**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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FORM 10-K

**(MARK ONE)**

**x**        Annual Report Pursuant to Section 13 or15(d) of the Securities Exchange Act of 1934

**Forthe Fiscal Year Ended December 31, 2004**

**Or**

**o**         Transition Report Pursuant to Section 13 or15(d) of the Securities Exchange Act of 1934

**Forthe Transition Period From              To             **

**COMMISSIONFILE NUMBER 33-90516**

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NEOPHARM, INC.

(Exact Name of Registrantas Specified in its Charter)

| **DELAWARE**                                                     | **51-0327886**                           |
|------------------------------------------------------------------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification Number) |

 

**150FIELD DRIVESUITE 195LAKE FOREST, ILLINOIS  60045**

(Address of PrincipalExecutive Offices)  (Zip Code)

**(847) 295-8678**

(Registrant’s TelephoneNumber, Including Area Code)

**SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OFTHE ACT:** NONE

**SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OFTHE ACT:**

**COMMON STOCK, $.0002145PAR VALUE**

(Title of class)

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Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicate by check markwhether Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)Yes x  No o

The aggregate market valueof the Registrant’s common stock held by non-affiliates (affiliates being, forthese purposes only, directors, executive officers and holders of 5% of theregistrant’s stock) of the registrant, par value $.0002145 per share, (based onthe closing price of such shares on the NASDAQ on June 30, 2004) was$110,569,851. As of March 1, 2005 there were 23,525,163 shares of CommonStock outstanding.

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Documents Incorporated byReference

Certaininformation required in Part III of the Registrant’s Annual Report on Form 10-Kfor December 31, 2004 is incorporated by reference to portions of theRegistrant’s definitive proxy statement for its 2005 Annual Meeting ofStockholders, which will be filed with the Securities and Exchange Commissionnot later than 120 days after the end of the fiscal year ended December 31,2004.

 

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**FORM 10-K TABLE OF CONTENTS**
|               | ** ** | ** **                                                                                                               | ** ** | **Page** |
|---------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I   |       |                                                                                                                     |       |     |   |   |
| Item 1.       |       | Business                                                                                                                 |       |     | 1 |   |
| Item 2.       |       | Properties                                                                                                               |       |     | 31 |   |
| Item 3.       |       | Legal  Proceedings                                                                                                       |       |     | 31 |   |
| Item 4.       |       | Submission  of Matters to a Vote of Security Holders                                                                     |       |     | 32 |   |
| PART II  |       |                                                                                                                     |       |     |   |   |
| Item 5.       |       | Market  for the Registrant’s Common Equity, Related Stockholder Matters, and Issuer  Purchases of Equity Securities |       |     | 34 |   |
| Item 6.       |       | Selected  Financial Data                                                                                                 |       |     | 35 |   |
| Item 7.       |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operation                               |       |     | 36 |   |
| Item 7A.      |       | Quantitative  and Qualitative Disclosures About Market Risk                                                              |       |     | 43 |   |
| Item 8.       |       | Financial  Statements and Supplementary Data                                                                        |       |     | 43 |   |
| Item 9.       |       | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                               |       |     | 43 |   |
| Item 9A.      |       | Controls  and Procedures                                                                                                 |       |     | 43 |   |
| Item 9B.      |       | Other Information                                                                                                        |       |     | 44 |   |
| PART III |       |                                                                                                                     |       |     |   |   |
| Item 10.      |       | Directors  and Executive Officers of the Registrant                                                                      |       |     | 44 |   |
| Item 11.      |       | Executive  Compensation                                                                                                  |       |     | 44 |   |
| Item 12.      |       | Security  Ownership of Certain Beneficial Owners and Management                                                          |       |     | 44 |   |
| Item 13.      |       | Certain  Relationships and Related Transactions                                                                          |       |     | 44 |   |
| Item 14.      |       | Principal  Accounting Fees and Services                                                                                  |       |     | 45 |   |
| PART IV  |       |                                                                                                                     |       |     |   |   |
| Item 15.      |       | Exhibits,  Financial Statement Schedules                                                                                 |       |     | 45 |   |
|          |       | Signatures                                                                                                               |       |     | 50 |   |

 

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**PART I**

**ITEM 1**.                BUSINESS

**FORWARD LOOKINGSTATEMENTS**

This annual reporton Form 10-K includes forward looking statements within the meaning of ThePrivate Securities Litigation Reform Act of 1995. We have based these forwardlooking statements largely on our current expectations and projections aboutfuture events and financial trends affecting the financial condition of ourbusiness. These forward looking statements are subject to a number of risks,uncertainties and assumptions about us, including, among other things:

·       failureto achieve positive results in clinical trials;

·       competitivefactors;

·       generaleconomic conditions;

·       theability to attract and retain qualified management;

·       availablefinancial resources and inability to secure adequate funding for developmentprojects;

·       relationshipswith pharmaceutical and biotechnology companies;

·       theability to develop safe and efficacious drugs;

·       variabilityof royalty, license and other revenue;

·       uncertaintyregarding the outcome of current legal proceedings;

·       failureto satisfy performance obligations in our licenses or other contracts;

·       abilityto enter into future collaborative agreements;

·       uncertaintyregarding our patents and patent rights (including the risk that we may beforced to engage in costly litigation to protect such patent rights and thematerial harm to us if there were an unfavorable outcome of any suchlitigation);

·       governmentalregulation;

·       technologicalchange;

·       changesin industry practices; and

·       one-timeevents.

In addition, in this annual report, the words “believe,”“may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect” andsimilar expressions, as they relate to us, our business, or our management, areintended to identify forward looking statements. All of our forward lookingstatements are qualified in their entirety by reference to the factorsdiscussed in this document under the heading ITEM 1.—“BUSINESS—RISK FACTORS,”and any documents incorporated by reference that describe risks and factorsthat could cause results to differ materially from those projected in theseforward looking statements.

We caution you that therisk factors contained herein are not exhaustive. We operate in a continuallychanging business climate and we do not intend to publicly update or revise anyforward looking statements, whether as a result of new information, futureevents, or otherwise, after the date of this annual report. In light of theserisks and uncertainties, the forward looking events and circumstances discussedin this annual report may not occur and actual results could differ materiallyfrom those 

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anticipatedor implied in the forward looking statements. Accordingly, you should not relyon forward looking statements as a prediction of actual results.

**BUSINESS OVERVIEW**

NeoPharm, Inc. is a Delaware corporationincorporated on June 15, 1990 under the name of OncoMed, Inc. In March 1995,we changed our name to NeoPharm, Inc. During 2004, we established awholly-owned subsidiary, NeoPharm EU Limited, in order to comply withregulatory requirements enacted by the European Union for clinical trialsconducted in member countries.

We area biopharmaceutical company engaged in the research, development, andcommercialization of drugs for the treatment of cancer. We have built our drugportfolio based on two proprietary technology platforms: the NeoLipid liposomaldrug delivery system and a tumor-targeting toxin platform. We have four drugproduct candidates in various stages of clinical development for the treatmentof cancer. The following table summarizes key information about our currentdrug product candidate pipeline:
| Drug product candidate  | ** ** | **Clinical indication(s)**                                          | ** ** | **Clinical development status** | ** ** | **Commercialization rights** |
|-------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------|------------|------------------------------|
| *Cintredekin besudotox* |       |                                                                |       |                            |       |                         |
| (IL13-PE38QQR)          |       | Glioblastoma multiforme  (brain cancer)                        |       | Phase III                       |       | Worldwide(1)                 |
| LE-SN38                 |       | Colorectal cancer and  other solid tumors                           |       | Phase II(2)                     |       | Worldwide                    |
| LEP-ETU                 |       | Breast cancer, lung  cancer, ovarian cancer, and other solid tumors |       | Phase I                         |       | Worldwide                    |
| LErafAON                |       | Cancer                                                              |       | Phase I                         |       | Worldwide                    |

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(1)          Development andcommercialization rights for Japan have been sublicensed to Nippon Kayaku Co.,Ltd.

(2)   Phase I clinicaltrial completed in 2004. Phase II expected to start in 2005.

Our most advanced drug product candidate iscintredekin besudotox, a tumor-targeting toxin being developed as a treatmentfor glioblastoma multiforme, a deadly form of brain cancer. Based on theresults from our Phase I/II clinical trials, we began a Phase III clinicaltrial (the “PRECISE” trial) in the first quarter of 2004. We currently estimatethat patient enrollment for the PRECISE trial should be completed in 2005.

In addition, threecompounds based on our NeoLipid drug delivery platform are currently in PhaseI  or Phase II clinical development.These compounds are:

·       LE-SN38,a liposomal formulation of SN-38, the active metabolite of the pro-drugirinotecan (marketed in the U.S. as Camptosar® by Pfizer), which is currentlyapproved by the U.S. Food and Drug Administration (FDA) for the treatment ofcolorectal cancer;

·       LEP-ETU,a liposomal formulation of the anti-cancer agent paclitaxel (marketed in theU.S. as Taxol® by Bristol-Myers Squibb), which is currently approved by the FDAfor the treatment of breast, lung, and ovarian cancer; and

·       LErafAON,our liposomal antisense oligonucleotide under development as a therapeuticenhancement for both radiation therapy and cancer chemotherapy.

NeoLipid technology combines drugs or other compoundswith our proprietary lipids and allows for the creation of a stable liposome.This physical property is especially important during drug storage and 

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after the drug has beenadministered intravenously to the patient. We believe our NeoLipid technologymay have applications in a variety of other areas in addition to our drugproduct candidates in clinical development. We have developed a newtransfection agent, NeoPhectinTM, which we began providing to researchlaboratories in January 2004. Furthermore, we are exploring ways toleverage our NeoLipid technology to develop therapeutic formulations of smallmolecules and biologic molecules such as RNAi, and we are currently conductingand planning research to investigate potential drug product candidates that canmake use of this technology.

In January 2004, wecompleted the sale of 4,312,500 shares of our common stock to the public.Proceeds to the Company were approximately $73.5 million net of underwritingfees and expenses. The proceeds from this sale of stock are being used to fundclinical trials of our drug product candidates; preclinical studies for otherpotential drug product candidates; and for working capital, capitalexpenditures and other general corporate purposes.

**MARKET OVERVIEW**

According to the American Cancer Society (ACS) *2005 Cancer Facts and Figures*, cancer is the second leadingcause of death in the United States, accounting for one in every four deaths.The ACS *2005 Cancer Facts and Figures* alsoestimates that doctors will diagnose over 1.3 million new cases of cancer inthe United States in 2005. The National Institutes of Health (NIH) estimatethat the annual cost of cancer in 2004 was approximately $189.8 billion,including $69.4 billion in direct medical costs and $16.9 billion for morbiditycosts, which includes the cost of lost productivity.

Cancer is characterized by uncontrolled cell divisionresulting in the growth of a mass of cells commonly known as a tumor. Canceroustumors can arise in almost any tissue or organ and cancer cells, if noteradicated, spread, or metastasize, throughout the body. Cancer is believed tooccur as a result of a number of factors, including hereditary andenvironmental factors.

For the most part, cancer treatment depends on thetype of cancer and the stage of disease progression. Generally, staging isbased on the size of the tumor and whether the cancer has metastasized.Following diagnosis, solid tumors are typically surgically removed or thepatient is given radiation therapy. Chemotherapy is the principal treatment fortumors that are likely to, or have, metastasized. Chemotherapy involves theadministration of cytotoxic drugs, which are designed to kill cancer cells, oradministration of hormones, which affect the growth of tumors.

Because in most cases cancer is fatal, cancerspecialists attempt to attack the cancer aggressively, with as many therapiesas available and with as high a dose as the patient can tolerate. Sincechemotherapy attacks both normal and cancerous cells, treatment often tends toresult in complicating side effects. Additionally, cells which have beenexposed to several rounds of chemotherapy develop a resistance to the cancerdrugs that are being administered. This is known as “multi-drug resistance”.The side effects of chemotherapy often limit the effectiveness of treatment.Cancers often recur and mortality rates remain high. Despite large sums ofmoney spent on cancer research, current treatments are inadequate and improvedanti-cancer agents are needed.

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Theproducts we currently have under development target a broad range of solidtumors. The table below shows the incidence and mortality estimated for theyear 2005 for various types of solid tumor cancers that our products seek totreat:
| **Cancer Indication** | ** ** | ** ** | ** ** | **New Cases** | ** ** | **Deaths** | ** ** |
|----------------------------|------------|------------|------------|--------------------|------------|------------|------------|
| Breast                     |       | 212,930    |       | 40,870             |       |
| Lung                       |       | 172,570    |       | 163,510            |       |
| Colorectal                 |       | 145,290    |       | 56,290             |       |
| Ovarian                    |       | 22,220     |       | 16,210             |       |
| Brain                      |       | 18,500     |       | 12,760             |       |

 

Source: American CancerSociety, 2005 Cancer Facts and Figures

**BUSINESS STRATEGY**

Our goal is to become aleading biopharmaceutical company focused on discovering, developing, andcommercializing innovative anti-cancer treatments. Our strategy consists of thefollowing key elements:

*Focus on thegrowing cancer market*

Cancer is the secondleading cause of death in the US, yet there remain unmet needs, and currenttreatments remain ineffective and inadequate for some populations. Given thelife-threatening nature of cancer, the FDA has adopted procedures to acceleratethe approval of cancer drugs. We intend to continue to use our expertise in thefield of cancer research to target this significant market opportunity forcancer drug development.

*Develop ourexisting product portfolio*

We currently have aportfolio of four anti-cancer drug product candidates which have advanced toclinical trials and are under development. We intend to further develop theseproducts both by expanding our internal resources and by continuing tocollaborate with other companies and leading governmental and educationalinstitutions.

*Create new productsby capitalizing on our NeoLipid platform*

We intend to furtherexplore the use of our proprietary NeoLipid liposomal technology to create newproducts in two ways: by extending the patent life of existing cancer drugs andby utilizing our platform to develop new drugs. We are aware of several widelyused cancer drugs that are nearing patent expiration, as well as other widelyused cancer drugs with patents that have expired. When a drug is combined withanother agent or delivery system in a novel way, its patent life may beextended. We are working to extend the marketing exclusivity for paclitaxelthrough our LEP-ETU compound. While many chemotherapeutic drugs such aspaclitaxel have been effective for the treatment of cancer, these drugs havebeen limited in their use because of adverse side effects and difficulties inadministration. Using our NeoLipid technology, we believe opportunities existfor us to increase the usefulness of these compounds as improved anti-cancertreatments. In addition, we believe that our liposomal technology may provideus with a platform for the development of novel therapeutic agents for cancerdrug development.

*Increase thepotential for commercial success through diversification*

We are developing severaldrug product candidates simultaneously in an attempt to increase our chances ofcommercial success through diversification. In addition, by broadening our drugproduct candidate portfolio, we increase our flexibility to eliminate drugproduct candidates that we determine may 

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haveless market potential while applying additional resources to the drug productcandidates that show promise.

*Commercializepharmaceutical products focused on cancer in selected markets*

Our goal is to bring tomarket novel drugs that address significant unmet needs in cancer treatment. InNorth America, we may develop a specialized cancer sales and marketingcapability or work with third parties to market our future products tospecialty physicians. As appropriate, we may establish collaborations withmultinational pharmaceutical companies to assist in the commercialization ofour drug product candidates outside of North America.

**DRUG PRODUCT CANDIDATES**

**Cintredekinbesudotox*(IL13-PE38QQR)***

We have initiated a pivotal Phase III clinical trial,which we refer to as the PRECISE trial, for cintredekin besudotox for thetreatment of glioblastoma multiforme, a deadly form of brain cancer. We haveexclusively licensed cintredekin besudotox from the NIH and the FDA, and havebeen developing this drug product candidate under a Cooperative Research andDevelopment Agreement (CRADA) with the FDA Center for Biologics Evaluation andResearch (CBER). Cintredekin besudotox has received orphan drug designation inthe US and Europe and fast track drug development program status from the FDA.In addition, cintredekin besudotox has been selected to participate in the FDA’sContinuous Marketing Application (CMA) Pilot 2 program.

To qualify for orphan drug designation, a proposedcompound must be intended for use in the treatment of a condition that affectsfewer than 200,000 people in the United States. The fast track program of theFDA is designed to facilitate the development and expedite the review of newdrugs that are showing positive progress in treating serious orlife-threatening conditions and that demonstrate the potential to address unmetmedical needs. The CMA Pilot 2 program was designed to evaluate the cost ofenhanced interaction between the FDA and applicants and whether it improves theefficiency and effectiveness of development programs, and is limited to no morethan one Fast Track product for each of 20 participating FDA review divisions.

Conventional, non-specific chemotherapeutic drugsattack abnormal cancer cells by stopping them from dividing and reproducing,but can also damage normal healthy cells because they do not discriminatebetween cancerous and healthy cells. Furthermore, standard chemotherapy drugsare usually administered systemically, which leads to their distributionthroughout the body rather than to one area, such as a tumor in the brain.Common side effects of chemotherapy that are caused by damage to bone marrowinclude the body’s inability to produce enough: red blood cells, causingweakness and fatigue; white blood cells, lowering the body’s resistance toinfections; or platelets, preventing blood from clotting properly, which canlead to excessive bleeding.

Cintredekin besudotox, on the other hand, is beingdeveloped as a highly specific tumor-targeting agent. Cintredekin besudotox isa recombinant protein consisting of a single molecule composed of two parts: atumor-targeting molecule and a cytotoxic agent. The targeting componentconsists of interleukin-13, an immune regulatory cytokine (IL-13).Malignant glioma cells, as compared to normal brain cells, express IL-13receptors at a higher density. IL-13 is an immune regulatory cytokine, orprotein, secreted by cells. The cytotoxic agent is a potent bacterially derivedtoxin called PE38. Cintredekin besudotox is designed to detect and bind IL-13receptors on the surface of malignant glioma cancer cells and selectivelydeliver PE38 to destroy tumor cells while sparing healthy surrounding cells.Cintredekin besudotox is administered by a technique known asconvection-enhanced delivery, or CED, in which the drug is delivered throughcatheters inserted in the tumor or brain tissue surrounding the tumor beforeand/or following surgical resection of the tumor. CED is designed to infusecintredekin besudotox directly 

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to the tumor site andadjacent brain tissue with the goal of killing resident tumor cells and preventingrecurrence of tumor cell growth.

Preliminary Phase I/II data published from the fourstudies of cintredekin besudotox conducted to date represent clinical data fromnearly 100 patients in various clinical settings, including intra andperitumoral delivery of cintredekin besudotox for treatment of malignantglioma. The findings suggest possible evidence of tumor cytotoxic (cancer cellkilling) effects of cintredekin besudotox against malignant glioma tumor cells.Although these studies were not designed to address efficacy, encouragingsurvival results continue to be observed beyond two years following treatment,in some patients.

Based on the data from these studies, we began thePRECISE trial in the first quarter of 2004. This trial is designated to be amulti-center, multi-national study enrolling approximately 300 patientssuffering from first recurrent glioblastoma multiforme tumors who will berandomized into one of two treatment arms of the study. One group,approximately 200 patients, will receive convection-enhanced infusion ofcintredekin besudotox after surgery and the other group, approximately 100patients, will be treated through placement of Gliadel® Wafers (GuilfordPharmaceuticals) at the time of surgery. Gliadel Wafers are approved fortreatment of patients undergoing initial surgery for and after recurrence ofthe disease. The primary end point of the study is to determine if there is astatistically significant overall patient survival difference between the twoarms of this study.

Additionally, we initiateda Phase I clinical trial of cintredekin besudotox during the third quarter of2004 that is designed to test the safety and tolerability of cintredekinbesudotox in malignant glioma patients at initial diagnosis. Malignant gliomasare a type of brain tumor that includes glioblastoma multiforme, anaplastic astrocytoma,and malignant mixed oligoastrocytoma, among others. The Phase I clinical trialis being conducted in collaboration with the American College of SurgeryOncology Group (ACOSOG), and is expected to complete enrollment in 2005.

***LE-SN38***

LE-SN38 is our NeoLipid liposomal formulation ofSN-38, the active metabolite of Camptosar, a chemotherapeutic pro-drug, whichis used as a first-line and second-line colorectal cancer treatment. At thepresent time, without the NeoLipid system, SN-38 is insoluble and can only beused to treat cancer by administering the pro-drug Camptosar. A pro-drug is acompound that is converted into the active drug in the body. However, Camptosaris converted into SN-38 in colorectal cancer cells at different rates bydifferent patients, and this variability in conversion rates can result insuboptimal dosing and adverse side effects, such as severe diarrhea. Byemploying our proprietary NeoLipid technology to deliver SN-38, we hope todeliver the active drug to the tumor cells without the need for conversion andwith fewer side effects. Other tumor cells convert Camptosar less efficientlythan colorectal cancer cells, and consequently Camptosar is currently approvedonly for the treatment of colorectal cancer. Since LE-SN38 does not depend onthe conversion process, it may have potential as a treatment for other types ofcancer such as breast, lung, prostate and pancreatic cancer.

During 2004, we completeda Phase I clinical trial for LE-SN38. The primary objectives of the Phase I studywere to determine the pharmacogenomics, pharmacokinetics, and safety of LE-SN38in patients with advanced local or metastatic solid tumors who have failedconventional therapy. Tumor progression was also monitored. In this trial,groups of patients received escalating doses of intravenous LE-SN38 infusionover 90 minutes every 21 days until disease progression or unacceptabletoxicity levels were reached. Results from this Phase I study demonstrated thesafety and tolerability of LE-SN38 and established a maximum tolerated dose(MTD) for all but a small subset of patients that metabolize SN-38 slowly.Pharmacokinetic analysis of blood samples from patients treated with LE-SN38showed that blood levels and systemic drug exposure to SN-38 were comparable toor greater than that expected from the marketed Camptosar dose based onpreviously published studies. In addition, dose limiting diarrhea was not 

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observed.We are currently planning to initiate a Phase II clinical trial in colorectalcancer patients during 2005 in collaboration with the Cancer and Leukemia GroupB (CALGB) cooperative study group.

***LEP-ETU***

LEP-ETU is our NeoLipid liposomal formulation of thewidely used cancer drug, paclitaxel. Paclitaxel, also known as Taxol® (Bristol-MyersSquibb Company), has been approved in the US for the treatment of ovarian,breast and lung cancers. Despite paclitaxel’s wide use and its tumor cytotoxiccharacteristics, its effectiveness can be limited by its adverse side effects,which can include nausea, vomiting, hair loss and nerve and muscle pain.Because of the chemical characteristics of paclitaxel, it cannot be introducedinto the body unless it is first formulated in a mixture of castor oil(Cremophor®) and ethanol, which can lead to significant side effects such ashypersensitivity reactions. We believe that by using our proprietary NeoLipidtechnology, which eliminates the need for Cremophor and ethanol, LEP-ETU mayovercome many current limitations of paclitaxel treatment for cancer patientsand may limit the adverse side effects of current treatments.

During 2004, we completed a Phase I clinical trial forLEP-ETU. Initial results, from 25 patients, indicated that LEP-ETU appeared tobe well tolerated in terms of typical paclitaxel side effects by the majorityof patients, including those receiving the higher doses of drug, as well asthose who were not premedicated with antihistamines and steroids. Antitumoractivity was observed, with three patients experiencing partial responses (shrinkageof tumor by 50% or more). Eleven other patients evidenced stable disease andwere able to complete 4 or more 3-week cycles of LEP-ETU treatment. Patientspreviously treated with taxanes were among those who responded to LEP-ETU.

LEP-ETU is currently in aclinical trial designed to assess whether LEP-ETU is bio-equivalent to Taxol. Ifresults of this trial confirm that LEP-ETU has the same pharmacokinetic profileas Taxol, we would be able to take a potentially faster, less expensive, pathto submit an application to the FDA for approval of the drug product candidate.

***LErafAON***

We are also developing a liposomal antisense drug,LErafAON. Antisense drugs are designed to work by interfering with geneexpression of proteins involved in a disease. Antisense molecules are thoughtto have a great potential as therapeutics, but delivery of the antisensemolecule to the cell has proven to be a significant obstacle to realizing thispotential. Two techniques have been used to deliver antisense into cells: liposomaldelivery and viral-vector delivery.

Viral delivery vehicles have not been widely adoptedand used because they can cause irreversible genetic changes that can havelong-term side effects, including possibly cancer, are difficult to establish,and may also cause an adverse immune response.

LErafAON utilizes our NeoLipid technology and isdesigned to interfere with the expression by tumor cells of a protein known asc-raf. This protein is expressed at higher levels in various tumors includingbreast, ovarian and prostate cancers. By inhibiting expression of the c-rafprotein, LErafAON may have independent anti-tumor activity and may render tumorcells more susceptible to radiation or chemotherapy. Pre-clinical studiesindicate that LErafAON may prove to be beneficial in enhancing the activity ofa broad range of chemotherapies in the treatment of various forms of cancer.Our liposomes provide a non-viral method of delivering the antisenseoligonucleotide into the cell via intravenous administration.

To date, we have completedtwo Phase I clinical trials using LErafAON. One study involved the use ofLErafAON as a single agent in cancer patients with various solid tumors, andthe second study involved the use of LErafAON in combination with radiationtherapy in cancer patients with radiation resistant 

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tumors.During the fourth quarter of 2004, we initiated a Phase I clinical trial ofLErafAON which now takes advantage of our new cationic cardiolipin basedNeoPhectinTM technology. The primary endpoint of the Phase I study is todetermine the dose limiting toxicity (DLT) and maximum tolerated dose (MTD) ofLErafAON. The pharmacokinetics and tumor treatment effect of LErafAON will alsobe assessed. Patient enrollment is anticipated to be completed in 2005, butdepends on the number of dose levels studied.

**Competition**

Eachof the drug product candidates we currently have under development will facecompetition from products currently on the market or under development. Thefollowing table lists our current principal competitors and their products,which compete with the listed drug product candidates we currently have underdevelopment:
| **Our drug  product candidate** | ** ** | ** **                           | ** ** | **Principal competitor** | ** ** | **Competitor’s product** |
|---------------------------------|------------|--------------------------------------|------------|--------------------------|------------|-------------------------------|
| Cintredekin besudotox           |       | Guilford  Pharmaceuticals, Inc. |       | Gliadel® Wafer      |
| LE-SN38                         |       | Pfizer Inc.                     |       | Camptosar®          |
| LEP-ETU                         |       | Bristol-Myers  Squibb Co.            |       | Taxol®              |
| LErafAON                        |       | Isis Pharmaceuticals Inc.       |       | Antisense products(1)    |

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(1)          There are currently noantisense products available on the market for the treatment of cancer, butIsis Pharmaceuticals, Genta, and others are developing such products.

We also compete with drugdevelopment companies for licenses to novel technologies as well as forcollaborations with large pharmaceutical and other companies.

**OTHER PRODUCTS**

In addition to developmentof our drug product candidates, our research efforts have yielded two newnon-drug products that we have commercialized.

**NeoPhectinTM andNeoPhectin-ATTM**

NeoPhectin is a novel *in vitro*transfectionreagent based on our proprietary cationic (positively charged) cardiolipin liposomebased technology. We designed NeoPhectin to enable researchers to transfect avariety of cell types in laboratory settings. We began providing NeoPhectingene transfection kits to distributors of scientific research supplies in January 2004.NeoPhectin-AT is our *in vivo*transfection reagent designed for use in animal testing and was first madeavailable to distributors in March 2004. NeoPhectin consists of small,stable homogeneous, ready-to-use liposomes that have shown less toxicity tocells and are able to transfect a variety of cell types.

