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UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




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Form 10-KSB



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|  |  |                                                                                         
|- |  | ----------------------------------------------------------------------------------------
|þ |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
| 
|  |  | For the fiscal year ended December 31,
    2003                                         
| 
|o |  | TRANSITION REPORT UNDER SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  
| 
|  |  | For the transition period
    from           to          .                              

Commission file number 000-24693

Scolr, Inc.


(Name of small business issuer in its
charter)


|                                                                                    |  |                                      
|----------------------------------------------------------------------------------- |  | -------------------------------------
|Delaware                                                                            |  | 91-1689591                           
|(State of Incorporation)                                                            |  | (IRS Employer
    Identification No.)
|                                                                                   
|3625 132nd Avenue S.E.
    Bellevue, WA(Address of principal executive
    offices) |  | 98006(Zip Code)                      

Issuers telephone number:

(425) 373-0171


Securities registered under Section 12(b)
of the Exchange Act:

|                                                                                             |  |                                          
|-------------------------------------------------------------------------------------------- |  | -----------------------------------------
|Title of Class                                                                               |  | Name of Each Exchange on Which Registered
|                                                                                             |  |                                          
|Common stock, $.001 par value
    (Including Associated Preferred Stock
    Purchase Rights) |  | American Stock Exchange                  

Securities registered under Section 12(g)
of the Exchange Act:

None


Check
whether the issuer (1) filed all reports required to be
filed by Section 13 or 15(d) of the Exchange Act during the
past 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past
90 days.     Yes þ          No o

Check
if disclosure of delinquent filers in response to Item 405
of Regulation S-B is not contained in this form, and no
disclosure will be contained, to the best of registrants
knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this
Form 10-KSB.     o

The
issuers revenues for the fiscal year ended
December 31, 2003 were $6,594,073

The
aggregate market value of the voting common stock held by
non-affiliates computed by reference to the price at which the
stock was last sold, as reported on the American Stock Exchange,
as of March 17, 2004 was approximately $89,039,894.

As
of March 17, 2004, there were 29,894,296 shares
outstanding of the issuers common stock.



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DOCUMENTS INCORPORATED BY REFERENCE

The
Registrant has incorporated by reference into Part III of
this Form 10-KSB portions of its Proxy Statement for the
2004 Annual Meeting of Shareholders.



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TABLE OF CONTENTS

SCOLR, INC.

FORM 10-KSB

|              |  |                                                                                               |  |      |    | 
|------------- |  | --------------------------------------------------------------------------------------------- |  | ---- | -- | 
|              |  |                                                                                               |  | Page
|              |  |                                                                                               |  |     
|Item 1.       |  | Description of Business                                                                       |  |      | 3  | 
|Item 2.       |  | Description of Property                                                                       |  |      | 10 | 
|Item 3.       |  | Legal Proceedings                                                                             |  |      | 11 | 
|Item 4.       |  | Submission of Matters to a
    Vote of Security Holders                                       |  |      | 11 | 
|Item 5.       |  | Market for Common Equity and
    Related Stockholder Matters                                  |  |      | 11 | 
|Item 6.       |  | Managements Discussion
    and Analysis of Financial Condition and Results of
    Operations |  |      | 12 | 
|Item 7.       |  | Financial Statements                                                                          |  |      | 23 | 
|Item 8.       |  | Changes in and Disagreements
    With Accountants on Accounting and Financial
    Disclosure  |  |      | 45 | 
|Item 8A.      |  | Controls and Procedures                                                                       |  |      | 45 | 
|Item 9.       |  | Directors and Executive
    Officers of the Registrant                                        |  |      | 45 | 
|Item 10.      |  | Executive Compensation                                                                        |  |      | 45 | 
|Item 11.      |  | Security Ownership of
    Certain Beneficial Owners and Management                            |  |      | 45 | 
|Item 12.      |  | Certain Relationships and
    Related Transactions                                            |  |      | 45 | 
|Item 13.      |  | Exhibits and Reports on
    Form 8-K                                                          |  |      | 46 | 
|Item 14.      |  | Principal Accountant Fees
    and Services                                                    |  |      | 48 | 
|EXHIBIT 10.33
|EXHIBIT 23.1 
|EXHIBIT 31.1 
|EXHIBIT 31.2 
|EXHIBIT 32.1 
|EXHIBIT 32.2 



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SCOLR, Inc.

FORM 10-KSB

CAUTIONARY STATEMENT PURSUANT TO THE

PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995


Except for the historical information, the
matters discussed in this Form 10-KSB contain
forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended and
Section 21E of the Securities Exchange Act of 1934, as
amended. These forward-looking statements include statements
regarding, among other things, (a) our expectations about
product development activities, (b) our growth strategies,
(c) anticipated trends in our industry, (d) our future
financing plans, and (e) our anticipated needs for working
capital. Forward-looking statements, which involve assumptions
and describe our future plans, strategies, and expectations, are
generally identifiable by use of the words may,
will, should, expect,
anticipate, estimate,
believe, intend, or project
or the negative of these words or other variations on these
words or comparable terminology. Readers should carefully review
the risk factors described in this document and in other
documents we file from time to time with The Securities and
Exchange Commission, including the Quarterly Reports on
Form 10-QSB to be filed later in the fiscal year, that
attempt to advise you of the risks and factors that may affect
our future results.






|        |                        
|------- | -----------------------
|Item 1. | Description of Business

Overview

We are a drug delivery company that develops and
formulates over-the-counter products, prescription drugs and
nutraceutical products that use our patented Controlled Delivery
Technology (CDT®). Over the last few years, we have engaged
in the drug delivery business as well as a probiotics business
in which we formulated and manufactured nutraceutical-based
health and dietary supplements for the animal and human
nutrition markets. Since 2001, we have transformed our business
from a nutraceutical company specializing in probiotic
formulations to a company concentrating on developing and
commercializing drug delivery technology. The purpose of this
transition was to allow us to take advantage of the perceived
long-term growth potential and prospects associated with our CDT
technology. The transition to a focused drug delivery business
was completed with the sale of our probiotics business,
effective as of December 31, 2003. See Sale of
Probiotics Division below.

We were incorporated on October 12, 1994 in
Delaware under the name Caddy Systems, Inc. From April 1995
to July 2002, we operated under the name Nutraceutix, Inc.
In July 2002, we changed our name to SCOLR, Inc. SCOLR is
an acronym for our lead technology: Self Correcting Oral Linear
Release Systems. Our website is www.scolr.com.
Information contained on our website is not part of, and is not
incorporated into, this annual report. Our filings with the SEC
are available without charge on our website as soon as
reasonably practicable after filing.

Drug Delivery Business

Our business is centered around the development
and licensing of our Controlled Delivery Technology. Our CDT
platform currently consists of three patented drug delivery
technologies for prescription drugs, over-the-counter
(OTC) products, and nutraceuticals. The basis of these
technologies is embodied in two issued U.S. patents
licensed exclusively to us by Temple University, and a third
issued U.S. patent assigned to us by Dr. Reza Fassihi.

Dr. Fassihi is Professor of Biopharmaceutics
and Industrial Pharmacy at the Temple University School of
Pharmacy. We have collaborated with Dr. Fassihi over the
last five years to develop prototype prescription drugs, OTC
products and dietary supplements that use the delivery system
concepts embodied in the three CDT patents. Dr. Fassihi has
been a consultant to the Company since 2000 and was appointed to
our board of directors in November 2003.

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The CDT platform is used in solid oral dosage
forms, the preferred route for drug administration. This
technology is designed to produce tablets or capsules that
release their active agents predictably and programmably over a
specified timeframe of up to 24 hours. We believe we can
apply our technology to create significant enhancements to
existing pharmaceutical, OTC and nutraceutical products.

For many reasons, pharmaceutical companies
increasingly prefer controlled release rather than immediate
release of the active agent in their drugs. We believe the
advantages of controlled drug delivery typically include
improved patient compliance, product differentiation, greater
efficacy, and an improved safety profile.

Our proprietary CDT technology improves upon
conventional multiple daily dose immediate release forms of
existing products by providing the therapeutic benefits of
controlled release drug delivery. In addition, we believe our
technology can provide enhanced dosage formats for existing
medications that provide superior patient convenience and
product differentiation.

A technology such as CDT may also allow
pharmaceutical companies to reformulate existing drugs, thereby
improving product release profiles and defending important
revenue streams, particularly for existing
blockbuster drugs nearing patent expiration.

We believe our CDT platform enjoys many
competitive advantages when compared to other controlled
delivery methodologies. Our CDT technology is robust and simple
allowing for low cost manufacturing (using conventional blending
and compression equipment in a two- or three-step process). It
can deliver comparatively high therapeutic payloads
of active ingredient. It is also highly programmable to deliver
active therapeutic agents over a wide range of release profiles
and timeframes.

Corporate Strategy

A critical part of our strategy is to enter into
various collaborative arrangements and alliances with corporate
partners, licensors and licensees to provide funding for the
research, development, clinical testing, manufacturing,
marketing and commercialization of our product candidates. In
March 2002, we entered a global strategic alliance with
Archer-Daniels-Midland Company (ADM) for the
development of certain CDT-based dietary supplement and
nutraceutical products. In August 2003, we entered into an
evaluation agreement for drug delivery systems with a Fortune
100 technology based company. Pursuant to this agreement we are
working together to identify potential opportunities where our
technology might be useful in complementing our clients
offerings and potentially accelerating introduction of our CDT
platform to the pharmaceutical market.

Following the successful completion of our CDT
proof-of-concept human clinical trial in late 2002,
we have received expressions of interest from several of the
largest pharmaceutical companies. Virtually all of these
potential licensing partners currently have prescription drug
franchises for which they are seeking technological enhancements
(such as CDT) to extend the life of those franchises in the face
of core patent expirations over the next 5-10 years. In our
active pursuit of collaborations with these pharmaceutical
companies, we are seeking upfront licensing fees, royalty
payments, and milestone payments for the use of our CDT
technology.

Our drug delivery business has begun generating
revenue from CDT-based sales to the dietary supplement markets.
These sales are being generated through existing relationships
with retailers such as Wal-Mart, Rite-Aid, Trader Joes and
the General Nutrition Corporation (GNC). We expect to realize
increased royalty income from our CDT dietary supplements in
2004. We do not expect royalty income from CDT prescription
drugs earlier than 2007.

Since 2002 we have achieved critical milestones
and invested significant resources in our CDT technology
(including $2,048,155 during 2002 and $2,176,018 during 2003),
bringing us closer to our goal of becoming a focused drug
delivery company. Most notably:



| |   |                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------
| |  | We successfully conducted proof-of-concept
    experiments that established the viability of our patented drug
    delivery concept.

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | In October 2002, we completed an in-vivo/in-vitro
    correlation, our first human clinical trial, establishing that
    results achieved in the test tube were achievable in human
    patients.                                                                                                                                                                                                                                                                                                               
|
| |  | In November 2002, we presented the results of our
    clinical trial to the pharmaceutical industry at the annual AAPS
    meeting (American Association of Pharmaceutical Scientists).                                                                                                                                                                                                                                                                                                                         
|
| |  | In collaboration with Dr. Fassihi, we
    developed technology embodied in the first CDT patent owned
    exclusively by us. Designed as a simpler solution to certain
    difficult formulation issues, this technology extends our
    capabilities to include poorly soluble drugs which are difficult
    and costly to formulate and produce with currently available
    manufacturing techniques and processes.                                                                                          
|
| |  | We changed our name to SCOLR, Inc. SCOLR is
    an acronym for our lead technology: Self Correcting Oral Linear
    Release systems.                                                                                                                                                                                                                                                                                                                                                                            
|
| |  | Archer-Daniels-Midland introduced NovaSoy®
    Daily DoseTM, the first ADM product to include our
    CDT technology, to the European markets in October 2002. This
    once-a-day supplement provides delivery of natural based soy
    isoflavones (a phytoestrogen) throughout the day. NovaSoy Daily
    Dose generated revenue of $195,788 in 2003.                                                                                                                                                        
|
| |  | During the first quarter of 2003, our first
    commercial CDT product, Once Daily Glucosamine &
    Chondroitin, was introduced to the U.S. nutraceutical
    industry. Our CDT Glucosamine & Chondroitin product is
    currently available nationwide in more than 8,000 retail
    outlets, including Wal Mart (under the Spring Valley label),
    Trader Joes (under the Trader Darwins label), and
    Rite Aid stores. In addition, GNC introduced its first two CDT
    based products in early 2004.
|
| |  | We realized our first CDT royalty revenues of
    $582,953 in 2003. We expect these revenues to increase in 2004.                                                                                                                                                                                                                                                                                                                                                                                               
|
| |  | In June 2003, we completed a $5.3 million
    financing of our 6.0% Convertible Notes Due
    June 25, 2006. The notes were converted into
    5,047,559 shares of common stock effective
    December 15, 2003.                                                                                                                                                                                                                                                                                                
|
| |  | In August 2003, we entered into an evaluation
    agreement for drug delivery systems with a Fortune 100
    technology based company. Pursuant to this agreement we work
    together to identify potential opportunities where our
    technology might be useful in complementing our clients
    offerings and potentially accelerating introduction of our CDT
    platform to the pharmaceutical market.                                                                                                 
|
| |  | In November 2003, we received payment and a
    letter of acceptance for completion of a feasibility study for
    the first molecule identified under the evaluation agreement
    with the Fortune 100 client. We are currently negotiating
    the second stage of development, under which we would work to
    advance the commercialization of the molecule utilizing our CDT
    platform. We have also held discussions with this client to
    initiate work on several other candidate compounds.     
|
| |  | Primarily as a result of our presentation and
    introductions at the AAPS meeting in November 2003, we have
    completed follow-up meetings with several of the top
    multinational pharmaceutical companies. Our goal is to secure
    licensing agreements and/or strategic alliances with corporate
    partners to develop new and innovative CDT products for the
    marketplace.                                                                                                                    
|
| |  | We completed the sale of our probiotics
    development and manufacturing assets as of December 31,
    2003.                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | In January 2004, we commenced an internal
    development program targeting a select group of significant,
    existing drugs for reformulation using our CDT platform. We
    commenced an in vivo animal study for the first drug candidate
    in February 2004.                                                                                                                                                                                                                                             
|
| |  | In late February 2004, we completed a private
    placement of 3,206,538 shares of common stock for
    $3.25 per share and gross proceeds of approximately
    $10.4 million. The purchasers also received five-year
    warrants to purchase 801,636 shares of common stock at an
    exercise price of $4.75 per share.                                                                                                                                                                                      

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Drug Delivery Technology

In December 1998, we obtained the exclusive
rights to a patent pending for technology pertaining to the
controlled delivery of dietary supplement capsules and tablets
from Temple University. We trademarked this technology as CDT
Controlled Delivery Technology. We consider the technology to be
distinctive in its ability to program in-vitro release patterns
for each health supplement contained in a single tablet or
capsule. We believe our technology provides a relatively low
cost of manufacture as compared to immediate release
formulations of the same active ingredient. We believe that the
wide applicability of its technology among the available range
of vitamin and herbal products suitable for once or twice daily
dosing or pulsed release provides a unique commercial
opportunity in the $19 billion U.S. dietary supplement
and nutraceutical market.

Controlled delivery technologies are widely
employed within the OTC and pharmaceutical industries, while
they are relatively rare within the dietary supplement industry.
In the pharmaceutical industry, sustained-release technologies
have been shown to optimize the therapeutic effectiveness,
enhance the compliance to the dosing schedule, and reduce the
frequency and severity of side effects of a single Active
Pharmaceutical Ingredient (API). We believe that
this unique technology will offer similar benefits within the
health and dietary supplement industry.

Our Controlled Delivery Technology was developed
at Temple University, School of Pharmacy for the chronic
administration of calcium channel blockers such as nifedipine,
diltiazem, and verapamil which are prescribed for the long-term
management of chronic angina pectoris and benign essential
hypertension. The physicochemical properties and intrinsic
pharmacological characteristics of these drugs, such as high or
low solubility, limited absorption, or pre-systemic metabolism,
necessitated the development of a highly controllable drug
delivery system to provide continuous active ingredient release
with zero-order kinetics typified by precise and reproducible
performance. The first generation of this technology is based on
swellable hydrophilic matrices, which allow for the controlled
diffusion of dietary supplements from the matrix through the
tablets progressive swelling and erosion. The CDT tablets or
capsules employ combinations of hydrophilic polymers and
poly-ionics or electrolytes specific to each health supplement
or OTC product and the desired release profile. Depending upon
the matrix composition, the selection and ratio of polymers,
ionic substrates, or electrolytes various release patterns and
rates can be achieved.

One of the most difficult challenges for a
controlled delivery technology is to produce a continuous
release formulation with near linear, zero-order kinetics of a
highly soluble API for periods up to 24 hours. Linear,
zero-order kinetics means that a precise quantity of API is
released during each unit of time over the entire course of the
release pattern until 100% of the API is released. There are no
bursts or lag phases in the release pattern. After obtaining the
exclusive license for the technology from Temple University, the
Company, in collaboration with Temple University, specifically
developed continuous, zero-order kinetics tablets of
Vitamin C. Vitamin C was considered to be a
technological challenge due to its high water solubility and its
high permeability. Following the Vitamin C project, the Company
and Temple University developed individual, controlled-release,
linear, zero-order kinetics tablets of glucosamine, Calcium
D-glucarate, several sports nutrition prohormones, and diet
formulations. The Company believes that both the dietary
supplement and nutraceutical industries offer many opportunities
to apply this technology.

In 1999, we licensed the right from Temple
University to apply the CDT Patent No. 1 technology to OTC
products. We have not yet manufactured OTC products using the
technology contained in the CDT Patent No. 1. In September
2001, we acquired the exclusive license for the rights to CDT
Patent No. 1 in prescription drugs. On January 8,
2002, CDT Patent No. 1 was issued by the United States
Patent and Trademark Office (USPTO) as
US Patent 6,337,091.

In September 2000, the Company acquired the
worldwide rights to Patent No. 6,090,411 (CDT Patent
No. 2) for application in dietary and health
supplements, OTC products and prescription drugs. This
technology (issued on July 18, 2000) provides for the
controlled and programmable release of the API with zero-order
kinetics through the dry blending and direct compression of a
salt, a polymer, and the API. We believe the CDT Patent
No. 2 technology possesses several critical and unique
advantages over comparable

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sustained-release technologies currently employed
by the drug delivery industry in manufacturing extended or
sustained-release products:




| |   |                                                                                                                                                                                                                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The technology does not involve a granulation
    step at manufacturing; thereby, shortening process times and
    eliminating potentially toxic solvents from the manufacturing
    process. Processes are faster and easily validated.                                                                                                                                             
|
| |  | The technology involves the development of the
    desired release pattern through the dry blending of a selected
    salt and polymer in various ratios in order to create a dry
    matrix. The resulting matrix is directly compressible on all
    currently available tableting equipment routinely used in the
    pharmaceutical industry.                                    
|
| |  | The technology and its applicability to dietary
    supplements, OTC products or prescription pharmaceuticals are
    extremely rugged and flexible; the in-vitro dissolution results
    are not affected by drug solubility, pH, tablet size or
    configuration, tablet hardness, or friability.                                                                                 
|
| |  | The technology has a remaining patent life of
    18 years.                                                                                                                                                                                                                                                                                                                          
|
| |  | The technology is a 2 step process involving
    GRAS (Generally Regarded as Safe) excipients in novel quantities
    and using standard pharmaceutical processing equipment and
    technology; thereby, enabling the manufacturer of CDT products
    to produce controlled release products at approximately the same
    costs as immediate release formulations of the same API.

