**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

----

**FORM 10-K**

**(MARK ONE)**

| **x**                                                | ** ** | **Annual Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934**     |
|------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| **For the Fiscal Year Ended December 31, 2005** |
| **Or**                                               |
| **o**                                                | ** ** | **Transition Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |

 

**Forthe Transition PeriodFrom               To               **

**COMMISSIONFILE NUMBER 33-90516**

**NEOPHARM, INC.**

(Exact Name of Registrantas Specified in its Charter)

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

 

**1850 LAKESIDE DRIVEWAUKEGAN, ILLINOIS  60085**

(Address of PrincipalExecutive Offices) (Zip Code)

**(847) 887-0800**

(Registrant’s TelephoneNumber, Including Area Code)

SECURITIES REGISTEREDPURSUANT TO SECTION 12(b) OF THE ACT:**NONE**

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

**COMMON STOCK, $.0002145 PARVALUE**

(Title of class)

----

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o  No x

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(D) of the Act. Yes o  No  x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x  No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

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

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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o No  x

The aggregate market valueof the registrant’s common stock held by non-affiliates (affiliates being, forthese purposes only, directors, executive officers and holders of 10% or more ofthe registrant’s stock) of the registrant, par value $.0002145 per share,(based on the closing price of such shares on the NASDAQ on June 30, 2005)was $158,976,794. As of March 1, 2006 there were 27,765,051 shares ofcommon stock outstanding.

**DocumentsIncorporated by Reference**

Certaininformation required in Part III of the registrant’s Annual Report on Form 10-Kfor December 31, 2005 is incorporated by reference to portions of theregistrant’s definitive proxy statement for its 2006 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, 2005.

 

----

**FORM 10-KTABLE OF CONTENTS**

|               | ** ** |                                                                                                                         | ** ** | **Page** | ** ** |
|---------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I   |       |                                                                                                                    |       |     |       |   |   |
| Item 1.  |       | Business                                                                                                                |       |     | 1          |   |   |
| Item 1A. |       | Risk  Factors                                                                                                           |       |     | 17         |   |   |
| Item 1B. |       | Unresolved Staff Comments                                                                                               |       |     | 34         |   |   |
| Item 2.  |       | Properties                                                                                                              |       |     | 34         |   |   |
| Item 3.  |       | Legal  Proceedings                                                                                                      |       |     | 34         |   |   |
| Item 4.  |       | Submission of Matters to a Vote of Security Holders                                                                     |       |     | 35         |   |   |
| PART II  |       |                                                                                                                    |       |     |       |   |   |
| Item 5.  |       | Market for the Registrant’s Common Equity, Related  Stockholder Matters, and Issuer Purchases of Equity Securities |       |     | 37         |   |   |
| Item 6.  |       | Selected  Financial Data                                                                                                |       |     | 38         |   |   |
| Item 7.  |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operation                              |       |     | 39         |   |   |
| Item 7A. |       | Quantitative and Qualitative Disclosures About Market  Risk                                                             |       |     | 45         |   |   |
| Item 8.  |       | Financial Statements and Supplementary Data                                                                             |       |     | 45         |   |   |
| Item 9.  |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                                   |       |     | 45         |   |   |
| Item 9A. |       | Controls and Procedures                                                                                                 |       |     | 45         |   |   |
| Item 9B. |       | Other  Information                                                                                                      |       |     | 48         |   |   |
| PART III |       |                                                                                                                    |       |     |       |   |   |
| Item 10. |       | Directors and Executive Officers of the Registrant                                                                      |       |     | 48         |   |   |
| Item 11. |       | Executive Compensation                                                                                                  |       |     | 48         |   |   |
| Item 12. |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                         |       |     | 48         |   |   |
| Item 13. |       | Certain Relationships and Related Transactions                                                                          |       |     | 49         |   |   |
| Item 14. |       | Principal Accounting Fees and Services                                                                                  |       |     | 49         |   |   |
| PART IV  |       |                                                                                                                    |       |     |       |   |   |
| Item 15. |       | Exhibits, Financial Statement Schedules                                                                                 |       |     | 50         |   |   |
|          |       | Signatures                                                                                                              |       |     | 55         |   |   |

 

----

**PART I**

**ITEM 1.**                BUSINESS

**FORWARD LOOKING STATEMENTS**

This annual reporton Form 10-K includes forward looking statements within the meaningof the Private Securities Litigation Reform Act of 1995. We have based theseforward looking statements largely on our current expectations and projectionsabout future events and financial trends affecting the financial condition ofour business. These forward looking statements are subject to a number ofrisks, 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 1A.—RISK FACTORS, and anydocuments incorporated by reference that describe risks and factors that couldcause results to differ materially from those projected in these forwardlooking statements.

We caution you that therisk factors contained herein are not exhaustive. We operate in a continuallychanging business climate which can be expected to impact our forward lookingstatements, whether as a result of new information, future events, orotherwise, after the date of this annual report. In light of these risks anduncertainties, the forward looking events and circumstances discussed in thisannual report may not occur and actual results could differ materially fromthose anticipated or implied in the forward 

1

----

lookingstatements. Accordingly, you should not rely on forward looking statements as aprediction of actual results.

**BUSINESS OVERVIEW**

NeoPharm, Inc. is a Delaware corporationincorporated on June 15, 1990. In 2004, we established a wholly-ownedsubsidiary, NeoPharm EU Limited, in order to comply with regulatoryrequirements enacted by the European Union for clinical trials conducted inmember countries.

We area biopharmaceutical company engaged in the research, development, andcommercialization of drugs for the treatment of cancer. We have built a drugportfolio based on two proprietary technology platforms: the NeoLipid®liposomal drug delivery system and a tumor-targeting toxin platform. We havefour drug product candidates in various stages of clinical development for thetreatment of cancer. The following table summarizes key information about ourcurrent drug 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 II(2)                |       | Worldwide                       |
| LErafAON                   |       | Cancer                                                              |       | Phase I                    |       | Worldwide                       |

----

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

(2)          Phase I clinical trialcompleted in 2004. Commencement of Phase II pending outcome of discussions withFDA regarding the optimal regulatory pathway.

Our most advanced drug product candidate iscintredekin besudotox, a tumor-targeting toxin being developed as a treatmentfor glioblastoma multiforme (GBM), a deadly form of brain cancer. We completedenrollment in the pivotal Phase III “PRECISE” clinical trial for patientssuffering from GBM at first recurrence in December 2005. PRECISE was designedto provide evidence of a statistically significant improvement in overallsurvival for patients on the cintredekin besudotox arm as compared to patientsreceiving treatment in the control arm, and includes two futility analyses (at50 deaths and 100 deaths), an interim efficacy analysis at 160 deaths and thefinal efficacy analysis at 215 total deaths in the study. The first twomilestones (the futility analyses) were reached in 2005 and subsequently theindependent Data Monitoring Committee (iDMC) recommended that we continue thePRECISE trial as planned. While we are blinded to the results of the PRECISEtrial, we currently estimate that the next milestone, the interim efficacyanalysis after 160 total deaths in the study, could occur as early as the secondquarter of 2006. The final analysis is currently expected to occur late in thefourth quarter of 2006 or early in 2007.

In addition, threecompounds based on our NeoLipid® drug delivery platform are currently in orhave completed Phase I  and we are makingpreparations to begin 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;

2

----

·       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.

The NeoLipid® drug delivery technology combines drugsor other compounds with our proprietary lipids and allows for the creation of astable liposome. This physical property is especially important during drugstorage and after the drug has been administered intravenously to the patient.We believe our NeoLipid® technology may have applications in a variety of otherareas in addition to our drug product candidates in clinical development.

In October 2005, Guillermo A. Herrera wasappointed as our new President and CEO and as a director. Mr. Herrerareplaced Mr. Ronald G. Eidell, a member of our Board of Directors, whoserved as interim President and CEO from March 2005 to October 2005.

In January 2006, we completed the sale of4,025,000 shares of our common stock to the public. Proceeds to the Companywere approximately $39.0 million, net of underwriting fees, but beforeexpenses. The proceeds from this sale of stock are being used to fund clinicaltrials of our drug product candidates; preclinical studies for other potentialdrug product candidates; and for working capital, capital expenditures, andother general corporate purposes.

Also in January 2006,we hired Timothy P. Walbert to serve as Executive Vice President CommercialOperations. Mr. Walbert is responsible for working with the other membersof our senior management team to develop and execute our overall commercialstrategy, including global marketing, business development, sales,reimbursement, and commercialization.

**MARKET OVERVIEW**

According to the American Cancer Society (“ACS”) *2006 Cancer Facts and Figures*, cancer is the second leadingcause of death in the United States, accounting for one in every four deaths.The ACS *2006 Cancer Facts and Figures* alsoestimates that doctors will diagnose approximately 1.4 million new cases ofcancer in the United States in 2006. The National Institutes of Health (“NIH”)estimate that the annual cost of cancer in 2005 was approximately $209.9billion, including $74.0 billion in direct medical costs and $17.5 billion formorbidity costs, 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 orspread. Following diagnosis, solid tumors are typically surgically removed orthe patient is given radiation therapy. Chemotherapy is the principal treatmentfor tumors that are likely to, or have, metastasized. Chemotherapy involves theadministration of drugs which are designed to kill cancer cells, affect thegrowth of tumors, or reduce bloodflow to tumors, in an effort to reduce oreliminate cancerous 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 

3

----

cancer drugs that arebeing administered. This is known as “multi-drug resistance.” The side effectsof chemotherapy often limit the effectiveness of treatment. Cancers often recurand mortality rates remain high. Despite large sums of money spent on cancerresearch, current treatments are largely inadequate and improved anti-canceragents are needed.

The productswe currently have under development target a broad range of solid tumors. Thetable below shows the incidence and mortality estimated for the year 2006 forvarious types of solid tumor cancers that our products seek to treat:

| **Cancer Indication** | ** ** | ** ** | ** ** | **New Cases** | ** ** | **Deaths** | ** ** |
|----------------------------|------------|------------|------------|--------------------|------------|------------|------------|
| Breast                     |       |       | 214,640    |               |       | 41,430     |       |
| Lung                       |       |       | 174,470    |               |       | 162,460    |       |
| Colorectal                 |       |       | 148,610    |               |       | 55,170     |       |
| Ovarian                    |       |       | 20,180     |               |       | 15,310     |       |
| Brain                      |       |       | 18,820     |               |       | 12,820     |       |

 

Source: American CancerSociety, 2006 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 clinical and pre-clinical anti-cancer drug product candidatesunder development. We intend to further develop these drug product candidatesboth by expanding our internal resources and by continuing to collaborate withother companies and leading governmental and educational institutions.

*Create new productsby capitalizing on our NeoLipid® drug delivery platform*

We intend to furtherexplore the use of our proprietary NeoLipid® liposomal drug delivery technologyto create new products in two ways: life cycle management, therefore extendingthe patent life and/or modifying the pharmacokinetic profile of existing cancerdrugs, and by utilizing our platform to develop new drugs. We are aware ofseveral widely used cancer drugs that are nearing patent expiration, as well asother widely used cancer drugs with patents that have expired. When a drug iscombined with another agent or delivery system in a novel way, its patent lifemay be extended. Secondly, while many chemotherapeutic drugs have beeneffective for the treatment of cancer, these drugs have been limited in theiruse because of adverse side effects and difficulties in administration. Usingour NeoLipid® drug delivery technology, we believe opportunities exist for usto increase the usefulness of these compounds as improved anti-cancer treatments.Thirdly, we believe that our liposomal drug delivery technology may provide uswith a platform for the development of novel therapeutic agents for cancer drugdevelopment.

4

----

*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 as well as potential partnershipswith third parties. In addition, by broadening our drug product candidate portfolio,we increase our flexibility to eliminate drug product candidates that wedetermine may have less market potential while applying additional resources tothe drug product candidates 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 withpharmaceutical companies, or others, to assist in the commercialization anddevelopment of our drug product candidates outside of North America.

**DRUG PRODUCT CANDIDATES**

**Cintredekin besudotox*(IL13-PE38QQR)***

We have completed enrollment in a pivotal Phase IIIclinical trial, which we refer to as the PRECISE trial, for cintredekinbesudotox for the treatment of glioblastoma multiforme, a deadly form of braincancer. We have exclusively licensed cintredekin besudotox from the NIH and theFDA, and have been developing this drug product candidate under a CooperativeResearch and Development Agreement (“CRADA”) with the FDA Center for BiologicsEvaluation and Research (“CBER”). Cintredekin besudotox has received orphandrug designation in the US and Europe and fast track drug development programstatus in the US from the FDA. In addition, cintredekin besudotox has beenselected to participate in the FDA’s Continuous 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 

5

----

besudotox is designed todetect and bind IL-13 receptors on the surface of malignant glioma cancercells and selectively deliver PE38 to destroy tumor cells while sparing healthysurrounding cells. Cintredekin besudotox is administered by a technique knownas convection-enhanced delivery, or CED, in which the drug is delivered throughcatheters inserted in the tumor (intratumoral administration) or brain tissuesurrounding the tumor (peritumoral administration) before and/or followingsurgical resection of the tumor. CED is designed to infuse cintredekinbesudotox directly to the tumor site and adjacent brain tissue with the goal ofkilling resident tumor cells and preventing recurrence of tumor cell growth.

Phase I/II data published from the four studies ofcintredekin besudotox completed to date represent clinical data fromapproximately  100 patients in variousclinical settings, including intra and peritumoral delivery of cintredekinbesudotox for treatment of malignant glioma. The findings suggest possibleevidence of tumor cytotoxic (cancer cell killing) effects of cintredekinbesudotox against malignant glioma tumor cells. Although these studies were notdesigned to address efficacy, encouraging survival results continue to beobserved beyond two years following treatment, in some patients. Promising datain the treatment of GBM (a type of malignant glioma) was observed in the PhaseI/II studies. In addition, the importance of adequate catheter positioning inorder to achieve optimal distribution of cintredekin besudotox in brain tissuewas assessed, leading to specific guidelines for catheter positioning anddeferred catheter placement. This translated into a better patient outcome forthe 45 recurrent GBM patients treated post-tumor resection in the Phase I/IIstudies, with an overall median survival of 44.0 weeks (95% Confidence Interval(CI): 36.1-52.4) including 42% of patients with less than 2 adequatelypositioned catheters, while patients with at least 2 catheters adequatelypositioned experienced median survival of 51.7 weeks (95% CI: 36.1-78.0).Separately, 1-year and 2-year survival rates for recurrent GBMpatients were 40% and 20%, respectively. These patients continue to be followedand the associated long-term survival data is updated periodically.

Based on the data from these studies, we beganenrolling patients in the PRECISE trial in the first quarter of 2004 andcompleted enrollment in December 2005. This trial is a multi-center,multi-national study that enrolled a total of 294 patients suffering from firstrecurrent GBM tumors who were randomized into one of two treatment arms of thestudy, which resulted in an intent-to-treat population of 276 patients withconfirmed recurrent GBM. One group, approximately 184 of the intent-to-treatpatients, received convection-enhanced infusion of cintredekin besudotox aftersurgery and the other group, approximately 92 of the intent-to-treat patients,was treated through placement of Gliadel® Wafers (MGI Pharma, Inc.) at thetime of surgery. Gliadel® Wafers are approved for treatment of patientsundergoing surgery after either initial or recurrent treatment of the disease.The primary end point of PRECISE is to determine if there is a statisticallysignificant difference in overall patient survival between the two arms of thestudy. In accordance with the PRECISE trial protocol, an interim efficacyanalysis will be conducted by the iDMC after notification of 160 deaths,currently expected to occur as early as the second quarter of 2006, to evaluatepotential superiority of long term patient survival of cintredekin besudotoxover Gliadel® Wafer. If results are considered statistically significant (p £ .005), we would at that pointevaluate plans to proceed with a biologics license application (“BLA”)submission prior to receiving results from the final efficacy analysis. Ifnecessary, a final analysis will be conducted after notification of 215 deaths,to demonstrate superiority of long-term survival of cintredekin besudotox overGliadel® Wafer. The final analysis is currently expected to occur late in thefourth quarter of 2006 or early in 2007.

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, anaplasticastrocytoma, and malignant mixed oligoastrocytoma, among others. The Phase Iclinical trial is being conducted in collaboration with the American College ofSurgery Oncology Group (ACOSOG). Enrollment in this trial is expected to becompleted in the first quarter of 2006.

6

----

***LE-SN38***

LE-SN38 is our NeoLipid® liposomal formulation of SN-38,the active metabolite of Camptosar®, a chemotherapeutic pro-drug, which is usedas a first-line and second-line colorectal cancer treatment. At the presenttime, 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,Camptosar® is converted into SN-38 in colorectal cancer cells atdifferent rates by different patients, and this variability in conversion ratescan result in suboptimal dosing and adverse side effects, such as severediarrhea. By employing our proprietary NeoLipid® technology to deliver SN-38,we hope to deliver the active drug to the tumor cells without the need forconversion, therefore minimizing variability and optimizing dose with minimalside effects.

During 2004, we completed a Phase I clinical trial forLE-SN38. The primary objectives of the Phase I study were to determine thepharmacogenomics, pharmacokinetics, and safety of LE-SN38 in patients withadvanced local or metastatic solid tumors who have failed conventional therapy.Tumor progression was also monitored. In this trial, groups of patientsreceived escalating doses of intravenous LE-SN38 infusion over 90 minutes every21 days until disease progression or unacceptable toxicity levels were reached.Results from this Phase I study demonstrated the safety and tolerability ofLE-SN38 and established a maximum tolerated dose (“MTD”) for all but a smallsubset of patients that metabolize SN-38 slowly. Pharmacokinetic analysisof blood samples from patients treated with LE-SN38 showed that blood levelsand systemic drug exposure to SN-38 were comparable to or greater thanthat expected from the marketed Camptosar® dose based on previously publishedstudies. In addition, dose limiting diarrhea was not observed. Phase IIplanning is underway and is pending the outcome of discussions with the FDAregarding the optimal regulatory pathway for this drug product candidate.

***LEP-ETU***

LEP-ETU is our NeoLipid® liposomal formulation of thewidely used cancer drug, paclitaxel. Paclitaxel, also known as Taxol®(Bristol-Myers Squibb Company), has been approved in the US for the treatmentof ovarian, breast and lung cancers. Despite paclitaxel’s wide use and itstumor cytotoxic characteristics, its effectiveness can be limited by itsadverse side effects, which can include nausea, vomiting, hair loss and nerveand muscle pain. Because of the chemical characteristics of paclitaxel, itcannot be introduced into the body unless it is first formulated in a mixtureof castor oil (Cremophor®) and ethanol, which can lead to significant sideeffects such as hypersensitivity reactions. We believe that by using ourproprietary NeoLipid® technology, which eliminates the need for Cremophor andethanol, LEP-ETU may overcome many current limitations of paclitaxel treatmentfor cancer patients and may limit the adverse side effects of currenttreatments.

During 2004, we completed a Phase I clinical trial forLEP-ETU. Results of the study indicated that LEP-ETU appeared to be welltolerated in terms of typical paclitaxel side effects by the majority ofpatients, including those receiving the higher doses of drug, as well as thosewho were not premedicated with antihistamines and steroids. Antitumor activitywas observed, with 16% of patients experiencing partial responses (shrinkage oftumor by 50% or more). Additionally, 44% of patients evidenced stable diseaseand were able to complete 4 or more 3-week cycles of LEP-ETU treatment.Patients previously treated with taxanes were among those who responded toLEP-ETU. The MTD was determined to be 375 mg/m2.

During 2005, we completeda Phase I clinical trial designed to assess the pharmacokinetic profile ofLEP-ETU compared to Taxol®. Although the study achieved total paclitaxelconcentration and area under the curve levels comparable to Taxol®, the FDA hasindicated that additional data is required to establish bioequivalence betweenLEP-ETU and Taxol®. We are currently engaged in a dialogue with the FDA todecide the optimal regulatory pathway. The next steps for LEP-ETU will bedetermined once we have received guidance from the FDA.

7

----

***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:liposomal delivery 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-raf protein,LErafAON may have independent anti-tumor activity and may render tumor cellsmore susceptible to radiation or chemotherapy. Pre-clinical studies indicatethat LErafAON may prove to be beneficial in enhancing the activity of a broadrange of chemotherapies in the treatment of various forms of cancer. Ourliposomes 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 tumors. During the fourth quarterof 2004, we initiated a Phase I clinical trial of LErafAON which now takesadvantage of our new cationic cardiolipin based NeoPhectinTM technology. Theprimary endpoint of the Phase I study is to determine the dose limitingtoxicity (“DLT”) and MTD of LErafAON. The pharmacokinetics and tumor treatmenteffect of LErafAON will also be assessed. Patient enrollment is anticipated tobe completed in 2006.

