UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) xQUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 2005 OR oTRANSITION
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(State
  or other jurisdiction of

94-3236309incorporation
  or organization)

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

94080(Address
  of Principal Executive Offices)

(Zip
  Code)(650) 624-1000(Registrants
  Telephone Number, Including Area Code) Indicate by
check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes 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 March 30,
2007.    VaxGen, Inc.

Form 10-Q

For the Quarter Ended September 30, 2005

Table of Contents

PagePart I
Financial InformationItem 1
Financial
  Statements (unaudited):Condensed
Consolidated Balance Sheets
3Condensed
Consolidated Statements of Operations
4Condensed
Consolidated Statements of Cash Flows
5Notes to
Condensed Consolidated Financial Statements
6Item 2
Managements
  Discussion and Analysis of Financial Condition and Results of Operations:Overview
21Critical
Accounting Policies and Estimates
23Results of
Operations
23Liquidity and
Capital Resources
28Item 3
Quantitative
  and Qualitative Disclosures About Market Risk
35Item 4
Controls
  and Procedures
36Part II
Other InformationItem 1
Legal
  Proceedings
36Item 1A
Risk
  Factors
37Item 2
Unregistered
  Sales of Equity Securities and Use of Proceeds
52Item 3
Defaults
  Upon Senior Securities
52Item 4
Submission
  of Matters to a Vote of Security Holders
52Item 5
Other
  Information
52Item 6
Exhibits
52Signatures
53Certifications
552

PART I  FINANCIAL
INFORMATION

Item 1. Financial Statements

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

September 30,
  2005

December 31,
  2004ASSETSCurrent assets:Cash
  and cash equivalents

$
10,549

$
20,698Investment
  securities


12,685


25,392Accounts
  receivable


3,183


4,794Unbilled
  accounts receivable


2,672


1,855Due
  from related party


432


Prepaid
  expenses and other current assets


18,629


2,760Total current assets


48,150


55,499Investment in affiliate


19,136


Property and equipment


28,297


138,246Restricted cash


3,246


1,298Other assets


2,793


3,424Total assets

$
101,622

$
198,467LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS
EQUITYCurrent liabilities:Accounts payable

$
5,523

$
7,235Accrued and other current
liabilities


17,521


12,219Due to related
parties





12,364Derivative
liabilities


1,346


Total current
liabilities


24,390


31,818Convertible debt


29,879


Non-current obligations





57,531Deferred rent and other
  liabilities


3,302


608Total liabilities


57,571


89,957Commitments and
  contingencies (Note 10 and 13)Minority interest in
  variable interest entity





31,284Stockholders equity:Common stock


296


292Additional paid-in
capital


265,543


265,635Deferred stock
compensation


(437
)

(1,640
)Accumulated deficit


(226,531
)

(192,132
)Accumulated other comprehensive
income


5,180


5,071Total stockholders
equity


44,051


77,226Total liabilities, minority
interest and stockholders equity

$
101,622

$
198,467See accompanying notes to condensed
consolidated financial statements.

3

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

Three
  Months Ended
  September 30,

Nine Months
  Ended
  September 30,2005

2004

2005

2004Revenues:Research contracts and
grants

$
6,093

$
7,254

$
23,720

$
22,308Related party
services


282





282


Total revenues


6,375


7,254


24,002


22,308Operating expenses:Research and
development


15,476


10,431


48,982


28,862General and
administrative


7,950


6,101


24,062


16,633Loss from operations


(17,051
)

(9,278
)

(49,042
)

(23,187
)Other income
(expense):Interest and other


(460
)

88


(1,107
)

503Gain on sale of
investment


11,196





11,196


Valuation adjustments


626


(2,461
)

450


(16,183
)Equity in loss of
affiliate


(1,055
)




(1,055
)

Foreign currency


1,050





1,050


Total other income
(expense)


11,357


(2,373
)

10,534


(15,680
)Net loss before minority
interest


(5,694
)

(11,651
)

(38,508
)

(38,867
)Minority interest in loss of
variable interest entity





819


4,109


1,944Net loss

$
(5,694
)
$
(10,832
)
$
(34,399
)
$
(36,923
)Basic and diluted net loss per
share

$
(0.19
)
$
(0.43
)
$
(1.16
)
$
(1.46
)Weighted average shares used in
computing basic and diluted net loss
  per share


29,607


25,371


29,597


25,214See accompanying notes to condensed
consolidated financial statements.

4

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






Nine
        Months Ended
        September 30,2005
    
    2004Cash
        flows from operating activities:Net
        loss
    
    
    $
    (34,399
    )
    $
    (36,923
    )Adjustments
        to reconcile net loss to net cash used in operating activities:Gain
        from sale of investment
    
    
    
    (11,196
    )
    
    Minority
        interest in loss of variable interest entity
    
    
    
    (4,109
    )
    
    (1,944
    )Depreciation
        and amortization
    
    
    
    3,566
    
    
    1,271Amortization
        of premiums and discounts on investment securities
    
    
    
    95
    
    
    232Stock
        compensation expense
    
    
    
    4,776
    
    
    1,394Valuation
        adjustments
    
    
    
    (450
    )
    
    15,402Non-cash
        interest expense
    
    
    
    353
    
    
    Equity
        in loss of affiliate
    
    
    
    1,055
    
    
    Foreign
        currency gain
    
    
    
    (1,050
    )
    
    Changes
        in assets and liabilities:Receivables
    
    
    
    (1,270
    )
    
    1,733Prepaid
        expenses and other current assets
    
    
    
    (1,903
    )
    
    105Accounts
        payable
    
    
    
    960
    
    
    3Accrued
        and other current liabilities
    
    
    
    8,848
    
    
    1,770Due
        to (from) related parties
    
    
    
    (432
    )
    
    (210
    )Deferred
        rent and other liabilities
    
    
    
    639
    
    
    (71
    )Net
        cash used in operating activities
    
    
    
    (34,517
    )
    
    (17,238
    )Cash
        flows from investing activities:Purchase
        of property and equipment
    
    
    
    (31,845
    )
    
    (28,667
    )Proceeds
        from sale of affiliate stock
    
    
    
    2,049
    
    
    Purchase
        of affiliate stock
    
    
    
    (1,152
    )
    
    Purchase
        of investment securities
    
    
    
    
    
    
    (15,975
    )Proceeds
        from sale and maturities of investment securities
    
    
    
    13,567
    
    
    21,163Cash
        (used in) provided by deconsolidation/consolidation of variable interest
        entity
    
    
    
    (3,811
    )
    
    9,723Change
        in restricted cash
    
    
    
    (2,142
    )
    
    8,481Other
    
    
    
    (1,916
    )
    
    (399
    )Net
        cash used in investing activities
    
    
    
    (25,250
    )
    
    (5,674
    )Cash
        flows from financing activities:Proceeds
        from private placements, net
    
    
    
    9,482
    
    
    2,965Proceeds
        from convertible debt and derivative liability, net
    
    
    
    29,722
    
    
    Proceeds
        from non-current obligations
    
    
    
    10,493
    
    
    13,267Payments
        on non-current obligations
    
    
    
    
    
    
    (1,169
    )Exercise
        of employee stock options
    
    
    
    
    
    
    575Employee
        stock purchase plan
    
    
    
    
    
    
    447Other
    
    
    
    (79
    )
    
    93Net
        cash provided by financing activities
    
    
    
    49,618
    
    
    16,178Effect
        of exchange rate changes on cash and cash equivalents
    
    
    
    
    
    
    228Decrease
        in cash and cash equivalents
    
    
    
    (10,149
    )
    
    (6,506
    )Cash
        and cash equivalents at beginning of period
    
    
    
    20,698
    
    
    13,221Cash
        and cash equivalents at end of period
    
    
    $
    10,549
    
    $
    6,715Supplemental
        schedule of non-cash activities:Accrued
        purchases of property and equipment
    
    
    $
    
    
    $
    5,652See accompanying notes to condensed
consolidated financial statements.

5

VaxGen, Inc.Notes to Condensed Consolidated Financial Statements

1. Description of Business and Basis of
Presentation

Nature
of Business Activities

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

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

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

VaxGens
principal source of revenue is the U.S. government, principally the National
Institutes of Health (NIH) and related entities.

Delisting
from the Nasdaq National Market

As a result of
the Companys inability to timely file financial statements, the Company was
delisted effective August 9, 2004 from the Nasdaq National Market, now the
Nasdaq Global Market (Nasdaq). Since that time, the Companys common stock
has traded over the counter, or OTC, and has been quoted on the Pink Sheets LLC
as VXGN.PK.

Basis
of Presentation

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

Certain
information or footnote disclosure normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America (GAAP) have been condensed or omitted pursuant to such
rules and regulations. In the opinion of the Companys management, the
accompanying unaudited condensed consolidated financial statements contain all
adjustments, consisting only of normal recurring adjustments, considered
necessary for a fair statement of the condensed consolidated financial
information included herein. While VaxGen believes that the disclosures are
adequate to make the information not misleading, these condensed consolidated
financial statements should be read in conjunction with VaxGens audited
financial statements contained in its Annual Report on Form 10-K for the year
ended December 31, 2004 as filed with the SEC on February 7, 2007.

The results of
operations for the nine month period ended September 30, 2005 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 February
2002, Celltrion was formed by VaxGen together with Nexol Biotech Co., Ltd
(Nexol), Nexol Co., Ltd. (Nexol Co), Korea Tobacco & Ginseng Corp.
(KT&G) and J. Stephen & Company Ventures Ltd. (JS, collectively
Korean Investors) to build and operate a mammalian cell culture biomanufacturing
facility in Incheon, Republic of Korea, and to provide partial funding for the
construction of VCI, a manufacturing facility under VaxGen control in South San
Francisco, California.

6

VCI has been
consolidated by VaxGen since its inception in the third quarter of 2002; and
Celltrion was consolidated by VaxGen from January 1, 2004 to June 30, 2005.
Prior to implementing the consolidation provisions within Interpretation No.
46, Consolidation of Variable Interest
Entities, as revised by the Financial Accounting Standards Board
(FASB) in December 2003 (FIN 46R) as well as beginning July 1, 2005, as
discussed below, VaxGen had reflected its investment in Celltrion in its
financial statements using the equity method.

The
liabilities recognized as a result of consolidating Celltrion do not represent
additional claims on VaxGens or VCIs assets. Rather, they represent claims
against the specific assets of Celltrion. Conversely, the assets recognized as
a result of consolidating Celltrion do not represent additional assets that
could be used to satisfy claims against VaxGens or VCIs assets. The general
creditors of VaxGen and VCI have no recourse to the general credit of
Celltrion. The general creditors of Celltrion have no recourse to the general
credit of VaxGen and VCI.

In September
2005, VaxGen entered into an agreement to raise approximately $15.1 million in
gross proceeds through the sale of 1.2 million of its shares in Celltrion to a
group of Korean investors. Nexol Co purchased 250,000 of these shares.
Subsequent to this transaction, Nexol and its affiliates, collectively, became
the largest stockholder of Celltrion. As a result, VaxGen was no longer the
primary beneficiary of Celltrion and, in accordance with FIN 46R, Celltrion has
been deconsolidated from VaxGen effective July 1, 2005; thereafter, VaxGens
investment in Celltrion is being accounted for under the equity method. At
September 30, 2005, VaxGens ownership interest in Celltrion was 22%.

In June 2005,
Celltrion entered into several agreements to manufacture biologic products
being developed by Bristol-Myers Squibb Company (BMS). Technology transfer
activities began immediately upon the execution of the BMS agreements.
Production of product, which will be manufactured according to U.S. cGMP
standards, is expected to utilize a significant portion of Celltrions 50,000
liters of bioreactor capacity and began in 2006. VaxGen and Celltrion entered
into a Technical Support and Services Sub-Agreement (Sub-Agreement) effective
in June 2005. The Sub-Agreement provides for VaxGen to assist Celltrion with
services required under the BMS agreement. Under the Sub-Agreement, VaxGen will
be paid for out-of-pocket expenses and services rendered. Amounts earned by
VaxGen under this agreement are included in related party service revenues in
the consolidated statement of operations.

2. Summary of Significant Accounting Policies

Valuation
of Derivative Instruments

The Company
values certain embedded features it issued in connection with the financing of
convertible notes in 2005 as derivative liabilities under FAS No. 133, Accounting
for Derivative Instruments and Hedging Activities (FAS 133). The
Company estimates the fair value of its derivative liabilities each quarter using
the Monte Carlo Simulation methodology. This methodology is complex and
requires significant judgments in the estimation of fair values based on
certain assumptions. Factors affecting the amount of these liabilities include
changes in the Companys stock price and other assumptions. Changes in value
are recorded as non-cash valuation adjustments within other income (expense) in
the Companys consolidated statements of operations. These changes in the
carrying value of derivatives can have a material impact on the Companys
consolidated financial statements. The derivative liabilities may be
reclassified into stockholders equity upon conversion or payment of the
convertible notes, or other events, the timing of which may be outside the
Companys control.

The embedded
derivative liabilities do not qualify for hedge accounting under FAS 133 and
therefore, subsequent changes in fair value are recorded as non-cash valuation
adjustments within other income (expense) in the consolidated statements of
operations.

Stock-Based
Compensation

The Company
accounts for stock-based compensation based on the provisions of Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees,
which states that, for fixed plans, no compensation expense is recorded for
stock options or other stock-based awards to employees that are granted with an
exercise price equal to or above the fair value per share of the common stock
on the grant date. In the event that stock options are granted with an exercise
price below the fair value of the common stock at the grant date, the
difference between the fair value of the common stock and the exercise price of
the stock option is recorded as deferred compensation. Deferred compensation is
amortized to compensation expense using the straight-line method over the
vesting period of the stock option.

7

The Company
has adopted the disclosure requirements of Statement of Financial Accounting
Standards (FAS) No. 123, Accounting for Stock-Based Compensation
(FAS 123) and FAS No. 148, Accounting for Stock Based CompensationTransition
and Disclosurean Amendment of FASB Statement No. 123, which requires compensation expense
to be disclosed based on the fair value of the options granted at the date of
the grant.

