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SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
|- | ----------------------------------------------------------------------------------------



For the Quarterly Period Ended September 30,
2004.



or



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
|- | -----------------------------------------------------------------------------------------



For the Transition Period from
 to .



Commission File No. 0-19651



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GENAERA CORPORATION

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 13-3445668                          
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification Number)
|                                                               | 
|5110 Campus Drive Plymouth Meeting, Pennsylvania               |  | 19462                               
|(Address of principal executive offices)                       |  | (Zip Code)                          



610-941-4020

(Registrants telephone number, including area code)



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No ̈



The number of outstanding shares of the Registrants Common Stock, par value $.002 per share, on November 5, 2004 was
56,860,899.



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##### Table of Contents

GENAERA CORPORATION

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2004



TABLE OF CONTENTS



|                               |  |                                                                                                               |  |     
|------------------------------ |  | ------------------------------------------------------------------------------------------------------------- |  | ----
|                               |  |                                                                                                               |  | Page
|PART I -
FINANCIAL INFORMATION |  |                                                                                                              
|                               |  |                                                                                                              
|Item 1.                        |  | Consolidated Financial Statements (unaudited):                                                                |  |     
|                               |  |                                                                                                              
|                               |  | Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003                                    |  | 3   
|                               |  |                                                                                                              
|                               |  | Consolidated Statements of Operations for the three- and nine-month periods ended September 30, 2004 and 2003 |  | 4   
|                               |  |                                                                                                              
|                               |  | Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2004 and 2003            |  | 5   
|                               |  |                                                                                                              
|                               |  | Notes to Consolidated Financial Statements                                                                    |  | 6   
|                               |  |                                                                                                              
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                         |  | 12  
|                               |  |                                                                                                              
|Item 3.                        |  | Quantitative and Qualitative Disclosures about Market Risk                                                    |  | 25  
|                               |  |                                                                                                              
|Item 4.                        |  | Controls and Procedures                                                                                       |  | 25  
|                               | 
|PART II -
OTHER INFORMATION    |  |                                                                                                              
|                               |  |                                                                                                              
|Item 1.                        |  | Legal Proceedings                                                                                             |  | 26  
|                               |  |                                                                                                              
|Item 2.                        |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                   |  | 26  
|                               |  |                                                                                                              
|Item 3.                        |  | Defaults Upon Senior Securities                                                                               |  | 26  
|                               |  |                                                                                                              
|Item 4.                        |  | Submission of Matters to a Vote of Security Holders                                                           |  | 26  
|                               |  |                                                                                                              
|Item 5.                        |  | Other Information                                                                                             |  | 26  
|                               |  |                                                                                                              
|Item 6.                        |  | Exhibits                                                                                                      |  | 26  
|                               | 
|SIGNATURES                     |  | 27                                                                                                           



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##### Table of Contents

PART I - FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



GENAERA CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(Amounts in thousands, except per share data)



|                                                                                                                                                                              |  |                    |          |   |                   |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                              |  | September 30, 2004 |          |   | December 31, 2003 |  
|ASSETS                                                                                                                                                                        | 
|Current assets:                                                                                                                                                               |  |                    |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                                     |  | $                  | 9,644    |   |                   | $ | 6,625    |  
|Short-term investments                                                                                                                                                        |  |                    | 11,935   |   |                   |   | 6,510    |  
|Prepaid expenses and other current assets                                                                                                                                     |  |                    | 841      |   |                   |   | 264      |  
|                                                                                                                                                                              |  |                    |          |   |                   |   |          |  
|Total current assets                                                                                                                                                          |  |                    | 22,420   |   |                   |   | 13,399   |  
|                                                                                                                                                                              |  |                   
|Fixed assets, net                                                                                                                                                             |  |                    | 806      |   |                   |   | 1,095    |  
|Other assets                                                                                                                                                                  |  |                    | 59       |   |                   |   | 59       |  
|                                                                                                                                                                              |  |                    |          |   |                   |   |          |  
|Total assets                                                                                                                                                                  |  | $                  | 23,285   |   |                   | $ | 14,553   |  
|                                                                                                                                                                              |  |                    |          |   |                   |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                          | 
|Current liabilities:                                                                                                                                                          |  |                    |          |   |                   |   |          |  
|Accounts payable and accrued expenses                                                                                                                                         |  | $                  | 2,109    |   |                   | $ | 1,917    |  
|Accrued development expense  short-term (NOTE 8)                                                                                                                             |  |                    | 563      |   |                   |   | 966      |  
|                                                                                                                                                                              |  |                    |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                                     |  |                    | 2,672    |   |                   |   | 2,883    |  
|                                                                                                                                                                              |  |                   
|Accrued development expense - long-term (NOTE 8)                                                                                                                              |  |                    |         |   |                   |   | 563      |  
|Other liabilities                                                                                                                                                             |  |                    | 580      |   |                   |   | 485      |  
|                                                                                                                                                                              |  |                    |          |   |                   |   |          |  
|Total liabilities                                                                                                                                                             |  |                    | 3,252    |   |                   |   | 3,931    |  
|Commitments, contingencies and other matters (NOTE 8)                                                                                                                         |  |                    |          |   |                   |   |          |  
|                                                                                                                                                                              |  |                   
|Stockholders equity (NOTE 3):                                                                                                                                                |  |                    |          |   |                   |   |          |  
|Preferred stock - $.001 par value per share; 9,211 shares authorized; none issued and outstanding at September 30, 2004 and December 31, 2003
(NOTE 4)                        |  |                    |         |   |                   |   |         |  
|Common stock - $.002 par value per share; 75,000 shares authorized; 52,663 and 47,024 shares issued and outstanding at September 30, 2004 and
December 31, 2003, respectively |  |                    | 105      |   |                   |   | 94       |  
|Additional paid-in capital                                                                                                                                                    |  |                    | 228,247  |   |                   |   | 205,826  |  
|Accumulated other comprehensive income - unrealized loss on investments                                                                                                       |  |                    | (10      | ) |                   |   |         |  
|Accumulated deficit                                                                                                                                                           |  |                    | (208,309 | ) |                   |   | (195,298 | )
|                                                                                                                                                                              |  |                    |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                                    |  |                    | 20,033   |   |                   |   | 10,622   |  
|                                                                                                                                                                              |  |                    |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                                                                    |  | $                  | 23,285   |   |                   | $ | 14,553   |  
|                                                                                                                                                                              |  |                    |          |   |                   |   |          |  



See accompanying notes
to consolidated financial statements.



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##### Table of Contents

GENAERA CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Amounts in thousands,
except per share data)



|                                                                                                                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                                                                                                                                         |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                                                                                                                                                         |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003    |  
|Collaborative research agreement and grant revenues (NOTE 7)                                                                                                                             |  | $                               | 672    |   |                                | $ | 124    |      |  | $ | 844     |   |  | $ | 1,000  |  
|                                                                                                                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Costs and expenses:                                                                                                                                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Research and development                                                                                                                                                                 |  |                                 | 4,241  |   |                                |   | 1,554  |      |  |   | 10,392  |   |  |   | 4,371  |  
|General and administrative                                                                                                                                                               |  |                                 | 1,194  |   |                                |   | 710    |      |  |   | 3,548   |   |  |   | 1,941  |  
|                                                                                                                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|                                                                                                                                                                                         |  |                                 | 5,435  |   |                                |   | 2,264  |      |  |   | 13,940  |   |  |   | 6,312  |  
|                                                                                                                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Loss from operations                                                                                                                                                                     |  |                                 | (4,763 | ) |                                |   | (2,140 | )    |  |   | (13,096 | ) |  |   | (5,312 | )
|Interest income                                                                                                                                                                          |  |                                 | 74     |   |                                |   | 17     |      |  |   | 206     |   |  |   | 63     |  
|Interest expense                                                                                                                                                                         |  |                                 | (1     | ) |                                |   | (1     | )    |  |   | (3      | ) |  |   | (65    | )
|Gain (loss) on sale of equipment                                                                                                                                                         |  |                                 |       |   |                                |   | 53     |      |  |   | (118    | ) |  |   | 257    |  
|                                                                                                                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Net loss                                                                                                                                                                                 |  |                                 | (4,690 | ) |                                |   | (2,071 | )    |  |   | (13,011 | ) |  |   | (5,057 | )
|Dividends on preferred stock, including amount attributable to a beneficial conversion feature of $2,945 and $3,050 for the three and nine
months ended September 30, 2003, respectively |  |                                 |       |   |                                |   | (2,945 | )    |  |   |        |   |  |   | (3,084 | )
|                                                                                                                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Net loss applicable to common stockholders                                                                                                                                               |  | $                               | (4,690 | ) |                                | $ | (5,016 | )    |  | $ | (13,011 | ) |  | $ | (8,141 | )
|                                                                                                                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Net loss applicable to common stockholders per share  basic and diluted                                                                                                                 |  | $                               | (0.09  | ) |                                | $ | (0.13  | )    |  | $ | (0.25   | ) |  | $ | (0.22  | )
|                                                                                                                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Weighted average shares outstanding  basic and diluted                                                                                                                                  |  |                                 | 52,607 |   |                                |   | 37,453 |      |  |   | 52,012  |   |  |   | 36,277 |  
|                                                                                                                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  



See accompanying notes
to consolidated financial statements.