**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          |       | MGI Pharma, Inc.          |       | Gliadel® Wafer      |
| LE-SN38                        |       | Pfizer Inc.               |       | Camptosar®          |
| LEP-ETU                        |       | Bristol-Myers  Squibb Co.      |       | Taxol®(1)           |
| LErafAON                       |       | Isis Pharmaceuticals Inc. |       | Antisense products(2)    |

----

(1)          This product iscurrently off-patent and generics are available.

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

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

8

----

**RESEARCH AND DEVELOPMENT 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. As of December 31, 2005, we employed 73 individualsin our pre-clinical and clinical research and development departments. We haveincurred research and development expenses of approximately $31,851,000 in2005, $44,513,000 in 2004 and $34,262,000 in 2003 to develop our drug productcandidates and pre-clinical compounds.

**COLLABORATIVERELATIONSHIPS AND LICENSES**

**License and Research 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 withGeorgetown University relating to various liposome- related products.

Under the Georgetownlicenses, and in return for sponsoring related research, we were grantedexclusive 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 paid an up-front licensing feeand advance royalty payments (which may be credited against future royalties)of $75,000. Additionally, we may be obligated to make milestone payments uponachieving certain development objectives for these compounds. The Georgetownlicenses expire in 2013 for LED, 2014 for LEP and 2020 for LErafAON. Thelicenses may also be terminated by either party in the event of a default bythe other party.

9

----

***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 | % |   |

 

Until February 2005,we had three annual contract research agreements, under each of which we paidor reimbursed Georgetown for all direct and indirect costs associated with researchon specific projects. In return, with respect to any project for which anapplication is ultimately approved by the FDA, we retain all rights to allinventions, developments, discoveries and other proprietary ideas which arefirst conceived, discovered or developed during the conduct of the researchupon making a one-time payment of 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 developand commercialize cintredekin besudotox (IL13-PE38QQR) for the treatment ofcancer. The cintredekin besudotox license required us to pay NIH an initial$75,000 non-refundable payment and requires minimum annual royalty payments toNIH of $10,000 that increase to $25,000 after the first commercial sale. Thecintredekin besudotox license also requires us to pay to NIH milestone paymentsof up to $585,000 upon completion of various phases of development ofcintredekin besudotox and a maximum royalty of 4% based on future productsales, if any. The license agreement terminates in 2018. However, we have theunilateral right to terminate the license agreement at any time upon 60 dayswritten notice. The NIH may terminate the agreement upon our default inperforming any material obligation under the agreement or if it determines thatsuch action is necessary to meet the requirements for public use specified byfederal regulations and we were not reasonably satisfying such requirements.While providing us with an exclusive license, it should be noted that, (i) theNIH does not make any representations or warranties in the license agreement asto the validity or enforceability of the licensed rights and retains certainrights of use for the government, and (ii) notwithstanding our exclusivelicense, co-rights to the technology are claimed by one of the originalinventors and he purports to have assigned such rights to a third party. SeeItem 1 A.—Risk Factors.

*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 $130,000 to the FDA in2005. Funding for the FDA CRADA expires April 30, 2006. Termination of theFDA CRADA, however, does not affect our rights under our license agreement withthe NIH for cintredekin besudotox.

10

----

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, 2005** | ** ** | **Additional Aggregate  Potential Payments(1)** | ** ** |
|-------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Georgetown                    |       |                                                                        | $          | 2,561,840                                                 |       |   |   | $ | 1,500,000 |   |   |
| NIH                           |       |                                                                        | 1,091,191  |                                                      |       |   | 450,000 |   |   |
| FDA                           |       |                                                                        | 1,910,000  |                                                      |       |   | — |   |   |
| Total Collaboration  Expenses |       |                                                                        | $          | 5,563,031                                                 |       |   |   | $1,950,000 |   |   |

----

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

**ClinicalTrial Monitoring 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 wecurrently only have a limited capacity to monitor clinical trials with internalstaff, we have contracted with third parties to provide us with CGCP services.

In December 2004, wefinalized an agreement with PPD Development, LP (“PPD”) to provide studymonitoring and administration services for our PRECISE trial. Under theagreement, PPD is responsible for recruiting study sites and monitoring patientprogress, among other responsibilities, throughout North America, Europe andIsrael. The terms of the agreement require NeoPharm to pay PPD a total ofapproximately $6.5 million for direct expenses through June 2006, whichare exclusive of clinical trial site costs for treating patients. As ofDecember 31, 2005, approximately $5.6 million in expense had been incurredunder the terms of the agrement. The remaining expense of approximately $0.9million consists of monthly fees and milestone payments payable as certainobjectives, related to submission of required documents, are met. The agreementcan be terminated with or without cause by either party upon 30 days priorwritten notice, and we believe there are at least 25 other organizations, someof which we currently have relationships with, which could provide us withthese services, though no assurance can be given that such services would beavailable to us when we need them or be available on terms and conditions thatwe would find acceptable.

**Manufacturing Agreements**

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.

11

----

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, 2005, Diosynth has completed themanufacturing of quantities of cintredekin besudotox necessary to complete thePRECISE trial. In September 2005, we amended the Diosynth agreement toprovide for completion of the necessary work related to certain sections of acintredekin besoudotox BLA submission that would be required in the event thePRECISE trial achieves its endpoint. The conclusion of this work is expected toprovide us with initial FDA approved commercial supplies of cintredekinbesudotox in the event FDA approves a BLA. We have not yet secured commercialmanufacturing capacity for cintredekin besudotox from Diosynth, but we believethere are at least two other sources available to us and we expect to securethat capacity in the future.

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 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, as needed.

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 or that having to obtain alternative sources of supply wouldnot substantially delay development of our drug candidates.

**Patents and Proprietary Rights**

We either own or have in-licensed over 50 UnitedStates patents or patent applications relating to our drug product candidatesand compounds. We have also filed applications in a number of foreignjurisdictions which are counterparts of our issued United States patents andpending patent applications, many of which have issued into patents in therespective countries. We believe all of our drug product candidates andcompounds under development are protected by patents owned or licensed to usand that we will not be infringing upon anyone else’s patented rights uponentry into the marketplace.

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 we maybe found to infringe and, therefore, adversely affect our ability to conductbusiness or are able to circumvent our patent position by designing around ourpatented technology. It is possible that other parties have invented compoundsor processes that would precede any of our discoveries in the United States.Finally, there can be no assurance that others will not independently developsimilar pharmaceutical products which will compete against ours, or cause ourdrug product candidates and 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 

12

----

information and inventionassignment agreements upon commencement of employment or consultingrelationships with us. These agreements provide that all confidentialinformation developed or made known to the individuals during the course oftheir relationship with us must be kept confidential, except in specifiedcircumstances. However, we cannot assure you that these agreements will providemeaningful protection for our trade secrets or other proprietary information inthe event of unauthorized use or disclosure of confidential information.Further, invention assignment agreements executed by consultants and advisorsmay conflict with, or be subject to, the rights of third parties with whom suchindividuals have employment or consulting relationships. In addition, we cannotassure you that others will not independently develop equivalent proprietaryinformation and techniques or otherwise gain access to our trade secrets, thatsuch trade secrets will not be disclosed, or that we can effectively protectour rights to unpatented trade secrets.

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 investigate any possible infringement upon or design aroundsuch patents, or we could find that the development, manufacture, or sale ofproducts requiring such licenses could be foreclosed due to infringement uponthose rights. Litigation may be necessary to defend against or assert claims ofinfringement, to enforce patents issued 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 Item 1A.—RISK FACTORS.

**Government Regulation**

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 scope of this regulationwill depend on the nature of the products we develop. We anticipate, however,that each of our drug product candidates will be subject to extensiveregulation during the pre-approval research and development phase, and thateach will require approval by the FDA prior to commercialization in the UnitedStates (and approval by comparable foreign government authorities prior tocommercialization in those countries). In particular, human therapeuticproducts are subject to extensive oversight during the preclinical and clinicalphases, as well as a rigorous approval standard and elaborate approvalprocedures, both in the United States and in foreign countries. Various Federalstatutes and regulations also govern or influence the manufacturing, packaging,labeling, and storing of human therapeutic products both during thepre-approval period and after approval. Various Federal statutes andregulations impose record-keeping and reporting requirements with respect to theseproducts both before and after approval and regulate the promotion andmarketing of these products after approval. The process of obtaining approvaland compliance with the appropriate Federal statutes and regulations bothbefore and after approval requires substantial time and financial resources.

The stepsordinarily required before a new drug may be marketed in the United States,which are similar to the steps required in most other countries, include:

·       preclinicallaboratory tests, preclinical studies in animals, formulation studies, and thesubmission to FDA of an investigational new drug application (“IND”);

13

----

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

·       thesubmission of a new drug application (“NDA”) or BLA to FDA; and,

·       FDAreview and approval of the NDA or BLA.

Preclinical tests include laboratory evaluation ofproduct chemistry, formulation, and toxicity, as well as animal studies. FDAregulates the laboratory work and facilities through good laboratory practice (“GLP”)regulations. The results of preclinical testing are submitted to FDA as part ofan IND. There is a 30-day waiting period after the filing of eachinvestigational new drug application before clinical testing in humans maybegin. At any time during the 30-day period, FDA may place the proposedstudy on clinical hold. A clinical hold means that the trial may not beginuntil FDA notifies the sponsor that it may begin. FDA may impose a clinicalhold, for example, if it finds that human subjects will be exposed to anunreasonable and significant risk of injury, or if the IND does not containsufficient information to assess the risks to subjects of the proposed study.

Clinical trials to support new drug applications aretypically conducted in three sequential phases, although the phases may overlap.During Phase I, clinical trials are conducted with a small number of subjectsto assess the metabolism, pharmacokinetics, and pharmacological actions of thedrug, to determine the side effects associated with increasing doses, and ifpossible to gain early evidence of the drug’s efficacy. Phase II usuallyinvolves studies in a limited patient population to assess the efficacy of thedrug in specific, targeted indications; assess dosage tolerance and optimaldosage; and  determine common short-termside effects and risks associated with the drug.

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 efficacy and to further test for safetyin an expanded patient population at geographically dispersed clinical trialsites. Phase III trials are intended to gather the additional information aboutsafety and efficacy that is needed to support product approval.

Any clinical trial conducted under an IND is subjectto FDA regulations, including its good clinical practices (“GCP”) requirements(which include safety reporting requirements), informed consent requirements,and institutional review board (“IRB”) requirements. FDA may at any time haltan ongoing clinical trial, if the agency believes that patients participatingin the trial will be or are being exposed to unacceptable health risks. FDA mayalso terminate an IND and require the sponsor to end all clinical trials underthe IND, if it finds deficiencies in the IND or in the conduct of the trialunder the IND. The regulatory authorities of foreign countries have comparableauthority to regulate, suspend, and terminate clinical trials. The clinicaltrial process is extremely costly, and positive results in the preclinicalphase do not necessarily ensure positive results in the subsequent clinicaltrials.

After successful completion of the required clinical trials,a new drug application or biologics license application (collectively an “application”)is generally submitted. In order for a new drug to be approved, the applicationmust demonstrate that it is safe and effective and that it is manufactured incompliance with CGMP. FDA may request additional information before acceptingan application for filing, in which case the application must be resubmittedwith the additional information. Once an application has been accepted forfiling, FDA reviews the application and responds to the applicant. FDA requestsfor additional information or clarification often significantly extend thereview process. FDA may refer the application to an appropriate advisorycommittee for review, evaluation, and recommendation as to whether theapplication should be approved, but FDA is not bound by the recommendations ofits advisory committees. FDA will typically also inspect the manufacturingfacility to ensure CGMP compliance.

FDA review of a BLA or NDA can take several years. IfFDA’s evaluations of the application and the manufacturing facilities arefavorable, FDA may issue an approval letter or an “approvable” letter. Anapprovable letter will usually contain a number of conditions that must be metin order to secure final 

14

----

approval of theapplication and authorization to market the drug commercially for the approvedindications.  FDA may also refuse toapprove the application or issue a “not approvable” letter outlining thedeficiencies in the submission. In this case, additional clinical testing maybe necessary before a new application will be ready for submission.

FDA has the authority to expedite its review of a drugintended for the treatment of a serious or life-threatening condition, if thesponsor demonstrates that the product has the potential to address an unmetmedical need.  Such products aredesignated as “fast track products.”   Anapplication for a fast track product may be approved if FDA determines that theproduct has an effect on a surrogate endpoint that is reasonably likely topredict clinical benefit. This means, for example, FDA has the authority toapprove a cancer therapy not only on the basis of patient survival rates andimproved quality of life, but also partial tumor shrinkage. FDA’s “fast track”authority can significantly shorten the clinical trial process and regulatoryreview period for new cancer therapies. Approval of a fast track product may besubject to the requirement that the sponsor conduct post-approval studies toconfirm the product’s effect on a clinical endpoint. Failure to conduct thesestudies with due diligence, or a negative result in these studies, can resultin expedited withdrawal of product approval. FDA often asks the sponsor of afast track product to agree to distribution restrictions or a risk managementplan.

Under the Orphan Drug Act, FDA may designate a drugproduct as an “orphan drug” if there is no reasonable expectation of recoveryof the costs of research and development from sales in the United States or ifthe drug is intended to treat a rare disease or condition, which is defined asa disease or condition that affects fewer than 200,000 persons in the UnitedStates. If FDA designates a drug product as an orphan drug, then once FDAapproves the product for marketing, it is entitled to seven years of marketexclusivity. This means the agency may not approve another sponsor’s marketingapplication for the same drug for the same orphan indication for seven years. Thereare two exceptions to the bar on new approvals. Specifically, FDA may approve asecond application for the same orphan drug if (1) the first applicationholder consents, or (2) the first application holder cannot assure theavailability of sufficient quantities of the drug to meet the needs of personswith the disease or condition.  Inaddition, the market exclusivity provision does not prevent 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 legislative proposalshave from time to time been introduced in Congress to modify this law,particularly the market exclusivity provisions.

Once a new drug is approved for sale in the UnitedStates, the product and its manufacturer continue to be subject to strict regulationby FDA. FDA imposes recordkeeping and reporting requirements, requires themanufacture of the product to comply with CGMP, and reviews the manufacturer’spromotional activities. The company is also subject to regular inspection byFDA. Serious unexpected adverse events after approval can result in a change tothe product’s labeling, a new or expanded risk management plan, and, in extremesituations, withdrawal of the product from the market and withdrawal of theapproved application.

Many of the legal requirements described in thepreceding paragraphs stem from the Federal Food, Drug, and Cosmetic Act (“FDCA”).Violation of the FDCA can result in product seizure, injunctions against thecompany, civil penalties, and criminal prosecution.

Sales of new drug products outside the United Statesare regulated under comparable laws. The requirements vary from country tocountry, but typically the pre-approval process takes several years, is heavilyregulated, and requires the investment of significant resources. As in theUnited States, manufacturing, labeling, distribution, and promotion continue tobe regulated after product approval.

In most cases, if FDA has not approved a product forsale in the United States, the product may be exported for sale outside of theUnited States only if it complies with the laws of, and has valid marketingauthorization from the appropriate authority in: the European Union, a countryin the European 

15

----

Economic Area, Australia,Canada, Israel, Japan, New Zealand, South Africa, or Switzerland. FDAregulations govern this process.

We are also subject to various Federal, state, andlocal laws, regulations, and recommendations relating to safe workingconditions, laboratory and manufacturing practices, and the use and disposal ofhazardous or potentially hazardous substances, including radioactive compoundsand infectious disease agents, used in connection with our research work.

Any of the Federal andstate laws, regulations, and requirements described in this section may changeat any time.

**Employees**

As of December 31,2005, we employed 98 people, of whom there are 73 in research and developmentand 25 in administration. Our employees are not represented by any collectivebargaining agreement and we believe our employee relations are good.

**Available Information**

Copies of our Annual Report on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-Kand amendments to those reports filed or furnished pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934 are available free of chargethrough our website (*www.neophrm.com*)as soon as reasonably practicable after we electronically file the materialwith, or furnish it to, the Securities and Exchange Commission (the “SEC”). Youmay read and copy any document we file with the SEC at the SEC’s PublicReference Room at 100 F Street, N.W., Washington, DC 20549. Pleasecall the SEC at 1-800-SEC-0330 for further information on thePublic Reference Room. Our SEC filings are also available to the public at theSEC’s website at *http://www.sec.gov.* Additionally,we have also adopted a Code of Conduct and Business Ethics applicable to allofficers, directors, and employees, which is also available on our website.

16

----

**ITEM 1A.**        RISK FACTORS

You should carefullyconsider the following risk factors, in addition to the other information setforth in this document as well as other information contained in the periodicreports we file with the SEC. Each of these risk factors could adversely affectour business, operating results and financial condition, as well as the valueof an investment in our common stock.

**If wewere unable to develop, obtain regulatory approvals for, and then market ourdrug product candidates, our business would be harmed.**

The process for developing new therapeutic products isinherently long, complex, and uncertain. We must make long-term investments andcommit significant resources before knowing whether our development programswill eventually result in products that will receive regulatory approval andachieve market acceptance.

We currently have four drug product candidates inclinical development. Each candidate is the subject of an effective IND that wefiled with FDA. The protocols for any clinical trials we perform under theseINDs must have institutional review board (“IRB”) approval, and the trials mustcomply with FDA’s good clinical practices (“GCP”) and other regulations. Thereis no assurance that the clinical trials we may seek to conduct under theseINDs will obtain IRB approval. There is also no assurance that FDA will allowus to continue the clinical trials that we have begun. FDA may suspend aclinical trial at any time if the agency believes that the patientsparticipating in the study are or will be exposed to unacceptable health risks.FDA may also terminate an IND and require the sponsor to end all clinicaltrials under that IND, if it finds deficiencies in the IND or in the conduct ofa trial under the IND. Some of our clinical trials are conducted in foreigncountries, and the regulatory authorities of those countries have comparableauthority to suspend and terminate clinical trials. Suspension or terminationof the clinical trials of our drug product candidates could substantially delayor even prevent regulatory approval of the drug product candidates.  There is no guarantee that clinical studies,if performed, will demonstrate the safety and efficacy of any drug productcandidate we have in development.

Sales of our drug product candidates will be subjectto pre-market approval requirements in the United States and in other countries.These requirements vary widely from country to country.  We cannot assure you that we will receive approvalto market any of our drug product candidates in any country. We have yet tosubmit an application for marketing approval for any of the drug productcandidates we currently have under development. We cannot predict withcertainty if or when we might submit any of these drug product candidates forregulatory review. We cannot assure you that once we submit a drug productcandidate for review, FDA or any other regulatory agency will approve thatproduct on a timely basis or at all.

Approval of our drug product candidates in the UnitedStates or a foreign country may depend on our agreement to perform burdensomeand expensive post-marketing studies or our agreement to a burdensome riskmanagement plan that could interfere with physician and patient acceptance ofour product. We cannot assure you that we will agree to perform such additionalstudies or to accept such a risk management plan. If we agree to performpost-market studies and then fail to conduct those studies with due diligence,or if those studies fail to verify the product’s clinical benefit, FDA maywithdraw its approval of the product.

If FDA or a foreign regulatory authority approves oneof our drug product candidates, we will need to manufacture, or contract withthird parties to manufacture, a sufficient volume of that product to meetmarket demand. This will require accurate forecasting of market demand. Thereis no guarantee that we will accurately forecast the market demand for any ofour drug product candidates or that there will be any market demand. There isalso no assurance that we will be able to successfully manufacture, or find athird 

17

----

party to manufacture,adequate quantities of any of our drug product candidates to meet any marketdemand.

Our most advanced drug product candidate iscintredekin besudotox (IL13-PE38QQR), which we believe has potential tobe used as a treatment for malignant gliomas. In September 1997, weexclusively licensed worldwide rights to cintredekin besudotox from the NIH andFDA. Our Phase I clinical trials to date involving this drug product candidatehave enrolled approximately 100 patients. On the basis of our preliminary PhaseI clinical trial findings for this drug product candidate, we initiated thePRECISE trial, a pivotal Phase III multi-center, multi-nationalclinical trial that enrolled a total of 294 patients, of which, in accordancewith the trial protocol, approximately 196 patients received cintredekinbesudotox. There are no assurances that cintredekin besudotox will prove to besafe and effective or receive regulatory approval for any indication.

We also have three other drug product candidates inclinical development for the treatment of various cancers: LE-SN38, LEP-ETU,and LErafAON. Each of these drug product candidates has either completed or iscurrently in Phase I clinical testing. There are no assurances that any ofthese drug product candidates will prove to be safe and effective or that anyof them will receive regulatory approval for the treatment of the indicationswhich we may pursue.