Celltrion
grants employees stock options with approval by its Board of Directors and
stockholders. Stock options are granted to Celltrion employees upon completion
of one year of service. Shares under option vest 40% upon completion of the
third year of service from the grant date. The remainder vests 30% each for the
fourth and fifth year of service from the grant date. All Celltrion stock
option grants expire no later than 9 years from the date of grant, unless
cancelled earlier due to termination of employment or other events defined in
the option agreement, such as the holder assigning or pledging their stock
options or Celltrion being unable to comply with the exercise of the stock
option due to bankruptcy or liquidation. The Celltrion stock option agreement
has an anti-dilution provision that is triggered by the issuance of new shares
or warrants at prices which are lower than the options exercise price,
accordingly, Celltrion stock options are subject to variable accounting.
Subsequent changes in the value of Celltrions stock will result in increases
or decreases in compensation expense until the options are exercised, cancelled
or expire unexercised.

Had
compensation cost for the Companys stock-based compensation plans been
determined in a manner consistent with the fair value approach described in FAS
123, the Companys net loss and net loss per share as restated would have been
increased to the pro forma amounts indicated below (in thousands, except per
share data):

Three
  Months Ended
  September 30,

Nine Months
  Ended
  September 30,2005

2004

2005

2004Net loss  as
reported

$
(5,694
)
$
(10,832
)
$
(34,399
)
$
(36,923
)Add: Stock-based employee
compensation expense included in reported
  net loss, net of minority interest


878


192


4,574


408Less: Total stock-based
employee compensation expense determined under
  fair value based method for all awards, net of minority interest


(2,124
)

(1,784
)

(9,222
)

(5,746
)Net loss  pro
forma

$
(6,940
)
$
(12,424
)
$
(39,047
)
$
(42,261
)Net loss per share basic
and diluted, as reported

$
(0.19
)
$
(0.43
)
$
(1.16
)
$
(1.46
)Net loss per share basic
and diluted, pro forma

$
(0.23
)
$
(0.49
)
$
(1.32
)
$
(1.68
)During the
nine months ended September 30, 2005, there were no stock options granted by
VaxGen and there were no enrollments in the Employee Stock Purchase Plan. The
value of each option grant and Employee Stock Purchase Plan grant was estimated
on the date of grant using the Black-Scholes option pricing model with the
following weighted average assumptions (no expected dividends):

Three
  Months Ended
  September 30,

Nine Months
  Ended
  September 30,2005

2004

2005

2004VaxGen
  Stock Option
  PlansRisk-free interest rate

n/a


3.61
%

n/a


3.77
%Expected life in years

n/a


5.0


n/a


5.0Volatility

n/a


102
%

n/a


100
%Celltrion
  Stock Option PlanRisk-free interest rate

n/a


4.88
%

4.30
%

4.88
%Expected life in years

n/a


6.0


6.0


6.0Volatility

n/a


71
%

62
%

72
%VaxGen
  Employee Stock Purchase PlanRisk-free interest rate

n/a


1.86
%

n/a


1.36
%Expected life in years

n/a


1.0


n/a


1.0Volatility

n/a


84
%

n/a


88
%8

Reclassifications

Customer
advances of $2.1 million at December 31, 2004 have been reclassified from
reductions of accounts receivable to accrued expenses to conform to the
Companys 2005 presentation.

New
Accounting Pronouncements

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

In December
2004, the FASB issued FAS No. 123(R), Share-Based Payment (FAS 123R) which is
a revision of FAS 123. Generally, the approach in FAS 123R is similar to the
approach described in FAS 123. However, FAS 123R requires all share-based
payments to employees, including grants of employee stock options, to be
recognized in the consolidated statement of operations based on their fair
values. Pro forma disclosure is no longer an alternative. The new rule applies
to option grants made after adoption as well as options that are not vested at
the date of adoption. FAS 123R must be adopted in annual periods beginning
after July 1, 2005. The Company plans to begin applying FAS 123R prospectively
in the first quarter of 2006. Additionally, in August 2005, the FASB issued
FASB Staff Position (FSP) FSP FAS 123R-1, Classification and Measurement of Freestanding
Financial Instruments Originally Issued in Exchange for Employee Services under
FASB Statement No. 123(R) (FSP1). In FSP1, the FASB decided to
defer the requirements in FAS 123 that make a freestanding financial instrument
subject to the recognition and measurement requirements of other GAAP when the
rights conveyed by the instrument are no longer dependent on the holder being
an employee. In October 2005, the FASB issued FSP FAS 123R-2, Practical
Accommodation to the Application of Grant Date as Defined in FASB Statement No.
123(R) (FSP2). In FSP2, the FASB is providing companies with a
practical accommodation when determining the grant date of an award that is
subject to the accounting provisions in FAS 123R. In November 2005, the FASB
issued FSP FAS 123R-3, Transition Election Related to Accounting for the Tax
Effects of Share-Based Payment Awards (FSP3). FSP3 provides an
elective alternative method that establishes a computational component to
arrive at the beginning balance of the accumulated paid-in capital pool related
to employee compensation and a simplified method to determine the subsequent
impact on the accumulated paid-in capital pool of employee awards that are
fully vested and outstanding upon the adoption of FAS 123R. In February 2006,
the FASB issued FSP FAS 123R-4, Classification of Options and Similar Instruments
Issued as Employee Compensation That Allow for Cash Settlement upon the
Occurrence of a Contingent Event (FSP4), which concludes that a
cash settlement feature that can be exercised only upon the occurrence of a
contingent event that is outside the employees control does not become a
liability until it becomes probable that the event will occur. An option or
similar instrument that is classified as equity, but subsequently becomes a
liability because the contingent cash settlement event is probable of
occurring, shall be accounted for similar to modification from an equity to
liability award. To the extent that the liability exceeds the amount previously
recognized in equity, the excess is recognized as compensation cost. The total
recognized compensation cost for an award with a contingent cash settlement
feature shall at least equal the fair value of the award at the grant date.
FSP4 is applicable only for options or similar instruments issued as part of
employee compensation arrangements. In October 2006, the FASB issued FSP FAS
123R-5, Amendment
of FASB Staff Position FAS 123(R)-1 (FSP5), which addresses
whether a modification of an instrument in connection with an equity
restructuring should be considered a modification for purposes of applying
FSP1. The provisions in FSP5 are effective for the first reporting period
beginning after October 10, 2006. Also, in October 2006, the FASB issued FSP
FAS 123R-6, Technical
Corrections of FASB Statement No. 123 (revised 2004) (FSP6), which
addresses certain technical corrections of FAS 123R. The provisions in FSP6 are
effective for the first reporting period beginning after October 20, 2006. The
guidance in FSP1, FSP2, FSP3, FSP4, FSP5 and FSP6 will be applied upon the
Companys adoption of FAS 123R. The Company is currently evaluating the impact
of adopting the guidance in FAS 123R, FSP1, FSP2, FSP3, FSP4, FSP5 and FSP6 on
the Companys consolidated financial position, results of operations and cash
flows.

In March 2005,
the SEC published Staff Accounting Bulletin No. 107 (SAB 107). The
interpretations in this staff accounting bulletin express the views of the
staff regarding the interaction between FAS 123R and certain SEC rules and
regulations and provide the staffs views regarding the valuation of
share-based payment arrangements for public companies. In particular, SAB 107
provides guidance related to share-based payment transactions with
non-employees, the transition from nonpublic to public entity status, valuation
methods (including assumptions such as expected volatility and expected term),
the accounting for certain redeemable financial instruments issued under
share-based payment arrangements, the classification of compensation expense,
non-GAAP financial measures, first-time adoption of FAS 123R in an interim
period, capitalization of compensation cost related to share-based payment
arrangements, the accounting for income tax effects of share-based payment
arrangements upon adoption of FAS 123R, the modification of employee share
options prior to adoption of FAS 123R and disclosures in Managements
Discussion and Analysis subsequent to adoption of FAS 123R. The Company will
comply with SAB 107 upon its adoption of FAS 123R. The Company is
currently evaluating the impact of adopting SAB 107 on the Companys
consolidated financial position, results of operations and cash flows.

9

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

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

In July 2005,
the FASB issued FSP APB 18-1, Accounting by an Investor for its Proportionate Share
of Accumulated Other Comprehensive Income of an Investee Accounted for under
the Equity Method in Accordance with APB Opinion No. 18 upon a Loss of
Significant Influence (FSP APB 18-1), which provides guidance on
how an investor should account for its proportional share of an investees
equity adjustments for other comprehensive income (OCI) upon a loss of
significant influence as detailed in paragraph 121 of FAS No. 130, Reporting
Comprehensive Income (FAS 130). APB Opinion No. 18, The Equity
Method of Accounting for Investments in Common Stock (APB 18)
requires a transaction of an equity method investee of a capital nature be
accounted for as if the investee was a consolidated subsidiary, which requires
the investor to record its proportionate share of the investees adjustments
for OCI as increases or decreases to the investment account with corresponding
adjustments in equity. FSP APB 18-1 requires that an investors proportionate
share of an investees equity adjustments for OCI should be offset against the
carrying value of the investment at the time significant influence is lost and
equity method accounting is no longer appropriate. However, to the extent that
the offset results in a carrying value of the investment that is less than
zero, an investor should (a) reduce the carrying value of the investment to
zero and (b) record the remaining balance in income. The guidance in FSP APB
18-1 is effective for the Company on October 1, 2005. The Company is currently
evaluating the impact of adopting FSP APB 18-1 on the Companys consolidated
financial position, results of operations and cash flows.

In September
2005, the Emerging Issues Task Force (EITF) reached a consensus on Issue No.
05-7, Accounting
for Modifications to Conversion Options Embedded in Debt Instruments and
Related Issues (EITF 05-7). EITF 05-7 requires that a change in
the fair value of a conversion option brought about by modifying the debt
agreement be included in analyzing in accordance with EITF consensus on Issue
No. 96-19, Debtors Accounting for a Modification or Exchange of Debt
Instruments (EITF 96-19), whether a debt instrument is considered
extinguished. Under EITF 96-19s requirements, an issuer who modifies a debt instrument
must compare the present value of the original debt instruments cash flows to
the present value of the cash flows of the modified debt. If the present value
of those cash flows varies by more than 10 percent, the modification is
considered significant and extinguishments accounting is applied to the
original debt. If the change in the present value of the cash flows is less
than 10 percent, the debt is considered to be modified and is subject to EITF
96-19s modification accounting. EITF 05-7 requires that in applying the 10
percent test the change in the fair value of the conversion option be
treated in the same manner as a current period cash flow. EITF 05-7 also
requires that, if a modification does not result in an extinguishment, the change
in fair value of the conversion option be accounted for as an adjustment to
interest expense over the remaining term of the debt. The issuer should not
recognize a beneficial conversion feature (BCF) or reassess an existing BCF
upon modification of the conversion option of a debt instrument that does not
result in an extinguishment. EITF 05-7 is effective for modifications of debt
instruments beginning in the first interim or annual reporting period beginning
after December 15, 2005. The Company does not expect the adoption of EITF 05-7
to have material impact on the Companys consolidated financial position,
results of operations or cash flows.

10

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

In November
2005, the FASB issued FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments (FSP FAS
115-1 and FAS 124-1). This FSP nullifies certain requirements of EITF Issue
No. 03-1 and supersedes EITF Abstracts, Topic No. D-44, Recognition of Other-Than-Temporary
Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value.
Based on the clarification provided in FSP FAS 115-1 and FAS 124-1, the amount
of any other-than-temporary impairment that needs to be recognized will
continue to be dependent on market conditions, the occurrence of certain events
or changes in circumstances relative to an investee and an entitys intent and
ability to hold the impaired investment at the time of the valuation. FSP FAS
115-1 and FAS 124-1 are effective for reporting periods beginning after
December 15, 2005. The Company is evaluating the impact of adopting the
guidance in FSP FAS 115-1 and FAS 124-1on the Companys consolidated financial
position, results of operations and cash flows.

In February
2006, the FASB issued FAS No. 155, Accounting for Certain Hybrid Financial Instruments
(FAS 155), which amends FAS 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 EITF reached a tentative consensus on Issue No. 06-3, How Sales Taxes Collected from
Customers and Remitted to Governmental Authorities Should Be Presented in the
Income Statement (That Is, Gross Versus Net Presentation) (EITF
06-3). EITF 06-03 addresses income statement classification and disclosure
requirements of externally-imposed taxes on revenue-producing transactions.
EITF 06-3 is effective for periods beginning after December 15, 2006. The
Company does not expect the implementation of EITF 06-3 to have a material
impact on the Companys consolidated financial position, results of operations
or cash flows.

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

11

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

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

In November
2006, the FASB ratified EITF Issue No. 06-6, Application of EITF Issue No. 05-7,
Accounting for Modifications to Conversion Options Embedded in Debt
Instruments and Related Issues (EITF 06-6). EITF 06-6 addresses
the modification of a convertible debt instrument that changes the fair value
of an embedded conversion option and the subsequent recognition of interest
expense for the associated debt instrument when the modification does not
result in a debt extinguishment pursuant to EITF 96-19. The Company does not
expect the adoption of EITF 06-6 to have a material impact on its consolidated
financial position, results of operations or cash flows.


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

12

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):

Nine Months Ended 
  September 30,2005

2004Potentially
  dilutive securities:Options to purchase common stock


4,518


4,560Warrants to purchase common stock


959


1,846Convertible notes


2,134


Total


7,611


6,406On August 8, 2005, at a special
meeting of stockholders, the stockholders of the Company approved an amendment
to the Companys Amended and Restated Certificate of Incorporation to increase
the authorized number of shares of common stock from 40 million shares to 65
million shares.

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 EndedSeptember 30,

Nine Months EndedSeptember 30,2005

2004

2005

2004Net loss

$
(5,694
)
$
(10,832
)
$
(34,399
)
$
(36,923
)Foreign currency translation adjustments


(7,505
)

10


147


84Unrealized gains (losses) on investment securities


21


49


(38
)

(38
)Comprehensive loss

$
(13,178
)
$
(10,773
)
$
(34,290
)
$
(36,877
)5.
Balance Sheet Components

Restricted
Cash

At September 30, 2005 and December 31, 2004, VaxGen
had restricted cash of $3.2 million and $1.1 million, respectively, as
compensating balances to support outstanding letters of credit. The letters of
credit, which increased as a result of the amended lease discussed below,
relate to the Companys facilities leases and utility services and are renewed
annually. At December 31, 2004, Celltrion had restricted cash of $0.2 million
representing a deposit for utility services.

