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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D. C. 20549
 
 FORM 10-K
 (MARK ONE)
 þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the fiscal year ended December 31, 2005
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
 For
the transition period from  to .
 Commission File Number 0-50632
 
 ANADYS PHARMACEUTICALS, INC.
 (Exact name of registrant as specified in its charter)
 Delaware
(State or other jurisdiction of
incorporation or organization)
    
    22-3193172
(I.R.S. Employer
Identification No.)
 3115 Merryfield Row, San Diego, California
(Address of principal executive offices)
    
    92121
(Zip Code)
 Registrants telephone number, including area code: 858-530-3600
 Securities registered pursuant to Section 12(b) of the Act: None
 Securities registered pursuant to Section 12(g) of the Act:
 Title of each class
Common Stock, $.001 par value
    
    Name of each exchange on which registered
Nasdaq National Market
 
 £ R
 £ R
 R £
 R
  Large accelerated filer £
    
    Accelerated filer R
    
    Non-accelerated filer £
 £ R
   DOCUMENTS INCORPORATED BY REFERENCE




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##### 



ANADYS PHARMACEUTICALS, INC.
ANNUAL REPORT ON FORM 10-K
 Table of Contents
 PagePART IItem 1.
    
    Business
    
    
    3Item 1A.
    
    Risk Factors
    
    
    21Item 1B.
    
    Unresolved Staff Comments
    
    
    42Item 2.
    
    Properties
    
    
    42Item 3.
    
    Legal Proceedings
    
    
    42Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    43PART IIItem 5.
    
    Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
    
    
    44Item 6.
    
    Selected Financial Data
    
    
    45Item 7.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operation
    
    
    47Item 7A.
    
    Quantitative and Qualitative Disclosure About Market Risk
    
    
    55Item 8.
    
    Financial Statements and Supplementary Data
    
    
    55Item 9.
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    55Item 9A.
    
    Controls and Procedures
    
    
    56Item 9B.
    
    Other Information
    
    
    57PART IIIItem 10.
    
    Directors and Executive Officers of the Registrant
    
    
    58Item 11.
    
    Executive Compensation
    
    
    58Item 12.
    
    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    
    
    58Item 13.
    

Certain Relationships and Related Transactions
    
    
    58Item 14.
    
    Principal Accounting Fees and Services
    
    
    58PART IVItem 15.
    
    Exhibits and Financial Statement Schedules
    
    
    59EXHIBIT 10.40EXHIBIT 23.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32




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PART I
 Item 1. Business
 Overview
  Toll-Like Receptors
  
 3




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ANA975
    ANA380
  ANA773
  AN 025-1
  4




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Industry Background
 Anti-Infectives
    Hepatitis C Virus
     5




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Hepatitis B Virus
 th
  Antibacterials
   TLR Agonists in Infectious Diseases & Cancer
  ä
 6




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Our Strategy
  
    
    Advance the Development of Our Lead Compounds in HCV and HBV.We are developing our two most advanced clinical
compounds for the potential treatment of HCV and HBV. In particular, during 2006 we expect to:
 
    
    Complete the Phase Ib 28-day clinical trial of ANA975 in HCV patients.
    
    File an Investigational New Drug (IND) application for ANA975
in HBV and  initiate a clinical trial of ANA975 in HBV patients.
    
    Complete the Phase II clinical trial of ANA380 in lamivudine-resistant HBV patients.
 
    
    Advance the Development of a Product Candidate in Cancer.We have selected ANA773, a compound derived from our
proprietary TLR drug discovery and delivery platform, for clinical development in certain cancers. During 2006 we
expect to:
 
    
    File an IND application for ANA773.
    
    Commence clinical trials of ANA773.
 
    
    Advance the Development of Another Lead Compound in HCV.We are advancing AN 025-1, a series of non-nucleoside
inhibitors of HCV NS5B polymerase. During 2006 we expect to:
 
    
    Nominate a specific compound from the AN 025-1 series and pursue its preclinical
development as an orally administered direct antiviral drug for the treatment of chronic HCV infection.
 
    
    Expand Our Product Candidate Portfolio. We intend to expand our product candidate portfolio
in the anti-infectives and cancer markets by leveraging our expertise in TLR-based small
molecule product candidates and structure-based drug design. In particular, we plan to:
 
    
    Utilize our internal drug discovery capabilities to identify and develop promising
product candidates for the anti-infective markets.
    
    Establish additional strategic collaborations to optimize our product candidate
portfolio, exploit additional TLR-based therapeutic opportunities and broaden our discovery
technology.
    
    Continue our focus on TLR-based biology and chemistry, which offer new opportunities for
the development of small-molecule, immune-based antiviral and cancer medicines.
    
    Extend our leadership in structure-based drug design. We continue to identify and
prioritize small molecules directed at key viral protein targets for combating infectious
diseases.
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
    
    Commercialize Our Product Candidates.We intend to commercialize in the U.S. certain
compounds for which we receive regulatory approval. To further our commercialization efforts,
we expect to:
 
    
    Either co-commercialize ANA975 in the U.S. with Novartis, assuming marketing
authorization by the FDA, and receive royalties on net sales of ANA975 in the rest of the
world, or forego co-commercialization and opt to receive royalties on
net sales of ANA975 on a
worldwide basis.
    
    Either commercialize ANA380 in our territories or enter into a partnership with a large
pharmaceutical company, such as Novartis, in which we would either co-commercialize ANA380
in certain countries and receive royalties in other countries, or receive royalties for all
our territories.
    
    Establish strategic collaborations to market other potential product candidates in the
U.S., Europe, Asia and elsewhere. We may also explore the possibility of using TLR agonists
in other indications and may enter into strategic partnerships for the development and
commercialization of such therapies. With respect to product candidates that are not of
strategic interest to us, we may license development and/or commercialization rights to
collaborators in exchange for up-front payments, research funding, milestone payments and/or
royalties.
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Our Development Programs
  
 HCV Programs
 ANA975
  9




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in vitro in vivo in vitro in vivo
      Other HCV Programs
   HBV Programs
 ANA975
  10




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ANA380
 st
  10
   Cancer
Program
 ANA773
  Bacterial Ribosomal Translation Inhibitors
 in vitro
 11




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Additional Oral Prodrugs of TLR-7 Agonists
  Our Drug Discovery and Development Capabilities
  Enabling
Technologies and Capabilities
 
 Core Expertise
 TLR-Based Small-Molecule Product Candidates
   12




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Structure-Based Drug Design & Medicinal Chemistry
   Collaboration and Licensing Agreements
 Novartis International Pharmaceuticals Ltd.
     Hoffmann-La Roche Inc.
  13




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LG Life Sciences, Ltd.
  Aphoenix, Inc.
  Valeant Pharmaceuticals International (formerly known as ICN Pharmaceuticals, Inc.)
  Manufacturing and Supply
  Intellectual Property and Patents
  14




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
    
    Obtain and maintain patent and other proprietary protection for the technology,
inventions and improvements we consider important to our business;
    
    Defend and enforce our patents;
    
    Preserve the confidentiality of our trade secrets; and
    
    Operate without infringing the patents and proprietary rights of third parties.
     15




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Competition
   Treating HCV with Interferon-based Therapies
    16




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Direct Antivirals in Development for Treating of HCV
  Treating HBV with Direct Antivirals & Interferon
  Competitive Risks
    e.g.
 17




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Government Regulations
    
    
    Phase I: Studies are conducted on normal, healthy human volunteers to determine safety,
dosage tolerance, absorption, metabolism, distribution and excretion. If possible, Phase I
studies may also be designed to gain early evidence of effectiveness.
    
    Phase II: Studies are conducted on small groups of patients afflicted with a specific
disease to gain preliminary evidence of efficacy, to determine the common short-term side
effects and risks associated with the substance being tested and to determine dosage
tolerance and optimal dosage.
    
    Phase III: Involves large-scale studies conducted on disease-afflicted patients to
provide statistical evidence of efficacy and safety and to provide an adequate basis for
physician labeling.
  Environmental and Safety Matters
   Employees
  18




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Executive Officers
  Name
    
    Age
    
    PositionKleanthis G. Xanthopoulos, Ph.D
    
    
    47
    
    
    Chief Executive Officer, President and DirectorStephen T. Worland, Ph.D.
    
    
    47
    
    
    Executive Vice President, PharmaceuticalsDevron R. Averett, Ph.D.
    
    
    56
    
    
    Chief Scientific OfficerJennifer K. Crittenden
    
    
    46
    
    
    Vice President, FinanceMary Yaroshevsky-Glanville
    
    
    41
    
    
    Vice President, Human CapitalElizabeth E. Reed, J.D.
    
    
    34
    
    
    Senior Director, Legal Affairs and Corporate Secretary
 Kleanthis G. Xanthopoulos, Ph.D.
 Steve Worland, Ph.D.
 Devron R. Averett, Ph.D.
 Jennifer K. Crittenden
 Mary Yaroshevsky-Glanville
 19




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Elizabeth E. Reed, J.D. cum laude
 Company Website
   20




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Item 1A. Risk Factors
 You should consider carefully the following information about the risks described below,
together with the other information contained in this Annual Report and in our other public filings
before making any investment decisions regarding our stock. If any of the following risks actually
occurs, our business, financial condition, results of operations and future growth prospects would
likely be materially and adversely affected. In these circumstances, the market price of our common
stock would likely decline, and you may lose all or part of the money you paid to buy our common
stock.
 Risks Related to Our Business
 We are at an early stage of development, and we may never attain product sales.
  We expect our net operating losses to continue for at least several years, and
we are unable to predict the extent of future losses or when we will become
profitable, if ever.
  The technologies on which we rely are unproven and may not result in the
discovery or development of commercially viable products.
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We currently depend on one collaboration partner, Novartis, for substantially
all our revenues and for commercialization of one of our lead product
candidates, and we may depend on Novartis for commercialization of other
product candidates. If our development, license and commercialization agreement
with Novartis terminates, our business and, in particular, our drug development
programs, will be seriously harmed.
  The success of ANA975 depends heavily on our collaboration with
Novartis, which was established only recently. If Novartis is
unwilling to further develop or commercialize ANA975, or
experiences significant delays in doing so, our business may be
materially harmed.
  We
expect to complete a 28-day clinical trial of
ANA975 in HCV infected patients in 2006, and our stock price
could decline significantly if the results are not favourable or are
not viewed favourably.
  Novartis has the right under certain circumstances to market and sell products
that compete with the product candidates and products that we license to it,
and any competition by Novartis could have a material adverse effect on our
business.
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We are dependent on the commercial success of ANA975 or another oral prodrug of
isatoribine or other TLR-7 agonists and we cannot be certain that ANA975 or any
other oral prodrug of isatoribine or other TLR-7 agonists will be
commercialized.
  Because the results of preclinical studies and initial clinical trials of
isatoribine, ANA975 and ANA380 are not necessarily predictive of future
results, we can provide no assurances that ANA975 or ANA380 will have favorable
results in later clinical trials, or receive regulatory approval.
  Although we have an active IND to conduct clinical trials of ANA975 for HCV in
the U.S., we will need to file an additional IND application to conduct trials
of ANA975 for HBV in the U.S. and will need to continue our dialogue with the
FDA as we and/or Novartis conduct additional trials of ANA975 in the U.S. for
either indication.
  23




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We may not realize the anticipated benefits of the development and potential commercialization of ANA380.
  Delays in the commencement of clinical testing of our current and potential
product candidates could result in increased costs to us and delay our ability
to generate revenues.
   