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##### Table of Contents

GENAERA CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Amounts in thousands)



|                                                                                                   |  |                                 |         |   |      |   |         |  
|-------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                                   |  | Nine Months Ended September 30, |        
|                                                                                                   |  | 2004                            |         |   | 2003 |  
|Cash Flows From Operating Activities:                                                              |  |                                 |         |   |      |   |         |  
|Net loss                                                                                           |  | $                               | (13,011 | ) |      | $ | (5,057  | )
|Adjustments to reconcile net loss to net cash used in operating activities:                        |  |                                 |         |   |      |   |         |  
|Depreciation and amortization                                                                      |  |                                 | 267     |   |      |   | 384     |  
|Amortization of investment discounts/premiums                                                      |  |                                 | (78     | ) |      |   | (56     | )
|Compensation expense on option grants and equity awards                                            |  |                                 | 709     |   |      |   | 194     |  
|(Gain) loss on sale of fixed assets                                                                |  |                                 | 118     |   |      |   | (257    | )
|Changes in operating assets and liabilities:                                                       |  |                                 |         |   |      |   |         |  
|Prepaid expenses and other assets                                                                  |  |                                 | (577    | ) |      |   | (223    | )
|Accounts payable and accrued expenses                                                              |  |                                 | 192     |   |      |   | (223    | )
|Accrued development expenses                                                                       |  |                                 | (966    | ) |      |   |        |  
|Other liabilities                                                                                  |  |                                 | 95      |   |      |   | 232     |  
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Net cash used in operating activities                                                              |  |                                 | (13,251 | ) |      |   | (5,006  | )
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Cash Flows From Investing Activities:                                                              |  |                                 |         |   |      |   |         |  
|Purchase of investments                                                                            |  |                                 | (27,857 | ) |      |   | (15,750 | )
|Proceeds from maturities of investments                                                            |  |                                 | 22,500  |   |      |   | 16,850  |  
|Proceeds from sale of fixed assets                                                                 |  |                                 |        |   |      |   | 257     |  
|Capital expenditures                                                                               |  |                                 | (96     | ) |      |   | (21     | )
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Net cash provided by (used in) investing activities                                                |  |                                 | (5,453  | ) |      |   | 1,336   |  
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Cash Flows From Financing Activities:                                                              |  |                                 |         |   |      |   |         |  
|Payment on note payable                                                                            |  |                                 |        |   |      |   | (2,500  | )
|Net proceeds from issuance of common stock                                                         |  |                                 | 19,930  |   |      |   |        |  
|Proceeds from exercise of stock options and warrants                                               |  |                                 | 1,793   |   |      |   | 1,136   |  
|Proceeds from issuance of Series C-1 and C-2 convertible preferred stock                           |  |                                 |        |   |      |   | 4,922   |  
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Net cash provided by financing activities                                                          |  |                                 | 21,723  |   |      |   | 3,558   |  
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                                               |  |                                 | 3,019   |   |      |   | (112    | )
|Cash and cash equivalents at beginning of period                                                   |  |                                 | 6,625   |   |      |   | 1,368   |  
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                                         |  | $                               | 9,644   |   |      | $ | 1,256   |  
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Supplemental Cash Flow Information:                                                                |  |                                 |         |   |      |   |         |  
|Cash paid during the period for interest                                                           |  | $                               | 2       |   |      | $ | 76      |  
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Supplemental Schedule of Non-Cash Investing & Financing Activities                                 |  |                                 |         |   |      |   |         |  
|Conversion of Series A redeemable convertible preferred stock into common stock                    |  | $                               |        |   |      | $ | 1,151   |  
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Issuance of warrants in connection with issuance of Series C-1 and C-2 convertible preferred stock |  | $                               |        |   |      | $ | 1,200   |  
|                                                                                                   |  |                                 |         |   |      |   |         |  
|Conversion of Series C-1 convertible preferred stock into common stock                             |  | $                               |        |   |      | $ | 2,500   |  
|                                                                                                   |  |                                 |         |   |      |   |         |  



See accompanying notes
to consolidated financial statements.



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##### Table of Contents

GENAERA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



NOTE 1. Basis of Presentation, Reclassification and Stock-Based Compensation



The accompanying financial statements of Genaera
Corporation (Genaera or the Company) are unaudited and have been prepared by the Company pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (SEC) for interim financial statements.
The December 31, 2003 balance sheet was derived from audited financial statements, however, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting
principles have been condensed or omitted pursuant to SEC rules and regulations. The Company believes that the financial statements include all adjustments of a normal and recurring nature necessary to present fairly the results of operations,
financial position, changes in stockholders equity and cash flows for the periods presented. Results of operations for interim periods are not necessarily indicative of those to be achieved for full fiscal years. These financial statements
should be read in conjunction with the financial statements and notes thereto included in the Companys Annual Report on Form 10-K for the year ended December 31, 2003. There have been no material changes in accounting policies from those
stated in the Companys Annual Report on Form 10-K for the year ended December 31, 2003.



Certain prior year amounts have been reclassified to conform to the current year presentation.



The Companys stock-based compensation awards include restricted stock granted to employees, stock options granted to non-employee service providers
and stock options granted to employees. The Company accounts for its fixed-plan stock options under the intrinsic-value-based method set forth by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25), and related interpretations including Financial Accounting Standards Board (FASB) Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an Interpretation of APB
No. 25, issued in March 2000. Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation (SFAS 123), established accounting and disclosure requirements using a
fair-value-based method of accounting for stock-based employee compensation. As allowed by SFAS 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above. With regard to stock option grants to
employees, the Company has adopted only the disclosure requirements of SFAS 123. The following table illustrates the effect on net loss applicable to common stockholders if the fair-value-based method had been applied to all outstanding and unvested
stock-based awards for the three- and nine-month periods ended September 30, 2004 and 2003 (in thousands, except per share amounts).



|                                                                                                                                                                 |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                                                                                                                 |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                                                                                                                                 |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003    |  
|Net loss applicable to common stockholders, as reported                                                                                                          |  | $                               | (4,690 | ) |                                | $ | (5,016 | )    |  | $ | (13,011 | ) |  | $ | (8,141 | )
|Add: Stock-based employee compensation expense included in reported net loss applicable to common stockholders, net of related tax effects, if
any               |  |                                 | 90     |   |                                |   |       |      |  |   | 194     |   |  |   |       |  
|Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all stock- based awards, net of related
tax effects, if any |  |                                 | (589   | ) |                                |   | (312   | )    |  |   | (1,408  | ) |  |   | (915   | )
|                                                                                                                                                                 |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Pro forma net loss applicable to common stockholders                                                                                                             |  | $                               | (5,189 | ) |                                | $ | (5,328 | )    |  | $ | (14,225 | ) |  | $ | (9,056 | )
|                                                                                                                                                                 |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Net loss applicable to common stockholders per share  basic and diluted:                                                                                        |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|As reported                                                                                                                                                      |  | $                               | (0.09  | ) |                                | $ | (0.13  | )    |  | $ | (0.25   | ) |  | $ | (0.22  | )
|                                                                                                                                                                 |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Pro forma                                                                                                                                                        |  | $                               | (0.10  | ) |                                | $ | (0.14  | )    |  | $ | (0.27   | ) |  | $ | (0.25  | )
|                                                                                                                                                                 |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  



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GENAERA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



The resulting effect on pro forma net loss applicable to common stockholders and pro forma net loss applicable to common stockholders per share disclosed above may not be representative of the effects on a pro forma
basis in future years. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:



|                                                                 |  |      |             |   |      |   |             |  
|---------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                                                 |  | 2004 |             |   | 2003 |  
|Range of risk free interest rates                                |  |      | 3.04% -3.96 | % |      |   | 3.04% -3.38 | %
|Dividend yield                                                   |  |      | 0           | % |      |   | 0           | %
|Volatility factor                                                |  |      | 121         | % |      |   | 99          | %
|Weighted average expected life of options (in years)             |  |      | 6.0         |   |      |   | 4.4         |  
|Weighted average fair value of options granted during the period |  | $    | 3.26        |   |      | $ | 2.14        |  



On April 22, 2003, the
FASB determined that stock-based compensation should be recognized as a cost in the financial statements and that such cost be measured according to the fair value of the stock options. In March 2004, the FASB issued a Proposed SFAS, Share-Based
Payment, an amendment of FASB Statements Nos. 123 and 25 (Exposure Draft), which is currently expected to be effective for public companies in periods beginning after June 15, 2005. The Exposure Draft would eliminate the ability to
account for share-based compensation transactions using APB 25, as the Company currently does, and generally would require such transactions be accounted for using a fair-value-based method and the resulting cost recognized in the financial
statements. The Company will continue to monitor developments related to the Exposure Draft in order to determine the impact on the Companys financial statements.



