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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 March 31, 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 is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



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 ̈



The number of outstanding shares of the Registrants Common Stock, par value $.002 per share, on May 7, 2004 was
52,420,102.



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##### Table of Contents

GENAERA CORPORATION

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED March 31, 2004



TABLE OF CONTENTS



|                                                                                                |  |     
|----------------------------------------------------------------------------------------------- |  | ----
|                                                                                                |  | Page
|PART I - FINANCIAL INFORMATION                                                                  |  |     
|                                                                                                | 
|Item 1.
Consolidated Financial Statements (unaudited):                                          |  |     
|                                                                                                | 
|Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003                          |  | 3   
|                                                                                                | 
|Consolidated Statements of Operations for the three-month periods ended March 31, 2004 and 2003 |  | 4   
|                                                                                                | 
|Consolidated Statements of Cash Flows for the three-month periods ended March 31, 2004 and 2003 |  | 5   
|                                                                                                | 
|Notes to Consolidated Financial Statements                                                      |  | 6   
|                                                                                                | 
|Item 2.
Managements Discussion and Analysis of Financial Condition and Results of Operations   |  | 11  
|                                                                                                | 
|Item 3.
Quantitative and Qualitative Disclosures about Market Risk                              |  | 23  
|                                                                                                | 
|Item 4.
Controls and Procedures                                                                 |  | 23  
|                                                                                                | 
|PART II - OTHER INFORMATION                                                                     |  |     
|                                                                                                | 
|Item 1.
Legal Proceedings                                                                       |  | 24  
|                                                                                                | 
|Item 2.
Changes in Securities and Use of Proceeds                                               |  | 24  
|                                                                                                | 
|Item 3.
Defaults Upon Senior Securities                                                         |  | 24  
|                                                                                                | 
|Item 4.
Submission of Matters to a Vote of Security Holders                                     |  | 24  
|                                                                                                | 
|Item 5.
Other Information                                                                       |  | 24  
|                                                                                                | 
|Item 6.
Exhibits and Reports on Form 8-K                                                        |  | 24  
|                                                                                                | 
|SIGNATURES                                                                                      |  | 26  



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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)



|                                                                                                                                                                          |  |                |          |   |                   |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                          |  | March 31, 2004 |          |   | December 31, 2003 |  
|ASSETS                                                                                                                                                                    |  |                |          |   |                   |   |          |  
|Current assets:                                                                                                                                                           |  |                |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                                 |  | $              | 10,242   |   |                   | $ | 6,625    |  
|Short-term investments                                                                                                                                                    |  |                | 18,952   |   |                   |   | 6,510    |  
|Prepaid expenses and other current assets                                                                                                                                 |  |                | 723      |   |                   |   | 264      |  
|                                                                                                                                                                          |  |                |          |   |                   |   |          |  
|Total current assets                                                                                                                                                      |  |                | 29,917   |   |                   |   | 13,399   |  
|Fixed assets, net                                                                                                                                                         |  |                | 1,003    |   |                   |   | 1,095    |  
|Other assets                                                                                                                                                              |  |                | 59       |   |                   |   | 59       |  
|                                                                                                                                                                          |  |                |          |   |                   |   |          |  
|Total assets                                                                                                                                                              |  | $              | 30,979   |   |                   | $ | 14,553   |  
|                                                                                                                                                                          |  |                |          |   |                   |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                      |  |                |          |   |                   |   |          |  
|Current liabilities:                                                                                                                                                      |  |                |          |   |                   |   |          |  
|Accounts payable and accrued expenses                                                                                                                                     |  | $              | 2,571    |   |                   | $ | 1,917    |  
|Accrued development expense  short-term (NOTE 8)                                                                                                                         |  |                | 563      |   |                   |   | 966      |  
|                                                                                                                                                                          |  |                |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                                 |  |                | 3,134    |   |                   |   | 2,883    |  
|                                                                                                                                                                          |  |               
|Accrued development expense - long-term (NOTE 8)                                                                                                                          |  |                |         |   |                   |   | 563      |  
|Other liabilities                                                                                                                                                         |  |                | 578      |   |                   |   | 485      |  
|                                                                                                                                                                          |  |                |          |   |                   |   |          |  
|Total liabilities                                                                                                                                                         |  |                | 3,712    |   |                   |   | 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 March 31, 2004 and December 31, 2003
(NOTE 4)                        |  |                |         |   |                   |   |         |  
|Common stock - $.002 par value per share; 75,000 shares authorized; 52,232 and 47,024 shares issued and outstanding at March 31, 2004 and
December 31, 2003, respectively |  |                | 104      |   |                   |   | 94       |  
|Additional paid-in capital                                                                                                                                                |  |                | 226,820  |   |                   |   | 205,826  |  
|Accumulated other comprehensive income - unrealized gain on investments                                                                                                   |  |                | 4        |   |                   |   |         |  
|Accumulated deficit                                                                                                                                                       |  |                | (199,661 | ) |                   |   | (195,298 | )
|                                                                                                                                                                          |  |                |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                                |  |                | 27,267   |   |                   |   | 10,622   |  
|                                                                                                                                                                          |  |                |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                                                                |  | $              | 30,979   |   |                   | $ | 14,553   |  
|                                                                                                                                                                          |  |                |          |   |                   |   |          |  



