##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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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 SEPTEMBER 30, 2005



OR



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



Commission File Number: 000-30347



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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



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



As of November 11, 2005, there were 49,339,994 shares of the Registrants common stock outstanding.



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##### Table of Contents

CURIS, INC. AND SUBSIDIARY

QUARTERLY REPORT ON FORM 10-Q



INDEX



|          |  |                                                                                                                                          |  |            
|--------- |  | ---------------------------------------------------------------------------------------------------------------------------------------- |  | -----------
|          |  |                                                                                                                                          |  | Page Number
|PART I.   |  | FINANCIAL INFORMATION                                                                                                                    |  |            
|          |  |                                                                                                                                         
|Item 1.   |  | Financial Statements                                                                                                                     |  |            
|          |  |                                                                                                                                         
|          |  | Condensed Consolidated Balance Sheets as of September 30, 2005 (unaudited) and December 31, 2004                                         |  | 3          
|          |  |                                                                                                                                         
|          |  | Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended September 30, 2005 and 2004 (unaudited) |  | 4          
|          |  |                                                                                                                                         
|          |  | Consolidated Statements of Cash Flows for the nine months ended September 30, 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                                                    |  | 29         
|          |  |                                                                                                                                         
|Item 3.   |  | Quantitative and Qualitative Disclosures About Market Risk                                                                               |  | 59         
|          |  |                                                                                                                                         
|Item 4.   |  | Controls and Procedures                                                                                                                  |  | 59         
|          |  |                                                                                                                                         
|PART II.  |  | OTHER INFORMATION                                                                                                                        |  |            
|          |  |                                                                                                                                         
|Item 6.   |  | Exhibits                                                                                                                                 |  | 61         
|          | 
|SIGNATURE |  | 62                                                                                                                                      



2



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##### Table of Contents

Item 1. FINANCIAL STATEMENTS



CURIS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ------------ | - | ---------------- | - | ------------ | -
|                                                                                                                                                                                                                                                          |  | September 30, 2005 |              |   | December 31,2004 |  
|                                                                                                                                                                                                                                                          |  | (unaudited)        |              |   |                  |  
|ASSETS                                                                                                                                                                                                                                                    |  |                    |              |   |                  |   |              |  
|Current Assets:                                                                                                                                                                                                                                           |  |                    |              |   |                  |   |              |  
|Cash and cash equivalents                                                                                                                                                                                                                                 |  | $                  | 22,884,331   |   |                  | $ | 22,679,924   |  
|Marketable securities                                                                                                                                                                                                                                     |  |                    | 20,013,996   |   |                  |   | 26,834,038   |  
|Accounts receivable                                                                                                                                                                                                                                       |  |                    | 2,026,140    |   |                  |   | 1,226,460    |  
|Prepaid expenses and other current assets                                                                                                                                                                                                                 |  |                    | 1,068,822    |   |                  |   | 843,198      |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|Total current assets                                                                                                                                                                                                                                      |  |                    | 45,993,289   |   |                  |   | 51,583,620   |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|Property and Equipment, net                                                                                                                                                                                                                               |  |                    | 5,015,497    |   |                  |   | 3,416,620    |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|Other Assets:                                                                                                                                                                                                                                             |  |                    |              |   |                  |   |              |  
|Long-term investments                                                                                                                                                                                                                                     |  |                    |             |   |                  |   | 2,606,681    |  
|Long-term investmentsrestricted                                                                                                                                                                                                                          |  |                    | 195,998      |   |                  |   | 193,166      |  
|Goodwill, net                                                                                                                                                                                                                                             |  |                    | 8,982,000    |   |                  |   | 8,982,000    |  
|Other intangible assets, net                                                                                                                                                                                                                              |  |                    | 45,818       |   |                  |   | 102,122      |  
|Deposits and other assets                                                                                                                                                                                                                                 |  |                    | 475,664      |   |                  |   | 750,604      |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|Total other assets                                                                                                                                                                                                                                        |  |                    | 9,699,480    |   |                  |   | 12,634,573   |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|                                                                                                                                                                                                                                                          |  | $                  | 60,708,266   |   |                  | $ | 67,634,813   |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                                                                      |  |                    |              |   |                  |   |              |  
|Current Liabilities:                                                                                                                                                                                                                                      |  |                    |              |   |                  |   |              |  
|Debt, current portion                                                                                                                                                                                                                                     |  | $                  | 1,634,680    |   |                  | $ | 1,141,294    |  
|Convertible notes payable                                                                                                                                                                                                                                 |  |                    | 2,556,962    |   |                  |   |             |  
|Accounts payable                                                                                                                                                                                                                                          |  |                    | 1,320,839    |   |                  |   | 1,643,219    |  
|Accrued liabilities                                                                                                                                                                                                                                       |  |                    | 2,271,819    |   |                  |   | 1,078,687    |  
|Deferred revenue, current portion                                                                                                                                                                                                                         |  |                    | 2,152,210    |   |                  |   | 1,939,708    |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|Total current liabilities                                                                                                                                                                                                                                 |  |                    | 9,936,510    |   |                  |   | 5,802,908    |  
|Long-term debt obligations, net of current portion portion                                                                                                                                                                                                |  |                    | 1,187,500    |   |                  |   |             |  
|Convertible notes payable, net of current portion                                                                                                                                                                                                         |  |                    |             |   |                  |   | 5,710,007    |  
|Deferred revenue, net of current portion                                                                                                                                                                                                                  |  |                    | 7,290,927    |   |                  |   | 6,941,545    |  
|Other long-term liabilities                                                                                                                                                                                                                               |  |                    | 763,800      |   |                  |   | 271,058      |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|Total liabilities                                                                                                                                                                                                                                         |  |                    | 19,178,737   |   |                  |   | 18,725,518   |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|Commitments                                                                                                                                                                                                                                               |  |                    |              |   |                  |   |              |  
|Stockholders Equity:                                                                                                                                                                                                                                     |  |                    |              |   |                  |   |              |  
|Common stock, $0.01 par value125,000,000 shares authorized; 49,333,495 and 48,285,788 shares issued and outstanding, respectively,
at September 30, 2005 and 48,565,120 and 47,517,413 shares issued and outstanding, respectively, at December 31, 2004 |  |                    | 493,335      |   |                  |   | 485,652      |  
|Additional paid-in capital                                                                                                                                                                                                                                |  |                    | 718,740,861  |   |                  |   | 713,202,427  |  
|Treasury stock (at cost, 1,047,707 shares at September 30, 2005 and December 31, 2004)                                                                                                                                                                    |  |                    | (891,274     | ) |                  |   | (891,274     | )
|Deferred compensation                                                                                                                                                                                                                                     |  |                    | (386,699     | ) |                  |   | (834,157     | )
|Accumulated deficit                                                                                                                                                                                                                                       |  |                    | (676,391,326 | ) |                  |   | (662,972,709 | )
|Accumulated other comprehensive loss                                                                                                                                                                                                                      |  |                    | (35,368      | ) |                  |   | (80,644      | )
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|Total stockholders equity                                                                                                                                                                                                                                |  |                    | 41,529,529   |   |                  |   | 48,909,295   |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  
|                                                                                                                                                                                                                                                          |  | $                  | 60,708,266   |   |                  | $ | 67,634,813   |  
|                                                                                                                                                                                                                                                          |  |                    |              |   |                  |   |              |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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##### Table of Contents

CURIS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (unaudited)



|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|-------------------------------------------------- |  | ------------------------------- | ---------- | - | ------------------------------ | - | ---------- | ---- |  | - | ----------- | - |  | - | ----------- | -
|                                                   |  | Three Months EndedSeptember 30, |            |   | Nine Months EndedSeptember 30, |  
|                                                   |  | 2005                            |            |   | 2004                           |   |            | 2005 |  |   | 2004        |  
|REVENUES:                                          |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Research and development contracts                 |  | $                               | 2,626,072  |   |                                | $ | 1,100,881  |      |  | $ | 7,358,750   |   |  | $ | 2,289,033   |  
|License fees                                       |  |                                 | 8,561      |   |                                |   | 385,345    |      |  |   | 892,295     |   |  |   | 1,123,067   |  
|Substantive milestones                             |  |                                 |           |   |                                |   |           |      |  |   | 250,000     |   |  |   | 50,000      |  
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Gross revenues                                     |  |                                 | 2,634,633  |   |                                |   | 1,486,226  |      |  |   | 8,501,045   |   |  |   | 3,462,100   |  
|Contra-revenues from co-development with Genentech |  |                                 | (819,491   | ) |                                |   |           |      |  |   | (5,697,993  | ) |  |   |            |  
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Net revenues                                       |  |                                 | 1,815,142  |   |                                |   | 1,486,226  |      |  |   | 2,803,052   |   |  |   | 3,462,100   |  
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|COSTS AND EXPENSES:                                |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Research and development                           |  |                                 | 3,820,650  |   |                                |   | 3,288,472  |      |  |   | 10,647,659  |   |  |   | 9,448,534   |  
|General and administrative                         |  |                                 | 1,832,802  |   |                                |   | 2,138,070  |      |  |   | 6,141,013   |   |  |   | 6,460,769   |  
|Amortization of intangible assets                  |  |                                 | 18,768     |   |                                |   | 18,768     |      |  |   | 56,304      |   |  |   | 56,304      |  
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Total costs and expenses                           |  |                                 | 5,672,220  |   |                                |   | 5,445,310  |      |  |   | 16,844,976  |   |  |   | 15,965,607  |  
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Loss from operations                               |  |                                 | (3,857,078 | ) |                                |   | (3,959,084 | )    |  |   | (14,041,924 | ) |  |   | (12,503,507 | )
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|OTHER INCOME (EXPENSE):                            |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Interest income                                    |  |                                 | 319,208    |   |                                |   | 116,358    |      |  |   | 861,869     |   |  |   | 332,530     |  
|Other income                                       |  |                                 |           |   |                                |   | 39,500     |      |  |   | 24,958      |   |  |   | 232,845     |  
|Interest expense                                   |  |                                 | (92,843    | ) |                                |   | (102,474   | )    |  |   | (263,519    | ) |  |   | (306,753    | )
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Total other income, net                            |  |                                 | 226,365    |   |                                |   | 53,384     |      |  |   | 623,308     |   |  |   | 258,622     |  
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Net loss                                           |  | $                               | (3,630,713 | ) |                                | $ | (3,905,700 | )    |  | $ | (13,418,616 | ) |  | $ | (12,244,885 | )
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Net loss per common share (basic and diluted)      |  | $                               | (0.08      | ) |                                | $ | (0.09      | )    |  | $ | (0.28       | ) |  | $ | (0.30       | )
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Weighted average common shares (basic and diluted) |  |                                 | 48,178,626 |   |                                |   | 41,620,123 |      |  |   | 47,998,663  |   |  |   | 41,398,656  |  
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Net loss                                           |  | $                               | (3,630,713 | ) |                                | $ | (3,905,700 | )    |  | $ | (13,418,616 | ) |  | $ | (12,244,885 | )
|Unrealized gain (loss) on marketable securities    |  |                                 | 25,585     |   |                                |   | 23,330     |      |  |   | 45,276      |   |  |   | (35,829     | )
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  
|Comprehensive loss                                 |  | $                               | (3,605,128 | ) |                                | $ | (3,882,370 | )    |  | $ | (13,373,340 | ) |  | $ | (12,280,714 | )
|                                                   |  |                                 |            |   |                                |   |            |      |  |   |             |   |  |   |             |  





See accompanying notes to unaudited condensed consolidated financial statements.



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##### Table of Contents

CURIS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)



|                                                                                                                      |  |                                |             |   |      |   |             |  
|--------------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ----------- | - | ---- | - | ----------- | -
|                                                                                                                      |  | Nine Months EndedSeptember 30, |            
|                                                                                                                      |  | 2005                           |             |   | 2004 |  
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                                                 |  |                                |             |   |      |   |             |  
|Net loss                                                                                                              |  | $                              | (13,418,616 | ) |      | $ | (12,244,885 | )
|Adjustments to reconcile net loss to net cash used in operating activities:                                           |  |                                |             |   |      |   |             |  
|Depreciation and amortization                                                                                         |  |                                | 668,720     |   |      |   | 833,045     |  
|Stock-based compensation expense                                                                                      |  |                                | 193,003     |   |      |   | 1,058,678   |  
|Non-cash interest on notes payable                                                                                    |  |                                | 152,478     |   |      |   | 293,549     |  
|Amortization of intangible assets                                                                                     |  |                                | 56,304      |   |      |   | 56,304      |  
|Decrease/increase in long-term receivables                                                                            |  |                                |            |   |      |   | 2,000,000   |  
|Changes in current assets and liabilities:                                                                            |  |                                |             |   |      |   |             |  
|Accounts receivable                                                                                                   |  |                                | (799,680    | ) |      |   | (396,368    | )
|Prepaid expenses and other assets                                                                                     |  |                                | 49,316      |   |      |   | (234,023    | )
|Accounts payable and accrued liabilities                                                                              |  |                                | 1,363,494   |   |      |   | 451,006     |  
|Deferred contract revenue                                                                                             |  |                                | 561,884     |   |      |   | 735,646     |  
|                                                                                                                      |  |                                |             |   |      |   |             |  
|Total adjustments                                                                                                     |  |                                | 2,245,519   |   |      |   | 4,797,837   |  
|                                                                                                                      |  |                                |             |   |      |   |             |  
|Net cash used in operating activities                                                                                 |  |                                | (11,173,097 | ) |      |   | (7,447,048  | )
|                                                                                                                      |  |                                |             |   |      |   |             |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                                                 |  |                                |             |   |      |   |             |  
|Purchase of marketable securities                                                                                     |  |                                | (24,904,025 | ) |      |   | (17,383,387 | )
|Sale of marketable securities                                                                                         |  |                                | 31,769,343  |   |      |   | 10,400,683  |  
|Increase in restricted cash                                                                                           |  |                                | (2,832      | ) |      |   |            |  
|Purchase of long-term investments                                                                                     |  |                                |            |   |      |   | (4,568,290  | )
|Sale of long-term investments                                                                                         |  |                                | 2,606,681   |   |      |   | 5,350,350   |  
|Purchases and dispositions of property and equipment                                                                  |  |                                | (2,267,597  | ) |      |   | (1,042,801  | )
|                                                                                                                      |  |                                |             |   |      |   |             |  
|Net cash provided by (used in) investing activities                                                                   |  |                                | 7,201,570   |   |      |   | (7,243,445  | )
|                                                                                                                      |  |                                |             |   |      |   |             |  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                                                 |  |                                |             |   |      |   |             |  
|Proceeds from issuance of common stock                                                                                |  |                                | 866,048     |   |      |   | 3,271,560   |  
|Proceeds from issuance of debt                                                                                        |  |                                | 1,993,386   |   |      |   | 591,930     |  
|Reclassification of deferred revenues to additional paid-in capital                                                   |  |                                | 1,629,000   |   |      |   |            |  
|Repayments of notes payable and capital leases                                                                        |  |                                | (312,500    | ) |      |   | (332,056    | )
|                                                                                                                      |  |                                |             |   |      |   |             |  
|Net cash provided by financing activities                                                                             |  |                                | 4,175,934   |   |      |   | 3,531,434   |  
|                                                                                                                      |  |                                |             |   |      |   |             |  
|                                                                                                                      |  |                               
|NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                                  |  |                                | 204,407     |   |      |   | (11,159,059 | )
|                                                                                                                      |  |                               
|CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                                                                        |  |                                | 22,679,924  |   |      |   | 27,734,548  |  
|                                                                                                                      |  |                                |             |   |      |   |             |  
|CASH AND CASH EQUIVALENTS, END OF PERIOD                                                                              |  | $                              | 22,884,331  |   |      | $ | 16,575,489  |  
|                                                                                                                      |  |                                |             |   |      |   |             |  
|                                                                                                                      |  |                               
|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 8) |  | $                              | 3,305,523   |   |      | $ |            |  
|                                                                                                                      |  |                                |             |   |      |   |             |  





See accompanying notes to unaudited condensed consolidated financial statements.