    
    Demonstrating sufficient safety and efficacy to obtain regulatory approval to commence a clinical trial;
    
    Reaching an agreement on acceptable terms with our collaborators on all aspects of the clinical trial,
including the contract research organizations and the trial sites;
    
    reaching agreement on acceptable terms with prospective contract research organizations and trial sites;
    
    Manufacturing sufficient quantities or producing drug meeting our quality standards of a product candidate;
    
    obtaining approval of an IND application or proposed trial design from the FDA; and
    
    obtaining institutional review board approval to conduct a clinical trial at a prospective site.
 .
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Delays in the completion of, or the termination of, clinical testing of our
current and potential product candidates could result in increased costs to us
and delay or prevent us from generating revenues.
  
    
    ongoing discussions with the FDA or other regulatory authorities regarding the scope or design of our clinical trials;
    
    failure to conduct clinical trials in accordance with regulatory requirements;
    
    lower than anticipated enrollment or retention rate of patients in clinical trials;
    
    inspection of the clinical trial operations or trial sites by the FDA or other regulatory authorities resulting in the imposition
of a clinical hold;
    
    lack of adequate funding to continue clinical trials;
    
    negative results of clinical trials;
    
    requests by the FDA for supplemental information on, or clarification of, the results of clinical trials conducted in other
countries;
    
    insufficient supply or deficient quality of drug candidates or other materials necessary for the conduct of our clinical trials; or
    
    serious adverse events or other undesirable drug-related side effects experienced by participants.
  The success of the clinical development program of ANA380 will depend, at least
in part, on our or our collaborators ability to maintain a positive working
relationship with the FDA and other regulatory authorities, and the failure to
do so may harm or delay our ability to commercialize ANA380 in the U.S. or
other countries.
  25




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If our efforts to obtain rights to new products or product candidates from
third parties do not yield product candidates for clinical development or are
not otherwise successful, we may not generate product revenues or achieve
profitability.
  
    
    we may be unable to purchase or license products or product candidates on terms that would
allow us to make an appropriate return from resulting products;
    
    competitors may be unwilling to assign or license product or product candidate rights to us; or
    
    we may be unable to identify suitable products or product candidates within, or complementary
to, our areas of interest relating to small-molecule anti-infective medicines and the
treatment of HCV, HBV, other serious infections and cancer.
  As we evolve from a company primarily involved in discovery and development to
one also involved in commercialization, we may encounter difficulties in
managing our growth and expanding our operations successfully.
  26




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Because we acquired isatoribine from Valeant Pharmaceuticals International
(formerly known as ICN Pharmaceuticals, Inc.) any dispute with Valeant
Pharmaceuticals International may adversely affect our ability to commercialize
isatoribine or prodrugs of isatoribine.
  Even if we successfully complete clinical trials of ANA975, ANA380 or any
future product candidate, there are no assurances that we will be able to
submit, or obtain FDA approval of, a new drug application.
  If we successfully develop products but those products do not achieve and
maintain market acceptance, our business will not be profitable.
  
    
    our ability to provide acceptable evidence of safety and efficacy;
    
    relative convenience and ease of administration;
    
    the prevalence and severity of any adverse side effects;
    
    availability of alternative treatments;
    
    pricing and cost effectiveness;
    
    effectiveness of our or our collaborators sales and marketing strategy; and
    
    our ability to obtain sufficient third-party insurance coverage or reimbursement.
  27




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
    
    new products or technologies are introduced that are more favorably received than our products,
are more cost effective or render our products obsolete; or
    
    complications, such as antibiotic or viral resistance, arise with respect to use of our products.
 If
we were to decide to pursue the commercialization of isatoribine and
were unable to obtain statutory marketing exclusivity after our patents covering isatoribine expire, we would face increased competition, which
could result in reduced potential revenues.
  We will need additional funding and may be unable to raise capital when needed,
which would force us to delay, reduce or eliminate our research and development
programs or commercialization efforts.
  
    
    fund our research and development programs;
    
    fund our share of the further clinical development and regulatory review and approval of ANA975 and ANA380;
    
    establish and maintain manufacturing, sales and marketing operations;
    
    commercialize our product candidates, if any, that receive regulatory approval; and
    
    acquire rights to products or product candidates, technologies or businesses.
 28




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
    
    the progress of our clinical trials;
    
    the progress of our research activities;
    
    the number and scope of our research programs;
    
    the progress of our preclinical development activities;
    
    our ability to establish and maintain strategic collaborations;
    
    the costs involved in enforcing or defending patent claims and other intellectual property rights;
    
    the pace and timing of development activities conducted under joint development arrangements with our collaborators;
    
    the cost and timing of regulatory approvals;
    
    the costs of establishing or expanding manufacturing, sales and distribution capabilities;
    
    the costs related to development and manufacture of pre-clinical, clinical and validation lots for regulatory andcommercialization of drug supply;
    
    the success of the commercialization of ANA380 and ANA975; and
    
    the extent to which we acquire or invest in other products technologies and businesses.
  Raising additional funds by issuing securities or through collaboration and
licensing arrangements may cause dilution to existing stockholders, restrict
our operations or require us to relinquish proprietary rights.
  29




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If we fail to establish new collaborations, we may not generate sufficient revenue to attain profitability.
  If we fail to maintain our existing and future collaborations, we may not generate sufficient revenue to attain profitability.
  
    
    we or our collaborators do not achieve our respective objectives under our collaboration agreements;
    
    we are unable to obtain patent protection for the product candidates or proprietary technologies we discover
in our collaborations;
    
    we are unable to properly manage multiple simultaneous product discovery and development collaborations;
    
    our present or potential collaborators are less willing to expend their resources on our programs due to
their focus on other programs or as a result of general market conditions;
    
    our collaborators become competitors of ours or enter into agreements with our competitors;
    
    we or our collaborators encounter regulatory hurdles that prevent commercialization of our product candidates;
    
    we develop products and processes or enter into additional collaborations that conflict with the business
objectives of our other collaborators;
    
    consolidation in our target markets or the pharmaceutical or biotechnology industry limits the number of
potential collaborators;
    
    the rights granted under our collaboration agreements prove insufficient to adequately develop and
commercialize our products and product candidates;
    
    a collaborator breaches, terminates or fails to renew a collaboration with us; or
    
    we are unable to negotiate additional collaboration agreements on terms satisfactory to us.
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We are dependent on collaborators allocating adequate resources to our
collaborations, and actions taken by collaborators could prevent us from
commercializing products and earning milestone and other contingent payments,
royalties or other revenue.
  
    
    decide not to devote the necessary resources due to internal constraints, such as
limited personnel with the requisite scientific expertise, limited cash resources or
specialized equipment limitations, or other drug development priorities that our
collaboration partners believe may have a higher likelihood of obtaining regulatory
approval or may potentially generate a greater return on investment;
    
    do not have sufficient resources necessary to carry the product candidate through
clinical development, regulatory approval and commercialization;
    
    are unable to allocate sufficient resources due to factors affecting their businesses
or operations or as a result of general market conditions;
    
    decide to pursue a competitive potential product developed outside of the collaboration;
    
    cannot obtain the necessary regulatory approvals; or
    
    are otherwise subject to adverse events affecting their business.
   If any conflicts arise between us and any of our collaborators, our reputation,
revenues and cash position could be significantly harmed.
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
    
    unwillingness on the part of a collaborator to pay us research funding, milestone payments or royalties we
believe are due to us under our collaboration agreement;
    
    uncertainty regarding ownership of intellectual property rights arising from our collaborative activities, which
could result in litigation and prevent us from entering into additional collaborations;
    
    unwillingness on the part of a collaborator to keep us informed regarding the progress of its development and
commercialization activities, or to permit public disclosure of the results of those activities;
    
    slowing or cessation of a collaborators development or commercialization efforts with respect to our products; or
    
    termination or non-renewal of the collaboration.
   We depend on outside parties to conduct our clinical trials, which may result
in costs and delays that prevent us from obtaining regulatory approval or
successfully commercializing product candidates.
  We do not have internal manufacturing capabilities, and if we fail to develop
and maintain supply relationships with collaborators or other outside
manufacturers, we may be unable to develop or commercialize any of our
non-partnered products.
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If we are unable to establish sales and marketing capabilities or enter into
agreements with third parties to sell and market any products we may develop,
we may not be able to generate product revenue.
  We will need to increase the size of our organization, and we may encounter
difficulties managing our growth, which could adversely affect our results of
operations.
  If we are unable to attract and retain key management and scientific staff, we
may be unable to successfully develop or commercialize our product candidates.
  Our quarterly results and stock price may fluctuate significantly.
  
    
    the status of development of ANA380, ANA975 and our other product
candidates, including results of preclinical studies
and clinical
trials;
 33