NOTE 2. Note Payable



In June 2003, the Companys note payable matured and was not refinanced. The Company used its collateralized cash to satisfy the outstanding balance
of $2,500,000, plus $6,000 of accrued but unpaid interest through maturity.



NOTE 3. Stockholders Equity



The changes
in stockholders equity from December 31, 2003 to September 30, 2004 are summarized as follows (in thousands):



|                                                                                     |  |                 |  |                          |     |                                        |   |         |                    |   |     |                            |  |   |          |   |  |   |         |  
|------------------------------------------------------------------------------------ |  | --------------- |  | ------------------------ | --- | -------------------------------------- | - | ------- | ------------------ | - | --- | -------------------------- |  | - | -------- | - |  | - | ------- | -
|                                                                                     |  | Common Stock    |  | AdditionalPaid-inCapital |     | AccumulatedOther Compre- hensiveIncome |   |         | AccumulatedDeficit |   |     | TotalStock- holdersEquity | 
|                                                                                     |  | Numberof Shares |  | Amount                   |     |                                        |   |        
|Balance at December 31, 2003                                                         |  | 47,024          |  | $                        | 94  |                                        | $ | 205,826 |                    | $ |    |                            |  | $ | (195,298 | ) |  | $ | 10,622  |  
|Exercise of stock options and compensation expense on option grants and stock awards |  | 689             |  |                          | 1   |                                        |   | 2,501   |                    |   |    |                            |  |   |         |   |  |   | 2,502   |  
|Common stock issued pursuant to private placement                                    |  | 4,950           |  |                          | 10  |                                        |   | 19,920  |                    |   |    |                            |  |   |         |   |  |   | 19,930  |  
|Comprehensive loss:                                                                  |  |                 |  |                          |     |                                        |   |         |                    |   |     |                            |  |   |          |   |  |   |         |  
|Net loss                                                                             |  |                |  |                          |    |                                        |   |        |                    |   |    |                            |  |   | (13,011  | ) |  |   | (13,011 | )
|Unrealized loss on investments                                                       |  |                |  |                          |    |                                        |   |        |                    |   | (10 | )                          |  |   |         |   |  |   | (10     | )
|                                                                                     |  |                 |  |                          |     |                                        |   |         |                    |   |     |                            |  |   |          |   |  |   |         |  
|Total comprehensive loss                                                             |  |                |  |                          |    |                                        |   |        |                    |   | (10 | )                          |  |   | (13,011  | ) |  |   | (13,021 | )
|                                                                                     |  |                 |  |                          |     |                                        |   |         |                    |   |     |                            |  |   |          |   |  |   |         |  
|Balance at September 30, 2004                                                        |  | 52,663          |  | $                        | 105 |                                        | $ | 228,247 |                    | $ | (10 | )                          |  | $ | (208,309 | ) |  | $ | 20,033  |  
|                                                                                     |  |                 |  |                          |     |                                        |   |         |                    |   |     |                            |  |   |          |   |  |   |         |  



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GENAERA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



NOTE 4. Preferred Stock



The Companys
certificate of incorporation provides the board of directors the power to issue shares of preferred stock without stockholder approval. This preferred stock could have voting rights, including voting rights that could be superior to that of the
Companys common stock, and the board of directors has the power to determine these voting rights. As of September 30, 2004, the Companys board of directors has designated 80,000 shares of preferred stock as Series A redeemable
convertible preferred stock (the Series A Preferred Stock), 10,000 shares of preferred stock as Series B convertible preferred stock (the Series B Preferred Stock), 2,500 shares of preferred stock as Series C-1 convertible
preferred stock (the Series C-1 Preferred Stock), and 2,500 shares of preferred stock as Series C-2 convertible preferred stock (the Series C-2 Preferred Stock) (the Series C-1 Preferred Stock and the Series C-2 Preferred
Stock collectively the Series C Preferred Stock). During 2003, each of the holders of Series A Preferred Stock, Series B Preferred Stock and Series C Preferred Stock elected to convert all of their outstanding and issued convertible
preferred stock into shares of the Companys common stock. As a result of these transactions, there are no longer any shares of convertible preferred stock outstanding.



NOTE 5. Common Stock



On January 21, 2004, the Company sold 4,950,500 shares of its common stock to four institutional investors in a private placement at a purchase price of
$4.04 per share. Net proceeds to the Company from the offering totaled approximately $19,930,000 after offering costs of approximately $70,000. The share price was calculated based on a 10% discount to the five day moving average of the closing
price of the Companys common stock on the Nasdaq SmallCap Market on January 20, 2004. In addition, an aggregate of 990,100 warrants to purchase 990,100 shares of the Companys common stock were issued to the institutional investors (See
NOTE 6. Common Stock Warrants).



NOTE 6. Common Stock Warrants



In connection with its May 2003 private placement, the
Company granted warrants to purchase 2,000,000 shares of its common stock at an exercise price of $1.37 per share. These warrants expire on May 23, 2008 and contain certain provisions in which the holder may elect to receive, without the payment by
the holder of any additional consideration, the Companys common stock equal to the value of the warrant, also known as net exercise provisions. Of this total, warrants to purchase 1.5 million shares were exercisable immediately. The remaining
warrants to purchase 500,000 shares are generally exercisable after 18 months from issuance, or beginning on November 23, 2004, or prior to November 23, 2004 if the holder exercises the warrants on a net exercise basis. On August 26, 2003, Ziff
Asset Management, L.P., exercised its warrant to purchase 600,000 shares of the Companys common stock at an exercise price of $1.37 per share, pursuant to the warrant issued in connection with the May 2003 private placement. Proceeds to the
Company from the exercise of these warrants were approximately $822,000. On October 23, 2003, Biotechnology Value Fund LP and associated entities and Ziff Asset Management, L.P. exercised their warrants to purchase 1,200,000 shares of the
Companys common stock under the net exercise provisions of these warrants resulting in the issuance of 892,361 shares of common stock. As of September 30, 2004, 200,000 of such warrants are outstanding at an exercise price of $1.37 per share.



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GENAERA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



In connection with its January 21, 2004 private placement, the Company granted warrants to purchase 990,100 shares of its common stock. The warrants have an exercise price of $5.38 per share and expire on January 23,
2009. The exercise price and the number of shares that may be purchased upon exercise of the warrants may be adjusted from time to time as a result of stock dividend, split or subdivision of shares, as well as, a combination of shares or merger or
consolidation.



NOTE 7. Collaboration Agreements



In April 2001, the Company entered into a research collaboration and
licensing agreement with MedImmune to develop and commercialize therapies related to the Companys IL9 program. Pursuant to the Agreement, MedImmune provided funding of $2,500,000 for research and development activities at the Company over a
two-year period from April 2001 to April 2003 (the R&D Funding). The R&D Funding was paid in eight quarterly installments and recognized by the Company as revenue on a straight-line basis over the two-year period. By the end of
that two-year period, licensed technology had been transferred to MedImmune, who assumed responsibility for development and commercialization efforts on the IL9 program. In addition to the R&D Funding, MedImmune also will reimburse the Company
for certain external costs incurred by the Company in connection with the IL9 research plan, which will be recognized by the Company as revenues when the related expenses are incurred. The Company could also receive up to $54,500,000 based on
successful completion of future milestones. The Company is also entitled to royalties on sales of commercial products resulting from the collaboration. In August 2004, the Company received the first of such milestone payments as a result of the
initiation of Phase I clinical trials. For the three- and nine-month periods ended September 30, 2004, the Company recognized $672,000 and $821,000 as revenue related to external cost reimbursements ($172,000 and $321,000) and milestone payments
($500,000 and $500,000), respectively. For the three- and nine-month periods ended September 30, 2003, the Company recognized $3,000 and $651,000 as revenue related to the R&D Funding ($0 and $370,000) and external cost reimbursements ($3,000
and $281,000), respectively. No revenue related to milestone payments was recognized during 2003.



In September 2001, the Company received a contingent award of up to $1.7 million from an affiliate of the Cystic Fibrosis Foundation, Cystic Fibrosis
Foundation Therapeutics (CFFT), to support early clinical evaluation of LOMUCIN involving patients with cystic fibrosis. This award has been granted and shall be paid to the Company from time to time upon the achievement of certain development milestones. Of this
grant, $513,000 had been received as of September 30, 2004 and was recorded as a long-term liability. The Company did not recognize this amount as revenue as it is refundable to the CFFT upon marketing approval by the FDA or if the Company elects
not to enter Phase III clinical trials or to commercialize the product within two years of the satisfaction of development milestones. CFFT is also due a royalty on net sales of any resultant product up to 1% based upon the amount of funding
ultimately provided by CFFT.



In February 2002, the Company
received a Phase II Small Business Innovative Research program grant from the National Institutes of Health (NIH) in the amount of $800,000 to support its aminosterol research program. The grant extended over a two-year period, which
ended in February 2004. In February 2004, the Company notified the NIH of a no-cost extension of the original budget period by twelve months. As a result of the notification, the grant will extend to February 2005. The Company recognized no revenue
related to this grant in the three- and nine-month periods ended September 30, 2004.