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##### 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 candidate, a topical therapy for the treatment of basal cell carcinoma, is currently in a phase I clinical trial and 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, or FDA, and in overseas markets 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 and licensors 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 unaudited 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 United States 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 consolidated financial statements contain all adjustments (all
of which were considered normal and recurring) necessary to present fairly the Companys financial position at September 30, 2005, the results of operations for the three- and nine-month periods ended September 30, 2005 and 2004, and
cash flows for the nine-month periods ended September 30, 2005 and 2004. The preparation of the Companys consolidated financial statements in conformity with accounting principles generally accepted in the United States 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 the full year or subsequent interim periods.



|3. | Financial Statement Reclassifications
|-- | -------------------------------------



The Company has reclassified $368,000 and $1,059,000, respectively, for the three- and nine-month periods ended September 30, 2004
from Stock-based compensation expense to Research and development expenses and General and administrative expenses in the Companys costs and expenses section of its consolidated statements of operations and comprehensive loss to conform with
the current period presentation. Of these amounts, $342,000 and $864,000 were reclassified to Research and development



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##### Table of Contents

CURIS, INC. AND SUBSIDIARY

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



expenses and $26,000 and $195,000 were reclassified to General and administrative expenses for the three- and nine-month periods ended September 30,
2004, respectively.



|4. | Revenue Recognition
|-- | -------------------



During the third quarter of 2005, the Company updated its disclosure relating to its revenue recognition policies that were previously
presented in the Companys Annual Report on Form 10-K for the year ended December 31, 2004. In addition, in the third quarter of 2005, the Company recorded adjustments to correct errors in recording the fair value of shares issued in connection
with its collaborations with Genentech and Wyeth. The shares were valued using the contractually-negotiated trailing average of closing prices, pursuant to the terms of the stock purchase agreements. The Company has determined that it should have
valued the shares using the quoted market price on the dates of issuance and, as a result, additional paid-in capital was understated and deferred revenues were overstated. The effect of these adjustments was to increase additional paid-in-capital
by $1,629,000, decrease noncurrent deferred revenue by $1,169,000 and to reverse $460,000 of revenue in the third quarter of 2005 to correct for the cumulative overstatement of revenues from June 2003 through June 30, 2005. The impact of these
errors, if recorded in the periods to which they related, would not effect the net loss per share previously reported by the Company for any prior year or quarter, nor, Company believes, otherwise have a material impact on previously reported
financial information. In addition, the Company does not believe that the impact of these adjustments is material to the financial statements for the quarter ended September 30, 2005 or to the projected results of operations for the year ending
December 31, 2005.



The Companys business
strategy includes entering into collaborative license and development agreements with biotechnology and pharmaceutical companies for the development and commercialization of the Companys product candidates. The terms of the agreements
typically include non-refundable license fees, funding of research and development, payments based upon achievement of clinical development milestones and royalties on product sales. The Company follows the provisions of the Securities and Exchange
Commissions Staff Accounting Bulletin (SAB) No. 104 (SAB No. 104), Revenue Recognition, Emerging Issues Task Force (EITF) Issue No. 00-21 (EITF 00-21), Accounting for Revenue Arrangements with Multiple Deliverables,
EITF Issue No. 99-19 (EITF 99-19), Reporting Revenue Gross as a Principal Versus Net as an Agent,and EITF Issue No. 01-9 (EITF 01-9), Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the
Vendors Products).



Non-refundable
license fees are recognized as revenue when the Company has a contractual right to receive such payment, the contract price is fixed or determinable, the collection of the resulting receivable is reasonably assured and the Company has no further
performance obligations under the license agreement. Multiple element arrangements, such as license and development arrangements are analyzed to determine whether the elements (the license and the performance obligations) can be separated or whether
they must be accounted for as a single unit of accounting in accordance with EITF 00-21. The Company recognizes up-front license payments as revenue upon delivery of the license only if the license has stand-alone value and the fair value of the
undelivered performance obligations, typically including research or steering committee services, can be determined. If the fair value of the undelivered performance obligations can be determined, such obligations would then be accounted for
separately as performed. If the license is considered to either (i) not have stand-alone value or (ii) have stand-alone value but the fair value of any of the undelivered performance obligations cannot be determined, the arrangement would
then be accounted for as a single unit of accounting and the license payments and payments for performance obligations are recognized as revenue over the estimated period of when the performance obligations are performed.



When the Company determines that an arrangement should be
accounted for as a single unit of accounting, it must determine the period over which the performance obligations will be performed and



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revenue will be recognized. Revenue will be recognized using either a relative performance or straight-line method. The Company recognizes revenue using the
relative performance method provided that the Company can reasonably estimate the level of effort required to complete its performance obligations under an arrangement and such performance obligations are provided on a best-efforts basis. Direct
labor hours or full-time equivalents are typically used as the measure of performance. Revenue recognized under the relative performance method would be determined by multiplying the total payments under the contract, excluding royalties and
payments contingent upon achievement of substantive milestones, by the ratio of level of effort incurred to date to estimated total level of effort required to complete the Companys performance obligations under the arrangement. Revenue is
limited to the lesser of the cumulative amount of payments received or the cumulative amount of revenue earned, as determined using the relative performance method, as of each reporting period.



If the Company cannot reasonably estimate the level of effort
required to complete its performance obligations under an arrangement and the performance obligations are provided on a best-efforts basis, then the total payments under the arrangement, excluding royalties and payments contingent upon achievement
of substantive milestones, would be recognized as revenue on a straight-line basis over the period the Company expects to complete its performance obligations. Revenue is limited to the lesser of the cumulative amount of payments received or the
cumulative amount of revenue earned, as determined using the straight-line basis, as of the period ending date.



Significant management judgment is required in determining the level of effort required under an arrangement and the period over which the
Company is expected to complete its performance obligations under an arrangement. In addition, if the Company is involved in a steering committee under a research arrangement, the Company assesses whether its involvement constitutes a performance
obligation or a right to participate. Steering committee services that are not inconsequential or perfunctory and that are determined to be performance obligations are combined with other research services or performance obligations required under
an arrangement, if any, in determining the level of effort required in an arrangement and the period over which the Company expects to complete its aggregate performance obligations.



Collaboration agreements may also contain substantive milestones. Substantive milestone payments are
considered to be performance bonuses that are recognized upon achievement of the milestone only if all of the following conditions are met:



| |  |  | the milestone payments are non-refundable;
| | - |  | ------------------------------------------



| |  |  | achievement of the milestone involves a degree of risk and was not reasonably assured at the inception of the arrangement;
| | - |  | --------------------------------------------------------------------------------------------------------------------------



| |  |  | substantive effort is involved in achieving the milestone;
| | - |  | ----------------------------------------------------------



| |  |  | the amount of the milestone payment is reasonable in relation to the effort expended or the risk associated with achievement of the milestone; and,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between each subsequent milestone payment.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



Determination as to whether a
milestone meets the aforementioned conditions involves managements judgment. If any of these conditions are not met, the milestone payment would not be considered a substantive milestone, and the resulting payment would be recognized as
revenue as such performance obligations are performed under either the relative performance or straight-line methods, as applicable, and in accordance with these policies as described above.



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Reimbursement of costs is recognized as revenue provided the provisions of EITF 99-19
are met, the amounts are determinable, and collection of the related receivable is reasonably assured.



Royalty revenue is recognized upon the sale of the related products, provided that the royalty amounts are fixed or determinable,
collection of the related receivable is reasonably assured and the Company has no remaining performance obligations under the arrangement. If royalties are received when the Company has remaining performance obligations, the royalty payments would
be attributed to the services being provided under the arrangement and therefore would be recognized as such performance obligations are performed under either the relative performance or straight-line methods, as applicable, and in accordance with
these policies as described above.



For
revenue-generating arrangements where the Company, as a vendor, provides consideration to a licensor or collaborator, as a customer, the Company applies the provisions of EITF 01-9. EITF 01-9 addresses the accounting for revenue arrangements where
both the vendor and the customer make cash payments to each other for services and/or products. A payment to a customer is presumed to be a reduction of the selling price unless the Company receives an identifiable benefit for the payment and the
Company can reasonably estimate the fair value of the benefit received. Payments to a customer that are deemed a reduction of selling price are recorded first as a reduction of revenue, to the extent of both cumulative revenue recorded to date and
probable future revenues, which include any unamortized deferred revenue balances under all arrangements with such customer, and then as an expense. Payments that are not deemed to be a reduction of selling price would be recorded as an expense.



Amounts received prior to satisfying the above
revenue recognition criteria are recorded as deferred revenue in the accompanying consolidated balance sheets. Amounts not expected to be recognized during the twelve-month period ended September 30, 2006 are classified as long-term deferred
revenue. As of September 30, 2005, the Company has short- and long-term deferred revenue of $2,152,000 and $7,291,000, respectively, related to its collaborations.



|5. | Research and Development Collaborations Entered Into in 2005
|-- | ------------------------------------------------------------



| | (a) |  | Procter & Gamble September 2005 Collaboration
| | --- |  | ---------------------------------------------



| | (i) |  | Collaboration Summary
| | --- |  | ---------------------



On September 18, 2005, the Company entered into a collaboration, research and license agreement with the Procter & Gamble
Company, or P&G, to evaluate and seek to develop potential treatments for hair growth regulation and skin disorders utilizing the Companys Hedgehog agonist technology.



Under the terms of the agreement, the Company granted P&G an exclusive, worldwide, royalty-bearing
license for the development and commercialization of topical dermatological and hair growth products that incorporate the Companys Hedgehog agonist technology. In accordance with the terms of the agreement, the parties shall jointly undertake
a research program with the goal of identifying one or more compounds to be developed and commercialized by P&G. P&G is solely responsible for the cost of worldwide development and commercialization of any product candidates developed
pursuant to the research program. At the time that P&G determines to file the first investigational new drug application with the U.S. Food and Drug Administration for a product candidate, the Company shall have the option, at its sole
discretion, to co-develop a product candidate through phases I and II of clinical development at a 20% or 50% participation rate. Should the Company elect to exercise its co-development option, the Company will forego development milestones that
would otherwise be payable during the period from investigational new drug application filing through the completion of a phase II clinical trial. The Company, however, would receive a higher royalty in the event that it exercises its co-development
option and subsequently shares in



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development expense through phase II clinical trials. The amount of the royalty increase is based on the co-development percentage elected by the Company.
Under the agreement, P&G paid the Company an up-front license fee of $500,000 and has agreed to fund up to $600,000 for two Curis full-time equivalents providing research and development activities during the initial one-year research term,
subject to its termination rights. P&G has an option to extend the initial one-year research term for up to three additional years in one-year increments. P&G has also agreed to make cash payments to the Company that are contingent upon the
successful achievement of certain research, development, clinical and drug approval milestones, including $2,800,000 in preclinical milestones. P&G will also pay the Company royalties on net product sales if product candidates derived from the
collaboration are successfully developed.



Unless terminated earlier in accordance with the terms of the agreement, the agreement shall continue until six months after the expiration of the last to expire of any patent rights covering a product being sold under the agreement. Early
termination rights are as follows:



| |  |  | During the first twelve months, the agreement may not be terminated by either party, except in the case of breach, as discussed below, or failure of all, or all but one, of the
licensed compounds to demonstrate acceptable results in certain tests as specified in the agreement and the research plan. In the event of such failure, P&G may terminate the agreement and the related research obligations (full-time equivalent
reimbursement) without cause, with 45 days prior written notice.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Following the initial twelve-month period, P&G shall have the right to terminate the agreement without cause upon at least six months prior written notice.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Upon or after the uncured breach of any material provision of the agreement by a party, the other party may terminate the agreement immediately upon written notice to the defaulting
party.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



If P&G terminates the
agreement without cause or the Company terminates the agreement as a result of P&Gs material breach, then, among other things, all licenses granted to P&G shall terminate. The Company shall have the exclusive option to acquire from
P&G all data generated by P&G and all regulatory approvals and other regulatory filings and submissions, clinical data, promotional, advertising, marketing and distribution rights or contracts, and other similar information and items related
to the compounds developed during the collaboration by P&G, on commercially reasonable terms to be mutually agreed to by the parties. Upon termination of the agreement by P&G as a result of a material breach by the Company, all rights and
licenses granted to P&G under the agreement shall terminate.



| | (ii) |  | Accounting Summary
| | ---- |  | ------------------



The Company considers its arrangement with P&G to be a revenue arrangement with multiple deliverables. The Companys deliverables
under this collaboration include an exclusive license to evaluate and develop potential treatments for hair growth regulation and skin disorders and certain performance obligations, including research and development services for at least one year
and participation on at least one steering committee. The Company applied the provisions of Emerging Issues Task Force Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (EITF 00-21) to determine whether the
performance obligations under this collaboration can be accounted for separately or as a single unit or multiple units of accounting. The Company determined that these performance obligations represented a single unit of accounting, since the
Company believes that the license does not have stand-alone value to P&G without the Companys research services and steering committee participation during certain phases of the development process and because objective and reliable
evidence of the fair value of the Companys research and steering committee participation could not be determined.



The Companys ongoing performance obligations under this collaboration consist of participation on a steering committee and the
performance of preclinical research services. The Company cannot reasonably



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



estimate the total level of effort required over the performance period and, therefore, is recognizing revenue on a straight-line basis over the performance
period, which it has estimated to be six years. In developing its estimate of the period to complete its performance obligations, the Company estimates the time required to complete phase II clinical trials of a product candidate under the
collaboration to be six years. The performance period was determined based on managements estimate of its involvement through co-development of phase IIB clinical trials since, should Curis exercise its co-development option, Curis last
deliverable under this arrangement would be its participation on the clinical development steering committee through phase IIB. The steering committee effort is also expected to be consistent over the six-year period.



The Company has attributed the $500,000 up-front fee plus
$600,000, the total amount of currently committed research funding which the Company expects to receive for providing two full-time equivalents at $300,000 each over the first year of the collaboration, to the undelivered research and steering
committee services. The $1,100,000 in total payments is being recognized as revenue over the Companys performance period of six years under the collaboration. If the research period, number of full-time equivalents requested by P&G, or the
estimate to complete phase II clinical trials changes, then the Company will update its estimated level of effort and total expected payments under the arrangement. During the three months ended September 30, 2005, the Company recorded revenue
of approximately $10,000. Of this amount, approximately $3,000 was attributed to the amortization of the up-front license fee and is included in the License fees line item within the Revenues section of the Companys Consolidated
Statement of Operations for the three months ended September 30, 2005. The remaining $7,000 was related to research services performed by the Companys two full-time equivalents and is included within the Research and development
contracts line item within the Revenues section of the Companys Consolidated Statement of Operations.



The Company views the preclinical and clinical development milestones, as well as the drug approval milestones under its collaboration
with P&G to be substantive in nature since the successful achievement of these milestones involves significant risk and uncertainty and a reasonable amount of time passes between the up-front license payment and the first milestone payment as
well as between each subsequent milestone payment. Should the Company ever successfully achieve any preclinical or clinical development milestones or drug approval milestones under this collaboration agreement, any related milestone payments would
be recorded as revenue within the Substantive milestones line item within the Companys Revenues section of its Consolidated Statement of Operations.



As of September 30, 2005, the Company has not provided any consideration, such as payments under
co-development arrangements, to P&G.



| | (b) |  | Genentech April 2005 Drug Discovery Collaboration
| | --- |  | -------------------------------------------------



| | (i) |  | Collaboration Summary
| | --- |  | ---------------------



On April 1, 2005, the Company entered into a drug discovery collaboration agreement with Genentech for the discovery and development
of small molecule compounds that modulate a signaling pathway that plays an important role in cell proliferation. This pathway is a regulator of tissue formation and repair, the abnormal activation of which 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. Curis has retained the rights for ex vivo cell therapy, except
in the areas 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 clinical development, manufacturing, and commercialization of products that may
result from the collaboration. Genentech paid the Company an



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up-front license fee of $3,000,000 and has agreed to fund up to $6,000,000 for research and development activities during the initial two-year research term,
subject to its termination rights described below. Genentech will also make cash payments to the Company that are contingent upon the successful achievement of certain preclinical and clinical development milestones and drug approval milestones.
Genentech has an option to extend the initial two-year research term for up to two additional years in one-year increments. 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 for uncured material breach by the other party. Genentech has the right to terminate the agreement without cause 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 without cause or if the agreement is terminated by Genentech due to
material breach, 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.



| | (ii) |  | Accounting Summary
| | ---- |  | ------------------



The Company considers this arrangement with Genentech to be a revenue arrangement with multiple deliverables. The Companys
deliverables under this collaboration include an exclusive license to its technologies in this signaling pathway and certain performance obligations, including research services for at least two years and participation on a steering committee. The
Company applied the provisions of EITF 00-21 to determine whether the performance obligations under this collaboration can be accounted for separately or as a single unit or multiple units of accounting. The Company determined that these
deliverables represented a single unit of accounting, since the Company believes that the license does not have stand-alone value to Genentech without the Companys research services and steering committee participation during certain phases of
research and because objective and reliable evidence of the fair value of the Companys research and steering committee participation could not be determined.