Prepaid
Expenses and Other Current Assets

In September 2005, VaxGen entered
into an agreement to raise approximately $15.1 million in gross proceeds
through the sale of 1.2 million of its shares in Celltrion to a group of Korean
investors. In September 2005, VaxGen received $2.0 million of the gross
proceeds from the transaction. The balance of the receivable is included in
prepaid expenses and other current assets at September 30, 2005. Included in
the other income for the three and nine months ended September 30, 2005 is an
$11.2 million gain on the sale and a $1.1 million foreign currency gain as a
result of the change in the value of the Korean Won.

13

Investment
in Affiliate

During the three months ended
September 30, 2005, Celltrion sold common stock as follows:


3,000,000 shares to the existing stockholders and others
  at a price of 5,000 Korean Won ($4.80 equivalent) per share, resulting in
  proceeds of 15,000 million Korean Won ($14.4 million equivalent);
1,986,301 shares to the existing stockholders and others
  at a price of 5,000 Korean Won ($4.91 equivalent) per share, resulting in
  proceeds of 9,932 million Korean Won ($9.8 million equivalent); and
33,924 shares to JS at a price of 22,500 Korean Won
  ($21.76 equivalent) per share, resulting in proceeds of 763 million Korean
  Won ($0.7 million equivalent).In July 2005, VaxGen participated
in a round of fund-raising with the Korean Investors and purchased from
Celltrion 239,068 shares of common stock for $1.2 million.

As a result of these transactions,
VaxGens ownership interest in Celltrion decreased from 32% to 22%, but because
of the amounts invested VaxGens net equity in Celltrion increased by $2.9
million. Because Celltrion is not yet an operating company, this increase has
been reflected as an equity transaction included in additional paid-in capital.

Accrued
and Other Current Liabilities

Accrued and other current
liabilities at September 30, 2005 and December 31, 2004 included employment
benefit accruals of $6.8 million (including $3.2 million for the ESPP Bonus
discussed in Note 7) and $2.5 million, respectively, customer advances of $4.5
million and $2.1 million, respectively, and a sub-contractor settlement accrual
from 2004 of $1.5 million.

Deferred
Rent and Other Liabilities

On April 14, 2005, VaxGen entered
into an amended lease agreement to secure space to support the production of
its recombinant anthrax vaccine candidate as well as its other programs. This
lease terminates in December 2016. Included in deferred rent and other
liabilities at September 30, 2005 is $3.1 million of deferred rent associated
with this amended lease. As a result of the timing of cash flows under the
amended lease this deferred rent increased by $0.7 million during the nine
months ended September 30, 2005 and will increase by $0.2 million, $0.7
million, $0.6 million, $0.5 million in the three months ended December 31, 2005
and the years ended December 31, 2006, 2007 and 2008, respectively. Thereafter,
the $5.1 million balance at December 31, 2008 will be amortized through 2016.

6.
Convertible Senior Subordinated Notes

In April 2005, the Company raised
net proceeds of $29.7 million through a private placement of $31.5 million of
5-1/2% convertible senior subordinated notes (Notes) due April 1, 2010. The
Notes require semi-annual payments of interest in cash at a rate of 5-1/2%;
convert, at the option of the holder, into the Companys common stock at an
initial conversion price of $14.76 per share subject to adjustment; convert, at
the Companys option, into common stock if the Companys common stock reaches a
price of $22.14 per share; will be provisionally redeemable at the Companys
option for a redemption price of 100% of the principal amount of the Notes to be
redeemed, plus accrued and unpaid interest, plus an interest make-whole
payment, under certain circumstances, including among others, that the closing
price of the Companys common stock has exceeded $22.14 per share, subject to
adjustment, for at least 20 trading days within a period of 30 consecutive
trading days; and constitute senior subordinated obligations of the Company.
The Company, at its own option, may redeem the Notes for face value plus
accrued interest and an interest make-whole payment. If a change in control
occurs on or prior to the stated maturity of the Notes, the holders of the
Notes may require the Company to repurchase the Notes and pay a make-whole
premium to the holders of the Notes. If the holders request such a repurchase,
the Company or the successor entity, may choose to pay in cash, common stock or
a combination of cash and common stock. This feature constitutes a put-option
derivative liability.

The Company initially valued the
derivative liability associated with the Notes at $1.8 million. This amount was
accounted for as a reduction in the initial carrying value of the Notes and an
increase to current liabilities. This discount to the Notes is being amortized
over five years using the effective interest method. Interest expense for the
three and nine months ended September 30, 2005 reflects non-cash amortization
charges of $0.1 million and $0.2 million, respectively, related to this
discount. For the three and nine months ended September 30, 2005, valuation
adjustments income of $0.6 million and $0.4 million, respectively, represented
the decrease in the fair value of the derivative liability.

The Company incurred financing
expenses associated with the Notes of $1.8 million. This amount was accounted
for as an increase to non-current other assets. The financing expenses are
being amortized over five years using the straight-line method. Interest
expense for the three and nine months ended September 30, 2005 reflects
non-cash amortization charges of $0.1 million and $0.2 million, respectively,
related to these expenses.

14

Interest expense on the Notes for
the three and nine months ended September 30, 2005 was $0.6 million and $1.2
million, respectively. The Company estimates the fair market value of the Notes
to be $40.1 million at September 30, 2005.

Valuation
of Note and Note Derivatives

The Note and related derivatives
have been valued using the Monte Carlo fair value methodology. The Company
completed the valuation of the Notes and the change in control put option. The
Monte Carlo methodology allows flexibility in incorporating various assumptions
such as probabilities of a change in control. The valuations are based on the
information available as of the various valuation dates.

The inputs for valuation analysis
of the derivatives embedded in the Notes include the market value of the
Companys common stock, the estimated volatility of the Companys common stock,
the Companys market capitalization, the conversion rate of the Notes, the risk
free interest rate as well as the credit spread, which represents the
Companys risk premium over the risk free interest rate.

The key inputs for the valuation
analysis of these embedded derivatives were as follows:

April 2005

September 30, 
  2005Volatility

99
%

95
%Risk free interest
  rate

4.1
%

4.1
%Credit spread

13.9
%

13.9
%Obligation
to Register Shares

Pursuant to the Notes, the Company
has agreed to register the shares issuable upon conversion of the Notes for
resale under the Securities Act of 1933, as amended (Securities Act). The
Company has agreed to file with the SEC a registration statement (Registration
Statement) with respect to these shares no later than thirty days following
(Filing Date) the first date it becomes current in its reporting requirements
under the Securities and Exchange Act of 1934 and to use its best efforts to
cause the Registration Statement to become effective on or before the date that
is the earlier of (1) in the event of no review by the SEC no later than
90 days after the Filing Date, (2) in the event of a review by the SEC, no
later than 120 days after the Filing Date (the earlier of (1) and (2),
Required Effective Date).

The Company will be liable for
liquidated damages under the following circumstances (Defaults):


if the
  Registration Statement is not filed on or before the Filing Date;
if the
  Registration Statement is not declared effective by the SEC on or prior to
  the Required Effective Date; or
if the
  Registration Statement (after its effectiveness date) ceases to be effective
  in certain circumstances.In the event of a Default, the
Company shall pay as liquidated damages, for each 30-day period of a Default,
an amount in cash equal to 1% of the principal amount of the Notes until the
applicable failure has been cured. The liquidated damages payable under the
Stock Purchase Agreement will apply on a pro rata basis for any portion of a
30-day period of a Default.

7.
Employee Stock Purchase Plan

The ESPP is implemented by a series of 24-month offering periods (each an
Offering Period and collectively Offering Periods). Offering Periods were
suspended effective July 1, 2004 as a result of the Companys delisting in
August 2004.

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. The
Offering Periods ending in June 2005 and September 2005 were also extended.
During the three and nine months ended September 30, 2005, the Company recorded
$0.5 million and $2.7 million, respectively, in non-cash research and
development compensation expense for these modifications. During the three and
nine months ended September 30, 2005, the Company recorded $0.1 million and
$0.8 million, respectively, in non-cash general and administrative compensation
expense for these modifications.

In September 2005, the Compensation
Committee of the Companys Board of Directors approved a contingent bonus program for
employees participating in the ESPP. Under this program, a bonus would
be payable to ESPP participants in the event the ESPP was
terminated by the Company (ESPP Bonus). In November 2005, the
Company terminated the ESPP and the ESPP Bonus therefore became payable.
Payment of this bonus was contingent upon the successful completion of a
financing subsequent to the termination of the ESPP and was available only to
individuals who were employees of the Company at the time of the bonus payment.
During the three months ended September 30, 2005, the Company recorded a
research and development expense of $2.5 million and a general and
administrative expense of $0.7 million for the estimated cost of this bonus
program.

15

8.
Warrants

On May 23, 2001, VaxGen sold 20,000
shares of Series A Preferred Stock and issued common stock purchase warrants
(Series A Warrants). VaxGen did not file its Quarterly Report on Form 10-Q
for the quarter ended March 31, 2004 by the extended filing deadline of May 17,
2004. As a result, its registration statement on Form S-3 covering the resale
of the common stock issuable upon exercise of the Series A Warrants was
suspended. On September 21, 2004, VaxGen exchanged the Series A Warrants
pursuant to section 3(a)(9) of the Securities Act of 1933, as amended, for
warrants to purchase a total of 1,146,388 shares of common stock, exercisable
until September 21, 2005, at an exercise price of $0.01 per share ($0.01
Warrants). In connection with the exchange, the agreements governing the
Series A Warrants were terminated. In 2004, $0.01 Warrants for 716,494 shares
were exercised. In January 2005, 429,640 shares of unregistered common stock
were issued as a result of the exercise of the remaining $0.01 Warrants.

On April 13, 2004, Celltrion
granted warrants to all of its existing stockholders to acquire 4.0 million
shares of its convertible preferred stock. The exercise price was 5,000 Korean
Won ($4.38 equivalent) per preferred share. The exercise period was April 13,
2004 to December 31, 2004. On December 30, 2004, Celltrions Board of Directors
agreed to extend the warrants expiration date from December 31, 2004 to March
31, 2005 (Extended Tranche). In March 2005, Celltrion issued 1,949,700 shares
of preferred stock under the Extended Tranche at a price of 5,000 Korean Won
($4.99 equivalent) per share, resulting in net proceeds of 9,698 million Korean
Won ($9.5 million equivalent).

9.
Related Party Transactions

In December 2002, Celltrion engaged
Daewoo Engineering and Construction Co., Ltd. (Daewoo) to manage the
construction of the Incheon manufacturing facility and administration
buildings. In January 2003, Daewoo purchased 260,000 shares of Celltrions
preferred stock at a price of 22,348 Korean Won per share (equivalent to $18.78
per share). At the time of this purchase, Nexols and Celltrions Chief
Executive Officer, who are the same person, entered into a purchase agreement
with Daewoo. Per the terms of this purchase agreement, upon the completion of
the construction of Celltrions facility, Daewoo would sell these shares to
Nexol at the original purchase price. Celltrions Chief Executive Officer
guaranteed this agreement. Effective July 1, 2005, Celltrion was deconsolidated
from VaxGen and accounted for under the equity method. During the three months
ended September 30, 2004, Celltrion paid Daewoo $2.9 million. During the nine months
ended September 30, 2005, while consolidated with VaxGen, and 2004, Celltrion
paid Daewoo $10.9 million and $16.5 million, respectively, related to the
construction of the Incheon facilities.

In June 2005, Celltrion entered
into several agreements to manufacture biologic products being developed by
Bristol-Myers Squibb Company (BMS). Technology transfer activities began
immediately upon the execution of the BMS agreements. Production of product,
which will be manufactured according to U.S. cGMP standards, is expected to
utilize a significant portion of Celltrions 50,000 liters of bioreactor
capacity and began in 2006. VaxGen and Celltrion entered into a Technical
Support and Services Sub-Agreement (Sub-Agreement) effective in June 2005.
The Sub-Agreement provides for VaxGen to assist Celltrion with services
required under the BMS agreement. Under the Sub-Agreement, VaxGen will be paid
for out-of-pocket expenses and services rendered. VaxGen recognized $0.2
million of revenue under this agreement during the three and nine months ended
September 30, 2005.

10.
Commitments and Contingencies

On April 14, 2005, VaxGen entered
into an amended lease agreement to secure space to support the production of
its recombinant anthrax vaccine candidate as well as its other programs. This
space, which totals 105,000 square feet, is used for manufacturing, quality
assurance, quality control, research and development and other functions. The
amended lease replaces VaxGens previous sublease for 49,919 square feet and
previous lease of 19,933 square feet. It also provides an additional 35,000
square feet of new space. This lease terminates in December 2016; however,
VaxGen has options to renew the lease for two additional five-year periods. In
connection with the amended lease agreement, an amended letter of credit in the
amount of $2.4 million was issued to the lessors. The letter of credit is
collateralized by a certificate of deposit held by the bank that issued the
letter of credit. The certificate of deposit is included in restricted cash in
the consolidated balance sheet as of December 31, 2005. In addition, the
amended lease agreement provides for up to $2.2 million in reimbursements for
the costs of certain tenant improvements. VaxGen billed for and received the
full $2.2 million in reimbursements.

16

Per the terms of the amended lease
agreement, VaxGens future minimum annual payments as of September 30, 2005
under operating lease obligations are as follows:

Year ending
  December 31:2005 remainder

$
9202006


3,9342007


3,2722008


2,8382009


3,4142010 and beyond


28,056Total

$
42,434Substantially all of the Companys
revenue is derived from government contracts and grants. Future sales to U.S.
government agencies will depend, in part, on the Companys ability to meet U.S.
government agency contract requirements. U.S. government contracts typically
contain unfavorable termination provisions and are subject to audit and
modification by the government at its sole discretion. The U.S. government may
terminate any of its contracts with the Company either for its convenience or
if the Company defaults by failing to perform in accordance with the contract
schedule and terms. If the U.S. government terminates any of its contracts, the
Company may be liable to the U.S. government for damages or to sub-contractors,
service providers or vendors for goods and services that may no longer be
reimbursable by the U.S. government. See Subsequent Events in Note 13.

11.
Legal Proceedings

On March 17, 2003, a civil
complaint for violation of Sections 10(b) and 20(a) of the Securities Exchange
Act was filed in the United States District Court for the Northern District of
California, entitled Janice Whitkens v. VaxGen, Inc., et al., Civil Action No.
C03-1129 JSW. Named, as defendants were VaxGen, Inc., Chief Executive Officer
Lance K. Gordon and former President Donald P. Francis. The plaintiff sought to
represent a class of persons who purchased our securities between August 6,
2002 and February 26, 2003, and alleged that the defendants misled investors
about the progress of certain clinical trials and our future manufacturing and
marketing plans. Following the filing of the Whitkens complaint, several
additional class action complaints were filed in the same court, each making
identical or similar allegations against the same defendants. In May 2005, the
United States District Court for the Northern District of California dismissed
with prejudice this class action lawsuit.

