays in our                        product development efforts;                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                         |
|   | • | real or perceived                        safety issues with any of our vaccine candidates;                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                         |
|   | • | failure to obtain or                        maintain required regulatory approvals;                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                         |
|   | • | delays in completion                        and/or validation of manufacturing activities relating to our partially                        owned facilities in the Republic of Korea;                                                        |
|   |   |                                                                                                                                                                                                                                         |
|   | • | changes in financial                        estimates by securities analysts and our failure to meet or exceed such                        estimates;                                                                                        |
|   |   |                                                                                                                                                                                                                                         |
|   | • | rumors about our                        business prospects, product development efforts or the progress, timing and                        completion of our clinical trials;                                                                |
|   |   |                                                                                                                                                                                                                                         |
|   | • | new products or                        services offered by us or our competitors or announcements relating to                        product developments by our competitors;                                                                |
|   |   |                                                                                                                                                                                                                                         |
|   | • | issuances of debt or                        equity securities;                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                         |
|   | • | actual or expected                        sales by our stockholders of substantial amounts of our common stock,                        including shares issued upon exercise of outstanding options and warrants;                        and |
|   |   |                                                                                                                                                                                                                                         |
|   | • | other events or                        factors, many of which are beyond our control.                                                                                                                                                        |

In addition, the stock market in            general, and the Nasdaq Global 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. If we face securities litigation in the            future, even if meritless or unsuccessful, it would result in substantial costs and a            diversion of management attention and resources, which could have a material adverse            effect on our business.

**We could experience            equipment, raw material, manufacturing, quality control or other production problems,            especially in periods of increasing volume.**

There can be no assurance that            we will be able to meet our projected manufacturing capacity. We have made and intend            to continue to make significant capital expenditures to expand our manufacturing            capacity. However, since customer demand is difficult to predict, we may be unable to            ramp up our production quickly enough to timely fill new customer orders. This could            cause us to lose new business and possibly existing business. In addition, if we            overestimate customer demand, we could incur significant costs from creating excess            capacity. We may experience manufacturing complications associated with increasing our            manufacturing capacity, including the adequate production capacity to meet order            requirements and delivery schedules. We may also experience difficulties implementing            new manufacturing processes or outsourcing some of our manufacturing. The addition of            fixed overhead costs increases our breakeven point and results in lower profit margins            unless compensated for by increased product sales. When purchasing raw materials for            our anticipated demand, we take into consideration the order-to-delivery lead times of            vendors and the economic purchase order quantity for such raw materials. If we            over-estimate customer demand, excess raw material inventory can result, which would            have an adverse effect on our results of operations.

**Failure of any portion of our            infrastructure at our California manufacturing facility could have a material adverse            effect on our business.**

We are highly dependent on our            wholly owned manufacturing infrastructure in California to achieve our business            objectives. If we experience a problem that impairs our manufacturing infrastructure,            such as a computer virus, intentional disruption of information technology systems by a            third party, a work stoppage, terrorist attack or manufacturing failure, the resulting            disruptions could impede our ability to book or process orders, manufacture and ship in            a timely manner or otherwise carry on our business in the ordinary course. Any such            events could cause us to lose significant customers or net sales and could require us            to incur significant expense to eliminate these problems and address related security            concerns.

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

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

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

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

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

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

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

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

Celltrion maintains its records            in accordance with Korean accounting principles; however, we require financial            information that is prepared in accordance with U.S. GAAP. In February 2006, Celltrion            and VaxGen entered into an agreement whereby Celltrion agreed to use its best efforts            to timely prepare annual and quarterly financial statements in accordance with U.S.            GAAP. However, Celltrion’s internal controls over financial reporting may be            insufficient to enable them to report their interim U.S. GAAP financial results to us            on a timely basis. In addition, their independent registered public accounting firm            could conclude that Celltrion’s internal controls over financial reporting are            insufficient to enable the registered public accounting firm to complete their required            review of Celltrion’s U.S. GAAP financial information in a timely fashion, if at            all.

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

**If we fail to cause a            registration statement to be declared effective in accordance with the timetable set            forth in the Notes, or in accordance with agreements we have made in connection with            private placements of our common stock, we will be subject to liquidated damages or            liability for breach of contract.**

We agreed to register under the            Securities Act shares of our common stock issuable upon conversion of the Notes, as            well as shares issued or issuable in private placements of our common stock. We have            agreed to file registration statements for these shares within 30 days following the            first date we become current in our reporting requirements under the Exchange Act, and            to use our best efforts to cause the registration statements to become effective in no            event later than 120 days after the filing of such registration statements. We have            also made other customary agreements regarding such registrations, including matters            relating to indemnification, maintenance of the registration statements, payment of            expenses and compliance with state “blue sky” laws. We may be liable for            liquidated damages to each Note holder and purchaser in the private placements (a) if            the registration statements are not filed on or prior to 30 days of becoming current in            our reporting requirements; (b) if the registration statements are not declared            effective by the SEC on or

43

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prior to 120 days from filing;            or (c) if the registration statements (after being declared effective) cease to be            effective in a manner that violates such agreements, collectively referred to as a            Registration Default. In the event of a Registration Default, we may be required to pay            liquidated damages. Should we become obligated to make payment of these liquidated            damages, it could have a material adverse effect on our financial position and our            results of operations, particularly if we become obligated to make a payment in full            for all liquidated damages potentially due and payable under these            agreements.