We believe that the technology embodied in the
CDT Patent No. 2 demonstrates significant advantages over
current sustained-release technologies that involve multiple
polymer systems, coated beads or coated tablets. Our technology
is easily manufactured on conventional pharmaceutical equipment
with fewer processing steps. Furthermore, it is applicable to a
wider range of APIs, dietary supplements and OTC products than
other technologies. We believe that the CDT Patent No. 2
will provide for more rapid product formulation and development
leading to faster submissions to the regulatory authorities,
faster time to market, and less expensive manufacturing.

On February 12, 2003, The USPTO issued
US Patent 6,517,868 (CDT Patent No. 3) for
an amino acid CDT drug delivery platform for pharmaceutically
active compounds. The amino acid CDT platform is one of three
patents for modified oral dosage release systems currently in
pre-commercialization development by the Company. Designed as a
simpler solution to certain difficult formulation issues, the
amino acid platform extends our capability to include poorly
soluble drugs which are difficult and costly to formulate and
produce with currently available manufacturing techniques and
processes. Although this is our third CDT patent, it is the
first CDT patent owned exclusively by us. In collaboration with
Dr. Fassihi, SCOLR has, over the last three years,
developed prototype prescription drugs, OTC products and dietary
supplements which employ the novel delivery system concepts
embodied in all three CDT patents.

The issuance of CDT Patent No. 3 is
significant because it demonstrates our transition from a
licensee of technology to our development as an innovator in
drug delivery. This new CDT amino acid technology broadens the
field of potential prescription drug candidates for our CDT
platform to include drugs with solubility issues where
developing controlled release formulations is currently both
difficult and costly. The new CDT amino acid patent, in
conjunction with the CDT salt patent and CDT dual polymer patent
combine to create a range of modified oral drug delivery systems
which address the most challenging hurdles of oral drug
delivery, including zero order kinetics, poorly soluble active
ingredients and ingredients difficult to tablet. The CDT
technology has been shown to accomplish this at reasonable cost
and time savings to the manufacturer.

We have taken advantage of the faster
time-to-market in the dietary supplement industry. Several
nutraceutical products employing CDT technology were introduced
in early 2003. The first commercial introduction of an OTC
product utilizing CDT is expected in 2005 and CDT based
prescription drugs are planned for not earlier than 2007.

The oral controlled release market for OTC
products and prescription drugs has been estimated at
$19.9 billion in 2000 with a forecast of approximately
$40.0 billion in the United States in 2010 (Data

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Monitor) and has been reported to be growing at
twice the annualized rate of the pharmaceutical market; in
general. A total of 42 out of 52 blockbuster drugs
($82 billion combined worldwide sales) will face patent
expiration by the year 2007. The Company believes that the drug
delivery industry will continue to show strong growth in the
future as many multi-national pharmaceutical companies seek new
drug delivery technologies to evergreen their
existing pharmaceutical franchises through new drug
introductions involving older molecules incorporating new
patented drug delivery technology. Since revenues from a drug
can drop by up to 70% when its patent expires, any method of
adding new life to an existing product will protect brand sales.
Incorporation of new, patented drug delivery technology is one
such proven strategy.


Competition

Our business is highly competitive and is
affected by new technologies, government regulations,
availability of financing and other factors. In the drug
delivery field, examples of our major competitors include Alza
Corporation, Biovail, Inc., Penwest, Skyepharma PLC, Elan,
Andrx, Inc., Impax Laboratories, Inc., Labopharm,
and KV Pharmaceuticals, Inc. The successful development and
commercialization of major controlled delivery prescription
drugs can take five to seven years and millions of dollars of
research and clinical trials. These major competitors are better
funded and equipped to fully realize the potential from new and
unique patented drug delivery systems and are in possession of
significantly stronger financial and research and development
resources. See Item 6. Managements Discussion
and Analysis or Plan of Operation  Risk Factors.

Research and Development

In 2000, we reorganized our research and
development capabilities and structure in order to focus on
exploitation of the newly acquired CDT Patent No. 2 and the
opportunities presented in the OTC and prescription drug markets
for drug delivery. In 2003 and 2002, we spent $403,186
(approximately 6% of revenues) and $540,826 (approximately 8% of
revenues), respectively, on product research and development. We
will have to increase our research and development expenditures
to take advantage of opportunities in the pharmaceutical and OTC
markets for our technology. As part of our strategy, we seek to
supplement our research and development efforts by entering into
research and development agreements, joint venture, and other
collaborative arrangements with other companies.

Our business includes the development of products
requested by private label customers and/or new product concepts
that can be licensed to customers. We also seek and review new
nutraceutical materials and drug delivery technologies developed
at universities or by independent researchers with the view to
acquiring the intellectual property. We then conduct applied
research on the intellectual property to develop a commercial
product or application which can be licensed to co-developers or
commercial partners.

Intellectual Property

Following the sale of our probiotics division,
the Company had four federal trademark registrations and 16
trademark applications pending with the USPTO. Our policy is to
pursue registrations for all of the trademarks associated with
its key products and technologies. A list of our registered and
pending trademarks is as follows: CDT, SCOLR, and SCORx.

Our success will depend in part on our ability to
obtain and maintain patent protection for our technologies and
to preserve our trade secrets. No assurance can be given that
our issued patents will not be challenged or circumvented by
competitors. With respect to already issued patents, there can
be no assurance that any patents issued to us will not be
challenged, invalidated, circumvented or that the patents will
provide us proprietary protection or a commercial advantage.

We are obligated to pay an annual license
maintenance fee, share in some up-front payments from customers
and pay royalties based on product sales with respect to the CDT
patents licensed by Temple University or assigned to us by
Dr. Fassihi. In addition, we are obligated to pay
Dr. Fassihi an annual license maintenance fee, share in
up-front payments from customers and pay royalties based on
product sales with respect to CDT Patent No. 3.

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Probiotics Business



| |                            
| | ---------------------------
| | Sale of Probiotics Division

On January 15, 2004, we completed the sale
of our probiotics development and manufacturing division to
Nutraceutix, Inc., a Washington corporation, pursuant to an
Asset Purchase Agreement dated as of December 31, 2003. The
new Nutraceutix entity was formed and is owned by Steven H.
Moger, the Companys former Vice President of Operations,
Chief Financial Officer and General Manager of the probiotics
division. Mr. Moger resigned his positions with the Company
in connection with the sale.

The assets sold comprise substantially all of the
assets and properties used in connection with our probiotics
division, including equipment, inventory and intellectual
property rights. The division engaged in the business of
formulating and manufacturing probiotics-based health and
dietary supplements for the animal and human nutrition markets.
The Company also granted Buyer the right to manufacture and sell
certain products utilizing SCOLRs patented CDT technology
pursuant to a License, Manufacture, and Distribution Agreement
also dated as of December 31, 2003.

We received $722,756 in cash at closing and the
Asset Purchase Agreement provides for deferred payments of at
least $2 million. The deferred payments are tied to the
Buyers achievement of certain sales levels and royalties.
The consideration for the sale was determined pursuant to
arms-length negotiations after extensive negotiations with
a number of third parties (including industry buyers) and took
into account various factors concerning the valuation of the
probiotics business, including valuations of comparable
companies, the operating results, financial condition and
prospects of the division and the opinion of the financial
advisor retained by the Board of Directors. See Note B to
the Companys Financial Statements for additional
information concerning the asset sale and the deferred payments
to the Company.

In connection with the sale we repaid
indebtedness of approximately $1,098,500, which debt had been
secured by the assets of the probiotics division.



| |              
| | -------------
| | Manufacturing

During 2003 and prior years the Company operated
manufacturing facilities in Redmond, Washington and Lafayette
Colorado. Both of these facilities and related manufacturing
operations were included in the sale of the probiotic assets. In
the future, we will employ contract manufacturers, including
Nutricia and Nutraceutix, to manufacture certain of our private
label products.

The probiotics unit manufactured private label
health supplements incorporating our patented and proprietary
technologies or the probiotics produced in the Redmond,
Washington fermentation facilities. Finished goods production
took place at its encapsulating, tableting, bottling, and
labeling facility in Lafayette, Colorado. In addition to its own
products, we manufactured microbial products for several
agriculture companies on a private label and OEM basis at its
fermentation plant located in Redmond, Washington. These
products included microbial inoculum, feed and food additives
and microbial-based dietary supplements.

Sources and Availability of Raw Materials and
Principal Suppliers

Our technology allows for the use of
conventional, readily available Generally Regarded As Safe
(GRAS) excipients. A wide variety of materials can be used
for formulation development and are available from a large
number of manufacturers and distributors. The materials used in
controlled delivery formulation are generally available.

Dependence on Significant Customers

In 2003, the Company received approximately 54%
of its total revenues from three customers: Rexall Sundown
(21%), Trader Joes (21%), and Supplement Sciences (12%).
There will be no continuing revenues from these customers or
other probiotics customers as a result of the sale of the
probiotic business. However, the Company will receive royalties
on the sale of products to Trader Joes and other customers
for certain

9



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##### Table of Contents



CDT products which were previously manufactured
by the probiotics unit. Royalty revenues in 2003 were primarily
attributable to our relationship with Nutricia and sales of
Glucosamine & Chondroitin.


Government Regulation

The Company must receive separate regulatory
approval for each of our product candidates before the Company
or its collaborators can sell them in the United States or
internationally. The manufacture and sale of OTC and
prescription drugs in the U.S. and internationally is governed
by a variety of statutes, regulations and policies which
require; among other things:



| |                                                                                                                                                                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. approval of manufacturing facilities and
    practices;                                                                                                                                                                                                                                                                       
|
| | 2. controlled research and testing of
    products;                                                                                                                                                                                                                                                                              
|
| | 3. review and approval of submissions
    containing manufacturing, preclinical, and clinical data in
    order to obtain marketing approval based on establishing the
    safety and efficacy of the product for each use sought,
    including adherence to Good Manufacturing Practices during
    production and storage; and
|
| | 4. control of marketing activities,
    including advertising and labeling.                                                                                                                                                                                                                                                      

The products currently under development will
require significant development, preclinical and clinical
testing and investment of significant funds prior to their
commercialization. The process of obtaining such approvals is
likely to take many years and require the expenditure of
substantial resources, and there can be no assurance that the
development and clinical trials performed by the Company or our
collaborators will be successful. See Item 6.
Managements Discussion and Analysis or Plan of
Operation  Liquidity and Capital Resources and
Risk Factors.

Compliance with Environment Laws

The Company may incur significant costs in
complying with environmental laws and regulations. The Company
is subject to federal, state, local and other laws and
regulations governing the use, manufacture, storage, handling,
and disposal of materials and certain waste products. The risk
of accidental contamination or injury from these materials
cannot be completely eliminated. In the event of an accident, we
could be held liable for any damages that result and any such
liability could exceed our resources. There can be no assurance
that the Company will not be required to incur significant costs
to comply with environmental laws and regulations in the future,
or that our operations, business, or assets will not be
materially adversely affected by current or future environmental
laws or regulations.

Employees

As of December 31, 2003 and prior to the
sale of the probiotics business the Company employed 37 full
time employees. Subsequent to the sale, the Company retained 10
employees consisting of three executives, one sales and
marketing personnel, four research and development personnel,
and two quality assurance personnel. None of the Companys
employees are represented by labor unions. The Company believes
its relationship with employees is good.






|        |                        
|------- | -----------------------
|Item 2. | Description of Property

The Companys corporate headquarters,
including administrative offices and research and development
facilities are located approximately fifteen miles east of
Seattle at 3625 132nd Avenue SE, Bellevue Washington 98006.
The property, consisting of 10,510 square feet, is leased
for a term of sixty (60) months at an average annual rent
of $112,639, with a lease termination date of September 30,
2008.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

Except as described below, the Company is not a
party to any material litigation. The Company is involved in a
dispute concerning rights purportedly granted to
Bionutrics, Inc. pursuant to a letter of intent dated
December 9, 2002. The Company has been advised that a
complaint has been filed by Bionutrics in

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Maricopa County, Arizona seeking specific
performance, a declaratory judgment and claiming breach of
contract, tortious interference with business expectancy and
seeking injunctive relief. However, the complaint has not been
served. We intend to vigorously defend the case if the complaint
is served.







|        |                                                          
|------- | ---------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of
    Securities Holders

No matters were submitted to our shareholders
during the quarter ended December 31, 2003.






|        |                                                             
|------- | ------------------------------------------------------------
|Item 5. | Market For Common Equity and Related
    Stockholder Matters

Our Common Stock was traded in the
over-the-counter bulletin board (Symbol: SCLL) until
February 5, 2004. Commencing on February 6, 2004, the
common stock has been traded on the American Stock Exchange
(Symbol: DDD). The following table sets forth the range of high
and low bid prices for the Companys Common Stock on a
quarterly basis for the past two full years, and reflects
inter-dealer prices, without retail mark-up, mark-down, or
commission and may not necessarily represent actual transactions.

COMMON STOCK

|                          |  |          |      |         |  |  |      | 
|------------------------- |  | -------- | ---- | ------- |  |  | ---- | 
|Period  Fiscal Year 2003 |  | High Bid |      | Low Bid
|                          |  |          |      |        
|First Quarter             |  |          | 1.00 |         |  |  | .95  | 
|Second Quarter            |  |          | 1.80 |         |  |  | 1.67 | 
|Third Quarter             |  |          | 2.25 |         |  |  | 2.18 | 
|Fourth Quarter            |  |          | 2.15 |         |  |  | 2.03 | 

|                          |  |          |      |         |  |  |      | 
|------------------------- |  | -------- | ---- | ------- |  |  | ---- | 
|Period  Fiscal Year 2002 |  | High Bid |      | Low Bid
|                          |  |          |      |        
|First Quarter             |  |          | 1.55 |         |  |  | 0.52 | 
|Second Quarter            |  |          | 1.60 |         |  |  | 0.90 | 
|Third Quarter             |  |          | 1.18 |         |  |  | 0.77 | 
|Fourth Quarter            |  |          | 1.28 |         |  |  | 0.72 | 

As of March 17, 2004, we had
1,428 shareholders of record. We have not paid or declared
any dividends upon its Common Stock since inception and do not
contemplate or anticipate paying any dividends upon the Common
Stock in the foreseeable future.

Recent Sales of Unregistered
Securities

We issued 3,206,538 shares of its common
stock and warrants (Warrants) to purchase
801,636 shares of common stock to pursuant to a Securities
Purchase Agreement dated February 24, 2004. The common
stock was sold at $3.25 per share for gross proceeds of
approximately $10.4 million. The Warrants are exercisable
until February 23, 2009 at $4.75 per share, subject to
customary anti-dilution provisions. After a period of
12 months following the effective date of a registration
covering the resale of shares issued upon exercise of the
Warrants, we have the right to call the Warrants for
cancellation if the volume weighted average price of the common
stock is above $8.00 for 20 consecutive trading days.

Rodman & Renshaw acted as the lead
placement agent for the transaction and Taglich
Brothers, Inc. assisted in the financing. The placement
agents received a cash commission of $729,487 and Warrants to
purchase 224,458 shares, of which Taglich Brothers received
$174,965 and Warrants to purchase 12,408 shares. Michael N.
Taglich and Robert C. Schroeder, directors of the Company, are
affiliates of Taglich Brothers. In addition, Mr. Taglich
(and a partnership of which Mr. Taglich is a general
partner) purchased 49,631 shares of common stock and
Warrants to purchase 12,408 shares as part of the private
placement. However, Mr. Taglichs agreement with the
Company was amended to increase the purchase price applicable to
the 49,631 shares purchased by him to $3.63 per share.

The Company also issued
(i) 32,000 shares of common stock and a Warrant to
purchase 15,000 shares to an unaffiliated third party as a
finders fee, and (ii) 23,077 shares of common
stock and Warrants to purchase

11



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##### Table of Contents



5,679 shares to Rostrevor Partners in
partial payment of its advisory fee in connection with the sale
of the Companys probiotics division.


The common stock and Warrants were issued to
accredited investors and such sales were exempt from
registration under the Securities Act of 1933, as amended,
pursuant to Rule 506 of Regulation D and
Section 4(2) of such Act. In connection with the offering,
the Company agreed to register the resale of the common stock
and shares to be issued upon exercise of the Warrants with the
Securities and Exchange Commission. The Company is subject to
certain penalties if the registration statement is not filed
within 30 days of the closing, or if the registration
statement is not declared effective by the Securities and
Exchange Commission within 120 days of such closing.






|        |                                                              
|------- | -------------------------------------------------------------
|Item 6. | Managements Discussion and Analysis
    or Plan of Operation

Introduction and Overview

We have historically generated substantially all
of our revenues through our probiotics unit which was sold as of
December 31, 2003. Accordingly, except for the deferred
purchase price and royalties relating to the CDT technology, we
will no longer receive revenues from the probiotics division.
Our drug delivery business has begun generating revenue from
CDT-based sales in the dietary supplement markets. We expect to
realize increased royalty income from our initial CDT dietary
supplement and OTC formations in 2004. However, we will continue
to incur substantial operating losses for the foreseeable future
as we develop our technology, expand our operations and develop
systems that support commercialization of our CDT platform. Our
strategy includes a significant commitment to research and
development activities in connection with the growth of our drug
delivery platform. Our results of operations going forward will
be dependent on our ability to commercialize our technology and
generate royalties, development fees, milestone and similar
payments.

In recent years, we have generated substantially
all of our working capital through the sale of securities. In
June 2003, we completed a $5.3 million financing of
6.0% convertible notes due June 25, 2006. These notes
were converted into 5,047,559 shares of common stock
effective December 15, 2003. In February 2004, we completed
a private placement of 3,206,538 shares of common stock for
$3.25 per share together with five-year warrants to
purchase 801,636 shares of common stock at $4.75 per
share for gross proceeds of $10.4 million.

Results of Operations



| |             
| | ------------
| | Net Revenues

Net revenues increased 1% percent or $79,830 to
$6,594,073 for the year ended December 31, 2003 from net
revenues of $6,514,243 for the year ended December 31,
2002. An analysis of our revenue-generating centers is outlined
below:



| |                           
| | --------------------------
| | Revenue Generating Centers

During 2002 and 2003 we operated the two primary
revenue-generating centers described below.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. Manufacturing Center (Probiotics
    business)  consisting of (A) dietary
    supplement manufacturing operations, including the manufacture
    of dietary supplement products, on an OEM or private label
    basis, and (B) fermentation operations involving the sale
    of viable (live) freeze dried microorganisms on a private
    label and OEM basis. Both of these sub-centers were included in
    the sale of the probiotics development and manufacturing
    operations effective December 31, 2003.
|
| | 2. Licensing Fees, Research &
    Development Contracts and Royalties Center (Drug delivery
    business)  We generate licensing fees, research
    and development contracts and royalties for the formulation                                                                                                                                                                                                                                                                                                        

12



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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | of Controlled Delivery Technology prescription
    drugs, OTC products, and dietary supplements. Licensing
    agreements and research and development contracts are expected
    to include royalty revenues that would be recognized in future
    years. Royalties for dietary supplements are expected to
    increase this year and beyond as CDT Glucosamine &
    Chondroitin and other CDT products are sold to Wal-Mart,
    Rite-Aid, Trader Joess, GNC and other retail outlets. In
    addition, we expect to receive royalties for sales of certain
    CDT products previously manufactured by our probiotics division.



| |                       
| | ----------------------
| | Manufacturing Revenues

Manufacturing revenues decreased 8% or $487,131
to $5,972,120 for the year ended December 31, 2003 from
revenues of $6,459,251 for the year ended December 31, 2002.

Dietary supplement manufacturing revenues
increased 17% or $546,721 to $3,852,697 for the year ended
December 31, 2003 from revenues of $3,305,976 for the year
ended December 31, 2002. The increase in dietary supplement
manufacturing revenues during the year ended December 31,
2003 is primarily attributable to sales of CDT
Glucosamine & Chondroitin products introduced during
the first quarter of 2003. Sales of CDT Glucosamine &
Chondroitin were $859,876 for the year.