Even if we receiveregulatory approval for one of our drug product candidates in the United Statesor a foreign country, there are no assurances that the product will prove to becommercially successful or profitable.

**Weare highly dependent on achieving success in the clinical testing, regulatoryapproval, and commercialization of our most advanced drug product candidate,cintredekin besudotox, which may never be approved for commercial use. If weare unable to commercialize cintredekin besudotox, our ability to generaterevenues would be impaired and our business would be harmed.**

We have invested a significant portion of our time andfinancial resources in the development of cintredekin besudotox, and weanticipate that for the foreseeable future, our potential to achieve revenuesfrom drug product sales will be dependent on its successful clinical testing,regulatory approval in the United States, and successful commercialization. Development,approval, and successful commercialization of new drug products is a highlyuncertain process.

We may suffer significant setbacks in our Phase IIIclinical trial of cintredekin besudotox (the PRECISE trial), even afterachieving potentially promising results in earlier clinical trials.  In the fourth quarter of 2005, we completedenrollment in the PRECISE trial for patients suffering from first recurrentglioblastoma multiforme tumors. Patients in the PRECISE trial receivedtreatment either with cintredekin besudotox or with Gliadel® Wafers, a productcurrently approved to treat this disease. The primary endpoint of the study isto determine if there is a statistically significant overall patient survivaldifference between patients treated with cintredekin besudotox and patientstreated with Gliadel® Wafers. The results from our clinical trial may notdemonstrate a statistically significant difference. If the results from thePRECISE trial do not demonstrate a statistically significant difference, FDAcould determine that additional clinical trials are necessary, which coulddelay or even prevent approval and commercialization.

Even if we conclude that the results from our clinicaltrial demonstrate a statistically significant difference, FDA may not agreewith us, for example because it evaluates the data using a different method. FDAcould also conclude that the clinical trial results are not clinicallymeaningful, that there were human errors in the conduct of the clinical trial,or that for some other reason the clinical trial results are inadequate tosupport approval of cintredekin besudotox. Even if FDA agrees that the resultsfrom the PRECISE trial demonstrate a statistically significant difference, FDAmay require statistically significant results in a second Phase III trialbefore it will approve cintredekin besudotox. Even if we believe that we havesubmitted all of the data and information necessary to satisfy FDA requirementsfor approval of a 

18

----

BLA, there is a risk thatFDA will require additional data and information that we are unable to provide.Finally, even if the results are statistically significant, adverse safetyfindings in the PRECISE trial could delay or prevent regulatory approval.

Even if the results of the PRECISE trial arestatistically significant, prior to commercialization of cintredekin besudotoxin the United States, we will have to submit, and FDA will have to approve, aBLA for cintredekin besudotox. FDA approval is contingent on many factors,including its evaluation of our clinical trial results, its assessment of theremaining portions of our BLA, and its inspection of facilities wherecintredekin besudotox is manufactured. If FDA does not approve the BLA, if FDAapproval is delayed, or if FDA requires additional clinical testing or otherinformation, our ability to achieve revenues from product sales will beimpaired and our stock price would be materially and adversely affected.

Even though FDA hasawarded orphan drug designation to cintredekin besudotox, a competitor couldobtain orphan drug designation for the same drug for the same indication andcomplete its clinical trials before we complete ours. FDA could approve thatcompetitor’s product first and give it seven years of market exclusivity. Inthis case, we might not be allowed to market our product in the United Statesfor seven years. This would have a material adverse effect on our business. Thelaw would permit FDA to approve our product during the seven years if certainconditions were met, but there is no assurance we could satisfy theseconditions. We might be able to market the product outside the United States,if certain conditions were met, but there is no guarantee that we would be ableto satisfy those conditions. The export process can be complex, and there are noassurances that export would be permitted or that another country would acceptthe product. Even if FDA approves cintredekin besudotox as an orphan drug andawards it seven years of exclusivity, the law permits FDA, in certainsituations, to approve a competitor’s product. This could have a materialadverse effect on the commercial success of our product.

**Becauseall of our drug product candidates are in clinical development, there is a highrisk that further development and testing will demonstrate that our drugproduct candidates are not approvable or suitable for commercialization, whichcould cause our business to suffer.**

None of our drug product candidates has receivedregulatory approval for commercial sale. Before we can obtain regulatoryapproval for the commercial sale of any of our drug product candidates, we mustdemonstrate through pre-clinical testing and clinical trials that the drugproduct candidate is safe and effective. Conducting pre-clinical and clinicaltesting is a lengthy, expensive, and uncertain process and may take severalyears or more. Success in pre-clinical testing does not assure success inclinical trials, and positive results in early phase clinical trials do notassure a positive outcome in later trials.

Clinical developmentof any of our drug product candidates, including, but not limited tocintredekin besudotox, may be curtailed, redirected, delayed, or eliminated atany time for any of the following reasons or for other reasons:

·       ourinability to manufacture, or secure third party sources to manufacture,sufficient quantities of drug compounds for use in clinical trials;

·       ourinability to attract suitable and willing investigators for our trials;

·       ourinability to locate, recruit, and qualify a sufficient number of patients forour trials;

·       negativeor ambiguous results regarding the effectiveness of the drug product candidate;

·       undesirableside effects that delay or extend the trials, or other unforeseen orundesirable safety issues that make the drug product candidate not medically orcommercially viable;

·       ourfailure, or the failure of any third party with whom we contract, to complyfully with the investigational new drug regulations and other regulationsapplicable to clinical trials;

19

----

·       delays,suspension, or termination of trials imposed by us or an independentinstitutional review board for a clinical trial site, or a clinical hold placedupon the trial by FDA;

·       regulatorydelays or other regulatory actions, including changes in regulatoryrequirements;

·       ourinability to adequately follow patients after treatment; and

·       delaysin importing or exporting clinical trial materials.

A delay or termination ofany of our clinical trials would have an adverse effect on our business. If anyof our clinical trials is unsuccessful, this could preclude us from obtainingregulatory approval, which would have an adverse effect on our business. If anyof our clinical trials is perceived as unsuccessful by FDA or physicians, ourbusiness, financial condition, and operations would be harmed.

**Ourbusiness is subject to extensive governmental regulation, and failure to complywith those regulations can lead to unanticipated delays in product developmentand approval and can prevent commercialization.**

FDA regulates the research, development, and testingof our drug product candidates. If any of our drug product candidates isapproved for marketing and introduced into the market, FDA will continue toregulate the manufacturing, labeling, distribution, marketing, and advertisingactivities of that product.  Publichealth authorities in foreign countries have comparable authority. Compliancewith these requirements before and after approval is expensive and timeconsuming. Failure to comply can lead to regulatory action that would have anegative impact on our business.

In order to market a new therapeutic product in theUnited States, we must prove that the product is safe and effective and thatthe product is manufactured in compliance with CGMP. Completing thepre-clinical and clinical testing necessary to prove the safety andeffectiveness of a new therapeutic product, and establishing the capability tocomply with CGMP, can take many years, be very costly, and still beunsuccessful. The results of pre-clinical testing and Phase I and II studiesare not necessarily indicative of the results in larger patient populations, asevaluated in Phase III studies.

In order to market any of our drug product candidates,once this lengthy research and development process is completed, we will need tosubmit a BLA or NDA to FDA. This will need to contain pre-clinical, clinical,manufacturing, labeling, and other information, and it must demonstrate thatthe drug product candidate is safe and effective for use in humans for eachproposed indication. FDA may refuse to accept any of our applications if itviews the application as incomplete. The manufacturing facilities must alsocomply with CGMP, and FDA will inspect the facility before it approves theapplication.

Even if we completethe lengthy and expensive research and development process for one of our drugproduct candidates and file a BLA or NDA seeking approval to market thecandidate, we do not know whether FDA will approve the application on a timelybasis, or at all. FDA’s review of a BLA or NDA that it accepts can take severalyears.  FDA can delay, limit, or denyapproval for many reasons, including if:

·       itdetermines that our drug product candidate is not safe or is not effective;

·       itinterprets the data from our pre-clinical testing and clinical trialsdifferently than we do;

·       itdetermines that our manufacturing processes or facilities, or the processes orfacilities of third parties involved in the manufacture of our drug productcandidates, do not comply with CGMP;

·       itchanges its approval policies or adopts new regulations; or

·       Congressamends the FDCA, the Public Health Service Act, or other applicable laws.

The process of obtaining approvals in foreigncountries is subject to uncertainty, delay, and failure for similar reasons.

20

----

In addition, FDA (and foreign regulatory authorities)may approve a drug product candidate for fewer than all the indicationsrequested or require that the drug product be labeled in a way that differsfrom our proposed labeling. Even if FDA (or a foreign regulatory authority)approves one of our drug product candidates, it may require that we performburdensome post-marketing studies and it may impose other burdensomerequirements, including the requirement that we institute and maintain aspecial risk management plan to monitor and manage potential safety issues. Theserequirements could reduce or eliminate the drug product’s market potential.

A drug product and its manufacturer are subject tostrict regulation after product approval by FDA and comparable foreignauthorities. FDA regulates manufacturing, labeling, distribution, andpromotional activities after product approval, as do comparable foreignregulatory agencies.  We must also reportcertain adverse events involving our drug products to these agencies. Failureto comply with applicable regulatory requirements can result in, among otherthings, product seizure, civil penalties, suspensions and withdrawals ofregulatory approvals, import and export problems, product recalls, operatingrestrictions, and criminal prosecution. The restriction, suspension, orrevocation of regulatory approvals or other adverse action taken on the basisof failure to comply with applicable regulatory requirements could have amaterial adverse effect on our business, financial condition, and operations.

Previously unidentified adverse events or an increasedfrequency of adverse events that may occur post-approval could result in FDA,or other agencies, requiring us to conduct further clinical research, whichcould be expensive and could lead to new and unfavorable information about thesafety or the effectiveness of our product. New safety or effectivenessinformation after approval can result in a change in the labeling of our drugproducts, new or more extensive distribution restrictions, a new or expandedrisk management program, product recalls, withdrawal of the drug product fromthe market, or withdrawal of product approval, any of which could materiallyaffect the commercial success of the product. Any unforeseen problems with oneof our drug product candidates after approval could preclude successfulcommercialization of that product and harm our business and stock price.

**Wehave a history of operating losses, expect to continue to incur losses for theforeseeable future, and may never be profitable.**

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 fiscal years, we have incurred aggregate net lossesof approximately $149.1 million. We expect to incur additional losses and,as our 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 drug product candidates, and it is possible thatrevenues from drug product sales will never be achieved. We have generated onlylimited amounts of revenue from license fees and sales of products based upon ourNeoPhectinTM technology (a novel cationic cardiolipinliposome based technology), and it is possible that additional license revenueand/or revenue from sales of NeoPhectinTM products willcontinue to be of limited significance. We cannot at this time predict when orif we will be able to develop other sources of revenue or when or if ouroperations will become profitable, even if we are able to commercialize some ofour drug product candidates.

**Budgetconstraints may force us to delay our efforts to develop certain drug productcandidates in favor of developing others, which may prevent us fromcommercializing all drug product candidates as quickly as possible.**

Because we are an emergingcompany with limited resources, and because research and development is anexpensive process, we must regularly assess the most efficient allocation ofour research and 

21

----

developmentbudget. As a result, we may have to prioritize development activities and maynot be able to fully realize the value of some of our drug product candidatesin a timely manner, as they will be delayed in reaching the market, if at all.Recently, we have undertaken efforts to substantially decrease our expenses,including a restructuring of our workforce and a reduction in research anddevelopment spending not related to our lead drug product candidate,cintredekin besudotox. If we are not successful in maintaining the plannedlevel of spending, our efforts to commercialize cintredekin besudotox may bedelayed. Additionally, the reduction in spending on our other drug productcandidates could delay our commercialization efforts and negatively impact ourstrategy to diversify our development risk across a broad portfolio of drugproduct candidates.

**Competitionin the biopharmaceutical field is intense and subject to rapid technologicalchange. Our principal competitors have substantially greater resources todevelop and market products that may be superior to ours.**

If we obtain regulatory approval for any of our drugproduct candidates, the extent to which they achieve market acceptance willdepend, in part, on competitive factors. Competition in our industry isintense, and it is increased by the rapid pace of technological development.Existing drug products or new drug products developed by our competitors may bemore effective or have fewer side effects, or may be more effectively marketedand sold, than any that we may develop. Each of our principal competitors hassubstantially greater research and development capabilities and experience andgreater manufacturing, marketing, financial, and managerial resources than wedo. Competitive drug compounds may render our technology and drug productcandidates obsolete or noncompetitive prior to our recovery of research,development, or commercialization expenses incurred through sales of any of ourdrug product candidates. The FDA’s policy of granting “fast track” approval forcancer therapies may also expedite the regulatory approval of our competitors’drug product candidates.

Eachof the drug product candidates we currently have under development will facecompetition from drug products currently on the market or under development.The following 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            |       | MGI PHARMA, Inc.     |       | Gliadel® Wafer      |
| LEP-ETU                          |       | Bristol-Myers  Squibb Co. |       | Taxol®(1)           |
| LE-SN38                          |       | Pfizer Inc.               |       | Camptosar®          |
| LErafAON                         |       | Isis Pharmaceuticals Inc. |       | Antisense products(2)    |

----

(1)         This product is currentlyoff-patent and generics are available.

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

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

**Ourstock price has been and is likely to continue to be volatile, and aninvestment in our common stock could decline in value.**

The stock market has experienced significant price andvolume fluctuations, which often has been unrelated to the operatingperformance of particular companies. In addition, the market price of our stockhas been highly volatile and is likely to continue to be so. For example,during 2004, the market price of our common stock fluctuated between $22.70 and$4.66 per share. During 2005, the market price of our common stock fluctuatedbetween $15.47 and $7.16 per share. On May 13, 2003, our Board ofDirectors 

22

----

declared a 15% commonstock dividend to stockholders of record on June 3, 2003, which was issuedon June 10, 2003. All share information and per share data for priorperiods has been restated to reflect this stock dividend.

The followingfactors, among others, could have a significant impact on the market price ofour 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, but not limited to, current class action lawsuits and resolution ofthe ongoing SEC investigation of the Company;

·                    actualor anticipated fluctuations in our financial results;

·                    ourability to obtain financing, when needed;

·                    economicconditions in the US and abroad;

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

·                    adverseregulatory actions or decisions;

·                    lossesof key management;

·                    changinggovernmental regulations;

·                    ourability to secure adequate third party reimbursement for products developed byus;

·                    developmentsor disputes concerning patents or other proprietary rights;

·                    productor patent litigation; and

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

Additionally, volatility or a lack of positiveperformance in our stock price may adversely affect our ability to retain keyemployees, all of whom have been granted stock options.

These factors and fluctuations, as well as politicaland market conditions, may materially adversely affect the market price of ourcommon stock.

23

----

**Weare currently named as a defendant in a number of securities class actionlawsuits. The volatility of our stock increases the risk that additionalsecurities class action litigation could be instituted against us in thefuture.**

Securities class action litigationis often brought against a company following periods of volatility in themarket price of its securities. We, along with certain of our officers, arecurrently named as defendants in a number of class action lawsuits which havebeen consolidated for trial and are currently pending in the federal districtcourt for the Northern District of Illinois, and each of which alleges variousviolations of the federal securities laws in connection with certain of ourpublic statements as they relate to our LEP drug product candidate. We may benamed as a defendant in similar litigation in the future. While we arevigorously defending this litigation, this litigation has resulted, and can beexpected to continue to result, in substantial costs and in a diversion ofmanagement’s attention and our resources, which could harm our business andfinancial condition, as well as the market price of our stock. Moreover, it mayresult in an adverse judgment against us or a settlement, either of which couldrequire us to make a payment to the plaintiffs to the extent a possible paymentexceeds or is not covered by our insurance.

**TheSEC has initiated an investigation of the Company. We believe that thisinvestigation was initiated as a consequence of our arbitration proceeding, nowconcluded, involving Pharmacia’s development of LEP and LED and the classaction lawsuits involving our public statements regarding LEP.**

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.

**Wewill need to raise additional capital in the future. If additional capital isnot available, we may have to curtail or cease operations.**

We estimate that asof December 31, 2005, our then existing cash reserves, plus capital raisedin our follow-on stock offering in January 2006, should be sufficient tofinance our operations at current and projected levels of development andgeneral corporate activity approximately through the fourth quarter 2007. Wecan offer no assurance that we will be able to generate revenues from productsales in the near term or in the future, at a rate sufficient to fund ouroperations. Even though we were successful in raising additional capital in January 2006,we will need additional future financing depending on a number 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;

24

----

·       thecosts of preparing, filing and prosecuting patent applications, maintaining andenforcing our patent claims and other intellectual property rights andinvestigating and defending against infringement claims asserted against us byothers;

·       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.

Additional financing maynot be available 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 developmentprograms.

**Wedepend on third parties for a variety of functions, including the research anddevelopment, manufacturing, clinical testing, and regulatory compliance of ourdrug product candidates. No assurance can be given that these third partiesarrangements will allow us to successfully develop and manufacture and marketour drug product candidates.**

We do not have the internal infrastructure to conductclinical trial management or certain other aspects of clinical testingourselves. As of December 31, 2005, we had 97 full-time employees. Wetherefore rely on third parties to perform a variety of functions with respectto the clinical development of our drug product candidates, including clinicaltrial management. If we develop additional drug product candidates withcommercial potential, we will have to either hire additional personnel skilledin clinical testing or engage third parties to perform such services.

We have engaged PPD to oversee our PRECISE trial forcintredekin besudotox. Our agreement with PPD obligates us to compensate PPD ona monthly basis plus make milestone payments as the trial progresses. Forassistance in the management and testing for our Phase I and Phase II clinicaltrials we have engaged Research Solutions Incorporated and Prologue ResearchInternational, Inc. on a per study basis. To oversee data management inour clinical trials we have contracted, on a per study basis, with AdvancedClinical Services. To conduct our large animal testing, we have engaged, againon a per study basis, Southern Research Institute.

While we have been satisfied with the performance ofthese various organizations, we do not directly control them. We depend onthese organizations to apply the appropriate expertise and resources toexpeditiously and competently perform the services for which they have beenretained. If any of these third parties with whom we contract breaches itsagreement with us or fails to comply with an applicable government regulation,we might be required to find a satisfactory alternative service provider. Inaddition, our drug development efforts could be delayed or impaired. We areaware of at least 25 other entities that could offer similar services to thoseoffered by each of PPD Development, Research Solutions, and Advanced ClinicalServices and three other entities offering services similar to those providedby Southern 

25

----

Research Institute. Wefrequently change vendors and consider such items as price, vendor capabilitiesto meet our needs, and ease of transition in choosing new vendors.

In order to commercialize our drug product candidatessuccessfully, we, or third parties with whom we contract, must be able tomanufacture products in commercial quantities in compliance with FDA’s CGMPrequirements at acceptable costs and in a timely manner.  We do not currently have CGMP manufacturingcapacity for any of the drug product candidates we are developing. Currently,all of our liposome compounds are produced at the Center for Advanced DrugDevelopment, which is affiliated with the University of Iowa Pharmacy School. TheCenter has indicated that it is currently able to meet our needs for researchand clinical trials, but we cannot be sure that it will be able to meet ourneeds in a timely manner or on a cost-effective basis in the future. If theCenter were unable to meet our needs in the future, we cannot be sure thatsuitable alternatives could be found in a timely manner, or at all.  In addition, we have an agreement withDiosynth RTP, Inc., pursuant to which this company produces cintredekinbesudotox in the quantities required to support our Phase III clinical trialand to manufacture the initial batches of this drug product candidate thatwould be necessary to support a BLA to market the product. Diosynth hasprovided us with quantities of cintredekin besudotox that we believe will allowus to complete the clinical testing of that drug product candidate and webelieve that they will be able to provide us with sufficient quantities ofcintredekin besudotox to support our initial commercial requirements, ifcintredekin besudotox is  eventually approved.

While we have been satisfied with the performance ofboth the Center for Advanced Drug Development and Diosynth, if either were tobreach its agreement with us or fail to comply with any applicable governmentalrequirement, such actions could delay or impair our drug development and/or BLAor NDA submission efforts and we may be required to find a satisfactoryalternative supplier. Though we are currently aware of at least two alternativemanufacturers who might be able to supply us with our requirements for drugproduct candidates, if we were unable to quickly reach an agreement with thesemanufacturers, this could be expected to result in delays in the development andpotential approval by FDA of our drug product candidates, particularly for cintredekinbesudotox.