We believe that cationicliposomes have significant market potential in DNA/RNA therapy if a successfulsystem, such as NeoPhectin, were to be available. As an alternative to viralsystems, cationic liposomes are the most commonly used systems fortransfection. While cationic liposomes form spontaneous complexes with DNA orRNA, and have shown greater transfection efficiency for *in vitro*use, the cationic liposomes which are currently commercially available have notbeen effective for*in vivo*applications. Cationicliposomes usage has been limited due to the toxicity and variable transfectionefficiency in different cell lines.

**RESEARCH ANDDEVELOPMENT PROGRAM**

In order to add new drugproduct candidates to our pipeline, we are actively conducting pre-clinicalresearch to investigate other compounds that could potentially benefit from ourNeoLipid technology. Most of our pre-clinical research is conducted at our35,500 square foot research and development facility 

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inWaukegan, Illinois, where we employed 43 individuals as of December 31,2004. We have incurred research and development expenses of approximately$44,513,000 in 2004, $34,262,000 in 2003 and $28,978,000 in 2002 to develop ourdrug product candidates, other products, and pre-clinical compounds.

**COLLABORATIVERELATIONSHIPS AND LICENSES**

**License andResearch Agreements**

*Nippon Kayaku Co.Ltd. License Agreement*

In December 2004,we signed a license agreement with Nippon Kayaku Co., Ltd., licensing to themcertain rights to develop and commercialize cintredekin besudotox in Japan. Thelicense agreement provides for up to $16 million in payments to us fromNippon Kayaku, as follows:

·       a$2 million non-refundable up-front license fee payable within 15 days ofexecution of the license agreement;

·       upto an additional $14 million in license fees and milestone payments.

We received the $2 million non-refundableup-front license fee in January 2005. Under the license agreement, NipponKayaku assumes all further responsibility for, and the costs associated with,the development and testing of cintredekin besudotox and obtaining allregulatory approvals in Japan. The license agreement provides us with the rightto receive royalties once commercial sales have begun. Prior tocommercialization, we are required to provide Nippon Kayaku with supplies ofcintredekin besudotox free of charge to conduct pre-clinical, Phase I and PhaseII testing. Upon commercialization, we are required to supply Nippon Kayakuwith cintredekin besudotox for commercial sales, at a pre-determined price.

The initial term of thelicense agreement is ten years from the date of the first commercial sale inJapan, and it may be extended at the option of Nippon Kayaku, for a mutuallyagreed upon period. Under the terms of the license agreement, each party mayterminate the license agreement upon the occurrence of certain defaults by theother.

*GeorgetownUniversity Agreements*

We currently have three license agreements and twocontract research agreements renewable annually with Georgetown Universityrelating to various liposome- related products.

Underthe Georgetown licenses, and in return for sponsoring related research, we weregranted exclusive licenses to manufacture and sell LED (liposome encapsulateddoxorubicin), LEP (liposome encapsulated paclitaxel), and LErafAON. We areobligated to pay royalties to Georgetown on commercial sales of these products.In addition, through December 31, 2004, we have paid an up-front licensingfee and advance royalty payments (which may be credited against futureroyalties) of $75,000. Additionally, we may be obligated to make milestonepayments upon achieving certain development objectives for these compounds. TheGeorgetown licenses expire in 2013 for LED, 2014 for LEP and 2020 for LErafAON.The licenses may also be terminated by either party in the event of a defaultby the other party.

***Georgetown LicenseAgreements***
| Compound | ** ** | ** ** | ** ** | **Potential Maximum Aggregate Milestone  Payments Remaining** | ** ** | **Maximum Potential  Royalty Rate** | ** ** |
|----------|------------|------------|------------|-----------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| LED      |       |       | $          | 250,000                                                                           |       |                                          |       | 5.00 | % |   |
| LEP      |       |       | $          | 250,000                                                                           |       |                                          |       | 2.50 | % |   |
| LErafAON |       |       | $          | 1,000,000                                                                         |       |                                          |       | 2.75 | % |   |

 

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Under the annual contractresearch agreements, which can be terminated upon 90 days written noticeby either party, we pay or reimburse Georgetown for all direct and indirectcosts associated with research on specific projects. For the contract researchagreements in effect during 2004, we paid a total of $500,000 to Georgetown. Inreturn, with respect to any project for which an application is ultimatelyapproved by the FDA, we retain all rights to all inventions, developments,discoveries and other proprietary ideas which are first conceived, discoveredor developed during the conduct of the research upon making a one-time paymentof up to $175,000 to Georgetown.

*National Institutesof Health*

In September 1997, weentered into an exclusive worldwide licensing agreement with the NIH (an agencyof the United States Public Health Service (PHS) within the Department ofHealth and Human Services) whereby we were granted the right to develop andcommercialize cintredekin besudotox. The cintredekin besudotox license requiredus to pay NIH an initial $75,000 non-refundable payment and requires minimumannual royalty payments to NIH of $10,000, that increase to $25,000 after thefirst commercial sale. The cintredekin besudotox license also requires us topay to NIH milestone payments of up to $585,000 upon completion of variousphases of development of cintredekin besudotox, and a maximum royalty of 4%based on future product sales, if any. The license agreement terminates in2018. However, we have the unilateral right to terminate the license agreementat any time upon 60 days written notice. The NIH may terminate theagreement upon our default in performing any material obligations under theagreement or if they determine that such action is necessary to meet therequirements for public use specified by federal regulations and we do notreasonably satisfy such requirements. While providing us with an exclusivelicense, it should be noted that, as is typical in such agreements, the NIHdoes not make any representations or warranties in the license agreement as tothe validity or enforceability of the licensed rights.

*U.S. Food and DrugAdministration*

In August 1997, we entered into a cooperativeresearch and development agreement with the FDA (the “FDA CRADA”) covering thecintredekin besudotox compound licensed from the NIH. Pursuant to the FDACRADA, we agreed to commercialize cintredekin besudotox and the FDA agreed tocollaborate on the clinical development and commercialization of the licensedcompound. Under the terms of the FDA CRADA, we paid $230,000 to the FDA in2004. Funding for the FDA CRADA expired on December 31, 2004 and wecurrently are negotiating to renew our funding of this agreement. Terminationof the FDA CRADA, however, does not affect our rights under our licenseagreement with the NIH for cintredekin besudotox.

Insummary, the amounts paid to our research and development collaborators underour various agreements, as well as our potential aggregate future commitmentsunder these agreements, are included in the following table:

***Research andDevelopment Collaboration Expenses***
| ** **                    | ** ** | **Aggregate Payments  Made through  December 31, 2004** | ** ** | **Additional Aggregate  Potential Payments(1)** | ** ** |
|-------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Georgetown                    |       |                                                              | $          | 2,561,840                                                 |       |   |   | $ | 1,500,000 |   |   |
| NIH                           |       |                                                              | 756,191    |                                                      |       |   | 575,000 |   |   |
| FDA                           |       |                                                              | 1,780,000  |                                                      |       |   | — |   |   |
| Total Collaboration  Expenses |       |                                                              | $          | 5,098,031                                                 |       |   |   | $ | 2,075,000 |   |   |

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(1)          Theseamounts do not include potential sales-based royalty payments that may berequired under the various license agreements.

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**Clinical TrialMonitoring Agreements**

In order to complete the clinical development of ourdrug product candidates, we, or third parties with whom we contract, must beable to conduct clinical trials in accordance with the FDA’s current GoodClinical Practices (“cGCP”) at acceptable costs and in a timely manner. As we currentlyonly have the limited capacity to monitor clinical trials with internal staff,we have contracted with third parties to provide us with cGCP services.

In December 2004, we finalizedan agreement with PPD Development, LP (PPD) to provide study monitoring andadministration services for our PRECISE trial. Under the agreement, PPD isresponsible for recruiting study sites and monitoring patient progress, amongother responsibilities, throughout North America, Europe and Israel. The termsof the agreement require NeoPharm to pay PPD a total of approximately $6.9million for direct expenses through June 2006, which are exclusive ofclinical trial site costs for treating patients. As of December 31, 2004,a total of $3,705,302 has been paid to PPD. The remaining payments to PPD ofapproximately $3.2 million consist of monthly fees and milestone paymentspayable as certain objectives, related to submission of required documents, aremet. The agreement can be terminated with or without cause by either party upon30 days prior written notice, and we believe there are at least 25 otherorganizations, some of which we currently have relationships with, which couldprovide us with these services, though no assurance can be given that suchservices would be available to us when we need them or be available on termsand conditions that we would find acceptable.

**ManufacturingAgreements**

In order to successfully commercialize our drugproduct candidates, we, or third parties with whom we contract, must be able tomanufacture products in commercial quantities in compliance with the FDA’scurrent Good Manufacturing Practices (“cGMP”) at acceptable costs and in atimely manner. As we do not currently own a cGMP manufacturing facility, wehave contracted with third parties to provide us with cGMP production capacity.

In August 2002, we entered into an agreement withDiosynth RTP, Inc. (Diosynth) to produce cintredekin besudotox inquantities that will be required to support our PRECISE trial for that drugproduct candidate. As of December 31, 2004, Diosynth has completed themanufacturing of quantities of cintredekin besudotox necessary to complete thePRECISE trial. We have not yet secured commercial manufacturing capacity forcintredekin besudotox from Diosynth, but we believe there are at least twoother sources available to us and we expect to secure that capacity in thefuture.

Currently, all of our liposome compounds are producedon a purchase order basis at the Center for Advanced Development (the “Center”),which is affiliated with the University of Iowa Pharmacy School. The Center hasindicated that it is currently able to meet our needs for research and clinicaltrials, but we cannot offer any assurance that they will be able to do so in atimely manner or on a cost effective basis in the future. We do not have aformal manufacturing agreement with the Center and, therefore, have no ongoingobligation to manufacture our compounds at this facility.

Our current laboratory facility provides us with thecapacity to produce the quantities of our compounds intended solely for ourpre-clinical research and development purposes. With respect to our new NeoPhectinTMproduct, which is used as a transfection agent for research and developmentpurposes, we anticipate that our laboratory facility, which is compliant withcurrent good laboratory practices, will also provide us with sufficientcapability to produce commercial quantities of the product.

In every case, we believethere are other sources of raw materials and contract manufacturing that wouldbe acceptable to the Company and would comply with the requirements of the FDA.However, there can be no assurances that we could enter into agreements withthese alternative suppliers or manufacturers on terms and conditions acceptableto us, if at all.

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**Patents andProprietary Rights**

We either own or have licensed over 50 United Statespatents or patent applications relating to our drug product candidates andcompounds. We have also filed applications in a number of foreign jurisdictionswhich are counterparts of our issued United States patents and patentapplications. We believe all of our drug product candidates and compounds underdevelopment are protected by patents owned or licensed to us.

Patent protection is important to our business. Thepatent position of companies in the pharmaceutical field generally is highlyuncertain, involves complex legal and factual questions, and has recently beenthe subject of much litigation. Therefore, we cannot assure you that any patentapplications relating to our products or processes will result in patents beingissued, or that the resulting patents, if any, will provide protection againstcompetitors who successfully challenge our patents, obtain patents that mayhave an adverse effect on our ability to conduct business, or are able tocircumvent our patent position. It is possible that other parties haveconducted or are conducting research and could make discoveries of compounds orprocesses that would precede any of our discoveries. Finally, there can be noassurance that others will not independently develop similar pharmaceuticalproducts which will compete against ours, or cause our drug product candidatesand compounds to become obsolete.

Our competitive position is also dependent uponunpatented trade secrets. In an effort to protect our trade secrets, we have apolicy of requiring our employees, consultants, and advisors to executeproprietary information and invention assignment agreements upon commencementof employment or consulting relationships with us. These agreements providethat all confidential information developed or made known to the individualduring the course of their relationship with us must be kept confidential,except in specified circumstances. However, we cannot assure you that theseagreements will provide meaningful protection for our trade secrets or otherproprietary information in the event of unauthorized use or disclosure ofconfidential information. Further, invention assignment agreements executed byconsultants and advisors may conflict with, or be subject to, the rights ofthird parties with whom such individuals have employment or consultingrelationships. In addition, we cannot assure you that others will notindependently develop equivalent proprietary information and techniques orotherwise gain access to our trade secrets, that such trade secrets will not bedisclosed, or that we can effectively protect our rights to unpatented tradesecrets.

We may be required toobtain licenses to patents or proprietary rights of others. We cannot assureyou that any licenses required under any such patents or proprietary rightswould be made available on terms acceptable to us or at all. If we do notobtain such licenses, we could encounter delays in product market introductionswhile we attempt to design around such patents, or could find that thedevelopment, manufacture, or sale of products requiring such licenses could beforeclosed. Litigation may be necessary to defend against or assert claims ofinfringement to enforce patents issued to us or exclusively licensed to us, toprotect trade secrets or know-how owned by us, or to determine the scope andvalidity of the proprietary rights of others. In addition, we may becomeinvolved in oppositions in foreign jurisdictions or interference proceedingsdeclared by the United States Patent and Trademark Office to determine thepriority of inventions with respect to our patent applications or those of ourlicensors. Litigation, opposition, or interference proceedings could result insubstantial costs to and diversion of effort by, and may have a materialadverse impact on, us. In addition, we cannot assure you that our efforts willbe successful. See “RISK FACTORS.”

**GovernmentRegulation**

Regulation by governmental authorities in the UnitedStates and foreign countries is a significant factor in the development,manufacture, and marketing of our drug product candidates and in our ongoingresearch and development activities. The nature and extent to which suchregulation will apply to us will 

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vary depending on thenature of any products developed. We anticipate that all of our drug productcandidates will require regulatory approval by governmental agencies prior tocommercialization. In particular, human therapeutic products are subject torigorous preclinical and clinical testing and other approval procedures of theFDA and similar regulatory authorities in foreign countries. Various federalstatutes and regulations also govern or influence testing, manufacturing,safety, labeling, storage, and record-keeping related to such products andtheir marketing. The process of obtaining these approvals and the subsequentcompliance with the appropriate federal statutes and regulations requiressubstantial time and financial resources. Any failure by us or ourcollaborators to obtain, or any delay in obtaining, regulatory approval couldadversely affect the marketing of any products developed by us, our ability toreceive product revenues, and our liquidity and capital resources.

The development,manufacture, marketing, and distribution of drug products are extensivelyregulated by the FDA in the U.S. and similar regulatory agencies in othercountries. The steps ordinarily required before a new drug may be marketed inthe U.S., which are similar to steps required in most other countries, include:

·       preclinicallaboratory tests, preclinical studies in animals, formulation studies and thesubmission to the FDA of an investigational new drug application;

·       adequateand well-controlled clinical trials to establish the safety and efficacy of thedrug for each type of cancer;

·       thesubmission of a new drug application to the FDA; and,

·       FDAreview and approval of the new drug application (NDA) or biologics licenseapplication (BLA).

Preclinical tests include laboratory evaluation ofproduct chemistry, formulation and toxicity, as well as animal studies. Theresults of preclinical testing are submitted to the FDA as part of aninvestigational new drug application. A 30-day waiting period after thefiling of each investigational drug application is required prior tocommencement of clinical testing in humans. At any time during the 30-dayperiod or at any time thereafter, the FDA may halt proposed or ongoing clinicaltrials until the FDA authorizes trials under specified terms. Theinvestigational new drug application process may be extremely costly andsubstantially delay development of our drug product candidates. Moreover,positive results of preclinical tests will not necessarily indicate positiveresults in subsequent clinical trials.

Clinical trials tosupport new drug applications are typically conducted in three sequential phases,although the phases may overlap. During Phase I, clinical trials are conductedwith a small number of subjects to assess metabolism, pharmacokinetics, andpharmacological actions and safety, including side effects associated withincreasing doses. Phase II usually involves studies in a limited patientpopulation to:

·       assessthe efficacy of the drug in specific, targeted indications;

·       assessdosage tolerance and optimal dosage; and

·       identifypossible adverse effects and safety risks.

If a compound is found to be potentially effective andto have an acceptable safety profile in Phase II evaluations, Phase III trialsare undertaken to further demonstrate clinical efficacy and to further test forsafety within an expanded patient population at geographically dispersedclinical trial sites.

After successful completion of the required clinicaltrials, a new drug application or biologics license application (collectivelyan “application”) is generally submitted. The FDA may request additionalinformation before accepting the application for filing, in which case theapplication must be resubmitted with the additional information. Once thesubmission has been accepted for filing, the FDA reviews the application andresponds to the applicant. FDA requests for additional information orclarification often 

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significantly extend thereview process. The FDA may refer the application to an appropriate advisorycommittee for review, evaluation, and recommendation as to whether theapplication should be approved, but the FDA is not bound by the recommendationof an advisory committee.

If the FDA evaluations of the application and themanufacturing facilities are favorable, the FDA may issue an approval letter oran “approvable” letter. An approvable letter will usually contain a number ofconditions that must be met in order to secure final approval of theapplication and authorization of commercial marketing of the drug for certainindications. The FDA may also refuse to approve the application or issue a “notapprovable” letter outlining the deficiencies in the submission and oftenrequiring additional testing or information.

The Food and Drug Administration’s Modernization Actcodified the FDA’s policy of granting “fast track” approval of cancer therapiesand other therapies intended to treat severe or life threatening diseases andhaving potential to address unmet medical needs. Previously, the FDA approvedcancer therapies primarily based on patient survival rates or data on improvedquality of life. The FDA considered evidence of partial tumor shrinkage, whileoften part of the data relied on for approval, insufficient by itself towarrant approval of a cancer therapy, except in limited situations. Under theFDA’s revised policy, which became effective in 1998, the FDA has broadenedauthority to consider evidence of partial tumor shrinkage or other clinicaloutcomes for approval. This revised policy is intended to facilitate the studyof cancer therapies and shorten the total time for marketing approvals. Weintend to take advantage of this policy; however, it is too early to tell whateffect, if any, these provisions may have on the approval of our drug productcandidates.

Under the Orphan Drug Act, the FDA may designate drugproducts as orphan drugs if there is no reasonable expectation of recovery ofthe costs of research and development from sales in the United States or ifsuch drugs are intended to treat a rare disease or condition, which is definedas a disease or condition that affects less than 200,000 persons in the UnitedStates. If certain conditions are met, designation as an orphan drug confersupon the sponsor marketing exclusivity for seven years following FDA approvalof the product, meaning that the FDA cannot approve another version of the “same”product for the same use during such seven year period unless the FDA findsthat the sponsor is not able to supply adequate quantities of the drug. Themarket exclusivity provision does not, however, prevent the FDA from approvinga different orphan drug for the same use or the same orphan drug for adifferent use. The Orphan Drug Act has been controversial, and many legislativeproposals have from time to time been introduced in Congress to modify variousaspects of the Orphan Drug Act, particularly the market exclusivity provisions.We cannot assure you that new legislation will not be introduced in the futurethat may adversely impact the availability or attractiveness of orphan drugstatus for any of our products.

Sales outside the United States of products we developwill also be subject to regulatory requirements governing human clinical trialsand marketing for drugs. The requirements vary widely from country to country,but typically the registration and approval process takes several years andrequires significant resources. In most cases, if the FDA has not approved aproduct for sale in the United States, the product may be exported for saleoutside of the United States, only if it has been approved in any one of thefollowing: the European Union, Canada, Australia, New Zealand, Japan, Israel,Switzerland and South Africa. There are specific FDA regulations that governthis process.

We are also subject tovarious Federal, state and local laws, regulations and recommendations relatingto safe working conditions, laboratory and manufacturing practices, and the useand disposal of hazardous or potentially hazardous substances, includingradioactive compounds and infectious disease agents, used in connection withour research work. We cannot accurately predict the extent of governmentregulation that might result from future legislation or administrative action.

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**Employees**

As of December 31,2004, we employed 99 people, of which there are 74 in research and developmentand 25 in administration. Our employees are not represented by any collectivebargaining agreement and we believe our employee relations are good.

**AvailableInformation**

Copies of our AnnualReport on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K and amendments to those reports filed orfurnished pursuant to Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934 are available free of charge through our website (*www.neophrm.com*) as soon as reasonably practicable after weelectronically file the material with, or furnish it to, the Securities andExchange Commission (SEC). You may read and copy any document we file with the SECat the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington,DC 20549. Please call the SEC at 1-800-SEC-0330 for furtherinformation on the Public Reference Room. Our SEC filings are also available tothe public at the SEC’s website at *http://www.sec.gov.*Additionally, we have also adopted a Code of Ethics applicable to all officers,directors, and employees, which is also available on our website.

**RISKFACTORS**

You should carefullyconsider the following risk factors, in addition to the other information setforth in this document. Each of these risk factors could adversely affect ourbusiness, operating results and financial condition, as well as the value of aninvestment in our common stock.

**If we were unable to develop, obtain regulatoryapprovals for, and then market our drug product candidates, our business wouldbe harmed.**

Our future operatingresults would be adversely affected if we are unable to develop, obtainregulatory approval for, and bring to market new drug product candidates in atimely manner. The process for developing new drugs and/or therapeutic productsis inherently long, complex, and uncertain. We must make long-term investmentsand commit significant resources before knowing whether our developmentprograms will eventually result in products that will receive regulatoryapproval and achieve market acceptance.

We currently have fourdrug product candidates in clinical development. As with any pharmaceuticalproduct under development, there are significant risks in development,regulatory approval, and commercialization of new compounds. During the drugproduct development phase, there is no assurance that the FDA will approve ourclinical trial protocols. There is also no guarantee that future clinicalstudies, if performed, will demonstrate the safety and efficacy of any drugproduct we have in development or that we will receive regulatory approval forsuch products. Further, the FDA can suspend clinical studies at any time if theFDA believes that the patients participating in such studies are being exposedto unacceptable health risks.

We have yet to submit anapplication for marketing approval for any of the drug product candidates wecurrently have under development and we cannot predict with certainty if orwhen we might submit any of these drug product candidates for regulatoryreview. Once we submit our drug product candidates for review, we cannot assureyou that the FDA or other regulatory agencies will grant approvals for any ofour proposed products on a timely basis or at all. Further, even if we receiveregulatory approval for a drug product candidate, there can be no assurance thatsuch product will prove to be commercially successful or profitable.

Sales of our drug productcandidates both inside and outside the US will be subject to regulatoryrequirements governing marketing approval. These requirements vary widely fromcountry to country and could delay the introduction of our drug productcandidates in those countries. If the FDA and 

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internationalregulatory authorities approve a drug product candidate, we must manufacture,or contract with third parties to manufacture, sufficient volumes to meetmarket demand. This is a process that requires accurate forecasting of marketdemand. There is no guarantee that there will be market demand for any futuredrug product candidates or that we will be able to successfully manufacture oradequately support sales of any future drug product candidates.

At the present time ourmost advanced drug product candidate is cintredekin besudotox (IL13-PE38QQR),which we believe has potential to be used as a treatment for malignant gliomas.In September 1997, we exclusively licensed worldwide rights to cintredekinbesudotox from the NIH and the FDA. On the basis of our preliminary Phase I/IIclinical trial findings for this drug product candidate, we initiated thePRECISE trial, a pivotal Phase III multi-center, multi-nationalclinical trial having a planned enrollment of 300 patients. Our Phase I/IIclinical trials to date involving this drug product candidate have enrolledfewer than 100 patients, and there are no assurances that cintredekin besudotoxwill prove to be safe and effective or receive regulatory approval for anyindication. Further, even if we were to receive regulatory approval for a drugproduct candidate utilizing cintredekin besudotox, there can be no assurancethat such a drug product candidate would prove to be commercially successful orprofitable.

We also presently havethree other drug product candidates in clinical development for the treatmentof various cancers: LE-SN38, LEP-ETU, and LErafAON. Each of these drug productcandidates is in either Phase I or Phase II clinical testing. There are noassurances that any of these drug product candidates will prove to be safe andeffective or that any of them will receive regulatory approval for thetreatment of the indications which we may pursue. Even if one or more of thesedrug product candidates eventually becomes an approved product, there can be noassurance that it will be successful in the marketplace.

**We are highly dependent on achieving success in theclinical testing, regulatory approval, and commercialization of our mostadvanced drug product candidate, cintredekin besudotox, which may never beapproved for commercial use. If we are unable to commercialize cintredekinbesudotox, our ability to generate revenues would be impaired and our businesswould be harmed.**

We have invested asignificant portion of our time and financial resources in the development ofcintredekin besudotox, and we anticipate that for the foreseeable future ourpotential to achieve revenues from drug product sales will be dependent on itssuccessful clinical testing, regulatory approval in the US, andcommercialization. Drug development is a highly uncertain process. We maysuffer significant setbacks in our Phase III clinical trials of cintredekinbesudotox, even after achieving potentially promising results in earlierclinical trials. Even if the clinical trials of cintredekin besudotox showpotential, prior to commercialization of cintredekin besudotox in the U.S., wewill have to submit, and the FDA will have to approve, a BLA for cintredekinbesudotox. If a BLA, assuming one is eventually filed, for cintredekinbesudotox is not approved by the FDA, or if approval is delayed, or ifadditional clinical testing is required, our ability to achieve revenues fromproduct sales will be impaired and our stock price would be materially andadversely affected. FDA approval is contingent on many factors, includingclinical trial results and the evaluation of those results.

We began the PRECISE trialin patients suffering from first recurrent glioblastoma multiforme tumors inthe first quarter of 2004. Patients in the PRECISE trial receive treatmenteither with cintredekin besudotox or Gliadel Wafers, a product currentlyapproved to treat this disease. The primary endpoint of the study is todetermine if there is a statistically significant overall patient survivaldifference between patients treated with cintredekin besudotox compared tothose treated with Gliadel Wafers. The results from our clinical trial may notdemonstrate a statistically significant difference between cintredekinbesudotox and treatment with Gliadel Wafers. Results from our clinical trialthat are not statistically significant would adversely affect our ability toobtain regulatory approval for cintredekin besudotox. In the event that theresults from the PRECISE trial do not demonstrate a statistically significantdifference, 

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the FDAcould determine that additional clinical trials are necessary, which could alsodelay commercialization. Adverse safety findings from our study would alsoadversely affect our ability to obtain regulatory approval. Even if we concludethat the results from our clinical trial are statistically significant, the FDAmay not agree with us because the FDA may evaluate the results by differentmethods or conclude that the clinical trial results are not clinicallymeaningful or that there were human errors in the conduct of the clinicaltrials or otherwise. Finally, even if we believe that we have met the FDArequirements for submission of data and information for a BLA, there is a riskthat the FDA will require additional data and information that we are unable toprovide.

**Because all of our drug product candidates are indevelopment, there is a high risk that further development and testing willdemonstrate that our drug product candidates are not suitable forcommercialization, which could cause our business to suffer.**

Wehave no drug product candidates that have received regulatory approval forcommercial sale. All of the drug product candidates and compounds that we arecurrently developing require extensive pre-clinical and clinical testing beforewe can submit any application for regulatory approval. Before obtainingregulatory approvals for the commercial sale of any of our drug productcandidates, we must demonstrate through pre-clinical testing and clinicaltrials that our drug product candidates are safe and effective in humans.Conducting clinical trials is a lengthy, expensive, and uncertain process.Completion of clinical trials may take several years or more. Our commencementand rate of completion of clinical trials, including, but not limited to, ourongoing PRECISE trial for cintredekin besudotox, may be delayed by manyfactors, including, but not limited to:

·       ineffectivenessof the study compound, or perceptions by physicians that the compound is noteffective for a particular indication;

·       failureto obtain significant survival improvement over existing treatment;

·       inabilityto manufacture, or secure third party sources to manufacture, sufficientquantities of drug compounds for use in clinical trials;

·       failureto comply fully with the investigational new drug (IND) regulations;

·       failureof the FDA to approve our clinical trial protocols;

·       aslower than expected rate of patient recruitment;

·       inabilityto adequately follow patients after treatment;

·       delaysin importing or exporting clinical trial materials;

·       unforeseensafety issues; and

·       governmentor regulatory delays.