See accompanying notes
to 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 Ended March 31, |       
|                                                                         |  | 2004                         |        |   | 2003 |  
|Collaborative research agreement and grant revenues                      |  | $                            | 136    |   |      | $ | 487    |  
|                                                                         |  |                              |        |   |      |   |        |  
|                                                                         |  |                             
|Costs and expenses:                                                      |  |                              |        |   |      |   |        |  
|Research and development                                                 |  |                              | 3,137  |   |      |   | 1,734  |  
|General and administrative                                               |  |                              | 1,426  |   |      |   | 457    |  
|                                                                         |  |                              |        |   |      |   |        |  
|                                                                         |  |                              | 4,563  |   |      |   | 2,191  |  
|                                                                         |  |                              |        |   |      |   |        |  
|Loss from operations                                                     |  |                              | (4,427 | ) |      |   | (1,704 | )
|Interest income                                                          |  |                              | 65     |   |      |   | 24     |  
|Interest expense                                                         |  |                              | (1     | ) |      |   | (34    | )
|Gain on sale of equipment                                                |  |                              |       |   |      |   | 130    |  
|                                                                         |  |                              |        |   |      |   |        |  
|Net loss                                                                 |  |                              | (4,363 | ) |      |   | (1,584 | )
|Dividends on preferred stock                                             |  |                              |       |   |      |   | 18     |  
|                                                                         |  |                              |        |   |      |   |        |  
|Net loss applicable to common stockholders                               |  | $                            | (4,363 | ) |      | $ | (1,602 | )
|                                                                         |  |                              |        |   |      |   |        |  
|Net loss applicable to common stockholders per share  basic and diluted |  | $                            | (0.09  | ) |      | $ | (0.04  | )
|                                                                         |  |                              |        |   |      |   |        |  
|Weighted average shares outstanding  basic and diluted                  |  |                              | 51,027 |   |      |   | 35,666 |  
|                                                                         |  |                              |        |   |      |   |        |  



See accompanying notes
to financial statements.



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##### Table of Contents

GENAERA CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Amounts in thousands)