Fermentation revenues decreased 33% or $1,033,852
to $2,119,423 for the year ended December 31, 2003 from
revenues of $3,153,275 for the year ended December 31,
2002. The decline is mainly attributable to the loss of
substantially all sales to one major customer and a decrease in
sales to another significant customer. We will not receive
manufacturing revenues due to the sale of the probiotics
development and manufacturing operations effective
December 31, 2003.



| |                                                                     
| | --------------------------------------------------------------------
| | Licensing Fees, Research and Development
    Contracts and Royalties

Licensing fees and research and development
contract revenues for 2003 were $39,000 as compared to $54,000
for 2002. Royalty revenues for 2003 were $582,953 compared to
$992 for 2002. This increase in royalty revenues was the result
of the introduction of CDT Glucosamine & Chondroitin
products and sales of Novasoy products which incorporate our CDT
technology during 2003. We anticipate future growth in revenues
derived from drug delivery technology licensing fees and
research and development contracts.



| |             
| | ------------
| | Gross Profit

Gross profit increased 46% or $639,760 to
$2,017,394 in 2003 compared to $1,377,634 in 2002. Gross profit
as a percentage of sales was 31% in 2003 and 21% in 2002. The
decrease in manufacturing revenues had a negative effect on
gross profit and gross profit as a percentage of sales but was
more than offset by lower manufacturing costs associated with
the downsizing of the fermentation facility in April 2003 and
increased royalty revenues from CDT technology licenses.



| |                                   
| | ----------------------------------
| | Selling and Marketing
    Expenses

Selling and marketing expenses increased 29% or
$106,992 to $479,714 in 2003 from $372,722 in 2002. The increase
in selling and marketing expenses for the year is largely
attributable to $93,000 in consulting fees paid for evaluation
and analysis of potential alliances and development agreements
with pharmaceutical companies. We anticipate significant
additional marketing expenses as we increase our business
development efforts to support our drug delivery business.



| |                                      
| | -------------------------------------
| | Research and Development
    Expenses

Research and development expenses decreased 25%
or $137,640 to $403,186 in 2003 from $540,826 in 2002. The
higher level of research and development expenses during 2002
was due to the costs associated with our first human clinical
trial conducted as an in vitro/in vivo proof of concept
study to support its patented CDT drug delivery system. We
expect to incur capital expenditures of $750,000 (including
equipment and patent and trademark expenses) during 2004. In
addition, we expect research and development expenses to

13



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increase significantly as we expand our research
and development activities to support our drug delivery business.




| |                                        
| | ---------------------------------------
| | General and Administrative
    Expenses

General and administrative expenses increased 53%
or $1,460,026 to $4,193,294 in 2003 compared to $2,733,268 in
2002. The increase for 2003 is primarily attributable to a
$896,955 non-cash expense for accelerated vesting of stock
options for employees terminated in connection with the sale of
the probiotics division. In addition, we incurred increased
legal fees relating to financing activities, compliance with new
regulatory requirements (including Sarbanes-Oxley), expansion of
the management team to include Daniel O. Wilds as President
and Chief Executive Officer, consulting fees to our Chairman,
David T. Howard, and additional rent for leased facilities.
Also, in conjunction with a separation agreement with our former
Chief Scientific Officer and our Vice President of
Administration, Secretary and Treasurer dated March 31,
2001, we recorded severance costs of $157,448 for the year ended
December 31, 2003 and $159,152 for the year ended
December 31, 2002. These expenses have been reclassified
from Other Expense to General and Administration expense as
previously reported. We expect general and administrative
expenses to decline in 2004 as significant expenses during 2003
will be nonrecurring.



| |                       
| | ----------------------
| | Operating Profit/ Loss

Operating loss for the year ended
December 31, 2003 was $3,058,800 as compared to an
operating loss of $2,269,182 for the year ended
December 31, 2002.



| |                 
| | ----------------
| | Interest Expense

Interest expense increased $5,369,459 to
$5,698,382 for the year ended December 31, 2003 compared to
$328,923 for the year ended December 31, 2002. The interest
was comprised of non-cash interest of $5,302,460 and cash
interest of $395,922. The non-cash amount is attributable to the
accounting treatment for the convertible notes issued in June
2003, including the amortization of debt discount and associated
debt issue costs, and expense associated with the issuance of a
warrant as part of the $1 million loan entered into with a
shareholder in 2002. See Notes K and U to Notes to
Financial Statements. The cash portion of the interest expense
is due to interest paid on outstanding indebtedness, including
the convertible notes, the $1 million shareholder loan, the
line of credit, and notes and leases for capital equipment.



| |                     
| | --------------------
| | Other Income/Expense

Other income was $14,645 for the year ended
December 31, 2003 compared to other expense of $63,047 for
the year ended December 31, 2002.



| |                    
| | -------------------
| | Net Earnings (Loss)

The net loss for the year ended December 31,
2003 was $8,742,537 compared to a net loss of $2,661,152 for the
year ended December 31, 2002. The substantial increase in
net loss was primarily the result of the increased interest
expense.

Restatement of Financial Information

During the year ended December 31, 2003, the
Company determined that certain costs that were incurred during
2002 and deferred as a prepaid expense at December 31,
2002, should have been expensed in the year ended
December 31, 2002. These costs totaled approximately
$104,000 and were incurred in conjunction with the anticipated
sale of its probiotics business. These costs have been recorded
as a prior period adjustment in the period ended
December 31, 2003.

During the year ended December 31,2003, the
Company determined that severance costs related to the
separation agreement with its former Chief Scientific Officer
and its former Vice President of Administration that were
classified as Other expense, should have been
classified as General and Administrative expense

14



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##### Table of Contents



on the Statement of Operations. These costs
totaling $157,448 and $159,152 for the years ended
December 31, 2003 and 2002, respectively have been reported
in General and Administration expense.


The following is a summary of the effects of such
restatement on the Companys financial statements as of
December 31, 2002 and for the year then ended:

|                         |                                    |               |   |             |   |  |   |             |  
|------------------------ | ---------------------------------- | ------------- | - | ----------- | - |  | - | ----------- | -
|                         |                                    | As Originally |   |            
|                         |                                    | Reported      |   | As Restated
|                         |                                    |               |   |            
|Balance Sheet:           |                                    |               |   |             |   |  |   |            
|                         | Current assets                     |               | $ | 1,645,766   |   |  | $ | 1,541,942   |  
|                         | Total assets                       |               |   | 4,013,837   |   |  |   | 3,910,013   |  
|                         | Accumulated deficit                |               |   | (12,830,343 | ) |  |   | (12,934,167 | )
|                         | Stockholders equity               |               |   | 1,231,907   |   |  |   | 1,128,083   |  
|Statement of Operations: |                                    |               |   |             |   |  |   |            
|                         | General and Administrative expense |               | $ | 2,470,292   |   |  | $ | 2,733,268   |  
|                         | Operating profit (loss)            |               | $ | (2,006,206  | ) |  | $ | (2,269,182  | )
|                         | Other expense (severance costs)    |               | $ | (159,152    | ) |  | $ | (0          | )
|                         | Net earnings (loss)                |               | $ | (2,557,328  | ) |  | $ | (2,661,152  | )
|                         | Net loss per share                 |               | $ | (0.13       | ) |  | $ | (0.13       | )

Liquidity and Capital Resources

As of December 31, 2003, the Company had
working capital of $817,107 as compared to negative working
capital of $145,692 at December 31, 2002. The change in
working capital reflects the issuance of $5.3 million of
convertible notes in June 2003 for net proceeds of approximately
$4.7 million and is offset by the net loss for the year
ended December 31, 2003. In February 2004, we completed the
sale of 3,206,538 shares of common stock and 801,636
warrants for net proceeds of approximately $9.4 million. We
believe that we have sufficient resources to fund our drug
delivery business at planned levels and to seek collaborative
development projects over the next two years.

In connection with the sale of our probiotics
unit, we repaid our $800,000 line of credit (of which $155,488
was outstanding on December 31, 2003) together with the
$1 million loan from a shareholder.

We will require substantial additional financing
to implement our business plan to develop our drug delivery
business. Our long term financing needs depend largely on our
ability to enter into alliances and collaborations that will
help finance the drug delivery business. We will be required to
fund research and development costs to create an effective
in-house drug delivery development unit. Additionally, we will
need to fund the significant costs associated with the research
and development and commercialization of a drug delivery
product. We anticipate that we will need to raise additional
financing to fund these efforts. See Risk Factors
for more information regarding our financing requirements and
the related risks and uncertainties.

As of December 31, 2003, we had accounts
receivable of $716,676 (less $0 for doubtful accounts), as
compared to $486,417 as of December 31, 2002 (less $12,524
for doubtful accounts), a net change of $230,259. The increase
in accounts receivable is mainly attributable to the accrual of
royalty revenue from the sales of CDT products. These royalties
are due 30 days after quarter end.

15



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##### Table of Contents



Contractual Obligations

As of December 31, 2003, our commitments to
make future payments under long term contractual obligations
were as follows (in thousands):

|                        |  |                        |         |           |  |         |        |         |  |   |         |  |  |   |         | 
|----------------------- |  | ---------------------- | ------- | --------- |  | ------- | ------ | ------- |  | - | ------- |  |  | - | ------- | 
|                        |  |                       
|                        |  | Payments Due by Period
|                        |  |                       
|                        |  |                        |         | Less than |  | 1 to    |        | 4 to   
|Contractual Obligations |  | Total                  |         | 1 Year    |  | 3 Years |        | 5 Years
|                        |  |                        |         |           |  |         |        |        
|Operating Leases        |  | $                      | 591,665 |           |  | $       | 8,008  |         |  | $ | 472,233 |  |  | $ | 111,424 | 
|Capital Lease           |  |                        | 121,367 |           |  |         | 65,896 |         |  |   | 55,471  |  |  |   |        | 
|                        |  |                        |         |           |  |         |        |         |  |   |         |  |  |   |         | 
|Total                   |  | $                      | 713,032 |           |  | $       | 73,904 |         |  | $ | 527,704 |  |  | $ | 111,424 | 
|                        |  |                        |         |           |  |         |        |         |  |   |         |  |  |   |         | 

New Accounting Pronouncements

In May 2003, Financial Accounting Standards Board
(FASB) issued Statement 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities
and Equity. Statement 150 requires that certain
financial instruments, which under previous guidance were
accounted for as equity, must now be accounted for as
liabilities. Statement 150 is effective for all financial
instruments entered into or modified after May 31, 2003.
The Company adopted Statement 150 on June 1, 2003. The
adoption of Statement 150 did not have any effect on the
Companys financial position, results of operations, or
cash flows.

The FASB has published a revision to
Interpretation 46 (46R) to clarify some of the
provisions of FASB Interpretation No. 46, Consolidation
of Variable Interest Entities, and to exempt certain
entities from its requirements. The additional guidance is being
issued in response to input received from constituents regarding
certain issues arising in implementing Interpretation 46.

Under the new guidance, special effective date
provisions apply to enterprises that have fully or partially
applied Interpretation 46 prior to issuance of this revised
Interpretation. Otherwise, application of
Interpretation 46R (or Interpretation 46) is required
in financial statements of public entities that have interests
in structures that are commonly referred to as special-purpose
entities for periods ending after December 15, 2003.
Application by public entities, other than small business
issuers, for all other types of variable interest entities is
required in financial statements for periods ending after
March 15, 2004. Application by small business issuers to
variable interest entities other than special-purpose entities
and by nonpublic entities to all types of variable interest
entities is required at various dates in 2004 and 2005. In some
instances, enterprises have the option of applying or continuing
to apply Interpretation 46 for a short period of time before
applying this revised Interpretation. We believe that adoption
of Interpretation 46 will have no effect on our financial
statements.

Risk Factors

The following is a description of some of the
risks and uncertainties that may cause our actual results of
operation to differ materially from those currently expected or
desired.



| |                                                                                                          
| | ---------------------------------------------------------------------------------------------------------
| | We have incurred substantial operating
    losses and expect to continue to incur substantial
    losses.



| |   |                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We had a net loss of $8,742,537 and $2,661,152
    for the years ended December 31, 2003 and December 31,
    2002, respectively;                                 
|
| |  | We used cash from operations of $2,830,620 and
    $960,207 in 2003 and 2002, respectively;                                                                       
|
| |  | We had an accumulated deficit of $21,676,704 at
    December 31, 2003;                                                                                            
|
| |  | We expect to incur capital expenditures of
    $750,000 (including equipment and patent and trademark expenses)
    during 2004; and                              
|
| |  | We expect to continue to incur significant
    operating losses as a result of research and development
    expenses associated with our drug delivery operations.

16



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| |                                                                                  
| | ---------------------------------------------------------------------------------
| | We will require additional financing to
    develop our drug delivery operations.

With the proceeds of our recently completed
$10.4 million common stock financing, we anticipate that we
will be able to fund our business at planned levels and have the
resources to seek collaborative research projects through 2005.
Our ability to develop the drug delivery business will depend
upon many factors, including:



| |   |                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------
| |  | the structure and timing of collaborations with
    strategic partners and licensees;                          
|
| |  | the progress of our research and development
    programs and expansion of such programs; and                  
|
| |  | the prosecution, defense and enforcement of
    potential patent claims and other intellectual property rights.

To some extent, the timing and amount of our
research and development spending is discretionary and subject
to the availability of appropriate opportunities and funding.

Our anticipated cash expenditures and need for
capital also assume that our revenues are not adversely affected
by the other factors set forth in this Risk Factors
section.



| |                                                                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we are unable to obtain additional
    financing, we will have to curtail our business operations and
    research and development programs and alter our business
    model.

Our long term financing needs depend largely on
our ability to enter into alliances and collaborations that will
help finance our drug delivery business. We will be required to
fund research and development costs to create an effective
in-house drug delivery development unit. Additionally, we will
need to fund the significant costs associated with the research
and development and commercialization of a drug delivery
product. If we are unable to find a partner to share or
subsidize these costs for a given product, we will need to raise
substantial additional financing to fund these efforts on our
own.

Additional financing may be unavailable to us on
acceptable terms. If adequate funds are unavailable, we may be
unable to meet our obligations. Our inability to raise
additional capital would require us to delay, reduce or
eliminate some of our business operations, including the pursuit
of licensing, strategic alliances and development of our drug
delivery business.

If we raise additional capital by issuing equity
securities, further dilution to our stockholders will result. In
addition, the terms of the financing may adversely affect the
holdings or the rights of our stockholders. If we raise
additional funds through strategic alliance and licensing
arrangements, we may be required to relinquish rights to certain
of our technologies or product candidates, or to grant licenses
on terms that are unfavorable to us. Either of these results
could reduce our value.



| |                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------
| | Our strategy to focus on our drug delivery
    business is very risky and may result in the loss of your
    investment.

While we believe our CDT business has good
prospects for growth, it is essentially a startup, high-risk
business that is not expected to produce any substantial revenue
or profits for some time, if ever. As discussed throughout this
Risk Factors section, developing drug delivery systems and drugs
using our CDT technology is extremely expensive, and taking a
single product to market takes years to complete.



| |                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------
| | We face intense competition in the drug
    delivery business, and our failure to compete effectively could
    severely limit our growth and potential.

Many of our competitors have longer operating
histories and greater financial, research and development,
marketing and other resources than we do. We are subject to
competition from numerous other entities that currently operate
or intend to operate in the industry. Such entities include
companies that are engaged in the development of
controlled-release drug delivery technologies and products as
well as other manufacturers that may decide to undertake
in-house development of these products. Some of our direct
competitors in the drug delivery industry include Alza, Andrx,
Biovail, KV Pharmaceuticals, Labopharm, Penwest and Skyepharma.

17



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We recently learned that another manufacturer has
introduced a controlled release version of
glucosamine & chondroitin which may compete with the
product we sell to Walmart and Trader Joes, among others.




| |                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we are unsuccessful in entering
    beneficial collaborations we will require substantial additional
    capital and we will be unable to execute our business
    plan.

A critical part of our strategy is to enter into
various collaborative arrangements and alliances with corporate
and academic partners, licensors and licensees to provide
funding for the research, development, clinical testing,
manufacturing, marketing, and commercialization of our product
candidates. Collaborations are essential as we require more
financial and other resources for our drug delivery business.
Currently all revenues from our drug delivery operations are the
result of licensing agreements or similar collaborations.

Our success depends on our ability to develop new
collaborator relationships and maintain our existing
collaborations. Moreover, we have no experience in conducting
full scale clinical trials, preparing and submitting regulatory
applications or manufacturing and selling pharmaceutical
products.

For our collaboration efforts to be successful,
we must identify partners whose competencies complement ours. We
must also enter into collaboration agreements with them on terms
attractive to us and integrate and coordinate their resources
and capabilities with our own. We may be unsuccessful in
entering into collaboration agreements with acceptable partners
or negotiating favorable terms in these agreements.

Factors that may affect the success of our
collaborations include the following:



| |   |                                                                                                                                                                                                   
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our collaborators may have insufficient economic
    motivation to continue their funding, research, development and
    commercialization activities;                                            
|
| |  | our collaborators may discontinue funding any
    particular program, which could delay or halt the development or
    commercialization of any product candidates arising out of the
    program;
|
| |  | our collaborators may choose to pursue
    alternative technologies or products, either on their own or in
    collaboration with others, including our competitors;                              
|
| |  | our collaborators may lack sufficient financial,
    technical or other capabilities to develop these product
    candidates;                                                                     
|
| |  | we may underestimate the length of time that it
    takes for our collaborators to achieve various clinical
    development and regulatory approval milestones; and                               
|
| |  | our collaborators may be unable to successfully
    address any regulatory or technical challenges they may
    encounter.                                                                        

We are highly dependent on our collaboration and
consulting arrangements with Dr. Fassihi. We have a
consulting agreement with Dr. Fassihi that expires in
December 2006 but may be terminated by either party on
30-days notice. Our agreement with ADM terminates upon the
expiration of the licensed patents. However, the agreement is
subject to termination on short notice under certain
circumstances if we breach the agreement or upon a bankruptcy
event. We also work with Nutricia, a subsidiary of General
Nutrition Corporation, in connection with the manufacture and
distribution of glucosomine & chondroitin to Walmart
and Rite Aid. We are currently finalizing a written agreement
with Nutricia. We believe we are current with respect to our
obligations under existing agreements.



| |                                                                                                         
| | --------------------------------------------------------------------------------------------------------
| | Any failure to obtain and protect our
    intellectual property could adversely affect our
    business.

Patent and trade secret protection is important
to our business and our success will depend in part on our
ability to obtain patents, maintain trade secret protection and
operate without infringing on the rights of others. We own or
have exclusive rights to several U.S. patents and patent
applications. We expect to apply for additional U.S. and foreign
patents in the future.

The patent positions of pharmaceutical,
nutraceutical, and bio-pharmaceutical firms, including ours, are
uncertain and involve complex legal and factual questions for
which important legal issues are largely

18



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##### Table of Contents



unresolved. The coverage claimed in our patent
applications can be significantly reduced before a patent is
issued. Furthermore, our patent applications may not result in
the issuance of patents. In addition, patents of others may
impede our collaborators ability to commercialize the
technology covered by our owned or licensed patents. The cost of
obtaining and protecting patents is substantial and could
increase materially if we are involved in patent litigation.
This potential cost could include the loss of revenue resulting
from enjoining our manufacture and sale of existing or potential
products. The issuance of a patent is inconclusive as to its
validity or as to the enforceable scope of the claims of the
patent. We cannot assure you that:




| |   |                                                                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our patents or any future patents will prevent
    other companies from developing similar or functionally
    equivalent products or from successfully challenging the
    validity of our patents;
|
| |  | any of our future processes or products will be
    patentable;                                                                                                                                     
|
| |  | any pending or additional patents will be issued
    in any or all appropriate jurisdictions;                                                                                                       
|
| |  | our processes or products will not infringe upon
    the patents of third parties; or                                                                                                               
|
| |  | we will have the resources to defend against
    charges of patent infringement by third parties or to protect
    our own patent rights against infringement by third parties.                     