The clinical results wehave obtained to date should not be viewed as predicting that the results offurther testing, including later stage controlled human clinical testing, willbe successful. If our trials are not successful or are perceived as notsuccessful by the FDA or physicians, our business, financial condition andresults of operations will be harmed.

**Our business is subject to extensive governmentalregulation, which can be costly and time consuming and subject us tounanticipated delays.**

Public health authoritiesin the US and other countries regulate the research, testing, manufacturing,labeling, distribution, marketing, and advertising activities with respect toall of our drug product candidates. The FDA and comparable agencies in foreigncountries impose substantial burdens on our ability and the ability of othersto introduce pharmaceutical products to the public, including lengthy and 

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detailedclinical testing procedures to demonstrate safety and efficacy andmanufacturing procedures to insure compliance with cGMP. This process can lastmany years, be very costly and still be unsuccessful. All clinical,manufacturing, labeling, and other information developed for proprietaryproducts will be required to be filed with the FDA in BLAs or new drugapplications for review and be subject to approval by that agency. We cannotassure you that this lengthy regulatory review process will result in theapproval and subsequent marketing of our products.

Oncewe submit our drug product candidates for review, we do not know whether the FDAor other regulatory agencies will grant approvals for any of them on a timelybasis or at all. The FDA can delay, limit, or deny approval for many reasons,including, but not limited to:

·       theFDA may determine that our drug product candidates may not be safe oreffective;

·       FDAofficials may interpret data from pre-clinical testing and clinical trials indifferent ways than we interpret it;

·       theFDA might not approve our manufacturing processes or facilities or theprocesses or facilities of our collaboration partners;

·       theFDA may change its approval policies or adopt new regulations; and

·       theFDA may approve a drug product candidate for fewer than all the indicationsrequested.

The process of obtainingapprovals in foreign countries is subject to delay and failure for similarreasons.

In addition, any marketeddrug product and its manufacturer continue to be subject to strict regulation.Any unforeseen problems with an approved drug product, or delays in receivingregulatory approval, or failing to receive such approval, would delay orprevent drug product commercialization and harm our business and stock price.Approval of a drug product candidate could also depend upon our commitment toconduct post-marketing studies.

Even if the FDA approvescintredekin besudotox with its orphan drug designation and exclusivity, the FDAcan, in certain situations prescribed by law, approve competitors’ products.

It is possible that theFDA may not approve our drug product candidates, but we choose to market themoutside of the United States. If certain legal conditions are met, we might beable to export these drug product candidates, without selling them in theUnited States. However, the export process can be complex, and there are noassurances that such export would be permitted or that a country would acceptthe product.

We have concluded, basedin part on the advice of an independent regulatory consultant, that it is notnecessary to obtain approval or clearance from the FDA prior to marketingeither NeoPhectin or NeoPhectin AT for their current intended use. If the FDAwere to take a different view or we choose to market the product commerciallyfor therapeutic or diagnostic purposes, we would need to comply with allapplicable regulations, including obtaining any necessary approvals orclearances.

**We have a history of operating losses, expect tocontinue to incur losses for the foreseeable future, and may never beprofitable.**

We have a limitedoperating history, and our operations consist primarily of the development ofour drug product candidates and the sponsorship of research and clinicaltrials. Over the past three years, we have incurred aggregate net losses ofapproximately $146.9 million. We expect to incur additional losses and, asour development efforts and clinical testing activities continue, our lossesmay increase. We also expect to experience negative cash flows for theforeseeable future as we fund our losses and capital expenditures. Our losseshave adversely impacted, and will continue to adversely impact, our workingcapital, total assets and stockholders’ equity. To date, we have not sold orreceived approval to sell any 

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drugproduct candidates, and it is possible that revenues from drug product saleswill never be achieved. We have generated only limited amounts of revenue fromlicense fees and sales of our NeoPhectin products, and it is possible thatadditional license revenue and/or revenue from sales of NeoPhectin productswill not be significant. We cannot at this time predict when or if we will beable to develop other sources of revenue or when or if our operations willbecome profitable, even if we are able to commercialize some of our drugproduct candidates.

**Budget constraints may force us to delay our effortsto develop certain drug product candidates in favor of developing others, whichmay prevent us from commercializing all drug product candidates as quickly aspossible.**

Because we are an emergingcompany with limited resources, and because research and development is an expensiveprocess, we must regularly assess the most efficient allocation of our researchand development budget. As a result, we may have to prioritize developmentactivities and may not be able to fully realize the value of some of our drugproduct candidates in a timely manner, as they will be delayed in reaching themarket, if at all. Recently, we have undertaken efforts to substantiallydecrease our expenses, including a restructuring of our workforce and areduction in research and development spending not related to our lead drugproduct candidate, cintredekin besudotox. If we are not successful inmaintaining the planned level of spending, our efforts to commercializecintredekin besudotox may be delayed. Additionally, the reduction in spendingon our other drug product candidates could delay our commercialization effortsand negatively impact our strategy to diversify our development risk across abroad portfolio of drug product candidates.

**Competition in the biopharmaceutical field is intenseand subject to rapid technological change. Our principal competitors havesubstantially greater resources to develop and market products that may besuperior to ours.**

If we obtain regulatoryapproval for any of our drug product candidates, the extent to which they achievemarket acceptance will depend, in part, on competitive factors. Competition inour industry is intense, and it is increased by the rapid pace of technologicaldevelopment. Existing drug products or new drug products developed by ourcompetitors may be more effective or have fewer side effects, or may be moreeffectively marketed and sold, than any that we may develop. Each of ourprincipal competitors has substantially greater research and developmentcapabilities and experience and greater manufacturing, marketing, financial,and managerial resources than we do. Competitive drug compounds may render ourtechnology and drug product candidates obsolete or noncompetitive prior to ourrecovery of research, development, or commercialization expenses incurredthrough sales of any of our drug product candidates. The FDA’s policy ofgranting “fast track” approval for cancer therapies may also expedite theregulatory approval of our competitors’ drug product candidates.

Eachof the drug product candidates we currently have under development will facecompetition from products currently on the market or under development. Thefollowing table lists our current principal competitors and their productswhich compete with the listed drug product candidates we currently have underdevelopment:
| **Our drug  product candidate** | ** ** | ** **                           | ** ** | **Principal competitor** | ** ** | **Competitor’s product** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|--------------------------|------------|-------------------------------|------------|
| Cintredekin  besudotox          |       | Guilford  Pharmaceuticals, Inc. |       | Gliadel®  Wafer     |       |
| LE-SN38                         |       | Pfizer  Inc.                         |       | Camptosar®          |       |
| LEP-ETU                         |       | Bristol-Myers  Squibb Co.            |       | Taxol®              |       |
| LErafAON                        |       | Isis Pharmaceuticals  Inc.           |       | Antisense products(1)    |       |

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(1)          Thereare currently no antisense products available on the market for the treatmentof cancer, but Isis Pharmaceuticals, Genta, and others are developing suchproducts.

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We also compete with otherdrug development companies for licenses to novel technologies as well as forcollaborations with large pharmaceutical and other companies.

**Our stock price has been and is likely to continue tobe volatile, and your investment in our common stock could decline in value.**

The stock market hasexperienced significant price and volume fluctuations, which often has beenunrelated to the operating performance of particular companies. In addition,the market price of our stock has been highly volatile and is likely tocontinue to be so. For example, during 2003, the market price of our commonstock fluctuated between $19.40 and $7.56 per share. During 2004, the marketprice of our common stock fluctuated between $22.70 and $4.66 per share. On May 13,2003, our Board of Directors declared a 15% common stock dividend tostockholders of record on June 3, 2003, which was issued on June 10,2003. All share information and per share data for prior periods has beenrestated to reflect this stock dividend.

Thefollowing factors, among others, could have a significant impact on the marketprice of our stock:

·       thesuccess or failure of our clinical trials, including, but not limited to, thePRECISE trial involving our lead compound, cintredekin besudotox, or those ofour competitors;

·       announcementsof technological innovations or new drug products by us or our competitors;

·       litigation,including class action lawsuits and resolution of the ongoing SEC investigationof the Company;

·       actualor anticipated fluctuations in our financial results;

·       ourability to obtain needed financing;

·       economicconditions in the US and abroad;

·       commentsby or changes in Company assessments or financial estimates by securitiesanalysts;

·       adverseregulatory actions or decisions;

·       anyadditional losses of key management;

·       changinggovernmental regulations;

·       developmentsor disputes concerning patents or other proprietary rights;

·       productor patent litigation; and

·       publicconcern as to the safety of products developed by us.

Additionally, volatilityor a lack of positive performance in our stock price may adversely affect ourability to retain key employees, all of whom have been granted stock options.

These factors andfluctuations, as well as political and market conditions, may materiallyadversely affect the market price of our common stock.

**We are currently named as a defendant in a number ofsecurities class action lawsuits. The volatility of our stock increases therisk that additional securities class action litigation could be institutedagainst us in the future.**

Securities class actionlitigation is often brought against a company following periods of volatilityin the market price of its securities. We, along with certain of our officers,are currently named as defendants in a number of class action lawsuits whichhave been consolidated for trial and are currently pending in the federaldistrict court for the Northern District of Illinois, and each of which allegesvarious violations of the federal securities laws in connection with certain ofour public statements as they relate to our LEP 

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drugproduct candidate. We may be named as a defendant in similar litigation in thefuture. While we are vigorously defending this litigation, this litigation hasresulted, and can be expected to continue to result, in substantial costs andin a diversion of management’s attention and our resources, which could harmour business and financial condition, as well as the market price of our stock.Moreover, it may result in an adverse judgment against us or a settlement,either of which could require us to make a payment to the plaintiffs.

**The SEC has initiated an investigation of the Company.We believe that this investigation was initiated as a consequence of ourarbitration proceeding, now concluded, involving Pharmacia’s development of LEPand LED and the class action lawsuits involving our public statements regardingLEP.**

On March 26, 2004, wereceived a letter from the Securities and Exchange Commission stating that theSEC is conducting a formal investigation of the Company. The SEC stated in itsletter that it had made no determination of any violation of law by the Companyor any individual at this time. Previously, this matter had been the subject ofan informal SEC inquiry. We continue to fully cooperate with the SEC and intendto do so in order to bring this ongoing inquiry to a conclusion as promptly aspossible. We believe the investigation is an outgrowth of the arbitration claimfiled by the Company against Pharmacia (now Pfizer) regarding the developmentof our LEP and LED drug product candidates, which was concluded in April 2004,and the ongoing class action lawsuits which have been filed against us relatingto public statements regarding the development of LEP. We cannot predict withcertainty the direction the investigation will take or its ultimate outcome,and therefore are unable to determine whether the results of the investigationwill have a material adverse impact on our results of operations and financialposition.

**We will need to raise additional capital in thefuture. If additional capital is not available, we may have to curtail or ceaseoperations.**

Weestimate that as of December 31, 2004, our existing cash reserves will besufficient to finance our operations at current and projected levels ofdevelopment and general corporate activity through approximately September 2006.We can offer no assurance that we will be able to generate revenues fromproduct sales in the near term or in the future, at a rate sufficient to fundour operations. Even though we were successful in raising additional capital inJanuary 2004, we will need additional future financing depending on anumber of factors, including, but not limited to, the following:

·       ourdegree of success in commercializing our drug product candidates;

·       therate of progress and cost of research and development and clinical trialactivities relating to our drug product candidates;

·       apossible obligation to pay damages arising from the ongoing consolidated classaction lawsuit or fines arising from the SEC investigation, to the extent thesepossible damages or fines exceed, or are not covered by, our insurance;

·       thecosts of preparing, filing, prosecuting, maintaining and enforcing patent claimsand other intellectual property rights;

·       emergenceof competing technologies and other adverse market developments;

·       changesin or terminations of our existing licensing arrangements;

·       theamount of milestone payments, if any, we receive from future collaborators, ifany;

·       thecosts of acquiring or licensing new technology, products or businesses if wedesire to expand our product portfolio; and

·       thecost of manufacturing scale-up and development of marketing operations, if weundertake those activities.

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Currently, the Company hasthe ability to issue approximately $70 million under its previously filed shelfregistration on Form S-3, but this shelf registration will expire onDecember 17, 2005, and is conditioned on the Company’s timely filing ofall required documents with the SEC. Although we do not currently anticipateneeding to access our shelf registration prior to August 2005, our ability todo so could be hindered by our late filing in August 2004 of a request forextension for filing our quarterly report on Form 10-Q, though the reportitself was filed within the extension period. Additional financing may not beavailable when we need it or be on terms acceptable to us. If adequatefinancing is not available, we may be required to delay, scale-back, oreliminate certain of our research and development programs, to relinquishrights to some of our technologies or products, or to grant licenses to thirdparties to commercialize products or technologies that we would otherwise seekto develop ourselves. We could also be required to cease operations. Ifadditional capital is raised through the sale of equity, our stockholders’ownership interest could be diluted and such securities may have rights,preferences, or privileges superior to those of our other stockholders. Theterms of any debt securities we may sell to raise additional capital may placerestrictions on our operating activities. Failure to secure additionalfinancing may cause us to delay or abandon some or all of our development programs.

**We depend on third parties for a variety of functions,including the research and development, manufacturing, clinical testing, andregulatory compliance of our drug product candidates. No assurance can be giventhat these arrangements will allow us to successfully develop and manufactureour drug product candidates.**

We rely, in part, on thirdparties to perform a variety of functions, including research and development,clinical trial management and testing, and production of our drug productcandidates. As of December 31, 2004, we had 99 full-time employees. If wedevelop additional drug product candidates with commercial potential, we willeither have to hire additional personnel skilled in clinical testing or engagethird parties to perform such services. We currently do not possess theinternal infrastructure to independently conduct clinical trial management andcertain aspects of clinical testing. Accordingly, we have engaged PPD tooversee our PRECISE trial for cintredekin besudotox under which we areobligated to compensate PPD on a monthly basis plus make milestone payments asthe trial progresses. For assistance in the management and testing for ourPhase I and Phase II clinical trials we have engaged Research SolutionsIncorporated and Prologue Research International, Inc. on a per studybasis. To oversee data management in our clinical trials we have contracted, ona per study basis, with Advanced Clinical Services and, to conduct our largeanimal clinical testing, we have engaged, again on a per study basis, SouthernResearch Institute. While we have been satisfied with the performance of thesevarious organizations, if problems were to develop we are confident thatsatisfactory alternative arrangements could be made. We are currently aware ofat least 25 other entities that could offer similar services to those offeredby each of PPD Development, Research Solutions, and Advanced Clinical Servicesand three other entities offering services similar to those provided bySouthern Research Institute. We frequently change vendors and consider suchitems as price, vendor capabilities to meet our needs, and ease of transitionin choosing new vendors. As we do not directly control the third parties withwhom we work, we depend on these companies to apply the appropriate expertiseand resources in expeditiously and competently performing the services forwhich they have been retained. If the third parties with whom we contractbreach their agreements with us or fail to comply with any governmental requirements,our drug development efforts could be seriously delayed or otherwise impaired.

We also in-licensetechnology from governmental and academic institutions in order to minimizeinvestments in basic research, and we enter into collaborative arrangements withcertain of these entities with respect to research and development of our drugproduct candidates. At this time we have research agreements in place withGeorgetown University and the FDA. The research agreement with FDA obligated usto fund research efforts there through December 31, 2004. We are currentlynegotiating the renewal of the FDA research agreement. The research agreementswith Georgetown obligated us to fund 

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researchefforts through February 28, 2005. We have not renewed the research agreementswith Georgetown. No assurance can be given that we will be able to maintainthese relationships or establish new ones on beneficial terms, that we canenter into renewals of these arrangements without undue delays or expenditures,or that these arrangements will allow us to compete successfully.

In order to commercializeour drug product candidates successfully, we, or third parties with whom wecontract, must be able to manufacture products in commercial quantities incompliance with the FDA’s cGMP requirements at acceptable costs and in a timelymanner. There can be no assurance that any current or future third-partymanufacturer will comply with good laboratory and clinical practices or cGMPand, if not, the FDA could take enforcement action, which could negativelyaffect the approval or sale of any products. We do not currently have cGMPmanufacturing capacity for any of the drug product candidates we aredeveloping. Currently, all of our liposome compounds are produced at the Centerfor Advanced Drug Development which is affiliated with the University of IowaPharmacy School. The Center has indicated that it is currently able to meet ourneeds for research and clinical trials, but we cannot be sure that they will beable to do so in a timely or cost effective basis in the future or thatsuitable alternatives can be found in a timely manner, or at all. In addition,we entered into an agreement with Diosynth RTP, Inc. to producecintredekin besudotox in the larger quantities that will be required to supportour Phase III clinical trial for that drug product candidate. Diosynth hasprovided us with quantities of cintredekin besudotox that we believe will allowus to complete the clinical testing of that drug product candidate. While wehave not experienced any difficulties with either the Center for Advanced DrugDevelopment or Diosynth, any failure to obtain adequate supplies of our drugproduct candidates could delay or prevent our development efforts, though weare aware of at least two alternative manufacturers with whom we could contractfor these drug product candidates and we do not anticipate that we wouldencounter any difficulties in establishing a new relationship should it benecessary to do so.

**If we, or our suppliers, fail to comply with FDA andother government regulations, our manufacturing operations could beinterrupted, and our drug product development, future sales, and profitabilitywould suffer.**

All new drugs, includingour drug product candidates under development, are subject to extensive andrigorous regulation by the FDA and comparable foreign authorities. Theseregulations govern, among other things, the development, pre-clinical andclinical testing, manufacturing, labeling, storage, pre-market approval,advertising, promotion, sale, and distribution of our drug product candidates.

Even if regulatoryapproval is obtained, our drug products would continue to be subject togovernmental review. Manufacturing, labeling, distribution, and promotionalactivities are continually regulated by the FDA and equivalent foreignregulatory agencies, and we must also report certain adverse events involvingour drug products to these agencies. Previously unidentified adverse events oran increased frequency of adverse events that may occur post-approval couldresult in product recalls or labeling modifications of approved products, whichcould adversely affect future marketing. Finally, approvals may be withdrawn ifcompliance with regulatory standards is not maintained or if problems occurfollowing initial marketing. The restriction, suspension, or revocation ofregulatory approvals or any other failure to comply with regulatoryrequirements could have a material adverse effect on our business, financialcondition, and results of operations.

Failure to comply with theapplicable regulatory requirements can result in, among other things, civilpenalties, suspensions of regulatory approvals, import and export problems,product recalls, operating restrictions, and criminal prosecution. In addition,the marketing and manufacturing of pharmaceutical products are subject tocontinuing FDA and other regulatory review, and later discovery of previouslyunknown problems with a drug product, manufacturer or facility may result inthe FDA and/or other regulatory agencies requiring further clinical research orrestrictions on the product or the manufacturer, including withdrawal of thedrug product from the market. The restriction, suspension, or revocation of 

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regulatoryapprovals or any other failure to comply with regulatory requirements couldhave a material adverse effect on our business, financial condition, andresults of operations.

We currently obtain thenecessary raw materials for our drug product candidates, as well as certainservices, such as testing, from third parties. We currently contract withsuppliers and service providers that are required to comply with strictstandards established by us. Certain suppliers and service providers arerequired to follow good laboratory and clinical practices and cGMP requirementsand are subject to routine unannounced periodic inspections by the FDA and bycertain state and foreign regulatory agencies for compliance with cGMPrequirements and other applicable regulations. There can be no assurance thatthe FDA and other regulatory agencies will find the manufacturing process orfacilities or other operations of our suppliers and other service providers tobe in compliance with cGMP requirements and other regulations.

While to the best of ourknowledge, none of our suppliers or service providers have been found to be outof compliance with cGMP with respect to the goods or services they provide tous, failure of any third party suppliers or service providers to maintainsatisfactory compliance with cGMP could have a material adverse effect on ourability to develop, market and distribute our drug product candidates in thefuture and, in the most serious cases, could result in the issuance of warningletters, seizure or recall of drug products, civil penalties or closure of suchmanufacturing facilities until such cGMP compliance is achieved.

**We do not have sales, marketing, or distributionexperience, which means we must either enter into agreements with third partiesto market or co-promote our drug product candidates or develop marketingexpertise ourselves.**

We have no experience insales, marketing, or distribution. To date, our focus has been on research anddevelopment, and we currently do not have internal sales, marketing, ordistribution resources. If we receive the required regulatory approvals, wecould elect to market and sell our drug product candidates throughdistribution, co-marketing, co-promotion, or licensing arrangements with thirdparties, as we have elected to do with our non-drug NeoPhectin products, whichare being sold through independent distributors. To the extent that we enterinto arrangements with third parties for the marketing and sale of our drugproduct candidates, any revenues we receive will depend primarily on theefforts of these third parties, and those revenues may be lower than if wemarketed our drug products directly. In addition, we may not be successful inentering into sales and distribution relationships with third parties and, evenif we are successful, we will not control the amount and timing of marketingresources such third parties devote to our drug product candidates.

On theother hand, if we elect to market our drug product candidates directly,significant additional expenditures and management resources will be required todevelop an internal marketing or sales force. We have no experience inestablishing or maintaining an effective sales or marketing effort. If wedecide to perform sales and marketing activities ourselves, we could face anumber of additional risks, including, but not limited to:

·       theinability to attract and retain a marketing or sales force with relevantpharmaceutical experience;

·       thecosts of establishing a marketing or sales force may not be recoverable ifproduct revenues are lower than expected; and

·       therecould be delays in product launch due to the time needed to develop and trainan effective marketing or sales force.

There can be no assurancethat we would be able to establish an effective marketing or sales force shouldwe choose to do so. The inability to successfully employ qualified marketingand sales personnel or 

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todevelop other sales and marketing capabilities through third parties would beharmful to our overall business operations.

**Our lack of operating experience may cause us difficultyin managing our growth.**

We have no experience inselling pharmaceutical or other products or in manufacturing or procuring drugproducts in commercial quantities in compliance with FDA rules, and we haveonly limited experience in negotiating, establishing and maintainingcollaborative relationships and conducting later stage phases of the regulatoryapproval process. Our ability to manage our growth, if any, will require us toimprove and expand our management and our operational and financial systems andcontrols. If our management is unable to manage growth effectively, ourbusiness and financial condition would be adversely affected. In addition, ifrapid growth occurs, it may strain our operational, managerial and financialresources, which are limited.

**Our inability to adequately protect our proprietarytechnologies could harm our competitive position and have a material adverseeffect on our business.**

The success of ourbusiness depends, in part, on our ability to obtain patents and maintain adequateprotection of our intellectual property for our proprietary technology andproducts in the United States and other countries. The laws of some foreigncountries do not protect proprietary rights to the same extent as the laws ofthe United States, and many companies have encountered significant problems inprotecting their proprietary rights in these foreign countries. These problemscan be caused, for example, by a lack of rules and processes allowing formeaningful defense of intellectual property rights. If we do not adequatelyprotect our intellectual property, competitors may be able to use ourtechnologies and impair our competitive position, with the result that ourbusiness and operating results could be harmed.

The patent positions ofpharmaceutical companies, including our patent positions, are often uncertainand involve complex legal and factual questions. We will be able to protect ourproprietary rights from unauthorized use by third parties only to the extentthat our proprietary technologies are covered by valid and enforceable patentsor are effectively maintained as trade secrets. We apply for patents coveringour technologies and drug product candidates, as we deem appropriate.Currently, we either own or have obtained licenses to more than 50 UnitedStates and foreign patents or patent applications relating to our technology,compounds, and drug product candidates. However, we may not obtain patents onall inventions for which we seek patents, and any patents we obtain may bechallenged and may be narrowed in scope or extinguished as a result of suchchallenges. Our existing patents and any future patents we obtain may not besufficiently broad to prevent others from practicing our technologies or fromdeveloping competing products. Others may independently develop similar oralternative technologies or design around our patented technologies or drugproduct candidates. These companies would then be able to develop, manufacture,and sell products, which compete directly with our drug product candidates. Inthat case, our revenues and operating results would decline.

We rely upon trade secretprotection for certain of our confidential information, including certain ofour trade secrets, know-how, technology advances and processes. While we havetaken measures to protect our confidential information, and to date have notexperienced any difficulties in maintaining the confidentiality of ourinformation, these measures may not provide adequate protection for our tradesecrets, know-how or other confidential information in the future. We seek toprotect our confidential information by entering into confidentialityagreements with employees, collaborators, and consultants. Nevertheless,employees, collaborators, or consultants may still disclose or misuse ourconfidential information, and we may not be able to meaningfully protect ourtrade secrets. In addition, others may independently develop substantiallyequivalent information or techniques or otherwise gain access to our tradesecrets. Disclosure or misuse of our confidential information would harm ourcompetitive position and could cause our revenues and operating results todecline.

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**We may be sued for infringing on the intellectualproperty rights of others.**

Our commercial successalso depends in part on ensuring that we do not infringe the patents orproprietary rights of third parties. The biotechnology industry has produced aproliferation of patents, and it is not always clear to industry participants,including us, which patents cover various types of products. The coverage ofpatents is subject to interpretation by the courts, and the interpretation isnot always uniform. While we have not been sued for infringing the intellectualproperty rights of others, there can be no assurance that the drug productcandidates that we have under development do not or will not infringe on thepatent or proprietary rights of others. Third parties may assert that we areemploying their proprietary technology without authorization. We know ofpatents issued to third parties relating to antisense and oligonucleotidetechnology, including patents about which such third parties have communicatedwith us suggesting possible infringement, but the claims of which we believe wedo not infringe or are invalid. Moreover, United States patent applicationsfiled in recent years are confidential for 18 months, while olderapplications are not published until the patent issues. As a result, there maybe patents of which we are unaware, and avoiding patent infringement may bedifficult. Patent holders sometimes send communications to a number ofcompanies in related fields, suggesting possible infringement, and we, like anumber of biotechnology companies, have received this type of communication. Ifwe are sued for patent infringement, we would need to demonstrate that weeither do not infringe the patent claims of the relevant patent and/or that thepatent claims are invalid, which we may not be able to do. Proving invalidity,in particular, is difficult since it requires a showing of clear and convincingevidence to overcome the presumption of validity enjoyed by issued patents.Parties making claims against us may be able to obtain injunctive or otherequitable relief that could effectively block our ability to further develop,commercialize and sell products, and such claims could result in the award ofsubstantial damages against us. In the event of a successful claim ofinfringement against us, we may be required to pay damages and obtain one ormore licenses from third parties. We may not be able to obtain these licensesat a reasonable cost, if at all. In that event, we could encounter delays inproduct introductions while we attempt to develop alternative methods orproducts or be required to cease commercializing affected products and ouroperating results would be harmed.

In the future, others mayfile patent applications covering technologies that we may wish to utilize withour proprietary technologies, or products that are similar to productsdeveloped with the use of our technologies. If these patent applications resultin issued patents and we wish to use the claimed technology, we would need toobtain a license from the third party, and this would increase our costs ofoperations and harm our operating results.

