##### Table of Contents

---



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



---



FORM 10-Q

(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, 2005



OR



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



Commission File Number: 000-30347



---



CURIS, INC.

(Exact Name of Registrant as Specified in Its Charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 04-3505116                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|61 Moulton Street Cambridge, Massachusetts                     |  | 02138                               
|(Address of Principal Executive Offices)                       |  | (Zip Code)                          



Registrants
Telephone Number, Including Area Code: (617) 503-6500



---



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.    x  Yes ̈No



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



As of April 27, 2005, there were
47,900,726 shares of the Registrants common stock outstanding.





---



---

##### Table of Contents

CURIS, INC. AND SUBSIDIARY

QUARTERLY REPORT ON FORM 10-Q



INDEX



|               |  |                                                                                                                             |  |            
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------- |  | -----------
|PART I.        |  | FINANCIAL INFORMATION                                                                                                       |  | Page Number
|               |  |                                                                                                                            
|Item 1.        |  | Financial Statements                                                                                                        |  |            
|               |  |                                                                                                                            
|               |  | Condensed Consolidated Balance Sheets as of March 31, 2005 (unaudited) and December 31, 2004                                |  | 3          
|               |  |                                                                                                                            
|               |  | Consolidated Statements of Operations and Comprehensive Loss for the Three Months ended March 31, 2005 and 2004 (unaudited) |  | 4          
|               |  |                                                                                                                            
|               |  | Consolidated Statements of Cash Flows for the Three Months ended March 31, 2005 and 2004 (unaudited)                        |  | 5          
|               |  |                                                                                                                            
|               |  | Notes to Unaudited Condensed 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                                                                  |  | 33         
|               |  |                                                                                                                            
|Item 4.        |  | Controls and Procedures                                                                                                     |  | 33         
|               |  |                                                                                                                            
|PART II.       |  | OTHER INFORMATION                                                                                                           |  |            
|               |  |                                                                                                                            
|Item 6.        |  | Exhibits                                                                                                                    |  | 34         
|               | 
|SIGNATURE      |  | 35                                                                                                                         
|               | 
|CERTIFICATIONS |  |                                                                                                                            



2



---

##### Table of Contents

PART IFINANCIAL INFORMATION



Item 1.    FINANCIAL STATEMENTS



CURIS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ------------ | - | ---------------- | - | ------------ | -
|                                                                                                                                                                                                                                                                                              |  | March 31, 2005 |              |   | December 31,2004 |  
|                                                                                                                                                                                                                                                                                              |  | (unaudited)    |              |   |                  |  
|ASSETS                                                                                                                                                                                                                                                                                        |  |                |              |   |                  |   |              |  
|Current Assets:                                                                                                                                                                                                                                                                               |  |                |              |   |                  |   |              |  
|Cash and cash equivalents                                                                                                                                                                                                                                                                     |  | $              | 17,530,187   |   |                  | $ | 22,679,924   |  
|Marketable securities                                                                                                                                                                                                                                                                         |  |                | 28,365,465   |   |                  |   | 26,834,038   |  
|Accounts receivable                                                                                                                                                                                                                                                                           |  |                | 2,089,904    |   |                  |   | 1,226,460    |  
|Prepaid expenses and other current assets                                                                                                                                                                                                                                                     |  |                | 1,286,919    |   |                  |   | 843,198      |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|Total current assets                                                                                                                                                                                                                                                                          |  |                | 49,272,475   |   |                  |   | 51,583,620   |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|Property and Equipment, net                                                                                                                                                                                                                                                                   |  |                | 4,165,719    |   |                  |   | 3,416,620    |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|Other Assets:                                                                                                                                                                                                                                                                                 |  |                |              |   |                  |   |              |  
|Long-term investments                                                                                                                                                                                                                                                                         |  |                | 1,048,348    |   |                  |   | 2,606,681    |  
|Long-term investmentsrestricted                                                                                                                                                                                                                                                              |  |                | 193,166      |   |                  |   | 193,166      |  
|Goodwill, net                                                                                                                                                                                                                                                                                 |  |                | 8,982,000    |   |                  |   | 8,982,000    |  
|Other intangible assets, net                                                                                                                                                                                                                                                                  |  |                | 83,353       |   |                  |   | 102,122      |  
|Deposits and other assets                                                                                                                                                                                                                                                                     |  |                | 488,164      |   |                  |   | 750,604      |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|Total other assets                                                                                                                                                                                                                                                                            |  |                | 10,795,031   |   |                  |   | 12,634,573   |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|                                                                                                                                                                                                                                                                                              |  | $              | 64,233,225   |   |                  | $ | 67,634,813   |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                                                                                                          |  |                |              |   |                  |   |              |  
|Current Liabilities:                                                                                                                                                                                                                                                                          |  |                |              |   |                  |   |              |  
|Debt obligations, current portion                                                                                                                                                                                                                                                             |  | $              | 751,595      |   |                  | $ | 1,141,294    |  
|Accounts payable                                                                                                                                                                                                                                                                              |  |                | 1,234,627    |   |                  |   | 1,643,219    |  
|Accrued liabilities                                                                                                                                                                                                                                                                           |  |                | 2,389,865    |   |                  |   | 1,078,687    |  
|Deferred revenue, current portion                                                                                                                                                                                                                                                             |  |                | 4,062,895    |   |                  |   | 1,939,708    |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|Total current liabilities                                                                                                                                                                                                                                                                     |  |                | 8,438,982    |   |                  |   | 5,802,908    |  
|Long-term debt obligations, net of current portion                                                                                                                                                                                                                                            |  |                | 1,500,000    |   |                  |   |             |  
|Convertible notes payable                                                                                                                                                                                                                                                                     |  |                | 2,460,325    |   |                  |   | 5,710,007    |  
|Deferred revenue, net of current portion                                                                                                                                                                                                                                                      |  |                | 4,344,909    |   |                  |   | 6,941,545    |  
|Other long-term liabilities                                                                                                                                                                                                                                                                   |  |                | 380,993      |   |                  |   | 271,058      |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|Total liabilities                                                                                                                                                                                                                                                                             |  |                | 17,125,209   |   |                  |   | 18,725,518   |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|Commitments                                                                                                                                                                                                                                                                                   |  |                |              |   |                  |   |              |  
|Stockholders Equity:                                                                                                                                                                                                                                                                         |  |                |              |   |                  |   |              |  
|Common stock, $0.01 par value125,000,000 shares authorized at March 31, 2005 and December 31, 2004; 48,930,583 and 47,882,876 shares
issued and outstanding, respectively, at March 31, 2005 and 48,565,120 and 47,517,413 shares issued and outstanding, respectively, at December 31, 2004 |  |                | 489,306      |   |                  |   | 485,652      |  
|Additional paid-in capital                                                                                                                                                                                                                                                                    |  |                | 716,124,121  |   |                  |   | 713,202,427  |  
|Treasury stock (at cost, 1,047,707 shares at March 31, 2005 and December 31, 2004)                                                                                                                                                                                                            |  |                | (891,274     | ) |                  |   | (891,274     | )
|Deferred compensation                                                                                                                                                                                                                                                                         |  |                | (433,841     | ) |                  |   | (834,157     | )
|Accumulated deficit                                                                                                                                                                                                                                                                           |  |                | (668,085,651 | ) |                  |   | (662,972,709 | )
|Accumulated other comprehensive income                                                                                                                                                                                                                                                        |  |                | (94,645      | ) |                  |   | (80,644      | )
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|Total stockholders equity                                                                                                                                                                                                                                                                    |  |                | 47,108,016   |   |                  |   | 48,909,295   |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  
|                                                                                                                                                                                                                                                                                              |  | $              | 64,233,225   |   |                  | $ | 67,634,813   |  
|                                                                                                                                                                                                                                                                                              |  |                |              |   |                  |   |              |  



See accompanying notes
to unaudited consolidated financial statements.



3



---

##### Table of Contents

CURIS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (unaudited)



|                                                                                                   |  |                              |            |   |      |   |            |  
|-------------------------------------------------------------------------------------------------- |  | ---------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                                                   |  | Three Months Ended March 31, |           
|                                                                                                   |  | 2005                         |            |   | 2004 |  
|REVENUES:                                                                                          |  |                              |            |   |      |   |            |  
|Gross revenues                                                                                     |  | $                            | 2,771,771  |   |      | $ | 855,805    |  
|Contra-revenues from co-development with Genentech (Note 3)                                        |  |                              | (3,304,502 | ) |      |   |           |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|Net revenues                                                                                       |  |                              | (532,731   | ) |      |   | 855,805    |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|COSTS AND EXPENSES:                                                                                |  |                              |            |   |      |   |            |  
|Research and development                                                                           |  |                              | 3,116,188  |   |      |   | 2,807,835  |  
|General and administrative                                                                         |  |                              | 1,697,864  |   |      |   | 1,915,149  |  
|Stock-based compensation (A)                                                                       |  |                              | (49,733    | ) |      |   | 301,701    |  
|Amortization of intangible assets                                                                  |  |                              | 18,768     |   |      |   | 18,768     |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|Total costs and expenses                                                                           |  |                              | 4,783,087  |   |      |   | 5,043,453  |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|Loss from operations                                                                               |  |                              | 5,315,818  |   |      |   | 4,187,648  |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|OTHER INCOME (EXPENSE):                                                                            |  |                              |            |   |      |   |            |  
|Interest income                                                                                    |  |                              | 259,460    |   |      |   | 107,331    |  
|Other income                                                                                       |  |                              | 24,958     |   |      |   | 153,845    |  
|Interest expense                                                                                   |  |                              | (81,541    | ) |      |   | (111,347   | )
|                                                                                                   |  |                              |            |   |      |   |            |  
|Total other income                                                                                 |  |                              | 202,877    |   |      |   | 149,829    |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|Net loss                                                                                           |  | $                            | 5,112,941  |   |      | $ | 4,037,819  |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|Net loss per common share (basic and diluted)                                                      |  | $                            | 0.11       |   |      | $ | 0.10       |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|Weighted average common shares (basic and diluted)                                                 |  |                              | 47,846,903 |   |      |   | 41,105,756 |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|Net loss                                                                                           |  | $                            | 5,112,941  |   |      | $ | 4,037,819  |  
|Unrealized loss (gain) on marketable securities                                                    |  |                              | 14,001     |   |      |   | (6,228     | )
|                                                                                                   |  |                              |            |   |      |   |            |  
|Comprehensive loss                                                                                 |  | $                            | 5,126,942  |   |      | $ | 4,031,591  |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|(A)   The following summarizes the departmental allocation of the stock-based compensation charge: |  |                              |            |   |      |   |            |  
|Research and development                                                                           |  | $                            | (51,521    | ) |      | $ | 211,114    |  
|General and administrative                                                                         |  |                              | 1,788      |   |      |   | 90,587     |  
|                                                                                                   |  |                              |            |   |      |   |            |  
|Total stock-based compensation                                                                     |  | $                            | (49,733    | ) |      | $ | 301,701    |  
|                                                                                                   |  |                              |            |   |      |   |            |  



See accompanying notes
to unaudited consolidated financial statements.



4



---

##### Table of Contents

CURIS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)



|                                                                                                                      |  |                              |            |   |      |   |            |  
|--------------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                                                                      |  | Three Months Ended March 31, |           
|                                                                                                                      |  | 2005                         |            |   | 2004 |  
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                                                 |  |                              |            |   |      |   |            |  
|Net loss                                                                                                              |  | $                            | (5,112,941 | ) |      | $ | (4,037,819 | )
|                                                                                                                      |  |                              |            |   |      |   |            |  
|Adjustments to reconcile net loss to net cash used in operating activities-                                           |  |                              |            |   |      |   |            |  
|Depreciation and amortization                                                                                         |  |                              | 196,817    |   |      |   | 301,935    |  
|Stock-based compensation expense                                                                                      |  |                              | (49,733    | ) |      |   | 301,701    |  
|Non-cash interest expense on notes payable                                                                            |  |                              | 55,844     |   |      |   | 103,518    |  
|Amortization of intangible assets                                                                                     |  |                              | 18,768     |   |      |   | 18,768     |  
|Changes in operating assets and liabilities:                                                                          |  |                              |            |   |      |   |            |  
|Accounts receivable                                                                                                   |  |                              | (863,444   | ) |      |   | (152,242   | )
|Prepaid expenses and other assets                                                                                     |  |                              | (181,281   | ) |      |   | 191,241    |  
|Accounts payable and accrued liabilities                                                                              |  |                              | 1,012,521  |   |      |   | 644,863    |  
|Deferred contract revenue                                                                                             |  |                              | (473,449   | ) |      |   | 1,147,622  |  
|                                                                                                                      |  |                              |            |   |      |   |            |  
|Total adjustments                                                                                                     |  |                              | (283,957   | ) |      |   | 2,557,406  |  
|                                                                                                                      |  |                              |            |   |      |   |            |  
|Net cash used in operating activities                                                                                 |  |                              | (5,396,898 | ) |      |   | (1,480,413 | )
|                                                                                                                      |  |                              |            |   |      |   |            |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                                                 |  |                              |            |   |      |   |            |  
|Purchase of marketable securities                                                                                     |  |                              | (7,916,071 | ) |      |   | (8,580,091 | )
|Sale of marketable securities                                                                                         |  |                              | 6,370,642  |   |      |   | 2,145,929  |  
|Purchase of long-term investments                                                                                     |  |                              |           |   |      |   | (3,249,395 | )
|Sale of long-term investments                                                                                         |  |                              | 1,558,333  |   |      |   | 1,027,208  |  
|Purchases of property and equipment                                                                                   |  |                              | (945,916   | ) |      |   | (84,985    | )
|                                                                                                                      |  |                              |            |   |      |   |            |  
|Net cash used in investing activities                                                                                 |  |                              | (933,012   | ) |      |   | (8,741,334 | )
|                                                                                                                      |  |                              |            |   |      |   |            |  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                                                 |  |                              |            |   |      |   |            |  
|Proceeds from issuance of common stock                                                                                |  |                              | 69,872     |   |      |   | 2,516,101  |  
|Proceeds from line of credit                                                                                          |  |                              | 1,110,301  |   |      |   |           |  
|Repayments of obligations under capital leases                                                                        |  |                              |           |   |      |   | (319,967   | )
|                                                                                                                      |  |                              |            |   |      |   |            |  
|Net cash provided by financing activities                                                                             |  |                              | 1,180,173  |   |      |   | 2,196,134  |  
|                                                                                                                      |  |                              |            |   |      |   |            |  
|                                                                                                                      |  |                             
|NET DECREASE IN CASH AND CASH EQUIVALENTS                                                                             |  |                              | (5,149,737 | ) |      |   | (8,025,613 | )
|                                                                                                                      |  |                             
|CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                                                                        |  |                              | 22,679,924 |   |      |   | 27,734,548 |  
|                                                                                                                      |  |                              |            |   |      |   |            |  
|CASH AND CASH EQUIVALENTS, END OF PERIOD                                                                              |  | $                            | 17,530,187 |   |      | $ | 19,708,935 |  
|                                                                                                                      |  |                              |            |   |      |   |            |  
|                                                                                                                      | 
|                                                                                                                      |  | Three Months Ended March 31, |           
|                                                                                                                      |  | 2005                         |            |   | 2004 |  
|SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES:                                                |  |                              |            |   |      |   |            |  
|Issuance of common stock in connection with conversion of note payable to Elan Pharma International, Limited (Note 4) |  | $                            | 3,305,523  |   |      | $ |           |  
|                                                                                                                      |  |                              |            |   |      |   |            |  