The Companys ongoing performance obligations under this collaboration consist of participation on a
steering committee and the performance of research services. Because the Company can reasonably estimate its level of effort over the term of the arrangement, the Company is accounting for the arrangement under the relative performance method. In
developing its estimate of the Companys level of effort required to complete its performance obligations, the Company estimated that Genentech would elect twice to extend the research service period and related funding, each in one-year
increments, although there can be no assurance Genentech will, in fact, make such an election. The Company estimates that it will provide an equal number of full-time equivalents for the four-year research and development service term. In developing
this estimate, the Company assumed that Genentech will maintain its initially elected number of twelve full-time equivalent researchers throughout the four-year period. The steering committee effort is also expected to be consistent over the
four-year period. The $3,000,000 up-front fee plus $12,000,000,the total amount of research funding which the Company will be entitled to for providing twelve full-time equivalents at $250,000 each over four years, is therefore being
attributed to the research services. Revenue is being recognized as the research services are provided over the four-year period through March 2009 at a rate of $312,500 per full-time equivalent. If the research period is changed or the number of
full-time equivalents requested by Genentech changes, then the Company will update its estimated level of effort and total expected payments under the arrangement.



The Company recorded revenue under this collaboration of $944,000 and $1,533,000, respectively, during the
three- and nine-month periods ended September 30, 2005. Of this amount, approximately $187,000 and $375,000, respectively, was attributed to the amortization of the up-front license fee and is



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included in the License fees line item within the Revenue section of the Companys Consolidated Statement of Operations for the three-and
nine-month periods ended September 30, 2005, respectively. The remaining $757,000 and $1,158,000, respectively, were related to research services performed by the Companys full-time equivalent researchers and are included within the
Research and development contracts line item within the Revenues section of the Companys Consolidated Statement of Operations.



The Company views the preclinical and clinical development milestones and drug approval milestones under this collaboration with Genentech
to be substantive in nature since the successful achievement of these milestones involves significant risk and uncertainty and a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between
each subsequent milestone payment. Should the Company ever successfully achieve any preclinical or clinical development milestones or drug approval milestones under this collaboration agreement, any related milestone payments would be recorded as
revenue within the Substantive milestones line item within the Companys Revenues section of its Consolidated Statement of Operations.



As of September 30, 2005, the Company has provided cash consideration to Genentech in the form of co-development payments for the
Companys equal share of U.S. development costs of a basal cell carcinoma product candidate that is being developed under a separate collaboration with Genentech.



| | (c) |  | Genentech April 2005 Hedgehog Antagonist Collaboration Amendment
| | --- |  | ----------------------------------------------------------------



| | (i) |  | Collaboration Summary
| | --- |  | ---------------------



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. The Company considered the provisions of EITF 00-21 and determined that this agreement is a separate contract from its June 2003 agreement since it was
not contemplated at the time of the June 2003 arrangement, was separately negotiated in order to increase the number of full-time equivalents providing research and development services and to provide xenograft tumor samples to Genentech, and was
not entered into at or near the time of the June 2003 agreement.



Under the terms of the amendment, Genentech will provide to the Company $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 by October 2005. Genentech
notified the Company in October 2005 of its decision to extend the research term, and will now fund ten Curis full-time equivalents through June 11, 2006. Genentech will pay the Company $1,250,000 in June 2006, provided that Curis has performed
the required research services. 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 June 2003 agreement, which remains in full force and effect.



| | (ii) |  | Accounting Summary
| | ---- |  | ------------------



The Company considers the April 2005 amendment to be a separate agreement and unit of accounting from the June 2003 agreement, and a
previous amendment entered into between the Company and Genentech in December 2004. The Companys performance obligations under this agreement are to provide research services and xenograft tumor samples to Genentech through June 11, 2006.
Since Genentech elected to exercise its option and extend the research services, the Companys performance obligations would extend for an additional period from December 2005 through June 2006. The Company has applied the provisions of SAB
No. 104 and is recognizing the research funding as revenues under this collaboration as such research services are performed. The amount payable to the Company and, accordingly, the amount of revenue to be recognized will vary if the Company
provides less than the required sixteen full-time equivalents through December 2005 or the ten full-time equivalents through June 2006. As of September 30, 2005, the Company had recorded $1,188,000 as accounts receivable from Genentech in the
Companys Current Assets section of its Consolidated Balance Sheet.



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|6. | Research and Development Collaborations Entered into Prior to January 1, 2005
|-- | -----------------------------------------------------------------------------



During the third quarter of 2005, the Company updated certain aspects of its disclosures related to its
research and development collaborations entered into prior to January 1, 2005. The disclosures previously presented in the Companys Annual Report on Form 10-K for the year ended December 31, 2004, are updated and presented within
this Note.



| | (a) |  | GENENTECH, INC. JUNE 2003 COLLABORATION
| | --- |  | ---------------------------------------



| | (i) |  | Collaboration Summary
| | --- |  | ---------------------



In June 2003, the Company licensed its proprietary Hedgehog pathway antagonists to Genentech for human therapeutic use. The primary focus
of the 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 Hedgehog antagonist formulated for the topical treatment for basal
cell carcinoma; and the development of systemically administered small molecule and antibody Hedgehog antagonists for the treatment of certain other solid tumor cancers. Pursuant to the collaboration agreement, Genentech agreed to make specified
cash payments, including an up-front payment of $5,000,000, license maintenance fee payments totaling $4,000,000 over the first two years of the collaboration and substantive milestone payments at various intervals during the clinical development
and regulatory approval process of small molecule and antibody Hedgehog antagonist product candidates, assuming specified clinical development and regulatory approval objectives are met. In addition, Genentech will pay a royalty on potential future
net product sales, which increases with increasing sales volume.



Under the collaboration agreement, the Company has the option to elect to co-develop Hedgehog antagonist products in the field of basal cell carcinoma in the U.S. In January 2005, the Company elected to exercise this
co-development option and will now share equally in both U.S. development costs and any future U.S. net profits and/or losses resulting from the development and commercialization of its basal cell carcinoma product candidate. This co-development
right includes basal cell carcinoma and any additional indications for which this product candidate may be developed in the U.S. As a result of participating in co-development, the Company will forego U.S. development milestone and royalty payments
on potential future U.S. sales of the basal cell carcinoma product candidate. Should the Company determine that it cannot continue funding its equal share of the development expenses, the Company may opt out of the co-development structure and
receive certain development and regulatory approval milestones and royalties on sales of the basal cell carcinoma product candidate, should any ever occur. In addition, in certain major international markets, the Company will receive substantive
milestone payments if specific clinical development objectives are achieved and a royalty on any international sales of any basal cell carcinoma product candidate.



Under the systemic Hedgehog antagonist program of the collaboration, Genentech is also obligated to make
substantive milestone payments to the Company assuming the successful achievement of clinical development and drug approval objectives. In addition, Genentech will pay a royalty on potential future net product sales, which increases with increasing
sales volume.



Unless terminated earlier, the
agreement shall expire six months after the later of the expiration of Genentechs obligation to pay royalties to the Company under the agreement or such time as no activities have occurred under the agreement for a period of twelve months.
Early termination provisions are as follows:



| |  |  | Either the Company or Genentech may terminate the agreement upon sixty days written notice for cause upon either the occurrence of bankruptcy, insolvency,
dissolution, winding up, or upon the
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | breach of any material provision of this agreement by the other party, provided such breach is not cured by the other party within the sixty day period
following written notice of termination by the other party.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Genentech may terminate the agreement without cause, effective no earlier than June 12, 2004, upon six months prior written notice. Genentech may also terminate the agreement
solely with respect to a particular compound, indication or country no earlier than June 12, 2004, upon six months prior written notice.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | If Genentech terminates the agreement for cause, all licenses granted by Genentech to the Company automatically terminate and revert to Genentech and specified licenses granted by
Curis to Genentech shall survive so long as Genentech is not then in breach under the Agreement. The consideration for any product that the Company shares gross profits and losses with Genentech through a co-development structure (i.e., the basal
cell carcinoma product candidate) will be modified so that the Company will no longer receive its share of gross profits and losses. The Company will instead receive clinical development and drug approval milestones and royalties on product sales
for such product.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | If the Company terminates the agreement for cause or Genentech terminates the agreement without cause, all licenses granted by the Company to Genentech automatically terminate and
revert to the Company and specified licenses granted by Genentech to the Company shall survive so long as the Company is not then in breach under the Agreement. At the time of such termination, Genentech shall no longer conduct any development or
commercialization activities on any compounds identified during the course of the agreement for so long as such compounds continue to be covered by valid patent claims.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As a result of its licensing agreements with various universities, the Company is obligated to make payments
to these university licensors when certain payments are received from Genentech.



In the quarter ended September 30, 2005, the Company recorded an adjustment to correct an error in recording the fair value of shares
issued in connection with its collaboration with Genentech. On June 11, 2003, in connection with the collaboration agreement, the Company sold to Genentech 1,323,835 shares of its common stock. The shares were recorded at a price of $2.644 per
share based on a 30-day trailing average of closing prices prior to June 11, 2003, pursuant to the terms of a stock purchase agreement. Therefore, the Company allocated $3,500,000 as stockholders equity in the Companys consolidated
balance at December 31, 2003. The fair market value of the Companys common stock was $3.77 per share on June 11, 2003, as determined by the quoted closing price on the NASDAQ national market. During the third quarter of 2005, the
Company determined that it should have ascribed $4,991,000 in value to the common stock, calculated as the $3.77 per share closing price multiplied by 1,323,835 shares sold to Genentech. Consequently, the Company recorded a credit of $1,491,000 to
additional-paid-in capital to correct the understatement in the fair value of the shares issued, a $1,072,000 reduction in deferred revenue to correct the overstatement of deferred revenue, and a $419,000 reduction in license fee revenue to correct
the cumulative overstatement of revenue. The Company also entered into a registration rights agreement with Genentech pursuant to which, at the request of Genentech, the Company shall use its reasonable best efforts to register the shares of common
stock for resale in the future under specified conditions.



| | (ii) |  | Accounting Summary
| | ---- |  | ------------------



The Company considers its June 2003 arrangement with Genentech to be a revenue arrangement with multiple deliverables. The Companys
deliverables, or performance obligations, under this collaboration include an exclusive license to its Hedgehog antagonist technologies and performance obligations, including



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research and development services for the first two years of the collaboration and participation on steering committees. The Company applied the provisions
of EITF 00-21 to determine whether the performance obligations under this collaboration could be accounted for separately or should be accounted for as a single unit of accounting. The Company determined that the performance obligations, the license
and the research and steering committee services, represented a single unit of accounting because the Company believes that the license, although delivered at the inception of the arrangement, does not have stand-alone value to Genentech without the
Companys research services and steering committee participation and because objective and reliable evidence of the fair value of the Companys research and steering committee services could not be determined.



The Company had attributed the $5,000,000 up-front fee and
the $4,000,000 of maintenance fees to the undelivered research and steering committee services. The $9,000,000 in total payments was being recognized as revenue over the Companys performance period under the collaboration, which the Company
estimates to be through June 2011, the estimated date that the products under the collaboration may receive regulatory approval. The Company cannot reasonably estimate the total level of effort required over the performance period and, therefore, is
recognizing the $9,000,000 on a straight-line basis over the performance period. During the third quarter of 2005, the Company recorded a cumulative adjustment reduction to its License fee revenue of $419,000. This cumulative adjustment was recorded
to correct license revenues that it had previously recorded relating to $1,491,000 in consideration that had been allocated to the $5,000,000 up-front license payment. As noted above, this consideration was reclassified from deferred revenue to
additional-paid-in capital accounts. As a result of a cumulative adjustment, the Company recorded negative revenues under this collaboration related to the license and maintenance fees of $206,000 during the third quarter of 2005. During the
nine-month periods ended September 30, 2005, the Company recorded $340,000 in license revenues. These amounts are included in License fees in the Companys Revenues section of its Consolidated Statement of Operations. The
$4,000,000 in maintenance fees were not considered substantive milestones because receipt of the payments did not involve significant risk at the inception of the arrangement and the receipt of such payments is not tied to the achievement of any
specific developmental objectives under the arrangement. Therefore, these payments were also attributed to the research and steering committee service performance obligations. The Companys ongoing performance obligations under this
collaboration consist of participation on two steering committees, one for BCC and one for solid tumors. The steering committees are comprised of an equal number of employees from the Company and Genentech. Each member of the steering committees
receives the right to cast one vote, but Genentech generally has the final decision making authority. While the Company is obligated to serve on the steering committees as long as any drug covered under the collaboration is being developed or
commercialized, the Company believes that it will provide significant contributions under its steering committee services only through the first product approved in both the basal cell carcinoma and systemic Hedgehog antagonist programs. The Company
has no manufacturing or selling capabilities and, as such, believes that its participation in the steering committees after regulatory approval would be inconsequential and does not represent a performance obligation.



In July 2004, the Company received the first maintenance fee
payment in the amount of $2,000,000. The second $2,000,000 maintenance payment was replaced by a $2,000,000 payment for research services in December 2004 as part of an amendment to the collaboration in December 2004. The Company considers the
December 2004 amendment to be a separate agreement and unit of accounting from the June 2003 agreement. However, because the $2,000,000 payment received in December 2004 was paid to the Company in exchange for research services conducted prior to
the execution of the December 2004 agreement, the Company determined it would amortize this payment over the remaining period in which the Company expects to fulfill its performance obligations under the collaboration (e.g., June 2011).



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The Company views the clinical development and drug approval milestones under this
collaboration with Genentech to be substantive milestones since the successful achievement of these milestones involves significant risk and uncertainty and a reasonable amount of time passes between the up-front license payment and the first
milestone payment as well as between each subsequent milestone payment. Should the Company ever successfully achieve any clinical development or drug approval milestones under this collaboration agreement, any related milestone payments would be
recorded as revenue upon achievement of the milestone in Substantive milestones in the Revenues section of its Consolidated Statement of Operations.



The Company considered the provisions of EITF 99-19 and recorded $91,000 and $130,000, respectively, during the three- and nine-month
periods ended September 30, 2005, as revenue related to expenses incurred on behalf of Genentech that were paid by the Company and for which Genentech is obligated to reimburse the Company. The Company will continue to recognize revenue for
expense reimbursement as such expenses are incurred, provided that such expense reimbursement meets the revenue criteria established under EITF 99-19.



The Companys right to co-develop the Hedgehog antagonist products in the field of basal cell carcinoma was not considered a
deliverable under EITF 00-21 and was exercisable only at the Companys option and, therefore, did not impact the initial accounting for this arrangement. As a result of its decision to exercise its right to co-develop the basal cell carcinoma
product candidate, the Company expects to make significant cash payments to Genentech during the period of clinical development. The Company has recorded $820,000 and $5,698,000, respectively, in co-development payments to Genentech for the three-
and nine-months periods ended September 30, 2005, as contra-revenues at its Consolidated Statement of Operations. The Company will follow the provision of EITF 01-09 and expects to record its future co-development payments first as a reduction
of revenue, to the extent of both cumulative revenue recorded to date and probable future revenues, which includes any unamortized deferred revenue balances under all arrangements with such customer, and then as an expense.



| | (b) |  | GENENTECH, INC. DECEMBER 2004 AGREEMENT
| | --- |  | ---------------------------------------



| | (i) |  | Collaboration Summary
| | --- |  | ---------------------



On December 10, 2004, the Company entered into an amendment to its June 2003 agreement with Genentech. The Company considered the
provisions of EITF 00-21 and determined that this agreement should be accounted for as a separate agreement and not part of its June 2003 agreement since it was not contemplated at the time of the June 2003 arrangement, was separately negotiated in
order to increase the number of full-time equivalents providing research and development services, included a separate performance obligation for the Company to provide xenograft tumor samples to Genentech, and was not entered into at or near the
time of the June 2003 agreement.