|                                                                            |  |                              |         |   |      |   |        |  
|--------------------------------------------------------------------------- |  | ---------------------------- | ------- | - | ---- | - | ------ | -
|                                                                            |  | Three Months Ended March 31, |        
|                                                                            |  | 2004                         |         |   | 2003 |  
|Cash Flows From Operating Activities:                                       |  |                              |         |   |      |   |        |  
|Net loss                                                                    |  | $                            | (4,363  | ) |      | $ | (1,584 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                              |         |   |      |   |        |  
|Depreciation and amortization                                               |  |                              | 103     |   |      |   | 112    |  
|Amortization of investment discounts/premiums                               |  |                              | (24     | ) |      |   | (21    | )
|Compensation expense on option grants and equity awards                     |  |                              | 272     |   |      |   | 21     |  
|Gain on sale of fixed assets                                                |  |                              |        |   |      |   | (130   | )
|Changes in operating assets and liabilities:                                |  |                              |         |   |      |   |        |  
|Prepaid expenses and other assets                                           |  |                              | (459    | ) |      |   | (178   | )
|Accounts payable and accrued expenses                                       |  |                              | 654     |   |      |   | 28     |  
|Accrued development expenses                                                |  |                              | (966    | ) |      |   |       |  
|Other liabilities                                                           |  |                              | 93      |   |      |   | 8      |  
|                                                                            |  |                              |         |   |      |   |        |  
|Net cash used in operating activities                                       |  |                              | (4,690  | ) |      |   | (1,744 | )
|                                                                            |  |                              |         |   |      |   |        |  
|Cash Flows From Investing Activities:                                       |  |                              |         |   |      |   |        |  
|Purchase of investments                                                     |  |                              | (19,914 | ) |      |   | (5,785 | )
|Proceeds from maturities of investments                                     |  |                              | 7,500   |   |      |   | 6,550  |  
|Proceeds from sale of fixed assets                                          |  |                              |        |   |      |   | 130    |  
|Capital expenditures                                                        |  |                              | (11     | ) |      |   | (21    | )
|                                                                            |  |                              |         |   |      |   |        |  
|Net cash provided by (used in) investing activities                         |  |                              | (12,425 | ) |      |   | 874    |  
|                                                                            |  |                              |         |   |      |   |        |  
|Cash Flows From Financing Activities:                                       |  |                              |         |   |      |   |        |  
|Net proceeds from issuance of common stock                                  |  |                              | 19,925  |   |      |   |       |  
|Proceeds from exercise of stock options and warrants                        |  |                              | 807     |   |      |   |       |  
|                                                                            |  |                              |         |   |      |   |        |  
|Net cash provided by financing activities                                   |  |                              | 20,732  |   |      |   |       |  
|                                                                            |  |                              |         |   |      |   |        |  
|Net increase (decrease) in cash and cash equivalents                        |  |                              | 3,617   |   |      |   | (870   | )
|Cash and cash equivalents at beginning of period                            |  |                              | 6,625   |   |      |   | 1,368  |  
|                                                                            |  |                              |         |   |      |   |        |  
|Cash and cash equivalents at end of period                                  |  | $                            | 10,242  |   |      | $ | 498    |  
|                                                                            |  |                              |         |   |      |   |        |  
|Supplemental Cash Flow Information:                                         |  |                              |         |   |      |   |        |  
|Cash paid during the period for interest                                    |  | $                            | 1       |   |      | $ | 34     |  
|                                                                            |  |                              |         |   |      |   |        |  



See accompanying notes
to financial statements.





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##### Table of Contents

GENAERA CORPORATION

NOTES TO 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 accounting principles generally
accepted in the United States of America 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 with the current year presentation.



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, and 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-month periods ended March 31, 2004 and 2003 (in thousands, except per share amounts).



|                                                                                                                                                                |  |                              |        |   |      |   |        |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                                                                                                |  | Three Months Ended March 31, |       
|                                                                                                                                                                |  | 2004                         |        |   | 2003 |  
|Net loss applicable to common stockholders, as reported                                                                                                         |  | $                            | (4,363 | ) |      | $ | (1,602 | )
|Add: Stock-based employee compensation expense included in reported net loss applicable to common stockholders, net of related tax effects, if
any              |  |                              | 104    |   |      |   |       |  
|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 |  |                              | (383   | ) |      |   | (314   | )
|                                                                                                                                                                |  |                              |        |   |      |   |        |  
|Pro forma net loss applicable to common stockholders                                                                                                            |  | $                            | (4,642 | ) |      | $ | (1,916 | )
|                                                                                                                                                                |  |                              |        |   |      |   |        |  
|Net loss applicable to common stockholders per share  basic and diluted:                                                                                       |  |                              |        |   |      |   |        |  
|As reported                                                                                                                                                     |  | $                            | (0.09  | ) |      | $ | (0.04  | )
|                                                                                                                                                                |  |                              |        |   |      |   |        |  
|Pro forma                                                                                                                                                       |  | $                            | (0.09  | ) |      | $ | (0.05  | )
|                                                                                                                                                                |  |                              |        |   |      |   |        |  