**We depend on intellectual property rights licensedfrom third parties. If we fail to meet our obligations under licenseagreements, we may lose our rights to key technologies on which our businessdepends.**

Our business depends onour technology, which is based in part on patents licensed from third parties.Those third-party license agreements impose obligations on us, such aspayment obligations and obligations to diligently pursue development ofcommercial products under the licensed patents. Our license agreement regardingcintredekin besudotox requires us to engage in clinical trials of the compoundin patients with renal cell carcinoma. Previous trials demonstrated thatcintredekin besudotox is toxic in those patients. However, we have insteadfocused on developing this compound for treating patients with glioblastomamultiforme. We have informed the governmental agency from which we licensedthese patents of this change, and we received no objections to it.

Because of our dependenceon intellectual property rights licensed to us by third parties, any adversedevelopment in our relationship with these licensors, including a disputeregarding our rights under the agreements or the grant of rights by ourlicensors to others, could materially and adversely affect our right tocommercialize the products we are developing or preclude others fromcommercializing these products. Currently, we are involved in a dispute withthe NIH regarding whether or not  additional monies are owed 

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by usunder a previously terminated license. A failure to adequately resolve thematter could affect our ability to license technology from the NIH in thefuture.

If a licensor believesthat we have failed to meet our obligations under a license agreement, thelicensor could seek to limit or terminate our license rights, which could leadto costly and time-consuming litigation and, potentially, a loss of thelicensed rights. During the period of any such litigation our ability to carryout the development and commercialization of potential products could besignificantly and negatively affected. If our license rights were restricted orultimately lost, our ability to continue our business based on the affectedtechnology platform would be severely adversely affected.

We depend in large part onour licensors to maintain the patent rights licensed to us. If our licensors donot have adequate rights to the patents we license, or do not adequatelymaintain these rights, our competitive position could be impaired. For example,we understand that patent rights exclusively licensed to us by the governmentrelating to cintredekin besudotox were assigned by our licensor to one of theinventors. We have been assured by the government that we have the exclusiverights to these patents, but we are unable to independently verify this. Ifthird parties acquire these rights from the inventor or otherwise, we might beunable to preclude them from commercializing a drug based on cintredekinbesudotox.

The government’s licenseto us of patents related to cintredekin besudotox retains to the governmentvarious rights with respect to these patents, including the right to practicethe related technology itself, grant foreign governments or internationalorganizations the right to practice the related technology or grant to anyperson a research license under the patents.

**We may in the future be a party to patent litigation,which could be expensive and divert our management’s attention.**

The field of biotechnologyhas been characterized by extensive litigation regarding patents and otherintellectual property rights, and companies in the industry have usedintellectual property litigation to gain a competitive advantage. We may becomea party to patent infringement claims and litigation or interference proceedingsdeclared by the US Patent and Trademark Office to determine the priority ofinventions. The defense and prosecution of these matters are both costly andtime consuming. We may need to commence proceedings against others to enforceour patents, to protect our trade secrets or know-how or to determine theenforceability, scope and validity of the proprietary rights of others. Theseproceedings could result in substantial expense to us and significant diversionof efforts by our technical and management personnel.

**If we lose additional key management and scientificpersonnel or are unable to attract and retain the talent required for ourbusiness, our business could be harmed.**

We are highly dependent onthe principal members of our management and scientific staff, including ourChief Scientific Officer, Dr. Imran Ahmad, our Chief Medical Officer, Dr. JeffreyW. Sherman, our Chief Financial Officer, Mr. Lawrence A. Kenyon, and ourChief Regulatory Officer, Dr. Steven B. Binion. On March 8, 2005,Mr. Gregory P. Young resigned as President and CEO and one of the independentmembers of our Board of Directors, Mr. Ronald G. Eidell, was appointed toserve as interim CEO and President while the Board completes a search for apermanent replacement for Mr. Young. The principal members of ourmanagement and scientific staff accepted employment on the basis of writtenoffers which set forth the salary and benefits to be provided, including, butnot limited to, salary continuation payments upon termination of employment. OnlyMr. Eidell has an employment contract with us. We do not have key maninsurance on any of these individuals. If we were to lose the services of Dr. Ahmad,Dr. Sherman, Mr. Kenyon, or Dr. Binion, and were unable toreplace them, or if our ongoing efforts to find a replacement forMr. Young take longer than the six months currently anticipated, ourproduct development and the achievement of our strategic objectives could bedelayed. In addition, our success will 

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dependon our ability to attract and retain qualified scientific, technical, andmanagerial personnel. While we have not experienced unusual difficulties todate in recruiting and retaining personnel, there is intense competition forqualified staff and no assurance can be given that we will be able to retainexisting personnel or attract and retain qualified staff in the future.

**The demand for our drug product candidates, if any,may be adversely affected by health care reform and potential limitations onthird-party reimbursement.**

In recent years, therehave been numerous proposals to change the health care system in the US. Someof these proposals have included measures that would limit or eliminatepayments for medical procedures and treatments or subject the pricing ofpharmaceutical products to government control. We cannot predict the effectthat health care reforms may have on our business, and it is possible that suchreforms will hurt our business. In addition, in both the US and elsewhere,sales of prescription pharmaceutical products are dependent in part on theavailability of reimbursement to the consumer from third party payors, such asgovernment and private insurance plans. Third party payors are increasinglychallenging the prices charged for medical products and services with respectto new drug products in particular. If we succeed in bringing any of our drugproduct candidates to the market, we cannot be certain that our products willbe considered cost effective or that reimbursement to the consumer will beavailable or will be sufficient to allow us or our collaborators to sell ourproducts on a competitive basis.

Inaddition, many health maintenance organizations and other third party payorsuse formularies, or lists of drugs for which coverage is provided under ahealth care benefit plan, to control the costs of prescription drugs. Eachpayor that maintains a drug formulary makes its own determination as to whethera new drug will be added to the formulary and whether particular drugs in atherapeutic class will have preferred status over other drugs in the sameclass. This determination often involves an assessment of the clinicalappropriateness of the drug and sometimes the cost of the drug in comparison toalternative products. We cannot be assured that:

·       ourfuture drug products, if any, will be added to payors’ formularies;

·       suchfuture drug products will have preferred status to alternative therapies; or

·       theformulary decisions will be conducted in a timely manner.

We may also decide toenter into discount or formulary fee arrangements with payors, which couldresult in us receiving lower or discounted prices for drug products we maydevelop in the future.

**Physicians,patients, payors, or the medical community in general may be unwilling toaccept, utilize, or recommend any of our drug products, and the failure toachieve market acceptance will harm our business.**

Even if approvedfor marketing, our drug products may not achieve market acceptance. The degreeof market acceptance of our drug products will depend upon a number of factors,including:

·       theestablishment and demonstration in the medical community of the safety andclinical efficacy of our drug products and their potential advantages overexisting therapeutic products, including non-liposomal forms of the activeagents included in our drug products; and

·       pricing and reimbursementpolicies of government and third party payors such as insurance companies,health maintenance organizations and other plan administrators.

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**Changes inaccounting standards regarding stock option plans could limit the desirabilityof granting stock options, which could harm our ability to attract and retainemployees, and could also negatively impact our results of operations.**

The Financial AccountingStandards Board has issued a requirement, beginning in mid-2005, for allcompanies to treat the fair value of stock options granted to employees as anexpense. Previously, we were generally not required to record compensationexpense in connection with stock option grants to employees of the Company. Nowthat we will be required to expense the fair value of stock option grants, itcould reduce the attractiveness of granting stock options because of theadditional expense associated with these grants, which would negatively impactour results of operations. For example, had we been required to expense stockoption grants by applying the measurement provisions of Statement of FinancialAccounting Standards No. 123, “Accounting for Stock-Based Compensation,”our recorded net loss of $57,608,709 would have been increased by $13,736,374to a net loss of $71,345,083 for the year ended December 31, 2004.Nevertheless, stock options are an important employee recruitment and retentiontool, and we may not be able to attract and retain key personnel if we reducethe scope of our employee stock option program. Accordingly, our future resultsof operations will be negatively impacted if we continue to use stock optionsas an employee recruitment and retention tool.

**Our investmentscould lose market value and consequently harm our ability to fund continuingoperations.**

The primary objective of our investment activities isto preserve principal while at the same time maximizing yields withoutsignificantly increasing risk. To achieve this objective, we maintain ourportfolio of cash and cash equivalents in a variety of securities, includinggovernment and corporate obligations and money market funds. The market valuesof these investments may fluctuate due to market conditions and otherconditions over which we have no control. Fluctuations in the market price andvaluations of these securities may require us to record losses due to animpairment in the value of the securities underlying our investment. This couldresult in future charges on our earnings. All of our investment securities aredenominated in US dollars.

Investments in bothfixed-rate and floating-rate interest earning instruments carry varying degreesof interest rate risk. Fixed-rate securities may have their fair market valueadversely impacted due to a rise in interest rates. In general, securities withlonger maturities are subject to greater interest rate risk than those withshorter maturities. While floating-rate securities generally are subject to lessinterest rate risk than fixed-rate securities, floating-rate securities mayproduce less income than expected if interest rates decrease. Due in part tothese factors, our investment income may fall short of expectations or we maysuffer losses in principal if securities are sold that have declined in marketvalue due to changes in interest rates.

**We handle hazardousmaterials and must comply with environmental laws and regulations, which can beexpensive and restrict how we do business. We could also be liable for damages,penalties, or other forms of censure if we are involved in a hazardous wastespill or other accident.**

Our research anddevelopment processes involve the controlled storage, use, and disposal ofhazardous materials and biological hazardous materials. We are subject tofederal, state, and local laws and regulations governing the use, manufacture,storage, handling, and disposal of hazardous materials and certain wasteproducts. Although we believe that our safety procedures for handling anddisposing of these hazardous materials comply with the standards prescribed bylaw and regulation, the risk of accidental contamination or injury fromhazardous materials cannot be completely eliminated. In the event of anaccident, even by a third party, we could be held liable for any damages thatresult, and such liability could exceed our current general liability insurancecoverage of $1,000,000 and our financial resources. In 

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thefuture, we may not be able to maintain insurance on acceptable terms, or atall. We could also be required to incur significant costs to comply withcurrent or future environmental laws and regulations.

**We may have productliability exposure, and insurance against such claims may not be available tous at reasonable rates or at all.**

While we maintaininsurance to cover the use of our drug product candidates in clinical trials,we currently do not have any product liability insurance for marketed humantherapeutic products. Although we plan to obtain product liability insurancewhen and if our drug product candidates become commercially available, wecannot assure you that we will be able to obtain or maintain this insurance onacceptable terms or that any insurance we obtain will provide us with adequatecoverage against potential liabilities. Claims or losses in excess of anyliability insurance coverage we obtain would have a material adverse effect onour business.

**Anti-takeoverprovisions could make a third party acquisition of us or the removal of ourboard of directors or management more difficult.**

In June 2003, weadopted a stockholder rights plan that provided for the issuance of rights topurchase shares of Series A Participating Preferred Stock (“Series APreferred”) of the Company. Under the plan, we distributed one preferred sharepurchase right for each outstanding share of common stock. Each purchase rightentitles the holder to purchase from the Company one one-thousandth (1/1000th)of a share of Series A Preferred at a price of $112.00 per share, subjectto adjustment. The rights become exercisable, with certain exceptions, tenbusiness days after any party, without prior approval of our Board ofDirectors, acquires, or announces an offer to acquire, beneficial ownership of15% or more of our common stock. An exception to this policy exists in the caseof our largest shareholder, Dr. John N. Kapoor, who is permitted toacquire up to 30% of our common stock without triggering the rights issuance. Inthe event that any party acquires 15% or more of our common stock (other than Dr. Kapoorfor whom the threshold is 30%), we are acquired in a merger or other businesscombination, or 50% or more of our assets are sold after the time that therights become exercisable, the rights provide that each right holder will receive,upon exercise, shares of the common stock of the surviving or acquiringcompany, as applicable, having a market value of twice the exercise price ofthe right. The stockholder rights plan may discourage or prevent certain typesof transactions involving an actual or potential change in control, whichtransactions may be beneficial to our shareholders, by causing substantialdilution to a party that attempts to acquire us on terms not approved by ourBoard of Directors. In addition, Section 203 and other provisions of theDelaware General Corporation Law as well as provisions of our charter andby-laws could make a takeover of us or the removal of the members of the boardof directors or management more difficult.

**The issuance ofpreferred stock could adversely affect the holders of our common stock.**

Our board of directors hasthe authority, without further stockholder approval, to issue from time to timeshares of preferred stock in one or more designated series or classes.Depending upon the rights and preferences which may be granted to any class ofpreferred shares which we may elect to issue, issuance of preferred stock couldadversely affect the voting power of holders of our common stock and reduce thelikelihood that our common stockholders will receive dividend payments andpayments upon liquidation. The issuance of preferred stock could also decreasethe market price of our common stock, or have terms and conditions that coulddiscourage a takeover or other transaction that might involve a premium pricefor our shares or that our stockholders might believe to be in their bestinterests.

**If there aresubstantial sales of common stock, the market price of our common stock coulddecline.**

Sales of substantialnumbers of shares of common stock could cause a decline in the market price ofour stock. Some of our stockholders are entitled to require us to registertheir shares of common stock for 

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offer orsale to the public. We have filed Form S-8 registration statementsregistering shares issuable pursuant to our equity compensation plans. Anysales by existing stockholders or holders of options may have an adverse effecton our ability to raise capital and may adversely affect the market price ofour common stock.

**ITEM 2**.                PROPERTIES

The Company’s administrativeoffices and clinical research and development personnel are located inapproximately 15,700 square feet of leased space in Lake Forest, Illinois.Additionally, the Company has leased a 35,500 square foot pre-clinical researchand development facility in Waukegan, Illinois. Both locations are wellmaintained and are sufficient for the current level of activity.

**ITEM 3**.                LEGALPROCEEDINGS

On April 19, 2002, the Company filed a Demand forArbitration with the American Arbitration Association in accordance with theterms of its license agreement dated February 19, 1999 (the “LicenseAgreement”) with Pharmacia Corporation, Pharmacia and Upjohn, Inc. andPharmacia and Upjohn Company (collectively, “Pharmacia”), for the purpose ofresolving a dispute with Pharmacia concerning delays in the developmentprograms for LEP (Liposome Encapsulated Paclitaxel) and LED (LiposomeEncapsulated Doxorubicin), which were being conducted by Pharmacia. The Companycontended that Pharmacia failed in its duty under the License Agreement to usereasonable efforts to develop LEP and LED and that such failure constituted abreach of the License Agreement. The Company further contended that Pharmaciabreached its duty to consult with NeoPharm on the progress of the drugdevelopment program and thereby impaired NeoPharm’s ability to monitor thedevelopment of these compounds. The Company sought all damages to which it wasentitled, including but not limited to, loss of co-promotion and royaltyrevenues that would have been received if LEP and LED had not been delayed, andmilestone payments that would have been received if the programs had beenproperly conducted by Pharmacia. On May 16, 2002, Pharmacia responded bydenying the Company’s allegations, asserting various counterclaims and seekingrestitution of monies paid, reimbursement of out-of-pocket expenses andsubstantial punitive damages. On April 30, 2004, the Company was advisedthat its claims against Pharmacia (now Pfizer) and Pharmacia’s claims againstthe Company were denied by arbitrators of the American Arbitration Association.In September 2004, the Company entered into a Termination Agreement withPfizer returning all development rights for LEP and LED to NeoPharm.

The Company has been named in several putative classaction lawsuits (the “Class Action Suits”) each of which alleges variousviolations of the federal securities laws in connection with the Company’spublic statements during the period from September 25, 2000 through April 19,2002 as they relate to the Company’s LEP drug product candidate. The originallawsuits also named as individual defendants John N. Kapoor, the formerChairman of the Company, and James M. Hussey, the Company’s former Presidentand CEO, and Dr. Aquilur Rahman, a former director and executive officerof the Company. The first of these Class Action Suits was filed on April 26,2002 and all of the Class Action Suits have been filed in the UnitedStates District Court for the Northern District of Illinois, Eastern District.On September 16, 2002, a consolidated amended complaint was filed againstNeoPharm in this matter. The amended complaint shortened the class period to October 31,2001 through April 19, 2002, removed Dr. Rahman as a defendant, andadded Dr. Imran Ahmad, the Company’s current Chief Scientific Officer andExecutive Vice President of Research and Development, as a defendant. TheCompany intends to vigorously defend each and every claim in the Class ActionSuits and, on November 4, 2002, moved to have the complaint dismissed. TheCompany’s motion to dismiss was granted in part and denied in part in February 2003.Dr. Kapoor was dismissed from the lawsuit at that time. In November 2004,the plaintiffs filed a motion to amend and a motion for summary adjudication. Themotion to amend seeks to again make Dr. Kapoor a defendant, and reallegesthat certain pre-class period statements are actionable. The 

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Company intends to opposeboth motions. No trial date has been set and discovery is ongoing. Managementis unable to estimate a range of possible losses, if any. In addition, theCompany maintains insurance coverage to mitigate the financial impact of anypotential loss.

On March 26, 2004,the Company received a letter from the Securities and Exchange Commission statingthat the SEC is conducting a formal investigation of the Company. The SECstated in its letter that it had made no determination of any violation of lawby the Company or any individual at this time. Previously, this matter had beenthe subject of an informal SEC inquiry. The Company continues to fullycooperate with the SEC and intends to do so in order to bring this ongoinginquiry to a conclusion as promptly as possible. The Company believes theinvestigation is an outgrowth of the arbitration claim filed by the Company againstPharmacia (now Pfizer) regarding the development of its LEP and LED drugproduct candidates and the Class Action Suits which have been filed against theCompany relating to its public statements regarding the development of LEP. TheCompany cannot predict with certainty the direction the investigation will takeor its ultimate outcome, and therefore is unable to determine whether theresults of the investigation will have a material adverse impact on the Company’sresults of operations and financial position.

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

On September 2, 2004,John N. Kapoor, Ph.D., a director and 21.7% stockholder of the Company, filed apreliminary consent solicitation statement with the SEC, pursuant to which Dr. Kapoor,among other requested actions, sought to remove, without cause, the Company’sother non-employee directors and replace them with nominees selected by Dr. Kapoor.On September 18, 2004, in accordance with the Company’s by-laws andDelaware law, the Board set September 28, 2004 as the record date for thedetermination of stockholders entitled to execute, withhold, or revoke consentsrelating to Dr. Kapoor’s proposals. On November 11, 2004, the Companyand Dr. Kapoor entered into a Settlement Agreement ending the consentsolicitation. Details of the Settlement Agreement were furnished by the Companyon a Report on Form 8-K filed on November 17, 2004.

**EXECUTIVE OFFICERSOF NEOPHARM**

*Erick E. Hanson, 58,* joined theCompany as a Director in 1997. Since June 2004, Mr. Hanson has servedas Chairman of the Board. Since 1998, Mr. Hanson has served as thePresident of Hanson and Associates, a consulting firm working with venture capitalcompanies. Mr. Hanson also serves as Senior Vice President of PriorityHealthCare Corporation, a publicly-traded pharmaceutical company, and asExecutive Vice President of Priority’s recently-acquired home healthcaresubsidiary Integrity Healthcare, where he served as director until July 2004.From 1995 to 1998, Mr. Hanson served as President and CEO of Option Care, Inc.,a publicly-traded provider of home health care services. Prior to joiningOption Care, Mr. Hanson held a variety of executive positions withCaremark, Inc., including Vice President Sales and Marketing. Mr. Hansonserved as President and Chief Operating Officer of Clinical Partners Inc.in Boston, MA from 1989 to 1991. Prior to 1989, Mr. Hanson was employedfor over 20 years at Anthem, Inc., most recently as Senior VicePresident.

*Gregory P. Young, 51,*joined theCompany in July 2004 as its President and Chief Executive Officer. Priorto joining the Company, Mr. Young was with Baxter International since1985, most recently serving as Corporate Vice President of Baxter HealthcareCorporation, and as President of Baxter’s Transfusion Therapies business. Mr. Youngreceived a bachelor’s degree in microbiology from Northern Illinois University,a bachelor’s degree in pharmacy from the University of Illinois and master’sdegree in business administration from the York College of Pennsylvania. He isa member of the board of directors of The Lake Forest Graduate School ofManagement, a member of the University of Illinois at Chicago College ofPharmacy Advisory Committee, a trustee of the National Blood Foundation and amember of the American Pharmaceutical Association. Mr. Young resigned asPresident and CEO on March 8, 2005, and 

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Mr. Ronald G. Eidell, anindependent member of the Board of Directors, was elected to serve as interimPresident and CEO while the Company conducts a search for a permanentreplacement.

*Ronald G. Eidell, 61,* was electedinterim President and CEO on March 8, 2005, where he has been a member ofthe Board of Directors since November 2004, and was an independent directoruntil his appointment as interim CEO. Mr. Eidell has been a partner withTatum Partners, LLP, a national professional services firm since October 2004.He has been the CFO with three public companies—NovaMed, Inc., 1998-2001,Metromail Corporation, 1996-1998, and Advanced Systems, Inc., 1987, and oneprivate company—Esoterix, Inc., 2001-2003. His professional experience includes10 years in public accounting with Arthur Andersen and 13 years with R. R. Donnelleywhere he served as General Auditor, Corporate Controller and Senior VicePresident of Finance and Treasurer. Prior to joining Tatum Partners,Mr. Eidell was Executive Vice President and CFO of Esoterix, Inc., from December2001 to December 2003. Mr. Eidell was retained as a consultant to Esoterixfrom February 2004 to June 2004. Mr. Eidell received his MBA from theUniversity of Chicago, and has a Bachelors of Science in BusinessAdministration from Drexel University, Philadelphia, Pennsylvania, where healso serves on the Dean’s Advisory Counsel to the University’s LeBow College ofBusiness.

*Dr Jeffrey W. Sherman, M.D., F.A.C.P., 50,*joined us in September 2000 as Executive Vice President and Chief MedicalOfficer. Previously, Dr. Sherman was employed by Searle/Pharmacia where,since joining that company in 1992, he held a variety of positions, mostrecently serving as Executive Director, Clinical Research, with his focus beingon Oncology Clinical Research and Head of Oncology Global Medical Operations inMedical Marketing. Dr. Sherman received his medical degree from TheChicago Medical School and is a member of numerous professional societies and aDiplomate of the National Board of Medical Examiners and the American Board ofInternal Medicine.

*Imran Ahmad. Ph.D., 40*, ExecutiveVice President and Chief Scientific Officer, joined NeoPharm in July 2000.Prior to joining NeoPharm, Dr. Ahmad held a variety of positions at theLiposome Company from 1993 until 2000, most recently serving as AssistantDirector of Research and Development where his responsibilities includeddirecting the pre-clinical research program. Dr. Ahmad conducted hispost-doctoral work at the University of Alberta, Canada.

*Lawrence A. Kenyon, CPA, 39,*ChiefFinancial Officer and Corporate Secretary, joined the Company in September 2000.From October 1999 until September 2000 Mr. Kenyon was SeniorVice President of the Gabelli Mathers Fund, a regulated investment company.Prior to that, Mr. Kenyon held a variety of positions with Mathers andCompany, Inc. an investment management firm, most recently serving as theChief Financial Officer for both Mathers and Company, Inc. and MathersFund, Inc. Mr. Kenyon is a Certified Public Accountant and receivedhis Bachelors of Business Administration degree in Accounting from theUniversity of Wisconsin—Whitewater in 1987.

*Steven B. Binion, Ph. D., 52,*VicePresident of Regulatory Affairs and Quality Assurance, joined the Company in December 2004.Previously, Dr. Binion spent over 10 years at Baxter International as VicePresident of Regulatory Affairs for the Transfusion Therapies Division. Priorto Baxter, Dr. Binion served as Director of Worldwide Regulatory Affairsfor the BOTOX program at Allergan Pharmaceuticals, Inc. Dr. Binionreceived a bachelor’s degree in microbiology from the University of Florida,and a master’s degree in business administration from the University of St.Thomas in Minnesota. Additionally, Dr. Binion holds a Ph.D. in immunologyfrom Kansas State University.

Officers are appointed to serve annually, subject tothe discretion of the Board of Directors, or until their successors areappointed. There are no family relationships between any of our directors orexecutive officers.

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**PART II**

**ITEM 5**.                MARKETFOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUERPURCHASES OF EQUITY SECURITIES

TheCompany’s common stock is listed on the Nasdaq National Market under the symbolNEOL. The following table provides the high and low sales prices as reported onthe exchange on which the Company’s stock was listed for the periods indicated.
| **2003**       | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $          | 10.426     |     | $          | 7.565   |       |
| Second Quarter |       | 17.280     |       | 9.870    |       |
| Third Quarter  |       | 18.710     |       | 13.000   |       |
| Fourth Quarter |       | 19.400     |       | 14.210   |       |
|                |            |            |            |          |            |         |            |  |  |

 
| **2004**       | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $          | 22.700     |     | $          | 15.710  |       |
| Second Quarter |       | 21.860     |       | 8.910    |       |
| Third Quarter  |       | 10.480     |       | 4.660    |       |
| Fourth Quarter |       | 13.590     |       | 6.260    |       |
|                |            |            |            |          |            |         |            |  |  |

 

As of March 1, 2005,there were 54 holders of record of the common stock. The calculation of holdersof record was based on reports received from Computershare Investor ServicesLLC, the Company’s transfer agent, based on information provided by the holdersof record, and maintained by the transfer agent.

**Dividends**

The Company has never paid a cash dividend on itscommon stock and has no present intention of paying cash dividends in theforeseeable future. Any determination in the future to pay cash dividends willdepend on the Company’s financial condition, capital requirements, results ofoperations, contractual limitations and other factors deemed relevant by theBoard of Directors.

On May 13, 2003, theCompany’s Board of Directors declared a 15% common stock dividend tostockholders of record on June 3, 2003, which was issued on June 10,2003. All share information and per share data for prior periods has beenrestated to reflect this stock dividend.

**Equity CompensationPlan Information**

Thefollowing table sets forth certain information as of December 31, 2004,with respect to compensation plans under which shares of NeoPharm, Inc.’scommon stock may be issued.

**EquityCompensation Plan Information**
| **Plan category**                                  | ** ** | ** ** | ** ** | **Number of securities  to be issued upon  exercise of  outstanding  options** | ** ** | **Weighted-average  exercise price of  outstanding options** | ** ** | **Number of securities  remaining available  for future issuance** | ** ** |
|---------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by stockholders     |       |       | 3,713,376  |                                                                                                         |       |                                                                        | $          | 13.17                                                                                       |       |   |   | 1,178,250 |   |   |
| Equity compensation plans not approved by  stockholders |       |       | —     |                                                                                                         |       |                                                                        | —     |                                                                                        |       |   | — |   |   |
| Total                                                   |       |       | 3,713,376  |                                                                                                         |       |                                                                        | $          | 13.17                                                                                       |       |   |   | 1,178,250 |   |   |

 

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Information on the Company’sequity compensation plan is contained in note 5 “Stock Options” of the Company’sfinancial statements included as part of this annual report on Form 10-K.