We also in-licensetechnology from governmental and academic institutions in order to minimize ourinvestment 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 a research agreement in place with FDA.The research agreement with FDA obligates us to fund research efforts at FDArelating to cintredekin besudotox through April 2006 and we expect torenew at contract expiration. We had a research agreement with Georgetown thatobligated us to fund research efforts through February 28, 2005. We didnot renew the research agreement with Georgetown.  No assurance can be given that we will enterinto more of these relationships, that we will be able to maintain or renew theresearch agreement with FDA, that this relationship will provide benefits tous, or that we will be able to establish new relationships on beneficial terms,without undue delays or expenditures.

**Ifwe, or our suppliers, fail to comply with FDA and other government regulations,our manufacturing operations could be interrupted, and our drug product development,future sales, and profitability would suffer.**

All new drugs, including our drug product candidatesunder development, are subject to extensive and rigorous regulation by FDA andcomparable foreign authorities. These regulations govern, among other things,the development, pre-clinical and clinical testing, manufacturing, labeling,storage, pre-market approval, advertising, promotion, sale, and distribution ofour drug product candidates. We rely on third parties to perform a variety offunctions, including research and development, clinical trial management andtesting, and manufacturing of our drug product candidates.

26

----

We currently obtain the necessary raw materials forour drug product candidates, as well as certain services, such as testing, fromthird parties. We currently contract with suppliers and service providers thatare required to comply with strict standards established by us. Certainsuppliers and service providers are required to follow GLP, GCP, and CGMPrequirements and are subject to routine unannounced periodic inspections by FDAand by certain state and foreign regulatory agencies for compliance with thoserequirements and other applicable regulations. There can be no assurance thatFDA and other regulatory agencies will find the manufacturing process orfacilities or other operations of our suppliers and other service providers tobe in compliance with GLP, GCP, CGMP or other applicable requirements.

While to the best of ourknowledge, none of our principal suppliers or service providers has been foundto be out of compliance with GLP, GCP, CGMP, or other applicable requirementswith respect to the goods or services they provide to us, failure of any of ourprincipal third party suppliers or service providers to maintain satisfactorycompliance with applicable requirements could have a material adverse effect onour ability to develop, market and distribute our drug product candidates inthe future and, in the most serious cases, could result in the issuance ofwarning letters, seizure or recall of drug products, criminal prosecution,civil penalties or closure of such manufacturing facilities until compliance isachieved.

**We donot have sales, marketing, or distribution experience, which means we musteither enter into agreements with third parties to market or co-promote ourdrug product candidates or develop marketing expertise ourselves.**

We have noexperience in sales, marketing, or distribution. To date, our focus has been onresearch and development, and we currently do not have internal sales,marketing, or distribution resources. If we receive the required regulatoryapprovals, we could elect to market and sell our drug product candidatesthrough distribution, co-marketing, co-promotion, or licensing arrangementswith third parties, as we have elected to do with our non-drug NeoPhectinTM products, which are being sold throughindependent distributors. If we elect to market our drug product candidates directly,significant additional expenditures and management resources will be requiredto develop 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.

On the other hand, to the extent that we enter intoarrangements with third parties for the marketing and sale of our drug productcandidates, any revenues we receive will depend primarily on the efforts ofthese third parties, and those revenues may be lower than if we marketed ourdrug products directly. In addition, we may not be successful in entering intosales and distribution relationships with third parties and, even if we aresuccessful, we will not control the amount and timing of marketing resourcessuch third parties devote to our drug product candidates.

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 to develop other sales and marketing capabilitiesthrough third parties would be harmful to our overall business operations.

27

----

**Ourlack of operating experience may cause us difficulty in 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.

**We depend onintellectual property rights licensed from third parties. If we fail to meetour obligations under our license agreements, or if technology licensed to usis subject to the rights of others, we could lose our rights of exclusivity ofuse to key technologies on which our business depends.**

**Our business depends on ourtechnology, which is based in part on patents and patent applications licensedfrom third parties. Those third-party license agreements impose obligations onus, such as payment obligations and obligations to diligently pursuedevelopment of commercial products under the licensed rights. Our licenseagreement regarding cintredekin besudotox requires us to engage in clinicaltrials of the compound in patients with renal cell carcinoma. Previous trialsdemonstrated that cintredekin besudotox is toxic in those patients. However, wehave instead focused on developing this compound for treating patients withglioblastoma multiforme. We have informed the governmental agency from which welicensed these patents of this change, and we received no objections to it.**

**Because of our dependence on intellectualproperty rights licensed to us by third parties, any adverse development in ourrelationship with these licensors, including a dispute regarding our rightsunder the agreements or the grant of rights by our licensors to others, couldmaterially and adversely affect our right to commercialize the products we aredeveloping or preclude others from commercializing these products.**

**If a licensor believes that we havefailed to meet our obligations under a license agreement, the licensor couldseek to limit or terminate our licensed rights, which could lead to costly andtime-consuming litigation and, potentially, a loss of the licensed rights.During the period of any such litigation, our ability to carry out thedevelopment and commercialization of potential products could be significantlyand negatively affected. If our licensed rights were restricted or ultimatelylost, our ability to continue our business based on the affected technologyplatform would be severely adversely affected.**

**We depend in large part on ourlicensors to have and maintain the patent rights licensed to us. Where ourlicensors cannot license technologies to us to the exclusion of third parties,our competitive position could be impaired. In this regard, we understand thatco-rights to the technologies exclusively licensed to us by NIH relating tocintredekin besudotox are claimed by one of the inventors, who has subsequentlyentered into an agreement assigning such rights as he may have to a thirdparty. We are in the process of determining the nature of his claimed rightsand whether or not this assignment is valid. Although we have been granted “orphandrug” status with respect to the use of cintredekin besudotox for malignantgliomas (a class of brain tumors which includes glioblastoma multiforme), andare thus potentially eligible to receive orphan drug exclusivity upon approval,in the event it were to be determined at a future date that we do not haveexclusive rights to the technology licensed to us by NIH, we may be unable topreclude third parties during or after any period of orphan drug exclusivityfrom commercializing a drug based on cintredekin besudotox for otherindications, which could cause our business to suffer. In order to receiveorphan drug exclusivity, we must be the first cintredekin besudotox productapproved for malignant glioma. We are currently unaware of anyone elsedeveloping a cintredekin besudotox based drug for the treatment of malignantglioma, and believe that significant hurdles exist to bringing such a productforward to compete with our drug product candidate. If we receive orphan drugexclusivity, it would prevent FDA**

28

----

**fora period of seven years from approving another sponsor’s marketing applicationfor the same drug for those orphan indications, except that a subsequentapplicant could still be approved if it demonstrated clinical superiority toour product. Other applicants could also receive approval of compounds otherthan cintredekin besudotox for malignant glioma, which would compete with ourproduct, or could receive approval of cintredekin besudotox for other uses, inwhich case the competing cintredekin besudotox products, if suitable, could beprescribed by physicians outside their FDA approvals for malignant glioma andharm our business. In addition, it should be noted that, even if it weredetermined at a future date that we do not have exclusivity with respect to thepatents and patent applications licensed from NIH, we have also filed variousadditional patent applications related to the methods of administration and useof cintredekin besudotox which are not part of the NIH patents. While webelieve that patents that may eventually be granted under these patentapplications would provide us with additional exclusivity of use for cintredekinbesudotox, these patent applications are still pending, may not be granted, andare subject to the risks described herein relating to patents in general.**

**Our inability toadequately protect our proprietary technologies could harm our competitiveposition and have a material adverse effect on our business.**

The success of our business depends, in part, on ourability to obtain patents and maintain adequate protection of our intellectualproperty for our proprietary technology and products in the United States andother countries. The laws of some foreign countries do not protect proprietaryrights to the same extent as the laws of the United States, and many companieshave encountered significant problems in protecting their proprietary rights inthese foreign countries. These problems can be caused, for example, by a lackof rules and processes allowing for meaningful defense of intellectualproperty rights. If we do not adequately protect our intellectual property,competitors may be able to use our technologies and impair our competitive position,with the result that our business and operating results could be harmed.

The patent positions of pharmaceutical companies,including our patent positions, are often uncertain and involve complex legaland factual questions. We will be able to protect our proprietary rights fromunauthorized use by third parties only to the extent that our proprietarytechnologies are covered by valid and enforceable patents or are effectivelymaintained as trade secrets. We apply for patents covering our technologies anddrug product candidates, as we deem appropriate. Currently, we either own orhave obtained licenses to more than 50 United States patents and patentapplications relating to our technology, compounds, and drug productcandidates, many of which have foreign counterparts either as issued patents orpending patent applications. However, we may not obtain patents on allinventions 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 

29

----

tradesecrets. Disclosure or misuse of our confidential information would harm ourcompetitive position and could cause our revenues and operating results todecline.

**Wemay be sued for infringing on the intellectual property rights of others.**

Our commercial success also depends in part onensuring that we do not infringe the patents or proprietary rights of thirdparties. The biotechnology industry has produced a proliferation of patents,and it is not always clear to industry participants, including us, whichpatents cover various types of products. The coverage of patents is subject tointerpretation by the courts, and the interpretation is not always uniform.While we have not been sued for infringing the intellectual property rights ofothers, there can be no assurance that the drug product candidates that we haveunder development do not or will not infringe on the patent or proprietaryrights of others. Third parties may assert that we are employing theirproprietary technology without authorization. We know of patents issued tothird parties relating to antisense and oligonucleotide technology, includingpatents about which such third parties have communicated with us suggestingpossible infringement, but the claims of which we believe we do not infringe orare invalid. Moreover, United States patent applications filed in recent yearsare confidential for 18 months, while older applications are not publisheduntil the patent issues. Further, some applications are kept secret during theentire length of their pendency by request of the applicant in specialcircumstances. As a result, there may be patents of which we are unaware, andavoiding patent infringement may be difficult. Patent holders sometimes sendcommunications to a number of companies in related fields, suggesting possibleinfringement, and we, like a number of biotechnology companies, have receivedthis type of communication. If we are sued for patent infringement, we wouldneed to demonstrate that we either do not infringe the patent claims of therelevant patent and/or that the patent claims are invalid, which we may not beable to do. Proving invalidity, in particular, is difficult since it requires ashowing of clear and convincing evidence to overcome the presumption ofvalidity enjoyed by issued patents. Parties making claims against us may beable to obtain injunctive or other equitable relief that could effectivelyblock our ability to further develop, commercialize and sell products, and suchclaims could result in the award of substantial damages against us. In theevent of a successful claim of infringement against us, we may be required topay damages and obtain one or more licenses from third parties. We may not beable to obtain these licenses at a reasonable cost, if at all. In that event,we could encounter delays in product introductions while we attempt to developalternative methods or products or be required to cease commercializingaffected products and our operating 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.

**Wemay in the future be a party to patent litigation, which could be expensive anddivert 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 interferenceproceedings declared by the US Patent and Trademark Office to determine thepriority of inventions. The defense and prosecution of these matters are bothcostly and time consuming. We may need to commence proceedings against othersto enforce our patents, trade secrets or other know-how or defend againstclaims of infringement asserted against us, which would require investigationand determination of the enforceability, scope and validity of the respectiveproprietary rights. These 

30

----

proceedingscould result in substantial expense to us and significant diversion of effortsby our technical and management personnel.

**If welose key management personnel or are unable to attract and retain the talentrequired for our business, our business could be harmed.**

We are highly dependent onthe principal members of our management staff, including, but not limited to,our President and Chief Executive Officer, Mr. Guillermo A. Herrera. Theprincipal members of our management and scientific staff accepted employment onthe basis of written offers which set forth the salary and benefits to beprovided, including, but not limited to, salary continuation payments upontermination of employment. Only Mr. Herrera has an employment contractwith us. We do not have key man insurance on any of our management. If we wereto lose the services of Mr. Herrera, or other members of our managementstaff, and were unable to replace them, our product development and theachievement of our strategic objectives could be delayed. In addition, oursuccess will depend on our ability to attract and retain qualified commercial, scientific,technical, and managerial personnel. While we have not experienced unusualdifficulties to date in recruiting and retaining personnel, there is intensecompetition for qualified staff and no assurance can be given that we will beable to retain existing personnel or attract and retain qualified staff in thefuture.

**Thedemand for our drug product candidates, if any, may be adversely affected byhealth care reform and potential limitations on third-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.

31

----

**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.**

Evenif approved for marketing, our drug products may not achieve market acceptance.The degree of market acceptance of our drug products will depend upon a numberof 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.

**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, cash equivalents and short-term investments in a variety ofsecurities, including government and corporate obligations and money marketfunds. The market values of these investments may fluctuate due to marketconditions and other conditions over which we have no control. Fluctuations inthe market price and valuations of these securities may require us to recordlosses due to impairment in the value of the securities underlying ourinvestment. This could result in future charges to our earnings. All of ourinvestment securities are denominated 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 toless interest rate risk than fixed-rate securities, floating-rate securitiesmay produce less income than expected if interest rates decrease. Due in partto these factors, our investment income may fall short of expectations or wemay suffer losses in principal if securities are sold that have declined inmarket value 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 the future, we may notbe able to maintain insurance on acceptable terms, or at all. We could also berequired to incur significant costs to comply with current or futureenvironmental laws and regulations.

32

----

**Wemay have product liability exposure, and insurance against such claims may notbe available to us 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 any of our drug product candidates become commercially available,we cannot assure you that we will be able to obtain or maintain this insuranceon acceptable terms or that any insurance we obtain will provide us withadequate coverage against potential liabilities. Claims or losses in excess ofany liability insurance coverage we obtain would have a material adverse effecton our 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.In the event that any party acquires 15% or more of our common stock (otherthan Dr. Kapoor for whom the threshold is 30%), we are acquired in amerger or other business combination, or 50% or more of our assets are soldafter the time that the rights become exercisable, the rights provide that eachright holder will receive, upon exercise, shares of the common stock of thesurviving or acquiring company, as applicable, having a market value of twicethe exercise price of the right. The stockholder rights plan may discourage orprevent certain types of transactions involving an actual or potential changein control, which transactions may be beneficial to our shareholders, bycausing substantial dilution to a party that attempts to acquire us on termsnot approved by our Board of Directors. In addition, Section 203 and otherprovisions of the Delaware General Corporation Law as well as provisions of ourcharter and by-laws could make a takeover of us or the removal of the membersof the board of directors or management more difficult.

**Theissuance of preferred stock could adversely affect the holders of our commonstock.**

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.

**Ifthere are substantial sales of common stock, the market price of our commonstock could decline.**

Sales of substantialnumbers of shares of common stock could cause a decline in the market price ofour stock. 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.

33

----

**ITEM 1B.**       UNRESOLVEDSTAFF COMMNETS

None

**ITEM 2.**                PROPERTIES

The Company’sadministrative offices and pre-clincial research and development personnel arelocated in approximately 35,500 square feet of leased space in Waukegan,Illinois. Additionally, the Company’s clinical research and development personnelare located in approximately 10,000 square feet of leased space in Lake Forest,Illinois. Both locations are well maintained and are sufficient for the currentlevel 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 usecommercially reasonable efforts to develop LEP and LED and that such failureconstituted a breach of the License Agreement. The Company further contendedthat Pharmacia breached its duty to consult with NeoPharm on the progress ofthe drug development program and thereby impaired NeoPharm’s ability to monitorthe development of these compounds. The Company sought all damages to which itwas entitled, 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. In April 2004, the Company was advised thatits claims against Pharmacia (now Pfizer) and Pharmacia’s claims against theCompany were denied by arbitrators of the American Arbitration Association. On September 30,2004, the Company entered into a Termination Agreement with Pfizer returningall 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 United StatesDistrict Court for the Northern District of Illinois, Eastern District. On September 16,2002, a consolidated amended complaint was filed against NeoPharm in thismatter. 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.The motion to amend seeks to again make Dr. Kapoor a defendant, andrealleges that certain pre-class period statements are actionable. The Companyfiled oppositions to both motions. The Court has not yet ruled on the motions. Notrial date has 

34

----

been set and discovery isongoing. Management is unable to estimate a range of possible losses, if any.In addition, the Company maintains insurance coverage to mitigate the financialimpact of any potential loss.

On March 26, 2004,the Company received a letter from the Securities and Exchange Commissionstating that the SEC is conducting a formal investigation of the Company. TheSEC stated in its letter that it had made no determination of any violation oflaw by the Company or any individual at this time. Previously, this matter hadbeen the 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 Companyagainst Pharmacia (now Pfizer) regarding the development of its LEP and LEDdrug product candidates and the Class Action Suits which have been filedagainst the Company relating to its public statements regarding the developmentof LEP. The Company cannot predict with certainty the direction theinvestigation will take or its ultimate outcome, and therefore is unable to determinewhether the results of the investigation will have a material adverse impact onthe Company’s results of operations and financial position.

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

No matters were submittedto a vote of security holders during the quarter ended December 31, 2005.

**EXECUTIVE OFFICERS OF NEOPHARM**

The following persons wereexecutive officers of NeoPharm as of March 16, 2006:

*Frank C.Becker*, 69, joined the Company as a Director in November 2004.Since June 2005, Mr. Becker has served as Chairman of the Board. Mr. Beckeris currently the President and a partner at Greenfield Chemical, apharmaceutical consulting and sourcing company. From 1999 to 2002, Mr. Beckerserved as President and Chief Operating Officer of Sicor Pharmaceuticals, aninjectable pharmaceutical company. Mr. Becker is a partner in SouthportMarina Development LLC, a firm operating Southport Marina in Kenosha, Wisconsin.Prior to that, Mr. Becker spent over 35 years at Abbott, most recently asVice President of Process Research and Chemical Manufacturing. Mr. Beckerreceived his MBA in Finance from the University of Chicago in 1971 and holds aB.S. in Chemical Engineering from Purdue University.

*GuillermoA. Herrera*, 52, joined NeoPharm in October 2005 asPresident and Chief Executive Officer. Previously, in 2004, Mr. Herrerajoined Rosetta Partners LLC to serve as the Partner and Principal in charge ofthe private equity division. Prior to Rosetta, Mr. Herrera spent 24 yearsat Abbot most recently serving as Senior Vice President, InternationalOperations and President of Abbott International. Mr. Herrera received hisMBA from the Kellogg Graduate School of Management at Northwestern Universityand his B.A. in Industrial Economics from the Universidad del Valle, Colombia.

*LawrenceA. Kenyon*, 40, Chief Financial Officer and CorporateSecretary, joined the Company in September 2000. From October 1999until September 2000 Mr. Kenyon was Senior Vice President of theGabelli Mathers Fund, a regulated investment company. Prior to that, Mr. Kenyonheld a variety of positions with Mathers and Company, Inc. an investmentmanagement firm, most recently serving as the Chief Financial Officer for bothMathers and Company, Inc. and Mathers Fund, Inc. Mr. Kenyon receivedhis Bachelors of Business Administration degree in Accounting from theUniversity of Wisconsin—Whitewater in 1987.

*DrJeffrey W. Sherman*, M.D., F.A.C.P., 51, joined us in September 2000as Executive Vice President and Chief Medical Officer. Previously, Dr. Shermanwas employed by Searle/Pharmacia where, since joining that company in 1992, heheld a variety of positions, most recently serving as Executive Director,Clinical Research, with his focus being on Oncology Clinical Research and Headof Oncology Global Medical Operations in Medical Marketing. Dr. Shermanreceived his medical degree from The Chicago 

35

----

MedicalSchool and is a member of numerous professional societies and a Diplomate ofthe National Board of Medical Examiners and the American Board of InternalMedicine.

*ImranAhmad. Ph.D.*, 41, Executive Vice President and ChiefScientific Officer, joined NeoPharm in July 2000. Prior to joiningNeoPharm, Dr. Ahmad held a variety of positions at the Liposome Companyfrom 1993 until 2000, most recently serving as Assistant Director of Researchand Development where his responsibilities included directing the pre-clinicalresearch program. Dr. Ahmad conducted his post-doctoral work at the Universityof Alberta, Canada.

*TimothyP. Walbert*, 38, Executive Vice President, CommercialOperations, joined the Company in January 2006. Previously, Mr. Walbertheld several positions of increasing responsibility at Abbott from 2001 untiljoining NeoPharm, most recently serving as Divisional Vice President,International Marketing. From 1998 to 2001, Mr. Walbert was a marketingdirector for Searle/Pharmacia. Mr. Walbert earned a Bachelor of Arts inBusiness and Marketing from Muhlenberg College in 1989.

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.