On or about March 21, 2003, two
separate but virtually identical shareholder derivative actions were filed in
California Superior Court for San Mateo County entitled Rhodes v. Allen, et al.
civil action No. CIV 430087, and MacDonald v. Allen, et al., civil action No.
CIV 430088. A consolidated complaint was filed in June 2003. Named as
defendants in the action were Company directors Lance K. Gordon, Randall L-W.
Caudill, and William D. Young, and former Company directors Donald P. Francis,
Phillip W. Berman, David W. Beier, and Stephen C. Francis (Company
Directors). Also named as defendants were Paul Allen and Vulcan Ventures, Inc.
(Vulcan Defendants). The allegations of the consolidated complaint were
similar to those contained in the class actions, although unlike the class
action, in the derivative action the plaintiff purports to seek recovery on
behalf of VaxGen, rather than from VaxGen. Plaintiffs alleged as well that the
Vulcan Defendants sold shares of our stock while in possession of material
non-public information about us. Plaintiffs, purportedly suing on behalf of
VaxGen, assert claims against all defendants for breach of fiduciary duty,
mismanagement, waste and unjust enrichment, and against the Vulcan Defendants
for breach of fiduciary duty and insider trading. The Company Directors and the
Vulcan Defendants filed demurrers challenging the demand futility allegations
in the consolidated complaint. The Court overruled the defendants demurrers
and the parties entered the discovery phase of the litigation. The parties
subsequently entered into settlement discussions. The Company settled the
shareholders derivative lawsuit in 2005. Under the terms of the settlement,
the Company paid $0.5 million to the derivative plaintiffs to cover attorneys
fees and also agreed to make certain changes in its disclosure practices and
procedures. The settlement was approved by the court in September 2005.

The Company is subject to a wide variety of
laws and regulations relating to land use and development and to environmental
compliance and permitting obligations, including those related to the use,
storage, discharge, emission and disposal of hazardous materials. Certain
claims, suits and complaints in the ordinary course of business are pending or
may arise. While there can be no assurance as to the ultimate outcome of any
litigation involving the Company, the Company does not believe any pending legal
proceeding will result in a judgment or settlement that would have a material
adverse effect on the Companys consolidated financial position, results of
operations or cash flows.

17

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 July
2005, from January 1, 2004 to June 30, 2005, the Company operated in two
business segments. 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.

Substantially all of VaxGens
revenue is derived from federal government contracts and grants, primarily from
the U.S. Department of Health and Human Services, the National Institutes of
Health and related entities. From its inception through September 30, 2005,
Celltrion had not been operational or earned any revenues. All of VaxGens
operating assets are located in the United States of America. Celltrions
operating assets are located in the Republic of Korea.

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

Three Months Ended 
  September 30,

Nine Months Ended
  September 30,Revenues

2005

2004

2005

2004VaxGen

$
6,375

$
7,346

$
24,129

$
22,666Celltrion


n/a








Eliminations


n/a


(92
)

(127
)

(358
)Total

$
6, 375

$
7,254

$
24,002

$
22,308Three Months Ended 
  September 30,

Nine Months EndedSeptember 30,Depreciation and Amortization

2005

2004

2005

2004VaxGen

$
1,097

$
404

$
2,959

$
1,150Celltrion


n/a


456


1,538


1,338Eliminations


n/a


(407
)

(931
)

(1,217
)Total

$
1,097

$
453

$
3,566

$
1,271Three Months Ended
  September 30,

Nine Months Ended
  September 30,Interest Expense

2005

2004

2005

2004VaxGen

$
642

$


$
1,232

$
Celltrion


n/a





524


Total

$
642

$


$
1,756

$
Three Months Ended 
  September 30,

Nine Months Ended
  September 30,Equity in Loss of Affiliate

2005

2004

2005

2004VaxGen (in
  Celltrion)

$
(1,055
)
$
(191
)
$
(3,081
)
$
(1,623
)Celltrion (in VCI)


n/a


(130
)




(657
)Eliminations


n/a


321


2,026


2,280Total

$
(1, 055
)
$


$
(1,055
)
$
Three Months Ended 
  September 30,

Nine Months EndedSeptember 30,Net Loss

2005

2004

2005

2004VaxGen

$
(5,694
)
$
(11,333
)
$
(34,308
)
$
(37,310
)Celltrion


n/a


(713
)

25,617


(3,764
)Eliminations


n/a


1,214


(25,708
)

4,151Total

$
(5,694
)
$
(10,832
)
$
(34,399
)
$
(36,923
)Property and Equipment, net

September 30,
  2005

December 31,
  2004VaxGen

$
28,297

$
22,017Celltrion


n/a


116,359Eliminations


n/a


(130
)Total

$
28,297

$
138,246Investment in Affiliate

September 30,
  2005

December 31,
  2004VaxGen (in
  Celltrion)

$
19,136

$
25,450Eliminations


n/a


(25,450
)Total

$
19,136

$
18

Total Assets

September 30, 
  2005

December 31,
  2004VaxGen

$
101,622

$
92,056Celltrion


n/a


165,641Eliminations


n/a


(59,230
)Total

$
101,622

$
198,467Three Months Ended 
  September 30,

Nine Months Ended 
  September 30,Purchases of Property and Equipment

2005

2004

2005

2004VaxGen

$
(3,085
)
$
(1,632
)
$
(9,379
)
$
(3,932
)Celltrion


n/a


(6,276
)

(22,466
)

(24,735
)Total

$
(3,085
)
$
(7,908
)
$
(31,845
)
$
(28,667
)13.
Subsequent Events

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. In December 2006, the department of Health and Human Services
(HHS) terminated for default VaxGens contract with the U.S. government
Strategic National Stockpile (SNS) (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 contract related to the development and
delivery of a next-generation anthrax vaccine through a separate contract
modification. As part of the settlement agreement, NIAID agreed to pay 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 was actively pursuing avenues to enhance stockholder value through a
strategic transaction. Restructuring costs included employee termination
benefits and costs associated with the consolidation of the California
facilities. Estimated costs of the related termination benefits are $3.2
million; estimated facilities-related and other costs are $0.8 million. These
costs were recovered from the U.S. government as part of the 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.

2003
Anthrax Contract

In December 2004, NIAID notified
the Company of its intent to terminate, for its convenience, a portion of the
2003 Anthrax Contract and redirect the funds earmarked for the terminated
portion into other contract milestones, leaving the total contract value
unchanged. The portion of the contract which was terminated included activities
the Company had subcontracted to a fill/finish service provider. In March 2006,
the Company agreed to pay this service provider $1.5 million for costs relating
to the termination of the subcontract, which are not reimbursable under the
terms of the Companys contract with NIAID.

Equity
Financings

In February 2006, VaxGen raised net
proceeds of $25.3 million through a private placement of 3.5 million shares of
common stock at $7.70 per share to a group of accredited institutional
investors. In connection with the February 2006 financing, VaxGen also issued
to the investors five-year warrants initially exercisable to purchase 700,000
shares of common stock at an exercise price of $9.24 per share. Because VaxGen
did not file all of its delinquent periodic reports with the SEC by January 31,
2007, the warrants became exercisable for an additional 700,000 shares of
common stock, at a price of $9.24 per share.

19

As part of the February 2006
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 Exchange Act of 1934. The
registration for resale applies to the common stock issued in both transactions
as well as the stock issuable upon exercise of the warrants from the February
2006 transaction. The Company may be liable for liquidated damages of 1% of the
purchase price per month to holders of the shares and shares issuable upon
exercise of the warrants (a) if the registration statement is not filed on or
prior to 30 days of the Company becoming current in its reporting requirements;
(b) if the registration statement is not declared effective by the SEC on or
prior to 120 days from filing; or (c) if the registration statement (after
being declared effective) ceases to be effective in a manner that violates such
obligations.

$16.00
Warrants

On September 21, 2004, the Company
completed transactions in which the warrants issued in 2001 in association with
Series A Preferred Stock were surrendered in exchange for two new series of
warrants (Exchange Warrants). The Company issued to the holders of the Series
A Warrants, Exchange Warrants to purchase a total of 1,146,388 shares of common
stock, exercisable until September 21, 2005, at an exercise price of $0.01 per
share, and Exchange Warrants to purchase a total of 655,078 shares of common
stock, exercisable until September 21, 2007, at an exercise price of $16.00 per
share ($16.00 Warrants).

In December 2006, the Company
entered into an addendum (Addendum) with the holders of the $16.00 Warrants
under which the term of these warrants was extended by three additional years.
The $16.00 Warrants, as amended, will expire September 21, 2010 instead of
September 21, 2007. No other terms of the $16.00 Warrants were amended. In
connection with entering into the Addendum, the Company received releases from
the holders of the $16.00 Warrants regarding potential claims related to these
warrants.

Agreements
between VaxGen and Celltrion

In February 2006, VaxGen and
Celltrion entered into an agreement whereby Celltrion agreed to use its best
efforts to timely prepare annual and quarterly financial statements in
accordance with U.S. GAAP (Agreement to Provide U.S. GAAP Financial
Information). Under the agreement, VaxGen agreed to reimburse Celltrion for
all invoiced costs of the independent accountants relating to the preparation
of U.S. GAAP financial statements as well as all invoiced costs of audits and
reviews performed by the independent auditors. In addition, VaxGen will
compensate Celltrion for the cost of internal resources utilized in support of
these activities at a rate of 190% of the employees hourly wage; such costs
shall not exceed 300 million Korean Won ($0.3 million equivalent) per year and
shall be subject to approval in advance by VaxGen. In March 2007, Celltrion and
VaxGen amended the Technical Support and Services Sub-Agreement as well as the
Agreement to Provide U.S. GAAP Financial Information to reflect a reduction in
overhead rate on services performed from 90% to 40%.

During 2006, VaxGen received gross
proceeds of $130 million from the sale of most of its Celltrion common stock to
Nexol and affiliates of Nexol. As a result, as of June 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.

20

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, 2004, filed on February 7, 2007, and our unaudited condensed
consolidated financial statements and related notes thereto appearing in Item 1
of this Quarterly Report on Form 10-Q. In addition to the other information
contained or incorporated by reference in this Quarterly Report on Form 10-Q,
you should carefully consider the risk factors described in Part II  Item 1A
herein when evaluating an investment in our common stock. This Quarterly Report
includes forward-looking statements within the meaning of Section 27A of the
Securities Act, and Section 21E of the Exchange Act. All statements other than
statements of historical fact are forward-looking statements for purposes of
these provisions, including any statements of the plans and objectives of
management for future operations, any statements regarding future operations,
any statements concerning proposed new products or services, any statements
regarding pending or future mergers or acquisitions, any statements regarding
future economic conditions or performance, and any statement of assumptions
underlying any of the foregoing. In some cases, forward-looking statements can
be identified by the use of terminology such as may, will, expects,
plans, anticipates, estimates, potential or continue or the negative
thereof or other comparable terminology.

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

When used in the report, unless
otherwise indicated, we, our and us refers to VaxGen.

OVERVIEW

We are a biopharmaceutical company
focused on the development, manufacture and commercialization of biologic
products for the prevention and treatment of human infectious disease. Our
business strategy focuses on the development and commercialization of biologic
products to counter potential bioterrorism threats, principally vaccines
against inhalation anthrax and smallpox.

We were incorporated in 1995 and
formed to complete the development of an investigational recombinant protein
vaccine (AIDSVAX) intended to prevent infection by human immunodeficiency
virus. In 2002, we broadened our product development portfolio to also include
biodefense vaccines.

We are developing vaccines against
inhalation anthrax and smallpox for the purpose of biodefense. In 2002 and
2003, we were awarded contracts with an aggregate consideration of up to $101.2
million for the development of our anthrax vaccine (NIAID Contracts). On
November 4, 2004, we were awarded the SNS contract for $877.5 million to
provide 75 million doses of our recombinant anthrax vaccine to the U.S.
government SNS for civilian defense. The SNS Contract also includes up to an
additional $69 million in cost-plus fixed-fee task orders, which may be awarded
at the governments discretion. We expect to receive payment under the SNS
Contract when we deliver our anthrax vaccine and it is accepted by the U.S.
government into the SNS.

On August 6, 2004, we announced that we had received notification from
the Nasdaq Listing Qualifications Panel (Nasdaq Panel) that our stock would
discontinue trading on the Nasdaq National Market, now the Nasdaq Global Market
(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. The Nasdaq Panels decision to delist our stock was based on our
filing delinquency and our determination that previously filed financial
statements for the years ended December 31, 2003, 2002 and 2001 should not be
relied upon.

21

Celltrion

During 2004, we adopted the
provisions of Financial Accounting Standards Board Interpretation No. 46,
Consolidation of Variable Interest Entities (as revised, FIN 46R), and
determined that Celltrion, Inc. (Celltrion), our equity method investee as of
the date of adoption, constituted a variable interest entity (VIE) and that
we are its primary beneficiary. Accordingly, in accordance with FIN 46R, our
consolidated financial statements include the accounts of our VIE from January
1, 2004 to June 30, 2005, as if Celltrion has been consolidated since its
inception.

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

As a part of the initial
capitalization of Celltrion, we made an in-kind contribution to Celltrion of
the license and sub-license of certain cell culture technology used for the
manufacture of pharmaceutical products. We received 7.8 million shares of
Celltrions common stock for this contribution, representing approximately half
of the then outstanding shares. In March 2002, we entered into a Supply
Agreement, a License Agreement and a Sub-License Agreement with Celltrion.

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

In September 2005, we entered into
purchase agreements to raise approximately $15.1 million in gross proceeds
through the sale of 1.2 million of our shares in Celltrion to a group of Korean
investors. Nexol Co., Ltd. (Nexol) purchased 250,000 of these shares and
subsequent to this transaction, Nexol and its affiliates, collectively, became
the largest stockholder of Celltrion. As a result, as of the quarter ended
September 30, 2005, we were no longer the primary beneficiary of Celltrion.
Effective July 1, 2005, the results of Celltrion are deconsolidated from our
results and thereafter, recorded in our accounts under the equity method of
accounting. At September 30, 2005, our ownership interest in Celltrion was 22%.