Our business and financial results could be
materially harmed if we fail to avoid infringement of the patent
or proprietary rights of others or to protect our patent rights.

Part of our intellectual property is in the form
of trade secrets and know-how and may not be protected by
patents. We cannot assure you that we will be able to protect
these rights. We require employees, consultants, advisors, and
collaborators to enter into confidentiality agreements. However,
these agreements may not provide meaningful protection for our
trade secrets, know-how, or other proprietary information if any
unauthorized use or disclosure occurs.



| |                                                                                                                                           
| | ------------------------------------------------------------------------------------------------------------------------------------------
| | Significant expenses in applying for patent
    protection and prosecuting our patent applications will increase
    our need for capital.

We intend to continue our substantial efforts in
applying for patent protection and prosecuting pending and
future patent applications both in the United States and
internationally. These efforts have historically required the
expenditure of considerable time and money, and we expect that
they will continue to require significant expenditures. If
future changes in United States or foreign patent laws
complicate or hinder our efforts to obtain patent protection,
the costs associated with patent prosecution may increase
significantly.



| |                                                                      
| | ---------------------------------------------------------------------
| | If we cannot retain key personnel, then our
    business will suffer.

As a small company, the success of our operations
will depend to a great extent on the collective experience,
abilities and continued service of relatively few individuals.
In particular, our success largely depends on our President and
CEO, Daniel Wilds (who joined us in August 2003), our Vice
President and Chief Technical Officer, Stephen Turner, and our
CDT Consultant, Dr. Reza Fassihi. The loss of
Mr. Wilds, Dr. Fassihi or Mr. Turner could
adversely impact our ability to develop and commercialize our
CDT technology. In addition, we depend on the continued
availability of our Chairman, David T. Howard, who previously
served as President and CEO. We do not have an employment
agreement with Mr. Wilds. Our consulting agreement with
Dr. Fassihi expires December 31, 2006 but may be
terminated by either of us on 30-days notice. We also rely
on members of our scientific staff for product research and
development. Our employment agreement with Mr. Turner has
no set term and may be terminated by Mr. Turner on
30 days notice. The loss of the services of key
members of this staff could substantially impair our ongoing
research and development and, also, our ability to obtain
additional financing. We do not carry life insurance on any of
our employees. We are not aware of any key employees planning to
leave or retire from the Company.



| |                                                                                                      
| | -----------------------------------------------------------------------------------------------------
| | If we cannot attract and retain the
    necessary personnel, our business will not be
    successful.

Our success significantly depends upon our
ability to attract and retain highly qualified personnel. We
face intense competition for personnel in the drug delivery
industry. To compete for personnel we may need to

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pay higher salaries and provide other incentives
than those paid and provided by more established entities. Our
limited financial resources may hinder our ability to provide
such salaries and incentives.




| |                                                                                      
| | -------------------------------------------------------------------------------------
| | If any of our products is deemed unsafe,
    our business could be materially harmed.

With respect to the registration, approval, and
commercialization of our CDT drug delivery technology, all
analytic work completed to-date has involved in-vitro scientific
studies and one proof-of-concept human clinical trial.
Additional human clinical bioavailability and bioequivalence
trials must be conducted to validate the asset value and
commercial advantages associated with our CDT patents. Until
such clinical trials are performed, we cannot assure you that
the patented CDT technologies possess the necessary correlation
between the available in-vitro analytic work and their
performance in human subjects to become commercially viable
technologies and products that are attractive to major
pharmaceutical and OTC companies.



| |                                                                                               
| | ----------------------------------------------------------------------------------------------
| | Unfavorable publicity could materially hurt
    our business and the value of your investment.

We believe that the nutritional supplement, OTC,
and pharmaceutical markets are affected by national media
attention regarding the consumption of dietary supplements, OTC
products and prescription drugs. There can be no assurance that
future scientific research or publicity will be favorable to
these industries or any particular product, or consistent with
earlier research or publicity. Future reports of research that
are perceived less favorably or that question such earlier
research could have a material adverse effect on us. Because of
our dependence upon consumer perceptions, adverse publicity
associated with illness or other adverse effects resulting from
the consumption of our products or any similar products
distributed by other companies could have a material adverse
impact on us. Such adverse publicity could arise even if the
adverse effects associated with such products resulted from
failure to consume such products as directed. In addition, we
may be unable to counter the effects of negative publicity
concerning the efficacy of our products.



| |                                                                                                  
| | -------------------------------------------------------------------------------------------------
| | Government regulators and regulations could
    adversely affect our ability to operate and grow.

Our products, potential products and
manufacturing and research activities are subject to varying
degrees of regulation by a number of government authorities in
the United States (including the DEA, FDA, FTC and EPA) and in
other countries.

The FDA regulates, to varying degrees and in
different ways, dietary supplements and pharmaceutical products,
including their manufacture, testing, exportation, labeling, and
in some cases, advertising. We anticipate that any FDA testing
and approvals of our products would be initiated as part of
future collaborations with strategic partners.

Our statements and our customers statements
regarding dietary supplement products are subject to regulation
by the FTC. The FTC enforces laws prohibiting unfair or
deceptive trade practices, including false or misleading
advertising. In recent years the FTC has brought a number of
actions challenging claims by nutraceutical companies.

Each OTC or pharmaceutical product developed by
us will require a separate costly and time consuming regulatory
approval before we or our collaborators can manufacture and sell
it in the United States or internationally. Even if regulatory
approval is received, there may be limits imposed by regulators
on a products use or it may face subsequent regulatory
difficulties. Our bioequivalence, bioavailability, or clinical
studies and other data may not result in FDA approval to market
our new products. Approved products are subject to continuous
review and the facilities that manufacture them are subject to
periodic inspections. Furthermore, regulatory agencies may
require additional and expensive post-approval studies. If
previously unknown problems with a product candidate surface or
the manufacturing or laboratory facility is deemed non-compliant
with applicable regulatory requirements, an agency may impose
restrictions on that product or on us, including requiring us to
withdraw the product from the market, close the facility, and/or
pay substantial fines.

Many of our nutraceutical products, including our
glucosamine & chondroitin and Novasoy Daily Dose
products, are regulated under DSHEA (Dietary Supplement
Health Education Act) regulations and

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contain ingredients that are Generally Regarded
As Safe (G.R.A.S.) by the FDA and, therefore, do not
currently require extended approvals. Recent legislation has
resulted in a regulatory environment which sets what we consider
to be reasonable limitations and guidelines on health claims and
labeling for natural products and dietary supplements under the
DSHEA. We may, however, be wrong in our belief that the current
and foreseeable governmental regulation of dietary supplements,
probiotics and animal nutrition products will have a minimal
impact on our nutraceutical business.


We also may incur significant costs in complying
with environmental laws and regulations. We are subject to
federal, state, local and other laws and regulations governing
the use, manufacture, storage, handling, and disposal of
materials and certain waste products. The risk of accidental
contamination or injury from these materials cannot be
completely eliminated. If an accident occurs, we could be held
liable for any damages that result and these damages could
exceed our resources.



| |                                                                                              
| | ---------------------------------------------------------------------------------------------
| | Future laws or regulations may hinder or
    prohibit the production or sale of our products.

We may be subject to additional laws or
regulations in the future, such as those administered by the FDA
or other federal, state or foreign regulatory authorities. Laws
or regulations that we consider favorable, such as the DSHEA,
may be repealed. Current laws or regulations may be interpreted
more stringently. We are unable to predict the nature of such
future laws, regulations or interpretations, nor can we predict
what effect they may have on our business. Possible effects or
requirements could include the following:



| |   |                                                                               
| | - | ------------------------------------------------------------------------------
| |  | The reformulation of certain products to meet new
    standards               
|
| |  | The recall or discontinuance of certain products
    unable to be reformulated
|
| |  | Imposition of additional record keeping
    requirements                      
|
| |  | Expanded documentation of the properties of
    certain products              
|
| |  | Expanded or different labeling, or scientific
    substantiation              

Any such requirement could have a material
adverse effect on our results of operations and financial
condition.



| |                                                                        
| | -----------------------------------------------------------------------
| | We will be adversely affected unless we
    properly manage our growth.

We are in the process of significantly increasing
spending on our drug delivery business. As part of this
increased spending, we are adding numerous personnel, and
several new research and development projects. Our rapid growth
may strain our management team, production facilities,
administrative capabilities, and other resources. In addition,
we may be unable to effectively allocate our existing and future
resources between our drug delivery and other businesses while
maintaining focus on our core competencies. We cannot assure you
that we will succeed in effectively managing our existing
operations or our growth, which could adversely affect our
financial performance.



| |                                                                                           
| | ------------------------------------------------------------------------------------------
| | Unfavorable economic conditions could
    hinder the growth of our drug delivery business.

Our success depends substantially on how our
potential collaborators decide to spend their money. Potential
collaborators for our drug delivery business may be hesitant to
spend the funds necessary for new collaborations in an uncertain
environment. The continuing war on terrorism, new terrorist
attacks, actual or threatened, and related political events, are
examples of events that may adversely impact the U.S. and
international economic environment and our business.



| |                                                                                             
| | --------------------------------------------------------------------------------------------
| | Our share price has fluctuated
    significantly and may be very volatile in the
    future.

For the 52-week period ended February 27,
2004, the sale price of our common stock has ranged between a
low of $0.82 and a high of $3.97.

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In the future, our share price could be affected
by a number of factors, including without limitation:



| |   |                                                            
| | - | -----------------------------------------------------------
| |  | fluctuations in our operating results                      
|
| |  | changes in expectations as to our financial
    performance
|
| |  | increased competition                                      
|
| |  | dilution from additional financings                        

In addition, the stock market, in general, has
experienced volatility that often has been unrelated to the
operating performance of particular companies. These broad
market and industry fluctuations may adversely affect the
trading price of our common stock regardless of our actual
operating performance.



| |                                                                                
| | -------------------------------------------------------------------------------
| | The value of your investment may be reduced
    by our nonpayment of dividends.

We have never paid any cash dividends on our
common stock and we do not anticipate paying cash dividends on
our common stock in the foreseeable future. The payment of
dividends on the common stock by us will depend on our earnings,
financial condition and other business and economic factors
affecting us at such time as the board of directors may consider
relevant.



| |                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------
| | Provisions in our charter documents could
    prevent or frustrate any attempts to replace our current
    management by stockholders.

Our certificate of incorporation and bylaws
contain provisions, such as undesignated preferred stock and
prohibitions on cumulative voting in the election of directors,
which could make it more difficult for a third party to acquire
us without the consent of our board of directors. The
Companys Certificate of Incorporation contains provisions
having anti-takeover effects, including the authorization of the
Board of Directors to issue up to 50,000,000 shares of
common stock and up to 5,000,000 shares of preferred stock
with such voting powers, designations, preferences and relative
participating, optional or other special rights, and
qualifications, or prescriptions as may be prescribed by the
Board of Directors. The issuance of such common stock or
preferred stock may be used by the Board of Directors to impede
a party seeking to acquire control of the Company. Also, our
bylaws provide for a staggered board. The staggered board
protects directors of the classes not being elected in a proxy
contest for control of the board and dilutes the ability of
stockholders to influence corporate governance policies. These
provisions may have the effect of preventing or hindering any
attempts by our stockholders to replace our current management,
even if such removal would be beneficial to stockholders
generally.



| |                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our Stockholder Rights Plan may delay or
    prevent beneficial takeover bids by third parties, which could
    decrease the values of your investment.

The Board of Directors adopted a Stockholders
Rights Plan or poison pill in November 2002. The
stockholders rights plan is intended to protect stockholders
interests in the event we are confronted with coercive or unfair
takeover practices. The poison pill is triggered ten days after
any person has become the beneficial owner of 15% or more of our
outstanding stock. An acquirer who triggers the rights faces
significant dilution of its interest in the Company. The
stockholders rights plan may also impede a party seeking to
acquire control of the Company. These provisions apply even if
the offer may be considered beneficial by some stockholders. The
anti-takeover provisions of our Stockholder Rights Plan may
entrench management and may delay or prevent beneficial takeover
bids by third parties, which could decrease the value of your
investment.

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|        |                     
|------- | --------------------
|Item 7. | Financial Statements

CONTENTS

|                                                   |                                   |      |    |    | 
|-------------------------------------------------- | --------------------------------- | ---- | -- | -- | 
|                                                   |                                   | Page
|                                                   |                                   |     
|Report of Independent Certified Public Accountants |                                   |      | 24 |   
|Financial Statements                               |                                   |      |    |   
|                                                   | Balance Sheets                    |      |    | 25 | 
|                                                   | Statements of Operations          |      |    | 26 | 
|                                                   | Statement of Stockholders Equity |      |    | 27 | 
|                                                   | Statements of Cash Flows          |      |    | 28 | 
|                                                   | Notes to Financial Statements     |      |    | 29 | 

23



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##### Table of Contents



REPORT OF INDEPENDENT CERTIFIED PUBLIC
ACCOUNTANTS

Board of Directors and Stockholders

SCOLR, Inc.


We have audited the accompanying balance sheets
of SCOLR, Inc. (a Delaware Corporation) as of
December 31, 2003 and 2002, and the related statements of
operations, stockholders equity and cash flows for the
years then ended. These financial statements are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant
estimates made by management, 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 financial statements referred
to above, present fairly, in all material respects, the
financial position of SCOLR, Inc. as of December 31,
2003 and 2002, and the results of its operations and its cash
flows for the years then ended, in conformity with accounting
principles generally accepted in the United States of America.

As discussed in Note V of Notes to the
Financial Statements, the 2002 financial statements have been
restated.

/s/ GRANT THORNTON LLP

Seattle, Washington


February 20, 2004, except for notes C
and W, as to


which the date is February 24, 2004


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##### Table of Contents



SCOLR, INC.

BALANCE SHEETS

|                                                                |                                                                                                                                                                      |                            |           |               |           |   |           |             |           | 
|--------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | --------- | ------------- | --------- | - | --------- | ----------- | --------- | 
|                                                                |                                                                                                                                                                      |                           
|                                                                |                                                                                                                                                                      | December 31,              
|                                                                |                                                                                                                                                                      |                           
|                                                                |                                                                                                                                                                      |                            |           | 2002         
|                                                                |                                                                                                                                                                      | 2003                       |           | (As Restated)
|                                                                |                                                                                                                                                                      |                            |           |              
|ASSETS                                                         
|CURRENT ASSETS                                                  |                                                                                                                                                                      |                            |           |               |           |   |           |            
|                                                                | Cash                                                                                                                                                                 |                            | $         | 1,282,656     |           |   | $         | 257,382     |          
|                                                                | Accounts receivable, less allowance for doubtful
    accounts of $0 and $12,524, respectively                                                                        |                            |           | 716,676       |           |   |           | 486,417     |          
|                                                                | Current portion of notes receivable                                                                                                                                  |                            |           | 961,854       |           |   |           | 166,154     |          
|                                                                | Inventories                                                                                                                                                          |                            |           |              |           |   |           | 493,541     |          
|                                                                | Prepaid expenses                                                                                                                                                     |                            |           | 227,363       |           |   |           | 138,448     |          
|                                                                |                                                                                                                                                                      |                            |           |               |           |   |           |            
|                                                                |                                                                                                                                                                      | Total current assets       |           |               | 3,188,549 |   |           |             | 1,541,942 | 
|PROPERTY AND EQUIPMENT  net                                    |                                                                                                                                                                      |                            | 299,371   |               |           |   | 1,494,315 |            
|OTHER ASSETS                                                    |                                                                                                                                                                      |                            |           |               |           |   |           |            
|                                                                | Intangible assets  net                                                                                                                                              |                            |           | 359,409       |           |   |           | 818,371     |          
|                                                                | Noncurrent portion of notes receivable                                                                                                                               |                            |           | 1,660,615     |           |   |           | 55,385      |          
|                                                                |                                                                                                                                                                      |                            |           |               |           |   |           |            
|                                                                |                                                                                                                                                                      | $                          | 5,507,944 |               |           | $ | 3,910,013 |            
|                                                                |                                                                                                                                                                      |                            |           |               |           |   |           |            
|                                                               
|LIABILITIES AND STOCKHOLDERS
    EQUITY                       
|CURRENT LIABILITIES                                             |                                                                                                                                                                      |                            |           |               |           |   |           |            
|                                                                | Line of credit                                                                                                                                                       |                            | $         | 155,488       |           |   | $         | 296,387     |          
|                                                                | Current maturities of long-term obligations                                                                                                                          |                            |           |              |           |   |           | 168,870     |          
|                                                                | Current maturities of capital lease obligations                                                                                                                      |                            |           | 52,801        |           |   |           | 215,347     |          
|                                                                | Stockholder loan payable, less discount on debt
    of $10,677                                                                                                       |                            |           | 989,323       |           |   |           |            |          
|                                                                | Accounts payable  trade                                                                                                                                             |                            |           | 544,246       |           |   |           | 782,385     |          
|                                                                | Accrued liabilities                                                                                                                                                  |                            |           | 529,584       |           |   |           | 124,645     |          
|                                                                | Deferred revenue                                                                                                                                                     |                            |           | 100,000       |           |   |           | 100,000     |          
|                                                                |                                                                                                                                                                      |                            |           |               |           |   |           |            
|                                                                |                                                                                                                                                                      | Total current liabilities  |           |               | 2,371,442 |   |           |             | 1,007,030 | 
|LONG-TERM OBLIGATIONS, less current maturities                  |                                                                                                                                                                      |                            |          |               |           |   | 56,650    |            
|CAPITAL LEASE OBLIGATIONS, less current maturities              |                                                                                                                                                                      |                            | 50,979    |               |           |   | 327,273   |            
|SHAREHOLDER LOAN PAYABLE, less discount on debt
    of $289,627 |                                                                                                                                                                      |                            |          |               |           |   | 710,373   |            
|COMMITMENTS AND CONTINGENCIES (Note L)                          |                                                                                                                                                                      |                            |           |               |           |   |           |            
|STOCKHOLDERS EQUITY                                            |                                                                                                                                                                      |                            |           |               |           |   |           |            
|                                                                | Preferred stock, authorized
    5,000,000 shares, $.01 par value, none issued or
    outstanding                                                                     |                            |           |              |           |   |           |            |          
|                                                                | Common stock, authorized 50,000,000 shares,
    $.001 par value, 26,462,646 and 21,198,947 issued and
    outstanding as of December 31, 2003 and 2002, respectively |                            |           | 26,463        |           |   |           | 21,199      |          
|                                                                | Additional contributed capital                                                                                                                                       |                            |           | 24,735,764    |           |   |           | 14,041,051  |          
|                                                                | Accumulated deficit                                                                                                                                                  |                            |           | (21,676,704   | )         |   |           | (12,934,167 | )        
|                                                                |                                                                                                                                                                      |                            |           |               |           |   |           |            
|                                                                |                                                                                                                                                                      | Total stockholders equity |           |               | 3,085,523 |   |           |             | 1,128,083 | 
|                                                                |                                                                                                                                                                      |                            |           |               |           |   |           |            
|                                                                |                                                                                                                                                                      | $                          | 5,507,944 |               |           | $ | 3,910,013 |            
|                                                                |                                                                                                                                                                      |                            |           |               |           |   |           |            

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

25



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##### Table of Contents



SCOLR, INC.