**ITEM 6**.                SELECTEDFINANCIAL DATA
| ** **                     | ** ** | **For the Years Ended December 31,** | ** **  |
|--------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                     | ** ** | **2004**                                                      | ** **  | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Statement of Operations  Data: |       |                                                          |        |   |   |   |   |   |   |   |   |
| Revenues                       |       | $                                                             | 156,780     |   | $ | — |   | $ | — |   | $ | — |   | $ | 3,000,000 |   |
| Loss from  operations          |       | (58,728,285                                                   | )           | (53,606,534 | ) | (38,834,775 | ) | (19,228,638 | ) | (3,832,338 | ) |
| Interest income                |       | 1,119,576                                                     |        | 815,435 |   | 2,343,036 |   | 5,796,552 |   | 3,322,163 |   |
| Net loss                       |       | $                                                             | (57,608,709 | ) | $ | (52,791,099 | ) | $ | (36,491,739 | ) | $ | (13,424,037 | ) | $ | (386,230 | ) |
| Basic net loss  per share      |       | $                                                             | (2.51       | ) | $ | (2.80 | ) | $ | (1.95 | ) | $ | (0.72 | ) | $ | (0.03 | ) |
| Diluted net loss  per share    |       | $                                                             | (2.51       | ) | $ | (2.80 | ) | $ | (1.95 | ) | $ | (0.72 | ) | $ | (0.03 | ) |

 
| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Balance Sheet Data:              |       |                  |       |   |   |   |   |   |   |   |   |
| Cash and  cash equivalents  |       | $                     | 63,106,655 |   | $ | 36,958,941 |   | $ | 87,591,975 |   | $ | 106,525,864 |   | $ | 139,777,330 |   |
| Working  capital(1)              |       | 55,335,552            |       | 36,256,650 |   | 87,664,717 |   | 120,305,964 |   | 139,841,734 |   |
| Total assets                     |       | 67,434,371            |       | 46,080,580 |   | 95,937,321 |   | 129,195,075 |   | 140,531,777 |   |
| Accumulated  deficit             |       | (189,300,028          | )          | (131,691,319 | ) | (78,900,220 | ) | (42,408,481 | ) | (2,092,799 | ) |
| Total stockholders’  equity |       | 58,230,275            |       | 40,017,355 |   | 91,908,994 |   | 127,343,550 |   | 140,092,078 |   |
|                                  |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)   Workingcapital is calculated as current assets minus current liabilities.

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**ITEM 7**.                MANAGEMENTSDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**Overview**

We are a biopharmaceutical company engaged in theresearch, development, and commercialization of drugs for the treatment ofvarious cancers. Our corporate strategy is to become a leader in the research,development, and commercialization of new and innovative anti-cancertreatments. We currently operate at two locations, and had 99 employees as of December 31,2004. Our corporate headquarters and clinical development team are located inLake Forest, Illinois and our research and development facility is in Waukegan,Illinois.

Since we began doing business in June 1990, wehave devoted our resources primarily to funding research and productdevelopment programs. To date, we have not received FDA approval of any of ourdrug product candidates. We expect to continue to incur losses for theforeseeable future as we continue our research and development activities,which include the sponsorship of human clinical trials for our drug productcandidates. Until we are able to consistently generate revenue through the saleof drug or non-drug products, we anticipate that we will continue to berequired to fund the development of our pre-clinical compounds and drugproduct candidates primarily by other means, including, but not limited to, licensingthe development rights to some of our drug product candidates to third parties,collaborating with third parties to develop formulations of their compoundsusing our technology, or selling stock in the Company.

During 2004, management’s efforts were devoted toraising additional capital, initiating and enrolling patients in the Phase IIIPRECISE clinical trial for our lead drug product candidate, cintredekinbesudotox**(IL13-PE38QQR), advancing our leadNeoLipid drug product candidates (LEP-ETU and LE-SN38) through Phase Iclinical development, initiating a Phase I clinical trial for our cationiccardiolipin based liposomal antisense oligonucleotide drug product candidate,LErafAON, engaging third parties in discussions for licensing of development rightsto some of our drug product candidates, responding to a consent solicitation byour former Chairman of the Board of Directors, completing our arbitrationdispute with Pharmacia (now Pfizer) in April 2004, and increasing sales ofour new cationic cardiolipin based transfection reagents, NeoPhectinTM  and NeoPhectin-ATTM.

Significant events occurring during 2004 included theresignation of the former President and Chief Executive Officer in June 2004,the announcement in June 2004 of Gregory P. Young as our new President andChief Executive Officer, and the completion of our arbitration case withPharmacia (now Pfizer). In April 2004, we learned that our claims againstPharmacia, and Pharmacia’s claims against us, were denied by arbitrators of theAmerican Arbitration Association. In September 2004, we entered into aTermination Agreement with Pfizer returning all development rights for LEP andLED to NeoPharm, and we are now free to further develop and/or license thesecompounds at our discretion. In March 2005, Mr. Young resigned asPresident and CEO.

The PRECISE trial, our Phase III clinical trial forcintredekin besudotox for the treatment of glioblastoma multiforme (GBM), beganin March 2004 with the enrollment of our first patient. The patientenrollment continues to accelerate as additional clinical study sites areactivated. As of January 31, 2005, 121 patients have been enrolled in thePRECISE trial. Our current plans continue to anticipate the completion ofenrollment (approximately 300 patients total) for PRECISE in 2005 and thesubmission of a Biologics License Application (BLA) with the FDA in late 2006seeking marketing approval of the drug. However, there can be no assurance thetrial will meet its endpoint or that the FDA will approve the BLA. Assumingthat we receive authorization to begin selling cintredekin besudotox, wecurrently anticipate the first sales of the product in 2007, at the earliest.During 2004, we incurred approximately $15.7 million in expenses related to thePRECISE trial associated with cintredekin besudotox. During 2004 we closedenrollment in our previous Phase I clinical trials for cintredekin besudotox. However,we did initiate a new 

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Phase I clinical trial ofcintredekin besudotox during the third quarter of 2004 for malignant gliomapatients at initial diagnosis.

During 2004, we continued to advance our Phase INeoLipidTM drug product candidates towards Phase II clinical trials. BothLE-SN38 and LEP-ETU completed a Phase I clinical trial in 2004. Currently, aPhase II clinical trial for LE-SN38 is expected to begin in 2005 for patientssuffering from colorectal cancer. LEP-ETU is currently in a clinical trial toassess whether the drug product candidate can be considered bioequivalent topaclitaxel, the active component of LEP-ETU. If so, we could be allowed to takeadvantage of a more expeditious path to submit an application for approval ofLEP-ETU. During 2005, we also anticipate completing a Phase I trial of ourLErafAON drug product candidate, depending on the number of dose levelsstudied.

It is difficult to predict with any certainty thetiming of and total estimated costs to complete development of drug productcandidates in early stage, or Phase I/II, clinical development, as well as theestimated date such drug product candidates would be available for sale, ifapproved by the FDA. A number of factors contribute to this uncertainty,including: side effects encountered in early stage clinical trials, ability toscale up manufacturing for commercial supply, and the fact that the size andscope of pivotal Phase III clinical trials are unknown until sufficient data isavailable to present a Phase III plan to the FDA for approval. In addition, ourdrug product candidates are required to be approved by the FDA after completingPhase III clinical trials before we can sell the drugs to generate revenue and,potentially, realize net cash inflows. Because our lead product candidate,cintredekin besudotox, has entered a Phase III clinical trial, we are ableto estimate that we will incur further direct expenses of approximately $18million to complete the Phase III PRECISE study. Additional Phase I and PhaseII expenses are also expected to be incurred for cintredekin besudotox as weare conducting other clinical trials to investigate the potential to usecintredekin besudotox in other forms and stages of malignant glioma, inaddition to recurrent glioblastoma multiforme.

Thetable below includes a summary of identified direct project costs incurred todate for our major research and development projects. Generally, identifiedproject costs include expenses incurred specifically for clinical trials andpre-clinical studies we conduct, and exclude expenses incurred for salariespaid to our professional staff, overhead expenses for our Lake Forest andWaukegan facilities and general laboratory supplies used in our research, whichare included with non-project specific.
| **Research Project**                | ** ** | ** ** | ** ** | **Total  Costs Incurred            2004          ** | ** ** | **Total  Costs Incurred            2003          ** | ** ** | **Total  Costs Incurred            2002          ** | ** ** | **Total Costs  Incurred Since  Beginning of Project** | ** ** |
|------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| Cintredekin  besudotox                   |       |       | $          | 19,912,321                                                                                                                                                   |       |                                                                                                                                                         |       | $                                                                                                                                                            | 12,434,953 |                                                                      |       |   | $ | 4,371,919 |   |   |   | $ | 38,970,607 |   |   |
| LE-SN38                                  |       |       | 1,866,183  |                                                                                                                                                         |       |                                                                                                                                                         | 1,718,069  |                                                                                                                                                         |       |                                                                      | 883,291    |   |   |   | 4,467,589 |   |   |
| LEP-ETU                                  |       |       | 3,085,018  |                                                                                                                                                         |       |                                                                                                                                                         | 855,629    |                                                                                                                                                         |       |                                                                      | 82,728     |   |   |   | 4,023,375 |   |   |
| LErafAON                                 |       |       | 1,196,529  |                                                                                                                                                         |       |                                                                                                                                                         | 808,333    |                                                                                                                                                         |       |                                                                      | 4,017,245  |   |   |   | 7,432,605 |   |   |
| Non-project  specific                    |       |       | 18,452,886 |                                                                                                                                                         |       |                                                                                                                                                         | 18,445,283 |                                                                                                                                                         |       |                                                                      | 19,622,510 |   |   |   | N/A |   |   |
| Total research and  development expenses |       |       | $          | 44,512,937                                                                                                                                                   |       |                                                                                                                                                         |       | $                                                                                                                                                            | 34,262,267 |                                                                      |       |   | $ | 28,977,693 |   |   |   | N/A |   |   |

 

We began selling our novel cationic cardiolipin basedtransfection reagents NeoPhectinTM and NeoPhectin-ATTM in 2004. NeoPhectinTM isour *in vitro*transfection reagent, andNeoPhectin-ATTM is our *in vivo*transfectionreagent for use in animals*.* Our currentlaboratory facilities provide us with the ability to produce commercialquantities of the material without reducing the level of our research anddevelopment activities. Accordingly, we do not expect to incur significantincremental costs to produce NeoPhectinTM products.

On September 2,2004, John N. Kapoor, a director and 21.7% stockholder of the Company, filed apreliminary consent solicitation statement with the SEC, pursuant to which Dr. Kapoor,among other 

37

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requestedactions, sought to remove, without cause, the Company’s other non-employee directorsand replace them with nominees selected by Dr. Kapoor. On November 12,2004, Dr. Kapoor and the Company entered into an agreement whereby Dr. Kapoorended his consent solicitation. Pursuant to the agreement:

·       Thesize of the NeoPharm Board was increased from six to eight directors;

·       Twoindependent non-employee NeoPharm directors resigned;

·       Fournew independent directors were appointed to fill the vacancies created by theincrease in the size of the Board and the resignations;

·       Theparties to the agreement and their affiliates and associates agreed to votetheir shares in favor of the Company’s eight directors at the 2005 AnnualMeeting of Stockholders; and

·       Dr. Kapoorwas reimbursed for $350,000 of out-of-pocket costs incurred in connection withthe solicitation.

In addition, the Company has amended its StockholderRights Plan (the “Plan”) to provide that Dr. Kapoor will not be deemed an “acquiringperson” under the Plan unless and until he becomes the beneficial owner of 30%or more of  NeoPharm’s outstanding commonstock, the level of ownership permitted by him under the Plan prior to theconsent solicitation.

In order to decrease expenses, we reduced ourworkforce by a total of 30 employees (approximately 23%) in November 2004,consisting of 26 employees from our research and development groups and 4employees from our selling, general and administrative group. Terminatedemployees were eligible to receive continued salary and insurance benefitsthrough December 31, 2004 (the termination date), 2004 earned bonuspayable in February 2005 (contingent on Board of Directors’ approval ofthe 2004 bonus pool, which was subsequently given), two months severance pay in2005, two months of Company paid medical insurance premiums paid in 2005, andoutplacement services. The reduction in workforce is expected to result inapproximately $3.8 million in annual payroll related savings. The total costsassociated with the reduction in workforce were approximately $1.1 million, allof which were expensed in 2004.

We successfully completed negotiations on twocollaborations in December 2004. The first collaboration is expected toresult in payments to us of $500,000 in 2005 when we provide a customizedNeoPhectin formulation of their proprietary compound to our partner, aprivately held biotechnology company. The collaboration allows us to negotiatea license agreement for any customized formulation using our NeoPhectintechnology that may be developed commercially. Additionally, we entered into anexclusive license agreement with Nippon Kayaku Co., Ltd. for the Japanesedevelopment rights for cintredekin besudotox. In addition to the $2 millionup-front licensing fee we received in January 2005, we are also entitledto receive future additional license fees, milestone payments and royalties. NipponKayaku is responsible for all development costs in Japan.

In addition to our ongoingefforts to enter into additional collaborations, we continue to monitor andanalyze our expenses in an effort to further reduce our net loss. We currentlyestimate that the 2005 net loss will be between $38 and $42 million, or $1.60to $1.80 per share. At that level, we expect that cash used in operations willbe between $36 and $40 million for 2005. This compares to our 2004 net loss ofapproximately $57.6 million, or $2.51 per share, and cash used in operations ofapproximately $52.2 million.

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**Results ofOperations**

***Years Ended December 31, 2004, 2003, and 2002***

The Company recorded revenue of $156,780 during 2004.The sole source of revenue was from sales of NeoPhectinTM and NeoPhectin-ATTM. Norevenue was recorded in 2003 or 2002.

Research and development expenses have increasedsteadily over the past three years due to the continued advancement of ourcompounds through the various stages of development. We incurred approximately$44.5 million in research and development expenses in 2004, as compared withapproximately $34.3 million in 2003, and approximately $29.0 million in 2002. In2004, research and development expenses increased by approximately $10.2million as compared to 2003. The increase in research and development expenseswas primarily related to increased expenses of approximately $7.5 millionfor the development of our lead drug product candidate, cintredekin besudotox,which began a Phase III clinical trial (PRECISE) in 2004. Total expensesincurred in 2004 related to PRECISE were approximately $15.7 million.Additionally, expenses for the development of our other clinical stage drugproduct candidates increased by approximately $2.8 million, as we continued tomove our Phase I drug product candidates towards Phase II clinical development.

In 2003, we incurred approximately $12.4 million inresearch and development expenses related to the development of our leadcompound, cintredekin besudotox, representing an increase of approximately $8.1 millionover expenses incurred in 2002, including approximately $4.4 million for thescale-up and production of the Phase III drug supply. Expenses for our otherclinical drug product candidate projects decreased by approximately $1.6million. In addition to the increase in expenses in 2003 related to the projectspecific costs listed above, material changes in 2003 non-project specificexpenses as compared with amounts incurred for these types of expenses in 2002include an increase in research and development headcount from 85 full timeemployees on December 31, 2002 to 95 full time employees on December 31,2003, and a reduction in the amount paid to Georgetown University for sponsoredresearch services of approximately $1.9 million as we focused our efforts onin-house research and development at our research and development facility inWaukegan, Illinois.

Expenses incurred for selling, general andadministrative, and related party expenses were approximately $13.2 million in2004, $19.3 million in 2003, and $9.9 million in 2002. For 2004, the reductionin selling, general and administrative expenses was directly related to theconclusion of our arbitration case against Pharmacia (now Pfizer) in April andthe decrease in arbitration related expenses of approximately $10.7 million from2003. This reduction was offset by an increase of approximately $4.6 millionin other selling, general and administrative expenses primarily related toincreased payroll related expenses of approximately $1.8 million from theexpansion of our information systems group and regulatory affairs group asrequired to better position us for commercialization of our drug productcandidates, expenses of approximately $1.1 million related to the resignationof our former CEO (of which approximately $700 thousand represents non-cashcompensation expense for stock options granted to James M. Hussey while he wasCEO that vest while he is a consultant to the Company), expenses ofapproximately $1.0 million to respond to and settle a consent solicitation in2004, and approximately $500 thousand in expenses directly related to ourSarbanes Oxley Act Section 404 (internal controls over financialreporting) compliance efforts.

The increase in 2003 selling, general andadministrative, and related party expenses was primarily related to ourarbitration case against Pharmacia. We incurred approximately$11.7 million in arbitration related expenses in 2003, representing anincrease of approximately $10.1 million over arbitration related expensesincurred in 2002. Excluding arbitration related expenses, 2003 general andadministrative expenses were approximately $2.2 million lower than 2002,due to a 2002 non-cash charge of approximately $2.2 million to fullyreserve our note receivable from Akorn, Inc.

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Approximately $1.1 million in employee terminationcosts were incurred in 2004 as a result of a reduction in workforce completedin November 2004. A total of 30 employees were terminated, and included 26employees in our research and development groups and 4 employees from our selling,general, and administrative group. No additional employee termination costs areexpected to be incurred for this reduction in workforce.

Interest income for 2004, 2003, and 2002 totaledapproximately $1.1 million, $0.8 million and $2.3 million, respectively.The increase in interest income in 2004 versus 2003 is directly related to anincrease in the cash available for investment due to the proceeds availablefrom our follow-on stock offering completed in January 2004. The reductionin interest income from 2002 to 2003 was primarily due to a reduction in theaverage cash available for investing in 2003 since we used our cash and shortterm investments to fund the development of our compounds and to pay expensesassociated with the arbitration case with Pfizer.

As a result of the aboveitems, net loss and basic and diluted loss per share for the three years ended December 31,2004, 2003, and 2002 were approximately $57,609,000, $52,791,000, and$36,492,000, respectively and $2.51, $2.80, and $1.95 per share, respectively.

***Liquidity and Capital Resources***

As of December 31, 2004, we had approximately$63.1 million in cash and cash equivalents, and no debt. All excess cash iscurrently invested in marketable securities with less than 90 days to maturity.We currently believe that our cash on hand at December 31, 2004 should beadequate to fund our operations for at least the next 21 months at current andprojected levels of development and general corporate activity. In January 2004,we received approximately $73.5 million net of underwriting fees and expenses,through the sale of common stock via a shelf registration. Approximately$70,000,000 remains available on the shelf registration for additional sales ofsecurities until early December 2005. In January 2005, we receivedapproximately $2.2 million for one time, nonrefundable collaboration andlicensing fees. These agreements allow for up to an additional $14.3 million infuture payments to us if certain milestones are achieved.

The primary use of cash over the next 12-24 monthswill be to fund our clinical and pre-clinical research and development efforts.The most significant expenses will be incurred in relation to the PRECISE trialfor our brain tumor drug product candidate, cintredekin besudotox. At thepresent time, we expect to spend approximately $18 million over the next 24months to complete the PRECISE trial. Additional expenses are also expected tobe incurred as we continue to move our Phase I and Phase II drug productcandidates towards, and potentially into, Phase II and Phase III clinicaltrials.

We may seek to satisfy our future funding requirementsthrough public or private offerings of securities, with collaborative or otherarrangements with corporate partners or from other sources including, but notlimited to, sales of NeoPhectinTM. Additional financing may not be availablewhen needed or on terms acceptable to us. If adequate financing is notavailable, we may be required to delay, scale back, or eliminate certain of ourresearch and development programs, relinquish rights to certain of ourtechnologies, cancer drugs or products, or license third parties tocommercialize products or technologies that we would otherwise seek to developourselves.

NeoPharm has no debt, no capital leases, no exposureto off-balance sheet arrangements, no special purpose entities, nor activitiesthat include non-exchange-traded contracts accounted for at fair value.

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Thefollowing table summarizes our estimated contractual obligations as of December 31,2004:
| ** **                                              | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                        | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More  than  5 years** | ** ** |
| Operating lease                                         |       | $                                         | 1,169,312  |   | $ | 550,732 |   | $ | 543,738 |   | $ | 74,842 |   | $ | 0 |   |
| Clinical trial  monitoring (CRO) agreements(1)          |       | 3,166,638                                 |       | 1,717,230 |   | 1,449,408 |   | 0 |   | 0 |   |
| License  agreements—milestone based payments(2)(3) |       | 2,525,000                                 |       | 475,000 |   | 600,000 |   | 350,000 |   | 1,100,000 |   |
| Total                                                   |       | $                                         | 6,860,950  |   | $ | 2,742,962 |   | $ | 2,593,146 |   | $ | 424,842 |   | $ | 1,100,000 |   |
|                                                         |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          These amounts include onlycontractual obligations for direct expenses for the PRECISE trial, exclusive ofclinical trial site costs for treating patients.

(2)          These amounts do notinclude potential sales-based royalty payments that may be required underthe various license agreements.

(3)          Milestonebased payment obligations are contingent upon successfully reaching objectivelydeterminable stages in the development of drug product candidates. The Companyhas estimated the period the payment may be due, if at all, based upon itsexpectations of the timeline for continued successful development of the drugproduct candidates.

**Recent AccountingPronouncements**

A description of recentaccounting pronouncements is included in Footnote 1 “Notes to ConsolidatedFinancial Statements” under the caption “Recent Accounting Pronouncements”.

**Critical AccountingPolicies**

In preparing the Company’sfinancial statements in conformity with U.S. generally accepted accountingprinciples, management must make a variety of decisions which impact thereported amounts and related disclosures. Such decisions include the selectionof the appropriate accounting principles to be applied, the assumptions onwhich to base accounting estimates, and the consistent application of thoseprinciples. Due to the type of industry in which the Company operates and thenature of its business, the following policies are those that managementbelieves are the most important to the portrayal of the Company’s financialcondition and results and that require management’s most difficult, subjectiveor complex judgments, often as a result of the need to make estimates about theeffect of matters that are inherently uncertain.

***Income Taxes***

In assessing therealizability of deferred tax assets, management considers whether it is morelikely than not that some portion or all of the deferred tax assets will not berealized. The ultimate realization of deferred tax assets is dependent upon thegeneration of future taxable income during the periods in which those temporarydifferences become deductible. Management considers the scheduled reversal ofdeferred tax liabilities, projected future taxable income, and tax planningstrategies in making this assessment. Significant judgments are required toestimate the generation of future taxable income and the timing of the reversalof deferred tax liabilities.

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***Contingencies***

To properly account forand provide disclosure of loss contingencies, management must apply judgment indetermining whether a loss contingency is: probable, reasonably possible, orremote. In instances management has determined that a loss contingency isprobable, it must make use of estimates to determine the amount of probableloss. Management must apply judgment in determining whether or not it can makea reasonable estimate. Management must also apply judgment in determiningwhether or not disclosure of loss contingencies that have been accrued shouldbe made for the consolidated financial statements not to be misleading.

***Stock-Based Compensation***

The Company applies theintrinsic value method of accounting prescribed by Accounting Principles Board(APB) Opinion No. 25, *Accounting for StockIssued to Employees,*and related interpretations including FASBInterpretation No. 44, *Accounting for CertainTransactions Involving Stock Compensation, an Interpretation of APB Opinion No. 25,*issued in March 2000, to account for its fixed-plan stockoptions. Under this method, compensation expense is measured on the date ofgrant if the current market price of the underlying stock exceeded the exerciseprice or when the number of shares and exercise price are known if both are notdeterminable at the date of grant. Compensation expense for fixed stock optionsis recognized ratably over the vesting period. SFAS No.123, *Accounting for Stock-Based Compensation,*establishedaccounting and disclosure requirements using a fair value method of accountingfor stock-based employee compensation plans. As allowed by SFAS No. 123,the Company has elected to continue to apply the intrinsic value method ofaccounting described above, and has adopted only the disclosure requirements ofSFAS No. 123. Significant judgments are required in determining anappropriate method for determining the fair value of stock-based compensation.The Company has elected to utilize the Black-Scholes option-pricing model tomake the fair value determination. Inputs into the option-pricing model aresubject to estimation that may significantly affect the determination of fairvalue.

***Revenue Recognition***

The Company follows the provisions as set forth bycurrent accounting rules, which primarily include Staff Accounting Bulletin(SAB) 104, *Revenue Recognition,*and Emerging IssuesTask Force (EITF) No. 00-21, *Accounting for RevenueArrangements with Multiple Deliverables.*Generally, revenue isrecognized when evidence of an arrangement exists, delivery has occurred orservices have been rendered, the price is fixed and determinable, andcollectibility is reasonably assured.

The Company provides for general rights of return ofproducts sold to its distributors. Appropriately determining revenuerecognition when the general right of return exists requires the use ofjudgment in estimating the level of returns. In certain circumstances,management may not be able to develop a reasonable estimate of the level ofreturns. Making such a determination requires the use of significant judgment.Management has determined that given the limited sales history of NeoPhectinTM,the Company is unable to develop a reasonable estimate of the level of returns.Accordingly, the Company is currently recognizing revenue for products shippedto its distributor upon the expiration of the right of return, which occursupon the earlier of the shipment by the distributor to an end user or,depending on the distributor, 60 to 180 days.

The Company has recentlyentered in collaboration and license agreements with third parties that containmultiple deliverables. Under the provisions of EITF 00-21, a determination mustbe made on each contract as to whether a deliverable constitutes a separateaccounting unit. The amount of revenue to be recognized is based on the fairvalue for each unit of accounting within the arrangement. Management judgmentis required to determine, based upon the facts and circumstances of eacharrangement, whether 

42

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or noteach deliverable has standalone value and whether or not there exists asufficient level of objective and reliable evidence of fair value of thedeliverables.

The Company has recentlyentered into collaboration and license agreements with third parties thatentitle it to collect non-refundable up-front payments. These payments arerecognized ratably over the term of the contractual arrangement or expectedperiod of performance, whichever is longer. Management judgment is required toestimate the period over which recognition of these payments occurs.

**ITEM 7A**.        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As of December 31,2004, we did not own any derivative instruments, but we were exposed to marketrisks, primarily changes in United States interest rates. As of December 31,2004, we held total cash and cash equivalents of $63,106,655. All cashequivalents have a maturity less than 90 days. Declines in interest rates overtime would reduce our interest income from our investments. Based upon our cashand cash equivalents as of December 31, 2004, a decrease in interest ratesof 1.0% would cause a corresponding decrease in our annual interest income ofapproximately $631,067.

**ITEM 8**.                FINANCIALSTATEMENTS AND SUPPLEMENTAL DATA

TheFinancial Statements and Supplementary Data are incorporated herein byreference to the Company’s Consolidated Financial Statements included asfollows:
|                                                          | ** ** | **Page** | ** ** |
|----------------------------------------------------------|------------|----------|------------|
| Report  of Independent Registered Public Accounting Firm |       | 51       |       |
| Consolidated  Balance Sheets                             |       | 52       |       |
| Consolidated  Statements of Operations                   |       | 53       |       |
| Consolidated  Statements of Stockholders’ Equity    |       | 54       |       |
| Consolidated  Statements of Cash Flows                   |       | 55       |       |
| Notes  to Consolidated Financial Statements              |       | 56       |       |

 

**ITEM 9**.                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

There were no changes inor disagreements with accountants on accounting or financial disclosures in thepast two fiscal years.

**ITEM 9A**.        CONTROLSAND PROCEDURES

As of December 31, 2004, we carried out anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures. Based on that evaluation, our management, including the Chief ExecutiveOfficer and Chief Financial Officer, concluded that our disclosure controls andprocedures are operating effectively as designed.

There have been no significant changes in our internalcontrols over financial reporting that occurred during the period covered bythis report that have materially affected, or are reasonably likely to affect,our internal control over financial reporting.

Management’s report oninternal control over financial reporting pursuant to Item 308 (a) ofRegulation S-K and the report of independent registered public accounting firmpursuant to Item 308 (b) of Regulation S-K have not beenincluded with this annual report on Form 10-K. The Company has elected toutilize the provisions of an exemptive order issued by the SEC, which allowsthe Company an additional 45 days to file the reports by amending this annualreport on Form 10-K.

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**ITEM 9B**.       OTHERINFORMATION

None.