Celltrions development activities
involve inherent risks. These risks include, among others, dependence on key
personnel and the ongoing need to finance its operations prior to commencement
of manufacturing operations. Successful future operations will depend on
Celltrions ability to secure contract manufacturing agreements for
biopharmaceutical products. In addition, Celltrion is dependent on us to
provide certain technical support.

Debt
financing

In April 2005, we raised aggregate
gross proceeds of $31.5 million through a private placement of 5-1/2%
Convertible Senior Subordinated Notes (Notes) due April 1, 2010.

Subsequent Events

In February 2006, we raised net
proceeds of $25.3 million through a private placement of 3.5 million shares of
common stock at $7.70 per share.

During 2006, we received gross
proceeds of $130 million from the sale of most of our Celltrion common stock to
Nexol and affiliates of Nexol.

In December 2006, the department of
Health and Human Services 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.

See Subsequent Events in Note 13 to
the unaudited condensed financial statements for more information regarding
events occurring after September 30, 2005.

22

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, 2004, filed with the SEC on February 7, 2007, for a description of
our critical accounting policies. The following policy on Valuation of
Derivative Instruments has been expanded to reflect its application to the
valuation of a derivative liability resulting from our April 2005 Notes
financing. There have been no other significant changes to our policies since
we filed that report.

Valuation
of Derivative Instruments

We value certain embedded features
we have issued in connection with the financing of our Notes in 2005 as
derivative liabilities. We estimate the fair value of our derivative
liabilities each quarter using the Monte Carlo Simulation methodology. This
methodology allows flexibility in incorporating various assumptions such as
probabilities of certain triggering events. The valuations are based on the
information available as of the various valuation dates. Factors affecting the
amount of these liabilities include the market value of our common stock, the
estimated volatility of our common stock, our market capitalization, the risk
free interest rate and other assumptions such as the probability of a change in
control event. Changes in value are recorded as non-cash valuation adjustments
within other income (expense) in our consolidated statements of operations.

RESULTS OF OPERATIONS

Comparison of Fiscal Quarters Ended
September 30, 2005 and 2004

Revenues

Three Months Ended
  September 30,



Nine Months Ended
  September 30,2005

2004

Percent
  change
  2005/2004

2005

2004

Percent
  change
  2005/2004(in thousands)



(in thousands)Revenues

$
6,375

$
7,254


(12%)

$
24,002

$
22,308


8%Research contracts and grants
revenue in the three months ended September 30, 2005 and 2004 were primarily
from our Anthrax Contracts principally reflecting work performed under our
NIAID Contracts. In 2005, as a result of the timing of NIAID-related activities
these revenues decreased by $1.4 million.

Research contracts and grants
revenue in the nine months ended September 30, 2005 and 2004 were primarily
from our Anthrax Contracts principally reflecting work performed under our
NIAID Contracts. In 2005, principally as a result of the timing of
NIAID-related activities these revenues increased by $1.9 million while
revenues from AIDSVAX-related activities decreased by $0.5 million from the
comparable period in the prior year. Revenues from related party services
performed for our affiliate were eliminated in consolidation in 2004. 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. The amounts
earned vary with the level of services required and increased over the periods
presented as Celltrions facility efforts increased. Celltrion did not earn any
revenues during these periods.

Revenues earned in one period are
not indicative of revenues to be earned in future periods. We expect future
years revenues to be progressively less, as efforts shift from work done under
the advanced development contracts to work under the SNS contract, from which
no revenues will be earned until shipments commence.

Research
and development expenses

Three Months Ended
  September 30,



Nine Months Ended
  September 30,2005

2004

Percent
  change
  2005/2004

2005

2004

Percent
  change
  2005/2004(in thousands)



(in thousands)Research
  and development expenses

$
15,476

$
10,431

48
%

$
48,982

$
28,862

70
%23

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

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

Three Months Ended
  September 30,



Nine Months Ended
  September 30,2005

2004

Percent
  change
  2005/2004

2005

2004

Percent
  change
  2005/2004(in thousands)



(in thousands)Direct Costs:Anthrax
  Contracts

$
7,107

$
4,964

43
%

$
20,800

$
13,834

50
%AIDSVAX


621


197

215
%


1,080


576

88
%Smallpox


1,136


858

32
%


3,181


2,154

48
%VCI


1,819


1,381

32
%


5,526


3,284

68
%Total
  direct costs


10,683


7,400

44
%


30,587


19,848

54
%Indirect and other
  costs


4,793


3,031

58
%


18,395


9,014

104
%Research and development expenses

$
15,476

$
10,431

48
%

$
48,982

$
28,862

70
%The increase of $5.0 million in
research and development expenses in the three months ended September 30, 2005
over the comparable period in 2004 was primarily due to:


Direct costs
  associated with our Anthrax Contracts, which increased by $2.1 million
  primarily due to increased development work;
Indirect research
  and development costs, which increased by $1.7 million, consisting primarily
  of:
Stock compensation charges, which increased by $3.0
  million consisting of $0.5 million in connection with the 2005 modification
  of offering periods of our employee stock purchase plan and $2.5 million for
  2005 ESPP bonuses;
Facilities overhead costs, which increased by $0.8 million
  due to the expansion of the VCI facility; and
Partially offset by Celltrion research and development
  costs, which decreased by $0.3 million due to the deconsolidation of
  Celltrion effective July 1, 2005, and other development costs, which
  decreased by $1.8 million;
Direct costs
  associated with supporting VCI, which increased by $0.5 million due to the
  expansion of the facility;
Direct costs
  associated with AIDSVAX, which increased by $0.4 million as we continued
  limited work on AIDSVAX-related activities; and
Direct costs
  associated with our smallpox program, consisting primarily of labor costs,
  which increased by $0.3 million as we expand our program efforts.The increase of $20.1 million in
research and development expenses in the nine months ended September 30, 2005
over the comparable period in 2004 was primarily due to:


Indirect research
  and development costs, which increased by $9.4 million, consisting primarily
  of:
Stock compensation charges, which increased by $5.2
  million consisting of $2.7 million in connection with the 2005 modification
  of offering periods of our employee stock purchase plan and $2.5 million for
  2005 ESPP bonuses;
Other development costs, which increased by $1.3 million
  due to expanded operations;
Celltrions research and development expenses in the nine
  months ended September 30, 2005 increased $0.7 million as Celltrion expanded
  its operations; Celltrions operations were included in our consolidated
  results from January 1, 2004 to June 30, 2005; and
Facilities overhead costs, which increased by $2.2 million
  due to the expansion of the VCI facility;
Direct costs
  associated with our Anthrax Contracts, which increased by $7.0 million
  primarily due to increased development work;24


Direct costs
  associated with supporting VCI, which increased by $2.2 million due to
  expansion of the VCI facility;
Direct costs
  associated with our smallpox program, consisting primarily of clinical and
  labor costs, which increased by $1.0 million as we expand our program
  efforts; and
Direct costs
  associated with AIDSVAX, which increased by $0.5 million as we continued
  limited work on AIDSVAX-related activities.The process of conducting
preclinical studies and clinical trials necessary to obtain FDA approval is
costly and time consuming. The probability of success for each product
candidate and clinical trial may be affected by a variety of factors,
including, among others, the quality of product candidate early clinical data,
investment in the program, competition, manufacturing capabilities and
commercial viability. As a result of the uncertainties discussed above, the
uncertainty associated with clinical trial enrollments and the risks inherent
in the development process, we are unable to determine the duration and
completion costs of current or future clinical stages of our product
candidates. Development timelines, probability of success and development costs
vary widely. While we are primarily focused on developing our anthrax product
candidate, we anticipate that we will make determinations as to which
additional programs to pursue and how much funding to direct to each program on
an ongoing basis in response to the scientific and clinical success of each
product candidate, as well as an ongoing assessment as to each product
candidates commercial potential. We anticipate developing additional product
candidates internally and we intend to consider in-licensing product
candidates, which will increase our research and development expenses in future
periods.

We expect VaxGens research and
development expenses to increase substantially during the remainder of 2005 and
in 2006 as we advance development of our product candidates.

General
and administrative expenses

Three Months Ended
  September 30,



Nine Months Ended
  September 30,2005

2004

Percent
  change
  2005/2004

2005

2004

Percent
  change
  2005/2004(in thousands)



(in thousands)General and
  administrative expenses

$
7,950

$
6,101

30
%

$
24,062

$
16,633

45
%General and administrative expenses
consist primarily of compensation costs, occupancy costs including depreciation
expense, fees for accounting, legal and other professional services and other
general corporate expenses.

The increase of $1.8 million in
general and administrative expenses in the three months ended September 30, 2005
over the comparable period of 2004 was primarily due to:


Personnel costs, which increased by $1.5 million due to
  increased headcount to support our expanding operations consisting of:-
Stock compensation charges, which increased by $0.8
  million consisting of $0.1 million in connection with the 2005 modification
  of offering periods of our employee stock purchase plan and $0.7 million for
  2005 ESPP bonuses; and-
Salary and related benefits, which increased by $0.7
  million as we expanded our administrative capabilities in support of the
  newly awarded supply contract;
Overhead expenses included in general and administrative
  expenses, which increased by $0.7 million in 2005 compared to 2004 consisting
  of:-
Occupancy costs, principally, rent and security services,
  which increased by $0.9 million due to our amended lease in April 2005 to
  secure space to support the production of our recombinant anthrax vaccine
  candidate as well as our other programs;-
Computer and office equipment purchases or leases as well
  as maintenance costs, which increased by $0.3 million in support of increased
  headcount;-
General operating expenses necessary to support our
  expanded infrastructure, which increased by $0.3 million;-
Partially offset by $0.8 million in 2005 for costs that
  were allocated to research and development resulting from increased
  headcount;25


Professional services, which decreased by $0.4 million
  principally reflecting services consisting of consulting fees associated with
  our efforts to comply with various reporting and regulatory requirements as
  well as investor relations expenses; and
Celltrions operating expenses were not included in our
  consolidated results effective July 1, 2005, which were $1.1 million in the
  three months ended September 30, 2004.The increase of $7.4 million in
general and administrative expenses in the nine months ended September 30, 2005
over the comparable period of 2004 was primarily due to:


Personnel costs, which increased by $3.8 million due to
  increased headcount to support our expanding operations consisting of:-
Stock compensation charges, which increased by $1.5
  million consisting of $0.8 million in connection with the 2005 modification
  of offering periods of our employee stock purchase plan and $0.7 million for
  2005 ESPP bonuses; and-
Salary and related benefits, which increased by $2.3
  million as we expanded our administrative capabilities in support of the
  newly awarded supply contract;
Overhead expenses included in general and administrative
  expenses, which increased by $1.0 million in 2005 compared to 2004 consisting
  of:-
Occupancy costs, principally, rent and security services,
  which increased by $1.7 million due to our amended lease in April 2005 to
  secure space to support the production of our recombinant anthrax vaccine
  candidate as well as our other programs;-
Computer and office equipment purchases or leases as well
  as maintenance costs, which increased by $0.6 million in support of increased
  headcount;-
General operating expenses necessary to support our
  expanded infrastructure, which increased by $0.9 million; and-
Partially offset by $2.2 million in 2005 for costs that
  were allocated to research and development resulting from increased
  headcount;
Professional services, which increased by $2.6 million
  principally reflecting:-
Consulting fees associated with our efforts to comply with
  various reporting and regulatory requirements, which increased by $3.1
  million;-
Partially offset by a decrease of $0.5 million for the
  settlement of derivative lawsuits which we had provided for in 2004; and
Celltrions general and administrative expenses, which
  increased by $1.6 million as Celltrion expanded its operations; effective
  July 1, 2005, Celltrions operating expenses were not included in our
  consolidated results.We expect that VaxGens general and
administrative expenses will exceed historical levels during the remainder of
2005 and in 2006 and will reflect substantial additional resources required to
support our increased research and development activities, operations and
public reporting requirements.

Other
income (expense)

Three Months Ended
  September 30,



Nine Months Ended
  September 30,2005

2004

Percent
  change
  2005/2004

2005

2004

Percent
  change
  2005/2004(in thousands)



(in thousands)Interest and other

$
(460
)
$
88


(623
%)
$
(1,107
)
$
503


(320
%)Gain on sale of
  investment


11,196





*


11, 196





*Valuation
  adjustments


626


(2,461
)

(125
%)

450


(16,183
)

(103
%)Equity in loss of
  affiliate


(1,055
)




*


(1,055
)




*Foreign currency


1,050





*


1.050





*Other income
  (expense)

$
11,357

$
(2,373
)

(579
%)
$
10,534

$
(15,680
)

(167
%)*         Calculation not meaningful

26

The change to other income of $11.4
million in the three months ended September 30, 2005 from other expense of $2.4
million in the comparable period in 2004 was primarily due to:


In September 2005,
  we sold 1.2 million of our shares in Celltrion resulting in a gain of $11.2
  million;
Net mark-to-market
  valuation adjustments expense related to our derivatives, which decreased by
  $3.1 million primarily because the 2004 derivatives were no longer
  outstanding in 2005 and the 2005 derivatives originated in April 2005;
Our equity
  ownership of Celltrions losses, which were $1.1 million in 2005 as a result
  of the deconsolidation of Celltrion effective July 1, 2005, compared to zero
  in 2004 when Celltrion was consolidated. At September 30, 2005, our ownership
  interest in Celltrion was 22%;
Interest expense,
  which increased by $0.6 million primarily due to the accrual of 5.5% interest
  due on the $31.5 million of convertible notes we issued in April 2005; and
Favorable foreign
  currency changes, which increased by $1.1 million primarily related to the
  sale of some of our Celltrion common shares.The change to other income of $10.5
million in the nine months ended September 30, 2005 from other expense of $15.6
million in the comparable period in 2004 was primarily due to:


In September 2005,
  we sold 1.2 million of our shares in Celltrion resulting in a gain of $11.2
  million;
Net mark-to-market
  valuation adjustments expense related to our derivatives, which decreased by
  $16.6 million primarily because the 2004 derivatives were no longer
  outstanding in 2005 and the 2005 derivatives originated in April 2005; other
  expense of $16.2 million associated with our 2004 derivatives resulted
  primarily due to the May 2004 suspension of our SEC registration statement
  which caused the Series A Warrants to become redeemable for cash at the
  option of the Series A Warrant holders as well as due to changes in the fair
  value of our common stock;
Interest expense,
  which increased by $1.2 million primarily due to the accrual of 5.5% interest
  due on the $31.5 million of convertible notes we issued in April 2005;
Our equity
  ownership of Celltrions losses, which were $1.1 million in 2005 as a result
  of the deconsolidation of Celltrion effective July 1, 2005, compared to zero
  in 2004 when Celltrion was consolidated; and
Favorable foreign currency changes, which increased by
  $1.1 million primarily related to the sale of some of our Celltrion common
  shares.We expect future mark-to-market
adjustments relating to the valuation of derivatives will fluctuate, as the
valuation calculation is sensitive to, and directly related to, the likelihood
of derivative instrument triggering events occurring and the market price of
our common stock on any given measurement date. Also, we anticipate future
investment income will fluctuate and will be primarily driven by our future
cash, cash equivalents and investments balances. In addition, we anticipate
quarterly interest expense in 2005 and 2006 to continue at the level for the
three months ended September 30, 2005 as a result of the Notes continuing to be
outstanding.