STATEMENTS OF OPERATIONS

|                       |                            |                          |                                       |               |            |            |           |           |            |            |  
|---------------------- | -------------------------- | ------------------------ | ------------------------------------- | ------------- | ---------- | ---------- | --------- | --------- | ---------- | ---------- | -
|                       |                            |                         
|                       |                            | Years Ended December 31,
|                       |                            |                         
|                       |                            |                          |                                       | 2002         
|                       |                            | 2003                     |                                       | (As Restated)
|                       |                            |                          |                                       |              
|Net revenues           |                            | $                        | 6,594,073                             |               |            | $          | 6,514,243 |          
|Cost of revenues       |                            |                          | 4,576,679                             |               |            |            | 5,136,609 |          
|                       |                            |                          |                                       |               |            |            |           |          
|                       |                            | Gross profit             |                                       |               | 2,017,394  |            |           |           | 1,377,634  |           
|Operating expenses     |                            |                          |                                       |               |            |            |           |          
|                       | Marketing and selling      |                          |                                       | 479,714       |            |            |           | 372,722   |           
|                       | Research and development   |                          |                                       | 403,186       |            |            |           | 540,826   |           
|                       | General and administrative |                          |                                       | 4,193,294     |            |            |           | 2,733,268 |           
|                       |                            |                          |                                       |               |            |            |           |          
|                       |                            |                          | 5,076,194                             |               |            |            | 3,646,816 |          
|                       |                            |                          |                                       |               |            |            |           |          
|                       |                            | Operating loss           |                                       |               | (3,058,800 | )          |           |           | (2,269,182 | )         
|Other income (expense) |                            |                          |                                       |               |            |            |           |          
|                       | Interest expense           |                          |                                       | (5,698,382    | )          |            |           | (328,923  | )         
|                       | Other                      |                          |                                       | 14,645        |            |            |           | (63,047   | )         
|                       |                            |                          |                                       |               |            |            |           |          
|                       |                            |                          | (5,683,737                            | )             |            |            | (391,970  | )        
|                       |                            |                          |                                       |               |            |            |           |          
|                       |                            |                          | NET LOSS                              |               | $          | (8,742,537 | )         |           | $          | (2,661,152 | )
|                       |                            |                          |                                       |               |            |            |           |          
|                       |                            |                          | Net loss per share, basic and diluted |               | $          | (0.41      | )         |           | $          | (0.13      | )
|                       |                            |                          |                                       |               |            |            |           |          

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

26



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##### Table of Contents



SCOLR, INC.

STATEMENT OF STOCKHOLDERS
EQUITY

Years Ended December 31, 2003 and 2002
(As Restated)


|                                                                                               |  |              |            |             |  |                   |        |        |  |              |            |             |  |         |         |       |  |   |          |   |  |   |          |   |  |   |             |   |  |   |            |  
|---------------------------------------------------------------------------------------------- |  | ------------ | ---------- | ----------- |  | ----------------- | ------ | ------ |  | ------------ | ---------- | ----------- |  | ------- | ------- | ----- |  | - | -------- | - |  | - | -------- | - |  | - | ----------- | - |  | - | ---------- | -
|                                                                                               |  |              |            |             |  |                   |        |        |  |              |            |             |  |        
|                                                                                               |  | Common Stock |            | Additional  |  | Accumulated Other |        |        |  |              |            |             |  |        
|                                                                                               |  |              |            | Contributed |  | Comprehensive     |        | Stock  |  | Subscription |            | Accumulated |  |        
|                                                                                               |  | Shares       |            | Amount      |  | Capital           |        | Income |  | Subscription |            | Receivable  |  | Deficit |         | Total
|                                                                                               |  |              |            |             |  |                   |        |        |  |              |            |             |  |         |         |      
|Balance at January 1, 2002                                                                     |  |              | 18,008,289 |             |  | $                 | 18,008 |        |  | $            | 11,871,184 |             |  | $       | (35,982 | )     |  | $ | 120,000  |   |  | $ | (120,000 | ) |  | $ | (10,273,015 | ) |  | $ | 1,580,195  |  
|Issuance of common stock for cash, net of fees of
    $4,963                                   |  |              | 2,890,658  |             |  |                   | 2,891  |        |  |              | 1,574,040  |             |  |         |        |       |  |   |         |   |  |   |         |   |  |   |            |   |  |   | 1,576,931  |  
|Impairment of available for sale security                                                      |  |              |           |             |  |                   |       |        |  |              |           |             |  |         | 35,982  |       |  |   |         |   |  |   |         |   |  |   |            |   |  |   | 35,982     |  
|Fair value of warrants issued with debt                                                        |  |              |            |             |  |                   |        |        |  |              | 331,002    |             |  |         |         |       |  |   |          |   |  |   |          |   |  |   |             |   |  |   | 331,002    |  
|Fair value of warrants issued for services                                                     |  |              |            |             |  |                   |        |        |  |              | 145,125    |             |  |         |         |       |  |   |          |   |  |   |          |   |  |   |             |   |  |   | 145,125    |  
|Issuance of common stock for stock subscription
    and note receivable exchanged for services |  |              | 300,000    |             |  |                   | 300    |        |  |              | 119,700    |             |  |         |         |       |  |   | (120,000 | ) |  |   | 120,000  |   |  |   |             |   |  |   | 120,000    |  
|Net loss for the year                                                                          |  |              |           |             |  |                   |       |        |  |              |           |             |  |         |        |       |  |   |         |   |  |   |         |   |  |   | (2,661,152  | ) |  |   | (2,661,152 | )
|                                                                                               |  |              |            |             |  |                   |        |        |  |              |            |             |  |         |         |       |  |   |          |   |  |   |          |   |  |   |             |   |  |   |            |  
|Balance at December 31, 2002                                                                   |  |              | 21,198,947 |             |  |                   | 21,199 |        |  |              | 14,041,051 |             |  |         |        |       |  |   |         |   |  |   |         |   |  |   | (12,934,167 | ) |  |   | 1,128,083  |  
|Issuance of common stock for cash                                                              |  |              | 216,140    |             |  |                   | 216    |        |  |              | 145,747    |             |  |         |        |       |  |   |         |   |  |   |         |   |  |   |            |   |  |   | 145,963    |  
|Fair value of stock options and warrants issued
    for services                               |  |              |            |             |  |                   |        |        |  |              | 43,400     |             |  |         |         |       |  |   |          |   |  |   |          |   |  |   |             |   |  |   | 43,400     |  
|Fair value of warrants issued with debt and
    beneficial conversion feature                  |  |              |            |             |  |                   |        |        |  |              | 4,313,659  |             |  |         |         |       |  |   |          |   |  |   |          |   |  |   |             |   |  |   | 4,313,659  |  
|Conversion of debt to common stock                                                             |  |              | 5,047,559  |             |  |                   | 5,048  |        |  |              | 5,294,952  |             |  |         |        |       |  |   |         |   |  |   |         |   |  |   |            |   |  |   | 5,300,000  |  
|Additional compensation due to accelerated
    vesting of employee stock options               |  |              |            |             |  |                   |        |        |  |              | 896,955    |             |  |         |         |       |  |   |          |   |  |   |          |   |  |   |             |   |  |   | 896,955    |  
|Net loss for the year                                                                          |  |              |           |             |  |                   |       |        |  |              |           |             |  |         |        |       |  |   |         |   |  |   |         |   |  |   | (8,742,537  | ) |  |   | (8,742,537 | )
|                                                                                               |  |              |            |             |  |                   |        |        |  |              |            |             |  |         |         |       |  |   |          |   |  |   |          |   |  |   |             |   |  |   |            |  
|Balance at December 31, 2003                                                                   |  |              | 26,462,646 |             |  | $                 | 26,463 |        |  | $            | 24,735,764 |             |  | $       |        |       |  | $ |         |   |  | $ |         |   |  | $ | (21,676,704 | ) |  | $ | 3,085,523  |  
|                                                                                               |  |              |            |             |  |                   |        |        |  |              |            |             |  |         |         |       |  |   |          |   |  |   |          |   |  |   |             |   |  |   |            |  

The accompanying notes are an integral part of
this financial statement.

27



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##### Table of Contents



SCOLR, INC.

STATEMENTS OF CASH FLOWS

|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |            |         |          |           |  
|------------------------------------------- | ------------------------------------------------------------------------------ | ----------------------------------------------------------------- | ---------------------------------------- | ----------------------------------------- | --------- | -------- | ---------- | ---------- | ------- | -------- | --------- | -
|                                            |                                                                                |                                                                  
|                                            |                                                                                | December 31,                                                     
|                                            |                                                                                |                                                                  
|                                            |                                                                                |                                                                   |                                          | 2002                                     
|                                            |                                                                                | 2003                                                              |                                          | (As Restated)                            
|                                            |                                                                                |                                                                   |                                          |                                          
|Cash flows from operating activities:       |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            | Net loss                                                                       |                                                                   | $                                        | (8,742,537                                | )         |          | $          | (2,661,152 | )      
|                                            | Adjustments to reconcile net loss to net cash
    used in operating activities |                                                                   |                                          |                                           |           |          |            |            |        
|                                            |                                                                                | Depreciation and amortization                                     |                                          |                                           | 490,684   |          |            |            | 489,300 |         
|                                            |                                                                                | Loss on the sale of equipment                                     |                                          |                                           |          |          |            |            | 38,045  |         
|                                            |                                                                                | Amortization of discount on debt                                  |                                          |                                           | 4,006,899 |          |            |            | 41,375  |         
|                                            |                                                                                | Loss on sale of intangible assets                                 |                                          |                                           | 15,930    |          |            |            |        |         
|                                            |                                                                                | Amortization of debt issuance costs                               |                                          |                                           | 1,295,563 |          |            |            |        |         
|                                            |                                                                                | Warrants, stock options, and common stock issued
    for services |                                          |                                           | 43,400    |          |            |            | 265,125 |         
|                                            |                                                                                | Impairment of available-for-sale security                         |                                          |                                           |          |          |            |            | 35,982  |         
|                                            |                                                                                | Expense for accelerated vesting of employee stock
    options     |                                          |                                           | 896,955   |          |            |            |        |         
|                                            |                                                                                | Loss on sale of operations                                        |                                          |                                           | 98,891    |          |            |            |        |         
|                                            |                                                                                | Changes in assets and liabilities                                 |                                          |                                           |           |          |            |            |         |         
|                                            |                                                                                |                                                                   | Accounts receivable                      |                                           |           | (230,259 | )          |            |         | 488,423  |          
|                                            |                                                                                |                                                                   | Notes receivable                         |                                           |           | 166,154  |            |            |         | 184,490  |          
|                                            |                                                                                |                                                                   | Inventories                              |                                           |           | (563,611 | )          |            |         | 251,557  |          
|                                            |                                                                                |                                                                   | Prepaid expenses                         |                                           |           | (144,945 | )          |            |         | 25,508   |          
|                                            |                                                                                |                                                                   | Accounts payable                         |                                           |           | (256,001 | )          |            |         | 54,268   |          
|                                            |                                                                                |                                                                   | Accrued liabilities and deferred revenue |                                           |           | 92,257   |            |            |         | (173,128 | )        
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            |                                                                                |                                                                   |                                          | Net cash used in operating activities     |           |          | (2,830,620 | )          |         |          | (960,207  | )
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|Cash flows from investing activities:       |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            | Proceeds from sale of intangible assets                                        |                                                                   |                                          | 130,000                                   |           |          |            |           |        
|                                            | Purchase of equipment and furniture                                            |                                                                   |                                          | (246,988                                  | )         |          |            | (44,170    | )      
|                                            | Proceeds from sale of equipment                                                |                                                                   |                                          |                                          |           |          |            | 49,504     |        
|                                            | Patent and technology rights expenditures                                      |                                                                   |                                          | (211,216                                  | )         |          |            | (154,140   | )      
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            |                                                                                |                                                                   |                                          | Net cash used in investing activities     |           |          | (328,204   | )          |         |          | (148,806  | )
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|Cash flows from financing activities:       |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            | Payments on long-term obligations and capital
    lease obligations            |                                                                   |                                          | (453,389                                  | )         |          |            | (606,663   | )      
|                                            | Payments on bridge note payable                                                |                                                                   |                                          | (550,000                                  | )         |          |            |           |        
|                                            | Proceeds from shareholder note payable &
    long-term obligations             |                                                                   |                                          | 42,276                                    |           |          |            | 1,124,940  |        
|                                            | Proceeds from convertible note payable, net of
    issuance costs              |                                                                   |                                          | 4,634,897                                 |           |          |            |           |        
|                                            | Proceeds from bridge note payable, net of
    issuance costs                   |                                                                   |                                          | 505,250                                   |           |          |            |           |        
|                                            | Net payments on line of credit                                                 |                                                                   |                                          | (140,899                                  | )         |          |            | (821,895   | )      
|                                            | Net proceeds from issuance of common stock, net
    of costs                   |                                                                   |                                          | 145,963                                   |           |          |            | 1,576,931  |        
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            |                                                                                |                                                                   |                                          | Net cash provided by financing activities |           |          | 4,184,098  |            |         |          | 1,273,313 |  
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|Net increase in cash                        |                                                                                |                                                                   | 1,025,274                                |                                           |           |          | 164,300    |           
|Cash at beginning of period                 |                                                                                |                                                                   | 257,382                                  |                                           |           |          | 93,082     |           
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|Cash at end of period                       |                                                                                | $                                                                 | 1,282,656                                |                                           |           | $        | 257,382    |           
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|Cash paid during the year for:              |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            | Interest                                                                       |                                                                   | $                                        | 395,922                                   |           |          |            | 287,548    |        
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|Noncash investing and financing activities: |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            | Purchase of equipment under capital lease
    obligations                      |                                                                   | $                                        |                                          |           |          | $          | 130,567    |        
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            | Issuance of warrants for debt issuance costs                                   |                                                                   | $                                        | 585,710                                   |           |          | $          | 331,002    |        
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            | Issuance of common stock for stock subscription                                |                                                                   | $                                        |                                          |           |          | $          | 120,000    |        
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            | Conversion of debt into common stock                                           |                                                                   | $                                        | 5,300,000                                 |           |          | $          |           |        
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            | Fair value of assets sold with probiotics unit                                 |                                                                   | $                                        | 2,588,678                                 |           |          | $          |           |        
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           
|                                            | Net liabilities assumed from sale of probiotics
    unit                       |                                                                   | $                                        | 253,247                                   |           |          | $          |           |        
|                                            |                                                                                |                                                                   |                                          |                                           |           |          |            |           

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

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##### Table of Contents



SCOLR, INC.

NOTES TO FINANCIAL STATEMENTS

December 31, 2003 and 2002


Note A  Summary of Significant
Accounting Policies

SCOLR, Inc. (the Company) is a drug delivery
company that develops and formulates pharmaceutical,
over-the-counter, and nutritional products. SCOLR is currently
active in the controlled delivery technologies business and was
active in 2003 and prior years in the nutraceutical industry,
including dietary supplements, probiotics, and specialty food
ingredients. The Company uses its patented CDTTM
controlled delivery technologies to develop products and license
technology to pharmaceutical and nutritional product companies.
Until 2003, the Company also manufactured and packaged
probiotics, developed proprietary nutritional product
formulations, and offered specialty nutraceutical ingredients,
including several that utilize CDTTM technologies.
Effective December 31, 2003, the Company sold its
probiotics development and manufacturing unit. The
Companys customers are located throughout the United
States.

A summary of the Companys significant
accounting policies consistently applied in the preparation of
the accompanying financial statements follows.



|   |                    
|-- | -------------------
|1. | Accounts Receivable

The majority of the Companys account
receivable are due from companies in the human and agricultural
nutraceutical industries. Credit is extended based on evaluation
of a customers financial condition and generally,
collateral is not required. Accounts receivable are due within
30 days and are stated at amounts due from customers net of
an allowance for doubtful accounts if considered necessary.
Accounts outstanding longer than the contractual payment terms
are considered past due. The Company determines its allowance by
considering a number of factors, including the length of time
trade accounts receivable are past due, the companys
previous loss history, the customers current ability to
pay its obligation to the Company, and the condition of the
general economy and the industry as a whole. The Company writes
off accounts receivable when they become uncollectible, and
payments subsequently received on such accounts are credited to
the allowance for doubtful accounts.



|   |            
|-- | -----------
|2. | Inventories

Inventories are stated at the lower of cost or
market; cost is determined using the first-in, first-out method.
The Company establishes an allowance for potentially obsolete
and slow moving items.



|   |                       
|-- | ----------------------
|3. | Property and Equipment

Property and equipment are stated at cost, less
accumulated depreciation and amortization. Depreciation and
amortization are provided for in amounts sufficient to relate
the cost of depreciable assets to operations over their
estimated service lives. Leasehold improvements are amortized
over the lives of the respective leases or the service lives of
the improvements, whichever is shorter. Leased property under
capital leases is amortized over the service lives of the assets
as the leases substantially transfer ownership and have bargain
purchase options. The straight-line method of depreciation is
followed for substantially all assets for financial reporting
purposes. The estimated useful lives in determining depreciation
and amortization are as follows:

|                                             |  |  |            | 
|-------------------------------------------- |  |  | ---------- | 
|Furniture and fixtures                       |  |  | 3-5 years  | 
|Machinery and equipment                      |  |  | 3-10 years | 
|Leasehold improvements                       |  |  | 3 years    | 
|Machinery and equipment under capital leases |  |  | 3-10 years | 

29



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##### Table of Contents



SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)



|   |                  
|-- | -----------------
|4. | Intangible Assets

Intangible assets include capitalized technical
and product rights, patents and trademarks. Technical and
product rights and patents and trademarks are stated at cost and
amortized to operations over their estimated useful lives or
statutory lives, whichever is shorter. The weighted average
remaining amortization period of patents and trademarks at
December 31, 2003 was 9.05 years. The Company
evaluates its technical and product rights and patents and
trademarks annually to determine potential impairment by
examining the carrying amount of the assets to determine if the
carrying amount is recoverable, and by comparing the carrying
amount to the assets fair value.



|   |                    
|-- | -------------------
|5. | Revenue Recognition

The Company generates revenue from technology
licenses, collaborative research and development arrangements,
and cost reimbursement contracts. Revenue under technology
licenses and collaborative agreements typically consists of
nonrefundable and/or guaranteed technology license fees,
technology access fees, and various milestone and future product
royalty payments.

Revenues from license fees, option fees and
up-front payments, which are received in connection with other
rights or services that represent continuing obligations of the
Company, are recognized systematically over the period that the
fees or payments are earned. Revenues from milestone payments
representing completion of separate and substantive earnings
processes are recognized when the milestone is achieved and
amounts are due and payable.

Revenues from royalties are received from related
and third parties for sales of products that include technology
developed or licensed by the Company. Revenues are recognized
when due and amounts are considered collectible.

Revenue from the sale of nutraceutical products
is recognized upon shipment to the customer.



|   |                               
|-- | ------------------------------
|6. | Research and Development Costs

All expenditures for research and development are
expensed in the period they are incurred.



|   |                          
|-- | -------------------------
|7. | Earnings (Loss) Per Share

Basic earnings (loss) per share are based on the
weighted average number of shares outstanding during the year
and income available to common shareholders. Earnings (loss) per
share assuming dilution are based on the assumption that
outstanding stock options and warrants were exercised. The
weighted average shares for computing basic earnings (loss) per
shares were 21,518,982 and 20,124,161 for the years ended
December 31, 2003 and 2002, respectively. At
December 31, 2003 there were 4,201,607 shares of
potentially issuable common stock. Because of the net loss for
the year ended December 31, 2003, potentially issuable
common stock was not included in the calculation of diluted loss
per share as their inclusion would be anti-dilutive.



|   |                         
|-- | ------------------------
|8. | Stock-Based Compensation

The Company has a stockbased employee
compensation plan, which is described more fully in Note R.
The Company applies APB Opinion 25, Accounting for Stock
Issued to Employees, and related Interpretations in accounting
for its plan. Because the exercise price of the Companys
common stock equals the market price of the underlying stock on
the date of the grant, no corresponding compensation expense has
been recognized. However, in 2003, in conjunction with the sale
of the probiotics development and manufacturing unit, the
Company recognized expense of $896,955 as the result of
accelerated vesting of 672,035 shares of employee stock
options.