36

----

**PART II**

**ITEM5.**                MARKET FOR THEREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASESOF 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.

| **2004**       | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $          | 22.70      |     | $          | 15.71   |       |
| Second Quarter |       | 21.86      |       | 8.91     |       |
| Third Quarter  |       | 10.48      |       | 4.66     |       |
| Fourth Quarter |       | 13.59      |       | 6.26     |       |
|                |            |            |            |          |            |         |            |  |  |

 

| **2005**       | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $          | 13.43      |     | $          | 7.56    |       |
| Second Quarter |       | 10.73      |       | 7.16     |       |
| Third Quarter  |       | 15.47      |       | 9.87     |       |
| Fourth Quarter |       | 13.03      |       | 7.75     |       |
|                |            |            |            |          |            |         |            |  |  |

 

As of March 1, 2006,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 paida cash dividend on its common stock and has no present intention of paying cashdividends in the foreseeable future. Any determination in the future to paycash dividends will depend on the Company’s financial condition, capitalrequirements, results of operations, contractual limitations and other factorsdeemed relevant by the Board 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.

**EquityCompensation Plan Information**

The information called forby Item 5(a) relating to related stockholder information is incorporatedherein by reference to Item 12 – Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters.

37

----

**ITEM6.**                SELECTED FINANCIALDATA

| ** **                    | ** ** | **For the Years Ended December 31,** | ** **  |
|-------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                    | ** ** | **2005**                                                      | ** **  | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Statement of Operations Data: |       |                                                          |        |   |   |   |   |   |   |   |   |
| Revenue                       |       | $                                                             | 542,740     |   | $ | 156,780 |   | $ | — |   | $ | — |   | $ | — |   |
| Loss from operations          |       | (40,231,367                                                   | )           | (58,728,285 | ) | (53,606,534 | ) | (38,834,775 | ) | (19,228,638 | ) |
| Interest income               |       | 1,506,680                                                     |        | 1,119,576 |   | 815,435 |   | 2,343,036 |   | 5,796,552 |   |
| Net loss                      |       | $                                                             | (38,724,687 | ) | $ | (57,608,709 | ) | $ | (52,791,099 | ) | $ | (36,491,739 | ) | $ | (13,424,037 | ) |
| Basic net loss per share      |       | $                                                             | (1.64       | ) | $ | (2.51 | ) | $ | (2.80 | ) | $ | (1.95 | ) | $ | (0.72 | ) |
| Diluted net loss per  share   |       | $                                                             | (1.64       | ) | $ | (2.51 | ) | $ | (2.80 | ) | $ | (1.95 | ) | $ | (0.72 | ) |

 

| ** **                                         | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                         | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Balance Sheet Data:                                |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents  and short-term investments |       | $                                     | 30,262,192 |   | $ | 63,106,655 |   | $ | 36,958,941 |   | $ | 87,591,975 |   | $ | 106,525,864 |   |
| Working capital(1)                                 |       | 21,608,267                            |       | 55,335,552 |   | 36,256,650 |   | 87,664,717 |   | 120,305,964 |   |
| Total assets                                       |       | 33,369,985                            |       | 67,434,371 |   | 46,080,580 |   | 95,937,321 |   | 129,195,075 |   |
| Accumulated deficit                                |       | (228,024,715                          | )          | (189,300,028 | ) | (131,691,319 | ) | (78,900,220 | ) | (42,408,481 | ) |
| Total stockholders’  equity                   |       | 21,945,324                            |       | 58,230,275 |   | 40,017,355 |   | 91,908,994 |   | 127,343,550 |   |
|                                                    |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Working capital iscalculated as current assets minus current liabilities.

38

----

**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*Thefollowing discussion of our financial condition and results of operationsshould be read together with our consolidated financial statements and notes tothose statements included in Item 15 of Part IV of this Form 10-K.*

**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 98 employees as of December 31,2005. Our corporate headquarters and research and development facility is inWaukegan, Illinois and our clinical research and development operations arelocated in Lake Forest, Illinois.

Since we began doing business in June 1990, wehave principally devoted our resources 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,selling stock in the Company, licensing the development rights to some of ourdrug product candidates to third parties, or collaborating with third partiesto develop formulations of their compounds using our technology.

Significant events occurring during 2005 included theresignation of former President and Chief Executive Officer Greg Young in March 2005,the March 2005 appointment of one of our directors, Mr. Ronald G.Eidell, to serve as interim President and CEO, the hiring in October 2005of Guillermo A. Herrera as our new President and Chief Executive Officer, andthe completion of enrollment in the PRECISE Trial for cintredekin besudotox forthe treatment of GBM in December 2005.

In addition to the completion of enrollment in thePRECISE trial, two other important PRECISE trial milestones were achieved in2005. In June and December 2005, the iDMC met, analyzed, and reviewedthe data for the PRECISE trial futility analyses, and recommended that thePRECISE Trial continue as planned under the approved protocol. The nextmilestones for PRECISE are an interim efficacy analysis after 160 deaths,currently expected as early as the second quarter of 2006, and the finalefficacy analysis after 215 deaths, potentially in late 2006 or early 2007. Weare currently preparing to submit a BLA with the FDA as early as 2006 to seekmarketing approval of the drug, in the event that the PRECISE trial achievesits endpoint of a statistically significant improvement in overall long termsurvival compared to the control arm. However, there can be no assurance thatthe trial will meet its endpoint in the time anticipated, that the FDA willapprove the BLA or that the FDA will not require additional data or testing.

During 2005, we continued to advance our NeoLipid®drug product candidates. We are currently working with the FDA to determine theappropriate regulatory pathway for our LEP-ETU and LE-SN38 drug productcandidates. Phase II planning for these drug product candidates is underway andcommencement of the trials is pending the outcome of our discussions with theFDA. Enrollment continued in our Phase I clinical trial of our LErafAON drugproduct candidate, with completion of enrollment dependent on the number ofdose levels studied.

39

----

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, if approvedby the FDA. A number of factors contribute to this uncertainty, including: sideeffects encountered in early stage clinical trials, ability to scale upmanufacturing for commercial supply, and the fact that the size and scope ofpivotal 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 $5 millionto complete the Phase III PRECISE study. Additional clinical trial expenses arealso expected to be incurred for cintredekin besudotox as we plan to conductother clinical trials to investigate the potential to use cintredekin besudotoxin other forms and stages of malignant glioma, in addition to recurrentglioblastoma multiforme. We also expect to incur additional expenses related tothe preparation of a cintredekin besudotox BLA submission.

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 Direct  Costs Incurred  2005** | ** ** | **Total Direct  Costs Incurred  2004** | ** ** | **Total Direct  Costs Incurred  2003** | ** ** | **Total Direct Costs  Incurred Since  Beginning of Project** | ** ** |
|------------------------------------------|------------|------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| Cintredekin  besudotox                   |       |       | $          | 15,754,459                                       |       |                                             |       | $                                                | 19,912,321 |                                                                                  |       |   | $ | 12,434,953 |   |   |   | $ | 54,725,066 |   |   |
| LEP-ETU                                  |       |       | 2,683,595  |                                             |       |                                             | 3,085,018  |                                             |       |                                                                                  | 855,629    |   |   |   | 6,706,970 |   |   |
| LE-SN38                                  |       |       | 506,119    |                                             |       |                                             | 1,866,183  |                                             |       |                                                                                  | 1,718,069  |   |   |   | 4,973,708 |   |   |
| LErafAON                                 |       |       | 305,077    |                                             |       |                                             | 1,196,529  |                                             |       |                                                                                  | 808,333    |   |   |   | 7,737,682 |   |   |
| Non-project  specific                    |       |       | 12,601,352 |                                             |       |                                             | 18,452,886 |                                             |       |                                                                                  | 18,445,283 |   |   |   | N/A |   |   |
| Total research and  development expenses |       |       | $          | 31,850,602                                       |       |                                             |       | $                                                | 44,512,937 |                                                                                  |       |   | $ | 34,262,267 |   |   |   | N/A |   |   |

 

**Results of Operations**

***Year Ended December 31, 2005 as compared to YearEnded December 31, 2004***

We recorded collaboration revenues of $0.5 millionin 2005 for a customized NeoPhectinTM formulation. No collaboration revenue wasrecognized in 2004. We recorded approximately $0.05 million of productrevenue during 2005 compared to $0.2 million in 2004.

Research and development expense for the year ended December 31,2005 decreased by approximately $12.7 million as compared to the sameperiod in 2004. This decrease was principally due to the impact of a costrationalization program we adopted in the fourth quarter of 2004 that led to ascaled back research and development effort resulting in a reduction in thenumber of clinical trials being conducted by the Company in 2005, which reducedresearch and development expense by approximately $6.8 million, reducedpayroll related expense by approximately $4.2 million, primarily resultingfrom the 2004 workforce reductions, and a reduction of approximately $1.7 millionin expense related to non-project specific research.

Selling, general and administrative expenses,including related party expenses, were approximately $11.4 million for theyear ended December 31, 2005 and $13.2 million for the year ended December 31,2005. This $1.8 million reduction was due to a $2.0 million reductionin legal fees due to the conclusion of 

40

----

the arbitration caseagainst Pharmacia, now Pfizer, and legal fees associated with the consentsolicitation filed by Dr. John N. Kapoor, former Chairman of the Board ofDirectors, a current director and our largest shareholder, all in 2004, and adecrease of $0.2 million in corporate insurance expense, offset by a $0.5 millionincrease related primarily to payments made to licensors for proceeds receivedfrom the Company’s agreement with Nippon Kayaku Co., Ltd. Additionally,non-cash stock-based compensation expense was reduced by $0.4 million ascompared to 2004 as a result of the resignations of our former CEOs JamesHussey in 2004 and Gregory Young in 2005.

On May 16, 2005, NeoPharm accepted $2.5 millionas payment in full for all outstanding principal and interest due and owing ona promissory note that had previously been determined to be impaired. As aresult of the payment, a $2.5 million benefit was recorded as Recovery ofNote Receivable.

Approximately $1.1 million in employeetermination costs were incurred in 2004 as a result of a reduction in workforcecompleted in November 2004. A total of 30 employees were terminated,including 26 employees in our research and development groups and 4 employeesfrom our selling, general, and administrative group. No additional employeetermination costs for this reduction in workforce were incurred in 2005.

Interest income for 2005and 2004 totaled approximately $1.5 million and $1.1 million,respectively. The increase in interest income in 2005 versus 2004 was primarilydue to increases in short-term interest rates, offset by the decline in averagecash and cash equivalents and short-term investments during 2005.

***Year Ended December 31, 2004 as compared to YearEnded December 31, 2003***

The Company recorded revenue of $0.2 millionduring 2004. The sole source of revenue was from sales of NeoPhectinTM andNeoPhectinTMAT. No revenue was recorded in 2003.

We incurred approximately $44.5 million inresearch and development expenses in 2004, as compared with approximately $34.3 millionin 2003 an increase of approximately $10.2 million. The increase inresearch and development expenses was primarily related to increased expensesof approximately $7.5 million for the development of our lead drug productcandidate, cintredekin besudotox, which began a Phase III clinical trial(PRECISE) in 2004. Total expenses incurred in 2004 related to PRECISE wereapproximately $15.7 million. Additionally, expenses for the development ofour other clinical stage drug product candidates increased by approximately$2.7 million, as we continued to move our Phase I drug product candidatestowards Phase II clinical development.

Expenses incurred for selling, general andadministrative, including related party expenses, were approximately $13.2 millionin 2004 and $19.3 million in 2003. For 2004, the reduction in selling,general and administrative expenses was directly related to the conclusion ofour arbitration case against Pharmacia (now Pfizer) in April 2004 and thedecrease in arbitration related expenses of approximately $10.7 millionfrom 2003. 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 theresignation of our former CEO (of which approximately $0.7 millionrepresents non-cash stock-based compensation expense for stock options grantedto James M. Hussey while he was CEO that vest while he is a consultant to theCompany), expenses of approximately $1.0 million to respond to and settlea consent solicitation in 2004, and approximately $0.5 million in expensesdirectly related to our Sarbanes Oxley Act Section 404 (internal controlover financial reporting) compliance efforts.

Approximately $1.1 million in employeetermination costs were incurred in 2004 as a result of a reduction in workforcecompleted in November 2004.

41

----

Interest income for 2004and 2003 totaled approximately $1.1 million and $0.8 million,respectively. The increase in interest income in 2004 versus 2003 is directly relatedto an increase in the cash available for investment due to the proceedsavailable from our follow-on stock offering completed in January 2004.

***Liquidity and Capital Resources***

Our primary source of cash is proceeds from issuanceof equity securities.

In 2005, we reclassified all auction rate certificatesto short-term investments. We believe the structural features of the auctionrate certificates now classified as short-term investments provide the Companywith liquidity characteristics similar to cash equivalents.

As of December 31, 2005, we had approximately$1.5 million in cash and cash equivalents and $28.8 million inshort-term investments, and no debt. We currently believe that our cash, cashequivalents and short-term investments on hand at December 31, 2005, whencombined with the cash raised in the January 2006 common stock offering (seeNote 12, Subsequent Event, to the Consolidated Financial Statements), cansupport our activities through the fourth quarter of 2007 at current andprojected levels of development and general corporate activity.

The primary use of cash over the next 12-24months will be to fund our regulatory and commercial efforts for cintredekinbesudotox and our clinical and pre-clinical research and development efforts.The most significant expenses will be incurred in relation to completing thework necessary for a possible cintredekin besudotox BLA submission andcompletion of the PRECISE trial. Additional expenses are also expected to beincurred as we continue to move our drug product candidates towards the nextphase of clinical development.

We may seek to satisfy future funding requirementsthrough public or private offerings of securities or with collaborative orother arrangements with corporate partners. Additional financing may not beavailable when needed or on terms acceptable to us. If adequate financing isnot available, we may be required to delay, scale back, or eliminate certain ofour research and development programs, relinquish rights to certain of ourtechnologies, drugs or products, or license third parties to commercializeproducts or technologies that we would otherwise seek to develop ourselves.

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.

42

----

The following tablesummarizes our estimated contractual obligations as of December 31, 2005:

| ** **                                              | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                        | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More  than  5 years** | ** ** |
| Operating lease                                         |       | $                                         | 935,839    |   | $ | 391,825 |   | $ | 544,014 |   | $ | — |   | $ | — |   |
| Clinical trial  monitoring (CRO) agreements(1)          |       | 998,061                                   |       | 998,061 |   | — |   | — |   | — |   |
| License  agreements—milestone based payments(2)(3) |       | 2,050,000                                 |       | 300,000 |   | 900,000 |   | — |   | 850,000 |   |
| Total                                                   |       | $                                         | 3,983,900  |   | $ | 1,689,886 |   | $ | 1,444,014 |   | $ | — |   | $ | 850,000 |   |
|                                                         |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          These amounts includeonly contractual obligations for direct expenses for the PRECISE trial,exclusive of clinical 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)          Milestone based paymentobligations are contingent upon successfully reaching objectively determinablestages in the development of drug product candidates. The Company has estimatedthe period the payment may be due, if at all, based upon its expectations ofthe timeline for continued successful development of the drug productcandidates.

**Recent Accounting Pronouncements**

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

**Critical Accounting Policies**

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.

***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 

43

----

instanceswhere management has determined that a loss contingency is probable, it mustmake use of estimates to determine the amount of probable loss. Management mustapply judgment in determining whether or not it can make a reasonable estimate.Management must also apply judgment in determining whether or not disclosure ofloss contingencies that have been accrued should be made for the consolidatedfinancial 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 an appropriatemethod for determining the fair value of stock-based compensation. The Companyhas elected to utilize the Black-Scholes option-pricing model to make the fairvalue determination. Inputs into the option-pricing model are subject toestimation that may significantly affect the determination of fair value.

***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 entered in collaboration and licenseagreements with third parties that contain multiple deliverables. Under theprovisions of EITF 00-21, a determination must be made on each contractas to whether a deliverable constitutes a separate unit of accounting. Theamount of revenue to be recognized is based on the fair value for each unit ofaccounting within the arrangement. Management’s judgment is required todetermine, based upon the facts and circumstances of each arrangement, whetheror not each deliverable has standalone value and whether or not there exists asufficient level of objective and reliable evidence of fair value of theundelivered items. Additionally, units of accounting may be delivered over anindeterminate period of time. Management judgment is required to estimate theperiod over which recognition of allocated revenue occurs.

44

----

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

As of December 31,2005, we did not own any derivative instruments, but we were exposed to marketrisks, primarily changes in United States interest rates. As of December 31,2005, we held total cash and cash equivalents of $1,486,172 and short-terminvestments in auction rate certificates of $28,776,020. Declines in interestrates over time would reduce our interest income from our investments. Basedupon our cash, cash equivalents,and short-term investments as of December 31,2005, a decrease in interest rates of 1.0% would cause a corresponding decreasein our annual interest income of approximately $302,622.

**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 |       |     | 56         |   |   |
| Consolidated  Balance Sheets                             |       |     | 57         |   |   |
| Consolidated  Statements of Operations                   |       |     | 58         |   |   |
| Consolidated  Statements of Stockholders’ Equity    |       |     | 59         |   |   |
| Consolidated  Statements of Cash Flows                   |       |     | 60         |   |   |
| Notes to Consolidated  Financial Statements              |       |     | 61         |   |   |

 

**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

**DISCLOSURE CONTROLS AND PROCEDURES**

As required by Rules 13a-15and 15d-15 of the Securities Exchange Act of 1934, the Company hasevaluated, with the participation of management, including the Chief ExecutiveOfficer and the Chief Financial Officer, as of the end of the period covered bythis report, the effectiveness of the design and operation of its disclosurecontrols and procedures. Based on such evaluation, the Chief Executive Officerand Chief Financial Officer have concluded that such disclosure controls andprocedures are effective in ensuring that material information relating to theCompany, including its consolidated subsidiary, is made known to the certifyingofficers by others within the Company and its consolidated subsidiary,particularly during the period in which this report is being prepared. Fromtime to time, the Company reviews the disclosure controls and procedures, andmay from time to time make changes aimed at enhancing their effectiveness andto ensure that the Company’s systems evolve with its business.

**INTERNALCONTROL OVER FINANCIAL REPORTING**

**Management’sReport on Internal Control over Financial Reporting**

The management of NeoPharm, Inc. (the Company),including the Company’s President and Chief Executive Officer and ChiefFinancial Officer,  is responsible forestablishing and maintaining adequate internal control over financialreporting.

The Company’s internal control over financialreporting is a process designed to provide reasonable assurance to the Company’smanagement and Board of Directors regarding the reliability and preparation ofpublished financial statements in accordance with U.S. generally acceptedaccounting principles. All 

45

----

internal control systems,no matter how well designed, have inherent limitations. Therefore, even thosesystems determined to be effective can provide only reasonable assurance withrespect to financial statement preparation and presentation and may not preventor detect misstatements. Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

The Company’s management assessed the effectiveness ofthe Company’s internal control over financial reporting as of December 31,2005. In making this assessment, the Company used the criteria set forth in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organization of the Treadway Commission (“COSO”). Basedon management’s assessment, the Company believes that as of December 31,2005, the Company’s internal control over financial reporting is effectivebased on the criteria established in *Internal Control—IntegratedFramework*.

Management’s assessment ofthe effectiveness of the Company’s internal control over financial reporting asof December 31, 2005, has been audited by the Company’s independentregistered public accounting firm whose report follows this report.

**Changesin Internal Control over Financial Reporting**

There was no change in the Company’s internal controlover financial reporting that occurred during the quarter ended December 31,2005 that has materially affected, or is likely to materially affect, theCompany’s internal control over financial reporting.

46

----

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

TheBoard of Directors and StockholdersNeoPharm, Inc.:

We have audited management’sassessment, included in the accompanying Management’s Report on InternalControl over Financial Reporting, that NeoPharm, Inc. maintained effectiveinternal control over financial reporting as of December 31, 2005, basedon criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO).**NeoPharm, Inc.’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management’s assessment and an opinion on the effectiveness of the Company’sinternal control over financial reporting based on our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design andoperating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinion.

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

In our opinion, management’sassessment that NeoPharm, Inc. maintained effective internal control overfinancial reporting as of December 31, 2005, is fairly stated, in allmaterial respects, based on criteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Also, in our opinion, NeoPharm, Inc.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2005, based on criteria established *in Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of NeoPharm, Inc. andsubsidiary as of December 31, 2005 and 2004, and the related consolidated**statements of operations, stockholders’equity, and cash flows for each of the years in the three-year period ended December 31,2005, and our report dated March 15, 2006 expressed an unqualified opinionon those consolidated financial statements.

/s/ KPMG LLP

Chicago, IllinoisMarch 15, 2006

47

----

**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 2006 Annual Meeting ofStockholders, (the “2006 Proxy Statement”) which is to be filed within 120 daysof the Company’s fiscal year end of December 31, 2005.

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 2006 Proxy Statement, which is to be filedwithin 120 days of the Company’s fiscal year end of December 31, 2005.