In April 2004, the Company received a Phase I Small Business Innovative Research program grant from the National Institute of Diabetes and Digestive and Kidney Diseases of the NIH in the amount of $100,000 to support
its trodusquemine program. The grant extends over a one-year period ending in March 2005. The Company recognized no revenue related to this grant during the three- and nine-month periods ended September 30, 2004.



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GENAERA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



In September 2004, the Company received a Phase I Small Business Innovative Research program grant from the National Eye Institute of the NIH in the amount of $100,000 to support its aminosterols for age-related
macular degeneration (AMD) program. The grant extends over a one-year period ending in August 2005. The company recognized no revenue related to this grant during the three- and nine-month periods ended September 30, 2004.



NOTE 8. Commitments, Contingencies and Liquidity



Employment Agreements



The Company has employment agreements with certain officers and employees. Employees covered under employment contracts who
are terminated without cause are entitled to receive from the Company continuation of base pay for periods ranging from six months to twelve months. Continuation of pay for officers other than the President, whose severance is to be paid
in a lump sum, will cease upon the attainment of full time employment elsewhere.



During the nine-month period ended September 30, 2004, two executives ceased employment with the Company. As a result, the Company recorded $561,000 of continuing compensation and stock compensation expense for the
nine-month period ended September 30, 2004.



Manufacturing Agreement



In January 1999 and prior, the Company entered into
several agreements with Abbott Laboratories providing for the purchase of approximately $10.0 million of bulk drug substance to be used in the manufacturing process for LOCILEX Cream. As the FDA did not approve LOCILEX Cream, the Company
renegotiated this agreement with Abbott in September 1999, paying Abbott $4.2 million at that time and receiving partial delivery of material. An additional $3.4 million was due to Abbott and payable if the Company received in excess of $10.0
million of additional funds (as defined in the agreement) in any year beginning in 2000, in which case the Company must pay 15% of such excess over $10.0 million to Abbott. The Company recorded this conditional obligation as a liability in 1999 at
its then present value. As a result of the Companys financing activities during 2000 and 2001 and other cash inflows, $1,392,000 and $480,000 of this liability was payable and paid to Abbott on March 1, 2001 and 2002, respectively. No portion
of the liability was payable to Abbott on March 1, 2003, as the Company did not receive in excess of $10.0 million of cash inflows during 2002. As a result of the Companys financing activities during 2003 and other cash inflows, $966,000 of
the remaining liability was payable and paid to Abbott on March 1, 2004. The remaining amount of $563,000 is included in short-term liabilities as of September 30, 2004, as it is due and payable to Abbott on March 1, 2005 as a result of the
Companys financing activities during the nine-month period ended September 30, 2004.



Liquidity



The Company
has not generated any revenues from product sales and has funded operations primarily from the proceeds of public and private placements of its securities. Substantial additional financing will be required by the Company in the near-term to fund its
continuing research and development activities. No assurance can be given that any such financing will be available when needed or that the Companys research and development efforts will be successful.



The Company regularly explores alternative means of financing its operations
and seeks funding through various sources, including public and private securities offerings and collaborative arrangements



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GENAERA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



with third parties. The Company currently does not have any commitments to obtain additional funds and may be unable to obtain sufficient funding in the future on acceptable terms, if at all. If the Company cannot obtain funding, it will
need to delay, scale back or eliminate research and development programs or enter into collaborations with third parties to commercialize potential products or technologies that it might otherwise seek to develop or commercialize independently, or
seek other arrangements. If the Company engages in collaborations, it will receive lower consideration upon commercialization of such products than if it had not entered into such arrangements or if it entered into such arrangements at later stages
in the product development process.



In January 2004, the
Company completed the sale of 4,950,500 shares of its common stock for gross proceeds for approximately $20.0 million. The Company believes that its current cash and investments as of September 30, 2004, are sufficient to sustain operations and meet
its research and development goals at least through the first half of 2005 or to sustain operations at a reduced level through 2005.



Litigation



On August 4, 2003, a lawsuit was filed against the Company by Perceptive Life Sciences Master Fund, LTD in the United States District Court for the
Eastern District of Pennsylvania alleging the existence and subsequent breaches of certain contractual obligations by the Company in connection with its sale of shares of Series C Preferred Stock in May 2003. The plaintiff is seeking monetary
damages from the Company or a judgment by the court that the Company should specifically perform the terms of an alleged agreement related to such sale. The Company believes that this lawsuit is without merit and intends to defend it vigorously. The
Company does not believe that a loss from this matter is probable and therefore has not recognized a liability.



NOTE 9. Subsequent Events



On November 8, 2004, the Company completed the sale of 4,183,422 shares of its common stock, to unaffiliated institutional investors in a registered
direct offering, at a purchase price of $3.45 per share for aggregate gross proceeds of approximately $14.4 million (net proceeds of approximately $13.5 million after offering expenses ($60,000) and placement agency fees ($866,000)). The shares were
offered through a prospectus supplement pursuant to the Companys effective shelf registration statement. The share price represents a 13% discount to the closing price on the Nasdaq SmallCap Market on November 1, 2004.



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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



Forward Looking Statements



Our disclosure and analysis in this Quarterly Report on Form 10-Q contains some forward-looking statements. Forward-looking statements give our current
expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current facts. Such statements may include words such as anticipate, estimate,
expect, project, intend, plan, believe, hope, and other words and terms of similar meaning. In particular, these include, among others, statements relating to present or
anticipated scientific progress, development of potential pharmaceutical products, future revenues, capital expenditures, research and development expenditures, future financing and collaborations, personnel, manufacturing requirements and
capabilities, the impact of new accounting pronouncements, and other statements regarding matters that are not historical facts or statements of current condition.



There are important factors that could cause actual results to differ materially from those expressed or implied by such
forward-looking statements, including those addressed below under Risk Factors Related to Our Business.



We undertake no obligation (and expressly disclaim any such obligation) to publicly update any forward-looking statements, whether as a result of new
information, future events or otherwise, except as required by law. You are advised, however, to consult any further disclosures we make on related subjects in our filings with the United States Securities and Exchange Commission, all of which are
available in the SEC EDGAR database at www.sec.gov and from us.



Critical Accounting Policies and Estimates



The preparation of our financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying
notes. Actual results could differ materially from those estimates. The following are critical accounting policies important to our financial condition and results of operations that require management to make judgments, assumptions and estimates
that are inherently uncertain:



Revenue Recognition



Contract revenue for research and development is recorded as earned based on
the performance requirements of the contract. Non-refundable contract fees for which no further performance obligations exist, and for which there is no continuing involvement by us, are recognized on the earlier of when the payments are received or
when collection is assured. Revenue from non-refundable upfront license fees and certain guaranteed payments where we continue involvement through development collaboration is recognized on a straight-line basis over the development period. Revenue
associated with performance milestones is recognized based upon the achievement of the milestones, as defined in the respective agreements. Revenue under research and development cost reimbursement contracts is recognized as the related costs are
incurred. Advance payments received in excess of amounts earned are classified as liabilities until earned. Payments received that are refundable also are classified as liabilities until the refund provision expires. We make an estimate as to the
appropriate deferral period for recognition of revenue on any collaborative fees received. Changes in these estimates, due to the evolution of the development program, can have a significant effect on the timing of revenue recorded.



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Research and Development Expenses



Research and development expenses include salaries, contractor fees, facility costs, and external activities. Research and
development expenses consist of independent research and development contract costs, contract manufacturing costs and costs associated with collaborative research and development arrangements. In addition, we fund research and development at other
research institutions under agreements that are generally cancelable. All such costs are charged to research and development expense systematically as incurred, which may be measured by percentage of completion, contract milestones, patient
enrollment or the passage of time. At the initiation of certain contracts, we must make an estimate as to the duration and expected completion date of the contract, which may require a change due to accelerations, delays or other adjustments to the
contract period or work performed. Changes in these estimates could have a significant effect on the amount of research and development costs in a specific period.



Stock-Based Compensation



We account for stock-based employee compensation under the intrinsic value-based method set forth by Accounting Principles Board (APB) Opinion
No. 25, Accounting for Stock Issued to Employees, and related interpretations. Effective January 1, 1996, we adopted the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for
Stock-Based Compensation(SFAS 123). Stock or other equity-based compensation for non-employees must be accounted for under the fair value-based method as required by SFAS 123 and Emerging Issues Task Force (EITF) No.
96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, and other related interpretations. Under this method, the equity-based instrument is valued at
either the fair value of the consideration received or the equity instrument issued on the date of grant. The resulting compensation cost is recognized and charged to operations over the service period, which is usually the vesting period.
Estimating the fair value of equity securities involves a number of judgments and variables that are subject to significant change. A change in the fair value estimate could have a significant effect on the amount of compensation cost.



Risk Factors Related to Our Business



Any investment in shares of our common stock involves a high degree of risk.
You should carefully consider the following risk factors, together with the other information presented in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2003.



If we do not raise additional capital, we may not be able to continue our research and
development programs and may never commercialize any products.