See accompanying notes to unaudited consolidated financial statements.



5



---

##### Table of Contents

CURIS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)



|1. | Nature of Business
|-- | ------------------



Curis, Inc. (the Company or Curis) is a therapeutic drug development company principally focused on the discovery,
development and future commercialization of products that modulate key regulatory signaling pathways controlling the repair and regeneration of human tissues and organs. The Companys product development approach involves using small molecules,
proteins or antibodies to modulate these regulatory signaling pathways. The Companys lead product, a topical therapy for the treatment of basal cell carcinoma, is being co-developed with Genentech, Inc., or Genentech, a collaborator. The
Company is sharing equally in all U.S. development costs and will share equally in any future U.S. net profits and/or losses, should its basal cell carcinoma product candidate be successfully developed and marketed. The Company operates in a single
reportable segment: developmental biology products. The Company expects that any successful products would be used in the health care industry and would be regulated in the United States by the U.S. Food and Drug Administration and in overseas
market by similar regulatory agencies.



The
Company is subject to risks common to companies in the biotechnology industry including, but not limited to, development by its competitors of new technological innovations, dependence on key personnel, its ability to protect proprietary technology,
reliance on corporate collaborators to successfully research, develop and commercialize products based on the Companys technologies, its ability to comply with FDA government regulations and approval requirements as well as its ability to grow
its business and obtain adequate financing to fund this growth.



|2. | Basis of Presentation
|-- | ---------------------



The accompanying consolidated financial statements of the Company have been prepared in accordance with the instructions to Form 10-Q and
Article 10 of Regulation S-X. These statements, however, are condensed and do not include all disclosures required by accounting principles generally accepted in the U.S. for complete financial statements and should be read in conjunction with the
Companys Annual Report on Form 10-K for the year ended December 31, 2004, as filed with the Securities and Exchange Commission on March 15, 2005.



In the opinion of the Company, the unaudited financial statements contain all adjustments (all of which were considered normal and
recurring) necessary to present fairly the Companys financial position at March 31, 2005 and the results of operations and cash flows for the three-month periods ended March 31, 2005 and 2004. The preparation of the Companys consolidated
financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts and disclosure of certain assets and liabilities at the balance sheet
date. Such estimates include the carrying value of property and equipment and intangible assets and the value of certain liabilities. Actual results may differ from such estimates.



These interim results are not necessarily indicative of results to be expected for a full year or subsequent
interim periods.



|3. | Genentech Collaboration Accounting
|-- | ----------------------------------



Pursuant to the terms of the Companys collaboration agreement with Genentech, on January 28, 2005, the Company elected to exercise a
co-development option with Genentech pursuant to which it will share equally in all U.S. development costs and any future net profits and/or losses derived from sales in the U.S. of a therapeutic product candidate for the topical treatment of basal
cell carcinoma. On March 31, 2005, Genentech filed an investigational new drug application with the FDA in order to initiate human clinical



6



---

##### Table of Contents

CURIS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)(continued)



investigation of the basal cell carcinoma product candidate. Assuming the acceptance of the investigational new drug application by the FDA and the
successful advancement of the basal cell carcinoma product candidate through phase I and phase II clinical trials, the Company expects that the phase II clinical trial will be completed in mid-2007. The Company expects to incur significant costs
related to the funding of its share of the development expenses through phase II clinical trials and additional costs to complete phase III clinical trials and complete the regulatory approval process, assuming that the Company and Genentech
successfully complete phase II clinical trials.



In connection with the co-development arrangement, the Company has applied the provisions of EITF Issue No. 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendors Products), or
EITF 01-9, which addresses revenue arrangements where both parties make cash payments to each other, as is the case with the Companys collaboration agreement with Genentech. The collaboration is generally divided between two development
programstopical therapy for the treatment of basal cell carcinoma and the systemic treatment of other solid tumor cancers. As noted above, the topical therapy for the treatment of basal cell carcinoma product candidate is being co-developed by
Genentech and the Company and the Company reimburses Genentech for the Companys equal share of the basal cell carcinoma development costs incurred and invoiced by Genentech. Under the systemic treatment of other solid tumor cancer program,
Genentech reimburses the Company for research services that the Company performs under the collaboration, as defined in the agreement. In addition, Genentech reimburses the Company for certain of the Companys patent and other expenses and will
pay the Company development milestones and royalties, should certain development objectives and/or commercial sales occur.



The Company records revenues equal to the amounts reimbursable by Genentech for research and development costs, as well as the
amortization of up-front fees received from Genentech. The amount of revenues recognized by the Company is reduced by its share of the co-development expenses which the Company pays to Genentech up to the total cumulative revenues recognized under
this collaboration. Costs incurred in excess of the total cumulative revenues recognized under this collaboration are first recorded against any remaining Genentech-related deferred revenue recorded by the Company. Once all Genentech-related
deferred revenue balances have been reduced to zero balances, co-development costs are then recognized as research and development expenses.



As of March 31, 2005, the Company has recorded cumulative revenues under the collaboration agreement with Genentech of $3,808,000. During
the first quarter of 2005, the Company incurred $3,305,000 in costs related to the co-development of the basal cell carcinoma therapeutic product candidate, which represents amounts owed to Genentech for the reimbursement of the Companys equal
share of costs incurred by Genentech under the agreement. In accordance with EITF 01-9, the Company has recorded a reduction to revenues, or contra-revenue, of $3,305,000 in its consolidated statement of operations and comprehensive loss for the
three-month period ended March 31, 2005.



7



---

##### Table of Contents

CURIS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)(continued)



|4. | Long-Term Debt and Capital Lease Obligations
|-- | --------------------------------------------



Long-term debt and capital lease obligations consisted of the following at March 31, 2005 and December 31, 2004:



|                                                                                                                                                                                                             |  |               |           |   |                  |   |            |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------- | --------- | - | ---------------- | - | ---------- | -
|                                                                                                                                                                                                             |  | March 31,2005 |           |   | December 31,2004 |  
|Notes payable to financing agencies for capital purchases                                                                                                                                                    |  | $             | 2,250,000 |   |                  | $ | 1,141,000  |  
|Convertible promissory note agreement with Elan Pharma International, Limited including approximately $298,000 and $115,000 of accrued
interest at December 31, 2004                                         |  |               |          |   |                  |   | 3,298,000  |  
|Convertible subordinated note payable to Becton Dickinson, net of $67,000 and $80,000 discount and including $527,000 and $492,000 of accrued
interest at March 31, 2005 and December 31, 2004, respectively |  |               | 2,460,000 |   |                  |   | 2,412,000  |  
|                                                                                                                                                                                                             |  |               |           |   |                  |   |            |  
|                                                                                                                                                                                                             |  |               | 4,710,000 |   |                  |   | 6,851,000  |  
|Lesscurrent portion                                                                                                                                                                                         |  |               | (750,000  | ) |                  |   | (1,141,000 | )
|                                                                                                                                                                                                             |  |               |           |   |                  |   |            |  
|Total long-term debt obligations                                                                                                                                                                             |  | $             | 3,960,000 |   |                  | $ | 5,710,000  |  
|                                                                                                                                                                                                             |  |               |           |   |                  |   |            |  



Effective January 7, 2005, the Company entered into an amendment with the Boston Private Bank & Trust Company to extend the drawdown date in which it can request periodic financings up to $2,250,000 for qualifying purchases of equipment
and leaseholds under the loan agreement through April 30, 2005. On March 23, 2005, the Company drew down the remaining balance under this agreement bringing the total amount financed to $2,250,000 and exercised its option to convert the then
outstanding balance into a 36-month term note that bears interest at a fixed rate of 7.36% for the repayment period. Under the terms of the note payable, the Company is required to make equal monthly payments of $62,500 beginning on May 1, 2005 and
extending through the 36-month term. Accordingly, the Company has classified $750,000 as a current obligation and $1,500,000 as a long-term obligation. The loan is collateralized by all of the Companys property, plant and equipment assets,
except for those that are affixed to the property and those that are purchased after March 23, 2005 under purchase money arrangements with equipment lenders. As of March 31, 2005, the Company was in compliance with the sole covenant under this
agreement to maintain a minimum working capital ratio. Should the Company fail to pay amounts when due or fail to maintain compliance with the covenant under this agreement, the entire obligation becomes immediately due at the option of the Boston
Private Bank & Trust Company.



On January
7, 2005, Elan Pharma International Limited, or EPIL, elected to convert the entire balance of its outstanding convertible note into shares of the Companys common stock. As of January 7, 2005, the outstanding balance of the EPIL note, including
interest, was $3,305,523. In accordance with the terms of the amended and restated convertible note payable with EPIL, 330,552 shares of the Companys common stock were issued to EPIL based on a conversion rate of $10.00 per share. The Company
has no further obligations to EPIL.



|5. | Accounting for Stock-Based Compensation
|-- | ---------------------------------------



The Company has two stock option plans. The Company applies APB Opinion No. 25, Accounting for Stock Issued to Employees and
related interpretations, including FASB Interpretation No. 44, in accounting for qualifying options granted to its employees and directors under its plans and applies Statement of Financial Accounting Standards No. 123, Accounting for
Stock-Based Compensation, as amended by FASB No. 148, for disclosure purposes only. The SFAS 123 disclosures include pro forma net loss and net loss per share as if the fair value method of accounting had been used. Stock issued to
non-employees is accounted for in accordance with SFAS 123 and related interpretations.



8



---

##### Table of Contents

CURIS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)(continued)



The following are the pro forma net loss and net loss per share, as if compensation
expense for the option plans had been determined based on the fair value at the date of grant, consistent with SFAS 123:



|                                                                                                                |  |                              |            |   |      |   |            |  
|--------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                                                                |  | Three months ended March 31, |           
|                                                                                                                |  | 2005                         |            |   | 2004 |  
|Net loss applicable to common stockholders, as reported                                                         |  | $                            | (5,113,000 | ) |      | $ | (4,038,000 | )
|Add back: employee stock-based compensation included in net loss applicable to common stockholders, as reported |  |                              | 2,000      |   |      |   | 209,000    |  
|Less: stock-based employee compensation expense determined under fair value based methods for all awards        |  |                              | (1,178,000 | ) |      |   | (1,952,000 | )
|                                                                                                                |  |                              |            |   |      |   |            |  
|Pro forma net loss                                                                                              |  | $                            | (6,289,000 | ) |      | $ | (5,781,000 | )
|Net loss per common share (basic and diluted)                                                                  |  |                              |            |   |      |   |            |  
|As reported                                                                                                     |  | $                            | (0.11      | ) |      | $ | (0.10      | )
|Pro forma                                                                                                       |  | $                            | (0.13      | ) |      | $ | (0.14      | )



The
effects on three months ended March 31, 2005 and 2004 pro forma net loss and net loss per share of the estimated fair value of stock options and shares are not necessarily representative of the effects on the results of operations in the future. In
addition, the estimates made utilize a pricing model developed for traded options with relatively short lives; the Companys option grants typically have a life of up to ten years and are generally not transferable. Therefore, the actual fair
value of a stock option grant may be different from these estimates. The Company believes that its estimates incorporate all relevant information and represent a reasonable approximation in light of the difficulties involved in valuing non-traded
stock options.



|6. | Subsequent Events
|-- | -----------------



| | (a) |  | Drug Discovery Collaboration Agreement with Genentech
| | --- |  | -----------------------------------------------------



On April 1, 2005, the Company entered into a Drug Discovery Collaboration Agreement with Genentech for discovery and development of small
molecule compounds that modulate an undisclosed signaling pathway that plays an important role in cell proliferation. This pathway is a regulator of tissue formation and repair and its abnormal activation is associated with certain cancers. Under
the terms of the agreement, the Company has granted Genentech an exclusive royalty-bearing license to make, use and sell the small molecule compounds that are modulators of the pathway for any use, except for ex vivo cell therapy purposes and in
areas outside of oncology and hematopoiesis.