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
    
    our recommendation of additional compounds for preclinical development;
    
    our execution of collaborative, licensing or other arrangements, and
the timing and accounting treatment of payments we make or receive
under these arrangements;
    
    whether or not we achieve specified research or commercialization
milestones under any agreement that we enter into or have entered into
with collaborators and the timely payment by commercial collaborators
of any amounts payable to us;
    
    our collaborators termination of any of our collaborative, licensing
or other arrangements, or any disputes regarding such arrangements;
    
    our addition or termination of research programs or funding support;
    
    variations in the level of expenses related to our product candidates
or potential product candidates during any given period; and
    
    the effect of competing technological and market developments.
  If we engage in any acquisition, we will incur a variety of costs, and we may
never realize the anticipated benefits of the acquisition.
  
    
    exposure to unknown liabilities;
    
    disruption of our business and diversion of our managements time and attention to
acquiring and developing acquired products or technologies;
    
    incurrence of substantial debt or dilutive issuances of securities to pay for acquisitions;
    
    higher than expected acquisition and integration costs;
    
    increased amortization expenses;
    
    negative effect on our earnings (or loss) per share;
    
    difficulty and cost in combining and integrating the operations and personnel of any
acquired businesses with our operations and personnel;
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
    
    impairment of relationships with key suppliers, contractors or customers of any acquired
businesses due to changes in management and ownership; and
    
    inability to retain key employees of any acquired businesses.
  Earthquake damage to our facilities could delay our research and development efforts and adversely affect our business.
  Risks Related to Our Industry
 Because our product candidates and development and collaboration efforts depend
on our intellectual property rights, adverse events affecting our intellectual
property rights will harm our ability to commercialize products.
   
    
    we might not have been the first to make, conceive, or reduce to practice the inventions covered by all
or any of our pending patent applications and issued patents;
    
    we might not have been the first to file patent applications for these inventions;
    
    others may independently develop similar or alternative technologies or duplicate any of our technologies;
    
    it is possible that none of our pending patent applications will result in issued patents;
    
    our issued or acquired patents may not provide a basis for commercially viable products, may not provide
us with any competitive advantages, or may be challenged by third parties;
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
    
    our issued patents may not be valid or enforceable;
    
    we may not develop additional proprietary technologies that are patentable; or
    
    the patents of others may have an adverse effect on our business.
     If we are sued for infringing intellectual property rights of others, it will
be costly and time- consuming, and an unfavorable outcome in that litigation
would have a material adverse effect on our business.
   
    
    cease selling, incorporating or using any of our product candidates or
technologies that incorporate the challenged intellectual property;
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
    
    obtain a license from the holder of the infringed intellectual
property right, which license may be costly or may not be available on
reasonable terms, it at all; or
    
    redesign our processes or technologies so that they do not infringe,
which could be costly and time-consuming and may not be possible.
   We may be involved in lawsuits or proceedings to protect or enforce our patent
rights, trade secrets or know-how, which could be expensive and time-
consuming.
   Confidentiality agreements with employees and others may not adequately prevent
disclosure of trade secrets and other proprietary information and may not
adequately protect our intellectual property.
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Many competitors have significantly more resources and experience, which may harm our commercial opportunity.
  
    
    research and development;
    
    preclinical testing;
    
    clinical trials;
    
    regulatory approvals;
    
    manufacturing; and
    
    sales and marketing of approved products.
  If our competitors develop treatments for HCV, HBV, cancer or in the other
fields in which we are developing products that are approved faster, marketed
better or demonstrated to be more effective than ANA975, ANA380 or any other
products that we may develop, our commercial opportunity will be reduced or
eliminated.
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If we cannot establish pricing of our product candidates acceptable to the
government, insurance companies, managed care organizations and other payors,
any product sales will be severely hindered.
  
    
    our ability to set a price we believe is fair for any products we or our collaborators may develop;
    
    our ability to generate adequate revenues and gross margins; and
    
    the availability of capital.
  If we cannot arrange for reimbursement policies favorable to our product candidates, their sales will be severely hindered.
  Product liability claims may damage our reputation and, if insurance proves
inadequate, the product liability claims may harm our results of operations.
  
    
    decreased demand for our product candidates;
    
    injury to our reputation;
    
    withdrawal of clinical trial participants;
    
    the inability to establish new collaborations with potential collaborators;
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
    
    substantial costs of related litigation;
    
    substantial monetary awards to patients; and
    
    the inability to commercialize our product candidates.
  Any claims relating to our improper handling, storage or disposal of
biological, hazardous and radioactive materials could be time-consuming and
costly.
  Our business and operations would suffer in the event of system failures.
  Risks Related to Our Common Stock
 Future sales of our common stock may cause our stock price to decline.
  40




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Our stock price may be volatile.
  
    
    changes in the regulatory status of our product candidates, including results of our clinical trials for ANA975 and ANA380;
    
    significant contracts, new technologies, acquisitions, commercial relationships, joint ventures or capital commitments;
    
    disputes or other developments relating to proprietary rights, including patents, trade secrets, litigation matters, and
our ability to patent or otherwise protect our product candidates and technologies;
    
    developments under our collaboration agreements with our collaborators;
    
    conditions or trends in the pharmaceutical and biotechnology industries;
    
    fluctuations in stock market prices and trading volumes of similar companies or of the markets generally;
    
    variations in our quarterly operating results;
    
    changes in securities analysts estimates of our financial performance;
    
    failure to meet or exceed securities analysts or investors expectations of our quarterly financial results, clinical
results or our achievement of milestones;
    
    changes in accounting principles including the implementation of SFAS No. 123R, Share-Based Payment,which we adopted
effective January 1, 2006. We expect that this accounting change will have a negative impact on our operating losses and
potential earnings in future periods;
    
    sales of large blocks of our common stock, or the expectation that such sales may occur, including sales by our executive
officers, directors and significant stockholders;
    
    additions or departures of key personnel;
    
    discussion of our business, products, financial performance, prospects or our stock price by the financial and scientific
press and online investor communities such as chat rooms;
    
    regulatory developments in the U.S. and foreign countries;
    
    economic and political factors, including wars, terrorism and political unrest; and
    
    technological advances by our competitors.
 Our largest stockholders may take actions that are contrary to your interests, including selling their stock.
  41




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##### Table of Contents



Anti-takeover provisions in our organizational documents and Delaware law may
discourage or prevent a change in control, even if an acquisition would be
beneficial to our stockholders, which could affect our stock price adversely
and prevent attempts by our stockholders to replace or remove our current
management.
  
    
    dividing our board of directors into three classes serving staggered three-year terms;
    
    prohibiting our stockholders from calling a special meeting of stockholders;
    
    permitting the issuance of additional shares of our common stock or preferred stock without stockholder approval;
    
    prohibiting our stockholders from making certain changes to our amended and restated certificate of
incorporation or amended and restated bylaws except with 66 2/3% stockholder approval; and
    
    requiring advance notice for raising matters of business or making nominations at stockholders meetings.
  We have never paid cash dividends on our capital stock and we do not anticipate paying dividends in the foreseeable future.
  
 Item 1B. Unresolved Staff Comments
  
 Item 2. Properties
  
 Item 3. Legal Proceedings
  42




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##### Table of Contents



Item 4. Submission of Matters to a Vote of Security Holders
  43




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##### Table of Contents



Part II
 
 Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchase of
Equity Securities
 Market Information
  2005
    
    High
    
    
    LowFirst Quarter
    
    $
    9.05
    
    
    $
    6.56Second Quarter
    
    
    9.61
    
    
    
    5.92Third Quarter
    
    
    14.20
    
    
    
    9.26Fourth Quarter
    
    
    12.15
    
    
    
    7.91
 2004
    
    High
    
    
    LowFirst Quarter (commencing March 26, 2004)
    
    $
    7.23
    
    
    $
    7.00Second Quarter
    
    
    8.69
    
    
    
    6.80Third Quarter
    
    
    7.55
    
    
    
    4.53Fourth Quarter
    
    
    7.50
    
    
    
    5.25
 Holders
  Dividend Policy
  Securities Authorized for Issuance Under Equity Compensation Plans
  (c)Number of securitiesremaining available for(a)
    
    (b)
    
    future issuance under equityNumber of securities to
    
    Weighted-average
    
    compensation plansbe issued upon exercise
    
    exercise price of
    
    (excluding securitiesof outstanding options
    
    outstanding options
    
    reflected in column (a))Equity
compensation plans
approved by
security holders
    
    3,089,271
    
    $6.06
    
    970,401
 Use of Proceeds from Registered Securities
  44




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##### Table of Contents



Item 6. Selected Financial Data
  For the years ended December 31,2005
    
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001(In thousands, except per share amounts)Consolidated Statements of Operations Data:Revenues
    
    $
    4,887
    
    
    $
    1,762
    
    
    $
    2,286
    
    
    $
    1,282
    
    
    $
    287Operating expenses:Research and development
    
    
    19,977
    
    
    
    24,173
    
    
    
    16,554
    
    
    
    18,054
    
    
    
    8,799General and administrative
    
    
    6,638
    
    
    
    5,666
    
    
    
    4,716
    
    
    
    5,434
    
    
    
    4,027Stock-based compensation:Research and development
    
    
    924
    
    
    
    2,538
    
    
    
    2,265
    
    
    
    610
    
    
    
    859General and administrative
    
    
    1,067
    
    
    
    2,594
    
    
    
    2,440
    
    
    
    430
    
    
    
    989Total operating expenses
    
    
    28,606
    
    
    
    34,971
    
    
    
    25,975
    
    
    
    24,528
    
    
    
    14,674Loss from operations
    
    
    (23,719
    )
    
    
    (33,209
    )
    
    
    (23,689
    )
    
    
    (23,246
    )
    
    
    (14,387
    )Other income (expense):Interest income
    
    
    2,103
    
    
    
    525
    
    
    
    229
    
    
    
    403
    
    
    
    899Interest expense
    
    
    (189
    )
    
    
    (228
    )
    
    
    (266
    )
    
    
    (176
    )
    
    
    (287
    )Other, net
    
    
    (118
    )
    
    
    (67
    )
    
    
    (272
    )
    
    
    (29
    )
    
    
    (253
    )Total other income, (expenses) net
    
    
    1,796
    
    
    
    230
    
    
    
    (309
    )
    
    
    198
    
    
    
    359Net loss
    
    
    (21,923
    )
    