We maintained cash, cash equivalents and investments of $21.6 million at September 30, 2004. At September 30, 2004, we had current liabilities of $2.7 million and long-term liabilities of $0.6 million. In January 2004, we completed the sale
of 4,950,500 shares of our common stock and 990,100 common stock warrants for gross proceeds of $20.0 million. We believe these resources are sufficient to sustain operations and meet our research and development goals at least through the first
half of 2005 or to sustain operations at a reduced level through 2005. However, we will need to raise substantial additional funds in the future to continue our research and development programs and to commercialize our potential products. If we are
unable to raise additional funds, we may be unable to complete our development activities for any of our proposed products.



We regularly explore alternative means of financing our operations and seek funding through various sources, including public and private securities
offerings, collaborative arrangements with third parties and other strategic alliances and business transactions. We currently do not have any commitments to provide us additional funds, and may be unable to obtain sufficient funding in the future
on acceptable



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terms, if at all. If we cannot obtain funding, we will need to delay, scale back or eliminate research and development
programs or enter into collaborations with third parties to commercialize potential products or technologies that we might otherwise seek to develop or commercialize ourselves, or seek other arrangements. If we raise additional capital by issuing
equity or securities convertible into equity, our stockholders may experience dilution and our share price may decline. Any debt financing may result in restrictions on spending or payment of dividends. If we engage in collaborations, we will
receive lower consideration upon commercialization of such products than if we had not entered into such arrangements, or if we entered into such arrangements at later stages in the product development process.



We expect to continue to incur substantial losses in the foreseeable future and may
never generate revenues or become profitable.



To
date, we have engaged primarily in the research and development of drug candidates. We have not generated any revenues from product sales and have incurred losses in each year since our inception. As of September 30, 2004, we had an accumulated
deficit of approximately $208.3 million.



Our proposed products
are in a relatively early developmental stage and will require significant research, development and testing. We must obtain regulatory approvals for any proposed product prior to commercialization of the product. Our operations also are subject to
various competitive and regulatory risks. As a result, we are unable to predict when or if we will achieve any product revenues or become profitable. We expect to experience substantial losses in the foreseeable future as we continue our research,
development and testing efforts.



We may be unable to maintain the
standards for listing on the Nasdaq SmallCap Market, which could adversely affect the liquidity of our common stock and could subject our common stock to the penny stock rules.



Our common stock is currently listed on the Nasdaq SmallCap Market. There
are several requirements that we must satisfy in order for our common stock to continue to be listed on the Nasdaq SmallCap Market. These requirements include, but are not limited to, maintaining a minimum per share price of our common stock of
$1.00 and a minimum level of stockholders equity of $2.5 million. In the future, we may not comply with all of these listing requirements, which might result in the delisting of our common stock. Delisting from the Nasdaq SmallCap Market could
also adversely affect the liquidity and the price of our common stock and could have a long-term adverse impact on our ability to raise future capital through a sale of our common stock.



If our common stock were delisted, our common stock would then be traded on an electronic bulletin board established for
securities that are not included in Nasdaq or traded on a national securities exchange or in quotations published by the National Quotation Bureau, Inc. that are commonly referred to as the pink sheets. If this occurs, it could be
difficult to sell our securities or obtain the same level of market information as to the price of our common stock as is currently available.



In addition, if our common stock were delisted, it would be subject to the so-called penny stock rules. The Securities and Exchange Commission
has adopted regulations that define a penny stock to be any equity security that has a market price of less than $5.00 per share, subject to certain exceptions, such as any securities listed on a national securities exchange or quoted on
the Nasdaq. For any transaction involving a penny stock, unless exempt, the rules impose additional sales practice requirements on broker-dealers, subject to certain exceptions.



For transactions covered by the penny stock rules, a
broker-dealer must make a special suitability determination for the purchaser and must have received the purchasers written consent to the transaction prior to the transaction. The penny stock rules also require broker-dealers to
deliver monthly statements to penny stock investors disclosing recent price information for the penny stock held in the account, and information on the limited market in penny stocks. Prior to the transaction, a
broker-dealer must provide a disclosure schedule relating to the penny stock market. In addition, the broker-dealer must disclose the following:



| |  | commissions payable to the broker-dealer and the registered representative; and
| | - | -------------------------------------------------------------------------------



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| |  | current quotations for the security as mandated by the applicable regulations.
| | - | ------------------------------------------------------------------------------



If our common stock were delisted and determined to be a penny stock, a broker-dealer may find it more difficult to trade our common stock
and an investor may find it more difficult to acquire or dispose of our common stock in the secondary market.



Development and commercial introduction of our products will take several more years and may not be successful.



We are dedicating substantially all of our resources to research and development, do not have any marketed products, and have not generated any product
revenue. Because substantially all of our potential products currently are in research, preclinical development or the early and middle stages of clinical testing, revenues from sales of any products will not occur for at least the next several
years, if at all. Our technologies are relatively new fields and may not lead to commercially viable pharmaceutical products. Before we can commercially introduce any products, we will likely incur substantial expense for, and devote a significant
amount of time to, preclinical testing and clinical trials. We cannot apply for regulatory approval of our potential products until we have performed additional research and development testing and demonstrated in preclinical testing and clinical
trials that our product candidates are safe and effective for use in humans. Some of our product candidates are in the early stages of research and development, and we may abandon further development efforts on these product candidates before they
reach clinical trials. Conducting clinical trials is a lengthy, time-consuming and expensive process. Our clinical trials may not demonstrate the safety and efficacy of our potential products, and we may encounter unacceptable side effects or other
problems in the clinical trials. Should this occur, we may have to delay or discontinue development of the potential products. Further, even if we believe that any product is safe or effective, we may not obtain the required regulatory approvals, be
able to manufacture our products in commercial quantities or be able to market any product successfully.



If we do not obtain required regulatory approvals, we will not be able to commercialize any of our product candidates.



Numerous governmental authorities, including the Food and Drug Administration, or FDA, in the United States, regulate our
business and activities. Federal, state and foreign government agencies impose rigorous preclinical and clinical testing and approval requirements on our product candidates. In general, the process of obtaining government approval for pharmaceutical
products is time consuming and costly.



Governmental
authorities may delay or deny the approval of any of our drug candidates. In addition, governmental authorities may enact new legislation or regulations that could limit or restrict our efforts. A delay or denial of regulatory approval for any of
our drug candidates, such as that which occurred for LOCILEX Cream, will have a material adverse effect on our business. Even if we receive approval of a product candidate, approval may be conditioned upon certain limitations and restrictions as to
the drugs used and may be subject to continuous review. If we fail to comply with any applicable regulatory requirements, we could be subject to penalties, including warning letters, fines, withdrawal of regulatory approval, product recalls,
operating restrictions, injunctions, and criminal prosecution.



While the FDA has granted fast track designation to squalamine for the treatment of wet age-related macular degeneration (AMD), squalamine could cease to meet the criteria for fast track designation for this indication at some
point in the future.



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We expect to rely on third parties to market any products we develop and expect to rely on third parties in
connection with the development of our products; if these parties do not perform as expected, we may never successfully commercialize our products.



We do not have our own sales and marketing staff. In order to successfully develop and market our future products, we must develop this infrastructure
with inherent risks or enter into marketing and distribution arrangements with third parties. We also expect to delegate the responsibility for all, or a significant portion, of the development and regulatory approval for certain products to third
parties. If these parties do not develop an approvable or marketable product or do not market a product successfully, we may never generate revenue or become profitable. Additionally, we may be unable to enter into successful arrangements with other
parties for such products.



We do not have control over the
amount and timing of resources to be devoted to our products by our collaborative partners. Our collaborators may not place a high priority on their contractual arrangements with us. Collaborators may develop products independently or through third
parties that could compete with our proposed products. For example, GlaxoSmithKline, a current collaborative partner, which entered into an agreement with us relating to the development of LOCILEX Cream, maintains a significant presence in the
antibiotic area and currently sells a topical antibiotic product indicated for the treatment of certain skin infections. In addition, a collaborator may decide to end a relationship with us. For example, in December 2000, Genentech provided notice
to us of its election to terminate the collaboration agreement covering the IL9 antibody development program and related respiratory technology.



We also may decide to establish our own sales force to market and sell certain products. Although some members of our management have limited experience
in marketing pharmaceutical products, we have no experience with respect to marketing our products. If we choose to pursue this alternative, we will need to spend significant additional funds and devote significant management resources and time to
establish a successful sales force. This effort may not be successful. Moreover, because our financial resources are limited, our sales and marketing expenditures in this area would likely be modest compared to our competitors.



We face formidable competition with respect to the products we are seeking to develop
and the recruitment of highly trained personnel.



The
pharmaceutical industry is characterized by intense competition. Many companies, research institutions and universities are conducting research and development activities in our fields of interest. Some of these companies are currently involved in
research and development activities focused on the pathogenesis of disease, and the competition among companies attempting to find genes responsible for disease is intense. In addition, we are aware that others are conducting research on compounds
derived from animal host-defense systems. We also may face competition from companies using different or advanced techniques that could render our future products obsolete. Most of these competitors have substantially greater financial, technical,
manufacturing, marketing, distribution and other resources than we have.