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GENAERA CORPORATION

NOTES TO 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.
There were no grants made during the three month period ended March 31, 2003. The fair value of each option grant for 2004 is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:



|                                                                 |  |      |              |  
|---------------------------------------------------------------- |  | ---- | ------------ | -
|                                                                 |  | 2004 |             
|Range of risk free interest rates                                |  |      | 3.04% - 3.36 | %
|Dividend yield                                                   |  |      | 0            | %
|Volatility factor                                                |  |      | 121          | %
|Weighted average expected life of options (in years)             |  |      | 6.0          |  
|Weighted average fair value of options granted during the period |  | $    | 3.72         |  



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). The Exposure Draft would eliminate the ability to account for share-based compensation transactions using APB 25 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 March 31, 2004 are summarized as follows (in thousands):



|                                                                                     |  |                 |  |                            |     |                                        |   |                     |  |   |                            |  |   |          |   |  |   |        |  
|------------------------------------------------------------------------------------ |  | --------------- |  | -------------------------- | --- | -------------------------------------- | - | ------------------- |  | - | -------------------------- |  | - | -------- | - |  | - | ------ | -
|                                                                                     |  | Common Stock    |  | Additional Paid-in Capital |     | Accumulated Other Comprehensive Income |   | Accumulated Deficit |  |   | Total Stockholders 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 |  | 258             |  |                            |    |                                        |   | 1,079               |  |   |                           |  |   |         |   |  |   | 1,079  |  
|Common stock issued pursuant to private placement                                    |  | 4,950           |  |                            | 10  |                                        |   | 19,915              |  |   |                           |  |   |         |   |  |   | 19,925 |  
|Comprehensive loss:                                                                  |  |                 |  |                            |     |                                        |   |                     |  |   |                            |  |   |          |   |  |   |        |  
|Net loss                                                                             |  |                |  |                            |    |                                        |   |                    |  |   |                           |  |   | (4,363   | ) |  |   | (4,363 | )
|Unrealized gain on investments                                                       |  |                |  |                            |    |                                        |   |                    |  |   | 4                          |  |   |         |   |  |   | 4      |  
|                                                                                     |  |                 |  |                            |     |                                        |   |                     |  |   |                            |  |   |          |   |  |   |        |  
|Total comprehensive loss                                                             |  |                |  |                            |    |                                        |   |                    |  |   | 4                          |  |   | (4,363   | ) |  |   | (4,359 | )
|                                                                                     |  |                 |  |                            |     |                                        |   |                     |  |   |                            |  |   |          |   |  |   |        |  
|Balance at March 31, 2004                                                            |  | 52,232          |  | $                          | 104 |                                        | $ | 226,820             |  | $ | 4                          |  | $ | (199,661 | ) |  | $ | 27,267 |  
|                                                                                     |  |                 |  |                            |     |                                        |   |                     |  |   |                            |  |   |          |   |  |   |        |  



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



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GENAERA CORPORATION

NOTES TO FINANCIAL STATEMENTS



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 March 31, 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 $19,925,000 after offering costs of approximately $75,000. 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 are 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 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 March 31, 2004, 200,000 of such warrants are outstanding at an exercise price of $1.37 per share.



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/consolidation.