Information regarding the identification of the AuditCommittee is incorporated by reference to the information under the caption “Boardof Directors and Its Committees” in the 2006 Proxy Statement, which is to befiled within 120 days of the Company’s fiscal year end of December 31,2005.

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 2006 Proxy Statement, which is to be filed within 120 days of the Company’sfiscal year end of December 31, 2005.

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 2006 Proxy Statement, which is to befiled within 120 days of the Company’s fiscal year end of December 31,2005.

**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 2006 ProxyStatement which is to be filed with the Commission within 120 days of theCompany’s fiscal year end of December 31, 2005.

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

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 2006 Proxy Statement, which is tobe filed with the Commission within 120 days of the Company’s fiscal year endof December 31, 2005.

48

----

The following table setsforth certain information as of December 31, 2005, with respect tocompensation plans under which shares of NeoPharm, Inc.’s common stock maybe 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     |       |       | 3,805,157  |                                                                                                         |       |                                                                        | $          | 12.64                                                                                       |       |   |   | 635,023 |   |   |
| Equity  compensation plans not approved by stockholders |       |       | —     |                                                                                                         |       |                                                                        | —     |                                                                                        |       |   | — |   |   |
| Total                                                   |       |       | 3,805,157  |                                                                                                         |       |                                                                        | $          | 12.64                                                                                       |       |   |   | 635,023 |   |   |

 

Information on theCompany’s equity compensation plan is contained in Note 6 “Stock Options” ofthe Company’s financial statements included as part of this annual report onForm 10-K.

**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 information appearing under the caption “CertainRelationships and Related Transactions” in the 2006 Proxy Statement, which isto be filed with the Commission within 120 days of the Company’s fiscal yearend of December 31, 2005.

**ITEM 14.**         PRINCIPALACCOUNTING FEES AND SERVICES

The information required by this item as to expensesfor principal accounting fees and services incurred by the Company is herebyincorporated by reference from the information appearing under the caption “Ratificationof the Appointment of Independent Registered Public Accounting Firm” in the2006 Proxy Statement which is to be filed with the Commission within 120 daysof the Company’s fiscal year end of December 31, 2005.

49

----

**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)          FinancialStatements:

|                                                          | ** ** | **Page** | ** ** |
|----------------------------------------------------------|------------|----------|------------|
| Report of Independent  Registered Public Accounting Firm |       |     | 55         |   |   |
| Consolidated  Balance Sheets                             |       |     | 56         |   |   |
| Consolidated  Statements of Operations                   |       |     | 57         |   |   |
| Consolidated  Statements of Stockholders’ Equity    |       |     | 58         |   |   |
| Consolidated  Statements of Cash Flows                   |       |     | 59         |   |   |
| Notes to Consolidated  Financial Statements              |       |     | 60         |   |   |

 

(2)          FinancialStatement Schedule:

| Report of Independent  Registered Public Accounting Firm                                                       |   |   |   |   |   |
|----------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|
| Schedule II—Valuation and Qualifying Accounts for the years ended  December 31, 2005, 2004, and 2003 |   |   |   |   |   |

 

(3)          Exhibits

**Item 15(a)(3) Exhibit List**

| 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)                                                                                                                                                                                                                                                                          |
| 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)                                                                                                                                                                                                                   |

50

----

 

| *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)                                                                                                                                                                                                                                                                                                               |
| 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.                                                             |

51

----

 

| 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.                                                                                                                                      |
| 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).                                                           |

52

----

 

| 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, incorporated by reference from Exhibit 10.01 to  the Company’s Current Report on Form 8-K filed January 4,  2005 (File No. 001-112493).                                                |
| *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).                        |
| *10.43 |   | Employment Agreement by  and between NeoPharm, Inc. and Ronald G. Eidell dated April 25,  2005, incorporated by reference from Exhibit 10.01 to the Company’s Current  Report on Form 8-K filed on April 28, 2005 (File No. 001-12493).                                                                     |
| 10.44  |   | Interim Engagement  Resources Agreement by and between NeoPharm, Inc. and Tatum CFO  Partners, LLP. dated April 25, 2005, incorporated by reference from  Exhibit 10.02 to the Company’s Current Report on Form 8-K  filed on April 28, 2005 (File No. 001-12493).                                          |
| 10.45  |   | Note Repayment Agreement  by and between NeoPharm, Inc. and Akorn, Inc. dated May 16,  2005, incorporated by reference from Exhibit 10.01 to the Company’s  Current Report on Form 8-K filed on May 20, 2005 (File  No. 001-12493).                                                                    |
| *10.46 |   | Non-Employee Director  Compensation dated June 16, 2005, incorporated by reference from  Exhibit 10.1 to the Company’s Current Report on Form 8-K  filed on June 22, 2005 (File No. 001-12493).                                                                                                                  |
| 10.47  |   | Modification to CRADA  No. 26-97 by and between the NeoPharm, Inc. and FDA dated  July 25, 2005 incorporated by reference from Exhibit 10.1 to the  Company’s Current Report on Form 8-K filed on August 11, 2005  (File No. 001-12493).                                                               |
| *10.48 |   | Employment Agreement by  and between NeoPharm, Inc. and Guillermo A. Herrera dated  October 28, 2005, incorporated by reference from Exhibit 10.01 to  the Company’s Current Report on Form 8-K filed on November 1,  2005 (File No. 001-12493).                                                            |

53

----

 

| *10.49 |   | Terms of Employment by  and between NeoPharm, Inc. and Timothy P. Walbert dated January 17,  2006, incorporated by reference from Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed on January 19, 2006 (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.

**             Filed herewith

(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 of1933 (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. (File No. 33-90516).

(3)          Incorporated byreference to Exhibit 10.11 of the Company’s Annual Report on Form 10-Kfor the year ended December 31, 1996. (File No. 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 Form S-8filed 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 are furnishedelsewhere in the financial statements or the notes thereto.

54

----

**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/  GUILLERMO A. HERRERA |
|   |   |                |   | Guillermo A.  Herrera |
|   |   |                | * * | *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/ FRANK C. BECKER      |          | Director,  Chairman of the Board              |       | March 17,  2006 |
| Frank C. Becker          |          |                                          |       |                 |
| /s/ GUILLERMO A. HERRERA |          | Director,  President, and Chief Executive     |       | March 17,  2006 |
| Guillermo A. Herrera     |          | Officer (Principal  Executive Officer)        |       |                 |
| /s/ RONALD G. EIDELL     |          | Director                                      |       | March 17,  2006 |
| Ronald G. Eidell         |          |                                          |       |                 |
| /s/ BERNARD A. FOX       |          | Director                                      |       | March 17,  2006 |
| Bernard A. Fox           |          |                                          |       |                 |
| /s/ PAUL E. FREIMAN      |          | Director                                      |       | March 17,  2006 |
| Paul E. Freiman          |          |                                          |       |                 |
| /s/ ERICK E. HANSON      |          | Director                                      |       | March 17,  2006 |
| Erick E. Hanson          |          |                                          |       |                 |
| /s/ JOHN N. KAPOOR       |          | Director                                      |       | March 17,  2006 |
| John N. Kapoor           |          |                                          |       |                 |
| /s/ KAVEH T. SAFAVI      |          | Director                                      |       | March 17,  2006 |
| Kaveh T. Safavi          |          |                                          |       |                 |
| /s/ LAWRENCE A. KENYON   |          | Chief Financial  Officer (Principal Financial |       | March 17,  2006 |
| Lawrence A. Kenyon       |          | Officer and Principal Accounting Officer)     |       |                 |

 

 

55

----

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

The Board ofDirectors and StockholdersNeoPharm, Inc.:

We have audited the accompanying consolidated balancesheets of NeoPharm, Inc. and subsidiary as of December 31, 2005 and2004, and the related consolidated statements of operations, stockholders’equity, and cash flows for each of the years in the three-year period ended December 31,2005. 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).Those standards 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 our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of NeoPharm, Inc. and subsidiary as of December 31, 2005 and2004, and the results of their operations and their cash flows for each of theyears in the three-year period ended December 31, 2005, in conformity withU.S. generally accepted accounting principles.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), the effectivenessof NeoPharm, Inc.’s internal control over financial reporting as of December 31,2005, based on criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), and our report dated March 15, 2006 expressedan unqualified opinion on management’s assessment of, and the effectiveoperation of, internal control over financial reporting.

/s/ KPMG LLP

Chicago, IllinoisMarch 15, 2006

56

----

**NEOPHARM, INC.AND SUBSIDIARYCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| ASSETS                                                                                                                                    |       |                  |       |   |   |
| Current assets:                                                                                                                           |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                 |       | $                     | 1,486,172  |   | $ | 52,736,320 |   |
| Short-term investments                                                                                                                    |       | 28,776,020            |       | 10,370,335 |   |
| Trade accounts receivable, net                                                                                                            |       | 1,285                 |       | 10,888 |   |
| Inventories                                                                                                                               |       | 5,677                 |       | 5,736 |   |
| Prepaid expenses                                                                                                                          |       | 727,432               |       | 1,108,282 |   |
| Other receivables                                                                                                                         |       | 155                   |       | 308,087 |   |
| Total current assets                                                                                                                      |       | 30,996,741            |       | 64,539,648 |   |
| Fixed assets, net  of accumulated depreciation                                                                                            |       | 2,157,507             |       | 2,894,723 |   |
| Other assets                                                                                                                              |       | 215,737               |       | — |   |
| Total assets                                                                                                                              |       | $                     | 33,369,985 |   | $ | 67,434,371 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                |       |                  |       |   |   |
| Current liabilities:                                                                                                                      |       |                  |       |   |   |
| Accounts payable                                                                                                                          |       | $                     | 683,168    |   | $ | 398,505 |   |
| Accrued clinical trial expenses                                                                                                           |       | 5,369,507             |       | 4,634,618 |   |
| Accrued legal expenses                                                                                                                    |       | 241,527               |       | 244,022 |   |
| Accrued compensation                                                                                                                      |       | 1,888,534             |       | 3,227,230 |   |
| Other accrued expenses                                                                                                                    |       | 1,205,738             |       | 696,321 |   |
| Unearned revenue                                                                                                                          |       | —                |       | 3,400 |   |
| Total current liabilities                                                                                                                 |       | 9,388,474             |       | 9,204,096 |   |
| Deferred revenue                                                                                                                          |       | 2,000,000             |       | — |   |
| Deferred rent                                                                                                                             |       | 36,187                |       | — |   |
| Stockholders’  equity:                                                                                                               |       |                  |       |   |   |
| Preferred stock,  $0.01 par value; 15,000,000 shares authorized; none issued and outstanding                                              |       | —                |       | — |   |
| Common stock,  $0.0002145 par value; 50,000,000 shares authorized; 23,740,051 and 23,372,755  shares issued and outstanding, respectively |       | 5,092                 |       | 5,013 |   |
| Additional paid-in  capital                                                                                                               |       | 249,964,947           |       | 247,525,290 |   |
| Accumulated  deficit                                                                                                                      |       | (228,024,715          | )          | (189,300,028 | ) |
| Total stockholders’ equity                                                                                                           |       | 21,945,324            |       | 58,230,275 |   |
| Total liabilities  and stockholders’ equity                                                                                          |       | $                     | 33,369,985 |   | $ | 67,434,371 |   |

 

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

57

----

**NEOPHARM, INC.AND SUBSIDIARYCONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                           | ** ** | **For the Years Ended December 31,** | ** **  |
|--------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                           | ** ** | **2005**                                                      | ** **  | **2004** | ** ** | **2003** | ** ** |
| Collaboration  revenue               |       | $                                                             | 500,000     |   | $ | — |   | $ | — |   |
| Product revenue                      |       | 42,740                                                        |        | 156,780 |   | — |   |
| Total revenue                        |       | 542,740                                                       |        | 156,780 |   | — |   |
| Expenses:                            |       |                                                          |        |   |   |   |   |
| Cost of product revenue              |       | 2,011                                                         |        | 5,236 |   | — |   |
| Research and development             |       | 31,850,602                                                    |        | 44,512,937 |   | 34,262,267 |   |
| Selling, general, and administrative |       | 11,421,494                                                    |        | 12,798,245 |   | 19,197,457 |   |
| Employee termination costs           |       | —                                                        |        | 1,149,277 |   | — |   |
| Recovery of note receivable          |       | (2,500,000                                                    | )           | — |   | — |   |
| Related party expenses               |       | —                                                        |        | 419,370 |   | 146,810 |   |
| Total expenses                       |       | 40,774,107                                                    |        | 58,885,065 |   | 53,606,534 |   |
| Loss from  operations                |       | (40,231,367                                                   | )           | (58,728,285 | ) | (53,606,534 | ) |
| Interest income                      |       | 1,506,680                                                     |        | 1,119,576 |   | 815,435 |   |
| Net loss                             |       | $                                                             | (38,724,687 | ) | $ | (57,608,709 | ) | $ | (52,791,099 | ) |
| Net loss per  share—            |       |                                                          |        |   |   |   |   |
| Basic and diluted                    |       | $                                                             | (1.64       | ) | $ | (2.51 | ) | $ | (2.80 | ) |
| Weighted average shares  outstanding |       |                                                          |        |   |   |   |   |
| Basic and diluted                    |       | 23,601,643                                                    |        | 22,941,668 |   | 18,830,065 |   |

 

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

58

----

**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, 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 | ) |
| Non-employee common stock option compensation                     |       |                                 | —     |                              |       | —         |       | —                           |       | 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 |   |
| Issuance of common stock pursuant to exercise of  stock options        |       |                                 | —     |                              |       | 285,519        |       | 61                               |       | 1,493,483                |       | —                                |       | 1,493,544 |   |
| Issuance of restricted common stock to non-employee  directors         |       |                                 | —     |                              |       | 36,010         |       | 8                                |       | 305,056                  |       | —                                |       | 305,064 |   |
| Employee common stock-based compensation                               |       |                                 | —     |                              |       | 22,075         |       | 5                                |       | 216,645                  |       | —                                |       | 216,650 |   |
| Non-employee common stock option compensation                     |       |                                 | —     |                              |       | —         |       | —                           |       | 236,125                  |       | —                                |       | 236,125 |   |
| Issuance of common stock in lieu of cash payment                  |       |                                 | —     |                              |       | 23,692         |       | 5                                |       | 188,348                  |       | —                                |       | 188,353 |   |
| Net loss                                                               |       |                                 | —     |                              |       | —         |       | —                           |       | —                   |       | (38,724,687                           | )          | (38,724,687 | ) |
| Balance at December 31,  2005                                     |       |                                 | —     |                              |       | 23,740,051     |       | $                                | 5,092      |                     | $          | 249,964,947                           |       | $ | (228,024,715 | ) | $ | 21,945,324 |   |

 

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

59

----

**NEOPHARM, INC.AND SUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                   | ** ** | **For the Years Ended December 31,** | ** **  |
|------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                                   | ** ** | **2005**                                                      | ** **  | **2004** | ** ** | **2003** | ** ** |
| Cash flows from  operating activities:                                       |       |                                                          |        |   |   |   |   |
| Net loss                                                                     |       | $                                                             | (38,724,687 | ) | $ | (57,608,709 | ) | $ | (52,791,099 | ) |
| Adjustments to reconcile  net loss to net cash used in operating activities: |       |                                                          |        |   |   |   |   |
| Depreciation                                                                 |       | 1,299,915                                                     |        | 1,329,367 |   | 1,341,237 |   |
| Stock-based  compensation expense                                            |       | 757,839                                                       |        | 1,161,555 |   | 615,230 |   |
| Loss on  retirement of assets                                                |       | 24,951                                                        |        | — |   | — |   |
| Provision for  losses on accounts receivable                                 |       | 10,219                                                        |        | — |   | — |   |
| Changes in current  assets and liabilities:                                  |       |                                                          |        |   |   |   |   |
| Increase in interest receivable on short-term  investments                   |       | (55,685                                                       | )           | (20,335 | ) | — |   |
| Increase in trade accounts receivable                                        |       | (616                                                          | )           | (10,888 | ) | — |   |
| Decrease/(increase) in inventories                                           |       | 59                                                            |        | (5,736 | ) | — |   |
| Decrease/(increase) in prepaid expenses                                      |       | 380,850                                                       |        | (198,449 | ) | (454,940 | ) |
| Decrease/(increase) in other receivables                                     |       | 267,768                                                       |        | (23,337 | ) | (146,796 | ) |
| (Increase) in other assets                                                   |       | (175,573                                                      | )           | — |   | — |   |
| Increase/(decrease) in accounts payable                                      |       | 284,663                                                       |        | (101,177 | ) | 6,866 |   |
| Increase in accrued expenses                                                 |       | 91,468                                                        |        | 3,238,648 |   | 2,028,032 |   |
| Increase in deferred/unearned revenue                                        |       | 1,996,600                                                     |        | 3,400 |   | — |   |
| Increase in deferred rent                                                    |       | 36,187                                                        |        | — |   | — |   |
| Net cash used in operating activities                                        |       | (33,806,042                                                   | )           | (52,235,661 | ) | (49,401,470 | ) |
| Cash flows from  investing activities:                                       |       |                                                          |        |   |   |   |   |
| Proceeds from  maturities of marketable securities                           |       | —                                                        |        | 1,046,168 |   | 3,847,924 |   |
| Proceeds from  sales of marketable securities                                |       | 59,100,000                                                    |        | 21,220,183 |   | 49,725,000 |   |
| Purchase of marketable  securities                                           |       | (77,450,000                                                   | )           | (18,000,000 | ) | (26,056,053 | ) |
| Purchase of  equipment and furniture                                         |       | (587,650                                                      | )           | (463,385 | ) | (857,665 | ) |
| Net cash used in  investing activities                                       |       | (18,937,650                                                   | )           | 3,802,966 |   | 26,659,206 |   |
| Cash flows from  financing activities:                                       |       |                                                          |        |   |   |   |   |
| Proceeds from  issuance of common stock                                      |       | —                                                        |        | 73,472,948 |   | — |   |
| Proceeds from  exercise of stock options                                     |       | 1,493,544                                                     |        | 1,187,126 |   | 293,291 |   |
| Cash paid in lieu  of fractional shares for stock dividend                   |       | —                                                        |        | — |   | (9,061 | ) |
| Net cash provided  by financing activities                                   |       | 1,493,544                                                     |        | 74,660,074 |   | 284,230 |   |
| Net increase/(decrease) in cash and cash equivalents                         |       | (51,250,148                                                   | )           | 26,227,379 |   | (22,458,034 | ) |
| Cash and cash  equivalents, beginning of period                              |       | 52,736,320                                                    |        | 26,508,941 |   | 48,966,975 |   |
| Cash and cash  equivalents, end of period                                    |       | $                                                             | 1,486,172   |   | $ | 52,736,320 |   | $ | 26,508,941 |   |
| Supplemental schedule of  non-cash financing activities:                     |       |                                                          |        |   |   |   |   |
| Issuance of  common stock in satisfaction of a liability                     |       | $                                                             | 188,353     |   | $ | — |   | $ | — |   |
| Supplemental  disclosure of cash paid for:                                   |       |                                                          |        |   |   |   |   |
| Interest                                                                     |       | $                                                             | —      |   | $ | — |   | $ | — |   |
| Income taxes                                                                 |       | $                                                             | —      |   | $ | — |   | $ | — |   |

 

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

60

----

**NEOPHARM, INC. AND SUBSIDIARYNOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**1.**   NATUREOF OPERATIONS AND PRINCIPAL ACCOUNTING POLICIES

***Natureof Operations***—NeoPharm, Inc. (the “Company”), aDelaware corporation, was incorporated on June 15, 1990, under the name ofOncoMed, Inc. In March 1995, the Company changed its name to NeoPharm, Inc.During 2004, the Company established a wholly-owned subsidiary, NeoPharm EULimited, to comply with regulatory requirements enacted for clinical trialsconducted in the European Union. All of the Company’s assets are located in theUnited States.

The Company is engaged inthe research, development, and commercialization of drugs for the treatment ofvarious forms of cancer. As of December 31, 2005, 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 Company’s future success 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.

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 

61

----

majordrug product candidates to Pharmacia & Upjohn Company (“Pharmacia”) inFebruary 1999. Accordingly, the inception to date information is notpresented in these consolidated financial statements.

***Basisof Presentation***—The consolidated financial statementsinclude the accounts of NeoPharm, Inc. and its wholly-owned subsidiary,NeoPharm EU Limited. As of December 31, 2005, the subsidiary had nominalassets and had not conducted any business. All significant intercompanyaccounts and transactions are eliminated in consolidation.

***Useof Estimates***—The preparation of financial statements inconformity with U.S. generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the consolidated financial statements and the reported amountsof revenue and expense during the reporting period. Actual results could differfrom those estimates.