Minority
interest in loss of variable interest entity

Three Months Ended
  September 30,



Nine Months Ended
  September 30,2005

2004

Percent
  change
  2005/2004

2005

2004

Percent
  change
  2005/2004(in thousands)



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

$


$
819

(100
%)

$
4,109

$
1,944

111
%Minority interest in loss of
variable interest entity reflects the interest of Celltrions other
stockholders in the net loss of Celltrion. As a result of the deconsolidation
of Celltrion, effective July 1, 2005, the other stockholders share of
Celltrions losses are no longer reflected in our consolidated results. The
increase while Celltrion was consolidated for the nine months ended September
30, 2005 over the comparable period in 2004 is the result of a $6.2 million
increase in losses as a result of expanded operations by Celltrion and an
increase in the average percentage ownership of the other stockholders to 69%
in 2005 from 53% in 2004; partially offset by no minority interest charge for
the three months ended September 30, 2005.

27

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

LIQUIDITY AND CAPITAL RESOURCES

2005

2004(in thousands)As of September 30:Cash, cash
  equivalents and investment securities

$
23,234

$
15,861Working capital


23,761


3,183Nine months ended September
  30:Cash provided by
  (used in):Operating
  activities

$
(34,517
)
$
(17,238
)Investing
  activities


(25,250
)

(5,674
)Financing
  activities


49,618


16,178Effect of exchange
  rate changes on cash and cash equivalents





228Capital
  expenditures (included in investing activities above)


(31,845
)

(28,667
)Our primary financing requirements
are for funding our day-to-day working capital requirements and capital
equipment expenditures related to the manufacturing facilities in the Republic
of Korea and California. Effective July 1, 2005, Celltrion was deconsolidated
from VaxGen and accounted for under the equity method. At September 30, 2005,
our ownership interest in Celltrion was 22%. The liabilities recognized as a
result of consolidating Celltrion from January 1, 2004 to June 30, 2005 did not
represent additional claims on VaxGens or VCIs assets. Rather, they
represented claims against the specific assets of Celltrion. Conversely, the
assets recognized as a result of consolidating Celltrion from January 1, 2004
to June 30, 2005 did not represent additional assets that could be used to
satisfy claims against VaxGens or VCIs assets. The general creditors of
VaxGen and VCI had no recourse to the general credit of Celltrion. The general
creditors of Celltrion had no recourse to the general credit of VaxGen and VCI.

Through September 30, 2005, we
financed our operations primarily through sales of our common stock, sales of
Celltrion preferred stock, the issuance of Series A Preferred Stock, the
issuance of convertible notes as well as through revenues from research
contracts and grants and debt to finance the purchase of land and construction
of facilities in the Republic of Korea. Our future capital requirements will
depend on several factors, including:


Our ability to negotiate government contracts or grants,
  particularly our ability to win contracts to continue to develop or to sell
  our vaccine candidates;
The timing of collection of accounts receivable from our
  government contracts and grants;
Progress of internal research and development projects;
Levels and timing of capital expenditures on the
  manufacturing facilities in the Republic of Korea and California; and
Our ability to identify and exploit business development
  opportunities.Net cash used in operating
activities of $34.5 million and $17.2 million for the nine months ended
September 30, 2005 and 2004, respectively, was primarily attributable to our
net losses although the effect of non-cash charges upon net cash used in
operating activities was significant in both periods. For example,


Valuation adjustment income of $0.4 million and expense of
  $15.4 million in the nine months ended September 30, 2005 and 2004,
  respectively, reflecting changes in the fair value of outstanding warrants
  and derivatives. This change in fair value primarily resulted from the May
  2004 suspension of our SEC registration statement which caused the Series A
  Warrants to become redeemable for cash at the option of the Series A Warrant
  holders and due to changes in the fair value of our common stock;
Minority interest in loss of variable interest entity of
  $4.1 million, for their share of Celltrions net losses for the nine months
  ended September 30, 2005, exceeded the $1.9 million recognized in 2004. This
  was the result of a $6.2 million increase in losses as a result of expanded
  operations by Celltrion and an increase in the average percentage ownership
  of the other stockholders to 69% in 2005 from 53% in 2004; partially offset
  by no minority interest charge for the three months ended September 30, 2005;28


Depreciation and amortization of $3.6 million and $1.3
  million for the nine months ended September 30, 2005, and 2004, respectively.
  The increase primarily reflects the California facility beginning operations
  during late 2004 and its expansion ($1.8 million) and the expansion of the
  Korean operations ($0.5 million); and
Stock compensation expense of $4.8 million and $1.4
  million for the nine months ended September 30, 2005, and 2004, respectively.
  The increase from 2004 is primarily the result of modifications to the
  Companys ESPP in 2005 ($3.5 million).In addition, the $11.2 million gain
on the 2005 sale of some of our investment in Celltrion was not fully collected
by September 30, 2005. This gain is removed from operating activities and the
proceeds received are reflected in investing activities. Cash used in operating
activities was also affected more in 2005 than 2004 as a result of a $9.7
million increase in accrued expenses and other current liabilities primarily
due to the accrual of $3.2 million for ESPP bonuses, an increase of $2.4
million in customer advances and an increase of $1.1 million in other
employment benefit accruals during the nine months ended September 30, 2005.

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 nine months ended September 30, 2005 and 2004 were made in connection
with the expansion of the Korean manufacturing facility ($22.5 million and
$24.7 million, respectively) and research and development laboratories and
leasehold improvements associated with the California manufacturing facility
and office facilities ($6.3 million and $3.9 million, respectively). In
addition, during 2005 we purchased $3.0 million of software and services
related to the implementation of a new enterprise resource planning system. We
expect capital expenditures during the remainder of 2005 and 2006 to decrease
substantially due to the deconsolidation of Celltrion. During the nine months
ended September 30, 2005, we spent $1.2 million purchasing additional shares in
Celltrion and sold some of our investment in Celltrion for $15.1 million, of which
$2.0 million was collected during the period. As a result of the consolidation
of Celltrion in 2004, our cash position was increased by $9.7 million; however,
as a result of the deconsolidation of Celltrion in 2005, our cash position was
decreased by $3.8 million during the nine months ended September 30, 2005.

Net cash provided by our financing
activities increased $33.3 million in the nine months ended September 30, 2005
over the comparable period in 2004. In April 2005, we raised net proceeds of
$29.7 million through a private placement of 5-1/2% convertible senior
subordinated notes due April 1, 2010. 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 May 2004, Celltrion issued 693,500 shares of preferred stock at
a price of 5,000 Korean Won per share ($4.28 equivalent), resulting in proceeds
of 3,447 million Korean Won ($3.0 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
(Loan). Funds from the Loan, $10.5 million in 2005 and $13.3 million in 2004,
are used for construction of the Incheon administration buildings and
manufacturing facility.

At September 30, 2005, $23.2
million, or 23%, of our assets consisted of cash, cash equivalents and
investment securities. We had working capital of $23.8 million at September 30,
2005, compared to $3.2 million at September 30, 2004. This $20.6 million
increase in working capital is primarily due to the sale of some of our
investment in Celltrion for $15.1 million in 2005 and amounts due to related
parties which reduced to zero at September 30, 2005 from $6.9 million at
September 30, 2004 as a result of the deconsolidation of Celltrion in 2005. In
addition to $2.0 million of cash received from the sale of some of our
investment in Celltrion, cash, cash equivalents and investments securities
increased an additional $5.3 million at September 30, 2005 relative to
September 30, 2004.  Accounts payable and accrued expenses increased $8.9 million
at September 30, 2005 relative to September 30, 2004 primarily due to an increase of $3.1 million in
customer advances and a $3.2 million accrual for ESPP Bonus payments.

We continually review alternatives
to obtain additional financing and to increase revenues by procuring future
contracts to supply anthrax and smallpox vaccines to the U.S. government and
other potential customers. Some of our alternatives to obtain additional
financing include the sale of our common stock, obtaining additional debt and
the sale of some or all of our investment in Celltrion. There can be no
assurances that we will be successful in these efforts. The cancellation of the
SNS Contract, the reaudit of our financial statements for the three years ended
December 31, 2003, the resulting restatement of reports previously filed with
the Securities and Exchange Commission, the lapsing of our registration
statements and the delisting of our common stock may have an adverse impact on
whether financing will be available or that it will be available on terms that
we will accept. See Subsequent Events in Note 13.

29

Contractual
Obligations

On April 14, 2005, VaxGen entered
into an amended lease agreement to secure space to support the production of
its recombinant anthrax vaccine candidate as well as its other programs. There
were no other significant changes in our contractual obligations during the
nine months ended September 30, 2005. The following table summarizes our
significant contractual obligations at September 30, 2005, and the effect such
obligations are expected to have on our liquidity and cash flows in future
periods.

Total

2005

2006-07

2008-09

2010 and beyond(in thousands)Note obligations
  (1)

$
40,162

$
866

$
3,465

$
3,465

$
32,366Operating lease
  obligations (2)


42,434


920


7,206


6,252


28,056Purchase
  obligations (3)


2,346


258


1,783


206


99Total contractual
  obligations

$
84,942

$
2,044

$
12,454

$
9,923

$
60,521(1) Note obligations consist of our
interest and principal payments on our Notes.

(2) Operating lease obligations
include office and laboratory facilities under non-cancelable operating leases.

(3) Purchase obligations include
service agreements, contracts related to manufacturing and research operations
and license agreements.

Off-Balance
Sheet Arrangements

As of September 30, 2005, we did
not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of
SEC Regulation S-K.

Recent Accounting Pronouncements

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

In December 2004, the FASB issued
Statement of Financial Accounting Standards (FAS) No. 123(R), Share-Based
Payment (FAS 123R) which is a revision of FAS No. 123, Accounting
for Stock-Based Compensation (FAS 123). Generally, the approach in
FAS 123R is similar to the approach described in FAS 123. However, FAS 123R
requires all share-based payments to employees, including grants of employee
stock options, to be recognized in the consolidated statement of operations
based on their fair values. Pro forma disclosure is no longer an alternative.
The new rule applies to option grants made after adoption as well as options
that are not vested at the date of adoption. FAS 123R must be adopted in annual
periods beginning after July 1, 2005. We began applying FAS 123R prospectively
in the first quarter of 2006. Additionally, in August 2005, the FASB issued
FASB Staff Position (FSP) FSP FAS 123R-1, Classification and Measurement of Freestanding
Financial Instruments Originally Issued in Exchange for Employee Services under
FASB Statement No. 123(R) (FSP1). In FSP1, the FASB decided to
defer the requirements in FAS 123 that make a freestanding financial instrument
subject to the recognition and measurement requirements of other GAAP when the
rights conveyed by the instrument are no longer dependent on the holder being
an employee. In October 2005, the FASB issued FSP FAS 123R-2, Practical
Accommodation to the Application of Grant Date as Defined in FASB Statement No.
123(R) (FSP2). In FSP2, the FASB is providing companies with a
practical accommodation when determining the grant date of an award that is
subject to the accounting provisions in FAS 123R. In November 2005, the
FASB issued FSP FAS 123R-3, Transition
Election Related to Accounting for the Tax Effects of Share-Based Payment
Awards (FSP3). FSP3 provides an elective alternative method that
establishes a computational component to arrive at the beginning balance of the
accumulated paid-in capital pool related to employee compensation and a
simplified method to determine the subsequent impact on the accumulated paid-in
capital pool of employee awards that are fully vested and outstanding upon the
adoption of FAS 123R. In February 2006, the FASB issued FSP FAS 123R-4, Classification of Options and Similar Instruments
Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence
of a Contingent Event (FSP4), which concludes that a cash
settlement feature that can be exercised only upon the occurrence of a
contingent event that is outside the employees control does not become a
liability until it becomes probable that the event will occur. An option or
similar instrument that is classified as equity, but subsequently becomes a
liability because the contingent cash settlement event is probable of occurring,
shall be accounted for similar to modification from an equity to liability award. To the extent that
the liability exceeds the amount previously recognized in equity, the excess is
recognized as compensation cost. The total recognized compensation cost for an
award with a contingent cash settlement feature shall at least equal the fair
value of the award at the grant date. FSP4 is applicable only for options or
similar instruments issued as part of employee compensation arrangements. In
October 2006, the FASB issued FSP FAS 123R-5, Amendment
of FASB Staff Position FAS 123(R)-1 (FSP5), which addresses
whether a modification of an instrument in connection with an equity
restructuring should be considered a modification for purposes of applying
FSP1. The provisions in FSP5 are effective for the first reporting period beginning
after October 10, 2006. Also, in October 2006, the FASB issued FSP FAS 123R-6, Technical Corrections of FASB Statement No. 123
(revised 2004) (FSP6), which addresses certain technical
corrections of FAS 123R. The provisions in FSP6 are effective for the first
reporting period beginning after October 20, 2006. The guidance in FSP1, FSP2,
FSP3, FSP4, FSP5 and FSP6 will be applied upon our adoption of FAS 123R. We are
currently evaluating the impact of adopting the guidance in FAS 123R, FSP1,
FSP2, FSP3, FSP4, FSP5 and FSP6 on our consolidated financial position, results
of operations and cash flows.