    
    (32,979
    )
    
    
    (23,998
    )
    
    
    (23,048
    )
    
    
    (14,028
    )Accretion to redemption value of
redeemable convertible preferred stock
    
    
    
    
    
    
    (175
    )
    
    
    (674
    )
    
    
    (319
    )
    
    
    Deemed dividend-beneficial conversion
feature for Series C preferred stock
    
    
    
    
    
    
    
    
    
    
    (6,942
    )
    
    
    
    
    
    
    Net loss applicable to common
stockholders
    
    $
    (21,923
    )
    
    $
    (33,154
    )
    
    $
    (31,614
    )
    
    $
    (23,367
    )
    
    $
    (14,028
    )Basic and diluted net loss per share(1):
    
    $
    (0.89
    )
    
    $
    (1.92
    )
    
    $
    (21.58
    )
    
    $
    (25.88
    )
    
    $
    (25.18
    )Shares used to compute basic and
diluted net loss per share(1):
    
    
    24,756
    
    
    
    17,233
    
    
    
    1,465
    
    
    
    903
    
    
    
    557
 
 (1)
    
    As a result of the conversion of our preferred stock into 13,330 shares of our common stock
upon completion of our initial public offering on March 31, 2004, there is a lack of
comparability in the basic and diluted net loss per share amounts for the periods presented
prior to the completion of our initial public offering. Please reference Note 1 for the basic
and diluted net loss per share calculation for the periods presented. 45




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##### Table of Contents



As of December 31,2005
    
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001(In thousands)Consolidated Balance Sheet Data:Cash, cash equivalents and
securities available-for-sale
    
    $
    104,851
    
    
    $
    33,674
    
    
    $
    14,499
    
    
    $
    25,542
    
    
    $
    10,985Working capital
    
    
    98,682
    
    
    
    28,001
    
    
    
    12,304
    
    
    
    22,239
    
    
    
    8,812Total assets
    
    
    116,976
    
    
    
    40,949
    
    
    
    20,242
    
    
    
    31,840
    
    
    
    16,604Long-term debt, net of current
portion
    
    
    682
    
    
    
    1,193
    
    
    
    1,401
    
    
    
    1,276
    
    
    
    967Redeemable convertible preferred
stock
    
    
    
    
    
    
    
    
    
    
    45,012
    
    
    
    36,210
    
    
    
    Accumulated deficit
    
    
    (187,720
    )
    
    
    (165,797
    )
    
    
    (132,643
    )
    
    
    (101,029
    )
    
    
    (77,662
    )Total stockholders equity (deficit)
    
    
    78,936
    
    
    
    31,285
    
    
    
    (30,059
    )
    
    
    (9,998
    )
    
    
    12,211
 46




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##### Table of Contents



Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
 MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
   Overview
  
    
    fund our portion of the development of ANA975 for the treatment of HCV and HBV;
    
    fund our portion of the global development costs of ANA380;
    
    continue the development of our other product candidates, including ANA773;
    
    advance our preclinical candidates into clinical development;
    
    develop and scale-up product candidates for clinical trials and potential commercialization;
    
    further our research and development programs;
    
    establish a commercial infrastructure;
    
    commercialize any product candidates that receive regulatory approval; and
    
    potentially in-license technology and acquire or invest in businesses, products or
technologies that are synergistic with our own.
 Research and Development
  47




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##### Table of Contents



For the years ended December 31,2005
    
    
    2004
    
    
    2003(In thousands)Direct external costs:Isatoribine family of compounds, excluding ANA975
    
    $
    558
    
    
    $
    1,798
    
    
    $
    1,846ANA975
    
    
    8,613
    
    
    
    2,038
    
    
    
    ANA380
    
    
    417
    
    
    
    5,638
    
    
    
    ANA773
    
    
    110
    
    
    
    
    
    
    
    Other
    
    
    
    
    
    
    5
    
    
    
    25Unallocated direct internal costs
    
    
    3,535
    
    
    
    1,843
    
    
    
    1,037Unallocated indirect internal costs and overhead
    
    
    12,534
    
    
    
    12,851
    
    
    
    13,646Reimbursement of ANA975 costs by Novartis
    
    
    (5,790
    )
    
    
    
    
    
    
    Total research and development
    
    $
    19,977
    
    
    $
    24,173
    
    
    $
    16,554
    General and Administrative
  Critical Accounting Policies
  48




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##### Table of Contents



Revenue Recognition. Revenue Recognition, Revenue Arrangements with Multiple Deliverables.
 
    
    Revenue from milestones is recognized when earned, as evidenced by written acknowledgment
from the collaborator or other persuasive evidence that the milestone has been achieved,
provided that (i) the milestone event is substantive and its achievability was not reasonably
assured at the inception of the agreement, (ii) our performance obligations after the
milestone achievement will continue to be funded by the collaborator at the comparable level
and (iii) the milestone is not refundable or creditable. If all of these criteria are not
met, the milestone payment is recognized over the remaining minimum period of our performance
obligations under the agreement. Upfront fees under our collaborations, such as technology
access fees, are recognized over the period the related services are provided. Non-refundable
upfront fees not associated with our future performance are recognized when received.
    
    Fees that we receive for research services are generally recognized as the services are
provided, as long as the amounts received are not refundable regardless of the results of the
research project. Research services may include agreements through which we will deploy our
internal capabilities to assist a collaborator to advance their target, such as our medicinal
chemistry and screening capabilities.
 Drug Development Costs.
 Recent Accounting Pronouncements
 Share Based Payment,
 49




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##### Table of Contents



Results of Operations
 Comparison of the Years Ended December 31, 2005, 2004 and 2003
 Revenue.
 Research
and Development Expenses.
 General and Administrative Expenses.
 Stock-based Compensation.
 Interest Income.
 50




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##### Table of Contents



Interest Expense.
 Other, net.
 Liquidity and Capital Resources
  Cash Flows from Operating Activities and Investing Activities
  For the years ended December 31,2005
    
    
    2004
    
    
    2003(In thousands)Net cash provided by (used in) operating activities
    
    $
    5,999
    
    
    $
    (22,574
    )
    
    $
    (18,333
    )Cash provided by (used in) investing activitiesPurchase of securities available-for-sale
    
    $
    (11,886
    )
    
    $
    (42,619
    )
    
    $
    (7,820
    )Proceeds from sale of securities available-for-sale
    
    
    28,416
    
    
    
    17,398
    
    
    
    23,960Purchase of property and equipment
    
    
    (1,338
    )
    
    
    (880
    )
    
    
    (674
    )Proceeds from disposal of property and equipment
    
    
    2
    
    
    
    35
    
    
    
    25Acquisition of facility leasehold improvements from lease incentive
    
    
    
    
    
    
    (1,550
    )
    
    
    Net cash provided by (used in) investing activities
    
    $
    15,194
    
    
    $
    (27,616
    )
    
    $
    15,491
  51




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##### Table of Contents




    
    Amortization of deferred compensation from employee stock options increased $1.4 million
from $4.9 million during 2004 compared to $3.5 million during 2003.
    
    During 2004, we received $1.6 million in lease incentives as a result of entering into a
lease for our new corporate headquarters and research and development facility. In addition,
we paid $1.3 million for a refundable security deposit on this facility.
   
    
    We purchased property, equipment, and facility leasehold improvements in the amount of
$880,000, which related primarily to research and development equipment.
    
    During 2004, we utilized $1.6 million of lease incentives to fund the construction of
certain tenant improvements to prepare our new corporate headquarters and research and
development facility for occupancy.
 Cash Flows from Financing Activities
  For the years ended December 31,2005
    
    
    2004
    
    
    2003(In thousands)Cash provided by financing activitiesProceeds from exercise of stock options and employee
stock purchase plan
    
    $
    1,057
    
    
    $
    560
    
    
    $
    27Proceeds from sale of common stock, net of issuance costs
    
    
    66,437
    
    
    
    43,656
    
    
    
    7Proceeds from sale of preferred stock, net of issuance
costs
    
    
    
    
    
    
    
    
    
    
    8,078Proceeds from long-term debt
    
    
    393
    
    
    
    1,198
    
    
    
    1,585Principal payments on long-term debt
    
    
    (1,409
    )
    
    
    (1,204
    )
    
    
    (1,753
    )Net cash provided by financing activities
    
    $
    66,478
    
    
    $
    44,210
    
    
    $
    7,944
   
    
    During 2004, we received proceeds from the exercise of employee stock options and from
our employee stock purchase plan of $560,000.
 52




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##### Table of Contents




    
    During 2004, we modified our existing loan and security agreement and as a result
increased the maximum amount available under the agreement to $3 million, provided for a
revolving credit facility and extended the availability of the credit facility to December
31, 2005. During 2004, we executed promissory notes under the loan and security agreement in
the amount of $1.2 million for eligible equipment and tenant improvements.
 Aggregate Contractual Obligations
  Lessthan 1
    
    
    2007 to
    
    
    2009 toContractual Obligations
    
    Total
    
    
    year
    
    
    2008
    
    
    2010
    
    
    ThereafterOperating leases
    
    $
    6,624
    
    
    $
    1,783
    
    
    $
    3,722
    
    
    $
    1,119
    
    
    $
    Equipment financing (1)
    
    
    1,559
    
    
    
    1,559
    
    
    
    
    
    
    
    
    
    
    
    Minimum royalty commitment
    
    
    1,025
    
    
    
    50
    
    
    
    175
    
    
    
    200
    
    
    
    600$
    9,208
    
    
    $
    3,392
    
    
    $
    3,897
    
    
    $
    1,319
    
    
    $
    600
 
 (1)
    
    During February 2006, we paid the outstanding principal due on all of the equipment
financing loans and as a result the entire outstanding balance is being reported as due
in fiscal year 2006.   Overview of Financial Position and Future Cash Requirements
  53




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##### Table of Contents




    
    the progress of our clinical trials;
    
    the progress of our research activities;
    
    the number and scope of our research programs;
    
    the progress of our preclinical development activities;
    
    our ability to establish and maintain strategic collaborations;
    
    the costs involved in enforcing or defending patent claims and other intellectual property rights;
    
    the pace and timing of development activities conducted under joint development agreements with our collaborators;
    
    the costs and timing of regulatory approvals;
    
    the costs of establishing or expanding manufacturing, sales and distribution capabilities;
    
    the costs related to development and manufacture of pre-clinical, clinical and validation lots for regulatory and
commercialization of drug supply;
    
    the success of the commercialization of ANA380, ANA975, ANA773 or any other product candidates we may develop; and
    
    the extent to which we acquire or invest in other products, technologies and businesses.
     54




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##### Table of Contents



Off-Balance Sheet Arrangements
  
 Item 7A. Quantitative and Qualitative Disclosure About Market Risk
  
 Item 8. Financial Statements and Supplementary Data
  
 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
  55




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##### Table of Contents



Item 9A. Controls and Procedures
 Managements Report on Internal Control over Financial Reporting
 Evaluation of Disclosure Controls and Procedures:
 Managements Annual Report on Internal Control over Financial Reporting
 Internal Control -
Integrated Framework Internal Control  Integrated Framework
  Changes in Internal Control Over Financial Reporting:
 Report of Independent Registered Public Accounting Firm
     56




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##### Table of Contents



.
   