**PART III**

**ITEM 10**.         DIRECTORSAND EXECUIVE OFFICERS OF THE REGISTRANT

Information regarding the Directors of the Company isincorporated by reference to the information under the caption “Election ofDirectors” in the Company’s Proxy Statement for the 2005 Annual Meeting ofStockholders, which is to be filed within 120 days of the Company’s fiscal yearend of December 31, 2004.

Information regarding the Executive Officers of theCompany can be found in Part I Item 4 of this annual report on Form 10-K.

Information regarding the Audit Committee FinancialExpert is incorporated by reference to the information under the caption “Reportof the Audit Committee” in the Company’s proxy statement for the 2005 AnnualMeeting of Stockholders, which is to be filed within 120 days of the Company’sfiscal year end of December 31, 2004.

Information regarding the identification of the AuditCommittee is incorporated by reference to the information under the caption “Boardof Directors and Its Committees” in the Company’s proxy statement for the 2005Annual Meeting of Stockholders, which is to be filed within 120 days of theCompany’s fiscal year end of December 31, 2004.

Information regarding compliance with Section 16(a) ofthe Exchange Act is incorporated by reference to the information under thecaption “Section 16(a) Beneficial Ownership Reporting Compliance” inthe Company’s proxy statement for the 2005 Annual Meeting of Stockholders,which is to be filed within 120 days of the Company’s fiscal year end of December 31,2004.

Information regarding theCompany’s code of ethics that applies to the Company’s Chief Executive Officer,Chief Financial Officer, and key financial and accounting personnel isincorporated by reference to the information under the caption “CorporateGovernance Policies and Practices” in the Company’s proxy statement for the2005 Annual Meeting of Stockholders, which is to be filed within 120 days ofthe Company’s fiscal year end of December 31, 2004.

**ITEM 11**.         EXECUTIVECOMPENSATION

The information requiredby this item as to executive compensation is hereby incorporated by referencefrom the information appearing under the captions “Executive Compensation”, “Compensationof Directors”, “Election of Directors-Compensation Committee Interlocks andInsider Participation”, and “Compensation Committee Report” in the Company’sdefinitive proxy statement which is to be filed with the Commission within 120days of the Company’s fiscal year end of December 31, 2004.

**ITEM 12**.         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information requiredby this item as to the ownership of management and others of securities of theCompany is hereby incorporated by reference from the information appearingunder the caption “Security Ownership” in the Company’s definitive proxystatement which is to be filed with the Commission within 120 days of theCompany’s fiscal year end of December 31, 2004.

**ITEM 13**.         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

The information requiredby this item as to certain business relationships and transactions withmanagement and other related parties of the Company is hereby incorporated byreference from the 

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informationappearing under the caption “Certain Relationships and Related Transactions” inthe Company’s definitive proxy statement which is to be filed with theCommission within 120 days of the Company’s fiscal year ended December 31,2004.

**ITEM 14**.         PRINCIPALACCOUNTING FEES AND SERVICES

The information requiredby this item as to expenses for principal accounting fees and services incurredby the Company is hereby incorporated by reference from the informationappearing under the caption “Ratification of the Appointment of IndependentRegistered Public Accounting Firm” in the Company’s definitive proxy statementwhich is to be filed with the Commission within 120 days of the Company’sfiscal year ended December 31, 2004.

**PART IV**

**ITEM 15**.         EXHIBITS,FINANCIAL STATEMENT SCHEDULES

(a)   Thefollowing documents are filed as part of this Annual Report on Form 10-Kbeginning on the pages referenced below:

(1)   Financial Statements:

|                                                          | ** ** | **Page** | ** ** |
|----------------------------------------------------------|------------|----------|------------|
| Report  of Independent Registered Public Accounting Firm |       | 51       |       |
| Consolidated  Balance Sheets                             |       | 52       |       |
| Consolidated  Statements of Operations                   |       | 53       |       |
| Consolidated  Statements of Stockholders’ Equity    |       | 54       |       |
| Consolidated  Statements of Cash Flows                   |       | 55       |       |
| Notes to Consolidated Financial  Statements              |       | 56       |       |

 

(2)   Financial Statement Schedule:

| Report of Independent  Registered Public Accounting Firm                                                   |   | 71 |   |
|------------------------------------------------------------------------------------------------------------|--------|----|--------|
| Schedule II-Valuation and  Qualifying Accounts for the years ended December 31, 2004, 2003, and  2002 |   | 72 |   |

 

(3)   Exhibits

(a)(3) Listof Exhibits
| Exhibit Number | ** ** | **Description**                                                                                                                                                                                                                                                 |
|----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1            |       | Amended and  Restated Certificate of Incorporation.(1)                                                                                                                                                                                                          |
| 3.1.1          |       | Amendment to the  Amended and Restated Certificate of Incorporation incorporated by reference  from Exhibit 3.01 contained in the Company’s Quarterly Report on  Form 10-Q for the quarter ended June 30, 2002. (File  No. 001-12493). |
| 3.2            |       | Amended and Restated  Bylaws of the Company incorporated by reference from Exhibit 3.2  contained in the Company’s Current Report on Form 8-K filed  September 7, 2004 (File No. 001-12493).(1)                                        |
| 4.1            |       | Specimen Common  Stock Certificate.(2)                                                                                                                                                                                                                          |

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| 4.1.1  |   | Preferred Stock  Rights Agreement between NeoPharm, Inc. and Computershare Investor  Services L.L.C. dated as of June 30, 2003, incorporated by reference  from Exhibit 4.1 contained in the Company’s Current Report on  Form 8-K filed July 7, 2003 (File  No. 001-12493). |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.1.2  |   | First Amendment  to Rights Agreement between NeoPharm, Inc. and Computershare Investor  Services L.L.C. dated as of September 10, 2004, incorporated by  reference from the Company’s Current Report on Form 8-K filed  September 24, 2004 (File  No. 001-12493).                 |
| 4.1.3  |   | Second Amendment  to Rights Agreement between NeoPharm, Inc. and Computershare Investor  Services, L.L.C. dated as of November 11, 2004, incorporated by  reference from the Company’s Current Report on Form 8-K filed  November 17, 2004 (File  No. 001-12493).                 |
| *10.1  |   | 1995 Stock Option  Plan, with forms of Incentive and Nonstatutory Stock Option Agreements.(2)                                                                                                                                                                                                                   |
| *10.2  |   | 1995 Director  Option Plan, with form of Director Stock Option Agreement.(2)                                                                                                                                                                                                                                    |
| 10.3   |   | Form of  Director and Officer Indemnification Agreement.(2)                                                                                                                                                                                                                                                |
| 10.4   |   | Cooperative  Research and Development Agreement between the Company and the National  Cancer Institute dated September 13, 1993.(2)                                                                                                                                                                        |
| 10.5   |   | License Agreement  between the Company and Georgetown University dated July 1990.(2)                                                                                                                                                                                                                       |
| 10.6   |   | License Agreement  between the Company and Georgetown University dated April 18, 1994.(2)                                                                                                                                                                                                                  |
| 10.7   |   | Loan Repayment  Note, dated June 18, 1990, by and between the Company and the  John N. Kapoor Trust.(2)                                                                                                                                                                                                    |
| 10.8   |   | Consulting  Agreement, dated July 1, 1994, by and between the Company and EJ  Financial Services, Inc.(2)                                                                                                                                                                                             |
| 10.9   |   | Harris Bank and  Trust Company Loan Agreement dated March 16, 1995, as amended  October 5, 1995.(2)                                                                                                                                                                                                   |
| *10.10 |   | Option Agreement,  dated as of August 13, 1996, between the Company and John N. Kapoor and  Anatoly Dritschilo.(3)                                                                                                                                                                                         |
| 10.11  |   | Cooperative  Research and Development Agreement between the Company and the Food and Drug  Administration dated August 27, 1997.(4)                                                                                                                                                                        |
| 10.12  |   | License Agreement  between the Company and the National Institute of Health dated  September 23, 1997.(4)                                                                                                                                                                                                  |
| *10.13 |   | Employment  Agreement between James M. Hussey and the Company dated March 16,  1998.(4)                                                                                                                                                                                                                    |
| *10.14 |   | 1998 Equity  Incentive Plan.(5)                                                                                                                                                                                                                                                                                 |

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| 10.15  |   | Collaboration  Agreement by and between the Company and BioChem Therapeutics dated  May 12, 1997.(4)                                                                                                                                                                                                                                                           |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.16  |   | License Agreement  by and between the Company and Pharmacia and Upjohn Company dated  February 19, 1999, incorporated by reference from Exhibit 10.1 of  the Company’s report on Form 8-K (File No. 33-09516).                                                                                                                             |
| 10.17  |   | Stock Purchase  Agreement by and between the Company and Pharmacia and Upjohn dated  February 19, 1999, incorporated by reference from Exhibit 10.2 of  the Company’s Report on Form 8-K (File No. 33-09516).                                                                                                                              |
| 10.18  |   | Amendment  No. 1 dated January 22, 1999 to the License Agreement between the  Company and Georgetown University dated January, 1990.(4)                                                                                                                                                                                                                   |
| 10.19  |   | Amendment  No. 1 dated January 22, 1999 to the License Agreement between the  Company and Georgetown University dated April 18, 1994.(4)                                                                                                                                                                                                             |
| 10.20  |   | Line of Credit  Agreement, dated as of September 30, 1998, by and between the Company  and the John N. Kapoor Trust dated September 20, 1989 incorporated by  reference from Exhibit 10.15 of the Company’s Quarterly Report on  Form 10-Q for the quarter ended September 30, 1998 (File  No. 33-09516).                        |
| 10.21  |   | Consulting  Agreement dated as of June 19,2000 by and between the Company and  Unicorn Pharma Consulting, Inc., incorporated by reference from  Exhibit 10.01 of the Company’s Quarterly Report on Form 10-Q for  the quarter ended June 30, 2000.                                                                                    |
| 10.22  |   | Consulting  Agreement dated as of November 12, 2001 by and between the Company and  Unicorn Pharma Consulting, Inc., incorporated by reference from  Exhibit 10.1 to the Company’s Annual Report on Form 10-K for the  fiscal year ended December 31, 2001.                                                                           |
| 10.23  |   | Promissory Note  dated as of December 20, 2001 by and between the Company and  Akorn, Inc., incorporated by reference from Exhibit 10.2 to the  Company’s Annual Report on Form 10-K for the fiscal year ended  December 31, 2001.                                                                                                    |
| 10.24  |   | Processing  Agreement dated as of December 20, 2001 by and between the Company and  Akorn, Inc., incorporated by reference from Exhibit 10.3 to the  Company’s Annual Report on Form 10-K for the fiscal year ended  December 31, 2001.                                                                                               |
| 10.25  |   | Subordination and  Intercreditor Agreement dated as of December 20, 2001 by and between the  Company and John N. Kapoor, as Trustee under the John N. Kapoor Trust, dated  September 20, 1989, incorporated by reference from Exhibit 10.4 to  the Company’s Annual Report on Form 10-K for the fiscal year ended  December 31, 2001. |
| 10.26  |   | Subordination,  Standby and Intercreditor Agreement dated as of December 20, 2001 by and  between the Company and the Northern Trust Company, incorporated by reference  from Exhibit 10.5 to the Company’s Annual Report on Form 10-K for  the fiscal year ended December 31, 2001.                                                       |
| *10.27 |   | Amendment to the  1998 Equity Incentive Plan, incorporated by reference from  Appendix A to the Company’s Definitive Proxy Statement on Schedule 14A for  the Annual Meeting of Stockholders held June 6, 2002.                                                                                                                                           |

47

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| 10.28  |   | First Amended and  Restated Synthetic Cardiolipin Supply Agreement dated as of  November 1999, by and between Avanti Polar Lipids, Inc. and  NeoPharm, Inc., incorporated by reference from Exhibit 10.1 to the  Company’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2003 (File No. 001-12493). |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.29  |   | Conditional  Option Agreement between Avanti Polar Lipids and NeoPharm, Inc. dated as  of January 26, 1999, incorporated by reference from Exhibit 10.2 to  the Company’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2003 (File  No. 001-12493).                                                      |
| 10.30  |   | Form of  Amendment to Processing Agreement dated as of October 7, 2003 by and  between NeoPharm, Inc. and Akorn, Inc.                                                                                                                                                                                                                        |
| 10.31  |   | Form of  Amended and Restated Promissory Note dated as of October 7, 2003 by and  between the Company and Akorn, Inc.                                                                                                                                                                                                                             |
| 10.32  |   | Subordination and  Intercreditor Agreement dated as of October 7, 2003 by and between the  Company and LaSalle Bank National Association.                                                                                                                                                                                                                   |
| *10.33 |   | Separation  Agreement and Full Release of Claims between the Company and James M. Hussey,  dated as of June 17, 2004, incorporated by reference from  Exhibit 10.01 contained in the Company’s Quarterly Report on  Form 10-Q for the quarter ended June 30, 2004.                                                                      |
| *10.34 |   | Employment  Agreement by and between NeoPharm, Inc. and Gregory P. Young dated as of  June 17, 2004, incorporated by reference from Exhibit 10.02  contained in the Company’s Quarterly Report on Form 10-Q for the quarter  ended June 30, 2004.                                                                                  |
| *10.35 |   | Form of  Director and Executive Officer Indemnification Agreement of  NeoPharm, Inc., as adopted on September 20, 2004, incorporated by  reference from Exhibit 10.01 to the Company’s Current Report on  Form 8-K filed September 30, 2004 (File No. 001-12493).                                                        |
| 10.36  |   | Settlement  Agreement among NeoPharm, Inc., John N. Kapoor, Ph.D., Erick E. Hanson,  Gregory P. Young, and Dr. Kaveh T. Safavi dated as of November 11,  2004, incorporated by reference from Exhibit 10.01 to the Company’s  Current Report on Form 8-K filed November 17, 2004 (File  No. 001-12493).                  |
| *10.37 |   | Separation  Agreement by and between NeoPharm, Inc. and Sander A. Flaum dated as of  November 11, 2004, incorporated by reference from Exhibit 10.02 the  Company’s Current Report on Form 8-K filed September 17, 2004 (File  No. 001-12493).                                                                                |
| *10.38 |   | Separation Agreement by  and between NeoPharm, Inc. and Matthew P. Rogan dated as of  November 11, 2004, incorporated by reference from Exhibit 10.03 to  the Company’s Report on Form 8-K filed on November 17, 2004 (File  No. 001-12493).                                                                                  |
| 10.39  |   | Sublicense and  License Agreement between Nippon Kayaku Co., Ltd. and NeoPharm, Inc.  dated as of December 28, 2004, incorporate by reference from  Exhibit 10.01 to the Company’s Current Report on Form 8-K filed  January 4, 2005 (File No. 001-112493).                                                                   |

48

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| *10.40 |   | Terms of  Employment by and between NeoPharm, Inc. and Ronald G. Eidell dated March 10,  2005, incorporated by reference from Exhibit 10.01 to the Company’s Current  Report on Form 8-K filed on March 14, 2005 (File No. 001-12493).                                               |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| *10.41 |   | Separation  Agreement and Full Release of Claims by and between NeoPharm, Inc. and  Gregory P. Young dated as of March 11, 2005, incorporated by reference from  Exhibit 10.02 to the Company’s Current Report on Form 8-K filed on March  14, 2005 (File No. 001-12493).  |
| *10.42 |   | Amendment No. 1  to Separation Agreement and Full Release of Claims by and between NeoPharm,  Inc and James M. Hussey dated March 10, 2005, incorporated by reference from  Exhibit 10.03 to the Company’s Current Report on Form 8-K filed on March 14,  2005 (File No. 001-12493). |
| 23.1   |   | Consent of Independent  Registered Public Accounting Firm.                                                                                                                                                                                                                                |
| 31.1   |   | Certification of  Chief Executive Officer                                                                                                                                                                                                                                                 |
| 31.2   |   | Certification of  Chief Financial Officer                                                                                                                                                                                                                                                 |
| 32.1   |   | Certification  pursuant to Section 906 of the Sarbanes-Oxley Act                                                                                                                                                                                                                     |
| 32.2   |   | Certification  pursuant to Section 906 of the Sarbanes-Oxley Act                                                                                                                                                                                                                     |

 

----

*       Denotesmanagement contract or compensatory plan or arrangement.

(1)          Incorporated byreference to the exhibit of the same number contained in the Company’sregistration statement on Form S-3 filed under the Securities Act of 1933(the “33 Act”) on October 1, 2003. (File No. 333-44396).

(2)          Incorporated byreference to the exhibit of the same number contained in the Company’sregistration statement on Form S-1 filed under the “33 Act. (FileNo. 33-90516).

(3)          Incorporated byreference to Exhibit 10.11 of the Company’s Annual Report onForm 10-K for the year ended December 31, 1996. (FileNo. 001-12493)

(4)          Incorporated byreference to the exhibit of the same number contained in the Company’s AnnualReport on Form 10-K for the year ended December 31,1998. (FileNo. 001-12493)

(5)          Incorporated byreference to the Exhibit 4.1 to the Company’s registration statement on FormS-8 filed under the “33 Act. (File No. 333-66365).

All schedules and exhibits, other than those listedabove are omitted as the information is not required or is furnished elsewherein the financial statements or the notes thereto.

49

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**SIGNATURES**

PURSUANTTO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITSBEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED
|          | NEOPHARM, INC. |
|----------|---------------------|
|     | By:                 | /s/ RONALD G. EIDELL |
|     | Ronald G. Eidell    |
| * * | * *            | *President and Chief Executive Officer* |

 

PURSUANTTO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS ANNUAL REPORTHAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE CAPACITIES AND ON THE DATESINDICATED.
|                         | **Signature** | ** **                                    | ** **           | ** ** | **Title** | ** ** | ** ** | **Date** | ** ** |
|-------------------------|---------------|-----------------------------------------------|----------------------|------------|-----------|------------|------------|----------|------------|
| /s/  ERICK E. HANSON    |          | Director, Chairman of  the Board              | March 16,  2005 |
| Erick E. Hanson         |          |                                          |                 |
| /s/  RONALD G. EIDELL   |          | Director, President, and  Chief Executive     | March 16,  2005 |
| Ronald G. Eidell        |          | Officer (Principal Executive Officer)         |                 |
| /s/  FRANK C. BECKER    |          | Director                                      | March 16,  2005 |
| Frank C. Becker         |          |                                          |                 |
| /s/  BERNARD A. FOX     |          | Director                                      | March 16,  2005 |
| Bernard A. Fox          |          |                                          |                 |
| /s/  PAUL E. FREIMAN    |          | Director                                      | March 16,  2005 |
| Paul E. Freiman         |          |                                          |                 |
| /s/  JOHN N. KAPOOR     |          | Director                                      | March 16,  2005 |
| John N. Kapoor          |          |                                          |                 |
| /s/  KAVEH T. SAFAVI    |          | Director                                      | March 16,  2005 |
| Kaveh T. Safavi         |          |                                          |                 |
| /s/  LAWRENCE A. KENYON |          | Chief Financial Officer  (Principal Financial | March 16,  2005 |
| Lawrence A.  Kenyon     |          | Officer and Principal Accounting Officer)     |                 |

 

50

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**REPORT**OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and StockholdersNeoPharm, Inc.:

We have audited the accompanying consolidated balancesheets of NeoPharm, Inc. and subsidiary as of December 31, 2004 and2003, and the related consolidated statements of operations, stockholders’equity, and cash flows for each of the years in the three-year period ended December 31,2004. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of NeoPharm, Inc.and subsidiary as of December 31, 2004 and 2003, and the results of theiroperations and their cash flows for each of the years in the three-year periodended December 31, 2004, in conformity with U.S. generally acceptedaccounting principles.
| /s/ KPMG LLP        |
|---------------------|
| Chicago, Illinois   |
| March 14, 2005 |

 

51

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**NEOPHARM, INC.AND SUBSIDIARYCONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ASSETS                                                                                                                                    |       |                  |       |   |   |
| Current assets:                                                                                                                           |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                 |       | $                     | 63,106,655 |   | $ | 36,958,941 |   |
| Investments in marketable securities                                                                                                      |       | —                |       | 4,166,351 |   |
| Trade accounts receivable                                                                                                                 |       | 10,888                |       | — |   |
| Inventories                                                                                                                               |       | 5,736                 |       | — |   |
| Prepaid expenses                                                                                                                          |       | 1,108,282             |       | 909,833 |   |
| Other receivables                                                                                                                         |       | 308,087               |       | 284,750 |   |
| Total current assets                                                                                                                      |       | 64,539,648            |       | 42,319,875 |   |
| Fixed assets, net  of accumulated depreciation                                                                                            |       | 2,894,723             |       | 3,760,705 |   |
| Total assets                                                                                                                              |       | $                     | 67,434,371 |   | $ | 46,080,580 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                 |       |                  |       |   |   |
| Current  liabilities:                                                                                                                     |       |                  |       |   |   |
| Accounts payable                                                                                                                          |       | $                     | 398,505    |   | $ | 499,682 |   |
| Accrued clinical trial expenses                                                                                                           |       | 4,634,618             |       | 1,658,293 |   |
| Accrued legal expenses                                                                                                                    |       | 244,022               |       | 1,076,228 |   |
| Accrued compensation                                                                                                                      |       | 3,227,230             |       | 2,144,163 |   |
| Other accrued expenses                                                                                                                    |       | 696,321               |       | 684,859 |   |
| Unearned revenue                                                                                                                          |       | 3,400                 |       | — |   |
| Total current liabilities                                                                                                                 |       | 9,204,096             |       | 6,063,225 |   |
| Stockholders’ equity:                                                                                                                |       |                  |       |   |   |
| Preferred stock,  $0.01 par value; 15,000,000 shares authorized; 0 shares issued and  outstanding                                         |       | —                |       | — |   |
| Common stock,  $0.0002145 par value; 50,000,000 shares authorized; 23,372,755 and 18,862,906  shares issued and outstanding, respectively |       | 5,013                 |       | 4,046 |   |
| Additional paid-in  capital                                                                                                               |       | 247,525,290           |       | 171,704,628 |   |
| Accumulated  deficit                                                                                                                      |       | (189,300,028          | )          | (131,691,319 | ) |
| Total stockholders’ equity                                                                                                           |       | 58,230,275            |       | 40,017,355 |   |
| Total liabilities  and stockholders’ equity                                                                                          |       | $                     | 67,434,371 |   | $ | 46,080,580 |   |

 

The accompanying notes to consolidated financial statements are an integral part of these financial statements.

52

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**NEOPHARM, INC.AND SUBSIDIARYCONSOLIDATED STATEMENTS OF OPERATIONS**
| ** **                            | ** ** | **For the Years Ended December 31,** | ** **  |
|---------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                            | ** ** | **2004**                                                      | ** **  | **2003** | ** ** | **2002** | ** ** |
| Revenues                              |       | $                                                             | 156,780     |   | $ | — |   | $ | — |   |
| Cost of revenues                      |       | 5,236                                                         |        | — |   | — |   |
| Gross margin                          |       | 151,544                                                       |        | — |   | — |   |
| Expenses:                             |       |                                                          |        |   |   |   |   |
| Research and development              |       | 44,512,937                                                    |        | 34,262,267 |   | 28,977,693 |   |
| Selling, general,  and administrative |       | 12,798,245                                                    |        | 19,197,457 |   | 9,660,585 |   |
| Employee  termination costs           |       | 1,149,277                                                     |        | — |   | — |   |
| Related party  expenses               |       | 419,370                                                       |        | 146,810 |   | 196,497 |   |
| Total expenses                        |       | 58,879,829                                                    |        | 53,606,534 |   | 38,834,775 |   |
| Loss from  operations                 |       | (58,728,285                                                   | )           | (53,606,534 | ) | (38,834,775 | ) |
| Interest income                       |       | 1,119,576                                                     |        | 815,435 |   | 2,343,036 |   |
| Net loss                              |       | $                                                             | (57,608,709 | ) | $ | (52,791,099 | ) | $ | (36,491,739 | ) |
| Net loss per  share—             |       |                                                          |        |   |   |   |   |
| Basic and diluted                     |       | $                                                             | (2.51       | ) | $ | (2.80 | ) | $ | (1.95 | ) |
| Weighted average shares  outstanding  |       |                                                          |        |   |   |   |   |
| Basic and diluted                     |       | 22,941,668                                                    |        | 18,830,065 |   | 18,727,256 |   |

 

The accompanying notes to consolidated financial statements are an integral part of these financial statements.

53

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**NEOPHARM, INC.AND SUBSIDIARYSTATEMENT OF STOCKHOLDERS’ EQUITY**
| ** **                                                             | ** ** | **Shares of  Preferred  Stock** | ** ** | **Shares of  Common  Stock** | ** ** | **Par  Value** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|----------------|------------|----------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
| Balance at  December 31, 2001                                     |       |                                 | —     |                              |       | 18,672,858     |       | $                                | 4,005      |                     | $          | 169,748,026                           |       | $ | (42,408,481 | ) | $ | 127,343,550 |   |
| Issuance of common  stock pursuant to exercise of stock options        |       |                                 | —     |                              |       | 130,812        |       | 28                               |       | 897,955                  |       | —                                |       | 897,983 |   |
| Issuance of common  stock options to non-employees                     |       |                                 | —     |                              |       | —         |       | —                           |       | 159,200                  |       | —                                |       | 159,200 |   |
| Net loss                                                               |       |                                 | —     |                              |       | —         |       | —                           |       | —                   |       | (36,491,739                           | )          | (36,491,739 | ) |
| Balance at  December 31, 2002                                     |       |                                 | —     |                              |       | 18,803,670     |       | $                                | 4,033      |                     | $          | 170,805,181                           |       | $ | (78,900,220 | ) | $ | 91,908,994 |   |
| Issuance of common  stock pursuant to exercise of stock options        |       |                                 | —     |                              |       | 36,236         |       | 8                                |       | 293,283                  |       | —                                |       | 293,291 |   |
| Issuance of  restricted common stock to non-employee directors         |       |                                 | —     |                              |       | 23,000         |       | 5                                |       | 479,225                  |       | —                                |       | 479,230 |   |
| Cash paid in lieu  of fractional shares pursuant to 15% stock dividend |       |                                 | —     |                              |       | —         |       | —                           |       | (9,061                   | )          | —                                |       | (9,061 | ) |
| Issuance of common  stock options to non-employees                     |       |                                 | —     |                              |       | —         |       | —                           |       | 136,000                  |       | —                                |       | 136,000 |   |
| Net loss                                                               |       |                                 | —     |                              |       | —         |       | —                           |       | —                   |       | (52,791,099                           | )          | (52,791,099 | ) |
| Balance at  December 31, 2003                                     |       |                                 | —     |                              |       | 18,862,906     |       | $                                | 4,046      |                     | $          | 171,704,628                           |       | $ | (131,691,319 | ) | $ | 40,017,355 |   |
| Issuance of common  stock pursuant to public offering                  |       |                                 | —     |                              |       | 4,312,500      |       | 925                              |       | 73,472,023               |       | —                                |       | 73,472,948 |   |
| Issuance of common  stock pursuant to exercise of stock options        |       |                                 | —     |                              |       | 172,367        |       | 37                               |       | 1,187,089                |       | —                                |       | 1,187,126 |   |
| Issuance of  restricted common stock to non-employee directors         |       |                                 | —     |                              |       | 24,982         |       | 5                                |       | 381,309                  |       | —                                |       | 381,314 |   |
| Employee common  stock option compensation                             |       |                                 | —     |                              |       | —         |       | —                           |       | 43,438                   |       | —                                |       | 43,438 |   |
| Non-employee  common stock option compensation                         |       |                                 | —     |                              |       | —         |       | —                           |       | 736,803                  |       | —                                |       | 736,803 |   |
| Net loss                                                               |       |                                 | —     |                              |       | —         |       | —                           |       | —                   |       | (57,608,709                           | )          | (57,608,709 | ) |
| Balance at  December 31, 2004                                     |       |                                 | —     |                              |       | 23,372,755     |       | $                                | 5,013      |                     | $          | 247,525,290                           |       | $ | (189,300,028 | ) | $ | 58,230,275 |   |

 

The accompanying notes to consolidated financial statements are an integral part of these financial statements.