Under the terms of the agreement, the Company will have primary responsibility for research and development activities and Genentech will be responsible for commercializing products that may result from the collaboration. Genentech is
obligated to pay the Company an up-front license fee of $3,000,000 by May 1, 2005 and has agreed to fund up to $6,000,000 for research and development activities during the initial research term, subject to its termination rights. Genentech will
also make cash payments to the Company contingent upon the successful achievement of certain development, clinical and drug approval milestones. The initial research term under the agreement is two years and Genentech has an option of extending the
term for up to two additional years. Genentech will also pay the Company royalties on net product sales if product candidates derived from the collaboration are successfully developed.



Each party has the right to terminate the agreement on 60 days notice for an uncured material breach
by the other party. Genentech has the right to terminate the agreement at any time after the first anniversary



9



---

##### Table of Contents

CURIS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)(continued)



of the effective date, upon six months prior written notice, if such termination is to be effective prior to the end of the initial research term, and upon
sixty days prior written notice otherwise. In the event of termination by Genentech, the Company would be entitled to receive only a reduced royalty for those products that are covered by a subset of certain intellectual property rights, in lieu of
the standard contract royalties that would otherwise apply.



| | (b) |  | Second Amendment to Collaborative Research, Development and License Agreement with Genenetech
| | --- |  | ---------------------------------------------------------------------------------------------



On April 13, 2005, the Company entered into a Second
Amendment to the Collaborative Research, Development and License Agreement with Genentech dated June 11, 2003. The effective date of the amendment was April 11, 2005. Under the terms of the amendment, Genentech will provide to the Company an
additional $2,000,000 of funding to continue development of therapeutics to treat solid tumor cancers, and the research term has been extended until December 11, 2005 (previously June 11, 2005). At Genentechs option, the research term may be
extended for an additional six-month period to June 11, 2006, upon written notice delivered to the Company no later than October 1, 2005. Other than the change to the period of the research term and payments associated with such research, the
amendment has not changed the terms of the agreement, which remains in full force and effect.



10



---

##### Table of Contents

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



The following discussion of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial
statements and the related notes appearing elsewhere in this report.



Overview



We are a therapeutic drug
development company principally focused on the discovery, development and future commercialization of products that modulate key regulatory signaling pathways controlling the repair and regeneration of human tissues and organs. Our product
development approach involves using small molecules, proteins or antibodies to modulate these regulatory signaling pathways, for example, to increase the pathway signals when they are insufficient or to decrease them when they are excessive. We have
successfully used our product development approach to produce multiple compounds with potential use for several different disease indications. For example, we have developed a product candidate for the topical treatment of basal cell carcinoma,
which is the subject of a recently submitted investigational new drug application, and several promising preclinical product candidates in the fields of cancer, kidney disease, neurological disorders, cardiovascular disease and hair growth
regulation. We operate in a single reportable segment: developmental biology products. We expect that any successful products would be used in the health care industry and would be regulated in the United States by the U.S. Food and Drug
Administration, or FDA, and in overseas markets by similar regulatory agencies.



Since our inception, we have funded our operations primarily through license fees, research and development funding from our strategic collaborators, the private and public placement of our equity securities, debt
financings and the monetization of certain royalty rights. We have never been profitable and have incurred an accumulated deficit of $668,086,000 as of March 31, 2005. We expect to incur significant operating losses for the next several years as we
devote substantially all of our resources to research and development of our product candidates. We will need to generate significant revenues to achieve profitability and do not expect to achieve profitability in the foreseeable future, if at all.



We currently have strategic collaborations with Genentech and
Wyeth Pharmaceuticals, or Wyeth, to develop therapeutics which modulate the signaling of the Hedgehog pathway and an additional collaboration with Genentech to develop therapeutics that modulate an undisclosed signaling pathway that plays an
important role in cell proliferation. We have also licensed our BMP pathway portfolio to Ortho Biotech Products, a subsidiary of Johnson & Johnson, for systemic administration for all non-orthopedic and dental therapeutic applications. Our
strategic collaborations and license agreements generally provide for our research, development and commercialization programs to be either a majority or wholly funded by our collaborators and provide us with the opportunity to receive additional
payments if specified milestones are achieved, as well as royalty payments upon the successful commercialization of any products based upon the collaboration. These strategic license and collaboration agreements included $18,000,000 in up-front
payments, including $5,000,000 received from the sale of shares of our common stock, and potential future clinical development milestones of approximately $650,000,000 in the aggregate, assuming that all of the collaborations continue for their full
terms and all milestone payments are received upon successful completion of specified research, development objectives and regulatory approval.



In the future, we plan to continue to seek corporate collaborators for the further development and commercialization of some of our technologies.



Pursuant to the terms of our Hedgehog pathway collaboration
agreement with Genentech, on January 28, 2005 we exercised a co-development option with Genentech pursuant to which we will share equally in all U.S. development costs and will share equally in any future net profits and/or losses derived from sales
in the U.S. of a therapeutic product candidate for the topical treatment of basal cell carcinoma. We expect that by exercising



11



---

##### Table of Contents

this co-development and equal cost-sharing option we will incur approximately $20,000,000 in development expenses through the planned completion of phase II
clinical trials. On March 31, 2005, Genentech filed an investigational new drug application with the FDA in order to initiate human clinical investigation of the basal cell carcinoma product candidate. Assuming the acceptance of the investigational
new drug application by the FDA and the successful advancement of the basal cell carcinoma product candidate through phase I and phase II clinical trials, we expect that the phase II clinical trial will be completed in mid-2007. We expect to incur
additional costs to complete phase III clinical trials and complete the regulatory approval process, assuming that we and Genentech successfully complete phase II clinical trials.



Financial Operations Overview



General.    Our future operating results will depend largely on the magnitude of payments from our current and potential future
corporate collaborators and the progress of other product candidates currently in our research and development pipeline. The results of our operations will vary significantly from year to year and quarter to quarter and depend on, among other
factors, the timing of our entry into new collaborations, the timing of the receipt of payments from collaborators and the cost and outcome of clinical trials. We believe that our existing capital resources at March 31, 2005 should enable us to
maintain current and planned operations into mid-2007, including expected spending related to our co-development of our lead product candidate for the treatment of basal cell carcinoma, under development with Genentech. Our ability to continue
funding our planned operations beyond mid-2007 is dependent upon the success of our collaborations, our ability to maintain or reduce our cash burn rate and our ability to raise additional funds through equity, debt or other sources of financing. A
discussion of certain risks and uncertainties that could affect our liquidity, capital requirements and ability to raise additional funds is set forth below under the heading Risk Factors that May Affect Results.



Revenue.    We do not expect to generate any
revenue from the sale of products for several years, if ever. Substantially all of our gross revenues to date has been derived from license fees, research and development payments, and other amounts that we have received from our strategic
collaborators and licensees, including Genentech, Ortho Biotech Products and Wyeth as well as royalty revenue and payments received upon monetization of such royalty rights from Stryker Corporation. We do not expect to generate any net revenue from
our Hedgehog antagonist collaboration with Genentech until we obtain FDA approval to commercialize a basal cell carcinoma product candidate, if ever, as our share of co-development costs will be recorded as a reduction to any revenue recognized
under this collaboration in accordance with EITF 01-9. In the future, we will seek to generate revenue from a combination of license fees, research and development funding and milestone payments and royalties resulting from the sale of products
which incorporate our intellectual property in connection with strategic licenses and collaborations, and from sales of any products we successfully develop and commercialize, either alone or in partnership with third parties. We expect that any
revenue we generate will fluctuate from quarter to quarter as a result of the timing and amount of payments received under our strategic collaborations, and the amount and timing of payments we receive upon the sale of our products, to the extent
that any are successfully commercialized.



Research and
Development.    Research and development expense consists of costs incurred to discover, research and develop product candidates. These expenses consist primarily of salaries and related expenses for personnel, outside
service costs including medicinal chemistry, consulting and sponsored research collaborations, and occupancy and depreciation charges. We expense research and development costs as incurred.



The following table summarizes our primary research and development programs,
including the current development status of each program. In the table below, the term early preclinical means we are seeking to obtain initial demonstrations of therapeutic efficacy in preclinical models of human disease, mid-preclinical means we
are seeking to obtain multiple demonstrations of efficacy in preclinical models of human disease, and late preclinical means we are seeking to obtain both multiple demonstrations of efficacy in preclinical models of human disease and relevant
toxicology and safety data required for an investigation new drug application filing with the FDA, referred to as an IND in the table below, seeking to commence a phase I clinical trial to assess safety in humans.



12



---

##### Table of Contents

Except for the public disclosures of Genentech, all of our estimates below regarding planned filing dates
for investigational new drug applications for our product development programs are solely our judgments. These estimates may not reflect the plans of our corporate collaborators or licensors, if applicable. Moreover, because of the early stage of
development of these programs, our ability and that of our collaborators and licensors to successfully complete preclinical studies of these product candidates, and the timing of completion of such programs, is highly uncertain. Accordingly, the
estimated period in which we or our collaborators or licensors may file an investigational new drug application for any of these product candidates may vary materially from the estimates set forth below:



|                                                  |  |                            |  |                                    |  |                  |  |                               
|------------------------------------------------- |  | -------------------------- |  | ---------------------------------- |  | ---------------- |  | ------------------------------
|Product Candidate                                 |  | Primary Indication         |  | Collaborator/Licensee              |  | Status           |  | Estimated period of IND
Filing
|Hh topical small molecule antagonist              |  | Basal cell carcinoma       |  | Genentech(1)                       |  | Late preclinical |  | March 31, 2005                
|Hh systemic small molecule or antibody antagonist |  | Cancer                     |  | Genentech                          |  | Mid preclinical  |  | 2006                          
|BMP-7 protein                                     |  | Kidney disease             |  | Ortho Biotech Products(2)          |  | Late preclinical |  | Late 2005 /Early 2006         
|Hh small molecule agonist                         |  | Nervous system disorders   |  | Wyeth                              |  | Mid preclinical  |  | 2006                          
|Hh small molecule agonist                         |  | Hair growth                |  | Internal development(3)            |  | Late preclinical |  | 2006                          
|Hh agonist/protein/gene                           |  | Cardiovascular disease     |  | Internal development(3),(4)        |  | Mid preclinical  |  | To be determined(5)           
|Discovery research                                |  | Spinal muscular atrophy    |  | Spinal Muscular Atrophy Foundation |  | Discovery        |  | To be determined(5)           
|Discovery research                                |  | Undisclosed pathway        |  | Genentech                          |  | Discovery        |  | To be determined(5)           
|Discovery research                                |  | Various signaling pathways |  | Internal development               |  | Discovery        |  | To be determined(5)           

---

|(1) |  | Genentech filed an investigational new drug application for our basal cell carcinoma product candidate on March 31, 2005.
|--- |  | -------------------------------------------------------------------------------------------------------------------------



|(2) |  | This product candidate has been licensed to Ortho Biotech Products. Under the license arrangement, we expect to incur no future costs related to these programs, assuming the license
agreement remains in effect. All development decisions are at the sole discretion of Ortho Biotech Products.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) |  | Our Hh small molecule agonists were licensed to Wyeth under our collaboration agreement, effective February 2004. Under the terms of our collaboration agreement with Wyeth, our
retained rights to use Hh small molecule agonists in our hair loss and cardiovascular disease programs are subject to the requirement that Wyeth must first determine that such compounds are less suitable for systemic use in the Wyeth neurological
disorders program and thus available for further development in our hair loss and cardiovascular disease programs. In December 2004, Wyeth made several compounds available to us for our further development in the hair growth program.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) |  | We have incurred nominal expenses related to our cardiovascular disease program. Our preclinical data relating to this program has been derived from studies conducted at Caritas St.
Elizabeths Medical Center in Boston, Massachusetts. We have entered into agreements under which additional third-party collaborators are attempting to replicate this preclinical data. We cannot estimate the period in which we will make an
investigational new drug filing for this program since we have not yet replicated the preclinical data and any investigational new drug filing will be dependent on the successful replication of these data. In addition, should we be successful in our
efforts to license this program in 2005, any investigational new drug filing will ultimately be the responsibility of a strategic collaborator. Wyeth has a right of first negotiation to obtain an exclusive license to the cardiovascular applications.
If Wyeth declines to exercise its option, or if we are unable to reach an agreement with Wyeth on terms within the contractually specified period, we are free to seek another collaborator for this program.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(5) |  | The programs included within this section are not well enough defined for us to generate estimates regarding the timing of filing an investigational new drug application.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------



There is a risk that any drug discovery and
development program may not produce products or revenue. Due to uncertainties inherent in drug discovery and development, including those factors described below under Risk Factors That May Affect Results, we and our collaborators may
not be able to successfully develop and commercialize any of the product candidates included in the table above.