30

In March 2005, the SEC published
Staff Accounting Bulletin No. 107 (SAB 107). The interpretations in this
staff accounting bulletin express the views of the staff regarding the
interaction between FAS 123R and certain SEC rules and regulations and provide
the staffs views regarding the valuation of share-based payment arrangements
for public companies. In particular, SAB 107 provides guidance related to
share-based payment transactions with non-employees, the transition from
nonpublic to public entity status, valuation methods (including assumptions
such as expected volatility and expected term), the accounting for certain
redeemable financial instruments issued under share-based payment arrangements,
the classification of compensation expense, non-GAAP financial measures, first-time adoption of FAS 123R in an
interim period, capitalization of compensation cost related to share-based
payment arrangements, the accounting for income tax effects of share-based
payment arrangements upon adoption of FAS 123R, the modification of employee
share options prior to adoption of FAS 123R and disclosures in Managements
Discussion and Analysis subsequent to adoption of FAS 123R. We will comply with
SAB 107 upon our adoption of FAS 123R. We are currently evaluating the impact
of adopting SAB 107 on our consolidated financial position, results of
operations and cash flows.

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

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

In July 2005, the FASB issued FSP
APB 18-1, Accounting
by an Investor for its Proportionate Share of Accumulated Other
Comprehensive Income of an Investee Accounted for under the Equity Method in
Accordance with APB Opinion No. 18 upon a Loss of Significant Influence (FSP
APB 18-1), which provides guidance on how an investor should account for its proportional share of an investees
equity adjustments

31

for other comprehensive income (OCI) upon a loss of
significant influence as detailed in paragraph 121 of FAS No. 130, Reporting
Comprehensive Income (FAS 130). APB Opinion No. 18, The Equity Method of
Accounting for Investments in Common Stock (APB 18) requires a transaction of
an equity method investee of a capital nature be accounted for as if the
investee was a consolidated subsidiary, which requires the investor to record
its proportionate share of the investees adjustments for OCI as increases or
decreases to the investment account with corresponding adjustments in equity.
FSP APB 18-1 requires that an investors proportionate share of an investees
equity adjustments for OCI should be offset against the carrying value of the
investment at the time significant influence is lost and equity method
accounting is no longer appropriate. However, to the extent that the offset
results in a carrying value of the investment that is less than zero, an
investor should (a) reduce the carrying value of the investment to zero and (b)
record the remaining balance in income. The guidance in FSP APB 18-1 is
effective for us on October 1, 2005. We are currently evaluating the impact of
adopting FSP APB 18-1 on our consolidated financial position, results of
operations and cash flows.

In September 2005, the EITF reached
a consensus on Issue No. 05-7, Accounting
for Modifications to Conversion Options Embedded in Debt Instruments and
Related Issues (EITF 05-7). EITF 05-7 requires that a change in
the fair value of a conversion option brought about by modifying the debt
agreement be included in analyzing in accordance with EITF consensus on Issue
No. 96-19, Debtors Accounting for a
Modification or Exchange of Debt Instruments (EITF 96-19), whether
a debt instrument is considered extinguished. Under EITF 96-19s requirements,
an issuer who modifies a debt instrument must compare the present value of the
original debt instruments cash flows to the present value of the cash flows of
the modified debt. If the present value of those cash flows varies by more than
10 percent, the modification is considered significant and extinguishments accounting
is applied to the original debt. If the change in the present value of the cash
flows is less than 10 percent, the debt is considered to be modified and is
subject to EITF 96-19s modification accounting. EITF 05-7 requires that in
applying the 10 percent test the change in the fair value of the conversion
option be treated in the same manner as a current period cash flow. EITF 05-7
also requires that, if a modification does not result in an extinguishment, the
change in fair value of the conversion option be accounted for as an adjustment
to interest expense over the remaining term of the debt. The issuer should not
recognize a beneficial conversion feature (BCF) or reassess an existing BCF
upon modification of the conversion option of a debt instrument that does not
result in an extinguishment. EITF 05-7 is effective for modifications of debt
instruments beginning in the first interim or annual reporting period beginning
after December 15, 2005. We do not expect the adoption of EITF 05-7 to have material
impact on our consolidated financial position, results of operations or cash
flows.

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

In November 2005, the FASB issued
FSP FAS 115-1 and FAS 124-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments
(FSP FAS 115-1 and FAS 124-1). This FSP nullifies certain requirements of
EITF Issue No. 03-01 and supersedes EITF Abstracts, Topic No. D-44, Recognition of Other-Than-Temporary Impairment upon
the Planned Sale of a Security Whose Cost Exceeds Fair Value.Based
on the clarification provided in FSP FAS 115-1 and FAS 124-1, the amount of any
other-than-temporary impairment that needs to be recognized will continue to be
dependent on market conditions, the occurrence of certain events or changes in
circumstances relative to an investee and an entitys intent and ability to
hold the impaired investment at the time of the valuation. FSP FAS 115-1 and
FAS 124-1 are effective for reporting periods beginning after December 15,
2005. We are evaluating the impact of adopting the guidance in FSP FAS 115-1
and FAS 124-1on our consolidated financial position, results of operations and
cash flows.

In February 2006, the FASB issued
FAS No. 155, Accounting for Certain Hybrid
Financial Instruments (FAS 155), which amends FAS No. 133, Accounting for Derivative Instruments and
Hedging
Activities (FAS 133) and FAS No. 140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, and improves the financial reporting
of certain hybrid financial instruments by requiring more consistent accounting
that eliminates exemptions and provides a means to simplify the
accounting for

32

these instruments. Specifically, FAS 155 allows financial
instruments that have embedded derivatives to be accounted for as a whole
(eliminating the need to bifurcate the derivative from its host) if the holder
elects to account for the whole instrument on a fair value basis. FAS 155 is
effective for all financial instruments acquired or issued after the beginning
of an entitys first fiscal year that begins after September 15, 2006. We
do not expect the adoption of FAS 155 will have a material impact on our
consolidated financial position, results of operations or cash flows.

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

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

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

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

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

33

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 (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.

34

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 September 30,
2005, we held available-for-sale securities in the principal amount of $12.7
million. If market interest rates were to increase immediately and uniformly by
10% from levels at September 30, 2005, the fair value of our portfolio would
decline by an immaterial amount, and would not have a significant effect on our
operations or cash flows. Our exposure to losses as a result of interest rate
changes is managed through investing in a portfolio of securities with a
weighted-average maturity of one year or less.

Indebtedness

At September 30, 2005, our
outstanding non-current liabilities include $31.5 million of our 5 1/2 %
Convertible Senior Notes due April 1, 2010 pursuant to our financing
through a private placement of these Notes in April 2005. As the Notes bear
interest at a fixed rate, our results of operations would not be affected by
interest rate changes.

As of September 30, 2005, we did
not invest in derivative financial instruments, interest rate swaps or other
investments that alter interest rate exposure.

Foreign
Currency Risk

Our exposure to foreign currency
exchange rates is related primarily to our investment in Celltrion. Our
international business is subject to risks, including, but not limited to,
differing economic conditions, changes in political climate, differing tax
structures, other regulations and restrictions and foreign exchange rate
volatility when compared to the United States dollar. Accordingly, our future
results could be materially affected by changes in these or other factors. We
are also affected by exchange rate fluctuations as the financial statements of
our foreign subsidiary are translated from Korean Won into the United States
dollar in consolidation. As exchange rates vary, these results, when
translated, may vary from expectations and could adversely impact overall
profitability. If market foreign currency exchange rates were to change
immediately and uniformly by 10% from levels at September 30, 2005, the change
would not have a significant effect on our operations or cash flows. As of
September 30, 2005, 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 convertible senior
subordinated 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 $0.6 million and $0.4 million
for the three and nine  months
ended September 30, 2005, respectively. At September 30, 2005, the embedded
derivative liability was valued at $1.3 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 September 30,
2005. 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.35

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 this evaluation
of the unremediated material weaknesses in internal control over financial
reporting as disclosed in Item 9A of our Form 10-K for the year ended December
31, 2004, our Chief Executive Officer and Chief Financial Officer have
concluded that our disclosure controls and procedures were not effective as of
the end of the period covered by this report.

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.

We have taken the remediation steps described in Item 9A of our 2004
10-K. In connection with the preparation of this Quarterly Report, 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 September 30, 2005, that has materially affected,
or is reasonably likely to materially affect, our internal control over
financial reporting. We continue to develop a 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 2004 10-K. We
expect that the implementation of this plan will extend through the rest of
2005 and beyond.

Inherent
Limitations on Effectiveness of Controls

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

PART
II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On March 17, 2003, a civil
complaint for violation of Sections 10(b) and 20(a) of the Securities Exchange
Act was filed in the United States District Court for the Northern District of
California, entitled Janice Whitkens v. VaxGen, Inc., et al., Civil Action No.
C03-1129 JSW. Named, as defendants were VaxGen, Inc., Chief Executive Officer
Lance K. Gordon and former President Donald P. Francis. The plaintiff sought to
represent a class of persons who purchased our securities between August 6,
2002 and February 26, 2003, and alleged that the defendants misled investors
about the progress of certain clinical trials and our future manufacturing and
marketing plans. Following the filing of the Whitkens complaint, several
additional class action complaints were filed in the same court, each making
identical or similar allegations against the same defendants. In May 2005, the
United States District Court for the Northern District of California dismissed
with prejudice this class action lawsuit.

36

On or about March 21, 2003, two
separate but virtually identical shareholder derivative actions were filed in
California Superior Court for San Mateo County entitled Rhodes v. Allen, et al.
civil action No. CIV 430087, and MacDonald v. Allen, et al., civil action No.
CIV 430088. A consolidated complaint was filed in June 2003. Named as
defendants in the action were Company directors Lance K. Gordon, Randall L-W.
Caudill, and William D. Young, and former Company directors Donald P. Francis,
Phillip W. Berman, David W. Beier, and Stephen C. Francis (Company
Directors). Also named as defendants were Paul Allen and Vulcan Ventures, Inc.
(Vulcan Defendants). The allegations of the consolidated complaint were
similar to those contained in the class actions, although unlike the class
action, in the derivative action the plaintiff purports to seek recovery on behalf
of VaxGen, rather than from VaxGen. Plaintiffs alleged as well that the Vulcan
Defendants sold shares of our stock while in possession of material non-public
information about us. Plaintiffs, purportedly suing on behalf of VaxGen, assert
claims against all defendants for breach of fiduciary duty, mismanagement,
waste and unjust enrichment, and against the Vulcan Defendants for breach of
fiduciary duty and insider trading. The Company Directors and the Vulcan
Defendants filed demurrers challenging the demand futility allegations in the
consolidated complaint. The Court overruled the defendants demurrers and the
parties entered the discovery phase of the litigation. The parties subsequently
entered into settlement discussions. The Company settled the shareholders
derivative lawsuit in 2005. Under the terms of the settlement, the Company
agreed to pay $0.5 million to the derivative plaintiffs to cover attorneys
fees, and also agreed to make certain changes in its disclosure practices and
procedures. The settlement was approved by the court in September 2005.

ITEM 1A. RISK FACTORS

For the nine months ended September
30, 2005, there has been no significant change to the identified risk factors
filed in our Annual Report on Form 10-K for the year ended December 31, 2004
filed with the Securities and Exchange Commission on February 7, 2007, other
than the addition of risk factors associated with the financing of our
convertible notes in 2005 as well as the potential impact on our operating
results of recently adopted changes in accounting for stock compensation plans,
which are discussed below.

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

Risks
Relating to Our Business

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.

Effective January 1, 2004, we are required to consolidate Celltrions
financial statements into our own. Celltrion maintains its records in
accordance with Korean accounting principles; however, we require financial
statements that are prepared in accordance with GAAP and which have been
audited in conformity with U.S. Auditing Standards. Celltrions internal
controls over financial reporting may be insufficient to enable them to report
their interim 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 annual
audit of Celltrions GAAP financial statements in a timely fashion, if at all.

If we do not receive adequate timely financial reporting from
Celltrion, we could 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 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.

37

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

As a result of our failure to have
current financial statements for the fiscal years ended December 31, 2003, 2002
and 2001, we were delisted from the 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 any other
exchange will approve our stock for listing. In order to be eligible for
relisting or listing, we must meet Nasdaqs or any other 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 not compliant with Section 404 under the Sarbanes-Oxley Act of 2002.

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

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

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

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, completed
the restatement of our 2001 through 2003 financial statements, filed amended
and outstanding 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.

In response to a letter the Audit Committee of our Board of Directors
received from our current independent registered public accounting firm
regarding material weaknesses in the effectiveness of our internal control over
financial reporting, 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.

38

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.

We will 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 notes
exchangeable into all or a portion of our interest in Celltrion prior to an
initial public offering by Celltrion, or through the sale of our Celltrion
stock after an initial public offering by Celltrion.

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 the shares 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. 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.

FAS123R, which we will implement 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. Accordingly, the adoption of FAS 123Rs fair value method will have a
significant impact on our results of operations. The 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 and the valuation model we
ultimately select. We plan to use the Black-Scholes option pricing model
allowed under FAS 123R.

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

In April 2005, we raised gross
proceeds of $31.5 million through a private placement of 5 1/2% Convertible
Senior Subordinated Notes (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;
convert, at our option, into common stock if our common
  stock reaches a market price of $22.14 per share;
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; and
constitute senior subordinated obligations.39


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.

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 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 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.

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 convertible 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.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 fulfill our obligations under our contract to supply the Strategic
National Stockpile (SNS) of anthrax vaccines to the U.S. government, and we
may be unable to commercialize our vaccine candidates.

The U.S. government has undertaken commitments to help secure improved
countermeasures against bioterrorism, including the stockpiling of vaccines for
anthrax and smallpox. On 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. We expect to substantially increase our employee
base to fulfill certain obligations under the SNS Contract. There is no
guarantee that we will be able to find and hire suitable employees or that we
will be able to integrate them into our operation properly so as to enable us
to fulfill the obligations under the SNS Contract. If we fail to fulfill
certain obligations under the SNS Contract, the government may terminate the
SNS Contract with us. In addition, the U.S. government may terminate any
government contract awarded to us for its convenience at any time.

40

The
governments determination to award the SNS Contract to us may be challenged by
an interested party, such as another bidder, at the General Accounting 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.
Given the high dollar value of the SNS 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
General Accounting Office or the applicable federal court, thus potentially
delaying delivery of and payment for the vaccines. 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 loss of the SNS Contract would make it difficult
for us to generate sufficient revenue to continue operations or commercialize
our anthrax vaccine.

The
U.S. Congress may instigate an investigation into the award of the SNS Contract
to us.