**ITEM 2.            UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

On February 8, 2006, VaxGen,            Inc. entered into stock and warrant purchase agreements with a group of accredited            investors pursuant to which VaxGen agreed to sell 3,500,000 shares of its common stock,            or Shares, at a price of $7.70 per share, and issue, for no additional consideration,            warrants to purchase up to 699,996 shares of VaxGen common stock, or Warrants, subject            to adjustment, as further described below. The Shares and Warrants were issued in a            private placement pursuant to Rule 506 of the Securities Act of 1933, as amended, or            Securities Act, and thus were exempt from the registration requirements of the            Securities Act. The transaction closed on February 10, 2006, and VaxGen received gross            proceeds of approximately $26.95 million. In connection with this financing, VaxGen            issued to the investors five-year warrants initially exercisable to purchase 699,996            shares of common stock at an exercise price of $9.24 per share. The warrants provide            that if VaxGen does not file all of its outstanding periodic reports with the SEC by            September 30, 2006 and January 30, 2007, the warrants will become exercisable for            additional shares.

**ITEM 3.            DEFAULTS UPON SENIOR SECURITIES**

None.

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

None.

**ITEM 5.****OTHER INFORMATION**

Please refer to Part II, Item 2            of this report for information regarding the Company’s issuance of unregistered            common stock in February 2006.

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**ITEM 6.            EXHIBITS**

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

The following exhibits are filed            as part of this report:

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

|                                   |   |                                                                                                                                                                                                                                                                                                   |   |     |   |                                                 |   |                                   |   |                                   |   |                                      |
|----------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|------------------------------------------------------|--------|----------------------------------------|--------|----------------------------------------|--------|-------------------------------------------|
|                                   |   |                                                                                                                                                                                                                                                                                                   |   |     |   | **Incorporated by                        Reference** |   |                                   |   |                                   |
| **Exhibit                        No.** |   | **Exhibit**                                                                                                                                                                                                                                                                                            |   | **Form** |   | **File                        No.**                  |   | **Filing                        Date** |   | **Exhibit                        No.** |   | **Filed                        Herewith** |
|                                        |   |                                                                                                                                                                                                                                                                                                        |   |          |   |                                                      |   |                                        |   |                                        |   |                                           |
| 10.1                                   |   | Contract No.                        HHSO100200500001C, between the Department of Health and Human Services,                        Office of Research and Development Coordination and Office of Public Health                        Emergency Preparedness and VaxGen, Inc. dated November 4, 2004.* |   | 8-K      |   | 0-26483                                              |   | 01-12-06                               |   | 99.1                                   |   |                                      |
|                                   |   |                                                                                                                                                                                                                                                                                                   |   |     |   |                                                 |   |                                   |   |                                   |   |                                      |
| 10.2                                   |   | Form of Stock and                        Warrant Purchase Agreement entered into by and between VaxGen, Inc. and                        certain accredited investors                                                                                                                                   |   | 8-K      |   | 0-26483                                              |   | 02-15-06                               |   | 10.1                                   |   |                                      |
|                                   |   |                                                                                                                                                                                                                                                                                                   |   |     |   |                                                 |   |                                   |   |                                   |   |                                      |
| 10.3                                   |   | Form of Warrant                        issued by VaxGen, Inc. pursuant to the Stock and Warrant Purchase                        Agreements entered into by and between VaxGen, Inc. and certain accredited                        investors                                                            |   | 8-K      |   | 0-26483                                              |   | 02-15-06                               |   | 10.2                                   |   |                                      |
|                                   |   |                                                                                                                                                                                                                                                                                                   |   |     |   |                                                 |   |                                   |   |                                   |   |                                      |
| 10.4                                   |   | Executive Employment                        Agreement between Matthew J. Pfeffer and VaxGen, Inc., dated March 28,                        2006. +                                                                                                                                                      |   | 8-K      |   | 0-26483                                              |   | 04-05-06                               |   | 10.1                                   |   |                                      |
|                                   |   |                                                                                                                                                                                                                                                                                                   |   |     |   |                                                 |   |                                   |   |                                   |   |                                      |
| 31.1                                   |   | Certification of Chief Executive Officer                                                                                                                                                                                                                                                               |   |     |   |                                                 |   |                                   |   |                                   |   | X                                         |
|                                   |   |                                                                                                                                                                                                                                                                                                   |   |     |   |                                                 |   |                                   |   |                                   |   |                                      |
| 31.2                                   |   | Certification of Principal Financial Officer                                                                                                                                                                                                                                                           |   |     |   |                                                 |   |                                   |   |                                   |   | X                                         |
|                                   |   |                                                                                                                                                                                                                                                                                                   |   |     |   |                                                 |   |                                   |   |                                   |   |                                      |
| 32.1                                   |   | Section 1350 Certification                                                                                                                                                                                                                                                                             |   |     |   |                                                 |   |                                   |   |                                   |   | X                                         |

|                                                                                                                                                                                     |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| * Confidential                        treatment requested. The redacted portions have been separately filed with                        the SEC as required by Rule 406 of Regulation C. |

**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                        29, 2007 |   | *By: /s/ James P.                        Panek*            |
|                                            |   |                                                            |
|                                            |
|                                            |   | James P.                        Panek                      |
|                                            |   | ***Chief                        Executive Officer***       |
|                                            |   | ***(Principal                        Executive Officer)*** |
|                                            |   |                                                       |
| *Dated:* August                        29, 2007 |   | *By: /s/ Matthew                        J. Pfeffer*        |
|                                            |   |                                                            |
|                                            |
|                                            |   | Matthew J.                        Pfeffer                  |
|                                            |   | ***Chief                        Financial Officer***       |
|                                            |   | ***(Principal                        Financial Officer)*** |

45

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