All of our product development initiatives are in various stages of preclinical testing. Because of the early stage of these programs, the successful
development of our preclinical product candidates is highly uncertain. We



13



---

##### Table of Contents

cannot reasonably estimate or know the nature, timing and estimated costs of the efforts necessary to complete the development of, or the period in which
material net cash inflows are expected to commence from any of our product candidates due to the numerous risks and uncertainties associated with developing drugs, including the uncertainty of:



| |  |  | the timing of when collaborators may make compounds that are subject to our retained rights available for our development;
| | - |  | --------------------------------------------------------------------------------------------------------------------------



| |  |  | the scope, quality of data, rate of progress and cost of clinical trials and other research and development activities undertaken by us or our collaborators;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | future clinical trials results;
| | - |  | -------------------------------



| |  |  | the terms and timing of any collaborative, licensing and other arrangements that we may establish;
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | the cost and timing of regulatory approvals;
| | - |  | --------------------------------------------



| |  |  | the cost and timing of establishing sales, marketing and distribution capabilities;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | the cost of establishing clinical and commercial supplies of our product candidates and any products that we may develop;
| | - |  | -------------------------------------------------------------------------------------------------------------------------



| |  |  | the effect of competing technological and market developments; and
| | - |  | ------------------------------------------------------------------



| |  |  | the cost of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights.
| | - |  | ------------------------------------------------------------------------------------------------------------------



Any failure to complete the development of our product candidates in a timely
manner could have a material adverse effect on our operations, financial position and liquidity. A discussion of risks and uncertainties associated with completing our projects on schedule, or at all, and some consequences of failing to do so, are
set forth below in Risk Factors That May Affect Results.



In December 2004, we received a development plan and budget from Genentech relating to the clinical development of a small molecule formulated for topical treatment for basal cell carcinoma. We and Genentech will co-develop this product
candidate and will share equally in all U.S. development costs. Based on Genentechs budget, we expect that we will incur approximately $20,000,000 in development expenses through phase II clinical trials. On March 31, 2005, Genentech filed an
investigational new drug application with the FDA, and assuming the acceptance of the investigational new drug application by the FDA and the successful advancement of the basal cell carcinoma product candidate through phase I and phase II clinical
trials, we expect that the phase II clinical trial will be completed in mid-2007. We expect to incur additional costs to complete phase III clinical trials and complete the regulatory approval process, assuming that we and Genentech successfully
complete phase II clinical trials.



General and
Administrative.    General and administrative expense consists primarily of salaries and other related costs for personnel in executive, finance, accounting, business development, legal, information technology, corporate
communications and human resource functions. Other costs include facility costs not otherwise included in research and development expense, insurance, and professional fees for legal, patent and accounting services.



Strategic Alliances and License
Agreements.    Since inception, substantially all of our revenue has been derived from collaborations and other research and development arrangements with third parties. Our current strategic collaborations and key license
agreements are with Genentech, Wyeth and Ortho Biotech Products. These strategic license and collaboration agreements included $18,000,000 in up-front payments, including $5,000,000 from the sale of shares of our common stock, and potential future
clinical development milestones of approximately $650,000,000 in the aggregate, assuming that all of the collaborations continue for their full terms and all milestone payments are received upon successful completion of specified research and
development objectives.



14



---

##### Table of Contents

The collaborations and licenses are summarized as follows:



Genentech Hedgehog Antagonist
Collaboration.    In June 2003, as amended in December 2004 and April 2005, we entered into a collaborative research, development and license agreement with Genentech in which we licensed our proprietary Hedgehog pathway
antagonists to Genentech for human therapeutic use. The primary focus of our collaborative research plan has been to develop these molecules for cancer indications. The collaboration consists of two main programs: the development of a small molecule
formulated for topical treatment of basal cell carcinoma, and the development of systemically administered small molecule and antibody Hedgehog antagonists for the treatment of certain other solid tumor cancers. The topical Hedgehog antagonist for
basal cell carcinoma is subject to a co-development arrangement with Genentech in which we share equally in both the U.S. development costs and any future U.S. net profits and/or losses of the product candidate, and on March 31, 2005, Genentech
filed an investigational new drug application with the FDA.



Genentech Discovery Research Collaboration.    On April 1, 2005, we entered into a drug discovery collaboration agreement with Genentech for discovery and development of small molecule compounds that modulate an
undisclosed signaling pathway that plays an important role in cell proliferation. This pathway is a regulator of tissue formation and repair and its abnormal activation is associated with certain cancers. Under the terms of the agreement, we granted
Genentech an exclusive license to make, use and sell the small molecule compounds that are modulators of the pathway for any use, except for ex vivo cell therapy purposes and in areas outside of oncology and hematopoiesis.



Under the terms of the agreement, we will have primary responsibility for
research and development activities and Genentech will be responsible for commercializing products that may result from the collaboration. Genentech is obligated to pay us an up-front license fee of $3,000,000 by May 1, 2005 and has agreed to fund
up to $6,000,000 for research and development activities during the initial research term, subject to its termination rights. Genentech will also make cash payments to us contingent upon the successful achievement of certain development, clinical
and drug approval milestones. The initial research term under the agreement is two years and Genentech has an option of extending the term for up to two additional years. Genentech will also pay us royalties on net product sales if product
candidates derived from the collaboration are successfully developed.



Each party has the right to terminate the agreement on 60 days notice for an uncured material breach by the other party. Genentech has the right to terminate the agreement at any time after the first anniversary of the effective date,
upon six months prior written notice, if such termination is to be effective prior to the end of the initial research term, and upon sixty days prior written notice otherwise. In the event of termination by Genentech, we would be entitled to receive
only a reduced royalty for those products that are covered by a subset of certain intellectual property rights, in lieu of the standard contract royalties that would otherwise apply.



Wyeth Hedgehog Agonist Collaboration.    Effective
February 2004, we entered into a collaobration, research and license agreement with Wyeth in which we licensed our Hedgehog proteins and small molecule Hedgehog pathway agonists to Wyeth on an exclusive worldwide, royalty-bearing basis for the
development and commercialization of pharmaceutical products for therapeutic applications in the treatment of diseases and disorders in humans with the primary focus of the research program on the treatment of neurological disorders, including
neurodegenerative diseases and neuropathies. Under the terms of the agreement, Wyeth paid us a license fee of $1,500,000 and purchased 315,524 shares of our common stock at a price of $4.754 per share for an aggregate purchase price of $1,500,000.
Wyeth will also provide us with research funding for a minimum of two years. In addition, Wyeth is obligated to make cash payments to us upon the successful achievement of development and drug approval milestones and is obligated to pay a royalty on
net product sales, if any, that escalates with increasing sales volume. On March 23, 2005, we achieved a development milestone under the Wyeth collaboration. The milestone is based on Wyeths and our continued progress in preclinical
development of Hedgehog pathway agonists for the treatment of stroke, neurological and other disorders. The milestone will trigger a $250,000 payment from Wyeth to us in accordance with the terms of their 2004 agreement.



15



---

##### Table of Contents

As part of our collaboration with Wyeth, we have retained development and licensing options for certain
therapeutic applications of the Hedgehog agonist technologies, including those applications that qualify as orphan drug indications, topical applications for hair growth and local delivery applications for treatment of cardiovascular disease. Wyeth
has a right of first negotiation to obtain an exclusive license to the cardiovascular applications. If Wyeth declines to exercise its option, or if we are unable to reach an agreement with Wyeth on terms within the contractually specified period, we
are free to seek another collaborator for this program.



We are
obligated to make payments to various university licensors when certain payments are received from Wyeth. We have paid to such university licensors a total of $125,000 upon receipt of the $1,500,000 up-front license fee from Wyeth. In addition, as
part of a termination agreement entered into with Elan, we will pay Elan royalty payments related to any revenues, other than revenues received as direct reimbursement for research, development and other expenses, that we receive in the field of
neurological disease.



Ortho Biotech BMP Products
License.    In November 2002, we entered into an agreement with Ortho Biotech Products in which we licensed our broad BMP technology portfolio to Ortho Biotech Products on an exclusive, worldwide royalty-bearing basis, for
all non-orthopedic and non-dental therapeutic applications in exchange for a $3,500,000 fee, a series of cash milestones if specified clinical research objectives and regulatory approvals are achieved, including a $30,000,000 milestone payment upon
U.S. regulatory approval of a product for the treatment of kidney disease, and a royalty on potential future product sales. Ortho Biotech Products has assumed all future costs and responsibility for BMP-based product development and has sole
responsibility for deciding if and when human clinical trials of BMP-based product candidates will begin.



Critical Accounting Policies and Estimates



The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires that we make estimates and assumptions that affect the reported
amounts and disclosure of certain assets and liabilities at our balance sheet date. Such estimates and judgments include the carrying value of property and equipment and intangible assets, revenue recognition and the value of certain liabilities. We
base our estimates on historical experience and on various other factors we believe are appropriate under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.



We believe the following accounting policies to be critical to understanding the judgments and estimates we use in preparing our financial statements:



Long-Lived Assets.    Long-lived
assets consist of goodwill, long-term receivables, equity securities held in Micromet, ES Cell International and Aegera Therapeutics, and long-term deposits. We assess the impairment of identifiable intangibles and long-lived assets whenever events
or changes in circumstances indicate that the carrying value may not be recoverable. In addition, we perform a goodwill impairment test annually. If we determined that the carrying value of intangible or long-lived assets might not be recoverable
based upon the existence of one or more indicators of impairment, we would measure any impairment based on a projected cash flow method.



Valuation of investments in privately held companies.    We have investments in Aegera, Micromet and ES Cell International with
carrying values of $167,000, $100,000 and $150,000, respectively. These investments are included in the Deposits and other assets category of our consolidated balance sheets. At each balance sheet date, we review these investments to
determine whether the fair value of these investments is less than the carrying value and, if so, whether we should write-down the investment. These companies are not publicly traded and, therefore, determining the fair value of our investments in
these companies involves significant judgment. We consider available information in estimating the fair value of these investments and, as of March 31, 2005, believe that the fair value of our investments is not less than their carrying value.



If the financial condition or results of Aegera or ES Cell
decline significantly or if Micromets financial condition continues to decline, the fair value of these investments would likely decline and, as a result, we may have to record an impairment charge to the extent such impairment is deemed other
than temporary.



16



---

##### Table of Contents

Revenue recognition.    Revenue is a key component of our results of
operations. We follow the provisions of the Securities and Exchange Commissions Staff Accounting Bulletin No. 104 (SAB No. 104), Revenue Recognition, EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables and
EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendors Products), or EITF 01-9.



In accordance with SAB No. 104, we recognize revenue related to research activities as they are performed, so long as there is persuasive evidence of an
arrangement, the fee is fixed or determinable and collection of the related receivable is probable.



We analyze our multiple-element arrangements entered into since July 2003 to determine whether the elements can be separated and accounted for
individually as separate units of accounting in accordance with EITF No. 00-21.We recognize license payments as revenue when received if the license has stand-alone value and the fair value of the undelivered items can be determined. If the
license is considered to have stand-alone value but the fair value on any of the undelivered items cannot be determined, the license payments are recognized as revenue over the period of performance for such undelivered items or services. We
recognize revenues from reimbursable research and development activities at the time these activities are performed under the terms of the related agreement, when the collaborator is obligated to pay and when no future performance obligations exist.



We apply EITF 01-9 for revenue arrangements where both parties
reimburse each other for certain costs, such as our collaboration agreement with Genentech, which includes payments from Genentech to us for license fees, reseach and development services, and development milestones as well as payments from us to
Genentech which represent our equal share of costs incurred by Genentech for the co-development of a therapeutic product candidate for the topical treatment of basal cell carcinoma. In accordance with EITF 01-9, we record revenues equal to the
amounts reimbursable by Genentech for research and development costs as well as the amortization of the up-front payments received from Genentech. We then record as a reduction to revenue, or contra-revenue, our share of the co-development expenses
which we pay to Genentech up to the total cumulative revenue recognized under this collaboration since its inception in June 2003. Costs incurred in excess of the total cumulative revenues recognized under this collaboration are first recorded
against any remaining Genentech-related deferred revenue recorded on our balance sheet. Once the Genentech-related deferred revenue balances have been reduced to zero balances, these costs are then recognized as research and development expenses.



As of March 31, 2005, we have recognized cumulative revenues
under our collaboration agreement with Genentech of $3,808,000. During the first quarter of 2005, we incurred $3,305,000 in costs related to the co-development of the therapeutic product candidate for the topical treatment of basal cell carcinoma,
which represents amounts owed to Genentech for the reimbursement of our equal share of costs incurred by Genentech under the agreement. In accordance with EITF 01-9, we have recorded a reduction to revenues of $3,305,000 in our consolidated
statement of operations and comprehensive loss for the three-month period ended March 31, 2005.



Amounts received for license fees are deferred and recognized as services are performed over the estimated performance period of the contract. Any
obligations related directly to the receipt of a license fee are also deferred and recognized as services are performed over the performance period of the contract. Amounts received for milestones are recognized upon achievement of the milestone, as
long as the milestone is deemed to be substantive and we have no other performance obligations with respect to that milestone. In the event that we have remaining performance obligations, the portion of the milestone payment equal to the lesser of
the non-refundable cash received or the percentage of the services performed through that date multiplied by the total milestone payment would be recognized as revenue. Revenue received under grants is being recognized as the services are provided
and payment is assured under the terms of the grant.