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**NEOPHARM, INC.AND SUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWS**
| ** **                                                                   | ** ** | **For the Years Ended December 31,** | ** **  |
|------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                                   | ** ** | **2004**                                                      | ** **  | **2003** | ** ** | **2002** | ** ** |
| Cash flows from  operating activities:                                       |       |                                                          |        |   |   |   |   |
| Net loss                                                                     |       | $                                                             | (57,608,709 | ) | $ | (52,791,099 | ) | $ | (36,491,739 | ) |
| Adjustments to reconcile  net loss to net cash used in operating activities: |       |                                                          |        |   |   |   |   |
| Depreciation                                                                 |       | 1,329,367                                                     |        | 1,341,237 |   | 492,704 |   |
| Stock-based  compensation expense                                            |       | 1,161,555                                                     |        | 615,230 |   | 159,200 |   |
| Provision for  related party note receivable                                 |       | —                                                        |        | — |   | 2,189,281 |   |
| Changes in current assets  and liabilities:                                  |       |                                                          |        |   |   |   |   |
| Increase in trade accounts receivable                                        |       | (10,888                                                       | )           | — |   | — |   |
| Increase in inventories                                                      |       | (5,736                                                        | )           | — |   | — |   |
| (Increase)/decrease in prepaid expenses                                      |       | (198,449                                                      | )           | (454,940 | ) | 14,969 |   |
| Increase in other receivables                                                |       | (23,337                                                       | )           | (146,796 | ) | (212,136 | ) |
| (Decrease)/increase in accounts payable                                      |       | (101,177                                                      | )           | 6,866 |   | (44,649 | ) |
| Increase in accrued expenses                                                 |       | 3,238,648                                                     |        | 2,028,032 |   | 2,221,451 |   |
| Increase in unearned revenue                                                 |       | 3,400                                                         |        | — |   | — |   |
| Net cash used in operating activities                                        |       | (52,215,326                                                   | )           | (49,401,470 | ) | (31,670,919 | ) |
| Cash flows from  investing activities:                                       |       |                                                          |        |   |   |   |   |
| Proceeds from  maturities of marketable securities                           |       | 1,046,168                                                     |        | 3,847,924 |   | 28,472,842 |   |
| Proceeds from  sales of marketable securities                                |       | 3,120,183                                                     |        | — |   | 9,168,783 |   |
| Purchase of  marketable securities                                           |       | —                                                        |        | (4,506,053 | ) | (23,381,239 | ) |
| Purchase of  equipment and furniture                                         |       | (463,385                                                      | )           | (857,665 | ) | (2,421,339 | ) |
| Net cash provided  by/(used in) investing activities                         |       | 3,702,966                                                     |        | (1,515,794 | ) | 11,839,047 |   |
| Cash flows from  financing activities:                                       |       |                                                          |        |   |   |   |   |
| Proceeds from  issuance of common stock                                      |       | 73,472,948                                                    |        | –– |   | –– |   |
| Proceeds from  exercise of stock options                                     |       | 1,187,126                                                     |        | 293,291 |   | 897,983 |   |
| Cash paid in lieu  of fractional shares for stock dividend                   |       | —                                                        |        | (9,061 | ) | — |   |
| Net cash provided  by financing activities                                   |       | 74,660,074                                                    |        | 284,230 |   | 897,983 |   |
| Net  increase/(decrease) in cash and cash equivalents                        |       | 26,147,714                                                    |        | (50,633,034 | ) | (18,933,889 | ) |
| Cash and cash  equivalents, beginning of period                              |       | 36,958,941                                                    |        | 87,591,975 |   | 106,525,864 |   |
| Cash and cash  equivalents, end of period                                    |       | $                                                             | 63,106,655  |   | $ | 36,958,941 |   | $ | 87,591,975 |   |
| Supplemental  disclosure of cash paid for:                                   |       |                                                          |        |   |   |   |   |
| Interest                                                                     |       | $                                                             | —      |   | $ | — |   | $ | — |   |
| Income taxes                                                                 |       | $                                                             | —      |   | $ | — |   | $ | — |   |

 

The accompanying notes to consolidated financial statements are an integral part of these financial statements.

55

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**NEOPHARM, INC. AND SUBSIDIARYNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.   NATURE OFOPERATIONS AND PRINCIPAL ACCOUNTING POLICIES**

***Nature of Operations****—*NeoPharm, Inc. (the “Company”), a Delawarecorporation, was incorporated on June 15, 1990, under the name of OncoMed, Inc.In March 1995, the Company changed its name to NeoPharm, Inc. During2004, the Company established a wholly-owned subsidiary, NeoPharm EU Limited,to comply with regulatory requirements enacted for clinical trials conducted inthe European Union. All of the Company’s assets are located in the UnitedStates.

The Company is engaged inthe research, development, and commercialization of drugs for the treatment ofvarious forms of cancer. As of December 31, 2004, the Company is currentlyconducting human clinical trials for four drug product candidates.Additionally, the Company’s research efforts have resulted in the developmentof two non-drug products, which began commercial sales in 2004.

One of the Company’s drugproduct candidates has been licensed from the National Institutes of Health (“NIH”)and is the subject of a Cooperative Research and Development Agreement (CRADA)with the United States Food and Drug Administration (“FDA”). The Company alsohas rights to drug product candidates developed under license and contractresearch agreements with Georgetown University (“Georgetown”).

The Company is continuingto develop its drug product candidates, which requires substantial capital forresearch, product development, and market development activities. The Companyhas not yet initiated marketing of a commercial drug product. Future productdevelopment will require clinical testing, regulatory approval, and substantialadditional investment prior to commercialization. The future success of theCompany is dependent on its ability to make progress in the development of itsdrug product candidates and, ultimately, upon its ability to attain futureprofitable operations through the successful manufacturing and marketing ofthose drug product candidates. There can be no assurance that the Company willbe able to obtain the necessary financing or regulatory approvals to be able tosuccessfully develop, manufacture, and market its products, or attainsuccessful future operations. Insufficient funds could require the Company todelay, scale back, or eliminate one or more of its research and developmentprograms or to license third parties to commercialize drug product candidatesor technologies that the Company would otherwise seek to develop without relinquishingits rights thereto. Accordingly, the predictability of the Company’s futuresuccess is uncertain.

The Company’s rights toits drug product candidates are subject to the terms of its agreements withNIH, FDA, and Georgetown. Termination of any, or all, of these agreements couldhave a material adverse effect on the Company’s business, financial position,and results of operations. In addition, uncertainty exists as to the Company’sability to protect its rights to patents and its proprietary information. Therecan also be no assurance that research and discoveries by others will notrender some or all of the Company’s technology or drug product candidatesnoncompetitive or obsolete. Nor can there be any assurance that unforeseenproblems will not develop with the Company’s technologies or applications, orthat the Company will be able to address successfully technological challengesit encounters in its research and development programs. While the Companymaintains insurance to cover the use of its drug product candidates in clinicaltrials, it does not maintain insurance covering the sale of its products nor isthere any assurance that it will be able to obtain or maintain such insuranceon acceptable terms or with adequate coverage against potential liabilities. Amore detailed description of the risks related to the Company’s business can befound in the Risk Factors section of this annual report on Form 10-K.

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From its inception on June 15,1990, through December 31, 1998, the Company was classified as adevelopment stage entity. The Company completed its development stage upon theout-licensing of its first major drug product candidates to Pharmacia &Upjohn Company (“Pharmacia”) in February of 1999. Accordingly, theinception to date information is not presented in these consolidated financialstatements.

***Basis of Presentation****—*The consolidated financial statements include the accountsof NeoPharm, Inc. and its wholly-owned subsidiary, NeoPharm EU Limited. Asof December 31, 2004, the subsidiary had nominal assets and had notconducted any business. All significant intercompany accounts and transactionsare eliminated in consolidation.

***Use of Estimates****—*The preparation of financial statements in conformity with U.S.generally accepted accounting principles requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the consolidatedfinancial statements and the reported amounts of revenue and expense during thereporting period. Actual results could differ from those estimates.

***Cash Equivalents and Investments****—*The Company considers all highly liquid investmentspurchased with an original maturity of three months or less to be cashequivalents. Included with cash are cash equivalents of $62,919,437 and$36,484,817 as of December 31, 2004 and 2003, respectively. The carryingvalue of these investments approximates their fair market value due to theirshort maturity and liquidity.

Investments in marketablesecurities include liquid investments purchased with an original maturity ofbetween three months and one year. As provided by Statement of FinancialAccounting Standards (SFAS) No. 115, *Accounting for CertainInvestment in Debt and Equity Securities,* the Company has elected totreat all of its investments in marketable securities as “available-for-sale,”which requires these investments to be recorded at fair market value.Unrealized gains and losses, net of related tax effect, on available-for-salesecurities deemed to be temporary are excluded from earnings and are reportedas a separate component of other comprehensive income until realized. Realizedgains and losses from the sale of available-for-sale securities are determinedon a specific identification basis.**A decline inmarket value of available-for-sale securities that is deemed to be other thantemporary, results in the reduction of the carrying amount to fair value. Theimpairment is charged to earnings and a new cost basis for the security isestablished. The Company has not experienced any declines in fair market valueof its investments that were other than temporary. Dividend and interest incomeare recognized when earned. As of December 31, 2004, the Company had noinvestments in marketable securities. Realized gain on investments sold in 2004was $192. No investments were sold during 2003. Realized gain on investmentssold during 2002 was $3,117 and realized loss on investments sold during 2002was $29,873.

***Inventory—***Inventoryis comprised solely of finished goods of NeoPhectin and is stated at the lowerof cost or market, as determined by the first in, first out method (FIFO).Inventory cost consists of direct material and direct labor costs. Sinceproducts are currently produced in the Company’s research and developmentfacilities, the Company has not allocated any overhead costs as a product cost.Application of overhead as a product cost is not material.

Inventoryas of December 31, 2004 (there was no inventory at December 31, 2003)consists of the following:
| Finished goods on  hand      |   | $   | 5,413  |   |
|------------------------------|--------|-----|--------|--------|
| Inventory subject  to return |   | 323 |   |
|                         |   | $   | 5,736  |   |

 

Inventory subject to return represents NeoPhectinproducts shipped to wholesale customers that have not been recognized asrevenue.

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***Fixed Assets****—*Fixed assets are recorded at cost and are depreciated usingthe straight line method over their estimated useful lives. During 2003, theCompany revised its estimate of the useful life of computer equipment from fiveyears to three years. Maintenance and repairs that do not extend the life ofassets are charged to expense when incurred. When properties are disposed of,the related costs and accumulated depreciation are removed from the accountsand any gain or loss is reported in the period the transaction takes place.Total depreciation expense for the years ended December 31, 2004, 2003,and 2002, was $1,329,367, $1,341,237 and $492,704, respectively.

Long-lived assets arereviewed for impairment whenever events or changes in circumstances indicatethe carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to estimated undiscounted cash flows expected to be generated bythe asset. If the carrying amount exceeds its estimated future cash flows, animpairment charge is recognized by the amount by which the carrying amountexceeds the fair value of the asset.

***Income Taxes****—*Income taxes are accounted for under the asset andliability method. Deferred tax assets and liabilities are recognized for thefuture tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases and operating loss and tax credit carryforwards. Deferredtax assets and liabilities are measured using enacted tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to be recovered or settled. The effect on deferred tax assets andliabilities of a change in tax rates is recognized in income in the period thatincludes the enactment date. Management provides valuation allowances againstthe deferred tax asset for amounts which are not considered “more likely thannot” to be realized.

***Revenue Recognition****—*The Company recognizes revenue when persuasive evidence ofan arrangement exists, delivery has occurred or services have been rendered,the price is fixed or determinable, and collectibility is reasonably assured.

For product sales notsubject to unconditional rights of return, the Company recognizes revenue uponshipment as title and risk of loss has passed to the customer. For productsales subject to unconditional rights of return, the Company recognizes revenueupon shipment when it can reasonably estimate the level of returns at the timeof shipment. Given the limited sales history of its products, the Company iscurrently unable to reasonably estimate the level of returns at the time ofshipment. Accordingly, revenue related to shipments to distributors that havebeen granted an unconditional right of return is currently being recognizedwhen the right of return has expired, which occurs upon the earlier of shipmentof the product by the distributor to an end user or expiration of the right ofreturn, which is 60-180 days depending upon the distributor. The Companywarrants its products in a manner consistent with industry standards and hasnot incurred any warranty costs related to the sale of NeoPhectin.

The Company enters intocollaboration and technology licensing arrangements, which contain multipledeliverables. Under the provisions of Emerging Issues Task Force (EITF) No. 00-21,*Accounting for Revenue Arrangements with MultipleDeliverables*, the Company evaluates whether these deliverablesconstitute separate units of accounting to which total arrangementconsideration is allocated. A deliverable qualifies as a separate unit ofaccounting when the item delivered to the customer has standalone value, thereis objective and reliable evidence of fair value of items that have not beendelivered to the customer, and, if there is a general right of return for theitems delivered to the customer, delivery or performance of the undelivereditems is considered probable and substantially in the control of the Company. Arrangementconsideration is allocated to units of accounting on a relative fair basis orthe residual method if the Company is unable to determine the fair value of alldeliverables in the arrangement. Consideration allocated to a unit ofaccounting is limited to the amount that is not contingent upon futureperformance by the Company. Upon determination of separate units of accountingand allocated consideration, the general criteria for revenue recognition areapplied to each unit of accounting. In 

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instanceswhere an arrangement provides for up-front non-refundable payments the Companyrecognizes these payments ratably over the term of the contract or expectedperiod of performance, whichever is longer.

***Research and Development****—*Research and development costs are expensed when incurred.These costs include, among other things, consulting fees and costs reimbursedto third parties under license and research agreements described in Note 9.Payments related to the acquisition of technology rights, for which developmentwork is in process, are expensed and are considered a component of research anddevelopment costs. The Company also allocates indirect costs, consistingprimarily of operational costs for administering research and developmentactivities, to research and development expenses.

***Stock-Based Compensation****—*The Company applies the intrinsic-value method ofaccounting prescribed by Accounting Principles Board (APB) Opinion No. 25,*Accounting for Stock Issued to Employees,*and related interpretations, to account for its fixed-plan options. Under thismethod, compensation expense is measured on the date of grant if the currentmarket price of the underlying stock exceeded the exercise price or when thenumber of shares and exercise price are known if both are not determinable atthe date of grant. Compensation expense for fixed stock options is recognizedratably over the vesting period. SFAS No. 123, *Accountingfor Stock-Based Compensation,*established accounting and disclosurerequirements using a fair-value method of accounting for stock-based employeecompensation plans. As allowed by SFAS No. 123, the Company has elected tocontinue to apply the intrinsic-value-based method of accounting describedabove, and has adopted only the disclosure requirements of SFAS No. 123.

Thefollowing table illustrates the effect on net loss if the fair-value method hadbeen applied in each period:
| ** **                                                                                                          | ** ** | **2004**    | ** **  | **2003**   | ** ** | **2002**    | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|------------|------------|-------------|------------|
| Net loss, as  reported                                                                                              |       | $           | (57,608,709 | )          | $          | (52,791,099 | )          | $ | (36,491,739 | ) |
| Add stock-based  employee compensation expense included in reported net loss(1)                                     |       | 424,752     |        | 479,230    |       | —      |       |
| Deduct total  stock-based employee compensation expense determined under fair-value-based  method for all awards(2) |       | (14,161,126 | )           | (7,927,891 | )          | (4,471,577  | )          |
| Pro forma net loss                                                                                                  |       | $           | (71,345,083 | )          | $          | (60,239,760 | )          | $ | (40,963,316 | ) |
| Basic and diluted  net loss per common share                                                                        |       |        |        |       |       |        |       |
| As reported                                                                                                         |       | $           | (2.51       | )          | $          | (2.80       | )          | $ | (1.95 | ) |
| Pro forma                                                                                                           |       | $           | (3.11       | )          | $          | (3.20       | )          | $ | (2.19 | ) |

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(1)          Value of restricted stockgranted to non-employee directors in 2004 and 2003 and compensation expenserelating to options granted to an executive at 85% of fair value in 2004.

(2)          Includesacceleration of vesting period due to change in control provision in 2004 (seeNote 5).

***Contingencies****—*Liabilities for loss contingencies arising from claims,assessments, litigation, fines, and penalties and other sources are recordedwhen it is probable that a liability has been incurred and the amount of theassessment can be reasonably estimated. Recoveries from other parties arerecorded when realized.

***Fair Value of FinancialInstruments***—Financial instruments consist of cash, cashequivalents, accounts receivable, and accounts payable. The carrying value ofthese financial instruments is a reasonable estimate of fair value.

***Recent Accounting Pronouncements******—***In November 2004, theFinancial Accounting Standards Board (FASB) issued SFAS No. 151 *Inventory Costs*, an amendment to Accounting ResearchBulletin (ARB) No. 43, Chapter 4, Inventory Pricing, to clarify theaccounting of abnormal amounts of idle facility expense, 

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freight, handlingcosts and wasted material. SFAS 151 requires that those items be recognized ascurrent-period charges. In addition, SFAS 151 requires that allocation of fixedproduction overheads to the costs of conversions be based on the normalcapacity of the production facilities. The provisions will become effective forinventory costs incurred during the fiscal years beginning after June 15,2005. The Company anticipates that this amendment will not have a materialeffect on its consolidated financial statements.

In December 2004, the FASBissued SFAS No. 123R, *Share-Based Payment*,a revision of SFAS No. 123, which requires the use of the fair valuemethod of accounting for stock-based employee compensation effective for allawards granted, modified, repurchased, or cancelled as of the beginning of thethird quarter, 2005. The standard provides for a prospective application of itsprovisions. Under this method, the Company will begin recognizing compensationcost for equity based compensation for all new or modified grants after thedate of adoption. In addition, the Company will recognize the unvested portionof the grant date fair value of awards issued prior to adoption based on thefair values previously calculated under the disclosure provisions of SFASNo. 123. At December 31, 2004, the aggregate value of unvestedoptions, as determined using a Black-Scholes option valuation model, was $2,319,300.Upon adoption of SFAS 123R, a portion of this amount will be recognized overthe remaining vesting period of these options.

**2.**   NETLOSS PER SHARE

Thefollowing table sets forth the computation of the basic and diluted net lossper share for the years ended December 31:
| ** **                            | ** ** | **2004**   | ** **  | **2003**   | ** ** | **2002**    | ** ** |
|---------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| Numerator:                            |       |       |        |       |       |        |       |
| Net loss                              |       | $          | (57,608,709 | )          | $          | (52,791,099 | )          | $ | (36,491,739 | ) |
| Denominator:                          |       |       |        |       |       |        |       |
| Weighted average  shares outstanding  |       | 22,941,668 |        | 18,830,065 |       | 18,727,256  |       |
| Loss per share—basic and diluted |       | $          | (2.51       | )          | $          | (2.80       | )          | $ | (1.95 | ) |
| Potential common  share equivalents:  |       |       |        |       |       |        |       |
| Stock options                         |       | 3,713,376  |        | 3,246,725  |       | 3,256,707   |       |

 

As the Company hasincurred a net loss for all periods presented, basic and diluted per shareamounts are the same, since the effect of potential common share equivalents isanti-dilutive.

**3.   FIXED ASSETS**

Fixedassets are comprised of the following as of December 31:
| ** **                     | ** ** | **Estimated  Useful Life  (years)** | ** ** | **2004** | ** ** | **2003**   | ** ** |
|--------------------------------|------------|------------------------------------------|------------|----------|------------|------------|------------|
| Computer  equipment            |       |                                     | 3          |     |       | $          | 1,327,196  |   | $ | 1,072,685 |   |
| Scientific  equipment          |       |                                     | 5          |     |       | 3,796,131  |       | 3,732,636 |   |
| Furniture                      |       |                                     | 7          |     |       | 960,781    |       | 880,367 |   |
| Leasehold  improvements        |       |                                     | *          |     |       | 659,984    |       | 595,019 |   |
| Less accumulated  depreciation |       |                                     |       |     |       | (3,849,369 | )          | (2,520,002 | ) |
| Fixed assets, net              |       |                                     |       |     |       | $          | 2,894,723  |   | $ | 3,760,705 |   |

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*     The estimated useful life ofleasehold improvements is the lesser of the lease term or five years.

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**4.   STOCKHOLDERS’ EQUITY**

On January 27, 2004,the Company received proceeds of $73,980,938 (net of the underwriting discountsand commissions of $4,722,188, but before expenses of $507,990) by issuing4,312,500 shares of common stock in a public offering.

In June 2003, theCompany’s Board of Directors adopted a stockholder rights plan that providedfor the issuance of rights to purchase shares of Series A ParticipatingPreferred Stock (“Series A Preferred”) of the Company. Under the plan, onepreferred share purchase right was distributed for each outstanding share ofcommon stock. Each purchase right entitles the holder to purchase from theCompany one one-thousandth (1/1000th) of a share of Series APreferred at a price of $112.00 per share, subject to adjustment. The rightsbecome exercisable, with certain exceptions, ten business days after any party,without prior approval of our Board of Directors, acquires, or announces anoffer to acquire, beneficial ownership of 15% or more of NeoPharm’s commonstock, NeoPharm is acquired in a merger or other business combination, or 50%or more of NeoPharm’s assets are sold after the time that the rights becomeexercisable, the rights provide that each right holder will receive, uponexercise, shares of the common stock of the surviving or acquiring company, asapplicable, having a market value of twice the exercise price of the right. Therights expire on July 28, 2013, unless they are earlier redeemed orexchanged by the Company. No rights were exercised at December 31, 2004.

On May 13, 2003, theCompany declared a 15% stock dividend payable on June 10, 2003 toshareholders of record on June 3, 2003. A total of 2,455,141 shares weredistributed as part of the stock dividend. All share and per share informationwas restated to reflect the stock dividend.

**5.   STOCK OPTIONS**

On July 23, 1998, theBoard of Directors approved the NeoPharm, Inc. 1998 Equity Incentive Plan(the “1998 Plan”), which replaced all prior equity incentive plans, andprovides for the grant of options to acquire up to 2,200,000 shares of theCompany’s common stock. Additionally, 275,000 of the 2,200,000 shares can beused for restricted stock grants to directors, officers, employees andconsultants. The option prices shall be not less than 85% of the fair marketvalue of the stock as determined by the Plan Administrator pursuant to the 1998Plan. The consideration paid for shares of restricted stock shall not be lessthan the par value of the Company’s common stock. Under the Plan, the optiongrants typically have a 10 year term, vest in increments of 25% of the totalgrant on the first four anniversaries of the original grant, and areexercisable as the options vest, subject to the Company’s policies in effectfrom time to time concerning transactions by employees in the Company’ssecurities. On June 6, 2002, the Company adopted an amendment to the 1998Plan, which was approved by shareholders, which increased the total sharesavailable under the Plan to 4,000,000 shares. As of December 31, 2004approximately 1,178,250 shares were available for issuance under the 1998 Plan.

In November 2004, theCompany entered into an agreement to end a shareholder consent solicitation.The terms of the agreement provided for expansion of the board of directors andreplacement of certain directors. These provisions constituted a “change incontrol” under the terms of the 1998 Plan. Accordingly, substantially alloutstanding unvested stock options were immediately vested pursuant to theiroriginal terms of grant upon the “change in control” event. Other than the CEO,all employees’ unvested stock options became vested, which resulted in thevesting of an additional 1,221,203 stock options in 2004 that would haveotherwise vested in future years.

During 2004, the Companyawarded its newly-hired CEO, Mr. Gregory P. Young, the right to receive up to350,000 common stock options, which will be granted at the then fair marketvalue upon the Company’s common stock reaching certain price levels for definedperiods of time. Mr. Young resigned as President and CEO on March 8, 2005.

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Thefollowing table summarizes the transactions in the Company’s stock option planfor the three year period ended December 31, 2004:
| ** **                                         | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Exercise  Price Per Share** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|------------------------------------------------------------|------------|
| Stock options  outstanding, December 31, 2001 |       | 2,407,252              |       |                                                       | $          | 12.33 |   |   |
| Options granted                                    |       | 1,028,361              |       |                                                       | $          | 12.38 |   |   |
| Options exercised                                  |       | (105,512               | )          |                                                       | $          | 7.85 |   |   |
| Options cancelled                                  |       | (73,394                | )          |                                                       | $          | 14.16 |   |   |
| Stock options  outstanding, December 31, 2002 |       | 3,256,707              |       |                                                       | $          | 12.45 |   |   |
| Options granted                                    |       | 139,225                |       |                                                       | $          | 11.95 |   |   |
| Options exercised                                  |       | (36,236                | )          |                                                       | $          | 8.09 |   |   |
| Options cancelled                                  |       | (112,971               | )          |                                                       | $          | 13.26 |   |   |
| Stock options  outstanding, December 31, 2003 |       | 3,246,725              |       |                                                       | $          | 12.45 |   |   |
| Options granted                                    |       | 821,500                |       |                                                       | $          | 15.28 |   |   |
| Options exercised                                  |       | (172,367               | )          |                                                       | $          | 6.89 |   |   |
| Options cancelled                                  |       | (182,482               | )          |                                                       | $          | 15.65 |   |   |
| Stock options  outstanding, December 31, 2004 |       | 3,713,376              |       |                                                       | $          | 13.17 |   |   |

 

Thefollowing table summarizes information about fixed stock options outstanding asof December 31, 2004:
| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                  | ** ** |
|---------------------------------------------|------------|------------------------------|------------|-----------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding  as of  12/31/04** | ** ** | **Weighted  Average  Remaining  Contractual  Life (years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable  as of  12/31/04** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $1.75 to $3.50                              |       | 182,793                      |       |                                          | 2.0        |   |   |   | $ | 2.25 |   |   | 182,793 |   |   | $ | 2.25 |   |   |
| $3.51 to $8.00                              |       | 720,774                      |       |                                          | 4.4        |   |   |   | $ | 5.57 |   |   | 470,774 |   |   | $ | 4.34 |   |   |
| $8.01 to $14.00                             |       | 1,366,745                    |       |                                          | 4.6        |   |   |   | $ | 11.62 |   |   | 1,316,745 |   |   | $ | 11.65 |   |   |
| $14.01 to $18.00                            |       | 367,582                      |       |                                          | 4.3        |   |   |   | $ | 16.16 |   |   | 367,582 |   |   | $ | 16.16 |   |   |
| $18.01 to $29.00                            |       | 1,075,482                    |       |                                          | 5.2        |   |   |   | $ | 21.08 |   |   | 1,075,482 |   |   | $ | 21.08 |   |   |
| $1.75 to $29.00                             |       | 3,713,376                    |       |                                          | 4.6        |   |   |   | $ | 13.17 |   |   | 3,413,376 |   |   | $ | 13.60 |   |   |
|                                             |            |                              |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In June 2004, the Company’s CEO resigned and became aconsultant to the Company. Under the terms of the consulting agreement, 473,625unvested options previously granted to the CEO continued to vest in accordancewith their original terms. The vesting of these options was accelerated uponthe change of control event. Upon acceleration of vesting of the options, theformer CEO’s performance commitment was reached and the Company measured thefair value of these options and recorded compensation expense of $736,803 forthe year ended December 31, 2004.