The December
2004 amendment, effective from June 12, 2004 to June 11, 2005, increases the Companys commitment of full-time equivalents providing research and development services for the systemic Hedgehog antagonist program from eight to sixteen
and increases Genentechs funding commitment from $2,000,000 to $4,000,000 for this period. The agreement also provides for the Company to provide xenograft tumor samples to Genentech during the period from June 12, 2004 to June 11,
2005, for which Genentech paid the Company $100,000 in December 2004. In addition, the second $2,000,000 maintenance payment due under the June 2003 arrangement was removed with no economic effect since it was replaced by a $2,000,000 payment for
research services made to the Company in December 2004. The remaining $2,000,000 for subsequent research services was paid in June 2005.



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| | (ii) |  | Accounting Summary
| | ---- |  | ------------------



The Company considers the December 2004 amendment to be a separate agreement and unit of accounting from the June 2003 agreement. The
Companys performance obligations under this agreement are to provide research services and xenograft tumor samples to Genentech through June 2005. The Company has applied the provisions of SAB No. 104 and is recognizing the $2,000,000 in
incremental funding as revenues under this collaboration as the incremental research services are performed from December 2004 through June 2005. The amount payable to the Company and, accordingly, the amount of revenue to be recognized will vary if
the Company provides less than sixteen full-time equivalents through June 2005. In April 2005, the Company entered into a second amendment with similar performance obligations. During the three- and nine-month periods ended September 30, 2005,
the Company recorded $973,000 and $2,861,000 respectively, related to its research and development services under both this agreement and the April 2005 amendment as revenue in Research and development contracts in the Companys
Revenues section of its Consolidated Statement of Operations.



| | (c) |  | WYETH PHARMACEUTICALS
| | --- |  | ---------------------



| | (i) |  | Collaboration Summary
| | --- |  | ---------------------



On January 12, 2004, the Company licensed its Hedgehog proteins and small molecule Hedgehog pathway agonists to Wyeth
Pharmaceuticals, or Wyeth, for therapeutic applications in the treatment of neurological and other disorders. Under the terms of the agreement, Wyeth paid the Company a $1,500,000 non-refundable license fee and $1,500,000 to purchase 315,524
unregistered shares of the Companys common stock. at a purchase price of $4.754 per share. The common stock purchase price was calculated as the 15-day trailing average closing price of the Companys common stock immediately prior to
January 12, 2004. In the quarter ended September 30, 2005, the Company recorded an adjustment to correct an error in recording the fair value of these shares issued to Wyeth. As noted above, in connection with the collaboration agreement,
the Company sold to Wyeth 315,524 shares of its common stock. The shares were recorded at a price of $4.754 per share based on a 15-day trailing average of closing prices prior to January 12, 2004, pursuant to the terms of a stock purchase
agreement and, therefore, the Company allocated $1,500,000 as stockholders equity in the Companys Consolidated Balance Sheet at December 31, 2004. The fair market value of the Companys common stock was $5.19 per share on
January 12, 2004, as determined by the quoted closing price on the NASDAQ national market. During the third quarter of 2005, the Company determined that that it should have ascribed $1,638,000 in value to the common stock, calculated as the
$5.19 per share closing price multiplied by 315,524 shares sold to Wyeth. Consequently, the Company recorded a credit of $138,000 to additional-paid-in capital to correct the understatement in the fair value of the shares issued, a $97,000 reduction
in deferred revenue to correct the overstatement of deferred revenue; and a $41,000 reduction in license fee revenue to correct the cumulative overstatement of revenue.



In addition to these initial payments, Wyeth is obligated to provide financial support of the Companys
research under the collaboration, at $250,000 per full-time equivalent researcher, for a period of up two years based on the number of full-time equivalent researchers performing services under the collaboration. The Company is obligated to dedicate
between five and ten full-time equivalents to this program, as determined by Wyeth in six-month intervals, for two years. After the initial two-year period, Wyeth can, at its option, elect to extend the Companys research obligation, and
Wyeths funding thereof, for two one-year increments. The agreement provides for a one-year evaluation period immediately following the end of the



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research term, during which the Company may be obligated to serve on the steering committee and may be required, at Wyeths expense, to perform
additional research and development services. The Company currently estimates that it will only be required to provide steering committee services during the evaluation period if it is also performing research services during that period. Wyeth is
also obligated to make substantive milestone payments if the licensed programs successfully achieve clinical development and drug approval objectives and to pay the Company a royalty on net product sales, if any should occur, that escalates with
increasing sales volume.



As part of the
agreement, the Company has retained development and licensing options for certain therapeutic applications of the Hedgehog agonist technologies, including 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 orphan drug indications and the cardiovascular applications. If Wyeth declines to exercise its right, or if the Company is unable to reach an
agreement with Wyeth on terms within the contractually specified period, the Company is free to seek another collaborator for this program.



Unless terminated earlier, the agreement shall expire upon the expiration of Wyeths obligation to pay royalties to the Company under
the agreement. Early termination provisions are as follows:



| |  |  | Either party may terminate the agreement unilaterally, in whole or in relevant part, during the research program in the event of issuance of third party patents that block
Wyeths right to use the licensed technology. If the agreement is terminated under this provision, license rights will revert to the respective parties and no royalties will be due and payable unless products continue to be sold after
termination. In such event, Wyeth would continue to pay royalties as defined in the agreement.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Wyeth may terminate the agreement at any time upon ninety days written notice, for safety reasons, if Wyeth concludes that a major mechanism-based toxicological finding would
preclude the development of licensed technology products for use in humans. If the agreement is terminated under this provision, license rights will revert to the respective parties and no royalties will be due and payable unless products continue
to be sold after termination. In such event, Wyeth would continue to pay royalties as defined in the agreement.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Upon sixty days written notice and subject to an additional thirty day period of discussion between the parties, Wyeth may terminate its research funding of Company personnel upon
the acquisition of the Company by a third party. Unless the agreement is terminated under another provision, this provision would permit Wyeth to retain the licenses granted provided that it continued to fulfill its non-research funding
obligations to the Company, including payment of milestones and royalties on product sales.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Wyeth may terminate the agreement without cause, for any reason in its entirety or on any compound, product, or country basis upon sixty days written notice, provided that such
complete or partial termination cannot occur before February 2006. If a termination occurs under this provision, any terminated license rights would revert to the respective party. If the Company were to subsequently sell products that were subject
to these reverted license rights, royalties would be due Wyeth in accordance with the terms of the agreement. In addition, Wyeth would continue to pay royalties to the Company on sales of specified compounds or products that were not terminated as
well as on sales of specified terminated compounds or products that Wyeth continued to sell despite such earlier termination.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Either party may terminate the agreement in the event of uncured material default by the other party. Depending upon the nature of the default, the cure period may
be extended from ninety days
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | to as long as one year. Subject to the restrictions described in the agreement, the non-defaulting party may terminate the agreement in its entirety or only
with respect to the compound or product that is affected by the default. If the Company elected to terminate the agreement, either partially or in its entirety, the relevant license rights would revert to the Company. In the event the Company
subsequently sold terminated compounds or products that were subject to both reverted license rights and certain Wyeth intellectual property rights, the Company would owe Wyeth a royalty for such product sales, in accordance with the terms of the
agreement. In the event of partial termination by the Company, Wyeths obligations with respect to those compounds or products that were not terminated would continue. If Wyeth terminates the agreement, all license rights become fully paid up
and perpetual provided that Wyeth pays the reduced royalty rate on product sales, as described in the termination provisions of the agreement.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | To the extent permitted by applicable law, either the Company or Wyeth may exercise certain rights upon the occurrence of the other partys bankruptcy, insolvency, dissolution,
winding up or assignment of assets for the benefit of creditors. Wyeth may terminate the research program or elect to keep the agreement in effect. The Company may terminate the agreement. If either party terminates the agreement, the licenses
granted to Wyeth by the Company under the agreement will terminate and revert to the Company.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In addition, as part of a termination agreement entered into between the Company and Élan Corporation, the Company will pay
Élan royalty payments related to any revenues in excess of the first $1,500,000 received by the Company from Wyeth, other than revenues received as direct reimbursement for research, development and other expenses that the Company receives
from Wyeth. The Company and Élan had previously collaborated on the development of the Hedgehog agonist technologies currently under development with Wyeth. The Company is also obligated to make payments to various university licensors when
certain payments are received from Wyeth. To date, all amounts have been paid to the university licensors.



| | (ii) |  | Accounting Summary
| | ---- |  | ------------------



The Company considers its arrangement with Wyeth to be a revenue arrangement with multiple deliverables, or performance obligations. The
Companys performance obligations under this collaboration include an exclusive license to its Hedgehog agonist technologies and performing services, including research and development services for at least two years and participation on a
steering committee. The Company applied the provisions of EITF 00-21 to determine whether the performance obligations under this collaboration could be accounted for separately or as a single unit or multiple units of accounting. The Company
determined that these performance obligations and research and steering committee services represented a single unit of accounting, since the Company believes that the license does not have stand-alone value to Wyeth without its research services
and steering committee participation and because objective and reliable evidence of the fair value of the Companys research and steering committee participation could not be determined.



The Companys ongoing performance obligations under this
collaboration consist of participation on a steering committee and the performance of research services. Because the Company can reasonably estimate its level of effort over the term of the arrangement, the Company is accounting for the arrangement
under the relative performance method. In developing its estimate of the Companys level of effort required to complete its performance obligations, the Company estimated that Wyeth would elect twice to extend the research and development
service period and related funding, each in one-year increments, for a total of four years. The agreement provides for a one-year evaluation period immediately following the end of the research term, during which time the Company may be obligated to
serve on the steering committee and



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may be required, at Wyeths expense, to perform additional research and development services. The Company estimates that it will provide an equal number
of full-time equivalents for the four-year research and development service term plus the one-year evaluation period. In developing this estimate, the Company assumed that Wyeth will maintain its initially elected number of eight full-time
equivalents throughout the five-year period. The steering committee effort is also expected to be consistent over the five-year period. The $1,500,000 up-front fee plus $10,000,000,the total amount of research funding which the Company will
be entitled to for providing eight full-time equivalents at $250,000 each over five years, is therefore being attributed to the research services. Revenue is being recognized as the research services are provided over the five- year period through
February 2009 at a rate of $287,500 per full-time equivalent. If the research period is shortened or the number of full-time equivalents requested by Wyeth changes, then the Company will update its estimated level of effort and total expected
payments under the arrangement.



During the
third quarter of 2005, the Company recorded a reduction to its License fee revenue of $41,000 to record the cumulative adjustment to license revenues that it had previously recorded relating to $138,000 in consideration that had been allocated to
the up-front license payment. As noted above, this consideration was reclassified from deferred revenue to additional-paid-in capital accounts. During the three- and nine- month periods ended September 30, 2005, the Company recorded revenue of
$585,000 and $2,169,000, respectively, related to the Companys research efforts under the Wyeth arrangement, of which $24,000 and $174,000, respectively, were recorded in License Fees and $561,000 and $1,745,000, respectively, were
recorded in Research and development contracts in the Companys Revenues section of its Consolidated Statement of Operations. Additionally, for the nine-month period ended September 30, 2005, the Company recorded $250,000 in
the Substantive milestones section of it Consolidated Statement of Operations. Included within Research and development contracts, the Company recorded $61,000 and $245,000 for the three- and nine- months ended
September 30, 2005 as revenue related to expenses incurred on behalf of Wyeth that were paid by the Company and for which Wyeth is obligated to reimburse the Company. The Company will continue to recognize revenue for expense reimbursement as
such reimbursable expenses are incurred, provided that the provisions of EITF 99-19 are met. As of September 30, 2005, the Company had recorded $142,000 as amounts receivable from Wyeth in Accounts receivable in the Companys
Current Assets section of its Consolidated Balance Sheets.



The Company views the clinical development and drug approval milestones under its collaboration with Wyeth to be substantive in nature since the successful achievement of these milestones involves significant risk and
uncertainty and a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between each subsequent milestone payment. Should the company ever successfully achieve any clinical development or
drug approval milestones under this collaboration agreement, any related milestone payments would be recorded as revenue in Substantive milestones in the Companys Revenues section of its Consolidated Statement of Operations.



As of September 30, 2005, the Company has
not provided any consideration to Wyeth.



| | (d) |  | ORTHO BIOTECH PRODUCTS, L.P.
| | --- |  | ----------------------------



| | (i) |  | Collaboration Summary
| | --- |  | ---------------------



In November 2002, the Company licensed its broad bone morphogenetic protein, or BMP, technology portfolio to Ortho Biotech Products, L.P.,
a member of the Johnson & Johnson family of companies. Two of Ortho Biotech Products research affiliates, Johnson & Johnson Pharmaceutical Research & Development, L.L.C. and Centocor Research & Development,
also members of the Johnson & Johnson family of companies, will have joint responsibility for further research and development of the Companys licensed BMP technology portfolio.



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The transaction relates to all of the Companys proprietary BMP compounds
including BMP-7, which has been studied in animal models as a treatment for chronic kidney disease and systemic complications, such as renal osteodystrophy, a form of bone disease, and blood vessel complications that have been associated with
chronic kidney disease. Use of the Companys BMPs for the repair or regeneration of local musculoskeletal tissue defects and dental defects is the subject of an exclusive agreement with Stryker and is not included as part of this transaction.



The agreement provides for Ortho Biotech to
pay the Company an up-front payment of $3,500,000, which was paid in December 2002, and substantive milestone payments at various intervals during the U.S. and European regulatory approval process assuming the first two therapeutic indications are
successfully developed. These substantive milestone payments include a $30,000,000 payment if Ortho Biotech achieves U.S. regulatory approval of a product for the treatment of kidney disease or associated complications. The agreement further
specifies that the Company will receive a royalty on net sales of products that incorporate the Companys BMP technologies.



Unless terminated earlier, the agreement shall remain in effect until the expiration of Ortho Biotechs obligation to pay royalties
to the Company under the agreement. Early termination provisions are as follows:



| |  |  | Ortho Biotech Products may terminate the agreement, for any reason, upon ninety days written notice to the Company.
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | Either the Company or Ortho Biotech Products may terminate the agreement immediately for cause upon the occurrence of bankruptcy, insolvency, or if the other party assigns
substantially all of its assets for the benefit of creditors.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Either the Company or Ortho Biotech may terminate the agreement upon ninety days prior written notice if the other party has materially breached or defaulted on any material
obligations under the contract, provided that the other party has not cured such breach within the ninety-day period following written notice of termination.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Ortho Biotech may terminate the agreement upon thirty days written notice if the Company breaches its representation to Ortho Biotech that certain of the Companys other
license agreements do not contain restrictions which would restrict Ortho Biotech from exercising its license rights under the agreement.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



If Ortho Biotech terminates the agreement for cause, the licenses granted by the Company to Ortho Biotech shall survive such termination
and the royalty rates owed to the Company would be reduced. If the Company terminates the agreement for cause or if Ortho Biotech terminates upon thirty days written notice without cause, the licenses granted by the Company to Ortho Biotech shall
terminate.



| | (ii) |  | Accounting Summary
| | ---- |  | ------------------



The Company has no future deliverables under this license agreement and has applied the provisions of SAB No. 104 for recognizing
revenue under this collaboration. The Company recognized the up-front payment of $3,500,000 as revenue in the fourth quarter of 2002 because the Company has no continuing performance obligations under the contract.