 
 Item 9B. Other Information
   57




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##### Table of Contents



Part III
  
 Item 10. Directors and Executive Officers of the Registrant
     www.anadyspharma.com
 
 Item 11. Executive Compensation
  
 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters
  
 Item 13. Certain Relationships and Related Transactions
  
 Item 14. Principal Accounting Fees and Services
  58




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##### Table of Contents



Part IV
 
 Item15. Exhibits and Financial Statement Schedules
  (1)
    
    Financial Statements. See index to consolidated financial statements on page F-1.(2)
    
    Financial Statement Schedules. All financial statements schedules for which
provision is made in Regulation S-X are omitted because they are not required under the
related instructions, are inapplicable, or the required information is given in the
financial statements, including the notes thereto.(3)
    
    Exhibits.
 ExhibitNumber
    
    Exhibit Description3.1(1)
    
    Form of Amended and Restated Certificate of Incorporation of the Registrant3.2(1)
    
    Form of Amended and Restated Bylaws of the Registrant4.1(2)
    
    Form of Specimen Common Stock Certificate4.2(3)
    
    Amended and Restated Registration
Rights Agreement dated as of June 20, 2002 by and among the Registrant and Stockholders named therein10.3(3)#
    
    2002 Equity Incentive Plan10.4(3)#
    
    Form of Stock Option Agreement under 2002 Equity Incentive Plan10.5(2)#
    
    2004 Equity Incentive Plan10.6(2)#
    
    Form of Stock Option Agreement under 2004 Equity Incentive Plan10.7(2)#
    
    2004 Employee Stock Purchase Plan10.8(2)#
    
    Form of Offering Document under the 2004 Employee Stock Purchase Plan10.9(2)#
    
    2004 Non-Employee Directors Stock Option Plan10.10(2)#
    
    Form of Stock Option Agreement Under 2004 Non-Employee Directors Stock Option Plan10.11(3)
    
    Form of Indemnification Agreement by and between the Registrant and each of its directors and officers10.12(2)#
    
    Severance Agreement dated June 9, 2000 by and between the Registrant and Kleanthis G. Xanthopoulos, Ph.D.10.13(2)#
    
    Severance Agreement dated June 9, 2000 by and between the Registrant and Devron R. Averett, Ph.D.10.21(2)*
    
    Agreement dated December 20,
2002 by and between the Registrant and Valeant Pharmaceuticals International (formerly known as ICN Pharmaceuticals, Inc.)10.22(3)#
    
    Terms of Compensation dated June 9, 2000 by and between the Registrant and Devron R. Averett10.23(3)
    
    Equipment Loan and Security
Agreement dated as of December 20, 2002 by and between the Registrant and GATX Ventures, Inc.10.24(3)
    
    Master Security Agreement dated as
of June 17, 2003 by and between the Registrant and General Electric Capital Corporation10.25(2)#
    
    Severance Agreement dated November 14, 2003 by and between the Registrant and Steve Worland, Ph.D.10.26(2)#
    
    Severance Agreement dated November 14, 2003 by and between the Registrant and Michael Kamdar10.27(3)#
    
    Terms of Employment dated February 1, 2001 by and between the Registrant and Steve Worland, Ph.D.10.28(3)#
    
    Terms of Employment dated March 5, 2001 by and between the Registrant and Michael Kamdar10.29(2)#
    
    Severance Agreement dated November 14, 2003 by and between the Registrant and Elizabeth E. Reed
 59




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##### Table of Contents



ExhibitNumber
    
    Exhibit Description10.30(2)#
    
    Terms of Employment dated October 2, 2001 by and between the Registrant and Elizabeth E. Reed10.31(2)*
    
    Agreement dated December 8, 2003 by and between the Registrant and Daiichi Pharmaceutical Co. Ltd.10.33(2)
    
    Sub-lease agreement dated February 23, 2004 by and between the Registrant and Torrey Mesa Research Institute.10.34(4)*
    
    Joint Development and License Agreement between LG Life Sciences and Anadys Pharmaceuticals, Inc.10.35(5)*
    
    Agreement dated July 28, 2004 by and between Hoffmann-La Roche, Inc. and Anadys Pharmaceuticals, Inc.10.36(5)*
    
    Collaboration Agreement dated September 3, 2004 by and between Aphoenix, Inc. and Anadys Pharmaceuticals, Inc.10.37(6)#
    
    Consulting Agreement dated May 25, 2005 by and between Marios Fotiadis and Anadys Pharmaceuticals, Inc.10.38(6)*
    
    License and Co-Development
Agreement dated June 1, 2005 by and between Novartis International Pharmaceutical Ltd. and Anadys Pharmaceuticals, Inc.10.39(6)#
    
    Separation Agreement dated May 2, 2005 by and between Michael J. Kamdar and Anadys Pharmaceuticals, Inc.10.40#
    
    Terms of Employment dated January 26, 2005 by and between the Registrant and Jennifer K. Crittenden21.1(3)
    
    List of Subsidiaries of the Registrant23.1
    
    Consent of Independent Registered Public Accounting Firm31.1
    
    Section 302 Certification by the Registrants President and Chief Executive Officer31.2
    
    Section 302 Certification by the Registrants Vice President, Finance32
    
    Section 906 Certification by the Registrants Chief Executive Officer and Vice President, Finance
 
 (1)
    
    Incorporated by reference to the Registrants Quarterly Report on Form 10-Q filed on May 14,
2004(2)
    
    Incorporated by reference to the Registrants Registration Statement on Form S-1 (SEC File
No. 333-110528) filed on March 19, 2004(3)
    
    Incorporated by reference to the Registrants Registration Statement on Form S-1 (SEC File
No. 333-110528) filed on November 14, 2003(4)
    
    Incorporated by reference to the Registrants Quarterly Report on Form 10-Q filed on August
16, 2004(5)
    
    Incorporated by reference to the Registrants Quarterly Report on Form 10-Q filed on November
12, 2004(6)
    
    Incorporated by reference to the Registrants Quarterly Report on Form 10-Q filed on August
12, 2005#
    
    Indicates management contract or compensatory plan.*
    
    Confidential treatment has been granted with respect to certain portions of this exhibit.
Omitted portions have been filed separately with the Securities and Exchange Commission. 60




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##### Table of Contents



SIGNATURES
  ANADYS PHARMACEUTICALS, INC.By:
    
    /s/ KLEANTHIS G. XANTHOPOULOS, PH.D.Kleanthis G. Xanthopoulos, Ph.D.Chief Executive Officer and President
  Signature
    
    Title
    
    Date/s/ KLEANTHIS XANTHOPOULOS, PH.D.
    
    President and Director
    
    March 15, 2006Kleanthis G. Xanthopoulos, Ph.D.
    
    (Principal Executive Officer)Vice President, Finance(Principal
    
    March 15, 2006/s/ JENNIFER K. CRITTENDEN
    
    Financial Officer and PrincipalJennifer K. Crittenden
    
    Accounting Officer)/s/ GEORGE A. SCANGOS, PH.D.
    
    Chairman of the Board
    
    March 15, 2006George A. Scangos, Ph.D./s/ MARK G. FOLETTA
    
    Director
    
    March 15, 2006Mark G. Foletta/s/ MARIOS FOTIADIS
    
    Director
    
    March 15, 2006Marios Fotiadis/s/ ARGERIS N. KARABELAS, PH.D.
    
    Director
    
    March 15, 2006Argeris N. Karabelas, Ph.D./s/ STEVEN H. HOLTZMAN
    
    Director
    
    March 15, 2006Steven H. Holtzman/s/ STELIOS PAPADOPOULOS, PH.D.
    
    Director
    
    March 15, 2006Stelios Papadopoulos, Ph.D./s/ DOUGLAS E. WILLIAMS, PH.D.
    
    Director
    
    March 15, 2006Douglas E. Williams, Ph.D.
 61




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##### Table of Contents



ANADYS PHARMACEUTICALS, INC.
 INDEX TO FINANCIAL STATEMENTS
 PageReport of Independent Registered Public Accounting Firm
    
    F-2Consolidated Balance Sheets as of December 31, 2005 and 2004
    
    F-3Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and 2003
    
    F-4Consolidated Statements of Stockholders Equity (Deficit) for the years ended December
31, 2005, 2004 and 2003
    
    F-5Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003
    
    F-7Notes to Consolidated Financial Statements
    
    F-8
 F - 1




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##### Table of Contents



Report of Independent Registered Public Accounting Firm
       
 F - 2




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##### Table of Contents



ANADYS PHARMACEUTICALS, INC.
 
 CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
 December 31,
    
    
    December 31,2005
    
    
    2004AssetsCurrent assets:Cash and cash equivalents
    
    $
    93,659
    
    
    $
    5,988Securities available-for-sale
    
    
    11,192
    
    
    
    27,686Accounts receivable
    
    
    6,025
    
    
    
    186Prepaid expenses and other current assets
    
    
    651
    
    
    
    1,138Total current assets
    
    
    111,527
    
    
    
    34,998Property and equipment, net
    
    
    3,809
    
    
    
    4,030Other assets, net
    
    
    1,640
    
    
    
    1,921Total assets
    
    $
    116,976
    
    
    $
    40,949Liabilities and Stockholders EquityCurrent liabilities:Accounts payable
    
    $
    1,016
    
    
    $
    1,120Accrued expenses
    
    
    3,863
    
    
    
    3,607Current portion of long-term debt
    
    
    854
    
    
    
    1,310Current portion of deferred rent
    
    
    433
    
    
    
    360Deferred revenue
    
    
    6,679
    
    
    
    600Total current liabilities
    
    
    12,845
    
    
    
    6,997Long-term debt, net of current portion
    
    
    682
    
    
    
    1,193Long-term portion of deferred rent
    
    
    1,370
    
    
    
    1,474Long-term portion of deferred revenue
    
    
    23,143
    
    
    
    Commitments and contingenciesStockholders equity:Preferred stock, $0.001 par value;
10,000,000 shares authorized at December
31, 2005 and December 31, 2004,
respectively; no shares issued and
outstanding at December 31, 2005 and
December 31, 2004.
    
    
    
    
    
    
    Common stock, $0.001 par value;
90,000,000 shares authorized at December
31, 2005 and December 31, 2004;
28,374,136 and 22,334,521 shares issued
and outstanding at December 31, 2005 and
December 31, 2004, respectively
    
    
    28
    
    
    
    22Additional paid-in capital
    
    
    267,499
    
    
    
    199,990Deferred compensation
    
    
    (839
    )
    
    
    (2,862
    )Accumulated other comprehensive loss
    
    
    (32
    )
    
    
    (68
    )Accumulated deficit
    
    
    (187,720
    )
    
    
    (165,797
    )Total stockholders equity
    
    
    78,936
    
    
    
    31,285Total liabilities and stockholders equity
    
    $
    116,976
    
    
    $
    40,949
 
 See accompanying notes to consolidated financial statements. F - 3




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##### Table of Contents



ANADYS PHARMACEUTICALS, INC.
 
 CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
 For the Years Ended December 31,2005
    
    
    2004
    
    
    2003Revenues:Collaborative agreements
    
    $
    4,408
    
    
    $
    1,672
    
    
    $
    2,155Grants
    
    
    479
    
    
    
    90
    
    
    
    131Total revenues
    
    
    4,887
    
    
    
    1,762
    
    
    
    2,286Operating Expenses:Research and development
    
    
    19,977
    
    
    
    24,173
    
    
    
    16,554General and administrative
    
    
    6,638
    
    
    
    5,666
    
    
    
    4,716Stock-based compensation:Research and development
    
    
    924
    
    
    
    2,538
    
    
    
    2,265General and administrative
    
    
    1,067
    
    
    
    2,594
    
    
    
    2,440Total operating expenses
    
    
    28,606
    
    
    
    34,971
    
    
    
    25,975Loss from operations
    
    
    (23,719
    )
    
    
    (33,209
    )
    
    
    (23,689
    )Other income (expense):Interest income
    
    
    2,103
    
    
    
    525
    
    
    
    229Interest expense
    
    
    (189
    )
    
    
    (228
    )
    
    
    (266
    )Other, net
    
    
    (118
    )
    
    
    (67
    )
    
    
    (272
    )Total other income (expense)
    
    
    1,796
    
    
    
    230
    
    
    
    (309
    )Net loss
    
    
    (21,923
    )
    
    
    (32,979
    )
    
    
    (23,998
    )Accretion to redemption value of redeemable convertible preferred stock
    
    
    
    
    
    
    (175
    )
    
    
    (674
    )Deemed dividend-beneficial conversion feature for Series C preferred stock
    
    
    
    
    
    
    
    
    
    
    (6,942
    )Net loss applicable to common stockholders
    
    $
    (21,923
    )
    
    $
    (33,154
    )
    
    $
    (31,641
    )Net loss per share, basic and diluted (1)
    
    $
    (0.89
    )
    
    $
    (1.92
    )
    
    $
    (21.58
    )Shares used in calculating net loss per share, basic and diluted (1)
    
    
    24,756
    
    
    
    17,233
    
    
    
    1,465
 
 (1)
    
    As a result of the conversion of the Companys preferred stock into 13,330 shares of our
common stock upon completion of our initial public offering on March 31, 2004, there is a lack
of comparability in the basic and diluted net loss per share amounts for the periods prior to
the completion of the Companys initial public offering. Please reference Note 1 for the pro
forma basic and diluted net loss per share calculation for the periods presented.  F - 4




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##### Table of Contents



ANADYS PHARMACEUTICALS, INC.
 
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)
(In thousands, except share data)
 Accumulatedother
    
    
    
    
    
    
    TotalConvertible
    
    
    
    
    
    
    
    
    
    
    Additional
    
    
    
    
    
    
    comprehensive
    
    
    
    
    
    
    stockholderspreferred stock
    
    
    Common stock
    
    
    paid-in
    
    
    Deferred
    
    
    income
    
    
    Accumulated
    
    
    equityShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    capital
    
    
    compensation
    
    
    (loss)
    
    
    deficit
    
    
    (deficit)Balance at December 31, 2002
    
    
    33,513,599
    
    
    $
    80,779
    
    
    
    1,772,729
    
    
    $
    2
    
    
    $
    10,480
    
    
    $
    (356
    )
    
    $
    126
    
    
    $
    (101,029
    )
    
    $
    (9,998
    )Issuance of common stock pursuant to exercise of stock
options
    
    
    
    
    
    
    
    
    
    
    8,984
    
    
    
    
    
    
    
    27
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    27Compensation related to stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    366
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    366Compensation related to restricted stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    814
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    814Issuance of restricted stock for cash
    
    
    
    
    
    
    
    
    
    
    26,993
    
    
    
    
    
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2Issuance of restricted stock for consulting services
    
    
    
    
    
    
    
    
    
    
    82,008
    
    
    
    
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4Issuance of restricted stock for acquired technology
    
    
    
    
    
    
    
    
    
    
    14,994
    
    
    
    
    
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1Accretion to redemption value of redeemable convertible
preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (674
    )
    
    
    (674
    )Deemed dividend- beneficial conversion feature for Series C
preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,942
    
    
    
    
    
    
    
    
    
    
    
    (6,942
    )
    
    
    Deferred compensation related to issuance of stock options
to employees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,096
    
    
    
    (5,096
    )
    
    
    
    
    
    
    
    
    
    
    Deferred compensation related to issuance of restricted stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    279
    
    
    
    (279
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of deferred compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,525
    
    
    
    
    
    
    
    
    
    
    
    3,525Comprehensive loss: Unrealized loss on short-term investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5
    )
    
    
    
    
    
    
    (5
    )Substantial dissolution of foreign operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (123
    )
    
    
    
    
    
    
    (123
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (23,998
    )
    
    
    (23,998
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (24,126
    )Balance at December 31, 2003
    
    
    33,513,599
    
    
    
    80,779
    
    
    
    1,905,708
    
    
    
    2
    
    
    
    24,011
    
    
    
    (2,206
    )
    
    
    (2
    )
    
    
    (132,643
    )
    
    
    (30,059
    )Conversion of convertible preferred stock into common stock
    
    
    (33,513,599
    )
    
    
    (80,779
    )
    
    
    6,519,467
    
    
    
    6
    
    
    
    80,773
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Conversion of redeemable preferred stock into common stock
    
    
    
    
    
    
    
    
    
    
    6,761,679
    
    
    
    7
    
    
    
    45,005
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    45,012Issuance of common stock in initial public offering, net
of underwriters cost and issuance costs
    
    
    
    
    
    
    
    
    
    
    6,993,950
    
    
    
    7
    
    
    
    43,649
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    43,656Issuance of common stock pursuant to the exercise of
employee stock options
    
    
    
    
    
    
    
    
    
    
    145,156
    
    
    
    
    
    
    
    430
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    430Issuance of common stock pursuant to the Companys
Employee Stock Purchase Plan
    
    
    
    
    
    
    
    
    
    
    22,069
    
    
    
    
    
    
    
    130
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    130Compensation related to stock options and warrants issued
to non-employees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    75
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    75Compensation related to restricted stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    172
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    172Repurchase and retirement of unvested restricted stock
    
    
    
    
    
    
    
    
    
    
    (13,508
    )
    
    
    
    
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1
    )Accretion of issuance costs on redeemable convertible
preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    175
    
    
    
    
    
    
    
    
    
    
    
    (175
    )
    
    
    Deferred compensation related to the issuance of stock
options to employees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,968
    
    
    
    (5,968
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of deferred compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,915
    
    
    
    
    
    
    
    
    
    
    
    4,915Reversal of deferred compensation associated with
cancelled stock options to employees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (397
    )
    
    
    397
    
    
    
    
    
    
    
    
    
    
    
    Comprehensive loss:Unrealized loss on short-term investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (66
    )
    
    
    
    
    
    
    (66
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (32,979
    )
    
    
    (32,979
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (33,045
    )
 F - 5




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##### Table of Contents



ANADYS PHARMACEUTICALS, INC.
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT) (Continued)
(In thousands, except share data)
 Accumulatedother
    
    
    
    
    
    
    TotalConvertible
    
    
    
    
    
    
    
    
    
    
    Additional
    
    
    
    
    
    
    comprehensive
    
    
    
    
    
    
    stockholderspreferred stock
    
    
    Common stock
    
    
    paid-in
    
    
    Deferred
    
    
    income
    
    
    Accumulated
    
    
    equityShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    capital
    
    
    compensation
    
    
    (loss)
    
    
    deficit
    
    
    (deficit)Balance at December 31, 2004
    
    
    
    
    
    $
    
    
    
    
    22,334,521
    
    
    $
    22
    
    
    $
    199,990
    
    
    $
    (2,862
    )
    
    $
    (68
    )
    
    $
    (165,797
    )
    
    $
    31,285Issuance of common stock from a follow-on public common
stock offering, net of underwriters discount and
offering expenses
    
    
    
    
    
    
    
    
    
    
    5,750,000
    
    
    
    5
    
    
    
    66,432
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    66,437Issuance of common stock pursuant to the exercise of
stock options
    
    
    
    
    
    
    
    
    
    
    222,593
    
    
    
    1
    
    
    