Many companies are working to develop and market products intended for the additional disease areas being targeted by us, including cancer, AMD and chronic obstructive respiratory diseases. A number of major
pharmaceutical companies have significant franchises in these disease areas, and can be expected to invest heavily to protect their interests. With respect to cancer and AMD, anti-angiogenic agents are under development at a number of companies. In
the respiratory field, other biopharmaceutical companies also have reported the discovery of genes relating to asthma and other respiratory diseases.



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Many of the companies developing or marketing competing products have significantly more experience than
we do in undertaking preclinical testing and human clinical trials of new or improved therapeutic products and obtaining regulatory approvals of such products. Some of these companies may be in advanced phases of clinical testing of various drugs
that may be competitive with our proposed products.



We expect
technological developments in the biopharmaceutical field to occur at a rapid rate and expect competition to intensify as advances in this field are made. Accordingly, we must continue to devote substantial resources and efforts to research and
development activities in order to maintain a competitive position in this field. Our efforts may not be successful.



Colleges, universities, governmental agencies and other public and private research organizations are becoming more active in seeking patent protection
and licensing arrangements to collect royalties for use of technology that they have developed, some of which may be directly competitive with our technology. In addition, these institutions, along with pharmaceutical and specialized biotechnology
companies, can be expected to compete with us in recruiting highly qualified scientific personnel.



If we do not develop and maintain relationships with contract manufacturers, we may not successfully commercialize our products.



We currently do not have the resources, facilities, or technical capabilities to manufacture any of our proposed products in
the quantities and quality required for commercial sale. We have no plans to establish a manufacturing facility. We expect to depend upon contract manufacturers for commercial scale manufacturing of our proposed products in accordance with
regulatory standards. For example, we are currently working with outside contractors for the chemical production of squalamine. This dependence on contract manufacturers may restrict our ability to develop and deliver products on a timely,
profitable and competitive basis especially because the number of companies capable of producing our proposed products is limited. These contract manufacturers generally have multiple projects and they may give ours a lower priority. As a result of
contract manufacture mishaps, our product could be lost or delivered late, delaying our clinical and preclinical programs, or may not be produced in accordance with all current applicable regulatory standards. Product not produced in accordance with
all current applicable regulatory standards may lead to adverse outcomes for patients and/or product recalls. Furthermore, the development of a robust, low-cost manufacturing process for the commercial production of squalamine and other proposed
products will require significant time and expenditure by us. We may be unable to maintain arrangements with qualified outside contractors to manufacture materials at costs that are affordable to us, if at all.



Contract manufacturers may utilize their own technology, our technology, or
technology acquired or licensed from third parties in developing a manufacturing process. In order to engage another manufacturer, we may need to obtain a license or other technology transfer from the original contract manufacturer. Even if a
license is available from the original contract manufacturer on acceptable terms, we may be unable to successfully effect the transfer of the technology to the new contract manufacturer. Any such technology transfer also may require the transfer of
requisite data for regulatory purposes, including information contained in a proprietary drug master file held by a contract manufacturer. If we rely on a contract manufacturer that owns the drug master file, our ability to change contract
manufacturers may be more limited.



We depend on our intellectual
property and, if we are unable to protect our intellectual property, our business may be harmed.



Patents



Our success
depends, in part, on our ability to develop and maintain a strong patent position for our products and technologies, both in the United States and other countries. As with most biotechnology and pharmaceutical companies, our patent position is
highly uncertain and involves complex legal and factual questions. Without patent and other protections, other companies could offer substantially identical



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products for sale without incurring the sizeable development and testing costs that we have incurred. As a result, our
ability to recover these expenditures and realize profits upon commercialization likely would be diminished.



The process of obtaining patents can be time consuming and expensive. Even after significant expenditure, a patent may not issue. We can never be certain
that we were the first to develop the technology or that we were the first to file a patent application for the particular technology because U.S. patent applications are maintained in secrecy by the U.S. Patent and Trademark Office until a patent
issues, and publications in the scientific or patent literature concerning new technologies occur some time after actual discoveries of the technologies are made.



We cannot be certain that:



| |  | patents will issue from any of our patent applications;
| | - | -------------------------------------------------------



| |  | our patent rights will be sufficient to protect our technology;
| | - | ---------------------------------------------------------------



| |  | others may not file patents ahead of us in time and prevent the issuing of our patent claims;
| | - | ---------------------------------------------------------------------------------------------



| |  | others will not design around the patented aspects of our technology; or
| | - | ------------------------------------------------------------------------



| |  | our patents will not be successfully challenged or circumvented by our competitors.
| | - | -----------------------------------------------------------------------------------



The cost of litigation related to patents can be substantial, regardless of the outcome.



Third Party Intellectual Property Rights



We cannot be sure that our products do not infringe on the intellectual
property rights of others, and we may have infringement claims asserted against us. These claims may harm our reputations, cost us money and prevent us from offering some products. Any claims or litigation in this area may be costly and result in
large awards against us and, whether we ultimately win or lose, could be time consuming, may injure our reputation, may result in costly delays or may require us to enter into royalty or licensing agreements. If there is a successful claim of
infringement against us or if we fail to develop non-infringing technology or license the proprietary rights on a timely basis, our ability to use certain technologies, products, services and brand names may be limited and our business may be
harmed.



Other Intellectual Property



In order to protect our proprietary technology and processes, we also rely
on trade secrets and confidentiality agreements with our employees, consultants, outside scientific collaborators, and other advisors. We may find that these agreements have been breached, or that our trade secrets have otherwise become known or
independently developed or discovered by our competitors.



Certain of our exclusive rights to patents and patent applications are governed by contract. Generally, these contracts require that we undertake certain obligations including the payment of royalties on sales of any products that are
covered by patent claims. If we do not meet those obligations, we may lose our patent rights. Additionally, some of these agreements also require that we develop the licensed technology or meet certain milestones within a given timeframe. If we do
not adhere to an acceptable schedule of commercialization, we may lose our rights.



We are currently attempting to register as a trademark the Genaera name in certain jurisdictions throughout the world. There can be no assurance that trademarks will be issued, or that our issued
trademarks will protect our name. If the Genaera name conflicts with the rights of a pre-existing trademark owner in a jurisdiction, we may need to operate under a different name in such jurisdiction, which could result in a loss of goodwill
associated with that name.



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Potential Ownership Disputes



Disputes may arise as to the ownership of our technology. Most of our research and development personnel previously worked
at other biotechnology companies, pharmaceutical companies, universities, or research institutions. These entities may raise questions as to when technology was developed, and assert rights to the technology. These kinds of disputes have occurred in
the past and were resolved. However, we may not prevail in any such disputes.



Similar technology ownership disputes may arise in the context of consultants, vendors or third parties, such as contract manufacturers. For example, our consultants are employed by or have consulting agreements with
third parties. There may be disputes as to the capacity in which consultants are operating when they make certain discoveries. We may not prevail in any such disputes.



If we cannot recruit and retain qualified management, we may not be able to successfully develop and commercialize our products.



We depend to a considerable degree on a limited
number of key personnel. Most significant responsibilities have been assigned to a relatively small number of individuals. All of our executive officers have executed individual employment agreements with us. We do not maintain key man
insurance on any of our employees. The loss of certain management and technical personnel could adversely affect our ability to develop and commercialize products.



We are subject to potential product liability claims that could result in significant costs.



We are subject to significant potential product liability risks inherent in
the testing, manufacturing and marketing of human therapeutic products, including the risk that:



| |  | our proposed products cause some undesirable side effects or injury during clinical trials;
| | - | -------------------------------------------------------------------------------------------



| |  | our products cause undesirable side effects or injury in the market; or
| | - | -----------------------------------------------------------------------



| |  | third parties that we have agreed to indemnify incur a related liability.
| | - | -------------------------------------------------------------------------



While we carry insurance, this coverage is expensive and we may be unable to maintain adequate coverage on acceptable terms.



If we do not receive adequate third-party reimbursement for any of our drug candidates,
some patients may be unable to afford our products and sales could suffer.



In both the United States and elsewhere, the availability of reimbursement from third-party payers, such as government health administration authorities, private health insurers and other organizations, can impact
prescription pharmaceutical sales. These organizations are increasingly challenging the prices charged for medical products and services, particularly where they believe that there is only an incremental therapeutic benefit that does not justify the
additional cost. If any of our products ever obtain marketing approval, coverage and reimbursement may not be available for these products, or, if available, may not be adequate. Without insurance coverage, many patients may be unable to afford our
products, in which case sales of the products would be adversely affected.



There also has been a trend toward government reforms intended to contain or reduce the cost of health care. In certain foreign markets, pricing or profitability of prescription pharmaceuticals is subject to
government control. In the United States, there have been a number of federal and state proposals to implement similar government control. We expect this trend to continue, but we cannot predict the nature or extent of any reform that results. These
reforms could adversely affect our ability to obtain financing for the continued development of our proposed products or market any of our products that are successfully developed. Furthermore, reforms could have a broader impact by limiting overall
growth of health care spending, such as Medicare and Medicaid spending, which could also adversely affect our business.