The Company views the clinical development and drug approval
milestones under its collaboration with Ortho Biotech to be substantive in nature since the successful achievement of these milestones involves significant risk and uncertainty and a reasonable amount of time passes between the up-front license
payment and the first milestone payment as well as between each subsequent milestone payment. Should the



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Company ever successfully achieve any clinical development or drug approval milestones under this collaboration agreement, any related milestone payments
would be recorded as revenue in Substantive milestones in the Companys Revenues section of its Consolidated Statement of Operations. The Company has not recognized any revenues under its arrangement with Ortho Biotech in either the
three- or nine- month periods ended September 30, 2005.



As of September 30, 2005, the Company has not provided any consideration to Ortho Biotech Products.



| | (e) |  | SPINAL MUSCULAR ATROPHY FOUNDATION
| | --- |  | ----------------------------------



| | (i) |  | Collaboration Summary
| | --- |  | ---------------------



Effective September 7, 2004, the Company entered into a sponsored research agreement with the Spinal Muscular Atrophy Foundation.
Under the agreement, the Foundation will grant the Company up to $5,364,000 over a three-year period for the identification of therapeutic compounds to treat spinal muscular atrophy, a neurological disease that is the leading genetic cause of infant
and toddler death.



The research will utilize
the Companys proprietary technologies and expertise to develop and refine assays in motor neurons and then use those assays to screen for potential drug candidates. The Company will own any compounds that it generates under this collaboration
and will also have the ability to bring any such compounds into the clinic, either using the Companys own resources or with a collaborating third party. If any drug candidates developed under the agreement are successfully commercialized, the
Company will be required to make payments to the SMA Foundation if cumulative revenues from the sales of such products exceed $100,000,000. Unless terminated earlier, the agreement will continue until the expiration of the research activities. The
Company or the SMA Foundation may terminate this agreement upon sixty days prior written notice upon the occurrence of bankruptcy, insolvency, dissolution or winding up of the other party; or upon the breach of any material provision of the
sponsored research agreement by the other party, provided that the other party has not cured such breach within the 60-day period following written notice of termination. Termination of the agreement will not relieve either party of obligations that
have accrued prior to termination, including the SMA Foundations obligation to make payments for research activities. In addition, the Company remains obligated to make payments to the SMA Foundation in the event the Company recognizes an
aggregate of $100,000,000 in revenues on products containing any drug candidates developed under the agreement.



| | (ii) |  | Accounting Summary
| | ---- |  | ------------------



The Companys sole deliverable under this sponsored research agreement is to provide research services. The Company has applied the
provisions of SAB No. 104 for recognizing revenue under this collaboration. The Company is recognizing revenues under this collaboration as the services are performed, provided that payment is reasonably assured under the terms of the grant.
For the three- and nine-month periods ended September 30, 2005, the Company recognized $205,000 and $1,425,000, respectively, related to the reimbursement of our research and development efforts under this sponsored research agreement. This
amount is included in Research and development contracts in the Companys Revenues section of its Consolidated Statement of Operations. As of September 30, 2005, the Company had recorded $127,000 in amounts due from the Spinal
Muscular Atrophy Foundation in Accounts receivable in the Companys Current Assets section of its Consolidated Balance Sheets.



Should the Company ever generate over $100,000,000 in cumulative future revenues from products developed under this agreement, we expect
to record any payments to the SMA Foundation as contra-revenues in accordance with EITF 01-9.



As of September 30, 2005, the Company has not provided any consideration to the SMA Foundation.



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|7. | Genentech Co-Development Accounting
|-- | -----------------------------------



In connection with its election to exercise its co-development option related to its basal cell carcinoma program under development with
Genentech (see Note 6(a)), 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 the accounting for revenue arrangements where both the vendor and the customer make cash payments to each other for services and/or products, as is the case with the Companys collaboration agreements with Genentech. EITF 01-9 states
that situations in which a vendor (the Company) is paying its customer (Genentech) must be evaluated in order to determine if the vendor payment can be treated as expense or as a reduction to revenues generated by the customer relationship. EITF
01-9 also requires that all transactions with a customer be considered when determining the appropriate accounting treatment, including separate collaborations with the same customer.



The Company has entered into two collaborations with Genentech, including the June 2003 license to its
Hedgehog antagonist technologies and an April 2005 license relating to another signaling pathway. Under these collaboration agreements with Genentech, the Company, as the vendor, sold licenses to Genentech and received or may receive from Genentech,
as the customer, license fees, development and drug approval milestones, royalties on potential future product sales, payments for research services, and reimbursement for certain patent expenses and other costs. In addition, the Company also makes
co-development payments to Genentech in connection with the basal cell carcinoma product candidate. The payments made by the Company to reimburse Genentech for co-development payments are considered by the Company to be within the scope of EITF 01-9
because the Company considers these payments to be payments from a vendor made to a customer, and the Company has concluded that such payments did not meet any of the scope exceptions outlined in EITF 01-9.



Because the Company concluded that its co-development
payments are within the scope of EITF 01-9, the Company is required to record all co-development costs as contra revenues, provided that the cumulative co-development costs do not exceed both cumulative revenues recognized to date and probable
future revenues, which includes unamortized deferred revenue balances, under both of our collaborations with Genentech. Any future co-development costs incurred by the Company in excess of the total cumulative revenues recognized and probable future
revenues under the Genentech collaborations will then be recorded against research and development expenses.



As of September 30, 2005, cumulative co-development costs of $5,698,000 incurred by the Company did not exceed cumulative revenues
recorded related to its collaborations with Genentech of $7,870,000. Therefore, in accordance with EITF 01-9, the co-development costs have been recorded as a reduction to revenues, or contra-revenue, of $820,000 and $5,698,000 in the Companys
Consolidated Statement of Operations for the three- and nine-month periods ended September 30, 2005, respectively.



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CURIS, INC. AND SUBSIDIARY

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



|8. | Long-Term Debt and Capital Lease Obligations
|-- | --------------------------------------------



The Company believes that the carrying value of its debt obligations approximate the market value since the underlying interest rates
approximate the current market rates for similar debt securities. Long-term debt obligations consisted of the following at September 30, 2005 and December 31, 2004:



|                                                                                                                                                                                                                 |  |                   |            |   |                  |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ---------- | - | ---------------- | - | ---------- | -
|                                                                                                                                                                                                                 |  | September 30,2005 |            |   | December 31,2004 |  
|Note payable to financing agency for capital purchases                                                                                                                                                           |  | $                 | 2,822,000  |   |                  | $ | 1,141,000  |  
|Convertible promissory note agreement with Elan Pharma International, Limited including approximately $298,000 of accrued interest at
December 31, 2004                                                          |  |                   |           |   |                  |   | 3,298,000  |  
|Convertible subordinated note payable to Becton Dickinson, net of $40,000 and $80,000 discount and including $597,000 and $492,000 of accrued
interest at September 30, 2005 and December 31, 2004, respectively |  |                   | 2,557,000  |   |                  |   | 2,412,000  |  
|                                                                                                                                                                                                                 |  |                   |            |   |                  |   |            |  
|                                                                                                                                                                                                                 |  |                   | 5,379,000  |   |                  |   | 6,851,000  |  
|Lesscurrent portion                                                                                                                                                                                             |  |                   | (4,192,000 | ) |                  |   | (1,141,000 | )
|                                                                                                                                                                                                                 |  |                   |            |   |                  |   |            |  
|Total long-term debt obligations                                                                                                                                                                                 |  | $                 | 1,187,000  |   |                  | $ | 5,710,000  |  
|                                                                                                                                                                                                                 |  |                   |            |   |                  |   |            |  



Effective June 9, 2005, the Company entered into a loan agreement with the Boston Private Bank & Trust Company to finance up to $1,450,000 in purchases of equipment and facility leasehold improvements. Under the terms of the
loan agreement, the Company can request periodic financings for qualifying purchases of equipment and leasehold improvements during the period from June 9, 2005 until December 9, 2005. Until December 9, 2005, the Company will pay
interest only on any borrowings on a monthly basis in arrears. On or before December 9, 2005, the Company will convert the then outstanding balance into a 36-month term note that bears interest at either a variable rate (7.75% as of
September 30, 2005) or a fixed rate (7.66% as of September 30, 2005) for the repayment period. The loan will be collateralized by any equipment and leasehold improvements financed thereunder. As of September 30, 2005, the Company has
financed $866,000 in equipment purchased under this loan agreement.



Effective January 7, 2005, the Company entered into an amendment with the Boston Private Bank & Trust Company to extend the drawdown date by which it can request periodic financings up to $2,250,000 for
qualifying purchases of equipment and leasehold improvements 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 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 plus
any accrued interest beginning on May 1, 2005 extending through the 36-month term. The loan is collateralized by all of the Companys property, plant and equipment assets, except for fixtures and those that are purchased after
March 23, 2005 under purchase money arrangements with equipment lenders. As of September 30, 2005, the Company was in compliance with the sole covenant under this agreement. This covenant requires the Company to maintain a minimum modified
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



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CURIS, INC. AND SUBSIDIARY

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



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.



|9. | Accounting for Stock-Based Compensation
|-- | ---------------------------------------



The Company has two stock option plans. In December 2004, the FASB issued SFAS No. 123(R), Accounting for Stock-Based
Compensation, which establishes standards for the accounting of transactions in which an entity exchanges its equity instruments for goods or services. This Statement focuses primarily on accounting for transactions in which an entity obtains
employee services in share-based payment transactions. SFAS No. 123(R) requires that the fair value of such equity instruments be recognized as an expense in the historical financial statements as services are performed. Prior to adopting SFAS
No. 123(R), only certain pro forma disclosures of fair value are required. The provisions of SFAS No. 123(R) are effective for the first annual reporting period beginning after June 15, 2005. Early adoption is encouraged and
retroactive application of the provisions of SFAS 123(R) to the beginning of the fiscal year that includes the effective date is permitted, but not required. The Company will implement the revised standard in the first quarter of fiscal year 2006.
Currently, the Company accounts for its share-based payment transactions under the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, which does not necessarily require the recognition of compensation cost in the
financial statements. The Company is evaluating its current compensation strategies as they relate to stock-based compensation. Management is assessing the implications of this revised standard which will materially impact the Companys results
of operations in the first quarter of fiscal year 2006 and thereafter.



For the three- and nine-month periods ended September 30, 2005, the Company applied APB No. 25 and related interpretations, including FASB Interpretation No. 44, in accounting for qualifying options
granted to its employees and directors under its plans and applies SFAS No. 123, 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.



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 September 30, |            |   | Nine months ended September 30, |  
|                                                                                                         |  | 2005                             |            |   | 2004                            |   |            | 2005 |  |   | 2004        |  
|Net loss, as reported                                                                                    |  | $                                | (3,631,000 | ) |                                 | $ | (3,906,000 | )    |  | $ | (13,419,000 | ) |  | $ | (12,245,000 | )
|Add back: employee stock based compensation included in net loss, as reported                            |  |                                  | 2,000      |   |                                 |   | 89,000     |      |  |   | 6,000       |   |  |   | 598,000     |  
|Less: stock-based employee compensation expense determined under fair value based methods for all awards |  |                                  | (1,148,000 | ) |                                 |   | (1,595,000 | )    |  |   | (3,713,000  | ) |  |   | (5,773,000  | )
|                                                                                                         |  |                                  |            |   |                                 |   |            |      |  |   |             |   |  |   |             |  
|Pro forma net loss                                                                                       |  | $                                | (4,777,000 | ) |                                 | $ | (5,412,000 | )    |  | $ | (17,126,000 | ) |  | $ | (17,420,000 | )
|                                                                                                         |  |                                  |            |   |                                 |   |            |      |  |   |             |   |  |   |             |  
|Net loss per common share (basic and diluted)                                                           |  |                                  |            |   |                                 |   |            |      |  |   |             |   |  |   |             |  
|As reported                                                                                              |  | $                                | (0.08      | ) |                                 | $ | (0.09      | )    |  | $ | (0.28       | ) |  | $ | (0.30       | )
|Pro forma                                                                                                |  | $                                | (0.10      | ) |                                 | $ | (0.13      | )    |  | $ | (0.36       | ) |  | $ | (0.42       | )



The
effects on the three- and ninemonth periods ended September 30, 2005 and 2004 pro forma net loss and net loss per share of the estimated fair value of stock options are not necessarily representative of the effects on the results of
operations in the future. In addition, the estimates made utilize a pricing model



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CURIS, INC. AND SUBSIDIARY

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



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.



|10. | Loss of Subtenant Income
|--- | ------------------------



Effective August 15, 2002, the Company sublet approximately 12,000 square feet, or 67%, of the rentable square footage of its
facility at 61 Moulton Street, Cambridge, MA. The original subtenants lease bears a contracted rate of $40.00 per square foot through the end of the Companys lease term of April 30, 2007. In addition to the sublease payments, the
subtenant is required to pay its pro rata share of all building operating costs. The sublease income exceeded the Companys cost of the sublet space so the Company did not record a loss on the lease at the time the Company ceased using the
space. The Company has continued to use a portion of the remaining 33% of the leased space.



In July 2005, the subtenant notified the Company that it expected that it would no longer be able to meet its obligations under the
sublease. Effective August 1, 2005, the Company amended its sublease agreement to lower the monthly sublease rent payments to an amount equal to the rate the Company must pay through the remainder of the lease term of April 30, 2007. No
other terms of the sublease agreement were changed. Should the tenant fail to comply with the lease as amended, the Company will seek to sublease the 61 Moulton Street facility to a new subtenant but is uncertain that its efforts will be successful.
Further, the Company expects that, should it be successful in its subleasing efforts, the sublease rent may be lower than the Companys cost to lease the space, based on an analysis of rental rates for similar space in the area.



The Company does not expect to utilize the space, if vacated
by the current tenant due to default of the amended sublease terms, for its current or future operations. In addition, the Company believes that its costs under the lease will exceed any future sublease income for the duration of the lease. Based on
these factors and on the potential for future default by the subtenant, the Company recorded a charge of $500,000 in the General and administrative expense line item of its Consolidated Statement of Operations during the second quarter
of 2005. This amount represents the Companys estimate of the total expected loss on the subleased space over the remaining term of the lease. There has been no change in the Companys estimate of the $500,000 liability, approximately
$350,000 and $150,000 are included as current and long-term liabilities, respectively, in the Companys balance sheet as of September 30, 2005.



|11. | Subsequent Events
|--- | -----------------



| | (a) |  | Extension of research funding by Genentech
| | --- |  | ------------------------------------------



In October 2005, Genentech exercised its option under the April 2005 Hedgehog antagonist collaboration amendment with the Company to
extend funding of ten full-time equivalents performing research services to continue development of therapeutics to treat solid tumor cancers. Genentech had previously supported a total of sixteen Curis and additional third party resources managed
by Curis scientists. The progress made by the two companies had reduced the need for the third party resources. By exercising this option, Genentech has agreed to extend the research term by six months through June 11, 2006 (previously
December 11, 2005). As a result of the extension, Genentech will provide to the Company an additional $1,250,000 of funding for research services performed from December 12, 2005 through June 11, 2006 payable in June 2006.



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CURIS, INC. AND SUBSIDIARY

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



| | (b) |  | Net gain on assets from former collaborator
| | --- |  | -------------------------------------------



On October 21, 2004, the Company amended a note receivable with Micromet, a former collaborator. Under the amended note, Micromet is
obligated to pay Curis a total amount of EUR 4,500,000, subject to certain conditions, of which EUR 1,250,000 was paid in November 2004. Pursuant to the payment terms of the amended note, Micromet made a second payment of EUR 1,250,000 on
October 27, 2005, which resulted in a gain of $1,500,000 based on the EUR-to-US dollar foreign exchange rate. This gain will be recorded in the Other income line item at the Other Income (Expense) section of the Companys
Consolidated Statement of Operations during the fourth quarter of 2005. The future amounts due to the Company under the amended note payable are dependent upon certain events and will be recorded in other income when and if such amounts are
collected.



|12. | New Accounting Standards
|--- | ------------------------



On June 2, 2005, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 154, Accounting Changes and Error
Corrections (FAS 154), which will require entities that voluntarily make a change in accounting principle to apply that change retrospectively to prior periods financial statements, unless this would be impracticable. FAS 154 supersedes
Accounting Principles Board Opinion No. 20, Accounting Changes(APB 20), which previously required that most voluntary changes in accounting principle be recognized by including in the current periods net income the cumulative effect of
changing to the new accounting principle. FAS 154 also makes a distinction between retrospective application of an accounting principle and the restatement of financial statements to reflect the correction of an error.
Another significant change in practice under the FAS 154 will be that if an entity changes its method of depreciation, amortization, or depletion for long-lived, non-financial assets, the change must be accounted for as a change in accounting
estimate. Under APB 20, such a change would have been reported as a change in accounting principle. FAS 154 applies to accounting changes and error corrections that are made in fiscal years beginning after December 15, 2005.