30



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SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

The Company has adopted the disclosure only
provisions of Statement of Financial Accounting Standards
No. 123, Accounting for Stock-Based Compensation
(SFAS 123). If the Company had elected to recognize
compensation expense based upon the fair value at the grant date
for awards under these plans consistent with the methodology
prescribed by SFAS 123, the Companys net loss would
change to the pro forma amounts indicated below.

The following table illustrates the effect on net
loss and loss per share if the Company had applied the fair
value recognition provisions of SFAS 123 using the
assumption described in Note R to its stock-based awards.

|                   |                                                                                     |      |   |               |   |  |   |            |  
|------------------ | ----------------------------------------------------------------------------------- | ---- | - | ------------- | - |  | - | ---------- | -
|                   |                                                                                     |      |   | (As Restated)
|                   |                                                                                     |      |   |              
|                   |                                                                                     | 2003 |   | 2002         
|                   |                                                                                     |      |   |              
|Net loss           |                                                                                     |      |   |               |   |  |   |           
|                   | As reported                                                                         |      | $ | (8,742,537    | ) |  | $ | (2,661,152 | )
|                   | Total stock-based compensation expense determined
    under fair-value-based method |      |   | (877,643      | ) |  |   | (127,091   | )
|                   | Stock-based compensation expense included in
    reported net loss                  |      |   | 896,955       |   |  |   |           |  
|                   |                                                                                     |      |   |               |   |  |   |           
|                   | Pro forma net loss                                                                  |      | $ | (8,723,225    | ) |  | $ | (2,788,243 | )
|Net loss per share |                                                                                     |      |   |               |   |  |   |           
|                   | As reported                                                                         |      | $ | (0.41         | ) |  | $ | (0.13      | )
|                   | Pro forma                                                                           |      | $ | (0.41         | ) |  | $ | (0.14      | )



|   |                 
|-- | ----------------
|9. | Use of Estimates

In preparing the Companys financial
statements in accordance with accounting principles generally
accepted in the United States of America, management is required
to make estimates and assumptions that affect the reported
amounts of assets and liabilities, the disclosure of contingent
assets and liabilities at the date of the financial statements,
and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those
estimates.



|    |                  
|--- | -----------------
|10. | Reclassifications

Certain reclassifications have been made to the
2002 financial statements to conform to the 2003 presentation.



|    |                              
|--- | -----------------------------
|11. | New Accounting Pronouncements

In May 2003, Financial Accounting Standards Board
(FASB) issued Statement 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities
and Equity. Statement 150 requires that certain financial
instruments, which under previous guidance were accounted for as
equity, must now be accounted for as liabilities.
Statement 150 is effective for all financial instruments
entered into or modified after May 31, 2003. The Company
adopted Statement 150 on June 1, 2003. The adoption of
Statement 150 did not have any effect on the Companys
financial position, results of operations, or cash flows.

The FASB has published a revision to
Interpretation 46 (46R) to clarify some of the
provisions of FASB Interpretation No. 46, Consolidation of
Variable Interest Entities, and to exempt certain entities from
its requirements. The additional guidance is being issued in
response to input received from constituents regarding certain
issues arising in implementing Interpretation 46. Under the
new guidance, special effective date provisions apply to
enterprises that have fully or partially applied
Interpretation 46 prior to issuance of this revised
Interpretation. Otherwise, application of
Interpretation 46R (or Interpretation 46) is required
in financial statements of public entities that have interests
in structures that are commonly referred to as special-purpose
entities for periods ending after December 15, 2003.
Application by public entities, other than

31



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SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

small business issuers, for all other types of
variable interest entities is required in financial statements
for periods ending after March 15, 2004. Application by
small business issuers to variable interest entities other than
special-purpose entities and by nonpublic entities to all types
of variable interest entities is required at various dates in
2004 and 2005. In some instances, enterprises have the option of
applying or continuing to apply Interpretation 46 for a
short period of time before applying this revised
Interpretation. The Company believes that adoption of
Interpretation 46 will have no effect on its financial
statements.

Note B  Sale of
Operations

The Companys operations are comprised of a
single reportable segment. The financial information used by the
Companys Chief Operating decision maker is only provided
for this single reportable segment.

Effective December 31, 2003, the Company
sold its probiotics development and manufacturing unit and
assets to Steven H. Moger, the Companys former Vice
President of Operations, Chief Financial Officer, and General
Manager. Mr. Moger has resigned his position as an officer
of the Company in connection with the sale. The purchase price
was $2.72 million, which included payment for certain
inventories and tangible assets, as well as all intellectual
property related to the Companys probiotics development
and manufacturing unit. In addition, Mr. Moger assumed
certain lease obligations. The Company received $722,756 cash at
closing, with the remaining $2 million subject to the
buyers achievement of certain sales levels and royalties.
Certain other indemnification obligations relating to title to
the assets sold, compliance with laws, and certain matters
relating to taxes continue until the expiration of the statute
of limitations applicable to claims with respect to such
matters. As of the December 31, 2003 transaction date, the
carrying amount of assets and liabilities included in the sale
transaction were as follows:

|            |                               |   |           |           | 
|----------- | ----------------------------- | - | --------- | --------- | 
|Assets      |                               |   |           |          
|            | Inventories                   |   | $         | 1,055,133 | 
|            | Prepaid expense               |   |           | 56,030    | 
|            | Property and Equipment        |   |           | 1,133,967 | 
|            | Technical and Property Rights |   |           | 114,975   | 
|            | Patents and Trademarks        |   |           | 228,573   | 
|            |                               |   |           |          
|            |                               | $ | 2,588,678 |          
|            |                               |   |           |          
|Liabilities |                               |   |           |          
|            | Note Payable                  |   | $         | 51,127    | 
|            | Lease Obligations             |   |           | 202,120   | 
|            |                               |   |           |          
|            |                               | $ | 253,247   |          
|            |                               |   |           |          

The purchase price includes the initial payment
of $722,756 and the Deferred Purchase Price of $2 million.
The Deferred Purchase Price is comprised of the following;
(1) Percentage of Buyers Total Covered Sales of
0%-10% per year as defined in the agreement, and
(2) Royalty fee equal to 10% of the Controlled Delivery
Technology sales. There are also minimum payments that must be
made each year regardless of the sales levels or royalty amounts
calculated. Payments of the Deferred Purchase Price shall be
made quarterly. Such payments shall be made for a period equal
to the longer of (a) four years, or (b) until the
combined total of payments of the Deferred Purchase Price and
Royalty payments equals $2 million. The Company has
calculated the Present value of the $2 million based on
estimated projected payments and using a rate equal to the
Federal Treasurys five-year treasury bill rate of 3.27% at
December 31, 2003. Since the Deferred Purchase Price is
known and is a minimum amount and the only contingency is the
amount to be paid per year, the $1,844,328 present value amount
is included in the total purchase price in determining the gain
or loss on the sale of assets.

32



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##### Table of Contents



SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

The loss resulting from the Companys sale
of its probiotics development and manufacturing unit is
summarized as follows:

|                                 |  |   |           | 
|-------------------------------- |  | - | --------- | 
|Cash received at closing         |  | $ | 722,756   | 
|Discounted note receivable       |  |   | 1,844,328 | 
|Liabilities assumed by purchaser |  |   | 253,247   | 
|                                 |  |   |           | 
|Total proceeds                   |  |   | 2,820,331 | 
|Carrying value of assets sold    |  |   | 2,588,678 | 
|Transaction expenses             |  |   | 330,544   | 
|                                 |  |   |           | 
|Loss on sale                     |  | $ | 98,891    | 
|                                 |  |   |           | 

Note C  Management Plans

The Company incurred a net loss of
$8.7 million for the year ended December 31, 2003 and
used cash from operation of $2.8 million. The Company has
$1.3 million in cash at December 31, 2003. Effective
December 31, 2003, the Company sold its probiotics
development and manufacturing operations, which was the
Companys primary revenue generating unit. In 2004, the
Company will devote its efforts to the development and marketing
of its Drug Delivery operations. Accordingly, revenues are
expected to be substantially less in 2004 and the Companys
Drug Delivery operations are expected to consume substantial
amounts of cash. Additionally, the Companys negative cash
flow from operations is expected to continue and possibly
accelerate, in the foreseeable future. The development of the
Companys technology and potential products will continue
to require substantial funds.

In February 2004, the Company raised
approximately $10.4 million through the sale of
3,206,538 shares of common stock. The Company also expects
to increase revenues related to its Drug Delivery business in
2004 and in the future. Due to this and other factors, the
Company believes it will continue as a going concern through
2004 and beyond.

The accompanying financial statements have been
prepared in conformity with accounting principles generally
accepted in the United States of America, which contemplate the
continuation of the Company as a going concern. The financial
statements do not include any adjustments to reflect the
possible effects on the recoverability and classification of
assets and liabilities that may result from the outcome of this
uncertainty.

Note D  Accounts
Receivable

Accounts receivable consist of the following at
December 31:

|                                        |  |      |         |      |  |   |         |  
|--------------------------------------- |  | ---- | ------- | ---- |  | - | ------- | -
|                                        |  | 2003 |         | 2002
|                                        |  |      |         |     
|Trade receivables                       |  | $    | 589,001 |      |  | $ | 498,941 |  
|Royalty receivable                      |  |      | 127,675 |      |  |   |        |  
|Less allowance for doubtful receivables |  |      |        |      |  |   | (12,524 | )
|                                        |  |      |         |      |  |   |         |  
|Net receivables                         |  | $    | 716,676 |      |  | $ | 486,417 |  
|                                        |  |      |         |      |  |   |         |  

33



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SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

Changes in the Companys allowance for
doubtful accounts are as follows at December 31:

|                                    |  |      |         |      |  |   |        |  
|----------------------------------- |  | ---- | ------- | ---- |  | - | ------ | -
|                                    |  | 2003 |         | 2002
|                                    |  |      |         |     
|Beginning Balance                   |  | $    | 12,524  |      |  | $ |       |  
|Write-off of uncollectible accounts |  |      | (12,524 | )    |  |   |       |  
|Bad debt expense                    |  |      | 5,000   |      |  |   | 18,051 |  
|Accounts written-off                |  |      | (5,000  | )    |  |   | (5,527 | )
|                                    |  |      |         |      |  |   |        |  
|Ending Balance                      |  | $    |        |      |  | $ | 12,524 |  
|                                    |  |      |         |      |  |   |        |  

Note E  Notes Receivable

Notes receivable consist of the following at
December 31:

|                                                                                                   |  |      |           |      |  |   |         | 
|-------------------------------------------------------------------------------------------------- |  | ---- | --------- | ---- |  | - | ------- | 
|                                                                                                   |  | 2003 |           | 2002
|                                                                                                   |  |      |           |     
|Note receivable for D-Glucarate agreement; with
    monthly payments of $13,846 through April 2004 |  | $    | 55,385    |      |  | $ | 221,539 | 
|Note receivable from sale of probiotics unit;
    payments per agreement (see Note B)              |  |      | 1,844,328 |      |  |   |        | 
|Note receivable from sale of probiotics unit;
    payment due on closing                           |  |      | 722,756   |      |  |   |        | 
|                                                                                                   |  |      |           |      |  |   |         | 
|                                                                                                   |  |      | 2,622,469 |      |  |   | 221,539 | 
|Less current portion                                                                               |  |      | 961,854   |      |  |   | 166,154 | 
|                                                                                                   |  |      |           |      |  |   |         | 
|                                                                                                   |  | $    | 1,660,615 |      |  | $ | 55,385  | 
|                                                                                                   |  |      |           |      |  |   |         | 

Aggregate maturities of notes receivable are as
follows:

|                         |  |   |           | 
|------------------------ |  | - | --------- | 
|Year Ending December 31, |  |  
|                         |  |  
|2004                     |  | $ | 961,854   | 
|2005                     |  |   | 458,515   | 
|2006                     |  |   | 571,120   | 
|2007                     |  |   | 510,845   | 
|2008                     |  |   | 120,135   | 
|                         |  |   |           | 
|Total                    |  | $ | 2,622,469 | 
|                         |  |   |           | 

The note receivable from the sale of the
probiotics unit is based on an estimate of the estimated
quarterly payments to be received discounted using to the five
year United States Treasury bill rate of 3.27% on
December 31, 2003.

Note F  Inventories

While inventories have historically been a
material component of the Companys financial statements,
there were no remaining inventories at the end of 2003 because
all inventories were sold with the sale of the probiotics
development and manufacturing unit on December 31, 2003.

34



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SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

Inventories consist of the following at
December 31:

|                                                  |  |      |   |      |  |   |         | 
|------------------------------------------------- |  | ---- | - | ---- |  | - | ------- | 
|                                                  |  | 2003 |   | 2002
|                                                  |  |      |   |     
|Raw materials                                     |  | $    |  |      |  | $ | 270,165 | 
|Work in progress                                  |  |      |  |      |  |   | 206,386 | 
|Finished goods                                    |  |      |  |      |  |   | 52,467  | 
|                                                  |  |      |   |      |  |   |         | 
|                                                  |  |      |  |      |  |   | 529,018 | 
|Less allowance for obsolete and slow moving items |  |      |  |      |  |   | 35,477  | 
|                                                  |  |      |   |      |  |   |         | 
|                                                  |  | $    |  |      |  | $ | 493,541 | 
|                                                  |  |      |   |      |  |   |         | 

Note G  Property and
Equipment

Property and equipment consist of the following
at December 31:

|                                                                                  |  |      |         |      |  |   |           | 
|--------------------------------------------------------------------------------- |  | ---- | ------- | ---- |  | - | --------- | 
|                                                                                  |  | 2003 |         | 2002
|                                                                                  |  |      |         |     
|Furniture and fixtures                                                            |  | $    | 29,511  |      |  | $ | 70,129    | 
|Machinery and equipment                                                           |  |      | 207,117 |      |  |   | 2,104,984 | 
|Leasehold improvements                                                            |  |      |        |      |  |   | 71,962    | 
|Machinery and equipment under capital leases                                      |  |      | 239,790 |      |  |   | 966,278   | 
|                                                                                  |  |      |         |      |  |   |           | 
|                                                                                  |  |      | 476,418 |      |  |   | 3,213,353 | 
|Less accumulated depreciation and amortization                                    |  |      | 28,262  |      |  |   | 1,437,172 | 
|Less accumulated amortization of machinery and
    equipment under capital leases |  |      | 148,785 |      |  |   | 281,866   | 
|                                                                                  |  |      |         |      |  |   |           | 
|                                                                                  |  | $    | 299,371 |      |  | $ | 1,494,315 | 
|                                                                                  |  |      |         |      |  |   |           | 

Note H  Intangible Assets

Intangible assets consist of the following at
December 31:

|                              |  |      |         |      |  |   |           | 
|----------------------------- |  | ---- | ------- | ---- |  | - | --------- | 
|                              |  | 2003 |         | 2002
|                              |  |      |         |     
|Technical and product rights  |  | $    |        |      |  | $ | 2,237,444 | 
|Patents and trademarks        |  |      | 497,346 |      |  |   | 899,527   | 
|                              |  |      |         |      |  |   |           | 
|                              |  |      | 497,346 |      |  |   | 3,136,971 | 
|Less accumulated amortization |  |      | 137,937 |      |  |   | 2,318,600 | 
|                              |  |      |         |      |  |   |           | 
|                              |  | $    | 359,409 |      |  | $ | 818,371   | 
|                              |  |      |         |      |  |   |           | 

For the years ended December 31, 2003 and
2002, amortization expense totaled $182,719 and $189,450,
respectively.

35



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##### Table of Contents



SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

The following is a schedule by years of future
amortization expense based on existing intangible assets as of
December 31, 2003.

|                         |       |   |        |         | 
|------------------------ | ----- | - | ------ | ------- | 
|Year Ending December 31, |       |  
|                         |       |  
|2004                     |       | $ | 62,568 |        
|2005                     |       |   | 58,735 |        
|2006                     |       |   | 47,651 |        
|2007                     |       |   | 42,235 |        
|2008                     |       |   | 38,234 |        
|                         |       |   |        |        
|                         | Total |   | $      | 249,423 | 
|                         |       |   |        |        

Note I  Line of Credit

On April 30, 2003, the Company renewed its
secured line of credit agreement for a term of one year with a
borrowing base equal to the lesser of 90% of eligible trade
receivables or $800,000, bearing interest at the rate of prime
plus 8% (12% at December 31, 2003). The line of credit is
collateralized by accounts receivable, inventories and equipment
and expires on April 30, 2004. The last advance on the line
was in December 2003 in anticipation of the sale of the
probiotics unit. The line was subsequently paid off in January
2004.

Note J  Long-Term
Obligations

The Company had no remaining notes payable at the
end of 2003 as all notes were either paid off during 2003 or
assumed by the purchaser upon the sale of the probiotics
development and manufacturing unit on December 31, 2003.

Long-term obligations consist of the following at
December 31:

|                                                                                                                                                                     |  |      |   |      |  |   |         | 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | - | ---- |  | - | ------- | 
|                                                                                                                                                                     |  | 2003 |   | 2002
|                                                                                                                                                                     |  |      |   |     
|Notes payable for equipment; with monthly
    installments totaling $13,801, including 16.4% interest;
    collateralized by production equipment; due in 2003       |  | $    |  |      |  | $ | 96,707  | 
|Notes payable to third party for leasehold
    improvement advance, payable in 34 monthly installments of
    $3,695 including 15.5% interest                        |  |      |  |      |  |   | 75,856  | 
|Note payable to a third party for payment of
    legal settlement; payable in 36 monthly installments of
    $5,000 beginning April 3, 2000; no stated interest rate |  |      |  |      |  |   | 10,000  | 
|Note payable to a third party; with monthly
    installments of $1,643, including interest at 12.7%;
    collateralized by equipment                                 |  |      |  |      |  |   | 26,800  | 
|Other notes payable                                                                                                                                                  |  |      |  |      |  |   | 16,157  | 
|                                                                                                                                                                     |  |      |   |      |  |   |         | 
|                                                                                                                                                                     |  |      |  |      |  |   | 225,520 | 
|Less current maturities                                                                                                                                              |  |      |  |      |  |   | 168,870 | 
|                                                                                                                                                                     |  |      |   |      |  |   |         | 
|                                                                                                                                                                     |  | $    |  |      |  | $ | 56,650  | 
|                                                                                                                                                                     |  |      |   |      |  |   |         | 

Note K  Shareholder Loan Payable
and Warrant Issuance

On September 30, 2002, the Company received
a $1,000,000 secured loan from an existing shareholder. The loan
is due on September 30, 2004 and bears interest at a rate
of 8% which is due monthly beginning November 1, 2002. The
loan is secured by substantially all of the assets of the
Company. In conjunction with the loan, the Company granted
warrants to purchase 750,000 shares of common stock at $0.50 per
share

36



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##### Table of Contents



SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

exercisable for ten years. The loan was
discounted for the relative fair value of the warrants totaling
approximately $331,000, which is being recognized as interest
expense over the loan term. The fair value of warrants was
determined using the Black-Scholes option-pricing model with the
following assumptions: volatility of 79%, risk-free interest
rate of 3%, expected life of ten years and 0% dividend yield. At
December 31, 2003, the balance of the loan was $989,323,
net of a discount of $10,677. The expected life of the loan was
shortened and the amortization of the discount accelerated due
to the subsequent payment in full of the note upon the closing
of the sale of the probiotics unit in January 2004. Interest
expense recognized from the amortization of the discount during
the year ended December 31, 2003 totaled $278,950.