    702
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    703Issuance of common stock pursuant to the Companys
Employee Stock Purchase Plan
    
    
    
    
    
    
    
    
    
    
    67,022
    
    
    
    
    
    
    
    354
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    354Compensation related to stock options and warrants issued
to non-employees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    333
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    333Amortization of deferred compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,711
    
    
    
    
    
    
    
    
    
    
    
    1,711Reversal of deferred compensation associated with
cancelled stock options to employees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (312
    )
    
    
    312
    
    
    
    
    
    
    
    
    
    
    
    Comprehensive loss:
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    


    

    
    Unrealized gain on short-term investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    36
    
    
    
    
    
    
    
    36Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    

    
    
    
    (21,923
    )
    
    
    (21,923
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (21,887
    )Balance at December 31, 2005
    
    
    
    
    
    $
    
    
    
    
    28,374,136
    
    
    $
    28
    
    
    $
    267,499
    
    
    $
    (839
    )
    
    $
    (32
    )
    
    $
    (187,720
    )
    
    $
    78,936
  F - 6




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##### Table of Contents



ANADYS PHARMACEUTICALS, INC.
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 For the years ended December 31,2005
    
    
    2004
    
    
    2003Operating Activities:Net loss
    
    $
    (21,923
    )
    
    $
    (32,979
    )
    
    $
    (23,998
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    1,468
    
    
    
    1,465
    
    
    
    1,756Amortization of deferred compensation
    
    
    1,711
    
    
    
    4,915
    
    
    
    3,525Compensation related to restricted stock
    
    
    
    
    
    
    172
    
    
    
    814Compensation related to stock option issuances to non-employees
    
    
    280
    
    
    
    45
    
    
    
    366Interest expense related to warrants issued in connection with debt
    
    
    49
    
    
    
    48
    
    
    
    42Rent expense related to warrants issued in connection with lease
    
    
    53
    
    
    
    30
    
    
    
    Substantial dissolution of foreign operations
    
    
    
    
    
    
    
    
    
    
    (135
    )Loss from disposal of property and equipment and related deposits
    
    
    89
    
    
    
    28
    
    
    
    235Accrued interest income on amounts due from related party, net of amount
forgiven
    
    
    
    
    
    
    
    
    
    
    169Cash received from lease incentives
    
    
    
    
    
    
    1,550
    
    
    
    Changes in operating assets and liabilities:Accounts receivable
    
    
    (5,839
    )
    
    
    339
    
    
    
    (183
    )Prepaid expenses and other current assets
    
    
    487
    
    
    
    30
    
    
    
    (630
    )Other assets, net
    
    
    281
    
    
    
    (999
    )
    
    
    (131
    )Accounts payable
    
    
    (104
    )
    
    
    355
    
    
    
    (467
    )Accrued expenses
    
    
    256
    
    
    
    1,943
    
    
    
    (60
    )Deferred rent
    
    
    (31
    )
    
    
    284
    
    
    
    (36
    )Deferred revenue
    
    
    29,222
    
    
    
    200
    
    
    
    400Net cash provided by (used in) operating activities
    
    
    5,999
    
    
    
    (22,574
    )
    
    
    (18,333
    )Investing ActivitiesPurchase of securities available-for-sale
    
    
    (11,886
    )
    
    
    (42,619
    )
    
    
    (7,820
    )Proceeds from sale and maturity of securities available-for-sale
    
    
    28,416
    
    
    
    17,398
    
    
    
    23,960Purchase of property and equipment
    
    
    (1,338
    )
    
    
    (880
    )
    
    
    (674
    )Proceeds from the sale of property and equipment
    
    
    2
    
    
    
    35
    
    
    
    25Acquisition of leasehold improvements from lease incentives
    
    
    
    
    
    
    (1,550
    )
    
    
    Net cash provided by (used in) investing activities
    
    
    15,194
    
    
    
    (27,616
    )
    
    
    15,491Financing ActivitiesProceeds from exercise of stock options and employee stock purchase plan
    
    
    1,057
    
    
    
    560
    
    
    
    27Proceeds from the sale of common stock, net of issuance costs
    
    
    66,437
    
    
    
    43,656
    
    
    
    7Proceeds from sale of preferred stock, net of issuance costs
    
    
    
    
    
    
    
    
    
    
    8,078Proceeds from issuance of long-term debt
    
    
    393
    
    
    
    1,198
    
    
    
    1,585Principal payments on long-term debt
    
    
    (1,409
    )
    
    
    (1,204
    )
    
    
    (1,753
    )Net cash provided by financing activities
    
    
    66,478
    
    
    
    44,210
    
    
    
    7,944Net increase (decrease) in cash and cash equivalents
    
    
    87,671
    
    
    
    (5,980
    )
    
    
    5,102Cash and cash equivalents at beginning of period
    
    
    5,988
    
    
    
    11,968
    
    
    
    6,866Cash and cash equivalents at end of period
    
    $
    93,659
    
    
    $
    5,988
    
    
    $
    11,968Supplemental Disclosure of Cash Flow Information:Cash paid during the year for interest
    
    $
    189
    
    
    $
    228
    
    
    $
    266Supplemental Disclosure of Non-Cash Investing and Financing Activities:Accretion of costs on redeemable convertible preferred stock
    
    $
    
    
    
    $
    175
    
    
    $
    674Forgiveness of note due from related party
    
    $
    
    
    
    $
    
    
    
    $
    169Deemed dividend-beneficial conversion feature for Series C preferred stock
    
    $
    
    
    
    $
    
    
    
    $
    6,942Conversion of redeemed convertible preferred stock to common stock
    
    $
    
    
    
    $
    45,012
    
    
    $
    Conversion of convertible preferred stock to common stock
    
    $
    
    
    
    $
    80,779
    
    
    $
    Unrealized gain (loss) on securities available-for-sale
    
    $
    36
    
    
    $
    (66
    )
    
    $
    (5
    )
  F - 7




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##### Table of Contents



ANADYS PHARMACEUTICALS, INC.
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 1. Organization and Summary of Significant Accounting Policies
 Organization and Business
  Principles of Consolidation
   Use of Estimates
  Cash and Cash Equivalents
  Securities Available-for-Sale
  F - 8




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##### Table of Contents



Fair Value of Financial Instruments
  Concentration of Credit Risk
   Property and Equipment
  Impairment of Long-Lived Assets
 Accounting for the Impairment or Disposal of Long-Lived
Assets
 Research and Development
   F - 9




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##### Table of Contents



Accumulated Other Comprehensive Income (Loss)
 Reporting Comprehensive Income
 Deferred Rent
  Stock-Based Compensation
 Accounting for Stock-Based Compensation Accounting for Stock Issued to Employees Accounting for
Stock Appreciation Rights and Other Variable Stock Option or Award Plans
 Accounting for Equity Instruments That
Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling Goods or Services
  F - 10




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##### Table of Contents



For the years ended December 31,2005
    
    
    2004
    
    
    2003Net loss applicable to common shareholders, as reported
    
    $
    (21,923
    )
    
    $
    (33,154
    )
    
    $
    (31,614
    )Add: Stock-based employee compensation included in reported net loss
    
    
    1,711
    
    
    
    4,903
    
    
    
    3,165Deduct: Total stock-based employee compensation determined under
fair value based method for all awards
    
    
    (4,205
    )
    
    
    (3,620
    )
    
    
    (3,065
    )Adjusted pro forma net loss
    
    $
    (24,417
    )
    
    $
    (31,871
    )
    
    $
    (31,514
    )Adjusted pro forma basic and diluted net loss per share
    
    $
    (0.99
    )
    
    $
    (1.85
    )
    
    $
    (21.51
    )
  For the years ended December 31,2005
    
    2004
    
    2003Risk-free interest rate
    
    
    4.27
    %
    
    
    3.25
    %
    
    
    3.04
    %Dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Volatility factors of the expected market price
of the Companys common stock
    
    
    67
    %
    
    
    70
    %
    
    
    70
    %Weighted-average expected life of option (years)
    
    
    6
    
    
    
    5
    
    
    
    5
  Net Loss Per Share
 Earnings Per Share
  F - 11




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##### Table of Contents



For the years ended December 31,2005
    
    
    2004
    
    
    2003(in thousands)Historical:Numerator:Net loss
    
    $
    (21,923
    )
    
    $
    (32,979
    )
    
    $
    (23,998
    )Accretion to redemption value of redeemable convertible preferred
stock
    
    
    
    
    
    
    (175
    )
    
    
    (674
    )Deemed dividend-beneficial conversion feature for Series C preferred
stock
    
    
    
    
    
    
    
    
    
    
    (6,942
    )Net loss applicable to common stockholders
    
    $
    (21,923
    )
    
    $
    (33,154
    )
    
    $
    (31,614
    )Denominator:Weighted average common shares
    
    
    24,756
    
    
    
    17,287
    
    
    
    1,847Weighted average unvested common shares subject to repurchase
    
    
    
    
    
    
    (54
    )
    
    
    (382
    )Denominator for basic and diluted earnings per share
    
    
    24,756
    
    
    
    17,233
    
    
    
    1,465Basic and diluted net loss per share
    
    $
    (0.89
    )
    
    $
    (1.92
    )
    
    $
    (21.58
    )Pro forma:Net loss
    
    
    
    
    
    $
    (32,979
    )
    
    $
    (23,998
    )Deemed dividend resulting from beneficial conversion feature on
Series C preferred stock
    
    
    
    
    
    
    
    
    
    
    (6,942
    )Pro forma net loss applicable to common shareholders
    
    
    
    
    
    $
    (32,979
    )
    
    $
    (30,940
    )Pro forma basic and diluted net loss per share
    
    
    
    
    
    $
    (1.61
    )
    
    $
    (2.26
    )Denominator
Shares used above
    
    
    
    
    
    
    17,233
    
    
    
    1,465Pro forma adjustments to reflect assumed weighted average affect of
conversion of preferred stock
    
    
    
    
    
    
    3,238
    
    
    
    12,249Pro forma shares used to compute basic and diluted net loss per share
    
    
    
    
    
    
    20,471
    
    
    
    13,714
 For the years ended December 31,2005
    
    2004
    
    2003(in thousands)Historical outstanding
antidilutive securities not
included in diluted net loss per
share calculationPreferred stock
    
    
    
    
    
    
    
    
    
    
    13,281Common stock subject to repurchase
    
    
    
    
    
    
    
    
    
    
    194Options to purchase common stock
    
    
    3,089
    
    
    
    2,365
    
    
    
    1,157Warrants
    
    
    376
    
    
    
    376
    
    
    
    3463,465
    
    
    
    2,741
    
    
    
    14,978
 Revenue Recognition
 Revenue Recognition, Revenue Arrangements with Multiple Deliverables.
 