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|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 growth, 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 or unregulated. 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 currently in a phase I clinical trial and under co-development with Genentech, Inc., or Genentech, a collaborator. We have also developed several promising preclinical product candidates in various fields,
including cancer, neurological disorders, hair growth regulation and cardiovascular disease. 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 $676,391,000 as of September 30, 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, Wyeth Pharmaceuticals, or Wyeth, and the Procter & Gamble Company, or P&G, to develop therapeutics which modulate the signaling of the Hedgehog, or Hh, pathway and an
additional collaboration with Genentech to develop therapeutics that modulate another signaling pathway that plays an important role in cell proliferation. We have also licensed our bone morphogenetic protein, or BMP, pathway portfolio to Ortho
Biotech Products, a subsidiary of Johnson & Johnson, for systemic administration for all applications excluding 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 $18,500,000 in up-front payments, of which we received $6,629,000 from the sale of shares of our common
stock, and also include potential future clinical development and regulatory approval milestones of approximately $750,000,000 in the aggregate, assuming that all of the collaborations continue for their full terms, multiple products for multiple
indications are developed, and all milestone payments are received upon successful completion of specified research and/or development objectives and regulatory approvals. In the future, we plan to continue to seek corporate collaborators for the
further development and commercialization of some of our other technologies.



In January 2005, pursuant to the terms of our Hedgehog pathway collaboration agreement with Genentech, we exercised a co-development option pursuant to which we will share equally in all U.S. development costs and
will also 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 should this product be successfully developed and marketed. Genentech
has primary responsibility for clinical trial design and management and we participate



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on a steering committee that oversees the clinical development of the basal cell carcinoma product candidate. As a result of our election to exercise our
co-development option, we will forego U.S. development and drug approval milestones and royalty payments on potential future U.S. sales of the basal cell carcinoma product candidate. 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 and, in the second quarter of 2005, the first patient was enrolled in our phase I clinical trial. We expect that by
exercising 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. We anticipate that the phase II clinical trials will be
completed in mid-2007, assuming that the basal cell carcinoma product candidate successfully completes its phase I clinical trial. We expect to incur additional costs to complete phase III clinical trials and the remainder of the regulatory approval
process, assuming that Genentech and we successfully complete phase II clinical trials.



Financial Operations Overview



General.    Our future operating results will largely depend 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 upon, 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 September 30, 2005, together with the payment of all contractually-defined payments under our collaborations and research
programs with Genentech, Wyeth, P&G and the SMA Foundation, assuming these programs continue as planned, should enable us to maintain current and planned operations into the second half of 2007, including expected spending related to our
co-development of our lead product candidate for the treatment of basal cell carcinoma. Our ability to continue funding our planned operations beyond into the second half of 2007 is dependent upon the success of our collaborations, our ability to
control 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 have been derived from license fees, research and development payments, milestone payments and other amounts that we have received from our strategic collaborators and licensees, including Genentech, Wyeth, Ortho Biotech
Products, and P&G, as well as royalty revenue and payments received upon monetization of certain royalty rights from Stryker Corporation. Since our equal share of the basal cell carcinoma co-development costs will be recorded as a reduction to
any revenue recognized under our collaborations with Genentech in accordance with EITF 01-9, we do not expect to generate any net revenue from our two collaborations with Genentech until we obtain FDA approval to commercialize our basal cell
carcinoma product candidate. In the future, we will seek to generate revenues from a combination of license fees, research and development funding and milestone payments, royalties resulting from the sale of products that incorporate our
intellectual property in connection with strategic licenses and collaborations, and sales of any products we successfully develop and commercialize, either alone or in collaboration with third parties. We expect that any revenues 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 our product candidates. These expenses consist primarily of salaries and related expenses for personnel, supplies
and reagents, 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, the term discovery means that we are searching for compounds



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that may be relevant for treating a particular disease area, 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, 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 investigational 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, and phase I means that we are currently treating human patients in a phase I clinical trial, the principal purpose of which is to evaluate safety of the compound being tested.



All of our estimates below regarding the status of our product development
programs are solely our judgments. These estimates may not reflect the beliefs or expectations of our corporate collaborators or licensors, if applicable. Moreover, because of the early stages of development of these programs, our ability and that
of our collaborators and licensors to successfully complete preclinical or clinical studies of these product candidates, and the timing of completion of such programs, is highly uncertain.



|                                                  |  |                                    |  |                                    |  |                 
|------------------------------------------------- |  | ---------------------------------- |  | ---------------------------------- |  | ----------------
|Product Candidate                                 |  | Primary Indication                 |  | Collaborator/Licensee              |  | Status          
|Hh topical small molecule antagonist              |  | Basal cell carcinoma               |  | Genentech                          |  | Phase I         
|Hh systemic small molecule or antibody antagonist |  | Cancer (1)                         |  | Genentech                          |  | Late preclinical
|Hh small molecule agonist                         |  | Nervous system disorders           |  | Wyeth                              |  | Mid preclinical 
|BMP-7 protein                                     |  | Kidney disease and other disorders |  | Ortho Biotech Products             |  | Mid preclinical 
|Hh small molecule agonist                         |  | Hair growth                        |  | Procter & Gamble                   |  | Late preclinical
|Hh agonist/gene                                   |  | Cardiovascular disease             |  | Internal development (2)           |  | Mid preclinical 
|Discovery research                                |  | Spinal muscular atrophy            |  | Spinal Muscular Atrophy Foundation |  | Discovery       
|Discovery research                                |  | Undisclosed pathway                |  | Genentech                          |  | Discovery       
|Discovery research                                |  | Various signaling pathways         |  | Internal development               |  | Discovery       

---

|(1) |  | Genentech has selected a lead clinical candidate for this program, a small molecule antagonist of the Hedgehog pathway.
|--- |  | -----------------------------------------------------------------------------------------------------------------------



|(2) |  | We have incurred nominal expenses related to our cardiovascular disease program. Our preclinical data relating to this program has been primarily derived from studies conducted at
Caritas St. Elizabeths Medical Center in Boston, Massachusetts. 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. In the event Wyeth declines to exercise its option, we will actively explore other licensing opportunities for this
program. Should we be successful in our efforts to license this program, either to Wyeth or to another collaborator, any investigational new drug filing will likely be the responsibility of the collaborator.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



Genentech and we are co-developing a Hedgehog small molecule antagonist formulated for the topical treatment of basal cell carcinoma. Genentech and we
will share equally in all U.S. development costs. As a result of our election to exercise our co-development option, we will forego U.S. development and drug approval milestones and royalty payments on potential future U.S. sales of the basal cell
carcinoma product candidate. On March 31, 2005, Genentech filed an investigational new drug application with the FDA and, in the second



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quarter of 2005, the first patient was treated in an ongoing phase I clinical trial. We expect that we will incur approximately $20,000,000 in development
expenses through phase II clinical trials and we anticipate that these trials will be completed in mid-2007, assuming the successful advancement of the basal cell carcinoma product candidate through phase I and phase II clinical trials. We expect to
incur additional costs to complete phase III clinical trials and the remainder of the regulatory approval process, assuming that Genentech and we successfully complete phase II clinical trials. Due to the uncertainties that are inherent to the drug
discovery process, as more fully described below, we are not currently able to estimate the cost and timing to complete the phase III trial and receive regulatory approval of this product candidate, if ever.



Except for our basal cell carcinoma product candidate, all of our product
development initiatives are in various stages of preclinical testing. Because of the early stages of these programs, the successful development of our preclinical product candidates is highly uncertain. We 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;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  |  | 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 and effectiveness 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 Future Results.



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. Within facility costs, we have recorded a $500,000 charge resulting from our expected loss of subtenant income on an operating lease for the remainder of our lease term ending on April 30, 2007.



Strategic Alliances and License
Agreements.    Since inception, substantially all of our revenues have 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, P&G and Ortho Biotech Products. These strategic license and collaboration agreements included $18,500,000 in up-front payments, including $6,629,000 from the sale of shares of our common stock, and have
potential future clinical development milestones of approximately $750,000,000 in the aggregate, assuming that all of the collaborations continue for their full terms, multiple products for multiple indications are successfully developed, and all
milestone payments are received upon successful completion of specified research, development and regulatory approval objectives.



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The collaborations and licenses are summarized as follows:



Genentech Hedgehog Antagonist
Collaboration.    In June 2003, we licensed our proprietary Hedgehog pathway antagonists to Genentech for human therapeutic use. The primary focus of the 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 Hedgehog antagonist formulated for the topical treatment for basal cell carcinoma; and the development of systemically administered small
molecule and antibody Hedgehog antagonists for the treatment of certain other solid tumor cancers. Pursuant to the collaboration agreement, Genentech agreed to make specified cash payments, including an up-front payment of $5,000,000, license
maintenance fee payments totaling $4,000,000 over the first two years of the collaboration and milestone payments at various intervals during the clinical development and regulatory approval process of small molecule and antibody Hedgehog antagonist
product candidates, assuming specified clinical development and regulatory approval objectives are met. In addition, Genentech will pay a royalty on potential future net product sales, which increases with increasing sales volume. As described
below, in December 2004, we entered into an amendment to this agreement which modified the maintenance and the payment arrangement.



On June 11, 2003, in connection with the collaboration agreement, we sold to Genentech 1,323,835 shares of our common stock. We also
entered into a registration rights agreement with Genentech pursuant to which, at the request of Genentech, we shall use our reasonable best efforts to register the shares of common stock for resale in the future under specified conditions. The
shares were initially recorded at a price of $2.644 per share based on a 30-day trailing average of closing prices prior to June 11, 2003, pursuant to the terms of a stock purchase agreement and, therefore, we allocated $3,500,000 as
stockholders equity in our consolidated balance at December 31, 2003. The fair market value of our common stock was $3.77 per share on June 11, 2003, as determined by the quoted closing price on the NASDAQ national market. During the
third quarter of 2005, we determined that we should have used the closing market price to calculate the value of the shares rather than the contractually agreed-upon price. Accordingly, we should have ascribed $4,991,000 in value to the common
stock, calculated as the $3.77 per share closing price multiplied by 1,323,835 shares sold to Genentech. Consequently, in the quarter ended September 30, 2005, we recorded a credit of $1,491,000 to additional-paid-in capital to correct the
understatement in the fair value of the shares issued, a $1,072,000 reduction in deferred revenue to correct the overstatement of deferred revenue; and a $419,000 reduction in revenue to correct the cumulative overstatement of revenue in the periods
from June 2003 to June 2005.



In January 2005,
pursuant to the collaboration agreement we exercised an option to co-develop Hedgehog antagonist products in the field of basal call carcinoma in the U.S. We are now sharing equally in both U.S. development costs and any future U.S. net profits
and/or losses resulting from the development and commercialization of our basal cell carcinoma product candidate. This co-development right includes basal cell carcinoma and any additional indications for which this product candidate may be
developed in the U.S. As a result of participating in co-development, we will forego U.S. development milestone and royalty payments on potential future U.S. sales of the basal cell carcinoma product candidate. Should we determine that we cannot
continue funding our equal share of the development expenses, we may opt out of the co-development structure and receive certain development and regulatory approval milestones and royalties on sales of the basal cell carcinoma product candidate,
should any ever occur. On March 31, 2005, Genentech filed an investigational new drug application for the basal cell carcinoma product candidate with the FDA and began enrollment of a phase I clinical trial for a basal cell carcinoma product
candidate during the second quarter of 2005. In addition to our co-development rights in the U.S. marketplace, in certain major international markets, we will receive milestones if specific clinical development objectives are achieved and a royalty
on any international sales of a basal cell carcinoma product candidate.



Under the systemic Hedgehog antagonist program of the collaboration, Genentech is also obligated to make milestone payments to us assuming the successful achievement of clinical development and drug approval
objectives. In addition, Genentech will pay a royalty on potential future net product sales, which increases with increasing sales.



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Amendments to the Genentech Hedgehog Antagonist
Collaboration.    In December 2004 and April 2005, we entered into separate amendments to our June 2003 agreement with Genentech. We considered the provisions of EITF 00-21 and determined that these agreements were separate
contracts from our June 2003 agreement since these agreements were not contemplated at the time of the June 2003 arrangement, were separately negotiated in order to increase the number of full-time equivalents providing research and development
services and to provide xenograft tumor samples to Genentech, and were not entered into at or near the time of the June 2003 agreement.



The December 2004 amendment, effective from June 12, 2004 to June 11, 2005, increases our commitment of full-time equivalents
providing research and development services for the systemic Hedgehog antagonist program from eight to sixteen, including six full-time equivalents that are employed by a third party but are managed by us, and increases Genentechs funding
commitment from $2,000,000 to $4,000,000 for this period of which Genentech paid us $2,000,000 for research services in December 2004 and the remaining $2,000,000 for subsequent research services was paid in June 2005. Pursuant to the agreement, we
also agreed to provide xenograft tumor samples to Genentech during the research period for which Genentech paid us $100,000 in December 2004. Also in accordance with the amendment, the second $2,000,000 maintenance payment due under the June 2003
arrangement was removed with no economic effect since it was replaced by a $2,000,000 payment for research services made to us in December 2004.



The April 2005 amendment, effective from June 12, 2005 to June 11, 2006, provided for sixteen of our full-time equivalent
researchers, including six full-time equivalents that are employed by a third party but are managed by us, to provide research and development services for the systemic Hedgehog antagonist program for the period of June 12, 2005 until
December 11, 2005, in exchange for an additional $2,000,000. The $2,000,000 is due in December 2005. The agreement also provided Genentech with the option to request that we provide up to sixteen full-time equivalent researchers to perform
research services during the period of December 12, 2005 until June 11, 2006, provided that Genentech supplies us with adequate notice. In October 2005, Genentech requested that we provide ten full-time equivalent researchers, all of which
are Curis employees, for work on the program from December 12, 2005 until June 11, 2006, in exchange for $1,250,000. The six full-time third party equivalents that were previously involved in the program are no longer needed, based on the
progress made under the program, which included the selection of a lead clinical candidate, a small molecule antagonist of the Hedgehog pathway. The remaining $1,250,000 for subsequent research services is payable by Genentech in June 2006.



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 a signaling pathway that plays an
important role in cell proliferation. This pathway is a regulator of tissue growth, formation and repair, the abnormal activation of which is associated with certain cancers. Under the terms of the agreement, we have granted Genentech an exclusive,
royalty-bearing license to make, use and sell the small molecule compounds that are modulators of the pathway. We have retained the rights for ex vivo cell therapy, except in the areas of oncology and hematopoiesis.



Under the terms of the agreement, we will have primary
responsibility for drug discovery and research activities and Genentech will be responsible for clinical development, manufacturing, and commercialization of products that may result from the collaboration. Genentech paid us an up-front license fee
of $3,000,000 and has agreed to fund up to $6,000,000 for research activities during the initial two-year research term, subject to certain termination rights. Genentech has also agreed to make cash payments to us that are contingent upon the
successful achievement of certain preclinical and clinical development milestones and drug approval milestones. Excluding royalties on potential net product sales, the total potential cash payments from this collaboration could exceed $140 million,
assuming that two products are commercialized in two indications each. Genentech has an option to extend the initial two-year research term for up to two additional years in one-year increments. Genentech will also pay us royalties on net product
sales if product candidates derived from the collaboration are successfully developed.