Note L  Lease Obligations

The Company conducts a substantial portion of its
operations utilizing leased manufacturing and office facilities,
expiring through 2007. Some of the operating leases provide that
the Company pays taxes, maintenance, insurance and other
occupancy expenses applicable to leased premises. The Company
also leases machinery and equipment under capital leases
expiring through 2006.

The following is a schedule by years of future
minimum lease payments together with the present value of the
minimum payments under capital and operating leases as of
December 31, 2003:

|                                        |  |         |         |           |  |   |         | 
|--------------------------------------- |  | ------- | ------- | --------- |  | - | ------- | 
|                                        |  | Capital |         | Operating
|Year Ending December 31,                |  | Leases  |         | Leases   
|                                        |  |         |         |          
|2004                                    |  | $       | 65,896  |           |  | $ | 8,008   | 
|2005                                    |  |         | 52,247  |           |  |   | 147,704 | 
|2006                                    |  |         | 3,224   |           |  |   | 160,896 | 
|2007                                    |  |         |        |           |  |   | 163,633 | 
|2008                                    |  |         |        |           |  |   | 111,424 | 
|                                        |  |         |         |           |  |   |         | 
|Future minimum lease payments           |  |         | 121,367 |           |  | $ | 591,665 | 
|                                        |  |         |         |           |  |   |         | 
|Less amount representing interest       |  |         | 17,587  |           |  |   |         | 
|                                        |  |         |         |           |  |   |         | 
|Present value of minimum lease payments |  | $       | 103,780 |           |  |   |         | 
|                                        |  |         |         |           |  |   |         | 
|Current maturities                      |  | $       | 52,801  |           |  |   |         | 
|Long-term maturities                    |  |         | 50,979  |           |  |   |         | 
|                                        |  |         |         |           |  |   |         | 
|                                        |  | $       | 103,780 |           |  |   |         | 
|                                        |  |         |         |           |  |   |         | 

Rent expense for leased facilities and equipment
was $777,770 and $708,284 for the years ended December 31,
2003 and 2002, respectively.

Note M  Income Taxes

The Company accounts for income taxes using the
liability method as prescribed by Statement of Financial
Accounting Standards No. 109, Accounting for Income
Taxes.

37



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##### Table of Contents



SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

The income tax provision reconciled to the tax
computed at the statutory federal rate was approximately as
follows at December 31:

|                                               |  |      |            |      |  |   |          |  
|---------------------------------------------- |  | ---- | ---------- | ---- |  | - | -------- | -
|                                               |  | 2003 |            | 2002
|                                               |  |      |            |     
|Tax benefit at statutory rate                  |  | $    | (2,972,500 | )    |  | $ | (869,500 | )
|Permanent differences                          |  |      | 1,237,800  |      |  |   | 2,400    |  
|Expiration of net operating losses and credits |  |      | 157,500    |      |  |   | 400,500  |  
|Increase (decrease) in valuation allowance     |  |      | 1,577,200  |      |  |   | 466,600  |  
|                                               |  |      |            |      |  |   |          |  
|                                               |  | $    |           |      |  | $ |         |  
|                                               |  |      |            |      |  |   |          |  

Deferred tax assets and liabilities consist of
the approximately following at December 31:

|                       |                                            |      |   |            |   |   |   |            |  
|---------------------- | ------------------------------------------ | ---- | - | ---------- | - | - | - | ---------- | -
|                       |                                            | 2003 |   | 2002      
|                       |                                            |      |   |           
|Current asset, net     |                                            |      |   |            |   |   |   |           
|                       | Inventory and accounts receivable reserves |      | $ |           |   |   | $ | 16,300     |  
|                       | Other accrued liabilities                  |      |   | 20,200     |   |   |   | 41,200     |  
|                       | Warrants issued for services and interest  |      |   | 383,200    |   |   |   | 63,400     |  
|                       | Less valuation allowance                   |      |   | (403,400   | ) |   |   | (120,900   | )
|                       |                                            |      |   |            |   |   |   |           
|                       |                                            | $    |  |            |   | $ |  |           
|                       |                                            |      |   |            |   |   |   |           
|Non-current asset, net |                                            |      |   |            |   |   |   |           
|                       | Net operating loss carry forwards          |      | $ | 3,242,000  |   |   | $ | 2,052,600  |  
|                       | Depreciation and amortization              |      |   | (136,500   | ) |   |   | (244,400   | )
|                       | Other tax credits                          |      |   |           |   |   |   | 2,600      |  
|                       | Less valuation allowance                   |      |   | (3,105,500 | ) |   |   | (1,810,800 | )
|                       |                                            |      |   |            |   |   |   |           
|                       |                                            | $    |  |            |   | $ |  |           
|                       |                                            |      |   |            |   |   |   |           

The Company has established a valuation allowance
of $3,508,900 and $1,931,700 as of December 31, 2003 and
2002, respectively, due to the uncertainty of future utilization
of net operating loss carryforwards and realization of other
deferred tax assets.

At December 31, 2003, an operating loss
carryforward of approximately $9,535,000 expiring through 2023
is available to offset future taxable income. Net operating loss
carryforwards of approximately $456,000 and $1,077,000 expired
during 2003 and 2002, respectively. Tax credits of approximately
$2,600 and $34,200 expired during 2002 and 2003, respectively.
If ownership changes should occur, there may be certain
limitations on the use of these carryforwards, as defined by
Internal Revenue Code Section 382.

Note N  Separation
Agreement

The Company entered into a separation agreement
with its former Chief Scientific Officer and a separation
agreement with its former Vice President of Administration,
Secretary and Treasurer, both of which became fully binding on
the parties on March 31, 2001 and effective as of
January 15, 2001. At December 31, 2003 and 2002, the
Company recorded severance costs totaling $157,448 and $159,152,
respectively. These costs have been reclassified from Other
Expense, as previously reported, to General and Administrative
expense.

Under this agreement the Company is to pay the
former Chief Scientific Officer $12,500 a month through
January 15, 2004. If this individual earns an income during
the three-year period from January 15, 2001 through
January 15, 2004, then the amounts earned will offset
payments due him. For the first twelve

38



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##### Table of Contents



SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

months of the agreement, no amounts offset the
monthly payments. Beginning with the period ended
January 15, 2002 and for each twelve-month period
thereafter, the former Chief Scientific Officer is to provide
the Company with an accounting of income earned during the
preceding twelve months. The amount earned will then be used to
offset future payments. As future payments are contingent upon
the earnings of this individual, no liability is established for
the preceding twelve months. At December 31, 2003, the
Company has accrued severance payments totaling approximately
$90,000 that may be used to offset amounts earned by the Chief
Scientific Officer.



|         |                                                       
|-------- | ------------------------------------------------------
|Note O  | Sale of Product Line and Related Intangible
    Assets

In February 2003, the Company sold its feed
additive product line for $230,000, net of certain royalties, to
a third party for $130,000 cash payment and an executed purchase
order of inventory for the remaining $100,000. The assets sold
included inventories of $2,019 and related intellectual property
of $122,311 resulting in a net gain of $5,670.



|         |                                                            
|-------- | -----------------------------------------------------------
|Note P  | Technical Rights, Patent License and Royalty
    Agreements

The Company has agreements with Temple University
(Temple) providing it with exclusive worldwide rights for
its Controlled Delivery technology, with the right to
sublicense. Under the terms of the agreements with Temple, the
Company is required to make minimum annual royalty payments
totaling $55,000.

Under a technical and product rights agreement
(the Feed Additives Agreement) with a limited
partnership, which has now been dissolved, the Company had full
and exclusive rights, title and interest to use and market
certain feed additive products developed under the agreement.
Also under the Feed Additives Agreement, the Company was
required to make royalty payments to the former partners of the
limited partnership on sales of feed additives until
December 31, 2010. During 2003 and 2002, royalty expense
for feed additives amounted to $4,772 and $64,929, respectively.
In February 2003, the Company sold it feed additive product line
to a third party for $230,000. The assets included inventories
and intellectual property of the feed additive product line.
Upon closing of the sale, the Company was relieved of all future
royalty payments.

On March 25, 2002, the Company entered into
an Exclusive Patent License Agreement with Archer-
Daniels-Midland Company (ADM). Under the terms of the agreement,
the Company will grant ADM an exclusive license to manufacture,
use, sell and offer to sell products covered by certain patents
owned by the Company. ADM will pay the Company a running royalty
on a quarterly basis. During the year ended December 31,
2003 and 2002, the Company recorded royalty revenue of $61,567
and contract revenue of $54,000 relating to this agreement,
respectively.

Note Q  Retirement
Plan

The Company has a defined contribution 401(k)
retirement plan (the Plan) which covers all employees. The
Company will match 25% of employee contributions, up to 8% of
employee contributions. The Company contributed $15,594 and
$21,740 to the Plan for the years ended December 31, 2003
and 2002, respectively.

Note R  Stock
Options

Under the terms of the Companys 1995 Stock
Option Plan, officers, directors, employees and others related
to the Company may be granted incentive stock options or
nonqualified stock options to purchase up to an authorized
4,000,000 shares of common stock. The options are generally
granted at exercise prices equal to the market value of the
Companys common stock on the date of the grant. The
options generally vest over three years and expire ten years
from date of grant.

39



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##### Table of Contents



SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

The fair value of option grants is estimated
using the Black-Scholes option-pricing model with the following
assumptions for the years ended December 31:

|                        |  |      |             |      |  |  |            | 
|----------------------- |  | ---- | ----------- | ---- |  |  | ---------- | 
|                        |  | 2003 |             | 2002
|                        |  |      |             |     
|Expected volatility     |  |      | 73% - 78%   |      |  |  | 83%        | 
|Expected dividend yield |  |      | 0%          |      |  |  | 0%         | 
|Risk-free interest rate |  |      | 3.5% - 4.5% |      |  |  | 3%         | 
|Expected life           |  |      | 10.0 years  |      |  |  | 10.0 years | 

A summary of the Companys stock option
plans activity is as follows:

|                                                                   |  |        |           |          |  |        |      |          |  |  |           |   |  |   |      | 
|------------------------------------------------------------------ |  | ------ | --------- | -------- |  | ------ | ---- | -------- |  |  | --------- | - |  | - | ---- | 
|                                                                   |  |        |           |         
|                                                                   |  | 2003   |           | 2002    
|                                                                   |  |        |           |         
|                                                                   |  |        |           | Weighted |  |        |      | Weighted
|                                                                   |  |        |           | Average  |  |        |      | Average 
|                                                                   |  |        |           | Exercise |  |        |      | Exercise
|                                                                   |  | Shares |           | Price    |  | Shares |      | Price   
|                                                                   |  |        |           |          |  |        |      |         
|Outstanding at beginning of year                                   |  |        | 2,507,675 |          |  | $      | .68  |          |  |  | 3,490,583 |   |  | $ | .67  | 
|Granted                                                            |  |        | 739,399   |          |  |        | 1.65 |          |  |  | 246,802   |   |  |   | 1.06 | 
|Exercised                                                          |  |        | (216,139  | )        |  |        | .67  |          |  |  | (307,328  | ) |  |   | .43  | 
|Forfeited                                                          |  |        | (528,598  | )        |  |        | .74  |          |  |  | (922,382  | ) |  |   | .85  | 
|                                                                   |  |        |           |          |  |        |      |          |  |  |           |   |  |   |      | 
|Outstanding at end of year                                         |  |        | 2,502,337 |          |  | $      | .95  |          |  |  | 2,507,675 |   |  | $ | .68  | 
|                                                                   |  |        |           |          |  |        |      |          |  |  |           |   |  |   |      | 
|Options exercisable at end of year                                 |  |        | 1,911,789 |          |  | $      | .80  |          |  |  | 1,552,050 |   |  | $ | .65  | 
|                                                                   |  |        |           |          |  |        |      |          |  |  |           |   |  |   |      | 
|Weighted-average fair value of options granted
    during the year |  |        |           |          |  | $      | 1.34 |          |  |  |           |   |  | $ | .88  | 
|                                                                   |  |        |           |          |  |        |      |          |  |  |           |   |  |   |      | 

The following is a summary of stock options
outstanding at December 31, 2003:

|               |  |                     |           |                            |  |                     |       |  |  |  |           | 
|-------------- |  | ------------------- | --------- | -------------------------- |  | ------------------- | ----- |  |  |  | --------- | 
|               |  |                    
|               |  | Options Outstanding
|               |  |                    
|               |  | Number              |           | Weighted-Average Remaining |  | Number of          
|Exercise Price |  | Outstanding         |           | Contractual Life (years)   |  | Options Exercisable
|               |  |                     |           |                            |  |                    
|$0.25 - $0.90  |  |                     | 1,626,042 |                            |  |                     | 5.868 |  |  |  | 1,486,612 | 
|$1.00 - $1.20  |  |                     | 466,896   |                            |  |                     | 8.639 |  |  |  | 270,632   | 
|$1.97 - $2.28  |  |                     | 409,399   |                            |  |                     | 9.669 |  |  |  | 154,545   | 
|               |  |                     |           |                            |  |                     |       |  |  |  |           | 
|               |  |                     | 2,502,337 |                            |  |                     |       |  |  |  | 1,911,789 | 
|               |  |                     |           |                            |  |                     |       |  |  |  |           | 

At December 31, 2003, the Company
accelerated the vesting of 672,035 common stock shares of
outstanding stock options for the employees terminated as result
of the sale of the probiotics unit. In addition, the options
that normally would have terminated three months after cessation
of employment were extended to terminate at December 31,
2004. As a result, the Company has recognized $896,955 of
compensation expense according to APB Opinion 25 for the
year ending December 31, 2003.

40



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##### Table of Contents



SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

Note S  Warrants

The Company has the following warrants
outstanding to purchase common stock at December 31, 2003:

|                                                                                                                                                                                                      |  |  |           | 
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | --------- | 
|Warrants issued in conjunction with financing
    costs whereby one warrant entitles the holder to purchase one
    share of common stock at an exercise price of $0.50, expiring
    September 2012  |  |  | 750,000   | 
|Warrants issued in conjunction with services
    received whereby one warrant entitles the holder to purchase one
    share of common stock at an exercise price of $0.50, expiring
    December 2007 |  |  | 82,000    | 
|Warrants issued in conjunction with services
    received whereby one warrant entitles the holder to purchase one
    share of common stock at an exercise price of $0.81, expiring
    December 2007 |  |  | 85,000    | 
|Warrants issued in conjunction with financing
    costs whereby one warrant entitles the holder to purchase one
    share of common stock at an exercise price of $1.11, expiring
    April 2006      |  |  | 256,079   | 
|Warrants issued in conjunction with financing
    costs whereby one warrant entitles the holder to purchase one
    share of common stock at an exercise price of $1.155, expiring
    June 2008      |  |  | 476,191   | 
|Warrants issued in conjunction with services
    received whereby one warrant entitles the holder to purchase one
    share of common stock at an exercise price of $1.00, expiring
    March 2008    |  |  | 50,000    | 
|                                                                                                                                                                                                      |  |  |           | 
|                                                                                                                                                                                                      |  |  | 1,699,270 | 
|                                                                                                                                                                                                      |  |  |           | 



|         |                                                     
|-------- | ----------------------------------------------------
|Note T  | Major Customers and Concentration of Credit
    Risk

In 2003, the Company had sales to three
customers, which accounted for approximately 21%, 21%, and 12%
of net revenues. In 2002, the Company had sales to three
customers, which accounted for 23%, 20%, and 10% of net
revenues. All of these sales are related to the probiotics
manufacturing unit sold in 2003.

The Company maintains its cash balances in two
financial institutions, which at times, may exceed federally
insured limits. The Company has not experienced any losses in
such accounts and believes it is not exposed to any significant
credit risk on cash.

Note U  Financing
Events



| |                          
| | -------------------------
| | Convertible Notes Payable

On June 25, 2003, the Company completed a
private placement and issued $5.3 million of Convertible
Notes due June 25, 2006. The transaction provided the
Company with approximately $4.7 million in net proceeds.
Interest accrues on the notes at 6% and is payable quarterly. Of
the $5.3 million of notes issued, $75,000 was issued to
Herbert L. Lucas, a director of the Company. The principal
balance of the notes was convertible into shares of the
Companys common stock at a conversion price equal to $1.05
per share, subject to certain anti-dilution adjustments. The
Company exercised its right to force conversion of all the notes
into shares of the Companys common stock effective
December 15, 2003, because the common stock had traded at
$2.10 or higher for 20 trading days within a 30-consecutive day
trading period, as allowed under the agreement.

In accordance with EITF 98-5, Accounting
for Convertible Securities with Beneficial Conversion Features
or Contingently Adjustable Conversion Ratios, and
EITF 00-27, Application of Issue No. 98-5 to
Certain Convertible Instruments, an embedded beneficial
conversion feature should be recognized and measured by
allocating a portion of the proceeds of the note equal to the
intrinsic value of that feature to additional paid-in

41



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SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

capital. That amount should be calculated at the
commitment date as the difference between the conversion price
and the fair value of the common stock into which the note is
convertible, multiplied by the number of shares into which the
note is convertible (intrinsic value). The fair value of the
Companys common stock on June 25, 2003 was $1.77,
resulting in a beneficial conversion feature of $0.72 per
share. As a result, the Company recorded a discount on the note
for the beneficial conversion feature of approximately
$3.6 million, which is being recognized as interest expense
over the earlier of the term of the notes (3 years) or upon
the conversion of the notes into the Companys common
stock. As a result of the conversion of the notes into common
stock, the Company recognized the entire amount of the discount
as interest expense for the year ended December 31, 2003.

In consideration of certain placement services,
the Company paid Taglich Brothers, Inc. a cash fee of
approximately $200,000, issued $300,000 of convertible notes and
issued warrants to purchase up to 476,191 shares at
$1.155 per share. Michael N. Taglich, an affiliate of
Taglich Brothers, Inc. became a director of the Company on
August 17, 2003. The fair value of the warrants was
determined using the Black-Scholes option pricing model using
the following assumptions: volatility of 72%, term of five
years, risk-free interest rate of 3.36% and 0% dividend yield.
The fair value of the warrants totaled approximately $586,000.
The total debt issuance costs of $1,250,813 were being amortized
as interest expense over the earlier of the term of the notes
(3 years) or upon conversion of the notes into the
Companys common stock. As a result of the conversion of
the notes into common stock, the Company recognized interest
expense of $1.3 million for the year ended
December 31, 2003.

The notes and warrants included registration
rights which required the Company to file a registration
statement with the Securities and Exchange Commission (SEC)
registering, for resale, the shares of common stock issuable
upon conversion of the notes or exercise of the warrants. The
registration statement was to be filed no later than
60 days after the final closing date (June 25, 2003)
with an effective date no later than 150 days after the
final closing date. The Company filed the registration statement
on August 13, 2003, and it was declared effective by the
SEC on November 6, 2003.



| |                           
| | --------------------------
| | Short-Term Notes Financing

Between April 30, 2003 and May 6, 2003
the Company issued $550,000 of subordinated notes to a group of
accredited investors, including Herbert L. Lucas, a director of
the Company, who purchased $75,000 of such subordinated notes.
The transaction provided the Company with approximately $505,000
in net proceeds. In conjunction with the sale of these notes the
Company granted warrants to purchase 235,722 shares of the
Companys common stock (including 32,144 warrants granted
to Mr. Lucas) at $1.11 per share exercisable for three
years. The notes were unsecured and did not accrue interest. The
notes were paid in full on June 25, 2003 with the proceeds
received from the Convertible Note financing discussed above.

The loan was discounted for the relative fair
value of the warrants totaling approximately $94,000, which was
recognized as interest expense upon payment of the loan. The
fair value of warrants was determined using the Black-Scholes
option-pricing model with the following assumptions: volatility
of 72%, risk-free interest rate of 2.25%, expected life of three
years and 0% dividend yield.