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GENAERA CORPORATION

NOTES TO FINANCIAL STATEMENTS



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. MedImmune provided funding of $2,500,000 for research and development activities at the
Company through April 2003 (the R&D Funding), which had been recognized by the Company as revenues on a straight-line basis over the two-year period. 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. For the three-month period ended March 31, 2004, the Company
recognized $133,000 as revenue related to the R&D Funding (none) and external cost reimbursements ($133,000). For the three-month periods ended March 31, 2003, the Company recognized $487,000 as revenue related to the R&D Funding ($308,000)
and external cost reimbursements ($179,000).



In September
2001, the Company received a contingent award of up to $1.7 million from an affiliate of the Cystic Fibrosis Foundation (CFF) 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 was received as of March 31, 2004 and was recorded as a long-term liability. The Company did not recognize this amount as revenue as it
is refundable to the CFF 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. The CFF is also due a royalty
on net sales of any resultant product up to 1% based upon the amount of funding ultimately provided by the CFF.



In February 2002, the Company received a Phase II Small Business Innovative Research program grant from the National Institutes of Health 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. The company recognized no revenue related to this grant in the three-month period ended March 31, 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 a period of twelve months in the case of the President and Executive Vice Presidents or six months in the case of the Senior Vice
Presidents. In either case, continuation of pay will cease upon the attainment of full time employment elsewhere.



On March 25, 2004, an executive ceased to be an employee of the Company. The Company recorded $351,000 of continuing compensation and stock compensation
expense for the three-month period ended March 31, 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



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GENAERA CORPORATION

NOTES TO FINANCIAL STATEMENTS



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 March 31, 2004, as it is due and payable to Abbott on
March 1, 2005 as a result of the Companys financing activities during the three-month period ended March 31, 2004, and other cash inflows.



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 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 the proceeds of this offering in addition to its current cash and investments as of March 31, 2004, are sufficient to meet its research and
development goals and sustain operations at least through the first half of 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.



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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 accounting principles generally accepted in the United States 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 presented in our financial statements and 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, and facility costs. 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. Research and development expenses also include external activities such as investigator-sponsored trials. 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 $29.2 million at March 31, 2004. At March 31 2004, we had current liabilities of $3.1 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 meet our
research and development goals and sustain operations at least through the first half of 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 March 31, 2004, we had an accumulated deficit
of approximately $199.7 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



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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
| | - | -------------------------------------------------------------------------------



| |  | 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.



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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 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, age-related macular degeneration (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.



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.



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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 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



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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;
| | - | ---------------------------------------------------------------------



| |  | 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.



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.



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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.



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.



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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 March 31, 2004, there were outstanding options to purchase an aggregate of approximately 3,852,000 shares of our common stock at prices ranging from
$0.40 per share to $11.63 per share, of which options to purchase 2,280,000 shares were exercisable as of such date. As of March 31, 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 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



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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 March 31, 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. For the three-month period ended March 31, 2004 and 2003, we recognized $133,000 and $487,000, respectively, in revenue related to this agreement, of which $133,000 and $179,000, respectively, related to external
cost reimbursements.



In February 2002, the Company received a
Phase II Small Business Innovation Research program grant from the National Institutes of Health in the amount of $800,000 to support our aminosterol research program. The grant extended over a two-year period and ended in February 2002. The Company
recognized no revenue related to this grant in the three-month periods ended March 31, 2004 and 2003.



Research and Development Expenses



We recognized research and development expenses of $3.1 million and $1.7 million for the three-month periods ended March 31, 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-month period ended March 31, 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. The increase in expenses was partially offset
by a decrease in expenses related to Phase I/II clinical trials. 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.



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General and Administrative Expenses



We recognized general and administrative expenses of $1.4 million and $451,000 for the three-month periods ended March 31,
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-month period ended March 31, 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, charges related to stock compensation and a charge related to continuing compensation for a
former executive.