***Reclassification***—Certainamounts in 2004, as reported on the Consolidated Balance Sheet and the 2004 and2003 Consolidated Statements of Cash Flows, have been reclassified to conformto the current year presentation. We reclassified $10,370,335 in auction ratecertificates from cash and cash equivalents to short-term investments on the ConsolidatedBalance Sheet as of December 31, 2005. This reclassification affected theclassification of cash flows from investing activities on the ConsolidatedStatements of Cash Flows for the years ended December 31, 2004 and 2003, whichreflect purchases of marketable securities of $18,000,000 and $21,550,000 in2004 and 2003 respectively, and proceeds from sales of marketable securities of$18,100,000 and $49,725,000 in 2004 and 2003 respectively, related to theauction rate certificates.

***Cashand Cash Equivalents***—The Company considers all highlyliquid investments purchased with an original maturity of three months or lessto be cash equivalents. Included with cash are cash equivalents of $104,305 and$52,569,437 as of December 31, 2005 and 2004, respectively. The carryingvalue of these investments approximates their fair market value due to theirshort maturity and liquidity.

***Short-termInvestments***—Short-term investments consist of auctionrate certificates and have scheduled maturities greater than 90 days at thetime of purchase. Management believes the structural features of the auctionrate certificates provides the Company with liquidity characteristics similarto cash equivalents. As provided by Statement of Financial Accounting Standards(“SFAS”) No. 115, *Accounting for CertainInvestments in Debt and Equity Securities*, the Company has electedto treat 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. However,given the interest rate reset features of the auction rate certificates the Companyhas purchased, the carrying value of the short-term investments represents theirfair value. Accordingly, there are no unrealized holding gains or lossesrecorded in other comprehensive income (loss). Realized gains and losses fromthe sale of available-for-sale securities are determined on a specificidentification basis. A decline in market value of available-for-salesecurities that is deemed to be other than temporary, results in the reductionof the carrying amount to fair value. The impairment is charged to earnings anda new cost basis for the security is established. The Company has notexperienced any declines in fair market value of its investments that wereother than temporary. Dividend and interest income are recognized when earned.The Company had $28,776,020 and $10,370,335 of investments in marketablesecurities as of  December 31, 2005and 2004, respectively. Included with the carrying value of theinvestments is accrued interest income receivable of $76,020 and $20,335 as of December 31,2005 and 2004, respectively. Realized gain on investments sold in 2005,2004, and 2003 was $0, $192, and $0, respectively.

***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 

62

----

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, 2005 and 2004 consists of the following:

| ** **                   | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| Finished goods on  hand      |       |                            | $          | 5,677                           |       |   |   | $ | 5,413 |   |   |
| Inventory subject  to return |       |                            | —     |                            |       |   | 323 |   |   |
|                         |       |                            | $          | 5,677                           |       |   |   | $ | 5,736 |   |   |

 

Inventory subject toreturn represents NeoPhectin products shipped to wholesale customers that havenot been recognized as revenue.

***FixedAssets***—Fixed assets are recorded at cost and aredepreciated using the straight line method over their estimated useful lives.During 2003, the Company revised its estimate of the useful life of computerequipment from five years to three years. Maintenance and repairs that do notextend the life of assets are charged to expense when incurred. When propertiesare disposed of, the related costs and accumulated depreciation are removedfrom the accounts and any gain or loss is reported in the period thetransaction takes place. Total depreciation expense for the years ended December 31,2005, 2004 and 2003, was $1,299,915, $1,329,367 and $1,341,237, 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.

***OtherAssets***—Other assets consist of a lease security depositas well as cash held by a bank as collateral for a standby letter of creditissued by the bank in favor of the Company. The cash held by the bank isrestricted as to use for the term of the standby letter of credit.

***IncomeTaxes***—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 assets for amounts which are not considered “more likely thannot” to be realized.

***RevenueRecognition***—The Company recognizes revenue whenpersuasive evidence of an arrangement exists, delivery has occurred or serviceshave been rendered, the price is fixed or determinable, and collectibility isreasonably 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 

63

----

thedistributor. The Company warrants its products in a manner consistent withindustry standards and has not incurred any warranty costs related to the saleof 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.Arrangement consideration is allocated to units of accounting on a relativefair-value basis or the residual method if the Company is unable to determinethe fair value of all deliverables in the arrangement. Consideration allocatedto a unit of accounting is limited to the amount that is not contingent uponfuture performance by the Company. Upon determination of separate units ofaccounting and allocated consideration, the general criteria for revenuerecognition are applied to each unit of accounting.

The Company has enteredinto collaboration and license agreements with third parties. The terms of oneof its collaboration agreements provided for an upfront nonrefundable paymentto the Company of $150,000 as well as an additional $350,000 upon deliveryof  a customized formulation ofNeoPhectin to the customer. The Company delivered the customized formulation inJune 2005 and the Company has recognized the full contract amount asrevenue. The Company has also entered into an agreement with Nippon Kayaku Co.,Ltd (“Nippon”) in which the development and commercialization rights in Japanfor cintredekin besudotox were licensed. The Company received a $2 millionupfront nonrefundable fee in January 2005 and is entitled to receive futureadditional fees, milestone payments and royalties. Nippon is reponsbile for alldevelopment costs in Japan. The Company has agreed to provide or arrange forcontract manufacture of a commmericial supply of cintredekin besudotox uponreceipt of marketing approval by Nippon. The up-front nonrefundable feereceived by the Company will be recognized ratably as revenue once the generalcriteria for revenue recognition has been met for the unit of accounting towhich the fee has been allocated.

***Researchand Development***—Research and development costs areexpensed as incurred. These costs include, among other things, consulting feesand costs reimbursed to third parties under license and research agreementsdescribed in Note 10, Commitments. Payments related to the acquisition oftechnology rights, for which development work is in process, are expensed andare considered a component of research and development costs. The Company alsoallocates indirect costs, consisting primarily of operational costs foradministering research and development activities, to research and developmentexpenses.

***Stock-BasedCompensation***—The Company applies the intrinsic-valuemethod of accounting 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.

64

----

Thefollowing table illustrates the effect on net loss if the fair-value method hadbeen applied in each period:

| ** **                                                                                                          | ** ** | **2005**   | ** **  | **2004**    | ** ** | **2003**    | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|------------|-------------|-------------|------------|-------------|------------|
| Net loss, as  reported                                                                                              |       | $          | (38,724,687 | )           | $          | (57,608,709 | )          | $ | (52,791,099 | ) |
| Add stock-based  employee compensation expense included in reported net loss(1)                                     |       | 521,714    |        | 424,752     |       | 479,230     |       |
| Deduct total  stock-based employee compensation expense determined under fair-value-based  method for all awards(2) |       | (1,647,062 | )           | (14,161,126 | )          | (7,927,891  | )          |
| Pro forma net  loss                                                                                                 |       | $          | (39,850,035 | )           | $          | (71,345,083 | )          | $ | (60,239,760 | ) |
| Basic and diluted net  loss per common share                                                                        |       |       |        |        |       |        |       |
| As reported                                                                                                         |       | $          | (1.64       | )           | $          | (2.51       | )          | $ | (2.80 | ) |
| Pro forma                                                                                                           |       | $          | (1.69       | )           | $          | (3.11       | )          | $ | (3.20 | ) |

----

(1)          Valueof restricted stock granted to non-employee directors in 2005, 2004 and 2003,compensation expense relating to options granted to an executive at 85% of fairvalue in 2005 and 2004, and grant of common stock to an executive in 2005.

(2)          Includesacceleration of vesting period due to change in control provision in 2004 (seeNote 6).

***Leases***—Withrespect to its operating leases, the Company applies the provisions of FASBTechnical Bulletin (“FTB”) 85-3 *Accounting for Operating Leaseswith Scheduled Rent Increases*, to scheduled rent increase provisionscontained in lease agreements by recognizing rent expense on a straight-linebasis over the lease term.

***Contingencies***—Liabilitiesfor loss contingencies arising from claims, assessments, litigation, fines, andpenalties and other sources are recorded when it is probable that a liabilityhas been incurred and the amount of the liability can be reasonably estimated.Recoveries from other parties are recorded when realized.

***FairValue of Financial Instruments***—Financial instrumentsconsist of cash, cash equivalents, short-term investments, accounts receivable,and accounts payable. The carrying value of these financial instruments is areasonable estimate of fair value.

***RecentAccounting Pronouncements***—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 with the first annualreporting period beginning after June 15, 2005. SFAS No. 123Rrequires the measurement of the cost of employee services received in exchangefor an award of the entity’s equity instruments based on the grant-date fairvalue of the award. The cost will be recognized over the period during which anemployee is required to provide service in exchange for the award.

The Company anticipatesadopting the standard using the modified prospective method. Under this method,the Company will begin recognizing compensation cost for equity basedcompensation for all amounts related to the unvested portion of existingstock-based awards granted prior to adoption, and for new or modified grantsafter the date of adoption. The Company will recognize the unvested portion ofthe awards issued prior to adoption based on the fair values previouslycalculated under the disclosure provisions of SFAS No. 123, adjusted forestimated forfeitures. At December 31, 2005, the aggregate fair value ofunvested options, was approximately $4,500,000. Upon adoption of SFAS 123R,a portion of this amount will be recognized in 2006. The Company is currentlyevaluating to what extent the Company’s equity instruments will be used in thefuture as compensation for employee services.

In May 2005, the FASBissued SFAS No. 154, *Accounting Changes andError Corrections*, a replacement of APB Opinion No. 20, *Accounting Changes* and FASB Statement No. 3, *Reporting*

65

----

*AccountingChanges in Interim Financial Statements*. SFAS No. 154applies to all voluntary changes in accounting principle. It also applies tochanges required by an accounting pronouncement in the unusual instance thatthe pronouncement does not include specific transition provisions.SFAS No. 154 requires theretrospective application to prior periods’ financial statements of the directeffect of a voluntary change in accounting principle unless it is impracticableto do so. Unless early adoption is elected, SFAS No. 154 is effectivefor fiscal years beginning after December 15, 2005. Early adoption ispermitted for fiscal years beginning after June 1, 2005. SFAS No. 154does not change the transition provisions of any existing accountingpronouncements, including those that are in a transition phase as of theeffective date of this statement. The Company will assess the impact of aretrospective application of a change in accounting principle in accordancewith SFAS No. 154, if the need for such a change arises.

In February 2006, theFASB issued SFAS No. 155, Accounting for Certain Hybrid FinancialInsturments-an amendment of FASB Statements No. 133 and 140, to simplfyand make more consistent the accounting for certain financial instruments. SFASNo. 155 applis to all financial instruments acquired or issued after thebeginning of an entity’s first fiscal year that begins after September 15, 2006with earlier application allowed. The adoption of SFAS No. 155 is notexpected to have a material impact on the Company’s consolidated financialcondition or results of operations.

**2.**   NETLOSS PER SHARE

Thefollowing table sets forth the computation of the basic and diluted net lossper share for the years ended December 31:

| ** **                             | ** ** | **2005**   | ** **  | **2004**   | ** ** | **2003**    | ** ** |
|----------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| Numerator:                             |       |       |        |       |       |        |       |
| Net loss                               |       | $          | (38,724,687 | )          | $          | (57,608,709 | )          | $ | (52,791,099 | ) |
| Denominator:                           |       |       |        |       |       |        |       |
| Weighted average  shares outstanding   |       | 23,601,643 |        | 22,941,668 |       | 18,830,065  |       |
| Loss per  share—basic and diluted |       | $          | (1.64       | )          | $          | (2.51       | )          | $ | (2.80 | ) |
| Potential common  share equivalents:   |       |       |        |       |       |        |       |
| Stock options                          |       | 3,805,157  |        | 3,713,376  |       | 3,246,725   |       |

 

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.**   SHORT-TERMINVESTMENTS

Short-terminvestments represent investments in auction rate certificates and have beenclassified as available-for-sale. Short-term investments as of December 31,2005 and 2004 are summarized as follows:

| ** **                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|
| State government  agencies |       | $        | 28,700,000 |     | $          | 10,350,000 |   |
| Total                      |       | $        | 28,700,000 |     | $          | 10,350,000 |   |

 

Included with the carryingvalue of the investments is accrued interest income receivable of $76,020 and$20,335 as of December 31, 2005 and 2004, respectively.

Short-term investments arestated at cost, which approximate fair value due to their variable interestrates, which typically reset every 7 to 35 days. As of December 31,2005, the Company’s investments in auctions rate certificates have contractualmaturities of greater than ten years. Despite the long-term nature of theirstated contractual maturities, the Company has demonstrated the ability toliquidate these securities as needed. Accordingly, as these securitiesrepresent the investment of cash, which is available for operations, they havebeen classified as a current asset on the accompanying Consolidated BalanceSheets.

66

----

**4.   FIXED ASSETS**

Fixedassets are comprised of the following as of December 31:

| ** **                     | ** ** | **Estimated  Useful Life  (years)** | ** ** | **2005** | ** ** | **2004**   | ** ** |
|--------------------------------|------------|------------------------------------------|------------|----------|------------|------------|------------|
| Computer  equipment            |       |                                     | 3          |     |       | $          | 1,446,763  |   | $ | 1,327,196 |   |
| Scientific  equipment          |       |                                     | 5          |     |       | 3,967,986  |       | 3,796,131 |   |
| Furniture                      |       |                                     | 7          |     |       | 980,846    |       | 960,781 |   |
| Leasehold  improvements        |       |                                     | *          |     |       | 868,613    |       | 659,984 |   |
| Less accumulated  depreciation |       |                                     |       |     |       | (5,106,701 | )          | (3,849,369 | ) |
| Fixed assets, net              |       |                                     |       |     |       | $          | 2,157,507  |   | $ | 2,894,723 |   |

----

*                    Theestimated useful life of leasehold improvements is the lesser of the lease termor five years.

**5.**   STOCKHOLDERS’EQUITY

In October 2005, the Company’s Board of Directorsproposed adoption of an Employee Stock Purchase Plan (the “Purchase Plan”) inwhich eligible employees of the Company may purchase shares of common stock atquarterly intervals, through payroll deductions. The purchase price per shareis 85% of the closing price of the common stock on (i) the first businessday of the plan period or (ii) the purchase date, whichever closing priceis less. The Purchase Plan imposes a limitation upon a participant’s right toacquire common stock if immediately after or prior to purchase the employeeowns 5% or more of the total combined voting power or value of the Company’scommon stock. The Purchase Plan is subject to shareholder approval andpurchases under the Purchase Plan will not take place unless shareholderapproval is received.

On January 27, 2004, the Company receivedproceeds of $73,980,938 (net of the underwriting discounts and commissions of$4,722,188, but before expenses of $507,990) by issuing 4,312,500 shares ofcommon stock in a public offering.

In June 2003, the Company’s Board of Directorsadopted 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, one preferred share purchase rightwas distributed 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 pershare, subject to adjustment. The rights become exercisable, with certainexceptions, ten business days after any party, without prior approval of theCompany’s Board of Directors, acquires, or announces an offer to acquire,beneficial ownership of 15% or more of NeoPharm’s common stock, NeoPharm isacquired in a merger or other business combination, or 50% or more of NeoPharm’sassets are sold after the time that the rights become exercisable. The rightsprovide that each right holder will receive, upon exercise, shares of thecommon stock of the surviving or acquiring company, as applicable, having amarket value of twice the exercise price of the right. The rights expire on July 28,2013, unless they are earlier redeemed or exchanged by the Company. No rightswere exercised at December 31, 2005.

On May 13, 2003, theCompany declared a 15% stock dividend payable on June 10, 2003 to stockholdersof record on June 3, 2003. A total of 2,455,141 shares were distributed aspart of the stock dividend. All share and per share information was restated toreflect the stock dividend.

67

----

**6.   STOCK-BASEDCOMPENSATION**

On July 23, 1998, the Board of Directors approvedthe NeoPharm, Inc. 1998 Equity Incentive Plan (the “1998 Plan”), whichreplaced all prior equity incentive plans, and provides for the grant ofoptions to acquire up to 2,200,000 shares of the Company’s common stock.Additionally, 275,000 of the 2,200,000 shares can be used for restricted stockgrants to directors, officers, employees and consultants. The option pricesshall not be less than 85% of the fair market value of the stock as determinedby the Plan Administrator pursuant to the 1998 Plan. The consideration paid forshares of restricted stock shall not be less than the par value of the Company’scommon stock. Under the Plan, the option grants typically have a 10 year term,vest in increments of 25% of the total grant on the first four anniversaries ofthe original grant, and are exercisable as the options vest, subject to theCompany’s policies in effect from time to time concerning transactions byemployees in the Company’s securities. On June 6, 2002, the Companyadopted an amendment to the 1998 Plan, which was approved by shareholders,which increased the total shares available under the Plan to 4,600,000 shares.As of December 31, 2005, approximately 635,023 shares were available forissuance under the 1998 Plan.

In November 2004, the Company entered into anagreement to end a shareholder consent solicitation. The terms of the agreementprovided for expansion of the board of directors and replacement of certain directors.These provisions constituted a “change in control” under the terms of the 1998Plan. Accordingly, substantially all outstanding unvested stock options wereimmediately vested pursuant to their original terms of grant upon the “changein control” event. Other than the then Chief Executive Officer (“CEO”), allemployees’ unvested stock options became vested, which resulted in the vestingof an additional 1,221,203 stock options in 2004 that would have otherwisevested in future years.

Thefollowing table summarizes the transactions in the Company’s stock option planfor the three year period ended December 31, 2005:

| ** **                                         | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Exercise  Price Per Share** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|------------------------------------------------------------|------------|
| 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 |   |   |
| Options granted                                    |       | 960,875                |       |                                                       | $          | 8.55 |   |   |
| Options exercised                                  |       | (285,519               | )          |                                                       | $          | 5.23 |   |   |
| Options cancelled                                  |       | (583,575               | )          |                                                       | $          | 13.02 |   |   |
| Stock options  outstanding, December 31, 2005 |       | 3,805,157              |       |                                                       | $          | 12.64 |   |   |

 

68

----

Thefollowing table summarizes information about fixed stock options outstanding asof December 31, 2005:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                  | ** ** |
|---------------------------------------------|------------|------------------------------|------------|-----------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding  as of  12/31/05** | ** ** | **Weighted  Average  Remaining  Contractual  Life (years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable  as of  12/31/05** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $1.75 to $3.50                              |       |                         | 94,875     |                                          |       |   | 2.7 |   |   |   | $ | 1.78 |   |   | 94,875 |   |   | $ | 1.78 |   |   |
| $3.51 to $8.00                              |       |                         | 838,899    |                                          |       |   | 5.0 |   |   |   | $ | 6.52 |   |   | 493,274 |   |   | $ | 5.51 |   |   |
| $8.01 to $14.00                             |       |                         | 1,650,753  |                                          |       |   | 5.5 |   |   |   | $ | 10.94 |   |   | 1,128,953 |   |   | $ | 11.81 |   |   |
| $14.01 to $18.00                            |       |                         | 290,595    |                                          |       |   | 3.6 |   |   |   | $ | 16.31 |   |   | 290,595 |   |   | $ | 16.31 |   |   |
| $18.01 to $29.00                            |       |                         | 930,035    |                                          |       |   | 4.5 |   |   |   | $ | 21.13 |   |   | 930,035 |   |   | $ | 21.13 |   |   |
|                                        |       |                         | 3,805,157  |                                          |       |   | 4.9 |   |   |   | $ | 12.64 |   |   | 2,937,732 |   |   | $ | 13.83 |   |   |
|                                             |            |                              |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Assumptionsused in the Black-Scholes option-pricing model for calculating the weightedaverage fair value of options granted in the most recent fiscal years isincluded in the following table:

| ** **                                    | ** ** | **2005**   | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Weighted average  fair value of option grants |       | $          | 5.73       |     | $          | 12.47    |       | $ | 8.06 |   |
| Weighted average  risk-free interest rate     |       | 4.25       | %          | 3.68     | %          | 3.94     | %          |
| Dividend yield                                |       | 0.00       | %          | 0.00     | %          | 0.00     | %          |
| Volatility factor                             |       | 70.46      | %          | 72.02    | %          | 57.74    | %          |
| Weighted average  expected life               |       | 6.25 years |       | 10 years |       | 10 years |       |
|                                               |            |            |            |          |            |          |            |  |  |  |

 

On October 28, 2005, the Company made a commonstock grant of 22,075 shares with an aggregate fair value of $200,000 toits newly hired CEO.

During 2004, the Company awarded its then newly-hiredCEO, Mr. Gregory P. Young, the right to receive up to 350,000 commonstock options, which would be granted at the then fair market value upon theCompany’s common stock reaching certain price levels for defined periods oftime. 