Senator Charles Grassley, Chairman of the U.S. Senate Finance
Committee, sent a letter to the Department of Health and Human Services (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 Senator Grassley or the U.S.
Senate Finance Committee or other Congressional committees will not pursue an
inquiry into the award of 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.

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

The award of one government contract does not necessarily secure the
award of future contracts covering the same vaccine. By law, the U.S.
government must usually seek competition when procuring goods and services. In
addition, if we do not perform in accordance with the terms of the SNS
Contract, we may receive a poor performance report which would be considered 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 contracts to supply a government stockpile of anthrax
vaccine. It is possible that future awards to provide the U.S. government with
emergency stockpiles of anthrax vaccine will be granted solely to another supplier.
If the U.S. government makes significant future contract awards for the supply
of its emergency stockpile to our competitors, such as Avecia, our business
will be harmed and it is unlikely that we will be able to ultimately
commercialize that particular vaccine. In addition, the determination of when
and whether a product is ready for large scale purchase and potential use will
be made by the government through consultation with a number of governmental
agencies, including the Food and Drug Administration (FDA), the National
Institutes of Health (NIH), the Centers for Disease Control (CDC) and the
Department of Homeland Security. President Bush has proposed, and Congress is
considering, measures to accelerate the development of biodefense products through
NIH funding, the review process by the FDA and the final government procurement
contracting authority. While this may help speed the approval of our vaccine
candidates, it may also encourage competitors to develop their own vaccine
candidates. 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.

41

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

We have experienced a period of rapid change in our business as a
result of increased emphasis on biodefense opportunities. In addition, we
expect to experience substantial growth in 2005 in manufacturing, quality
systems, clinical and regulatory functions associated with our SNS Contract.
This change and growth 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
our expected growth and to maintain an adequate system of internal controls.
Furthermore we will have to increase our capital expenditures in order to
fulfill certain obligations under the SNS Contract, far in excess of what we
have done in the past. As a result of a rapid increase in hiring employees and
increased capital expenditures our operating budgets are significantly greater
that they have been in the past. If we are unable to manage the change and
growth of our business effectively, we may be unable to obtain future
government contracts and our results of operations and financial condition will
be adversely affected.

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

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

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


suspend or prevent us for a set period of time from
  receiving new contracts or extending existing contracts based on violations
  or suspected violations of laws or regulations;
terminate our existing contracts;
reduce the scope and value of our existing contracts;
audit and object to our contract-related costs and fees,
  including allocated indirect costs;
control and potentially prohibit the export of our
  products; and
change certain terms, 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 may make
us liable for excess costs incurred by the U.S. government in procuring
undelivered items from another source.

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

42

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

Government
contracts are subject to competitive bidding.

We obtain all of our government contracts through a competitive bidding
process. We cannot assure you that we will continue to win competitively
awarded contracts or that awarded contracts will generate revenues sufficient to
result in profits. We are also subject to risks associated with:


the frequent need to bid on programs in advance of the
  completion of their design, which may result in unforeseen technological
  difficulties and/or cost overruns; and
the substantial time and effort, including design and
  development activities, required to prepare bids and proposals for contracts
  that may not be awarded to us.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.

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

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

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

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

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

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

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 subcontractors to perform certain tasks related to our
fulfilling the requirements of our contracts. In particular, to fulfill our
obligations under the SNS Contract, we will provide bulk quantities of our
anthrax vaccine candidate to subcontractors and our subcontractors will fill
sterile individual-use syringes for delivery to the U.S. government. The
processes and procedures used by our subcontractors in performing these tasks
must be validated and approved by the U.S. government as compliant with applicable
legal requirements, including the FDAs cGMP regulations. Any significant
delays in performing these tasks by our subcontractors, or a failure to perform
them in compliance with applicable FDA or other governmental regulations, could
cause us to fail to perform under our contracts, which may cause us to be in
breach under those contracts and cause those contracts to be terminated. We
cannot assure you that one or more of these subcontractors will not be delayed
in performing, or fail to perform their obligations under these contracts in
compliance with applicable legal requirements.

43

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

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, we will be required to submit to the FDA a
Biologics License Application (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 effectiveness trials conducted in patients
with the disease or 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 commercial sale. We believe that, according to the FDAs current
BLA requirements for certain biologics that cannot be feasibly or ethically
tested in humans in Phase 3 efficacy studies, we may instead be able to obtain
BLA approval based on clinical data from Phase 2 and Phase 3 trials in healthy
subjects that demonstrate adequate safety and immune response and effectiveness
data from studies in animals. 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 pre-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. 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, and we cannot
guarantee that the FDA will approve our anthrax and smallpox vaccines.

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

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


slower-than-anticipated enrollment of volunteers in the
  trials;
lower-than-anticipated recruitment or retention rate of
  volunteers in the trials;
serious adverse events related to the vaccine candidates;
unsatisfactory results of any clinical trial;
the failure of our principal third-party investigators to
  perform our clinical trials on our anticipated schedules; or
different interpretations of our 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.

44

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

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

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

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

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

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

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


the FDA or foreign regulators may refuse to approve an
  application if they believe that applicable regulatory criteria are not
  satisfied;
the FDA or foreign regulators may require additional
  testing for safety and effectiveness;
the FDA or foreign regulators may interpret data from
  preclinical testing and clinical trials in different ways than we interpret
  them;
If regulatory approval of a product is granted, the
  approval may be limited to specific indications or limited with respect to
  its distribution. In addition, many foreign countries control pricing and
  coverage under their respective national social security systems;
the FDA or foreign regulators may not approve our
  manufacturing processes or manufacturing facilities;
the FDA or foreign regulators may change their approval
  policies or adopt new regulations;
even if regulatory approval for any product is obtained,
  the marketing license will be subject to continual review, and newly
  discovered or developed safety or effectiveness data may result in suspension
  or revocation of the marketing license;
if regulatory approval of the vaccine candidate is
  granted, the marketing of that vaccine would be subject to adverse event
  reporting requirements and a general prohibition against promoting products
  for unapproved or off-label uses;
in some foreign countries, we may be subject to official
  release requirements that require each batch of the vaccine we produce to be
  officially released by regulatory authorities prior to its distribution by
  us; and45

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


warning letters;
civil penalties;
criminal penalties;
injunctions;
product seizure or detention;
product recalls;
total or partial suspension of production; and
suspension or revocation of the marketing license.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 cGMP (current Good Manufacturing
Practices) 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 the
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. We expect that a
significant portion of the research that we will conduct will involve new and
unproven technologies. Development of a product requires substantial technical,
financial and human resources even if the product is not successfully
completed.

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

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

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

46

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. Given the rights
retained and licenses granted to the U.S. government in regard to our anthrax
vaccine, 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 will 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.
Accordingly, we cannot predict the scope and breadth of patent claims that may
be afforded to other companies patents. In addition, we could incur
substantial costs in litigation if we are required to defend against patent
suits brought by third parties, or if we initiate these suits.

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

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

Our
Korean manufacturing joint venture may not be successful.

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

Even if Celltrion successfully completes the construction of its Korean
manufacturing facility, we cannot be certain that the facility will pass
domestic or foreign regulatory approvals or be able to manufacture mammalian
cell culture products in commercial quantities on a cost-effective basis or at
all. In addition, it is uncertain whether there will be sufficient demand for
mammalian cell culture biomanufacturing to make this facility profitable.

47

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

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

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

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

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

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

Natural
disasters, including earthquakes, may damage our facilities.

VaxGens corporate and manufacturing facilities are primarily located
in the San Francisco Bay area. In addition to office and research facilities,
through our ownership position in both Celltrion and VCI, we have a significant
investment in VCIs biomanufacturing facilities in California, which contain
sensitive and expensive bioreactor equipment. The San Francisco Bay area is in
close proximity to known earthquake fault zones. As a result, our corporate,
research and manufacturing facilities are susceptible to damage from
earthquakes and other natural disasters, such as fires, floods and similar
events.

48

Although VaxGen maintains general business insurance against fires and
some general business interruptions, there can be no assurance that the amount
of coverage will be adequate in any particular case.

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

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

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

Any such activities will be accompanied by certain risks including:

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

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

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

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

We face an inherent risk of exposure to product liability suits in
connection with vaccines being tested in human clinical trials or sold
commercially. We may become subject to a product liability suit if any vaccine
we develop causes injury, or if vaccinated individuals subsequently become
infected or otherwise suffer adverse effects from our vaccines or products.
Regardless of merit or eventual outcome, product liability claims may result in
decreased demand for a vaccine or product, injury to our reputation, withdrawal
of clinical trial volunteers and loss of revenues. If a product liability claim
is brought against us, the cost of defending the claim could be significant and
any adverse determination may result in liabilities in excess of our insurance
coverage. We currently have product liability insurance in the amount of $25.0
million for our anthrax program including the supply of three million doses of
anthrax vaccine to NIAID, as well as separate product liability coverage in the
amount of $25.0 million for our smallpox and AIDSVAX programs. However, we
cannot be certain that our current insurance can be maintained, or that
additional insurance coverage could be obtained, on acceptable terms, if at
all.

49

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

Legislation relating to medical products used to fight bioterrorism is
evolving, and may enable the U.S. government to release and use certain medical
products prior to such products obtaining FDA or other regulatory approval.
According to the terms of one proposed bill, upon a declaration of emergency,
the U.S. government may authorize the introduction and use of a qualified medical
product prior to such medical product obtaining FDA regulatory approval.
Further, such proposed legislation provides that the United States government
may elect to purchase and stockpile quantities of vaccines or products prior to
receipt of regulatory approval to fight bioterrorism. Legislation limiting or
restricting liability for the use of such vaccines is evolving, and we cannot
be certain that any such protections will apply to the vaccines or products
developed by us. If the legislation does not provide sufficient protection, and
we are not able to obtain these protections by contract, we may become subject
to product liability suits and other third party claims if vaccines or products
developed by us cause injury, or if vaccinated individuals subsequently become
infected or otherwise suffer adverse effects from such vaccines or products.

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

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

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

We are highly dependent on our senior management and scientific staff.
These individuals have played a critical role in raising capital, negotiating
business development opportunities, developing the vaccine candidates, conducting
clinical trials and manufacturing products. If we lose the services of any key
members of senior management or scientific staff and we are unable to recruit
qualified replacements where we deem it necessary, we may be unable to achieve
our business objectives.

We
currently do not have an internal marketing and sales force and may rely on
third parties for the sales or marketing of some or all of our vaccines if they
are successfully developed. Our dependence on third parties may delay or impair
our ability to generate revenues, or adversely affect our profitability.

We lack any sales or marketing history, and as of present do not have
plans on developing internally such capability, other than for sales directly
to the U.S. government and certain foreign governments. We intend to rely on
third parties for the sales and marketing of our products to entities other
than the U.S. and foreign governments. Our lack of sales and marketing
personnel and distribution relationships may impair our ability to generate
revenues.

Other
Risks

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

Our board of directors has the authority to establish the designation
of 20 million additional shares of preferred stock that are convertible into
common stock without any action by our stockholders, and to fix the rights,
preferences, privileges and restrictions, including voting rights, of such
shares. The issuance and conversion of any such preferred stock would further
dilute the percentage ownership of our stockholders.

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

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


failure to win future government contracts for anthrax or
  smallpox vaccines;
adverse results or delays in clinical trials;
delays in our product development efforts;
real or perceived safety issues with any of our vaccine
  candidates;50


failure to obtain or maintain required regulatory
  approvals;
delays in completion and/or validation of our
  manufacturing facilities in the Republic of Korea;
changes in financial estimates by securities analysts;
rumors about our business prospects, product development
  efforts or clinical trials;
if our stock is delisted or not quoted on an approved stock
  exchange or the Nasdaq National Market or Small Cap Market for five
  consecutive days; or
new products or services offered by us or our competitors
  or announcements relating to product developments by our competitors;
issuances of debt or equity securities;
sales by our stockholders of substantial amounts of our
  common stock, including shares issued upon exercise of outstanding options
  and warrants; and
other events or factors, many of which are beyond our
  control.In addition, the stock market in general, and the Nasdaq National
Market and biotechnology companies in particular, have experienced extreme
price and volume fluctuations that have often been unrelated or
disproportionate to the operating performance of these companies. Broad market
and industry factors may negatively affect the market price of our common
stock, regardless of actual operating performance. In the past, following
periods of volatility in the market price of a companys securities, securities
class action litigation has often been instituted against companies.

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

The operations of Celltrion expose
us to currency fluctuations and exchange rate risks. Celltrion, which is
incorporated in the Republic of Korea, records its transactions in Korean Won.
Our share of Celltrions results, however, are 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 GAAP financial statements for
Celltrion and until we receive this information, we may not be able to evaluate
our financial condition or operating results on a timely basis.

Celltrion maintains its records in
accordance with Korean accounting principles; however, we require financial
information that is prepared in accordance with GAAP. Celltrions internal
controls over financial reporting may be insufficient to enable them to report
their interim 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 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 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.

51

ITEM
  2.

UNREGISTERED
  SALES OF EQUITY SECURITIES AND USE OF PROCEEDSNone.ITEM
  3.

DEFAULTS
  UPON SENIOR SECURITIESNone.ITEM
  4.

SUBMISSION
  OF MATTERS TO A VOTE OF SECURITY HOLDERSVaxGen, Inc. held a special meeting of stockholders on August 8, 2005.
At that meeting, a quorum was present and one proposal was voted upon: an
amendment to the Companys Amended and Restated Certificate of Incorporation,
to increase the authorized number of shares of common stock from 40,000,000 to
65,000,000 shares. The proposal was approved, as follows:

For

Against

Abstain21,611,859

2,755,358

694,625ITEM
  5.

OTHER INFORMATIONNone.ITEM
  6.

EXHIBITS(a)

Exhibits required by Item
  601 of Regulation S-K:The following exhibits are filed as
part of this report:

Incorporated by ReferenceExhibit 
  No.

Exhibit

Form

File No.

Filing Date

Exhibit
  No.

Filed 
  Herewith3.4

Amendment to the
  Amended and Restated Certificate of Incorporation, dated as of August 8,
  2005.









X31.1

Certification of Chief
  Executive Officer









X31.2

Certification of Chief
  Financial Officer









X32.1

Section 1350
  Certification









X52

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: May 30, 2007
By: /s/ James P. PanekJames P. PanekChief Executive Officer(Principal Executive Officer)Dated: May 30, 2007
By: /s/ Matthew J. PfefferMatthew J. PfefferChief Financial Officer(Principal Financial Officer)53