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The FDA has deemed our NDA for LOCILEX Cream to be not approvable, and the product may never be approved.



In July 1999, we received notification from the FDA
that our New Drug Application, or NDA, for LOCILEX Cream had been deemed not approvable. LOCILEX Cream, a topical cream antibiotic for the treatment of infection in diabetic foot ulcers, had been our lead product development candidate. As a result
of the FDAs decision, near-term commercialization of LOCILEX Cream will not occur, and we will generate no revenues from LOCILEX Cream in the near future, if ever.



In order to again seek approval of LOCILEX Cream, the FDA has indicated that we must conduct further development activities,
including clinical and manufacturing activities. As a result of its review of manufacturing of the cream product, the FDA issued certain observations of deficiencies in compliance with their current good manufacturing procedures regulations. The
Company will need to initiate new manufacturing relationships to conduct further development activities. Any additional manufacturing batches of the active ingredient and cream product that must be manufactured must meet strict product
specifications in compliance with FDA-determined current good manufacturing practices. The time required to conduct such further clinical and manufacturing development efforts may be lengthy and costly, and the results may ultimately prove
unsuccessful.



Our stock price is extremely volatile, and your investment
in our stock could decline in value. We may become involved in securities class action litigation.



The market prices and trading volumes for securities of biopharmaceutical and biotechnology companies, including ours, have historically been, and will
likely continue to be, highly volatile. Future events affecting our business, or that of our competitors, may have a significant impact on our stock price. Among these events are the following:



| |  | product testing results from us or our competitors;
| | - | ---------------------------------------------------



| |  | technological innovations by us or our competitors;
| | - | ---------------------------------------------------



| |  | new commercial products from us or our competitors;
| | - | ---------------------------------------------------



| |  | regulatory developments in the United States and foreign countries;
| | - | -------------------------------------------------------------------



| |  | developments concerning proprietary rights, including patents;
| | - | --------------------------------------------------------------



| |  | regulatory actions;
| | - | -------------------



| |  | litigation;
| | - | -----------



| |  | economic and other external factors or other disasters or crises;
| | - | -----------------------------------------------------------------



| |  | period-to-period fluctuations in our financial results; and
| | - | -----------------------------------------------------------



| |  | the general performance of the equity markets and, in particular, the biotechnology sector of the equity markets.
| | - | -----------------------------------------------------------------------------------------------------------------



In the past, following periods of volatility in the market price of a
particular companys securities, securities class action litigation has often been brought against that company. We may become involved in this type of litigation in the future. Litigation of this type is often extremely expensive and diverts
managements attention and resources.



The exercise of options and
warrants and other issuances of shares will likely have a dilutive effect on our stock price.



As of September 30, 2004, there were outstanding options to purchase an aggregate of approximately 3,545,000 shares of our common stock at prices ranging
from $0.40 per share to $11.63 per share, of which options to purchase 1,868,000 shares were exercisable as of such date. As of September 30, 2004, there were outstanding warrants to purchase 1,407,266 shares of our common stock. Of this total,
warrants to purchase 167,166 shares of our common stock are currently exercisable at $3.33



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per share, subject to adjustment under the anti-dilution provisions of the warrants, and warrants to purchase 50,000
shares are currently exercisable at $3.79 per share. In May 2003, in connection with a private placement of our Series C convertible preferred stock, we issued warrants to purchase 2,000,000 shares of our common stock at an exercise price of $1.37
per share, of which 1,800,000 have been exercised and 200,000 are exercisable 18 months after issuance beginning on November 23, 2004 and may be exercised immediately if the holder elects to receive, without the payment by the holder of any
additional consideration, a number of shares of our common stock equal to the value of the warrants, also known as net exercise provisions. In January 2004, in connection with a private placement of our common stock, we issued warrants to purchase
990,100 shares of our common stock at an exercise price of $5.38 per share. In connection with an April 2002 private placement of our common stock, we granted to the placement agent warrants to purchase 100,000 shares of our common stock at an
exercise price of $2.75 per share. As of September 30, 2004, these warrants have not yet been issued.



The exercise of options and warrants at prices below the market price of our common stock could adversely affect the price of our common stock. Additional
dilution may result from the issuance of shares of our capital stock in connection with collaborations or manufacturing arrangements or in connection with other financing efforts.



Our certificate of incorporation and Delaware law contain provisions that could discourage a takeover.



Our certificate of incorporation provides our board of directors the power
to issue shares of preferred stock without stockholder approval. This preferred stock could have voting rights, including voting rights that could be superior to that of our common stock. In addition, Section 203 of the Delaware General Corporation
Law contains provisions that impose restrictions on stockholder action to acquire control of us. The effect of these provisions of our certificate of incorporation and Delaware law provisions could discourage third parties from seeking to obtain
control, even though the price at which such third parties seek to acquire our common stock is in excess of the market price for our stock.



Results of Operations



Revenues



We have
received no revenues to date from product sales. Revenues recorded to date have consisted principally of revenues recognized under collaborations with third parties. In April 2001, we entered into a research collaboration and licensing agreement
with MedImmune, Inc. to develop and commercialize therapies related to our IL9 program. MedImmune provided funding of $2.5 million, payable in eight equal quarterly installments through April 2003, plus funds external cost reimbursement for our
research and development activities. We could also receive up to $54.5 million based on successful completion of future milestones. In August 2004, we received the first of such milestone payments as a result of the initiation of Phase I clinical
trials. For the three- and nine-month periods ended September 30, 2004, we recognized $672,000 and $821,000 as revenue related to external cost reimbursements ($172,000 and $321,000) and milestone payments ($500,000 and $500,000), respectively. For
the three- and nine-month periods ended September 30, 2003, we recognized $3,000 and $651,000 as revenue related to the R&D Funding ($0 and $370,000) and external cost reimbursements ($3,000 and $281,000), respectively. No revenue related to
milestone payments was recognized during 2003.



In February
2002, the Company received a Phase II Small Business Innovative Research program grant from the National Institutes of Health (NIH) in the amount of $800,000 to support its aminosterol research program. The grant extended over a two-year
period, which ended in February 2004. In February 2004, the Company notified the NIH of a no-cost extension of the original budget period by twelve months. As a result of the notification, the grant will extend to February 2005. The Company
recognized no revenue related to this grant in the three- and nine-month periods ended September 30, 2004. The company recognized $121,000 and $349,000 as revenue related to this grant in three- and nine-month periods ended September 30, 2003,
respectively.



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In April 2004, the Company received a Phase I Small Business Innovative Research program grant from the
National Institute of Diabetes and Digestive and Kidney Diseases of the NIH in the amount of $100,000 to support its trodusquemine program. The grant extends over a one-year period ending in March 2005. The Company recognized no revenue related to
this grant during the three- and nine-month periods ended September 30, 2004.



In September 2004, the Company received a Phase I Small Business Innovative Research program grant from the National Eye Institute of the NIH in the amount of $100,000 to support its aminosterols for age-related
macular degeneration (AMD) program. The grant extends over a one-year period ending in August 2005. The company recognized no revenue related to this grant during the three- and nine-month periods ended September 30, 2004.



Research and Development Expenses



We recognized research and development expenses of $4.2 million and $1.6
million for the three- month periods ended September 30, 2004 and 2003, respectively. We recognized research and development expenses of $10.4 million and $4.4 million for the nine-month periods ended September 30, 2004 and 2003, respectively.
Research and development expenses consist principally of personnel costs, contract research, development and manufacturing costs and facility costs. Research and development expenses increased for the three- and nine- month periods ended September
30, 2004, as compared to the same period in 2003, due to increased development efforts related to squalamine for the treatment of age related macular degeneration and resulting increases in non-clinical and clinical expenses including personnel and
consulting expenses, as well as, charges related to stock compensation. The level of research and development expenses in future periods will depend principally upon the progress of our research and development programs and our capital resources.



General and Administrative Expenses



We recognized general and administrative expenses of $1.2 million and $0.7
million for the three-month periods ended September 30, 2004 and 2003, respectively. We recognized general and administrative expenses of $3.6 million and $1.9 million for the nine-month periods ended September 30, 2004 and 2003, respectively.
General and administrative expenses consist principally of personnel costs, professional fees and public company expenses. General and administrative expenses increased for the three- and nine-month periods ended September 30, 2004, as compared to
the same period in 2003, due principally to increases in personnel as a result of expanded development efforts, increased professional fees partially due to maintaining compliance with the Sarbanes-Oxley Act of 2002, and increases in public company
and investor relation expenses.