In March 2005, the Company’s CEO, Mr. Young,resigned and became a consultant to the Company. Under the terms of theconsulting agreement, Mr. Young agreed to serve as a consultant to theCompany for a period of up to 12 months or until the termination of theSeparation Agreement, whichever was earlier, during which time all optionspreviously granted to Mr. Young continued to vest and remained exercisableuntil 90 days after termination as a consultant, resulting in the vesting of62,500 options. All other options granted to Mr. Young were forfeited. Forthe year ended December 31, 2005, the Company recorded compensationexpense of $236,125 related to the options granted to Mr. Young thatcontinued to vest during the term of the consulting agreement.

In June 2004, the Company’s then CEO, Mr. JamesHussey, resigned and became a consultant to the Company. Under the terms of theconsulting agreement, 473,625 unvested options previously granted to the CEOcontinued to vest in accordance with their original terms. The vesting of theseoptions was accelerated upon the change of control event. Upon acceleration ofvesting of the options, the former CEO’s performance commitment was reached andthe Company measured the fair value of these options and recorded compensationexpense of $736,803 for the year ended December 31, 2004.

The Company has granted options to purchase 886,495shares to certain non-employees of which 234,025 remain outstanding andunexercised as of December 31, 2005. 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,$0, and $136,000 relating to these options for the years ended December 31,2005, 2004 and 2003, respectively.

69

----

The Company has issuedrestricted stock to its non-employee directors which generally vests over oneyear. Common stock grants and their related fair values were 36,010 and $351,615during 2005, 24,982 and $366,531 during 2004, and 23,000 and $194,350 during2003.

**7.   INCOME TAXES**

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                                                     |       | 3,296,000  |        |
| 2021                                                     |       | 12,500,000 |        |
| 2022                                                     |       | 35,488,000 |        |
| 2023                                                     |       | 52,200,000 |        |
| 2024                                                     |       | 57,597,000 |        |
| 2025                                                     |       | 41,023,000 |        |
| Total gross net  operating loss carry forwards available |       | $          | 209,077,000 |       |

 

The Company has general business credit carry forwardsof approximately $5,790,000 which expire in the years 2011-2025, and analternative minimum tax credit carry forward of approximately $40,000 which canbe carried forward for an indefinite period.

The Company’s federal statutory rate is 35% and itseffective rate is 0%. Differences between the federal statutory and effectiverates are primarily attributable to state income taxes and the establishment ofa valuation allowance to reduce the carrying value of deferred tax assets tozero.

Significantcomponents of the Company’s deferred tax assets (liabilities) as of December 31are as follows:

| ** **                                          | ** ** | **2005**    | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|-----------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Net operating  loss carry forwards                  |       | $           | 81,540,000 |        | $          | 65,932,000  |       | $ | 43,469,000 |   |
| General business  credit carry forwards             |       | 5,790,000   |       | 4,896,000   |       | 3,232,000   |       |
| Charitable  contribution carry forwards             |       | 418,000     |       | 378,000     |       | 267,000     |       |
| Alternative  minimum tax credit carry forwards      |       | 40,000      |       | 40,000      |       | 40,000      |       |
| Deferred revenue                                    |       | 780,000     |       | —      |       | —      |       |
| Depreciation                                        |       | (292,000    | )          | (403,000    | )          | 2,000       |       |
| Expenses not  currently deductible for tax purposes |       | 405,000     |       | 1,542,000   |       | 1,262,000   |       |
| Total deferred  tax assets                          |       | 88,681,000  |       | 72,385,000  |       | 48,272,000  |       |
| Valuation  allowance                                |       | (88,681,000 | )          | (72,385,000 | )          | (48,272,000 | )          |
| Net deferred tax assets                             |       | $           | —     |        | $          | —      |       | $ | — |   |

 

The valuation allowanceincreased by $16,296,000, $24,113,000 and $22,972,000 for the years ended December 31,2005, 2004, and 2003, 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 

70

----

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.

**8.   TRANSACTIONS WITHRELATED 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. Dr. Kapoor isalso the Chairman of the Akorn Board of Directors. The consulting agreement wasterminated in 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**                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| E.J. Financial  Enterprises   |       | Consulting      |       |                                                      | $          | — |   |   | $ | 62,500 |   | $ | 125,000 |   |
| E.J. Financial  Enterprises   |       | Direct  Expense |       |                                                      | —     |   |   | 350,620 |   | 2,891 |   |
| Akorn, Inc.              |       | Consulting      |       |                                                      | —     |   |   | 6,250 |   | 18,919 |   |
| Total related party  expenses |       |            |       |                                                      | $          | — |   |   | $ | 419,370 |   | $ | 146,810 |   |
|                               |            |                 |            |                                                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

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. Kapoorholds 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, dated September 20, 1989 andNeoPharm; and a Subordination, Standby and Intercreditor Agreement, dated December 20,2001, by and among Akorn, Akorn (New Jersey), Inc., The Northern TrustCompany and NeoPharm. The Promissory Note issued by Akorn was due in December 2006,and accrued interest at a rate equal to that received on the Company’sinvestments in marketable securities, which was lower than the interest ratepaid by Akorn on its other outstanding debt. The Processing Agreement grantedNeoPharm access to at least 15% of the annual lyophilization manufacturingcapacity at Akorn at most favored customer pricing, upon completion of thefacility. The Processing Agreement also provided that Akorn was to beginproviding lyophilization services on or before June 30, 2003. At the timethese transactions were entered into, Akorn represented that the manufacturingfacility would be operational in 2003, approximately the time when NeoPharmoriginally anticipated it would need to manufacture its lyophilized drugproduct candidates for Phase II/III clinical trials. In 2001, NeoPharmrecorded the Promissory Note net of a discount of $1,266,619 reflecting the 

71

----

differencebetween the actual loan amount and the present value of the loan using anestimated market interest rate of 10%. As of December 31, 2002, theCompany determined the Promissory Note was impaired and recorded a charge tofully reserve for the Promissory Note and related accrued interest. On August 18,2003, NeoPharm presented Akorn with a formal “Notice of Default” on thePromissory Note. Because the carrying value of the Promissory Note was zero,there was no financial statement impact as a result of any event of defaultunder, or non-payment of, the Promissory Note. In September 2003, Akornadvised NeoPharm that it wished to refinance its senior debt with a new seniorlender, which lender would require NeoPharm to subordinate its debt. In orderto preserve the possibility of collecting Akorn’s debt to NeoPharm, NeoPharmand Akorn entered into an Amended and Restated Promissory Note in considerationof a higher rate of interest (which would now equal that to be charged by thenew senior lender, which was the prime rate plus 175 basis points) and thepossibility of accelerated mandatory repayments once Akorn’s senior debt wasrepaid in full. NeoPharm also agreed to waive Akorn’s default, to allow Akornuntil October 2004 to provide the manufacturing rights and to subordinateAkorn’s indebtedness to NeoPharm to Akorn’s indebtedness to its new seniorlender. Akorn’s refinancing was completed on October 7, 2003. On October 6,2004, NeoPharm presented Akorn with a formal “Notice of Default” on the Amendedand Restated Promissory Note resulting from Akorn’s failure to meet itsobligations under the Processing Agreement. Because the carrying value of thePromissory Note was zero, there was no financial statement impact as a resultof any event of default under, or non-payment of, the Amended and Restated PromissoryNote. On May 16, 2005, the Company and Akorn entered into a Note RepaymentAgreement (“Repayment Agreement”), whereby the Company agreed to accept$2,500,000 as payment in full for any and all amounts due and owing under thePromissory Note, which has been paid. In addition, the parties mutually agreedto terminate the Processing Agreement. As a result of the Repayment Agreement,the Company recorded a $2,500,000 benefit which included the reversal of thevaluation allowance previously recorded against the Promissory Note as “Recoveryof Note Receivable” in the Company’s Consolidated Statement of Operations forthe year ended December 31, 2005.

**9.**   EMPLOYEETERMINATION 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 for the year ended December 31, 2004. Of this amount, $388,518 waspaid as of December 31, 2004 and the remaining $760,759 was paid by February28, 2005.

**10.   COMMITMENTS**

***License and Research Agreements***—Fromtime to time, the Company enters into license and research agreements withthird parties. As of December 31, 2005, the Company had significantagreements with three parties, as described below.

***Georgetown University***—TheCompany has entered into three license agreements with Georgetown Universitywhereby the Company obtained an exclusive worldwide license to use certaintechnologies. In exchange for the grant of these exclusive licenses, theCompany will pay Georgetown beginning with the first commercial sale of aproduct incorporating the licensed technologies, a royalty, ranging from 2.50%to 5.00%, on net sales by the Company of products incorporating any suchtechnologies. The royalty will be payable for the life of the related patents.Additionally, the Company may be obligated to make milestone payments totaling$1,500,000 upon achievement of certain development objectives.

72

----

In addition, the Company previously entered into twoannually renewable contract research agreements with Georgetown that expired inFebruary 2005, and was obligated to pay Georgetown an aggregate of$500,000 in 2004 under the agreements. Under the now expired contract researchagreements, which were terminable upon 90 days written notice by either party,the Company was obligated to pay or reimburse Georgetown for all direct andindirect costs associated with research on specific projects. In return, withrespect to any project for which an NDA is ultimately approved, the Company retainedall rights to all inventions, developments, discoveries and other proprietaryideas which are first conceived, discovered or developed during the conduct ofthe research upon making a one time payment of up to $175,000 to Georgetown.

***National Institutes of Health***—TheCompany entered into an exclusive worldwide licensing agreement with the NIH todevelop and commercialize cintredekin besudotox (IL13-PE38QQR). Theagreement required the Company to pay NIH a $75,000 non-refundable licenseissue payment and minimum annual royalty payments of $10,000, which increase to$25,000 after the first commercial sale. The agreement further provides formilestone payments of up to $585,000 to be paid by the Company to NIH androyalties of up to 4.00% based on future product sales. The Company made itsfirst milestone payment of $25,000 to NIH in November 1999 after thefiling of the U.S. Investigational New Drug (“IND”) application for IL13-PE38QQR.The Company is required to pay the costs of filing and maintaining productpatents on the licensed products. The agreement shall extend to the expirationof the last to expire of the patents on the licensed products, if notterminated earlier. The agreement may be terminated by mutual consent of NIHand the Company. Either party may terminate if the other party breaches amaterial term or condition and such breach is not cured within a certain periodof time. Also, either party may unilaterally terminate by giving advancednotice.

***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 chimericprotein which it licensed from NIH. The FDA agreed to collaborate on theclinical development and commercialization of IL13-PE38QQR. In January 2001,the parties 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. On August 8, 2005, the Company and the FDA agreed to extend the termand funding of the CRADA through April 30, 2006 for $130,000.

***Lease Commitments***—TheCompany has noncancelable operating leases, for its office space and researchand development facility, which expire over the next three years. These leasesgenerally contain renewal options for periods up to 60 months and require theCompany to pay all executory costs such as maintenance and insurance. Rentalpayments include minimum rentals plus contingent rentals based on common area maintenanceexpenses and property taxes.

Rentalexpense for the three most recent fiscal years consisted of the following:

| ** **          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------|------------|----------|------------|----------|------------|----------|------------|
| Minimum rentals     |       | $        | 541,388    |     | $          | 532,263  |       | $ | 532,306 |   |
| Contingent  rentals |       | 193,413  |       | 195,104  |       | 188,849  |       |
| Rental expense      |       | $        | 734,801    |     | $          | 727,367  |       | $ | 721,155 |   |

 

73

----

Futureminimum lease payments under noncancelable operating leases (with initial orremaining terms in excess of one year) as of December 31, 2005 are:

| ** **                     | ** ** | **Operating  leases** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| Year ending  December 31: |       |                  |       |
| 2006                           |       | $                     | 391,825    |   |
| 2007                           |       | 430,634               |       |
| 2008                           |       | 113,380               |       |
| 2009                           |       | —                |       |
| 2010                           |       | —                |       |
| Later years                    |       | —                |       |
| Total minimum  lease payments  |       | $                     | 935,839    |   |

 

***Termination and EmploymentAgreements***—On June 17, 2004, James M. Husseyresigned as the Company’s President, Chief Executive Officer and a member ofthe Board of Directors. In accepting Mr. Hussey’s resignation, the Boardof Directors authorized the Company to enter into a Separation Agreement andFull Release of all Claims (the “Separation Agreement”) with Mr. Hussey.Under the terms of the Separation Agreement, Mr. Hussey received a salarycontinuance for 12 months based upon his annual base salary at the time of hisresignation ($339,768); Company paid insurance premiums under the Company’smedical insurance plan, plus a payment of 50% of Mr. Hussey’s targetmilestone bonus when 2004 bonuses were paid to the Company’s employees. Additionally,Mr. Hussey agreed to serve as a consultant to the Company for a period ofup to 24 months or upon the termination of the Separation Agreement, whicheveris earlier, during which time all options previously granted to Mr. Husseycontinue to vest and remain exercisable until 90 days after termination as aconsultant. For the year ended December 31, 2004, the Company recordedcompensation expense 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. Youngreceived an annual base salary of $325,000 and a sign-on bonus of $97,500. Thesign-on bonus was paid in two installments, with the first $25,000 installmentpaid upon commencement of employment on July 12, 2004 and the secondinstallment of $72,500 was paid on February 15, 2005. Mr. Young wasalso entitled to an annual performance-based milestone bonus payment, a monthlycar allowance of $600, and an annual reimbursement of up to $3,000 for the costof financial and estate planning. Additionally, upon commencement of his employmenton July 12, 2004, Mr. Young received a stock option grant of 250,000shares with a grant price of 85% of the Company’s closing stock price on July 12,2004. These options were scheduled to vest in four equal annual installments onthe anniversary of the option grant date. The Employment Agreement also allowedfor additional specified option grants of up to 350,000 shares in the future ifthe Company’s common stock reached certain pre-determined closing price levels.Mr. Young resigned as the Company’s President and CEO on March 8,2005. Under the terms of a Separation Agreement with Mr. Young, hisoptions continued to vest for a period of 12 months, resulting in the vestingof 62,500 options. All other options granted to Mr. Young have beenforfeited.

On April 25, 2005, the Company and Ronald G.Eidell, a director of the Company, finalized an Employment Agreement underwhich Mr. Eidell was employed, on an interim basis, as the Company’sPresident and CEO. Mr. Eidell had been serving as President and CEO since March 8,2005 under a principal terms employment agreement (“PTA”) executed between theCompany and Mr. Eidell on March 10, 2005, in which Mr. Eidellhad agreed to a base salary of $325,000, which was superseded by the EmploymentAgreement. Additionally, the Company entered into a separate agreement withTatum LLC 

74

----

(“Tatum”), of which Mr. Eidellcontinues to be a partner, providing for up to 20% of Mr. Eidell’s basesalary and bonus, if any, to be remitted to Tatum. Under the terms of theagreement entered into with Tatum, an annualized amount of $65,000, proratedfor the period of Mr. Eidell’s employment by the Company, is to be paid toTatum. Under the Employment Agreement, Mr. Eidell received a base salaryof $260,000, as well as Mr. Eidell was entitled to an annualperformance-based milestone bonus payment, of which 20% would be payable toTatum, as per the Tatum agreement, and a monthly transportation allowance of$1,500. On March 10, 2005, Mr. Eidell received a stock option grantof 80,000 shares at an exercise price equal to the closing price of the Company’sstock on that date. The stock options vest at the earlier of the termination ofthe Employment Agreement as a result of Mr. Eidell’s resignation to allowa new permanent CEO to take office or one year from the date of grant. On October 28,2005, Mr. Eidell resigned as interim President and CEO to allow hissuccessor to take office as President and CEO. In accordance with the terms ofthe Employment Agreement, a $96,000 performance based bonus was paid to him. Inaddition, under the terms of the Tatum agreement, the Company paid $24,000 toTatum upon making the bonus payment to Mr. Eidell. Additionally, the80,000 options granted earlier to Mr. Eidell vested pursuant to theoriginal terms of the option grant.

On October 28, 2005, NeoPharm entered into anemployment agreement with Guillermo A. Herrera (the “Herrera Agreement”) toserve as its President and CEO and member of the Board of Directors. Under theterms of the Herrera Agreement, Mr. Herrera will receive an annual basesalary of $425,000 and a grant of shares of the Company’s common stock, at thetime of hire, equal to a total fair market value of $200,000 based upon theclosing price as of October 28, 2005. Mr. Herrera is also eligiblefor an annual performance-based bonus payment and receives a monthly carallowance of $1,000. Additionally, Mr. Herrera received a common stockoption grant of 500,000 options with a grant price equal to the fair marketvalue on the date of grant. The options vest in four equal annual installmentson the anniversary of the option grant date.

***DefinedContribution Retirement Plan (401(k) Plan)***—The Companysponsors a 401(k) Plan covering all full-time employees. Participants maycontribute up to legal limitations. The 401(k) Plan provides for Companymatch contributions of 50% of employee contributions up to 3% of the employee’seligible compensation. The Company match contributions were $288,425, $306,130and $226,541 for the years ended December 31, 2005, 2004 and 2003,respectively.

**11.   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.The motion to amend seeks to again make Dr. Kapoor a defendant, andrealleges that certain pre-class period statements are actionable. The 

75

----

Company filed oppositionsto both motions. The Court has not yet ruled on the motions. No trial date hasbeen set and discovery is ongoing. Management is unable to estimate thepotential outcome or 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 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 Class ActionSuits 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 orfinancial position.

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 be able toobtain or maintain such insurance on acceptable terms or with adequate coverageagainst potential liabilities.

**12.   SUBSEQUENT EVENT**

On January 10, 2006,the Company received proceeds of $39,002,250 (net of the underwriting discountsand commissions, but before expenses) by issuing 4,025,000 shares of commonstock in a public offering.

76

----

**13.   QUARTERLYFINANCIAL DATA (unaudited)**

Thefollowing table summarizes the quarterly financial data for the years ended December 31,2005 and 2004:

| ** **                                                   | ** ** | **First**   | ** ** | **Second**  | ** ** | **Third**   | ** ** | **Fourth**  | ** ** |
|--------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|
| ** **                                                   | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** |
| **2005 quarters**                                            |       |        |       |        |       |        |       |        |       |
| Revenue                                                      |       | $           | 71,300     |        | $          | 454,600     |       | $           | 9,480      |   | $ | 7,360 |   |
| Research and  development expenses                      |       | (8,073,761  | )          | (7,960,917  | )          | (8,538,368  | )          | (7,277,556  | )          |
| Selling, general,  administrative and related party expenses |       | (3,233,309  | )          | (3,051,288  | )          | (2,388,388  | )          | (2,748,509  | )          |
| Recovery of note  receivable                                 |       | —      |       | 2,500,000   |       | —      |       | —      |       |
| Loss from  operations                                        |       | (11,236,060 | )          | (8,058,665  | )          | (10,917,663 | )          | (10,018,979 | )          |
| Net loss                                                     |       | (10,864,273 | )          | (7,657,301  | )          | (10,532,943 | )          | (9,670,170  | )          |
| Net loss per  share basic and diluted                        |       | $           | (0.46      | )           | $          | (0.32       | )          | $           | (0.45      | ) | $ | (0.41 | ) |
| **2004  quarters**                                           |       |        |       |        |       |        |       |        |       |
| Revenue                                                      |       | $           | 12,200     |        | $          | 19,080      |       | $           | 84,740     |   | $ | 40,760 |   |
| 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 | ) |

 

77

----

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

**The Board of Directors and StockholdersNeoPharm, Inc.:**

Under the date of March 15, 2006, we reported onthe consolidated balance sheets of NeoPharm, Inc. and subsidiary (theCompany) as of December 31, 2005 and 2004, and the related consolidatedstatements of operations, stockholders’ equity, and cash flows for each of theyears in the three-year period ended December 31, 2005. 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 ouraudits.

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, IllinoisMarch 15, 2006

78

----

**NEOPHARM, INC. AND SUBSIDIARY**

**ScheduleII—Valuation and Qualifying AccountsFor the Years Ended December 31, 2005, 2004, and 2003**

| ** **                         | ** ** | **Valuation allowance  for note receivable** | ** ** |
|------------------------------------|------------|-------------------------------------------------------------|------------|
| Balance at  December 31, 2003 |       |                                                        | $          | 2,189,281 |   |   |
| Charged to  operations             |       |                                                        | —     |   |   |
| Balance at  December 31, 2004 |       |                                                        | 2,189,281  |   |   |
| Reversed to  operations            |       |                                                        | (2,189,281 | ) |   |
| Balance at  December 31, 2005 |       |                                                        | $          | — |   |   |

 

79

----