The Company has granted options to purchase 886,495shares to certain non-employees of which 402,761 remain outstanding andunexercised as of December 31, 2004. These consultants served asscientific and/or business advisors to the Company. The Company accounts forthese options using the fair value method generally determined at the dateperformance of the service was complete. The Company recorded expense of $0,$136,000 and $159,200 relating to these options for the years ended December 31,2004, 2003 and 2002, respectively.

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Assumptionsused in the Black-Scholes option-pricing model for calculating the weightedaverage fair value of options granted (both employee and non-employee) in themost recent fiscal years is included in the following table:
| ** **                                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Weighted average  fair value of option grants |       | $        | 12.47      |     | $          | 8.06     |       | $ | 11.23 |   |
| Weighted average risk-free interest rate      |       | 3.68     | %          | 3.94     | %          | 4.51     | %          |
| Dividend yield                                |       | 0.00     | %          | 0.00     | %          | 0.00     | %          |
| Volatility factor                             |       | 72.02    | %          | 57.74    | %          | 70.25    | %          |
| Weighted average  expected life               |       | 10 years |       | 10 years |       | 10 years |       |
|                                               |            |          |            |          |            |          |            |  |  |  |

 

**6.   INCOMETAXES**

From inception through October 11, 1995, theCompany operated as an S Corporation for income tax purposes. Losses incurredduring this period were reported on the stockholders’ tax returns, and are notavailable to the Company as a net operating loss carry forward. Since thattime, losses incurred represent net operating loss carry forwards which can beused to offset future taxable income.

Thenet operating loss carry forwards will expire as follows:
| **Year of Expiration**                         | ** ** | ** ** | ** **  | **Amount** | ** ** |
|----------------------------------------------------------|------------|------------|-------------|------------|------------|
| 2011                                                     |       | $          | 1,882,000   |       |
| 2012                                                     |       | 1,969,000  |        |
| 2018                                                     |       | 3,122,000  |        |
| 2020                                                     |       | 3,316,000  |        |
| 2021                                                     |       | 12,662,000 |        |
| 2022                                                     |       | 35,734,000 |        |
| 2023                                                     |       | 52,457,000 |        |
| 2024                                                     |       | 57,916,000 |        |
| Total gross net  operating loss carry forwards available |       | $          | 169,058,000 |       |
|                                                     |       |       |        |

 

The Company has general business credit carry forwardsof approximately $4,896,000 which expire in the years 2011-2024, and analternative minimum tax credit of $40,000 which can be carried forward for anindefinite period.

TheCompany’s federal statutory rate is 35% and its effective rate is 0%.Differences between the federal statutory and effective rates are primarilyattributable to state income taxes and the establishment of a valuationallowance to reduce the carrying value of deferred tax assets to zero.

Significantcomponents of the Company’s deferred tax assets as of December 31 are asfollows:
| ** **                                                | ** ** | **2004**    | ** ** | **2003**    | ** ** | **2002**    | ** ** |
|-----------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Net operating  loss carry forwards                        |       | $           | 65,932,000 |        | $          | 43,569,000  |       | $ | 22,903,000 |   |
| General business  credit carry forwards                   |       | 4,896,000   |       | 3,232,000   |       | 1,311,000   |       |
| Alternative  minimum tax credit carry forwards            |       | 40,000      |       | 40,000      |       | 40,000      |       |
| Expenses not  currently deductible for tax purposes  |       | 1,517,000   |       | 1,431,000   |       | 1,046,000   |       |
| Total deferred  tax assets                                |       | 72,385,000  |       | 48,272,000  |       | 25,300,000  |       |
| Valuation  allowance                                      |       | (72,385,000 | )          | (48,272,000 | )          | (25,300,000 | )          |
| Net deferred tax assets                                   |       | $           | —     |        | $          | —      |       | $ | — |   |

 

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The valuation allowanceincreased by $24,113,000, $22,972,000, and $14,182,000 for the years ended December 31,2004, 2003, and 2002, respectively. In assessing the realizability of deferredtax assets, management considers whether it is more likely than not that someportion or all of the deferred tax assets will not be realized. The ultimaterealization of deferred tax assets is dependent upon the generation of futuretaxable income during the periods in which those temporary differences becomedeductible. Management considers the scheduled reversal of deferred taxliabilities, projected future taxable income, and tax planning strategies inmaking this assessment. Based upon the Company’s history of taxable losses andprojections for future taxable income over the periods in which the deferredtax assets are deductible, management does not believe realization of these taxassets is more likely than not. As such, the Company has established fullvaluation allowances for the deferred tax assets.

**7.   TRANSACTIONSWITH RELATED PARTIES**

The Company received management consulting servicesfrom EJ Financial Enterprises, Inc. (“EJ Financial”), a healthcareconsulting and investment firm in which John N. Kapoor, Ph.D., a member of theCompany’s Board of Directors and the Company’s former Chairman of the Board ofDirectors, is the sole stockholder. The consulting agreement with EJ Financialexpired on June 30, 2004 and was not renewed.

In November 2004, the Company paid $350,000 to EJFinancial to reimburse Dr. Kapoor for his out-of-pocket costsincurred in his consent solicitation action, under the terms of a settlementagreement between the Company and Dr. Kapoor.

The Company had entered into a consulting agreementwith an individual who is also an employee of Akorn, Inc. NeoPharm’sformer Chairman of the Board of Directors and a current Director is also theChairman of the Akorn Board of Directors. The consulting agreement wasterminated in 2004.

In June 2000, the Company entered into aconsulting agreement with Unicorn Pharma Consulting, Inc. (“Unicorn”) toassist the Company in the clinical development of Company products. Dr. MatthewP. Rogan, a former Director of the Company, is also President and CEO ofUnicorn. The agreement was terminated by mutual consent in October 2000,but was renewed in November 2001. No amounts were paid to Unicorn in 2003or 2004.

Thefollowing table provides further information about related party expensesreflected in the consolidated statements of operations:
| ** **                            | ** ** | ** **      | ** ** | **For the Years Ended  December 31,** | ** ** |
|---------------------------------------|------------|-----------------|------------|-----------------------------------------------------------|------------|
| **Related Party**                | ** ** | ** **      | ** ** | **Expense Type**                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| E.J. Financial  Enterprises           |       | Consulting      |       | $                                                         | 62,500     |   | $ | 125,000 |   | $ | 125,000 |   |
| E.J. Financial  Enterprises           |       | Direct  Expense |       | 350,620                                                   |       | 2,891 |   | 1,443 |   |
| Akorn, Inc.                      |       | Consulting      |       | 6,250                                                     |       | 18,919 |   | 30,675 |   |
| Unicorn Pharma  Consulting, Inc. |       | Consulting      |       | —                                                    |       | — |   | 39,379 |   |
| Total related party  expense          |       |            |       | $                                                         | 419,370    |   | $ | 146,810 |   | $ | 196,497 |   |
|                                       |            |                 |            |                                                           |            |  |  |  |  |  |  |  |  |  |

 

In December 2001,NeoPharm entered into a transaction whereby NeoPharm loaned to Akorn, Inc.,a Louisiana corporation, $3,250,000 to assist Akorn in the completion of itslyophilized products manufacturing facility in Decatur, Illinois. Dr. Kapoor,a member of the Company’s Board of Directors and the Company’s former Chairmanof the Board of Directors, is the Chairman of the Akorn Board of Directors andholds a substantial stock position in both companies. In connection with theloan transaction, NeoPharm entered into the following agreements: PromissoryNote, dated December 20, 2001, in the original principal amount of$3,250,000 by Akorn to NeoPharm; Processing Agreement, dated December 20,2001, by and between Akorn and NeoPharm; Subordination and IntercreditorAgreement, dated December 20, 2001, by and between John N. Kapoor, asTrustee under The John N. Kapoor Trust, 

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dated September 20,1989 and NeoPharm; and a Subordination, Standby and Intercreditor Agreement,dated December 20, 2001, by and among Akorn, Akorn (New Jersey), Inc.,The Northern Trust Company and NeoPharm. The Promissory Note issued by Akornwas due in December 2006, and accrued interest at a rate equal to thatreceived on the Company’s investments in marketable securities, which is lowerthan the interest rate paid by Akorn on its other outstanding debt. TheProcessing Agreement grants NeoPharm access to at least 15% of the annuallyophilization manufacturing capacity at Akorn at most favored customerpricing, upon completion of the facility. The Processing Agreement alsoprovided that Akorn was to begin providing lyophilization services on or beforeJune 30, 2003. At the time these transactions were entered into, Akornrepresented that the manufacturing facility would be operational in 2003,approximately the time when NeoPharm originally anticipated it would need tomanufacture its lyophilized drug product candidates for Phase II/III clinicaltrials. In 2001, NeoPharm recorded the Promissory Note net of a valuationallowance of $1,266,619 reflecting the difference between the actual loanamount and the present value of the loan using an estimated market interestrate of 10%. As of December 31, 2002, the Company determined thePromissory Note was impaired and recorded a charge to fully reserve for thePromissory Note and related accrued interest. On August 18, 2003, NeoPharmpresented Akorn with a formal “Notice of Default” on the Promissory Note.Because the carrying value of the Promissory Note was zero, there was nofinancial statement impact as a result of any event of default under, ornon-payment of, the Promissory Note. In September 2003, Akorn advisedNeoPharm that it wished to refinance its senior debt with a new senior lender,which lender would require NeoPharm to subordinate its debt. In order topreserve the possibility of collecting Akorn’s debt to NeoPharm, NeoPharm andAkorn entered into an Amended and Restated Promissory Note in consideration ofa higher rate of interest (which would now equal that to be charged by the newsenior lender, which is the prime rate plus 175 basis points) and thepossibility of accelerated mandatory repayments once Akorn’s senior debt wasrepaid in full.  NeoPharm also agreed towaive Akorn’s default, to allow Akorn until October 2004 to provide themanufacturing rights and to subordinate Akorn’s indebtedness to NeoPharm toAkorn’s indebtedness to its new senior lender. Akorn’s refinancing wascompleted on October 7, 2003. On October 6, 2004, NeoPharm presentedAkorn with a formal “Notice of Default” on the Amended and Restated PromissoryNote resulting from Akorn’s failure to meet its obligations under theProcessing Agreement. Because the carrying value of the Promissory Note waszero, there was no financial statement impact as a result of anyevent ofdefault under, or non-payment of, the Promissory Note.

**8.   EMPLOYEE TERMINATION BENEFITS**

In aneffort to decrease expenses, the Company reduced its workforce by a total of 30employees (approximately 23%) in November 2004, consisting of 26 employeesfrom its research and development groups and 4 employees from theadministrative group. Terminated employees were eligible to receive salarycontinuation through December 31, 2004, severance, 2004 earned bonus,Company paid insurance benefits and outplacement services. All $1,149,277 ofemployee termination costs were expensed in 2004 and are reported under thecaption “Employee termination costs” in the Company’s consolidated statement ofoperations. Amounts accrued as of December 31, 2004 will be paid out by February 28,2005. The total costs associated with the reduction in workforce are summarizedin the following table:
| **Description**             | ** ** | ** ** | ** ** | **Total  Provision** | ** ** | **Amounts Paid** | ** ** | **Accrued as of   December 31, 2004** | ** ** |
|-----------------------------|------------|------------|------------|----------------------|------------|-----------------------|------------|-----------------------------------------------------------|------------|
| Employee  termination costs |       | $          | 1,149,277  |                 |       | $                     | 388,518    |                                                      |       |   | $ | 760,759 |   |   |
|                             |            |            |            |                      |            |                       |            |                                                           |            |  |  |  |  |  |  |  |

 

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**9.   COMMITMENTS**

***Licenseand Research Agreements***—From time to time theCompany enters into license and research agreements with third parties. As of December 31,2004, the Company had significant agreements with three parties, as describedbelow.

***GeorgetownUniversity***—The Company has entered into threelicense agreements with Georgetown University whereby the Company obtained anexclusive worldwide license to use certain technologies. In exchange for thegrant of these exclusive licenses, the Company will pay Georgetown beginningwith the first commercial sale of a product incorporating the licensedtechnologies, a royalty, ranging from 2.50% to 5.00%, on net sales by theCompany of products incorporating any such technologies. The royalty will bepayable for the life of the related patents. Additionally, the Company may beobligated to make milestone payments totaling $1,500,000 upon achievement ofcertain development objectives.

In addition, the Companyhas entered into two annually renewable contract research agreements withGeorgetown that expire in February 2005, and was obligated to payGeorgetown an aggregate of $500,000 in 2004 under the agreements. Under theannual contract research agreements, which can be terminated upon 90 dayswritten notice by either party, the Company is obligated to pay or reimburseGeorgetown for all direct and indirect costs associated with research onspecific projects. In return, with respect to any project for which an NDA isultimately approved, the Company retains all rights to all inventions,developments, discoveries and other proprietary ideas which are firstconceived, discovered or developed during the conduct of the research uponmaking a one time payment of up to $175,000 to Georgetown.

***NationalInstitutes of Health***—The Company entered into anexclusive worldwide licensing agreement with the NIH to develop andcommercialize IL13-PE38QQR (cintredekin besudotox). The agreement required theCompany to pay NIH a $75,000 non-refundable license issue payment and minimumannual royalty payments of $10,000, which increase to $25,000 after the firstcommercial sale. The agreement further provides for milestone payments of up to$585,000 to be paid by the Company to NIH and royalties of up to 4.00% based onfuture product sales. The Company made its first milestone payment of $25,000to NIH in November 1999 after the filing of the U.S. Investigational NewDrug (“IND”) application for IL13-PE38QQR. The Company is required to pay thecosts of filing and maintaining product patents on the licensed products. Theagreement shall extend to the expiration of the last to expire of the patentson the licensed products, if not terminated earlier. The agreement may beterminated by mutual consent of NIH and the Company. Either party may terminateif the other party breaches a material term or condition and such breach is notcured within a certain period of time. Also, either party may unilaterallyterminate by giving advanced notice.

***U.S. Food and Drug Administration***—In1997 the Company entered into a CRADA with the FDA. Pursuant to the CRADA, theCompany committed to work to commercialize the IL13-PE38QQR chimeric proteinwhich it licensed from NIH. The FDA agreed to collaborate on the clinicaldevelopment and commercialization of IL13-PE38QQR. In January 2001, theparties agreed to expand the scope of the CRADA and increase the Company’sfunding requirement to $400,000 per year and extend the term of the agreementthrough December 31, 2003. In 2004, the parties agreed to reduce thefunding under the CRADA for 2004 to $230,000. Funding for the CRADA expired on December 31,2004. However, both the Company and the FDA are involved in negotiations torenew the Company’s funding of the CRADA in 2005.

***LeaseCommitments***—The Company has several noncancelableoperating leases, for its office space and research and development facility,which expire over the next four years. These leases generally contain renewaloptions for periods up to 60 months and require the Company to pay allexecutory costs such as maintenance and insurance. Rental payments includeminimum rentals plus contingent rentals based on common area maintenanceexpenses and property taxes.

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Rentalexpense for the three most recent fiscal years consisted of the following:
| ** **          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------|------------|----------|------------|----------|------------|----------|------------|
| Minimum rentals     |       | $        | 532,263    |     | $          | 532,306  |       | $ | 494,352 |   |
| Contingent  rentals |       | 195,104  |       | 188,849  |       | 174,341  |       |
| Rental expense      |       | $        | 727,367    |     | $          | 721,155  |       | $ | 668,693 |   |

 

Futureminimum lease payments under noncancelable operating leases (with initial orremaining terms in excess of one year) as of December 31, 2004 are:
| ** **                     | ** ** | **Operating  leases** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| Year ending  December 31: |       |                  |       |
| 2005                           |       | $                     | 550,732    |   |
| 2006                           |       | 269,597               |       |
| 2007                           |       | 274,141               |       |
| 2008                           |       | 74,842                |       |
| 2009                           |       | —                |       |
| Later years                    |       | —                |       |
| Total minimum  lease payments  |       | $                     | 1,169,312  |   |

 

***Terminationand Employment Agreements***—On June 17, 2004,James M. Hussey resigned as the Company’s President, Chief Executive Officerand a member of the Board of Directors. In accepting Mr. Hussey’sresignation, the Board of Directors authorized the Company to enter into aSeparation Agreement and Full Release of all Claims (the “Separation Agreement”)with Mr. Hussey. Under the terms of the Separation Agreement, Mr. Husseywill receive a salary continuance for 12 months based upon his annual basesalary at the time of his resignation ($339,768), Company paid insurancepremiums under the Company’s medical insurance plan, plus a payment of 50% of Mr. Hussey’starget milestone bonus when 2004 bonuses are paid to the Company’s employees.The salary continuance and medical insurance premium payments will cease atsuch time as Mr. Hussey accepts full-time employment or the first datethat Mr. Hussey provides consulting or other services to any otherpharmaceutical or biotechnology organization. Additionally, Mr. Husseyagreed to serve as a consultant to the Company for a period of up to 24 monthsor upon the termination of the Separation Agreement, whichever is earlier,during which time all options previously granted to Mr. Hussey continue tovest and remain exercisable until 90 days after termination as a consultant.For the year ended December 31, 2004, the Company recorded compensationexpense of $736,803 relating to the options previously granted to Mr. Husseythat continue to vest during the term of the consulting agreement.

On June 17, 2004, NeoPharm also entered into anEmployment Agreement with Gregory P. Young to serve as the Company’s President,Chief Executive Officer and a Director in place of Mr. Hussey. Under theterms of the Employment Agreement, effective July 12, 2004, Mr. Youngreceives an annual base salary of $325,000 and a sign-on bonus of $97,500. Thesign-on bonus was payable in two installments, with the first $25,000installment paid upon commencement of employment on July 12, 2004 and thesecond installment of $72,500 payable on February 15, 2005. Mr. Youngis also entitled to an annual performance-based milestone bonus payment, amonthly car allowance of $600, and an annual reimbursement of up to $3,000 forthe cost of financial and estate planning. Additionally, upon commencing hisemployment on July 12, 2004, Mr. Young received a stock option grantof 250,000 shares with a grant price of 85% of the Company’s closing stockprice on July 12, 2004. These options vest in four equal annualinstallments on the anniversary of the option grant date. The EmploymentAgreement also allows for additional specified option grants of up to 350,000shares in the future if the Company’s common stock reaches certainpre-determined closing price levels. Mr. Young resigned as the Company’sPresident and CEO on March 8, 

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2005. Under the terms of aSeparation Agreement with Mr. Young, his options will continue to vest fora period of 12 months, resulting in the anticipated vesting of 62,500 options.All other options granted to Mr. Young are expected to be forfeited.

***DefinedContribution Retirement Plan (401(k) Plan)***—TheCompany sponsors a 401(k) Plan covering all full-time employees.Participants may contribute up to legal limitations. The 401(k) Planprovides for Company match contributions of 50% of employee contributions up to3% of the employee’s eligible compensation. The Company match contributionswere $306,130, $226,541 and $167,768 for the years ended December 31,2004, 2003, and 2002, respectively.

**10.   CONTINGENCIES**

The Company has been named in several putative classaction lawsuits (the” Class Action Suits”) each of which alleges variousviolations of the federal securities laws in connection with the Company’spublic statements during the period from September 25, 2000 through April 19,2002 as they relate to the Company’s LEP drug product candidate. The originallawsuits also named as individual defendants John N. Kapoor, the formerChairman of the Company, and James M. Hussey, the Company’s former Presidentand CEO, and Dr. Aquilur Rahman, a former director and executive officerof the Company. The first of these Class Action Suits was filed on April 26,2002 and all of the Class Action Suits have been filed in the UnitedStates District Court for the Northern District of Illinois, Eastern District.On September 16, 2002, a consolidated amended complaint was filed againstNeoPharm in this matter. The amended complaint shortened the class period to October 31,2001 through April 19, 2002, removed Dr. Rahman as a defendant, andadded Dr. Imran Ahmad, the Company’s current Chief Scientific Officer andExecutive Vice President of Research and Development, as a defendant. TheCompany intends to vigorously defend each and every claim in the Class ActionSuits and, on November 4, 2002, moved to have the complaint dismissed. TheCompany’s motion to dismiss was granted in part and denied in part in February 2003.Dr. Kapoor was dismissed from the lawsuit at that time. In November 2004,the plaintiffs filed a motion to amend and a motion for summary adjudication. Themotion to amend seeks to again make Dr. Kapoor a defendant, and reallegethat certain pre-class period statements are actionable. The Company intends tooppose both motions. No trial date has been set and discovery is ongoing. Managementis unable to estimate the potential outcome or a range of possible losses, ifany. In addition, the Company maintains insurance coverage to mitigate thefinancial impact of any potential loss.

On March 26, 2004, the Company received a letterfrom the Securities and Exchange Commission (SEC) stating that the SEC isconducting a formal investigation of the Company. The SEC stated in its letterthat it had made no determination of any violation of law by the Company or anyindividual at this time. Previously, this matter had been the subject of aninformal SEC inquiry. The Company continues to fully cooperate with the SEC andintends to do so in order to bring this ongoing inquiry to a conclusion aspromptly as possible. The Company believes the investigation is an outgrowth ofthe arbitration claim filed by the Company against Pharmacia (now Pfizer)regarding the development of its LEP and LED drug product candidates and the ClassAction Suits which have been filed against the Company relating to its publicstatements regarding the development of LEP. The Company cannot predict withcertainty the direction the investigation will take or its ultimate outcome,and therefore is unable to determine whether the results of the investigationwill have a material adverse impact on the Company’s results of operations or financialposition.

The pharmaceuticalindustry has traditionally experienced difficulty in maintaining productliability insurance coverage at desired levels. To date, no significant productliability suit has ever been filed against the Company. However, if a suit wasfiled and a judgment entered against the Company, it could have a materialadverse effect upon the Company’s operations and financial condition. While theCompany maintains insurance to cover the use of its drug product candidates inclinical trials, the Company does not maintain insurance covering the sale ofits drug product candidates, nor is there any assurance that it will 

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be ableto obtain or maintain such insurance on acceptable terms or with adequatecoverage against potential liabilities.

**11.   SUBSEQUENT EVENTS**

On March 8, 2005, Mr. Gregory P. Young resigned asPresident and CEO, and as a director of the Company. Mr. Ronald G. Eidell, anindependent member of the Company’s Board of Directors, was elected to serve asinterim President and CEO while the Company conducts a search to replace Mr. Young.

On March 10, 2005, the Company and Mr. Eidell agreedto the principal terms under which Mr. Eidell will be employed on an interimbasis. Under the terms, Mr. Eidell will receive a base salary of $325,000 untila successor is named or Mr. Eidell is terminated, 80,000 stock options, monthlytransportation allowance of $1,500, eligibility in benefit programs, andeligibility for a performance bonus.

On March 11, 2005, the Company and Mr. Young enteredinto a Separation Agreement and Full Release of All Claims. Under theagreement, Mr. Young will receive 12 months salary continuance, medical insurancefor 12 months, and his stock options will continue to vest over the 12 monthagreement. Mr. Young has the right to revoke the agreement within seven days ofthe effective date of the agreement (March 11, 2005).

**12.   QUARTERLYFINANCIAL DATA (unaudited)**

Thefollowing table summarizes the quarterly financial data for the years ended December 31,2004 and 2003:
| ** **                                                   | ** ** | **First**   | ** ** | **Second**  | ** ** | **Third**   | ** ** | **Fourth**  | ** **  |
|--------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|-------------|
| ** **                                                   | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** **  |
| **2004 quarters**                                            |       |        |       |        |       |        |       |        |        |
| Revenues                                                     |       | $           | 12,200     |        | $          | 19,080      |       | $           | 84,740      |   | $ | 40,760 |   |
| Gross margin                                                 |       | 11,956      |       | 18,782      |       | 81,274      |       | $           | 39,532      |   |
| Research and  development expenses                      |       | (11,249,227 | )          | (12,008,378 | )          | (10,621,195 | )          | $           | (10,634,137 | ) |
| Selling, general,  administrative and related party expenses |       | (3,235,433  | )          | (3,018,566  | )          | (3,712,207  | )          | $           | (3,251,409  | ) |
| Employee  termination costs                                  |       | —      |       | —      |       | —      |       | $           | (1,149,277  | ) |
| Loss from  operations                                        |       | (14,472,704 | )          | (15,008,162 | )          | (14,252,128 | )          | $           | (14,995,291 | ) |
| Net loss                                                     |       | (14,247,190 | )          | (14,759,479 | )          | (13,954,570 | )          | $           | (14,647,470 | ) |
| Net loss per  share basic and diluted                   |       | $           | (0.65      | )           | $          | (0.63       | )          | $           | (0.60       | ) | $ | (0.63 | ) |
| **2003  quarters**                                           |       |        |       |        |       |        |       |        |        |
| Revenues                                                     |       | $           | —     |        | $          | —      |       | $           | —      |   | $ | — |   |
| Gross margin                                                 |       | —      |       | —      |       | —      |       | —      |        |
| Research and  development expenses                      |       | (7,108,556  | )          | (8,767,286  | )          | (9,164,262  | )          | (9,222,163  | )           |
| Selling, general,  administrative and related party expenses |       | (4,443,576  | )          | (7,916,096  | )          | (3,203,950  | )          | (3,780,645  | )           |
| Loss from  operations                                        |       | (11,552,132 | )          | (16,683,382 | )          | (12,368,212 | )          | (13,002,808 | )           |
| Net loss                                                     |       | (11,267,240 | )          | (16,428,828 | )          | (12,219,597 | )          | (12,875,434 | )           |
| Net loss per share basic  and diluted                   |       | $           | (0.60      | )           | $          | (0.87       | )          | $           | (0.65       | ) | $ | (0.68 | ) |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

TheBoard of Directors and Stockholders

NeoPharm, Inc.:

Under the date of March 14, 2005, we reported onthe consolidated balance sheets of NeoPharm, Inc. and subsidiary (theCompany) as of December 31, 2004 and 2003, and the related consolidatedstatements of operations, stockholders’ equity, and cash flows for each of theyears in the three-year period ended December 31, 2004. In connection withour audits of the aforementioned consolidated financial statements, we alsoaudited the related financial statement schedule. This financial statementschedule is the responsibility of the Company’s management. Our responsibilityis to express an opinion on the financial statement schedule based on our audits.

In ouropinion, such financial statement schedule, when considered in relation to thebasic consolidated financial statements taken as a whole, presents fairly, inall material respects, the information set forth therein.
| /s/ KPMG LLP        |   |
|---------------------|--------|
| Chicago, Illinois   |
| March 14, 2005 |

 

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**NEOPHARM, INC. ANDSUBSIDIARY**

**Schedule** II—Valuation andQualifying AccountsFor the Years Ended December 31, 2004, 2003, and 2002
| ** **                         | ** ** | **Valuation allowance  for note receivable** | ** ** |
|------------------------------------|------------|-------------------------------------------------------------|------------|
| Balance at  December 31, 2002 |       |                                                        | $          | 2,189,281 |   |   |
| Charged to  operations             |       |                                                        | —     |   |   |
| Balance at  December 31, 2003 |       |                                                        | 2,189,281  |   |   |
| Charged to  operations             |       |                                                        | —     |   |   |
| Balance at  December 31, 2004 |       |                                                        | $          | 2,189,281 |   |   |

 

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