17



---

##### Table of Contents

Although we follow detailed guidelines in measuring revenue, certain judgments affect the application of
our revenue policy. For example, in connection with our existing collaboration agreements, we have recorded on our balance sheet short- and long-term deferred revenue based on our best estimate of when such revenue will be recognized. We have
recorded short-term deferred revenue of $4,063,000 and long-term deferred revenue of $4,345,000 as of March 31, 2005. Short-term deferred revenue consists of amounts that are expected to be recognized as revenue, or applied against future
co-development costs, by March 31, 2006. Amounts that we expect will not be recognized prior to March 31, 2006 are classified as long-term deferred revenue. However, this estimate is based on our current operating plan as of March 31, 2005. If our
operating plan should change in the future, we may recognize a different amount of deferred revenue over the twelve-month period from April 1, 2005 through March 31, 2006.



The estimate of deferred revenue also reflects managements estimate of the periods of our involvement in certain of
our collaborations. Our performance obligations under these collaborations consist of participation on steering committees and the performance of other research and development services. Our period of involvement is largely determined by the time to
commercialize our basal cell carcinoma clinical candidate that we are co-developing with Genentech and our estimate of time to reach clinical development for candidates under our collaboration with Wyeth. Since the timing of clinical development is
difficult to estimate, our estimates may change in the future. Such changes to estimates would result in a change in revenue recognition amounts. If these estimates and judgments change over the course of these agreements, it may affect the timing
and amount of revenue that we recognize and record in future periods.



The above list is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no
need for managements judgment in their application. There are also areas in which managements judgment in selecting any available alternative would not produce a materially different result.



Results of Operations



Quarters Ended March 31, 2005 and March 31, 2004



Revenues.    Total revenues are summarized as
follows:



|                                                |  |                                     |            |                               |      |   |         |  |      |   
|----------------------------------------------- |  | ----------------------------------- | ---------- | ----------------------------- | ---- | - | ------- |  | ---- | --
|                                                |  | For the Three Months EndedMarch 31, |            | PercentageIncrease/(Decrease) |     
|                                                |  | 2005                                |            |                               | 2004 |  
|Gross Revenues:                                 |  |                                     |            |                               |      |   |         |  |      |   
|Genentech                                       |  | $                                   | 1,252,000  |                               |      | $ | 463,000 |  | 170  | % 
|Wyeth                                           |  |                                     | 932,000    |                               |      |   | 343,000 |  | 172  | % 
|Spinal Muscular Atrophy Foundation              |  |                                     | 588,000    |                               |      |   |        |  | 100  | % 
|Other                                           |  |                                     |           |                               |      |   | 50,000  |  | (100 | %)
|                                                |  |                                     |            |                               |      |   |         |  |      |   
|Subtotal                                        |  |                                     | 2,772,000  |                               |      |   | 856,000 |  | 224  | % 
|Contra-revenue on co-development with Genentech |  |                                     | (3,305,000 | )                             |      |   |        |  | (100 | %)
|                                                |  |                                     |            |                               |      |   |         |  |      |   
|Net revenues                                    |  | $                                   | (533,000   | )                             |      | $ | 856,000 |  | (162 | %)
|                                                |  |                                     |            |                               |      |   |         |  |      |   



Gross revenues
generated under our ongoing collaborations with Genentech and Wyeth as well as our grant from the Spinal Muscular Atrophy Foundation, were $2,772,000 for the first quarter of 2005 as compared to $856,000 for the same period in prior year, an
increase of $1,916,000, or 224%, summarized as follows:



Genentech Collaboration.    We recognized $1,252,000 in gross revenues related to our collaboration with Genentech for the three months ended March 31, 2005. Of this amount, $273,000 was from the amortization of
$9,000,000 in license and up-front payments previously received from Genentech. In addition, we recognized gross revenues of $955,000 for the reimbursement for support of full-time equivalents and $24,000 relating to other research and development
services performed under the collaboration agreement with Genentech for the three months ended March 31, 2005. We recognized $463,000 in revenue for the three months ended March 31, 2004.



18



---

##### Table of Contents

Wyeth Collaboration.    We recognized $932,000 in gross revenue related to our
collaboration with Wyeth for the three months ended March 31, 2005. This amount consists of revenue of $75,000 from the amortization of a $1,500,000 license fee payment received from Wyeth in February 2004. In addition, we recognized $607,000
relating to research and development services performed under the collaboration agreement with Wyeth and $250,000 for the achievement of a preclinical development milestone for the three months ended March 31, 2005. We recognized $343,000 in revenue
for the three months ended March 31, 2004.



Spinal Muscular
Atrophy Foundation Grant.    We recognized $588,000 in gross revenue relating to research and development services performed under the $5,364,000, three-year grant from the Spinal Muscular Atrophy Foundation for the three
months ended March 31, 2005. Since this grant was not received until September 2004, no revenue related to the Spinal Muscular Atrophy Foundation was recognized in the first quarter of 2004.



For the three month period ending March 31, 2005, we also recorded
contra-revenue, or a reduction to gross revenues, of $3,305,000 related to our co-development option with Genentech. This reduction in gross revenue represents amounts owed for the reimbursement of costs incurred by Genentech under our collaboration
related to the co-development of a basal cell carcinoma therapeutic product candidate. Of the amount classified as contra-revenue, $2,178,000 relates to costs incurred by Genentech for the basal cell carcinoma program in 2004 and $1,127,000 relates
to costs incurred in the first quarter of 2005.



Research
and Development Expenses.    Research and development expenses are summarized as follows:



|                                          |                    |                          |      |                                     |           |                               |   |           |  |     |   
|----------------------------------------- | ------------------ | ------------------------ | ---- | ----------------------------------- | --------- | ----------------------------- | - | --------- |  | --- | --
|Research and Development Program          |                    |                          |      | For the Three Months EndedMarch 31, |           | PercentageIncrease/(Decrease) |  
|                                          | Primary Indication |                          | 2005 |                                     | 2004      |                              
|Hh small molecule antagonist              |                    | Basal cell carcinoma     |      | $                                   | 16,000    |                               | $ | 48,000    |  | (67 | %)
|Hh small molecule and antibody antagonist |                    | Cancer                   |      |                                     | 950,000   |                               |   | 1,032,000 |  | (8  | %)
|Hh small molecule agonist                 |                    | Nervous system disorders |      |                                     | 704,000   |                               |   | 863,000   |  | (18 | %)
|Hh small molecule agonist                 |                    | Hair loss                |      |                                     | 243,000   |                               |   | 185,000   |  | 31  | % 
|Discovery research                        |                    | Spinal muscular atrophy  |      |                                     | 661,000   |                               |   |          |  | 100 | % 
|Discovery research                        |                    | Various                  |      |                                     | 542,000   |                               |   | 680,000   |  | (20 | %)
|                                          |                    |                          |      |                                     |           |                               |   |           |  |     |   
|Total research and development expense    |                    |                          |      | $                                   | 3,116,000 |                               | $ | 2,808,000 |  | 11  | % 
|                                          |                    |                          |      |                                     |           |                               |   |           |  |     |   



The increase of
$308,000 in total research and development expenses in the three months ended March 31, 2005 was primarily due to an increase in spending of $661,000, or 100%, on our discovery research program, which is under a sponsored research agreement with the
Spinal Muscular Atrophy Foundation. As this agreement was not entered into until September 2004, we incurred no expenses for this program during the period ended March 31, 2004. Reduced spending in other programs, particularly decreases of $159,000
and $138,000 in our Hedgehog small molecule agonist program for nervous system disorders and other discovery research program, respectively, offset this increase.



General and Administrative Expenses.    General and administrative expenses are summarized as
follows:



|                                          |  |                                     |           |                               |   |           |  |     |   
|----------------------------------------- |  | ----------------------------------- | --------- | ----------------------------- | - | --------- |  | --- | --
|                                          |  | For the Three Months EndedMarch 31, |           | PercentageIncrease/(Decrease) |  
|                                          |  | 2005                                |           | 2004                          |  
|Personnel                                 |  | $                                   | 745,000   |                               | $ | 791,000   |  | (6  | %)
|Occupancy and depreciation                |  |                                     | 134,000   |                               |   | 193,000   |  | (31 | %)
|Legal services                            |  |                                     | 291,000   |                               |   | 304,000   |  | (4  | %)
|Professional and consulting services      |  |                                     | 279,000   |                               |   | 269,000   |  | 4   | % 
|Insurance costs                           |  |                                     | 107,000   |                               |   | 133,000   |  | (20 | %)
|Other general and administrative expenses |  |                                     | 142,000   |                               |   | 225,000   |  | (37 | %)
|                                          |  |                                     |           |                               |   |           |  |     |   
|Total general and administrative expenses |  | $                                   | 1,698,000 |                               | $ | 1,915,000 |  | (11 | %)
|                                          |  |                                     |           |                               |   |           |  |     |   



19



---

##### Table of Contents

The decrease in total general and administrative expenses for the three months ended March 31, 2005, was
primarily due to decreases in personnel costs of $46,000, occupancy and depreciation expenses of $59,000 and other general and administrative expenses of $83,000. Other general and administrative expenses are comprised of travel expenses, temporary
help, computer and office supplies.



Stock-based
Compensation.    We recorded a $50,000 reversal of stock-based compensation expense for the three-month period ended March 31, 2005 related to mark-to-market adjustments of stock options issued to non-employees. We recognized
expense of $302,000 for the three-month period ended March 31, 2004, a decrease of $352,000, or 117%. The decrease was primarily attributable to a decrease of compensation expense recorded on options to purchase common stock that were issued to
employees with exercise prices below fair market value on August 18, 2000 that became fully vested as of August 18, 2004. No related additional expense was recognized for these August 2000 stock options beyond August 2004. We recorded $257,000 in
stock-based compensation related to these options for the three months ended March 31, 2004. We also recorded $45,000 in stock-based compensation related to non-employee options for the period ended March 31, 2004. The decrease was also attributable
to options issued to non-employees that are marked-to-market liabilities. As our stock price fluctuates, the liability either increases or decreases. Because our stock price declined, we recorded a reversal of our liability for stock-based
compensation expense.



Amortization of
Intangibles.    Amortization of intangible assets was $19,000 for each of the three-month periods ended March 31, 2005 and 2004.



Interest Income.    Interest income was $259,000 for the three-month period ended March 31, 2005 as compared to $107,000 for
the three-month period ended March 31, 2004, an increase of $152,000, or 142%. The increase in interest income resulted from higher interest rates and a higher available investment balance for the period ended March 31, 2005.



Other Income.    Other income for the three-month
period ended March 31, 2005 was $25,000 as compared to $154,000 for the three-month period ended March 31, 2004, a decrease of $129,000, or 84%. For the quarter ended March 31, 2004, other income primarily consisted of an adjustment to an estimate
of an amount payable to a former collaborator.



Interest
Expense.    Interest expense for the three-month period ended March 31, 2005 was $82,000 as compared to $111,000 for the three-month period ended March 31, 2004, a decrease of $29,000, or 26%. The decrease in interest expense
was attributable to a decrease in interest expense accrued under our convertible note payable to Elan Pharma International Limited, or EPIL, an affiliate of Elan Corporation. We recorded $8,000 and $46,000, respectively, for the three-month periods
ended March 31, 2005 and 2004 under the convertible note payable to EPIL. In addition, we recorded $26,000 and $17,000, respectively, for the three-month periods ended March 31, 2005 and 2004 under our debt and capital lease obligations. At March
31, 2005, we had outstanding debt of $2,250,000 under a loan agreement with Boston Private Bank & Trust Company.



Net Loss Applicable to Common Stockholders.    As a result of the foregoing, we incurred a net loss applicable to common
stockholders of $5,113,000 for the three-month period ended March 31, 2005 as compared to a net loss applicable to common stockholders of $4,038,000 for the three-month period ended March 31, 2004.



Liquidity and Capital Resources



We have financed our operations primarily through license fees, research and
development funding from our collaborators, the private and public placement of our equity securities, debt financings and the monetization of certain royalty rights.



At March 31, 2005, our principal sources of liquidity consisted of cash, cash equivalents, and marketable securities of
$45,896,000, excluding restricted long-term investments of $193,000. Our cash and cash equivalents are highly liquid investments with a maturity of three months or less at date of purchase and consist of time



20



---

##### Table of Contents

deposits and investments in money market funds with commercial banks and financial institutions, short-term commercial paper, and government obligations. We
also maintain cash balances with financial institutions in excess of insured limits. However, we do not anticipate any losses with respect to such cash balances because the balances are invested in highly rated securities. Our marketable securities
are investments with original maturities of greater than three months, but less than twelve months, and consist of commercial paper, corporate debt securities, and government obligations.



The use of our cash flows for operations has primarily consisted of salaries and wages for our employees, facility and
facility-related costs for our office and laboratory, fees paid in connection with preclinical studies, laboratory supplies, consulting fees, and legal fees. To date, the source of our cash flows from operations has been payments received from our
collaborators. In general, our only source of cash flows from operations for the foreseeable future will be the up-front license payments, payments for the achievement of milestones, if any, and funded research and development that we may receive
under collaboration agreements. The timing of any new collaboration agreements and any payments under existing collaboration agreements cannot be easily predicted and may vary significantly from quarter to quarter.



Net cash used in operating activities was $5,397,000 for the three-month
period ended March 31, 2005 as compared to $1,480,000 for the three-month period ended March 31, 2004. Cash used in operating activities during the three-month period ended March 31, 2005 was primarily the result of our net loss for the period
partially offset by an increase in working capital and by non-cash charges including depreciation, amortization and non-cash interest expense. Cash used in operating activities during the three-month period ended March 31, 2004 was primarily the
result of our net loss for the period partially offset by non-cash charges including stock-based compensation, depreciation and non-cash interest expense. In addition, increases in operating cash as a result of changes in certain current assets and
liabilities during the three-month period ended March 31, 2004, including a $1,500,000 up-front payment received for a licensing agreement with Wyeth, further offset our net loss.