Other Income and Expense



We recognized interest income of $65,000 and $24,000 for the three-month
periods ended March 31, 2004 and 2003, respectively. We recognized interest expense of $1,000 and $34,000 for the three-month periods ended March 31, 2004 and 2003, respectively. Interest income is primarily comprised of income generated from cash
and investments. Interest expense during the three-month period ended March 31, 2003 was primarily comprised of expense related to our indebtedness to a bank. Interest income for the three-month period ended March 31, 2004 increased, as compared to
the same period in 2003, due to an increase in average investment balances. Interest expense for the three-month period ended March 31, 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 gain on the sale of assets of $130,000 during the three-month period ended March 31, 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 $29.2 million at
March 31, 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 $3.1 million and $2.9 million at March 31, 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 the Cystic Fibrosis Foundation.



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 March 31, 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.



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Contractual Cash Obligations



The table below sets forth our contractual cash obligations at March 31, 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                            |  |       | 1,434 |                             |   | 374       |  |           | 1,060 |               |   |  |  |   | 
|Operating leases and maintenance contracts on equipment |  |       | 337   |                             |   | 231       |  |           | 106   |               |   |  |  |   | 
|Clinical trial contracts                                |  |       | 318   |                             |   | 318       |  |           |      |               |   |  |  |   | 
|Research and development contracts                      |  |       | 196   |                             |   | 164       |  |           | 32    |               |   |  |  |   | 
|Manufacturing contracts                                 |  |       | 97    |                             |   | 97        |  |           |      |               |   |  |  |   | 
|                                                        |  |       |       |                             |   |           |  |           |       |               |   |   |  |   |  
|Total contractual cash obligations                      |  | $     | 2,945 |                             | $ | 1,747     |  | $         | 1,198 |               | $ |  |  | $ | 
|                                                        |  |       |       |                             |   |           |  |           |       |               |   |   |  |   |  

---

|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 March 31, 2004, our portfolio
investments consisted of $10.2 million in cash and cash equivalents and $19.0 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 three-month period ended
March 31, 2004 would have decreased by approximately $65,000. 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 three-month period ended March 31, 2004 would have increased by $77,000. 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 March 31, 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 Senior 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 Senior Vice President and Chief Financial Officer concluded that, as of March
31, 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 March 31, 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. CHANGES IN SECURITIES AND USE OF PROCEEDS



In January 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 $19,925,000 after offering costs of approximately $75,000. 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. The warrants have an exercise price of $5.38 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/consolidation.
The shares and warrants for shares were sold pursuant to the Companys shelf registration statement on Form S-3 (File No. 333-73798), and the proceeds form such sale are being used for working capital and general corporate purposes.



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 AND REPORTS ON FORM 8-K



| | (a) | Exhibits
| | --- | --------



|     |  |                                                                                                                                                                                                                           
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|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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| | (b) | Reports on Form 8-K
| | --- | -------------------



We filed a Current Report on Form 8-K on January 13, 2004 incorporating a press release regarding the election of Osagie O. Imasogie to our Board of
Directors.



We filed a Current Report on Form 8-K on January
22, 2004 incorporating a press release regarding the closing of the sale, to four institutional investors in a registered direct offering, of 4,950,500 shares of its common stock at a purchase price of $4.04 per share, for aggregate gross proceeds
of approximately $20 million and the issuance of an aggregate of 990,100 warrants, with an exercise price of $5.38 per share, to purchase 990,100 shares of commons stock to the same institutional investors.



We filed a Current Report on Form 8-K on March 26, 2004 incorporating a
press release regarding the financial results for the year and quarter ended December 31, 2003.



We filed a Current Report on Form 8-K on March 26, 2004 incorporating a press release regarding appointment of Roger Vogel, M.D. as Acting Chief Medical
Officer and the announcement that Kenneth Holroyd, MD, MBA, has stepped down as Chief Operating Officer and Executive Vice President of Genaera to pursue other interests.



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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: May 10, 2004 |  | By:                 |  | /s/ John A. Skolas                                                                            
|                   |  |                     |  | John A. Skolas                                                                                
|                   |  |                     |  | Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)





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EXHIBIT INDEX



|            |  |                                                                                                                                                                                                                           
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                               
|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                                                                         



27