Wyeth Hedgehog Agonist Collaboration.    In January 2004, we licensed our Hedgehog proteins and small molecule
Hedgehog pathway agonists to Wyeth Pharmaceuticals, or Wyeth, for therapeutic



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applications in the treatment of neurological diseases and other disorders. Under the terms of the agreement, Wyeth paid us $3,000,000 in up-front
consideration, of which we had originally allocated $1,500,000 to a non-refundable license fee and $1,500,000 to the purchase of 315,524 unregistered shares of our common stock. In determining the allocation of the up-front consideration, we had
previously used a purchase price of $4.754 per share for the common stock, which was based on the contractually negotiated 15-day trailing average closing price of our common stock in the 15-day period prior to the January 12, 2004 date of the
common stock sale. The fair market value of our common stock was $5.19 per share on January 12, 2004, as determined by the quoted closing price on the NASDAQ national market. During the third quarter of 2005, we determined that we should have
used the closing market price on the date of sale to calculate the value of the shares rather than the contractually agreed-upon price. Accordingly, we should have ascribed $1,638,000 in value to the common stock, calculated as the $5.19 per share
closing price multiplied by 315,524 shares sold to Wyeth. Consequently, in the quarter ended September 30, 2005, we recorded a credit of $138,000 to additional-paid-in capital to correct the understatement in the fair value of the shares issued, a
$97,000 reduction in deferred revenue to correct the overstatement of deferred revenue; and a $41,000 reduction in revenue to correct the cumulative overstatement of revenue in the periods from January 2004 to June 2005.



Wyeth is also obligated to make milestone payments if the
licensed programs successfully achieve clinical development and drug approval objectives and to pay us a royalty on net product sales, if any should occur, that escalates with increasing sales volume. Our agreement with Wyeth includes more than $170
million in milestone payments, assuming at least two products are successfully developed and commercialized.



In addition to these initial and potential future milestone payments, Wyeth is obligated to provide financial support of our research
under the collaboration, at $250,000 per full-time equivalent researcher, for a period of up two years based on the number of full-time equivalent researchers performing services under the collaboration. We are obligated to dedicate between five and
ten full-time equivalents to this program, as determined by the steering committee in six-month intervals, for two years. After the initial two-year period, Wyeth can, at its option, elect to extend our research obligation, and Wyeths funding
thereof, for an initial one-year extension on the same terms and conditions as the initial two-year term. Thereafter, the agreement may be extended for additional one-year periods upon recommendation of the steering committee with such full-time
equivalent resources and related Wyeth funding obligations as may be consistent with fulfilling the objectives of the research plan. The senior Wyeth representative on the Joint Steering Committee has the deciding vote in the event the parties
disagree on matters relating to the research program. The agreement provides for a one-year evaluation period immediately following the end of the research term, during which we may be obligated to serve on the steering committee and may be
required, at Wyeths expense, to perform additional research and development services. We currently estimate we will only be required to provide steering committee services during the evaluation period if we are also performing research
services during that period.



As part of the
agreement, we have retained development and licensing options for certain therapeutic applications of the Hedgehog agonist technologies, including topical treatment for skin diseases and disorders including hair growth regulation, ex vivo cell
therapy, local delivery applications for treatment of cardiovascular disease, and those applications that qualify as orphan drug indications. Wyeth has a right of first negotiation to obtain an exclusive license to the orphan drug indications and
the cardiovascular applications. If Wyeth declines to exercise its right, 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 these programs.



Procter & Gamble Hedgehog Agonist
Collaboration for Hair Growth and Skin Disorders.    On September 18, 2005, we entered into a collaboration, research and license agreement with P&G, to evaluate and develop potential treatments for hair growth
regulation and skin disorders utilizing our Hedgehog agonist technology.



Under the terms of the agreement, we granted to P&G an exclusive, worldwide, royalty-bearing license for the development and commercialization of topical dermatological and hair growth products that



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incorporate our Hedgehog agonist technology. In accordance with the terms of the agreement, the parties shall jointly undertake a research program with the
goal of identifying one or more compounds to be developed and commercialized by P&G. P&G is solely responsible for the cost of worldwide development and commercialization of any product candidates developed pursuant to the research program,
provided however, that at the time that P&G determines to file the first investigational new drug application with the U.S. Food and Drug Administration for a product candidate, we shall have the option, at our sole discretion, to co-develop a
product candidate through phases I and II of clinical development. We, however, would receive a higher royalty in the event that we exercise our co-development option and subsequently share in development expense through phase II clinical trials.
Should we elect to exercise this co-development option, we will forego development milestones that would otherwise be payable during the period from investigational new drug application filing through the completion of a phase II clinical trial.
P&G has paid us an up-front license fee of $500,000 and has agreed to fund up to $600,000 for two of our full-time equivalent employees providing research and development activities during the initial one-year research term, subject to its
termination rights. P&G has an option to extend the initial one-year research term for up to three additional years in one-year increments.



P&G has also agreed to make cash payments to us that are contingent upon the successful achievement of certain research, development,
clinical and drug approval milestones. P&G will also pay us royalties on net product sales if product candidates derived from the collaboration are successfully developed. We will receive a higher royalty in the event that we exercise our
co-development option and subsequently share in development expenses through phase II clinical trials.



Ortho Biotech Products BMP License.    In November 2002, we licensed our broad bone morphogenetic protein, or
BMP, technology portfolio to Ortho Biotech Products, L.P., a member of the Johnson & Johnson family of companies. Two of Ortho Biotech Products research affiliates, Johnson & Johnson Pharmaceutical Research &
Development, L.L.C. and Centocor Research & Development, also members of the Johnson & Johnson family of companies, will have joint responsibility for further research and development of our licensed BMP technology portfolio.



The transaction relates to all of our
proprietary BMP compounds including BMP-7, which has been studied in animal models in various disease indications, including as a treatment for chronic kidney disease and systemic complications, such as renal osteodystrophy, a form of bone disease,
and blood vessel complications that have been associated with chronic kidney disease. Use of our BMPs for the repair or regeneration of local musculoskeletal tissue defects and dental defects is the subject of an exclusive agreement with Stryker and
is not included as part of this transaction.



Pursuant to the agreement, Ortho Biotech paid us an up-front payment of $3,500,000, in December 2002, and has agreed to make milestone payments at various intervals during the U.S. and European regulatory approval process assuming the first
two therapeutic indications are successfully developed. These milestones include a $30,000,000 payment if Ortho Biotech achieves U.S. regulatory approval of a product for the treatment of kidney disease or associated complications. The agreement
further specifies that we will receive a royalty on net sales of products that incorporate our BMP technologies. Unless terminated earlier, the agreement shall remain in effect until the expiration of Ortho Biotechs obligation to pay royalties
to us under the agreement.



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 revenue recognition, the carrying value of property and equipment and intangible assets and the value of certain liabilities. We base our estimates on historical experience and on various other factors that 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.



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



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 (SAB) No. 104 (SAB No. 104), Revenue
Recognition, Emerging Issues Task Force (EITF) Issue No. 00-21 (EITF 00-21), Accounting for Revenue Arrangements with Multiple Deliverables, EITF Issue No. 99-19 (EITF 99-19), Reporting Revenue Gross as a Principal Versus Net as
an Agent,and EITF Issue No. 01-9 (EITF 01-9), Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendors Products).



Non-refundable license fees are recognized as revenue when we have a contractual right to receive such payment, the contract
price is fixed or determinable, the collection of the resulting receivable is reasonably assured and we have no further performance obligations under the license agreement. Multiple element arrangements, such as license and development arrangements
are analyzed to determine whether the elements, the license and the performance obligations, can be separated or whether they must be accounted for as a single unit of accounting in accordance with EITF 00-21. We recognize up-front license payments
as revenue upon delivery of the license only if the license has stand-alone value and the fair value of the undelivered performance obligations, typically including research or steering committee services, can be determined. If the fair value of the
undelivered performance obligations can be determined, such obligations would then be accounted for separately as performed. If the license is considered to either (i) not have stand-alone value or (ii) have stand-alone value but the fair
value of any of the undelivered performance obligations cannot be determined, the arrangement would then be accounted for as a single unit of accounting and the license payments and payments for performance obligations are recognized as revenue over
the estimated period of when the performance obligations are performed.



Whenever we determine that an arrangement should be accounted for as a single unit of accounting, we must determine the period over which the performance obligations will be performed and revenue will be recognized. Revenue will be
recognized using either a relative performance or straight-line method. We recognize revenue using the relative performance method provided that we can reasonably estimate the level of effort required to complete our performance obligations under an
arrangement and such performance obligations are provided on a best-efforts basis. Direct labor hours or full-time equivalents are typically used as the measure of performance. Revenue recognized under the relative performance method would be
determined by multiplying the total payments under the contract, excluding royalties and payments contingent upon achievement of substantive milestones, by the ratio of level of effort incurred to date to estimated total level of effort required to
complete our performance obligations under the arrangement. Revenue is limited to the lesser of the cumulative amount of payments received or the cumulative amount of revenue earned, as determined using the relative performance method, as of each
reporting period.



If we cannot reasonably estimate the level
of effort required to complete our performance obligations under an arrangement and the performance obligations are provided on a best-efforts basis, then the total payments under the arrangement, excluding royalties and payments contingent upon
achievement of substantive milestones, would be recognized as revenue on a straight-line basis over the period we expect to complete our performance obligations. Revenue is limited to the lesser of the cumulative amount of payments received or the
cumulative amount of revenue earned, as determined using the straight-line basis, as of the period ending date.



Significant management judgment is required in determining the level of effort required under an arrangement and the period over which we are expected to
complete our performance obligations under an arrangement. In addition, if we are involved in a steering committee under a research arrangement, we assess whether our involvement constitutes a performance obligation or a right to participate.
Steering committee services that are not inconsequential or perfunctory and that are determined to be performance obligations are combined with other research services or performance obligations required under an arrangement, if any, in determining
the level of effort required in an arrangement and the period over which we expect to complete our aggregate performance obligations.



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Collaboration agreements may also contain substantive milestones. Substantive milestone payments are
considered to be performance bonuses that are recognized upon achievement of the milestone only if all of the following conditions are met:



| |  |  | the milestone payments are non-refundable;
| | - |  | ------------------------------------------



| |  |  | achievement of the milestone involves a degree of risk and was not reasonably assured at the inception of the arrangement;
| | - |  | --------------------------------------------------------------------------------------------------------------------------



| |  |  | substantive effort is involved in achieving the milestone;
| | - |  | ----------------------------------------------------------



| |  |  | the amount of the milestone payment is reasonable in relation to the effort expended or the risk associated with achievement of the milestone; and,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between each subsequent milestone payment.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



Determination as to whether a milestone meets
the aforementioned conditions involves managements judgment. If any of these conditions are not met, the milestone payment would not be considered a substantive milestone, and the resulting payment would be recognized as revenue as such
performance obligations are performed under either the relative performance or straight-line methods, as applicable, and in accordance with these policies as described above.



Reimbursement of costs is recognized as revenue provided the provisions of EITF 99-19 are met, the amounts are determinable,
and collection of the related receivable is reasonably assured.



Royalty revenue is recognized upon the sale of the related products, provided that the royalty amounts are fixed or determinable, collection of the related receivable is reasonably assured and we have no remaining performance obligations
under the arrangement. If royalties are received when we have remaining performance obligations, the royalty payments would be attributed to the services being provided under the arrangement and therefore would be recognized as such performance
obligations are performed under either the relative performance or straight line methods, as applicable, and in accordance with these policies as described above.



For revenue generating arrangements where we, as a vendor, provide consideration to a licensor or collaborator, as a
customer, we apply the provisions of EITF 01-9. EITF 01-9 addresses the accounting for revenue arrangements where both the vendor and the customer make cash payments to each other for services and/or products. A payment to a customer is presumed to
be a reduction of the selling price unless we receive an identifiable benefit for the payment and we can reasonably estimate the fair value of the benefit received. Payments to a customer that are deemed a reduction of selling price are recorded
first as a reduction of revenue, to the extent of both cumulative revenue recorded to date and of probable future revenues, which include any unamortized deferred revenue balances, under all arrangements with such customer and then as an expense.
Payments that are not deemed to be a reduction of selling price would be recorded as an expense.



Amounts received prior to satisfying the above revenue recognition criteria are recorded as deferred revenue in the accompanying consolidated balance
sheets. Amounts not expected to be recognized during the twelve-month period ended September 30, , 2006 are classified as long-term deferred revenue. As of September 30, 2005, we have short- and long-term deferred revenue of $2,152,000 and
$7,291,000, respectively, related to our collaborations.



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. Short-term deferred revenue consists of amounts that are expected to be recognized as revenue, or applied against future co-development costs, by
September 30, 2006. Amounts that we expect will not be recognized prior to September 30, 2006 are classified as long-term deferred revenue. However, this estimate is



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based on our current operating plan as of September 30, 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 October 1, 2005 through September 30, 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. 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.



Goodwill.    We assess the impairment of goodwill 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 goodwill 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 September 30, 2005, we believe that the fair value of these investments is not less than their carrying value.



If the financial condition or results of Aegera, Micromet or ES Cell decline significantly, 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.



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.



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Results of Operations



Three-Month Periods Ended September 30, 2005 and September 30, 2004



Revenues.    Total revenues are summarized as follows:



|                                                   |  |                                         |           |                               |      |   |           |  |      |   
|-------------------------------------------------- |  | --------------------------------------- | --------- | ----------------------------- | ---- | - | --------- |  | ---- | --
|                                                   |  | For the Three Months EndedSeptember 30, |           | PercentageIncrease/(Decrease) |     
|                                                   |  | 2005                                    |           |                               | 2004 |  
|Revenues:                                          |  |                                         |           |                               |      |   |           |  |      |   
|Research and development contracts                 |  |                                         |           |                               |      |   |           |  |      |   
|Genentech                                          |  | $                                       | 1,791,000 |                               |      | $ | 301,000   |  | 495  | % 
|Wyeth                                              |  |                                         | 561,000   |                               |      |   | 661,000   |  | (15  | )%
|Procter & Gamble                                   |  |                                         | 7,000     |                               |      |   |          |  | 100  | % 
|Spinal Muscular Atrophy Foundation                 |  |                                         | 205,000   |                               |      |   | 139,000   |  | 47   | % 
|Other                                              |  |                                         | 62,000    |                               |      |   |          |  | 100  | % 
|                                                   |  |                                         |           |                               |      |   |           |  |      |   
|Subtotal                                           |  |                                         | 2,626,000 |                               |      |   | 1,101,000 |  | 139  | % 
|                                                   |  |                                         |          
|License fees                                       |  |                                         |           |                               |      |   |           |  |      |   
|Genentech                                          |  | $                                       | (18,000   | )                             |      | $ | 310,000   |  | (106 | )%
|Wyeth                                              |  |                                         | 24,000    |                               |      |   | 75,000    |  | (68  | )%
|Procter & Gamble                                   |  |                                         | 3,000     |                               |      |   |          |  | 100  | % 
|                                                   |  |                                         |           |                               |      |   |           |  |      |   
|Subtotal                                           |  |                                         | 9,000     |                               |      |   | 385,000   |  | (98  | )%
|                                                   |  |                                         |          
|Gross Revenues                                     |  |                                         | 2,635,000 |                               |      |   | 1,486,000 |  | 77   | % 
|                                                   |  |                                         |           |                               |      |   |           |  |      |   
|Contra-revenues from co-development with Genentech |  |                                         | (820,000  | )                             |      |   |          |  | (100 | )%
|                                                   |  |                                         |           |                               |      |   |           |  |      |   
|Net Revenue                                        |  | $                                       | 1,815,000 |                               |      | $ | 1,486,000 |  | 22   | % 
|                                                   |  |                                         |           |                               |      |   |           |  |      |   



The 77% increase in
gross revenues for the third quarter of 2005 as compared to the same period in the prior year, was primarily due to increased revenues from our Genentech collaborations of $1,490,000 offset by a $460,000 cumulative reduction in license revenues
attributable to the correction of an error in recording equity related to the June 2003 Hedgehog antagonist collaboration agreement with Genentech and the January 2004 Hedgehog agonist collaboration with Wyeth . For the three-month period ending
September 30, 2005, we also recorded $820,000 in contra-revenue, or a reduction to gross revenues, related to our co-development payments to Genentech. This reduction in gross revenue represents amounts owed for the reimbursement of our equal
share of costs incurred by Genentech under our collaboration related to the co-development of a basal cell carcinoma therapeutic product candidate.