    
    Revenue from milestones is recognized when earned, as evidenced by written acknowledgment
from the collaborator or other persuasive evidence that the milestone has been achieved,
provided that (i) the milestone event is substantive and its achievability was not reasonably
assured at the inception of the agreement, (ii) the Companys performance obligations after
 F - 12




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##### Table of Contents



the milestone achievement will continue to be funded by the collaborator at the comparable
level and (iii) the milestone is not refundable or creditable. If all of these criteria are
not met, the milestone payment is recognized over the remaining minimum period of the
Companys performance obligations under the agreement. Upfront fees under collaborations, such
as technology access fees, are recognized over the period the related services are provided.
Non-refundable upfront fees not associated with the Companys future performance are
recognized when received.
 
    
    Fees the Company receives for research services are generally recognized as the services
are provided, as long as the amounts received are not refundable regardless of the results of
the research project. Research services may include agreements through which the Company will
deploy its internal capabilities to assist a collaborator to advance their target, such as
the Companys medicinal chemistry and screening capabilities.
 Recent Accounting Pronouncements
 Share Based Payment Statement of Cash Flows
   2. Investments
  December 31, 2005UnrealizedAmortized Cost
    
    
    Gain
    
    
    Loss
    
    
    Market ValueU.S. Government agency securities
    
    $
    8,470
    
    
    $
    
    
    
    $
    (28
    )
    
    $
    8,442Corporate debt securities
    
    
    2,754
    
    
    
    
    
    
    
    (4
    )
    
    
    2,750$
    11,224
    
    
    $
    
    
    
    $
    (32
    )
    
    $
    11,192
 December 31, 2004UnrealizedAmortized Cost
    
    
    Gain
    
    
    Loss
    
    
    Market ValueCorporate debt securities
    
    $
    27,754
    
    
    $
    6
    
    
    $
    (74
    )
    
    $
    27,686
  F - 13




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##### Table of Contents



3. Property and Equipment
  For the years ended December 31,2005
    
    
    2004Furniture and fixtures
    
    $
    119
    
    
    $
    105Equipment
    
    
    8,057
    
    
    
    7,521Computers and software
    
    
    1,922
    
    
    
    1,728Leasehold improvements
    
    
    1,818
    
    
    
    1,91711,916
    
    
    
    11,271Less accumulated depreciation and amortization
    
    
    (8,107
    )
    
    
    (7,241
    )$
    3,809
    
    
    $
    4,030
   4. Other Balance Sheet Captions
 As of December 31,2005
    
    
    2004(in thousands)Prepaid expenses and other current assets consisted of the following:Prepaid expenses
    
    $
    319
    
    
    $
    244Prepaid rent
    
    
    
    
    
    
    70Prepaid insurance
    
    
    199
    
    
    
    216Other receivables
    
    
    132
    
    
    
    551Deposits
    
    
    1
    
    
    
    57$
    651
    
    
    $
    1,138Other assets consisted of the following:Lab compounds, net
    
    $
    380
    
    
    $
    641Deposits
    
    
    1,260
    
    
    
    1,280$
    1,640
    
    
    $
    1,921Accrued expenses consisted of the following:Accrued employee benefits
    
    $
    408
    
    
    $
    361Accrued employee bonus
    
    
    822
    
    
    
    669Accrued drug development
    
    
    1,886
    
    
    
    1,702Accrued legal and patent costs
    
    
    301
    
    
    
    221Accrued audit and tax costs
    
    
    70
    
    
    
    124Accrued annual report costs
    
    
    58
    
    
    
    100Accrued facility costs
    
    
    105
    
    
    
    95Other accrued expenses
    
    
    213
    
    
    
    335$
    3,863
    
    
    $
    3,607
 5. Debt
  F - 14




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##### Table of Contents



6. Commitments and Contingencies
   2006
    
    $
    1,7832007
    
    
    1,8352008
    
    
    1,8882009
    
    
    1,119Total
    
    $
    6,625
 7. Collaboration and License Agreements
  Hoffman-La Roche, Inc.
  F - 15




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##### Table of Contents



Aphoenix, Inc.
  Novartis International Pharmaceutical Ltd.
      F - 16




---



##### Table of Contents



LG Life Sciences, Ltd.
    Valeant Pharmaceuticals International
  Grants
  8. Redeemable Convertible Preferred Stock and Stockholders Equity
 Redeemable Convertible Preferred Stock
 Accounting for Convertible
Securities with Beneficial Conversion Features
  F - 17




---



##### Table of Contents



Convertible Preferred Stock
  Common Stock
  Warrants
    Stock Options
    F - 18




---



##### Table of Contents



Options Outstanding
    
    
    Options ExercisableWeighted
    
    
    Weighted
    
    
    
    
    
    
    WeightedRange of
    
    
    
    
    
    Average
    
    
    Average
    
    
    
    
    
    
    AverageExercise
    
    Number
    
    
    Remaining
    
    
    Exercise
    
    
    Number
    
    
    ExercisePrice
    
    Outstanding
    
    
    Contractual Life
    
    
    Price
    
    
    Exercisable
    
    
    Price$2.95-$4.99
    
    
    1,165,769
    
    
    
    7.2
    
    
    $
    2.95
    
    
    
    727,123
    
    
    $
    2.95$5.00-$7.00
    
    
    774,827
    
    
    
    8.4
    
    
    $
    6.08
    
    
    
    294,005
    
    
    $
    6.18$7.01-$8.15
    
    
    789,025
    
    
    
    9.9
    
    
    $
    8.11
    
    
    
    9,459
    
    
    $
    7.61$8.16-$13.65
    
    
    359,650
    
    
    
    9.6
    
    
    $
    11.59
    
    
    
    9,584
    
    
    $
    9.503,089,271
    
    
    
    
    
    
    
    
    
    
    
    1,040,171
  WeightedOptions
    
    
    AverageOutstanding
    
    
    Exercise PriceBalance at December 31, 2002
    
    
    707,223
    
    
    $
    3.50Granted
    
    
    581,527
    
    
    
    2.95Exercised
    
    
    (8,984
    )
    
    
    2.95Cancelled
    
    
    (122,319
    )
    
    
    3.00Balance at December 31, 2003
    
    
    1,157,447
    
    
    
    3.28Granted
    
    
    1,451,947
    
    
    
    4.66Exercised
    
    
    (145,156
    )
    
    
    2.95Cancelled
    
    
    (99,084
    )
    
    
    3.20Balance at December 31, 2004
    
    
    2,365,154
    
    
    
    4.12Granted
    
    
    1,178,351
    
    
    
    9.13Exercised
    
    
    (222,593
    )
    
    
    3.16Cancelled
    
    
    (231,641
    )
    
    
    4.65Balance at December 31, 2005
    
    
    3,089,271
    
    
    $
    6.06
 F - 19




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##### Table of Contents



December 31, 2005Warrants
    
    
    375,697Stock options under the Companys Plans:Granted and outstanding
    
    
    3,089,271Reserved for future grant
    
    
    575,4924,040,460
 Employee Stock Purchase Plan
  9. Related Party Transactions
  10. Income Taxes
 Accounting for Income Taxes
 For the years ended December 31,2005
    
    
    2004(in thousands)Deferred tax assets:Net operating loss carryforwards
    
    $
    35,163
    
    
    $
    26,620Research and development credits
    
    
    6,614
    
    
    
    5,946Depreciation and amortization
    
    
    1,559
    
    
    
    Non-qualified stock options
    
    
    1,368
    
    
    
    1,326Capitalized research and development expense
    
    
    19,322
    
    
    
    24,059Accruals
    
    
    435
    
    
    
    1,643Deferred Revenue
    
    
    4,016
    
    
    
    245Other
    
    
    3
    
    
    
    Total deferred tax assets
    
    
    68,480
    
    
    
    59,839Deferred tax liabilities:Capital lease obligation, net
    
    
    
    
    
    
    (443
    )Total deferred tax liabilities
    
    
    
    
    
    
    (443
    )Net deferred tax assets
    
    
    68,480
    
    
    
    59,396Valuation allowance for deferred tax assets
    
    
    (68,480
    )
    
    
    (59,396
    )Net deferred taxes
    
    $
    
    
    
    $
    
 F - 20




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##### Table of Contents



11. Savings Plan
  12. Unaudited Quarterly Results of Operations
  First
    
    
    Second
    
    
    Third
    
    
    FourthFiscal year 2005
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter(in thousands, expect per share data)Revenues
    
    $
    563
    
    
    $
    581
    
    
    $
    1,737
    
    
    $
    2,006Net loss
    
    
    (8,383
    )
    
    
    (7,058
    )
    
    
    (3,414
    )
    
    
    (3,068
    )Net loss attributable to common shareholders
    
    
    (8,383
    )
    
    
    (7,058
    )
    
    
    (3,414
    )
    
    
    (3,068
    )Basic and diluted net loss per share
    
    
    (0.38
    )
    
    
    (0.31
    )
    
    
    (0.13
    )
    
    
    (0.11
    )
 First
    
    
    Second
    
    
    Third
    
    
    FourthFiscal year 2004
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter(in thousands, except per share data)Revenues
    
    $
    683
    
    
    $
    214
    
    
    $
    356
    
    
    $
    509Net loss
    
    
    (7,442
    )
    
    
    (10,948
    )
    
    
    (7,041
    )
    
    
    (7,548
    )Net loss attributable to common shareholders
    
    
    (7,617
    )
    
    
    (10,948
    )
    
    
    (7,041
    )
    
    
    (7,548
    )Basic and diluted net loss per share
    
    
    (3.77
    )
    
    
    (0.50
    )
    
    
    (0.32
    )
    
    
    (0.34
    )
 F - 21