Investing activities used cash of $933,000 for the three-month period ended March 31, 2005 as compared to $8,741,000 used in
the three-month period ended March 31, 2004. Net cash used in investing activities resulted principally from $946,000 in fixed asset purchases for the three months ended March 31, 2005. We expect that we will continue to use cash in our investing
activities as we expand our infrastructure. Cash used results principally from $8,656,000 in net investment purchases for the quarter ended March 31, 2004.



Financing activities provided cash of approximately $1,180,000 for the three-month period ended March 31, 2005, resulting from proceeds of $1,110,000 from
the issuance of debt for the purchase of fixed assets and $70,000 received upon stock option exercises. Financing activities provided approximately $2,196,000 of cash for the three-month period ended March 31, 2004, resulting primarily from the sale
of our common stock, including the sale of 315,524 shares to Wyeth and proceeds received upon stock option exercises. This increase was offset by $320,000 in repayments of obligations under capital leases.



Pursuant to our co-development arrangement with Genentech, under which we
share equally in U.S. development costs and any future net profits and/or losses derived from sales in the U.S. of a therapeutic product candidate for the topical treatment of basal cell carcinoma, we expect that we will incur approximately
$20,000,000 in development expenses through phase II clinical trials, of which $2,178,000 was paid during the first quarter of 2005 and an additional $1,127,000 has been accrued. Genentech filed an investigational new drug application with the FDA
on March 31, 2005 in order to initiate human clinical investigation of the basal cell carcinoma product candidate. Assuming the acceptance of the investigational new drug application by the FDA and the successful advancement of the basal cell
carcinoma product candidate through phase I and phase II clinical trials, we expect that the phase II clinical trial will be completed in mid-2007. We expect to incur additional costs to complete phase III clinical trials and complete the regulatory
approval process, assuming that Genentech and we successfully complete phase II clinical trials.



21



---

##### Table of Contents

Effective January 7, 2005, we entered into an amendment with the Boston Private Bank & Trust Company
to extend the drawdown date in which we can request periodic financings up to $2,250,000 for qualifying purchases of equipment and leaseholds under the loan agreement through April 30, 2005. On March 23, 2005, we drew down the remaining balance
under this agreement bringing the total amount financed to $2,250,000 and exercised our option to convert the outstanding balance into a 36-month term note that bears interest at a fixed rate of 7.36% for the repayment period. Under the terms of the
note payable, we are required to make equal monthly payments of $62,500 beginning on May 1, 2005 extending through the 36-month term. The loan is collateralized by all of our property, plant and equipment assets, except for those that are affixed to
the property and those that are purchased after March 23, 2005 under purchase money arrangements with equipment lenders. As of March 31, 2005, we were in compliance with the sole covenant under this agreement. Should we fail to pay amounts when due
or fail to maintain compliance with the covenant under this agreement, the entire obligation becomes immediately due at the option of the Boston Private Bank & Trust Company.



On June 26, 2001, we received $2,000,000 from Becton Dickinson under a convertible subordinated note payable in connection
with the exercise by Becton Dickinson of an option to negotiate a collaboration agreement. The note is repayable at any time up to its maturity date of June 26, 2006 by us, at our discretion, in either cash or upon issuance to Becton Dickinson of
shares of our common stock. The note bears interest at 7%. As of March 31, 2005, there was approximately $2,527,000, including approximately $527,000 in accrued interest, outstanding under the note agreement.



Contractual Obligations



In addition to our loan agreement with Boston Private Bank & Trust Company, we also have contractual obligations related
to our facility lease, research services agreements, consulting agreements, and license agreements. The following table summarizes our contractual obligations due by the period indicated at March 31, 2005:



|                                           |  |                     |       |      |   |       |  |      |       |      |   |            |  |       |     |  |   |     |  |   |       
|------------------------------------------ |  | ------------------- | ----- | ---- | - | ----- |  | ---- | ----- | ---- | - | ---------- |  | ----- | --- |  | - | --- |  | - | ------
|                                           |  | (amounts in 000s) 
|                                           |  | Remainderof 2005(3) |       | 2006 |   | 2007  |  | 2008 |       | 2009 |   | Thereafter |  | Total
|Convertible subordinated long-term debt(1) |  | $                   |      |      | $ | 2,805 |  | $    |      |      | $ |           |  | $     |    |  | $ |    |  | $ | 2,805 
|Debt obligations under note payable        |  |                     | 600   |      |   | 853   |  |      | 798   |      |   | 254        |  |       |    |  |   |    |  |   | 2,505 
|Operating lease obligations                |  |                     | 610   |      |   | 1,323 |  |      | 1,105 |      |   | 948        |  |       | 948 |  |   | 948 |  |   | 5,882 
|Outside service obligations(2)             |  |                     | 1,206 |      |   |      |  |      |      |      |   |           |  |       |    |  |   |    |  |   | 1,206 
|Licensing obligations                      |  |                     | 225   |      |   |      |  |      |      |      |   |           |  |       |    |  |   |    |  |   | 225   
|                                           |  |                     |       |      |   |       |  |      |       |      |   |            |  |       |     |  |   |     |  |   |       
|Total future obligations.                  |  | $                   | 2,641 |      | $ | 4,981 |  | $    | 1,903 |      | $ | 1,202      |  | $     | 948 |  | $ | 948 |  | $ | 12,623
|                                           |  |                     |       |      |   |       |  |      |       |      |   |            |  |       |     |  |   |     |  |   |       

---

|(1) |  | Convertible subordinated debt is convertible into either shares of our common stock or cash at our option.
|--- |  | ----------------------------------------------------------------------------------------------------------



|(2) |  | Outside service obligations consist of agreements we have with outside labs, consultants and various other service organizations.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------



|(3) |  | Obligations do not include amounts we will owe Genentech under our co-development arrangement.
|--- |  | ----------------------------------------------------------------------------------------------



We anticipate that existing capital resources at March 31, 2005, should enable us to maintain current and planned operations
into mid-2007, including spending related to the co-development of our basal cell carcinoma product candidate under development with Genentech. We expect to incur substantial additional research and development and other costs, including costs
related to preclinical studies and clinical trials for the foreseeable future. Our ability to continue funding planned operations beyond mid-2007 is dependent upon the success of our collaborations, our ability to maintain or reduce our cash burn
rate and our ability to raise additional funds through equity or debt financings, or from other sources of financing. Our ability to generate sufficient cash flows depends on a number of factors, including the ability of either us, or our
collaborators, to obtain regulatory approval to



22



---

##### Table of Contents

market and commercialize products to treat indications in major commercial markets. We are seeking additional collaborative arrangements and also expect to
raise funds through one or more financing transactions, if conditions permit. Due to our significant long-term capital requirements, we intend to seek to raise funds through the sale of debt or equity securities when conditions are favorable, even
if we do not have an immediate need for additional capital at such time. Additional financing may not be available or, if available, it may not be available on favorable terms. In addition, the sale of additional debt or equity securities could
result in dilution to our stockholders. If substantial additional funding is not available, our ability to fund research and development and other operations will be significantly affected and, accordingly, our business will be materially and
adversely affected.



Off-Balance Sheet Arrangements



We have no off-balance sheet arrangements as of March 31, 2005.



Inflation



We believe that inflation has not had a significant impact on our revenue and results of operations since inception.



Factors That May Affect Results



RISKS RELATING TO OUR FINANCIAL RESULTS AND NEED FOR FINANCING



We have incurred substantial losses, we expect to continue to incur
substantial losses and we may never achieve profitability.



We expect to incur substantial operating losses for the foreseeable future, and we have no current sources of material ongoing revenue. As of March 31, 2005, we had an accumulated deficit of approximately $668,086,000. Other than OP-1,
which we and Stryker commercialized under a former collaboration, we have not commercialized any products to date, either alone or with a third party collaborator. All of our product candidates are in early stages of development. If we are not able
to commercialize any products, whether alone or with a collaborator, we will not achieve profitability. Even if our collaboration agreements provide funding for a portion of our research and development expenses for some of our programs, we expect
to spend significant capital to fund our research and development programs for the foreseeable future. As a result, we will need to generate significant revenues in order to achieve profitability. We cannot be certain whether or when this will occur
because of the significant uncertainties that affect our business. Our failure to become and remain profitable may depress the market price of our common stock and could impair our ability to raise capital, expand our business, diversify our product
offerings or continue our operations.



We will require additional financing,
which may be difficult to obtain and may dilute your ownership interest in us.



We will require substantial funds to continue our research and development programs. In particular, our currently-planned operating and capital requirements primarily include the need for working capital to:



| |  |  | fund our portion of the development costs for a basal cell carcinoma drug candidate pursuant to our equal cost-sharing co-development arrangement with our collaborator, Genentech;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | support our research and development activities for our internal programs; and
| | - |  | ------------------------------------------------------------------------------



| |  |  | fund our general and administrative costs and expenses.
| | - |  | -------------------------------------------------------



We believe that our existing cash and working capital should be sufficient to fund our operations until mid-2007, however, our future capital requirements
may vary from what we expect. There are factors that may affect our future capital requirements and accelerate our need for additional financing. Many of these factors are outside our control, including the following:



23



---

##### Table of Contents

| |  |  | continued progress in our research and development programs, as well as the magnitude of these programs;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | the cost of additional facilities requirements including the current expansion of the animal facility and such others as may be required;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to establish and maintain collaborative arrangements;
| | - |  | -----------------------------------------------------------------



| |  |  | the timing, receipt and amount of research funding and milestone, license, royalty and other payments, if any, from collaborators;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | the timing, payment and amount of research funding and milestone, license, royalty and other payments due to licensors of patent rights and technology used to make, use and sell our
product candidates;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the timing, receipt and amount of sales revenues and associated royalties to us, if any, from our product candidates in the market; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the costs of preparing, filing, prosecuting, maintaining and enforcing patent claims and other patent-related costs, including litigation costs and technology license fees.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We expect to seek additional funding through
public or private financings and may seek additional funding for programs that are not currently licensed to collaborators, from new strategic collaborators. However, the biotechnology market in general, and the market for our common stock, in
particular, is highly volatile. Due to market conditions and the status of our development pipeline, additional funding may not be available to us on acceptable terms, if at all. If we fail to obtain such additional financing on a timely basis, our
ability to continue all of our research and development, activities will be adversely affected.



If we raise additional funds by issuing equity securities, dilution to our stockholders will result. In addition, the terms of such a financing may
adversely affect other rights of our stockholders. We also could elect to seek funds through arrangements with collaborators or others that may require us to relinquish rights to certain technologies, product candidates or products.



If the estimates we make and the assumptions on which we rely in preparing our financial
statements prove inaccurate, our actual results may vary significantly.



Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments
that affect the reported amounts of our assets, liabilities, revenues and expenses, the amounts of charges taken by us and related disclosure. We base our estimates on historical experience and on various other assumptions that we believe to be
reasonable under the circumstances. We cannot assure you that our estimates, or the assumptions underlying them, will be correct. Accordingly, our actual financial results may vary significantly from the estimates contained in our financial
statements.



RISKS RELATING TO OUR COLLABORATIONS



We are dependent on collaborators for the development and
commercialization of many of our product candidates and for a significant portion of our revenue. If we lose any of these collaborators, of if they fail or delay in developing or commercializing our product candidates, our anticipated product
pipeline and operating results would suffer.



The success
of our strategy for development and commercialization of product candidates depends upon our ability to form and maintain productive strategic collaborations. We currently have strategic collaborations with Genentech, Ortho Biotech Products, and
Wyeth. $2.2 million and $4.4 million, or 79% and 88%, respectively, of our gross revenue for the first quarter of 2005 and for the year ended December 31, 2004 were derived from licensing and research and development payments paid to us by these
collaborators. We expect to enter into additional collaborations in the future. Our existing and any future collaborations may not be scientifically or commercially successful.



24



---

##### Table of Contents

The risks that we face in connection with these collaborations include the following:



| |  |  | Each of our collaborators has significant discretion in determining the efforts and resources that they will apply to the collaboration. The timing and amount of any future royalty
and milestone revenue that we may receive under such collaborative arrangements will depend on, among other things, such collaborators efforts and allocation of resources.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | All of our strategic collaboration agreements are for fixed terms and are subject to termination under various circumstances, including in some cases, on short notice without cause.
If any collaborator were to terminate an agreement, we may be required to undertake product development, manufacturing and commercialization and we may not have the funds or capability to do this, which could result in a discontinuation of such
program.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our collaborators may develop and commercialize, either alone or with others, products and services that are similar to or competitive with the products and services that are the
subject of the collaboration with us.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our collaborators may change the focus of their development and commercialization efforts or pursue higher-priority programs. The ability of certain of our product candidates to
reach their potential could be limited if our collaborators decrease or fail to increase spending related to such product candidates.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We may not be successful in establishing additional strategic collaborations, which could adversely affect our ability to develop and commercialize products.



As an integral part of our ongoing research and
development efforts, we periodically review opportunities to establish new collaborations, joint ventures and strategic collaborations for the development and commercialization of products in our development pipeline. We face significant competition
in seeking appropriate collaborators and the negotiation process is time-consuming and complex. We may not be successful in our efforts to establish additional strategic collaborations or other alternative arrangements. Even if we are successful in
our efforts to establish a collaboration or agreement, the terms that we establish may not be favorable to us. Finally, such strategic alliances or other arrangements may not result in successful products and associated revenue.