For placement services associated with the
financing, the Company paid Taglich Brothers, Inc. a fee of
$23,750 and issued warrants to purchase up to 20,357 shares of
the Companys common stock at $1.11 per share exercisable
for three years. The fair value of the warrants was valued using
the Black-Scholes option-pricing model with the same assumptions
as the bridge notes discussed above. The total debt issuance
costs of approximately $44,750 were recognized as interest
expense upon the payment of the notes.

The warrants include registration rights
requiring the Company to register the underlying shares of
common stock with the SEC. The underlying shares were registered
by the Company via the registration statement discussed above
that was declared effective by the SEC on November 6, 2003.

42



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SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

Note V  Restatement of Financial
Information

During the year ended December 31, 2003, the
Company determined that certain costs that were incurred during
2002 and deferred as a prepaid expense at December 31,
2002, should have been expensed in the year ended
December 31, 2002. These costs totaled approximately
$104,000 and were incurred in conjunction with the anticipated
sale of its Probiotics unit. The financial statements as of and
for the year ended December 31, 2002 have been restated to
correct the accounting for these costs.

Also during the year ended December 31,
2003, the Company determined that severance costs related to the
separation agreement discussed in Note N that were
classified as Other expense, should have been
classified as General and Administrative expense on
the Statement of Operations. These costs totaling $157,448 and
$159,152 for the years ended December 31, 2003 and 2002,
respectively, have been reclassed in General and Administration
expense in the accompanying Statements of Operations.

The following is a summary of the effects of such
restatement on the Companys financial statements as of
December 31, 2002 and for the year then ended:

|                         |                                    |               |   |             |   |  |   |             |  
|------------------------ | ---------------------------------- | ------------- | - | ----------- | - |  | - | ----------- | -
|                         |                                    | As Originally |   |            
|                         |                                    | Reported      |   | As Restated
|                         |                                    |               |   |            
|Balance Sheet:           |                                    |               |   |             |   |  |   |            
|                         | Current assets                     |               | $ | 1,645,766   |   |  | $ | 1,541,942   |  
|                         | Total assets                       |               |   | 4,013,837   |   |  |   | 3,910,013   |  
|                         | Accumulated deficit                |               |   | (12,830,343 | ) |  |   | (12,934,167 | )
|                         | Stockholders equity               |               |   | 1,231,907   |   |  |   | 1,128,083   |  
|Statement of Operations: |                                    |               |   |             |   |  |   |            
|                         | General and administrative expense |               | $ | 2,470,292   |   |  | $ | 2,733,268   |  
|                         | Operating profit (loss)            |               | $ | (2,006,206  | ) |  | $ | (2,269,182  | )
|                         | Other expense (severance costs)    |               | $ | (159,152    | ) |  | $ |            |  
|                         | Net earnings (loss)                |               | $ | (2,557,328  | ) |  | $ | (2,661,152  | )
|                         | Net loss per share                 |               | $ | (0.13       | ) |  | $ | (0.13       | )

Note W  Subsequent Event

The Company issued 3,206,538 shares of its common
stock and warrants (Warrants) to purchase 801,636
shares of common to pursuant to a Securities Purchase Agreement
dated February 24, 2004. The common stock was sold at $3.25
per share for gross proceeds of approximately
$10.4 million. The Warrants are exercisable until
February 23, 2009 at $4.75 per share, subject to customary
anti-dilution provisions. After a period of 12 months
following the effective date of a registration covering the
resale of shares issued upon exercise of the Warrants, the
Company has the right to call the Warrants for cancellation if
the volume weighted average price of the common stock is above
$8.00 for 20 consecutive trading days.

Rodman & Renshaw acted as the lead placement
agent for the transaction and Taglich Brothers, Inc. assisted in
the financing. The placement agents received a cash commission
of $729,487 and Warrants to purchase 224,458 shares, of which
Taglich Brothers received $174,965 and Warrants to purchase
12,408 shares. Michael N. Taglich and Robert C. Schroeder,
directors of the Company, are affiliates of Taglich Brothers. In
addition, Mr. Taglich (and a partnership of which
Mr. Taglich is a general partner) purchased 49,631 shares
of common stock and Warrants to purchase 12,408 shares as part
of the private placement. However, Mr. Taglichs
agreement with the Company was amended to increase the purchase
price applicable to the 49,631 shares purchased by him to $3.63
per share.

43



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##### Table of Contents



SCOLR, INC.


NOTES TO FINANCIAL
STATEMENTS  (Continued)

The Company also issued (i) 32,000 shares of
common stock and a Warrant to purchase 15,000 shares to an
unaffiliated third party as a finders fee, and
(ii) 23,077 shares of common stock and Warrants to purchase
5,679 shares to Rostrevor Partners in partial payment of
its advisory fee in connection with the sale of the
Companys probiotics unit.

The common stock and Warrants were issued to
accredited investors and such sales were exempt from
registration under the Securities Act of 1933, as amended,
pursuant to Rule 506 of Regulation D and
Section 4(2) of such Act. In connection with the offering,
the Company agreed to register the resale of the common stock
and shares to be issued upon exercise of the Warrants with the
Securities and Exchange Commission. The Company is subject to
certain penalties if the registration statement is not filed
within 30 days of the closing, or if the registration
statement is not declared effective by the Securities and
Exchange Commission within 120 days of such closing.

44



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##### Table of Contents








|        |                                                                                              
|------- | ---------------------------------------------------------------------------------------------
|Item 8. | Changes in and Disagreements with
    Accountants on Accounting and Financial
    Disclosures

None.






|         |                        
|-------- | -----------------------
|Item 8A. | Controls and Procedures

Evaluation of Disclosure Controls and
Procedures

Our Chief Executive Officer and Principal
Financial Officer have reviewed and evaluated the effectiveness
of our disclosure controls and procedures, as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange
Act of 1934, as amended (Exchange Act), as of December 31,
2003. Based on that evaluation, the Chief Executive Officer and
the Chief Financial Officer have concluded that our disclosure
controls and procedures are adequate and effective for the
purposes set forth in the definition of disclosure
controls and procedures in Exchange Act
Rule 15d-15(e).

Changes in Internal Controls

There has been no change in our internal controls
over financial reporting that occurred during our last fiscal
year that has materially affected or is reasonably likely to
materially affect our internal controls over financial reporting.






|        |                                                       
|------- | ------------------------------------------------------
|Item 9. | Directors and Executive Officers of the
    Registrant

We will file a definitive proxy statement
(Proxy Statement) relating to our 2004 Annual
Meeting of Shareholders within 120 days after the end of
the fiscal year covered by this Report. The information required
by this item is incorporated by reference to the Proxy Statement
under the headings Directors and Executive Officers
and Section 16(a) Beneficial Ownership Reporting
Compliance.






|         |                       
|-------- | ----------------------
|Item 10. | Executive Compensation

The information required by this item is
incorporated by reference to the Proxy Statement under the
heading Executive Compensation and Director
Compensation.






|         |                                                                                                       
|-------- | ------------------------------------------------------------------------------------------------------
|Item 11. | Security Ownership of Certain Beneficial
    Owners and Management and Related Stockholder
    Matters

The information required by this item is
incorporated by reference to the Proxy Statement under the
heading Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters.






|         |                                                   
|-------- | --------------------------------------------------
|Item 12. | Certain Relationships and Related
    Transactions

The information required by this item is
incorporated by reference to the Proxy Statement under the
heading Certain Relationships and Related
Transactions.

45



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##### Table of Contents








|         |                                     
|-------- | ------------------------------------
|Item 13. | Exhibits and Reports on Form
    8-K

(a) Exhibits

The following exhibits are filed herewith and
this list is intended to constitute the exhibit index:

|        |    |       |  |             |       |  |  |                                                                                                                                                                    
|------- | -- | ----- |  | ----------- | ----- |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |       |  |            
|Number  |    | Notes |  | Description
|        |    |       |  |            
|        | 2  | .1    |  |             | (14)  |  |  | Asset Purchase Agreement by and between
    SCOLR, Inc. and Nutraceutix, Inc., dated as of
    December 31, 2003                                                   
|        | 4  | .1    |  |             | (5)   |  |  | SCOLR, Inc. Certificate of Incorporation, as
    amended                                                                                                           
|        | 4  | .2    |  |             | (12)  |  |  | Certificate of Designation of Series A
    Junior Participating Preferred Stock of SCOLR, Inc.                                                                     
|        | 4  | .3    |  |             | (4)   |  |  | SCOLR, Inc. Bylaws, as amended                                                                                                                                     
|        | 10 | .1    |  |             | (9)   |  |  | Form of Note Purchase Agreement, Subordinated
    Note and Warrant dated as of April 30, 2003                                                                      
|        | 10 | .2    |  |             | (15)  |  |  | Form of 6.0% Convertible Note dated
    June 25, 2003                                                                                                              
|        | 10 | .3    |  |             | (15)  |  |  | Form of Common Stock Purchase Warrant dated
    June 25, 2003                                                                                                      
|        | 10 | .4    |  |             | (15)  |  |  | Convertible Note Purchase Agreement dated
    June 25, 2003                                                                                                        
|        | 10 | .5    |  |             | (19)  |  |  | Securities Purchase Agreement dated
    February 24, 2004                                                                                                          
|        | 10 | .6    |  |             | (19)  |  |  | Registration Rights Agreement dated
    February 24, 2004                                                                                                          
|        | 10 | .7    |  |             | (19)  |  |  | Form of Common Stock Purchase Warrant dated
    February 24, 2004                                                                                                  
|        | 10 | .8    |  |             | (6)   |  |  | Promissory Note to Clyde Berg in the principal
    amount of $1 million together with related Security
    Agreement and Warrant Agreement dated September 30, 2002
|        | 10 | .9    |  |             | (1)   |  |  | Company 1995 Stock Option Plan, together with
    amendment No. 1 thereto                                                                                          
|        | 10 | .10   |  |             | (10)  |  |  | Amendment No. 2 to Company 1995 Stock Option
    Plan                                                                                                              
|        | 10 | .11   |  |             | (15)  |  |  | Form of Incentive Stock Option Agreement                                                                                                                           
|        | 10 | .12   |  |             | (15)  |  |  | Form of Nonqualified Stock Option Agreement                                                                                                                        
|        | 10 | .13   |  |             | (7)   |  |  | Exclusive Patent License Agreement dated
    March 8, 2002, by and between Archer-Daniels-Midland
    Company and the Company                                      
|        | 10 | .14   |  |             | (15)  |  |  | Research and Transfer Agreement dated
    September 11, 1998, by and among Temple University,
    Dr. Reza Fassihi, and the Company                                
|        | 10 | .15   |  |             | (15) |  |  | License Agreement dated December 22, 1998,
    as amended, by and between Temple University and the Company                                                        
|        | 10 | .16   |  |             | (15) |  |  | License Agreement dated September 6, 2000,
    by and between Temple University and the Company                                                                    
|        | 10 | .17   |  |             | (15) |  |  | Master Research and Development Agreement dated
    May 1, 2001, by and between Temple University and the
    Company                                              
|        | 10 | .18   |  |             | (15)  |  |  | Consulting Agreement dated December 22,
    2000, by and between Dr. Reza Fassihi and the Company                                                                  
|        | 10 | .19   |  |             | (15) |  |  | Intellectual Property Assignment and Assumption
    Agreement dated May 24, 2001, by and between Dr. Reza
    Fassihi and the Company                              
|        | 10 | .20   |  |             | (15) |  |  | License Agreement dated September 1, 2001,
    by and between Temple University and the Company                                                                    
|        | 10 | .21   |  |             | (15) |  |  | Intellectual Property Assignment and Assumption
    Agreement dated August 1, 2002, by and between
    Dr. Reza Fassihi and the Company                            
|        | 10 | .22   |  |             | (15)  |  |  | Additional Services Agreement dated
    August 7, 2002, by and between Dr. Reza Fassihi and
    the Company                                                        
|        | 10 | .23   |  |             | (14)  |  |  | License, Manufacture, and Distribution Agreement
    by and between SCOLR, Inc. and Nutraceutix, Inc.,
    dated as of December 31, 2003                           
|        | 10 | .24   |  |             | (15)  |  |  | Building Lease  3625 132nd Avenue
    SE, Bellevue, WA, dated April 15, 2003                                                                                      

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|        |    |       |  |             |      |  |  |                                                                                                                                                 
|------- | -- | ----- |  | ----------- | ---- |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |       |  |            
|Number  |    | Notes |  | Description
|        |    |       |  |            
|        | 10 | .25   |  |             | (11) |  |  | Separation Agreement dated January 15, 2001,
    by and between William D. St. John and the Company                                             
|        | 10 | .26   |  |             | (15) |  |  | Employment Agreement dated July 2, 2003, by
    and between Stephen Turner and the Company                                                      
|        | 10 | .27   |  |             | (15) |  |  | Separation Agreement dated August 7, 2003,
    by and between David T. Howard and the Company                                                   
|        | 10 | .28   |  |             | (15) |  |  | Advisory Agreement dated August 7, 2003, by
    and between David T. Howard and the Company                                                     
|        | 10 | .29   |  |             | (18) |  |  | Amendment to Advisory Agreement dated
    December 30, 2003, by and between David T. Howard and the
    Company                                 
|        | 10 | .30   |  |             | (14) |  |  | Separation Agreement dated December 31,
    2003, by and between Steven H. Moger and the Company                                                
|        | 10 | .31   |  |             | (6)  |  |  | Loan and Security Agreement dated April 30,
    2002, by and between Access Business Finance LLC and the Company                                
|        | 10 | .32   |  |             | (8)  |  |  | Second Amendment of Loan and Security Agreement
    dated May 1, 2003, by and between Access Business Finance
    LLC and the Company           
|        | 10 | .33   |  |             | *    |  |  | Letter Agreement between the Company, Michael N.
    Taglich and Tag Kent Partners dated March 2, 2004                                          
|        | 23 | .1    |  |             | *    |  |  | Consent of Grant Thornton LLP, Independent
    Certified Public Accountants                                                                     
|        | 31 | .1    |  |             | *    |  |  | Certification of Daniel O. Wilds pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002                                                  
|        | 31 | .2    |  |             | *    |  |  | Certification of Gail Vitulli pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002                                                     
|        | 32 | .1    |  |             | *    |  |  | Certification of Daniel O. Wilds pursuant to
    18 U.S.C. Section 1350 as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002
|        | 32 | .2    |  |             | *    |  |  | Certification of Gail Vitulli pursuant to
    18 U.S.C. Section 1350 as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002   

Notes



---



| |   |                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------
| |  | Portions of such exhibit have been omitted
    pursuant to a request for confidential treatment filed with the
    SEC.



| |   |                   
| | - | ------------------
| | * | Included herewith.



| |     |                                                                                                                                                                           
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Incorporated by reference to the Companys
    registration statement on Form 10-SB (File No. 000-24693),
    filed with the SEC on July 27, 1998.                        
|
| | (2) | Incorporated by reference to Amendment No. 1
    to the Companys registration statement on Form 10-SB
    (File No. 000-24693), filed with the SEC on March 25,
    1999.
|
| | (3) | Incorporated by reference to the Companys
    Form 10-KSB for the fiscal year ended December 31,
    1999.                                                               
|
| | (4) | Incorporated by reference to the Companys
    Form 10-KSB for the fiscal year ended December 31,
    2001.                                                               
|
| | (5) | Incorporated by reference to the Companys
    Form 10-QSB for the quarterly period ending June 30,
    2002.                                                             
|
| | (6) | Incorporated by reference to the Companys
    Form 10-QSB for the quarterly period ending
    September 30, 2002.                                                        
|
| | (7) | Incorporated by reference to the Companys
    Form 10-KSB for the fiscal year ended December 31,
    2002.                                                               
|
| | (8) | Incorporated by reference to the Companys
    Form 10-QSB for the quarterly period ending March 31,
    2003.                                                            
|
| | (9) | Incorporated by reference to the Companys
    current report on Form 8-K, filed with the SEC on
    May 5, 2003.                                                         

47



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##### Table of Contents





|     |                                                                                                                                                                                               
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the Companys
    registration statement on Form S-8 (File
    No. 333-40290), filed with the SEC on June 28, 2000.                                              
|    
|(11) | Incorporated by reference to the Companys
    current report on Form 8-K, filed with the SEC on
    April 6, 2001.                                                                           
|    
|(12) | Incorporated by reference to the Companys
    current report on Form 8-K, filed with the SEC on
    November 6, 2002.                                                                        
|    
|(13) | Incorporated by reference to the Companys
    Form 10-QSB/ A for the quarterly period ending
    June 30, 2003.                                                                              
|    
|(14) | Incorporated by reference to the Companys
    current report on Form 8-K, filed with the SEC on
    January 23, 2003.                                                                        
|    
|(15) | Incorporated by reference to the Companys
    registration statement on Form S-2, File
    No. 333-107906, filed with the SEC on August 13, 2003.                                            
|    
|(16) | Incorporated by reference to Amendment No. 1
    to the Companys registration statement on Form S-2
    (File No. 333-107906), filed with the SEC on
    October 3, 2003.                    
|    
|(17) | Incorporated by reference to Amendment No. 2
    to the Companys registration statement on Form S-2
    (File No. 333-107906), filed with the SEC on
    October 30, 2003.                   
|    
|(18) | Incorporated by reference to Post-Effective
    Amendment No. 1 to the Companys S-2 registration
    statement on Form S-3 (File No. 333-107906), filed
    with the SEC on January 29, 2004.
|    
|(19) | Incorporated by reference to the Companys
    current report on Form 8-K, filed with the SEC on
    February 26, 2004.                                                                       

(b) Reports on Form 8-K

A form 8-K was filed on November 12, 2003,
under Item 9, relating to (i) the appointment of
Dr. Reza Fassihi and Robert C. Schroeder to its Board of
directors, (ii) the effectiveness of its Registration
Statement on Form S-2, and (iii) the conversion of
$5.3 million of convertible notes into common stock.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accountant Fees and
    Services

The information required by this item is
incorporated by reference to the Proxy Statement under the
heading Principal Accountant Fees and Services.

48



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##### Table of Contents



SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the registrant
has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.



| |            
| | -----------
| | SCOLR, INC.



| |     |                    
| | --- | -------------------
| | By: | /s/ DANIEL O. WILDS

| |                                    
| | -----------------------------------
| |                                    
| | Daniel O. Wilds                    
| | Chief Executive Officer, President,
| | (Principal Executive Officer)      

Date: March 19, 2004

|                                             |  |                                                                                   |  |                |  | 
|-------------------------------------------- |  | --------------------------------------------------------------------------------- |  | -------------- |  | 
|                                             |  |                                                                                   |  |               
|Signature                                    |  | Title                                                                             |  | Date          
|                                             |  |                                                                                   |  |               
|                                            
|/s/ RANDALL L-W. CAUDILLRandall L-W. Caudill |  | Director                                                                          |  | March 19, 2004
|                                            
|/s/ REZA FASSIHIReza Fassihi                 |  | Director                                                                          |  | March 19, 2004
|                                            
|/s/ DAVID T. HOWARDDavid T. Howard           |  | Chairman of the Board                                                             |  | March 19, 2004
|                                            
|/s/ HERBERT L. LUCASHerbert L. Lucas         |  | Director                                                                          |  | March 19, 2004
|                                            
|/s/ ROBERT C. SCHROEDERRobert C. Schroeder   |  | Director                                                                          |  | March 19, 2004
|                                            
|/s/ MICHAEL N. TAGLICHMichael N. Taglich     |  | Director                                                                          |  | March 19, 2004
|                                            
|/s/ GAIL T. VITULLIGail T. Vitulli           |  | Director of Finance, Controller (Principal
    Financial and Accounting Officer)  |  | March 19, 2004
|                                            
|/s/ DANIEL O. WILDSDaniel O. Wilds           |  | President, Chief Executive Officer (Principal
    Executive Officer) and Director |  | March 19, 2004

49