Other Income and Expense



We recognized interest income of $74,000 and $17,000 for the three-month
periods ended September 30, 2004 and 2003, respectively. We recognized interest expense of $500 and $1,000 for the three-month periods ended September 30, 2004 and 2003, respectively. We recognized interest income of $206,000 and $63,000 for the
nine-month periods ended September 30, 2004 and 2003, respectively. We recognized interest expense of $3,000 and $65,000 for the nine-month periods ended September 30, 2004 and 2003, respectively. Interest income is primarily comprised of income
generated from cash and investments. Interest expense during the nine-month period ended September 30, 2003 was primarily comprised of expense related to our indebtedness to a bank. Interest income for the three- and nine-month periods ended
September 30, 2004 increased, as compared to the same period in 2003, due to an increase in average investment balances. Interest expense for the three- and nine-month periods ended September 30, 2004 decreased, as compared to the same period in
2003, as a result of the maturity and satisfaction of our indebtedness to a bank in June 2003. We recognized a loss on the write-off of fixed assets of



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$118,000 during the nine-month period ended September 30, 2004 and a gain on the sale of assets of $257,000 during the
nine-month period ended September 30, 2003, as a result of the sale of excess research equipment.



Financial Condition, Liquidity and Capital Resources



Cash, cash equivalents and short-term investments were $21.6 million at September 30, 2004 as compared to $13.1 million at December 31, 2003. The primary use of cash was to finance our research and development
operations.



Current liabilities were $2.7 million and $2.9
million at September 30, 2004 and December 31, 2003, respectively. Current liabilities include $0.6 million due to Abbott Laboratories under our agreement with them. Long-term liabilities include $0.5 million received as a contingent award from an
affiliate of the Cystic Fibrosis Foundation, Cystic Fibrosis Foundation Therapeutics.



Our capital expenditure requirements will depend upon numerous factors, including the progress of our research and development programs, the time and cost required to obtain regulatory approvals, our ability to enter
into additional collaborative arrangements, the demand for products based on our technology, if and when such products are approved, and possible acquisitions of products, technologies and companies. We had no significant commitments for capital
expenditures as of September 30, 2004.



We regularly explore
alternative means of financing our operations and seek funding through various sources, including public and private securities offerings, collaborative arrangements with third parties and other strategic alliances and business transactions. We
currently do not have any commitments to obtain additional funds and may be unable to obtain sufficient funding in the future on acceptable terms, if at all. If we cannot obtain funding, we will need to delay, scale back or eliminate research and
development programs or enter into collaborations with third parties to commercialize potential products or technologies that we might otherwise seek to develop or commercialize ourselves, or seek other arrangements. If we engage in collaborations,
we will receive lower consideration upon commercialization of such products than if we had not entered into such arrangements, or if we entered into such arrangements at later stages in the product development process. Additional factors that may
impact our ability to raise capital are described under Risk Factors Related to Our Business.



Recent Developments



On
September 30, 2004, we were notified by the FDA that the FDA had granted Fast Track designation to squalamine, an intravenously administered, first in class, small molecule anti-angiogenic drug for the treatment of wet age-related
macular degeneration. Under the FDA Modernization Act of 1997, Fast Track drug development programs are designed to expedite the review and facilitate the development of a new drug that demonstrates the potential to address unmet medical needs for
the treatment of a serious life-threatening condition.



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Contractual Cash Obligations



The table below sets forth our contractual cash obligations at September 30, 2004 (in thousands):



|                                                        |  |       |       |                             |   |           |  |           |     |               |   |   |  |   |  
|------------------------------------------------------- |  | ----- | ----- | --------------------------- | - | --------- |  | --------- | --- | ------------- | - | - |  | - | -
|                                                        |  |       |       | Cash Payments Due by Period
|Contractual Cash Obligations                            |  | Total |       | Less than 1 year            |   | 1-3 years |  | 4-5 years |     | After 5 years
|Abbott settlement                                       |  | $     | 563   |                             | $ | 563       |  | $         |    |               | $ |  |  | $ | 
|Operating lease on building1                            |  |       | 1,249 |                             |   | 380       |  |           | 869 |               |   |  |  |   | 
|Manufacturing contracts                                 |  |       | 655   |                             |   | 655       |  |           |    |               |   |  |  |   | 
|Operating leases and maintenance contracts on equipment |  |       | 179   |                             |   | 102       |  |           | 77  |               |   |  |  |   | 
|Clinical trial contracts                                |  |       | 244   |                             |   | 244       |  |           |    |               |   |  |  |   | 
|Research and development contracts                      |  |       | 259   |                             |   | 227       |  |           | 32  |               |   |  |  |   | 
|                                                        |  |       |       |                             |   |           |  |           |     |               |   |   |  |   |  
|Total contractual cash obligations                      |  | $     | 3,149 |                             | $ | 2,171     |  | $         | 978 |               | $ |  |  | $ | 
|                                                        |  |       |       |                             |   |           |  |           |     |               |   |   |  |   |  

---

|1 | The lease provides for annual escalations relating to increases in the Consumer Price Index not to exceed 7% but no less than 3.5% beginning in December 2002. We
have assumed an annual minimum lease payment escalation of 3.5% for the purposes of this table.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



We are exposed to risks associated with interest rate changes. Our exposure to market risk for changes in interest rates relates primarily to our
investment portfolio. We invest in only U.S. government debt instruments that meet high quality credit standards, as specified in our investment policy. The policy also limits the amount of credit exposure we may have to any one issue, issuer or
type of investment.



As of September 30, 2004, our portfolio
investments consisted of $9.6 million in cash and cash equivalents and $12.0 million in U.S government debt instruments having a maturity of less than one year. Due to the nature of our investment portfolio, management believes that a sudden change
in interest rates would not have a material effect on the value of the portfolio. Management estimates that if the average annualized yield of our investments had decreased by 100 basis points, our interest income for the nine-month period ended
September 30, 2004 would have decreased by approximately $200,000. This estimate assumes that the decrease occurred on the first day of 2004 and reduced the annualized yield of each investment instrument by 100 basis points. Correspondingly, if the
average annualized yield of our investments had increased by 100 basis points, our interest income for the nine-month period ended September 30, 2004 would have increased by $200,000. This estimate assumes that the increase occurred on the first day
of 2004 and increased the annualized yield of each investment instrument by 100 basis points. The impact on our future interest income will depend largely on the gross amount of our investment portfolio.



We do not currently have any significant direct foreign currency exchange
rate risk.



ITEM 4. CONTROLS AND PROCEDURES



(a) Evaluation of disclosure controls and procedures: For the quarterly period ended September 30, 2004, we carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief
Executive Officer and our Executive Vice President and Chief Financial Officer (the principal financial and accounting officer), of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rules 13a-14 and
15d-14 under the Securities Exchange Act of 1934, as amended (the Exchange Act). Based upon this evaluation, our President and Chief Executive Officer and our Executive Vice President and Chief Financial Officer concluded that, as of
September 30, 2004, our disclosure controls and procedures provided reasonable assurance that information required to be disclosed by us in the reports filed or submitted by us under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in the rules and forms of the Securities and Exchange Commission. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and
the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.



(b) Internal control over financial reporting: No change in our internal
control over financial reporting (as defined in the Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2004 that has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting.



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PART II - OTHER INFORMATION



ITEM 1.    LEGAL PROCEEDINGS



On August 4, 2003, a lawsuit was filed against the Company by Perceptive Life Sciences Master Fund, LTD in the United States District Court for the Eastern District of Pennsylvania alleging the existence and
subsequent breaches of certain contractual obligations by the Company in connection with its sale of shares of Series C Preferred Stock in May 2003. The plaintiff is seeking monetary damages from the Company or a judgment by the court that the
Company should specifically perform the terms of an alleged agreement related to such sale. The Company believes that this lawsuit is without merit and intends to defend it vigorously.



ITEM 2.    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS



None.



ITEM 3.    DEFAULTS UPON SENIOR SECURITIES



None.



ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



None.



ITEM 5.    OTHER INFORMATION



None.



ITEM 6. EXHIBITS



Exhibits



|     |  |                                                                                                                                                                                                                           
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.1 |  | Change in Control Agreement with Roy C. Levitt, M.D.                                                                                                                                                                      
|     | 
|10.2 |  | Change in Control Agreement with John L. Armstrong, Jr.                                                                                                                                                                   
|     | 
|10.3 |  | Change in Control Agreement with John A. Skolas                                                                                                                                                                           
|     | 
|31.1 |  | Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002
|     | 
|31.2 |  | Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002
|     | 
|32.1 |  | Certification of Chief Executive Officer 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 Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002                                                                         



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SIGNATURES



Pursuant to the
requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                       |  |                     |  |                                                                                                  
|---------------------- |  | ------------------- |  | -------------------------------------------------------------------------------------------------
|                       |  | GENAERA CORPORATION
|                       |  |                    
|Date: November 9, 2004 |  | By:                 |  | /s/ John A. Skolas                                                                               
|                       |  |                     |  | John A. Skolas                                                                                   
|                       |  |                     |  | Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)



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EXHIBIT INDEX



|            |  |                                                                                                                                                                                                                           
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                               
|10.1        |  | Change in Control Agreement with Roy C. Levitt, M.D.                                                                                                                                                                      
|            | 
|10.2        |  | Change in Control Agreement with John L. Armstrong, Jr.                                                                                                                                                                   
|            | 
|10.3        |  | Change in Control Agreement with John A. Skolas                                                                                                                                                                           
|            | 
|31.1        |  | Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002
|            | 
|31.2        |  | Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002
|            | 
|32.1        |  | Certification of Chief Executive Officer 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 Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002                                                                         



28