RISKS RELATED TO OUR BUSINESS, INDUSTRY, STRATEGY AND OPERATIONS



We face substantial competition, which may result in our competitors
discovering, developing or commercializing products before or more successfully than we do.



Our product candidates face competition with existing and new products being developed by biotechnology, medical device and pharmaceutical companies, as
well as universities and other research institutions. For example, research in the fields of regulatory signaling pathways and functional genomics, which includes our work with Genentech in the field of cancer, with Ortho Biotech Products in the
field of renal disease, and with Wyeth in the field of neurology, is highly competitive. A number of entities are seeking to identify and patent randomly sequenced genes and gene fragments, typically without specific knowledge of the function that
such genes or gene fragments perform. Our competitors may discover, characterize and develop important inducing molecules or genes in advance of us. We also face competition from these and other entities in gaining access to DNA samples used in our
research and development projects. Many of our competitors have substantially greater capital resources, research and development staffs and facilities than we have. Efforts by other biotechnology, medical device and pharmaceutical companies could
render our programs or products uneconomical or result in therapies superior to those that we develop alone or with a collaborator. For those programs that we have selected for further internal development, we face competition from companies that
are more experienced in product development and commercialization, obtaining regulatory approvals and product manufacturing. As a result, they may develop competing products more rapidly and at a lower cost. For those programs that are subject to a
collaboration agreement, competitors may discover, develop and commercialize products which render our products non-competitive or obsolete. We expect competition to intensify in genomics research and regulatory signaling pathways as technical
advances in the field are made and become more widely known.



25



---

##### Table of Contents

Since our technologies have many potential applications and we have limited resources, our election to focus on a
particular application may result in our failure to capitalize on other potentially profitable applications of our technologies.



We have limited financial and managerial resources. These limitations require us to focus on a select group of product candidates in specific therapeutic
areas and to forego the exploration of other product opportunities. While our technologies may permit us to work in multiple areas, resource commitments may require trade-offs resulting in delays in the development of certain programs or research
areas, which may place us at a competitive disadvantage. Our decisions as to resource allocation may not lead to the development of viable commercial products and may divert resources away from other market opportunities which ultimately prove to be
more profitable.



If we or our collaborators fail to achieve market
acceptance for our products under development, our future revenue and ability to achieve profitability may be adversely affected.



Our future products, if any are successfully developed, may not gain commercial acceptance among physicians, patients and third-party payors, even if
necessary marketing approvals have been obtained. We believe that recommendations and endorsements by physicians will be essential for market acceptance of any products we successfully develop. If we are not able to obtain a positive reception for
such products, our expected revenues from sales of these products would be adversely affected.



We could be exposed to significant risk from liability claims if we are unable to obtain insurance at acceptable costs or otherwise protect ourselves against potential product liability claims.



Product liability claims, inherent in the process of researching and
developing human health care products, could expose us to significant liabilities and prevent or interfere with the development or commercialization of our product candidates. Product liability claims would require us to spend significant time,
money and other resources to defend such claims and could ultimately lead to our having to pay a significant damage award. Product liability insurance is expensive to procure for biopharmaceutical companies such as ours. Although we maintain product
liability insurance coverage for the clinical trials of our products under development, it is possible that we will not be able to obtain additional product liability insurance on acceptable terms, if at all, and that our product liability insurance
coverage will not prove to be adequate to protect us from all potential claims.



If we are not able to attract and retain key management and scientific personnel and advisors, we may not successfully develop our product candidates or achieve our other business objectives.



We highly depend upon our senior management and scientific staff. The loss
of the service of any of the key members of our senior management may significantly delay or prevent the achievement of product development and other business objectives. Key members of our senior management team include Daniel R. Passeri, our
president and chief executive officer and Dr. Lee L. Rubin, our senior vice president and chief scientific officer. Our executive officers, including these individuals, can terminate their employment with us at any time. The loss of the services of
any of our executive officers may significantly delay or prevent the achievement of product research and development and other business objectives. We are not aware of any present intention of any of these individuals to leave our company. Replacing
key employees may be difficult and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to research, develop and successfully commercialize products in
our areas of core competency. We do not maintain key man life insurance on any of these executive officers.



Our ability to operate successfully will depend on our ability to attract and retain qualified personnel, consultants and advisors. We face intense
competition for qualified individuals from numerous pharmaceutical and biotechnology companies, universities, governmental entities and other research institutions. We may be unable to attract and retain these individuals, and our failure to do so
would have an adverse effect on our business.





26



---

##### Table of Contents

If we make any acquisitions, we will incur a variety of costs and may never successfully integrate the acquired
business into ours.



We may attempt to acquire businesses,
technologies, services or products that we believe are a strategic complement to our business model. We may encounter operating difficulties and expenditures relating to integrating an acquired business, technology, service or product. These
acquisitions may also absorb significant management attention that would otherwise be available for ongoing development of our business. Moreover, we may never realize the anticipated benefits of any acquisition. We may also make dilutive issuances
of equity securities, incur debt, experience a decrease in the cash available for our operations, or incur contingent liabilities in connection with any future acquisitions.



RISKS RELATING TO INTELLECTUAL PROPERTY



If we breach any of the agreements under which we license or have acquired intellectual property from others, we could lose intellectual
property rights that are important to our business.



We
are a party to intellectual property licenses and agreements that are important to our business and expect to enter into similar licenses and agreements in the future. These licenses and agreements impose various research, development,
commercialization, sublicensing, royalty, indemnification, insurance and other obligations on us. If we or our collaborators fail to perform under these agreements or otherwise breach obligations thereunder, we could lose intellectual property
rights that are important to our business.



We may not be able to obtain
patent protection for our discoveries and our technologies may be found to infringe patent rights of third parties.



The patent positions of pharmaceutical and biotechnology companies, including ours, are generally uncertain and involve complex legal, scientific and
factual questions.



The long-term success of our enterprise
depends in significant part on our ability to:



| |  |  | obtain patents to protect our discoveries;
| | - |  | ------------------------------------------



| |  |  | protect trade secrets from disclosure to third-party competitors;
| | - |  | -----------------------------------------------------------------



| |  |  | operate without infringing upon the proprietary rights of others; and
| | - |  | ---------------------------------------------------------------------



| |  |  | prevent others from infringing on our proprietary rights.
| | - |  | ---------------------------------------------------------



Patents may not issue from any of the patent applications that we own or license. If patents do issue, the allowed claims may not be sufficiently broad to
protect our technology from exploitation by our competitors. In addition, issued patents that we own or license may be challenged, invalidated or circumvented. Our patents also may not afford us protection against competitors with similar
technology. Because patent applications in the United States are maintained in secrecy until 18 months after filing, it is possible that third parties have filed or maintained patent applications for technology used by us or covered by our pending
patent applications without our knowledge.



We may not have
rights under patents which may cover one or more of our product candidates. In some cases, these patents may be owned or controlled by third party competitors and may impair our ability to exploit our technology. As a result, we or our collaborative
partners may be required to obtain licenses under third-party patents to develop and commercialize some of our product candidates. If we are unable to secure licenses to such patented technology on acceptable terms, we or our collaborative partners
will not be able to develop and commercialize the affected product candidate or candidates.



27



---

##### Table of Contents

If we are unable to keep our trade secrets confidential, our technology and proprietary information may be used by
others to compete against us.



We rely significantly upon
proprietary technology, information, processes and know-how that is not subject to patent protection. We seek to protect this information through confidentiality agreements with our employees, consultants and other third-party contractors as well as
through other security measures. These confidentiality agreements and security measures may be breached, and we may not have adequate remedies for any such breach. In addition, our trade secrets may otherwise become known or be independently
developed by competitors.



We may become involved in expensive patent
litigation or other intellectual property proceedings which could result in liability for damages or stop our development and commercialization efforts.



There have been substantial litigation and other proceedings regarding patent and other intellectual property rights in the pharmaceutical and
biotechnology industries. We may become a party to patent litigation or other proceedings regarding intellectual property rights.



Situations which may give rise to patent litigation or other disputes over the use of our intellectual property include:



| |  |  | initiation of litigation or other proceedings against third parties to enforce our patent rights;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | initiation of litigation or other proceedings against third parties to seek to invalidate the patents held by these third parties or to obtain a judgment that our product candidates
do not infringe the third parties patents;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | participation in interference or opposition proceedings to determine the priority of invention if our competitors file patent applications that claim technology also claimed by us;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | initiation of litigation by third parties claiming that our processes or product candidates or the intended use of our product candidates infringe their patent or other intellectual
property rights; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | initiation of litigation by us or third parties seeking to enforce contract rights relating to intellectual property which may be important to our business.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



The costs associated with any patent litigation
or other proceeding, even if resolved favorably, will likely be substantial. Some of our competitors may be able to sustain the cost of such litigation or other proceedings more effectively than we can because of their substantially greater
financial resources. If a patent litigation or other intellectual property proceeding is resolved unfavorably, we or our collaborative partners may be enjoined from manufacturing or selling our products and services without a license from the other
party and be held liable for significant damages. Moreover, we may not be able to obtain required licenses on commercially acceptable terms or any terms at all. In addition, we could be held liable for lost profits if we are found to have infringed
a valid patent, or liable for treble damages if we are found to have willfully infringed a valid patent. Litigation results are highly unpredictable and we or our collaborative partners may not prevail in any patent litigation or other proceeding in
which we may become involved.



Uncertainties resulting from the
initiation and continuation of patent litigation or other proceedings could damage our ability to compete in the marketplace. Patent litigation and other proceedings may also absorb significant management time and expense.



If licensees or assignees of our intellectual property rights breach any of the agreements
under which we have licensed or assigned our intellectual property to them, we could be deprived of important intellectual property rights and future revenue.



We are a party to intellectual property out-licenses, collaborations and agreements that are important to our business and
expect to enter into similar agreements with third parties in the future. Under these agreements, we license or transfer intellectual property to third parties and impose various research, development, commercialization, sublicensing, royalty,
indemnification, insurance, and other obligations on them. If a third



28



---

##### Table of Contents

party fails to comply with these requirements, we generally retain the right to terminate the agreement, and to bring a legal action in court or in
arbitration. In the event of breach, we may need to enforce our rights under these agreements by resorting to arbitration or litigation. During the period of arbitration or litigation, we may be unable to effectively use, assign or license the
relevant intellectual property rights and may be deprived of current or future revenues that are associated with such intellectual property.



RISKS RELATING TO CLINICAL AND REGULATORY MATTERS



We expect to rely heavily on third parties for the conduct of clinical trials of our product candidates. If these clinical trials are not successful, or if we or our
collaborators are not able to obtain the necessary regulatory approvals, we will not be able to commercialize our product candidates.



In order to obtain regulatory approval for the commercial sale of our product candidates, we and our collaborators will be required to complete extensive
preclinical studies as well as clinical trials in humans to demonstrate to the FDA and foreign regulatory authorities that our product candidates are safe and effective. We have limited experience in conducting clinical trials and expect to rely
primarily on collaborative partners and contract research organizations for their performance and management of clinical trials of our product candidates.



Clinical development, including preclinical testing, is a long, expensive and uncertain process. Accordingly, preclinical testing and clinical trials, if
any, of our product candidates under development may not be successful. We and our collaborators could experience delays in preclinical or clinical trials of any of our product candidates, obtain unfavorable results in a development program, or fail
to obtain regulatory approval for the commercialization of a product. Preclinical studies or clinical trials may produce negative, inconsistent or inconclusive results, and we or our collaborators may decide, or regulators may require us, to conduct
additional preclinical studies or clinical trials. The results from early clinical trials may not be statistically significant or predictive of results that will be obtained from expanded, advanced clinical trials. Furthermore, the timing and
completion of clinical trials, if any, of our product candidates depend on, among other factors, the number of patients we will be required to enroll in the clinical trials and the rate at which those patients are enrolled. Any increase in the
required number of patients, decrease in recruitment rates or difficulties retaining study participants may result in increased costs, program delays or both. Also, our products under development may not be effective in treating any of our targeted
disorders or may prove to have undesirable or unintended side effects, toxicities or other characteristics that may prevent or limit their commercial use. Institutional review boards or regulators, including the FDA, may hold, suspend or terminate
our clinical research or the clinical trials of our product candidates for various reasons, including noncompliance with regulatory requirements or if, in their opinion, the participating subjects are being exposed to unacceptable health risks.
Additionally, the failure of third parties conducting or overseeing the operation of the clinical trials to perform their contractual or regulatory obligations in a timely fashion could delay the clinical trials. Failure of clinical trials can occur
at any stage of testing. Any of these events would adversely affect our ability to market a product candidate.



The development process necessary to obtain regulatory approval is lengthy, complex and expensive. If we and our collaborative partners do not obtain necessary regulatory approvals, then our business will be
unsuccessful and the market price of our common stock will substantially decline.



To the extent that we, or our collaborative partners, are able to successfully advance a product candidate through the clinic, we, or such partner, will be required to obtain regulatory approval prior to marketing and
selling such product.



The process of obtaining FDA and other
required regulatory approvals is expensive. The time required for FDA and other approvals is uncertain and typically takes a number of years, depending on the complexity and novelty of the product. The process of obtaining FDA and other required
regulatory approvals for many of our products under development is further complicated because some of these products use non-traditional or novel materials in non-traditional or novel ways, and the regulatory officials have little precedent to
follow. With respect to internal programs to date, we have limited experience in filing and prosecuting applications to obtain marketing approval.



29



---

##### Table of Contents

Any regulatory approval to market a product may be subject to limitations on the indicated uses for which
we, or our collaborative partners, may market the product. These limitations may restrict the size of the market for the product and affect reimbursement by third-party payors. In addition, regulatory agencies may not grant approvals on a timely
basis or may revoke or significantly modify previously granted approvals.



We, or our collaborative partners, also are subject to numerous foreign regulatory requirements governing the manufacturing and marketing of our potential future products outside of the United States. The approval
procedure varies among countries, additional testing may be required in some jurisdictions, and the time required to obtain foreign approvals often differs from that required to obtain FDA approvals. Moreover, approval by the FDA does not ensure
approval by regulatory authorities in other countries, and vice versa.



As a result of these factors, we or our collaborators may not successfully begin or complete clinical trials in the time periods estimated, if at all. Moreover, if we or our collaborators incur costs and delays in development programs or
fail to successfully develop and commercialize products based upon our technologies, we may not become profitable and our stock price could decline.



Even if marketing approval is obtained, any products we or our collaborators develop will be subject to ongoing regulatory oversight which may affect the successful
commercialization of such products.



Even if regulatory
approval of a product candidate is obtained by us or our collaborators, the approval may be subject to limitations on the indicated uses for which the product is marketed or require costly post-marketing follow-up studies. After marketing approval
for any product is obtained, the manufacturer and the manufacturing facilities for that product will be subject to continual review and periodic inspections by the FDA and other regulatory agencies. The subsequent discovery of previously unknown
problems with the product, or with the manufacturer or facility, may result in restrictions on the product or manufacturer, including withdrawal of the product from the market.



If there is a failure to comply with applicable regulatory requirements, we or our collaborator may be subject to fines,
suspension or withdrawal of regulatory approvals, product recalls, seizure of products, operating restrictions, and criminal prosecution.



We, and our collaborators, are subject to governmental regulations other than those imposed by the FDA. We, and any of our collaborators, may not be able to comply
with these regulations, which could subject us, or such collaborators, to penalties and otherwise result in the limitation of our or such collaborators operations.



In addition to regulations imposed by the FDA, we and our collaborators are subject to regulation under the Occupational
Safety and Health Act, the Environmental Protection Act, the Toxic Substances Control Act, the Research Conservation and Recovery Act, as well as regulations administered by the Nuclear Regulatory Commission, national restrictions on technology
transfer, import, export and customs regulations and certain other local, state or federal regulations. From time to time, other federal agencies and congressional committees have indicated an interest in implementing further regulation of
biotechnology applications. We are not able to predict whether any such regulations will be adopted or whether, if adopted, such regulations will apply to our business, or whether we or our collaborators would be able to comply with any applicable
regulations.



Our research and development activities involve
the controlled use of hazardous materials and chemicals. Although we believe that our safety procedures for handling and disposing of such materials comply with all applicable laws and regulations, we cannot completely eliminate the risk of
accidental contamination or injury caused by these materials.



RISKS RELATING TO PRODUCT MANUFACTURING AND SALES



We will
depend on our collaborators and third-party manufacturers to produce most, if not all, of our products under development, and if these third parties do not successfully manufacture these products our business will be harmed.



30



---

##### Table of Contents

We have no manufacturing experience or manufacturing capabilities. In order to continue to develop
products, apply for regulatory approvals, and commercialize our products, we or our collaborators must be able to manufacture products in clinical and commercial quantities, in compliance with regulatory requirements, at acceptable costs and in a
timely manner. The manufacture of our product candidates may be complex, difficult to accomplish and difficult to scale-up when large-scale production is required. Manufacture may be subject to delays, inefficiencies and poor or low yields of
quality products. The cost of manufacturing some of our products may make them prohibitively expensive. If supplies of any of our product candidates or related materials become unavailable on a timely basis or at all or are contaminated or otherwise
lost, clinical trials by us and our collaborators could be seriously delayed. This is due to the fact that such materials are time-consuming to manufacture and cannot be readily obtained from third-party sources.



To the extent that we, or our collaborators, seek to enter into manufacturing
arrangements with third parties, we and such collaborators will depend upon these third parties to perform their obligations in a timely and effective manner and in accordance with government regulations. Contract manufacturers may breach their
manufacturing agreements because of factors beyond our control or may terminate or fail to renew a manufacturing agreement based on their own business priorities at a time that is costly or inconvenient for us. Contract manufacturers are subject to
ongoing periodic, unannounced inspection by the FDA and corresponding state and foreign agencies or their designees to ensure strict compliance with current good manufacturing practices and other governmental regulations and corresponding foreign
standards. Failure of contract manufacturers or our collaborators or us to comply with applicable regulations could result in sanctions being imposed, including fines, injunctions, civil penalties, failure of regulatory authorities to grant
marketing approval of our product candidates, delays, suspension or withdrawal of approvals, seizures or recalls of product candidates, operating restrictions and criminal prosecutions, any of which could significantly and adversely affect our
business. If we need to change manufacturers, the FDA and corresponding foreign regulatory agencies must approve these manufacturers in advance. This would involve testing and pre-approval inspections to ensure compliance with FDA and foreign
regulations and standards. If third-party manufacturers fail to perform their obligations, our competitive position and ability to generate revenue may be adversely affected in a number of ways, including;



| |  |  | we and our collaborators may not be able to initiate or continue clinical trials of products that are under development;
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | we and our collaborators may be delayed in submitting applications for regulatory approvals for our product candidates; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | we and our collaborators may not be able to meet commercial demands for any approved products.
| | - |  | ----------------------------------------------------------------------------------------------



We have no sales or marketing experience and, as such, will depend significantly on third parties who may not successfully sell our
products.



We have no sales, marketing or product
distribution experience. If we receive required regulatory approvals, we plan to rely primarily on sales, marketing and distribution arrangements with third parties, including our collaborative partners. For example, as part of our agreements with
Genentech, Ortho Biotech Products and Wyeth, we have granted our collaborators exclusive rights to distribute certain products resulting from such collaborations, if any are ever successfully developed. We may have to enter into additional marketing
arrangements in the future and we may not be able to enter into these additional arrangements on terms which are favorable to us, if at all. In addition, we may have limited or no control over the sales, marketing and distribution activities of
these third parties and sales through these third parties could be less profitable to us than direct sales. These third parties could sell competing products and may devote insufficient sales efforts to our products. Our future revenues will be
materially dependent upon the success of the efforts of these third parties.



We may seek to independently market products that are not already subject to marketing agreements with other parties. If we determine to perform sales, marketing and distribution functions ourselves, we could face a
number of additional risks, including:





31



---

##### Table of Contents

| |  |  | we may not be able to attract and build a significant and skilled marketing staff or sales force;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | the cost of establishing a marketing staff or sales force may not be justifiable in light of the revenues generated by any particular product; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our direct sales and marketing efforts may not be successful.
| | - |  | -------------------------------------------------------------



RISKS RELATED TO OUR COMMON STOCK



Our stock price will fluctuate significantly and the market price of our common stock could drop below the price you paid.



The trading price of our common stock has been volatile and may continue to
be volatile in the future. For example, our stock has traded as high as $6.59 and as low as $2.46 per share for the period January 1, 2004 through March 31, 2005. The stock market, particularly in recent years, has experienced significant volatility
with respect to biopharmaceutical- and biotechnology-based company stocks. The volatility of biopharmaceutical- and biotechnology-based company stocks often does not relate to the operating performance of the companies represented by the stock.
Prices for our stock will be determined in the market place and may be influenced by many factors, including:



| |  |  | announcements regarding new technologies by us or our competitors;
| | - |  | ------------------------------------------------------------------



| |  |  | market conditions in the biotechnology and pharmaceutical sectors;
| | - |  | ------------------------------------------------------------------



| |  |  | rumors relating to us or our competitors;
| | - |  | -----------------------------------------



| |  |  | litigation or public concern about the safety of our potential products;
| | - |  | ------------------------------------------------------------------------



| |  |  | actual or anticipated variations in our quarterly operating results;
| | - |  | --------------------------------------------------------------------



| |  |  | deviations in our operating results from the estimates of securities analysts;
| | - |  | ------------------------------------------------------------------------------



| |  |  | adverse results or delays in clinical trials being conducted by us or our collaborators;
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | any intellectual property lawsuits involving us;
| | - |  | ------------------------------------------------



| |  |  | sales of large blocks of our common stock;
| | - |  | ------------------------------------------



| |  |  | sales of our common stock by our executive officers, directors or significant stockholders;
| | - |  | -------------------------------------------------------------------------------------------



| |  |  | the loss of any of our key scientific or management personnel;
| | - |  | --------------------------------------------------------------



| |  |  | FDA or international regulatory actions; and
| | - |  | --------------------------------------------



| |  |  | general market conditions.
| | - |  | --------------------------



While we cannot predict the individual effect that these factors may have on the price of our common stock, these factors, either individually or in the
aggregate, could result in significant variations in price during any given period of time. Moreover, in the past, securities class action litigation has often been instituted against companies following periods of volatility in their stock price.
This type of litigation could result in substantial costs and divert our managements attention and resources.



Substantially all of our outstanding common stock may be sold into the market at any time. This could cause the market price of our common stock to drop significantly.



Sales of a substantial number of shares of our common
stock in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell shares, could reduce the market price of our common stock. As of March 31, 2005, we had
outstanding approximately 47.9 million shares of common stock. Substantially all of these shares may also be resold in the public market at any time. In addition, we have a significant number of shares that are subject to outstanding options. The
exercise of these options and the subsequent sale of the underlying common stock could cause a further decline in our stock price. These sales also might make it difficult for us to sell equity securities in the future at a time and at a price that
we deem appropriate.



32



---

##### Table of Contents

We have anti-takeover defenses that could delay or prevent an acquisition that our stockholders may consider favorable
and the market price of our common stock may be lower as a result.



Provisions of our certificate of incorporation, our bylaws and Delaware law may have the effect of deterring unsolicited takeovers or delaying or preventing changes in control of our management, including transactions in which our
stockholders might otherwise receive a premium for their shares over then current market prices. In addition, these provisions may limit the ability of stockholders to approve transactions that they may deem to be in their best interest. For
example, we have divided our board of directors into three classes that serve staggered three-year terms, we may issue shares of our authorized blank check preferred stock and our stockholders are limited in their ability to call special
stockholder meetings.



In addition, we are subject to the
anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibits a publicly-held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its
affiliates owns, or within the last three years has owned, 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a
prescribed manner. These provisions could discourage, delay or prevent a change in control transaction.



Item 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



We invest our cash balances in excess of operating requirements in cash equivalents and short-term marketable securities, generally money market funds,
corporate debt and government securities with an average maturity of less than one year. All marketable securities are considered available for sale. The primary objective of our cash investment activities is to preserve principal while at the same
time maximizing the income we receive from our invested cash without significantly increasing risk of loss. Our marketable securities are subject to interest rate risk and will fall in value if market interest rates increase. However, because of the
short-term nature of the marketable securities, we do not believe that interest rate fluctuations would materially impair the principal amount of our investments. Our investments are investment grade securities, and deposits are with investment
grade financial institutions. We believe that the realization of losses due to changes in credit spreads is unlikely as we expect to hold our investments to maturity. We do not use derivative financial instruments in our investment portfolio. We
have operated primarily in the United States. Accordingly, we do not have any material exposure to foreign currency rate fluctuations.



Item 4.    CONTROLS AND PROCEDURES



Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2005. The term disclosure
controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act, means controls and other procedures of a company that are designed to ensure that information
required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the U.S. Securities and Exchange Commission.
Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and
communicated to the companys management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no
matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the
evaluation of our disclosure controls and procedures as of March 31, 2005, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance
level.



No change in our internal control over financial
reporting occurred during the fiscal quarter ended March 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



33



---

##### Table of Contents

PART IIOTHER INFORMATION



Item 6.    EXHIBITS



(a) Exhibits.



See exhibit index.



34



---

##### Table of Contents

SIGNATURE



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



|                      |  |  |  |             |  |                        |  |                                                                                                                   
|--------------------- |  |  |  | ----------- |  | ---------------------- |  | ------------------------------------------------------------------------------------------------------------------
|                      |  |  |  | CURIS, INC.
|                      |  |  | 
|Dated: April 29, 2005 |  |  |  | By:         |  | /s/    MICHAEL P. GRAY
|                      |  |  |  |             |  |                        |  | Michael P. Gray Vice President of Finance and Chief Financial Officer (Principal Financial and Accounting
Officer)



35



---

##### Table of Contents

EXHIBIT INDEX



|              |  |                                                                                                                      
|------------- |  | ---------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                          
|              | 
|10.1         |  | Drug Discovery and Collaboration Agreement dated April 1, 2005 by and between Curis, Inc. and Genentech, Inc.        
|              | 
|31.1          |  | Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act                          
|              | 
|31.2          |  | Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act                          
|              | 
|32.1          |  | Certification of the Chief Executive Officer pursuant to Rule 13a-14(b) of the Exchange Act and18 U.S.C. Section
1350
|              | 
|32.2          |  | Certification of the Chief Financial Officer pursuant to Rule 13a-14(b) of the Exchange Act and18 U.S.C. Section
1350

---

| |  | Confidential treatment has been requested as to certain portions of this exhibit.
|- |  | ---------------------------------------------------------------------------------



36