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



|                                          |  |                          |  |                                          |           |                               |   |           |  |     |   
|----------------------------------------- |  | ------------------------ |  | ---------------------------------------- | --------- | ----------------------------- | - | --------- |  | --- | --
|Research and Development Program          |  | Primary Indication       |  | For the Three Months Ended September 30, |           | PercentageIncrease/(Decrease) |  
|                                          |  | 2005                     |  | 2004                                     |          
|Hh small molecule and antibody antagonist |  | Cancer                   |  | $                                        | 1,085,000 |                               | $ | 1,072,000 |  | 1   | % 
|Hh small molecule agonist                 |  | Nervous system disorders |  |                                          | 708,000   |                               |   | 577,000   |  | 23  | % 
|Hh small molecule agonist                 |  | Hair loss                |  |                                          | 218,000   |                               |   | 225,000   |  | (3  | )%
|Discovery research                        |  | Spinal muscular atrophy  |  |                                          | 578,000   |                               |   | 139,000   |  | 316 | % 
|Discovery research                        |  | Various                  |  |                                          | 1,061,000 |                               |   | 932,000   |  | 14  | % 
|Other                                     |  | Various                  |  |                                          | 7,000     |                               |   | 2,000     |  | 250 | % 
|Stock-based compensation                  |  | N/A                      |  |                                          | 164,000   |                               |   | 342,000   |  | (52 | )%
|                                          |  |                          |  |                                          |           |                               |   |           |  |     |   
|Total research and development expense    |  |                          |  | $                                        | 3,821,000 |                               | $ | 3,289,000 |  | 16  | % 
|                                          |  |                          |  |                                          |           |                               |   |           |  |     |   



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The increase of $532,000 in research and development expenses for the three-month period ended
September 30, 2005 was primarily due to an increase in spending of $568,000 on our discovery research programs, one of which is under a grant with the Spinal Muscular Atrophy Foundation and another of which is under collaboration with
Genentech.



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



|                                          |      |                                         |           |                               |   |           |  |     |   
|----------------------------------------- | ---- | --------------------------------------- | --------- | ----------------------------- | - | --------- |  | --- | --
|                                          |      | For the Three Months EndedSeptember 30, |           | PercentageIncrease/(Decrease) |  
|                                          | 2005 |                                         | 2004      |                              
|Personnel                                 |      | $                                       | 771,000   |                               | $ | 749,000   |  | 3   | % 
|Occupancy and depreciation                |      |                                         | 170,000   |                               |   | 136,000   |  | 25  | % 
|Legal services                            |      |                                         | 423,000   |                               |   | 568,000   |  | (26 | )%
|Consulting and professional services      |      |                                         | 223,000   |                               |   | 481,000   |  | (54 | )%
|Insurance costs                           |      |                                         | 107,000   |                               |   | 114,000   |  | (6  | )%
|Other general and administrative expenses |      |                                         | 137,000   |                               |   | 64,000    |  | 114 | % 
|Stock-based compensation                  |      |                                         | 2,000     |                               |   | 26,000    |  | (92 | )%
|                                          |      |                                         |           |                               |   |           |  |     |   
|Total general and administrative expenses |      | $                                       | 1,833,000 |                               | $ | 2,138,000 |  | (14 | )%
|                                          |      |                                         |           |                               |   |           |  |     |   



The decrease in
general and administrative expenses of $305,000 for the three-month period ended September 30, 2005 was primarily due to decreases in professional services and legal services of $258,000 and $145,000 respectively, offset by increases in other
expenses of $73,000.



Amortization of
Intangibles.    Amortization of intangible assets was $19,000 for each of the three-month periods ended September 30, 2005 and 2004.



Interest Income.    Interest income for the three-month period ended September 30, 2005 was
$319,000 as compared to $116,000 for the three-month period ended September 30, 2004, an increase of $203,000, or 175%. The increase in interest income resulted from higher interest rates and a higher available investment balance for the period
ended September 30, 2005 as compared to the three-month period ended September 30, 2004.



Other Income.    We recorded no other income for the three months ended September 30, 2005. Other income was $40,000 for
the three-month period ended September 30, 2004, which primarily consisted of a gain recognized on currency rate fluctuations on a Euro-denominated note receivable from a former collaborator.



Interest Expense.    Interest expense of $93,000
for the three-month period ended September 30, 2005, was comparable to interest expense of $102,000 for the three-month period ended September 30, 2004.



Net Loss.    As a result of the foregoing, we incurred a net loss of $3,631,000 for the
three-month period ended September 30, 2005 as compared to a net loss of $3,906,000 for the three-month period ended September 30, 2004.



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Nine-Month Periods Ended September 30, 2005 and September 30, 2004



Revenues.    Total revenues are summarized as
follows:



|                                                   |      |                                        |            |                               |  |   |           |  |      |   
|-------------------------------------------------- | ---- | -------------------------------------- | ---------- | ----------------------------- |  | - | --------- |  | ---- | --
|                                                   |      | For the Nine Months EndedSeptember 30, |            | PercentageIncrease/(Decrease) | 
|                                                   | 2005 |                                        |            | 2004                          | 
|Revenues:                                          |      |                                        |            |                               |  |   |           |  |      |   
|Research and development contracts                 |      |                                        |            |                               |  |   |           |  |      |   
|Genentech                                          |      | $                                      | 4,119,000  |                               |  | $ | 625,000   |  | 559  | % 
|Wyeth                                              |      |                                        | 1,745,000  |                               |  |   | 1,525,000 |  | 14   | % 
|Procter & Gamble                                   |      |                                        | 7,000      |                               |  |   |          |  | 100  | % 
|Spinal Muscular Atrophy Foundation                 |      |                                        | 1,425,000  |                               |  |   | 139,000   |  | 925  | % 
|Other                                              |      |                                        | 62,000     |                               |  |   |          |  | 100  | % 
|                                                   |      |                                        |            |                               |  |   |           |  |      |   
|Subtotal                                           |      |                                        | 7,358,000  |                               |  |   | 2,289,000 |  | 221  | % 
|                                                   |      |                                        |           
|License Fees                                       |      |                                        |            |                               |  |   |           |  |      |   
|Genentech                                          |      | $                                      | 716,000    |                               |  | $ | 931,000   |  | (23  | )%
|Wyeth                                              |      |                                        | 174,000    |                               |  |   | 192,000   |  | (9   | )%
|Procter & Gamble                                   |      |                                        | 3,000      |                               |  |   |          |  | 100  | % 
|                                                   |      |                                        |            |                               |  |   |           |  |      |   
|Subtotal                                           |      |                                        | 893,000    |                               |  |   | 1,123,000 |  | (21  | )%
|                                                   |      |                                        |           
|Substantive milestones                             |      |                                        | 250,000    |                               |  |   | 50,000    |  | 400  | % 
|                                                   |      |                                        |            |                               |  |   |           |  |      |   
|Gross Revenues                                     |      |                                        | 8,501,000  |                               |  |   | 3,462,000 |  | 146  | % 
|                                                   |      |                                        |            |                               |  |   |           |  |      |   
|Contra-revenues from co-development with Genentech |      |                                        | (5,698,000 | )                             |  |   |          |  | (100 | )%
|                                                   |      |                                        |            |                               |  |   |           |  |      |   
|Net Revenue                                        |      | $                                      | 2,803,000  |                               |  | $ | 3,462,000 |  | (19  | )%
|                                                   |      |                                        |            |                               |  |   |           |  |      |   



Gross revenues
generated under our ongoing collaborations with Genentech, Wyeth, P&G and our grant from the Spinal Muscular Atrophy Foundation were $8,439,000 for the first nine months of 2005 as compared to $3,462,000 for the same period in the prior year, an
increase of $4,977,000, or 144%. This increase is net of a $460,000 cumulative reduction in license revenues attributable to the correction of an error in recording equity related to the June 2003 Hedgehog antagonist collaboration agreement with
Genentech and the January 2004 Hedgehog agonist collaboration with Wyeth. For the nine-month period ending September 30, 2005, we also recorded $5,698,000 in contra-revenue, or a reduction to gross revenues, related to our co-development
payments to Genentech. This reduction in gross revenue represents amounts paid or owed for the reimbursement of our equal share of costs incurred by Genentech under our collaboration related to the co-development of a basal cell carcinoma
therapeutic product candidate.



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



|                                          |  |                          |  |                                        |            |                               |   |           |  |       |   
|----------------------------------------- |  | ------------------------ |  | -------------------------------------- | ---------- | ----------------------------- | - | --------- |  | ----- | --
|                                          |  |                          |  | For the Nine Months EndedSeptember 30, |            | PercentageIncrease/(Decrease) |  
|Research and Development Program          |  | Primary Indication       |  | 2005                                   |            | 2004                          |  
|Hh small molecule and antibody antagonist |  | Cancer                   |  | $                                      | 3,048,000  |                               | $ | 3,226,000 |  | (6    | )%
|Hh small molecule agonist                 |  | Nervous system disorders |  |                                        | 2,189,000  |                               |   | 2,243,000 |  | (2    | )%
|Hh small molecule agonist                 |  | Hair loss                |  |                                        | 664,000    |                               |   | 603,000   |  | 10    | % 
|Discovery research                        |  | Spinal muscular atrophy  |  |                                        | 2,046,000  |                               |   | 139,000   |  | 1,372 | % 
|Discovery research                        |  | Various                  |  |                                        | 2,488,000  |                               |   | 2,301,000 |  | 8     | % 
|Other                                     |  | Various                  |  |                                        | 25,000     |                               |   | 73,000    |  | (66   | )%
|Stock-based compensation                  |  | N/A                      |  |                                        | 188,000    |                               |   | 864,000   |  | (78   | )%
|                                          |  |                          |  |                                        |            |                               |   |           |  |       |   
|Total research and development expense    |  |                          |  | $                                      | 10,648,000 |                               | $ | 9,449,000 |  | 13    | % 
|                                          |  |                          |  |                                        |            |                               |   |           |  |       |   



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The increase of $1,199,000 in research and development expenses for the nine-month period ended
September 30, 2005, was primarily due to an increase in spending of $1,907,000 on one of our discovery research programs which is under a sponsored research agreement with the Spinal Muscular Atrophy Foundation. This program began in
mid-September 2004 and we incurred costs of $139,000 during the nine-month period ended September 30, 2004. Reduced spending of $178,000 in our Hedgehog small molecule and antibody antagonist for cancer programs partially offset this increase.
This increase was partially offset by a decrease in stock-based compensation, which was $188,000 as compared to $864,000 for the nine-month periods ended September 30, 2005 and 2004, respectively. 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 in August 2000 that became fully vested as of August 2004. No related additional expense was
recognized for these August 2000 stock options beyond August 2004.



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



|                                          |      |                                        |           |                               |   |           |  |     |   
|----------------------------------------- | ---- | -------------------------------------- | --------- | ----------------------------- | - | --------- |  | --- | --
|                                          |      | For the Nine Months EndedSeptember 30, |           | PercentageIncrease/(Decrease) |  
|                                          | 2005 |                                        | 2004      |                              
|Personnel                                 |      | $                                      | 2,549,000 |                               | $ | 2,273,000 |  | 12  | % 
|Occupancy and depreciation                |      |                                        | 946,000   |                               |   | 500,000   |  | 89  | % 
|Legal services                            |      |                                        | 1,019,000 |                               |   | 1,443,000 |  | (29 | )%
|Consulting and professional services      |      |                                        | 797,000   |                               |   | 1,137,000 |  | (30 | )%
|Insurance costs                           |      |                                        | 319,000   |                               |   | 378,000   |  | (16 | )%
|Other general and administrative expenses |      |                                        | 506,000   |                               |   | 535,000   |  | (5  | )%
|Stock-based compensation                  |      |                                        | 5,000     |                               |   | 195,000   |  | (97 | )%
|                                          |      |                                        |           |                               |   |           |  |     |   
|Total general and administrative expenses |      | $                                      | 6,141,000 |                               | $ | 6,461,000 |  | (5  | )%
|                                          |      |                                        |           |                               |   |           |  |     |   



The decrease of
$320,000 in general and administrative expenses for the nine-month period ended September 30, 2005 was due to decreases in most cost categories, offset by an increase in personnel costs and by the recognition of a $500,000 charge resulting from
the expected loss of subtenant income under an operating lease for the remainder of our lease term.



Amortization of Intangibles.    Amortization of intangible assets was $56,000 for each of the nine-month periods ended
September 30, 2005 and 2004.



Interest
Income.    Interest income for the nine-month period ended September 30, 2005 was $862,000 as compared to $333,000 for the nine-month period ended September 30, 2004, an increase of $529,000, or 159%. The increase
in interest income resulted from higher interest rates and a higher available investment balance for the period ended September 30, 2005 as compared to September 30, 2004.



Other Income.    Other income for the nine-month period ended September 30, 2005 was $25,000
as compared to $233,000 for the nine-month period ended September 30, 2004. For the nine-month period ended September 30, 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 nine-month period ended September 30, 2005 was $264,000 as compared to $307,000 for the nine-month period ended September 30, 2004, a decrease of $43,000, or 14%. The decrease resulted from lower outstanding debt
obligations at September 30, 2005 as compared to September 30, 2004.



Net Loss.    As a result of the foregoing, we incurred a net loss of $13,419,000 for the nine-month period ended September 30, 2005 as compared to a net loss of $12,245,000 for the
nine-month period ended September 30, 2004.



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Liquidity and Capital Resources



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



At September 30, 2005, our principal sources of liquidity consisted of cash, cash equivalents, and marketable securities of $42,898,000, excluding
restricted long-term investments of $196,000. 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 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 expected 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 clinical trials, 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 and liaisons. In general, our only source of cash flows from operations for the foreseeable future will be the
up-front license payments, if any, 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 $11,173,000 for the nine-month period ended September 30, 2005 as compared to $7,447,000 for the nine-month
period ended September 30, 2004. Cash used in operating activities during the nine-month period ended September 30, 2005 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 resulted from changes in certain current assets and liabilities during the nine-month period ended September 30, 2005, including the receipt of
payments from our collaborators including, a $3,000,000 license fee from Genentech associated with our April 2005 discovery research agreement and $2,000,000 from Genentech for our research and development services under our Hedgehog agonist
collaboration. Net cash used in operating activities during the nine-month period ended September 30, 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 nine-month period ended September 30, 2004, including a $1,500,000 up-front payment
received for a licensing agreement with Wyeth and a $2,000,000 maintenance fee payment received from Genentech, further offset our net loss.



We expect to continue to use cash in operations as we continue to develop our products in clinical trials and advance new products into preclinical
development. In addition, in the future we may owe royalties and other contingent payments to our licensees based on the achievement of developmental milestones, product sales and specified other objectives.



Investing activities provided $7,202,000 of cash for the nine-month period
ended September 30, 2005 as compared to $7,243,000 used in the nine-month period ended September 30, 2004. Cash provided by investing activities resulted principally from $9,470,000 in net investment sales offset by $2,268,000 in fixed
asset purchases for the nine-month period ended September 30, 2005. For the nine-month period ended September 30, 2004, cash used in investing activities resulted principally from $6,201,000 in net investment purchases and $1,043,000 in
fixed asset purchases.



Financing activities provided
approximately $4,176,000 of cash for the nine-month period ended September 30, 2005, principally resulting from net proceeds of $1,681,000 from the issuance of debt for the



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purchase of fixed assets and proceeds of $866,000 received upon stock option exercises. Included in the $4,176,000 is a $1,629,000 correction of a
classification error in recording equity related to the June 2003 Hedgehog antagonist collaboration agreement with Genentech and the February 2004 Hedgehog collaboration with Wyeth. Financing activities provided approximately $3,531,000 of cash for
the nine-month period ended September 30, 2004 resulting primarily from the sale of $3,272,000 of our common stock, including $1,500,000 from the sale of 315,524 shares to Wyeth and $1,567,000 in proceeds received upon stock option exercises.
In addition, proceeds from the issuance of debt for the purchase of fixed assets provided $592,000 for the nine-month period ended September 30, 2004. These increases were offset by $332,000 in repayments of obligations under capital leases.



Pursuant to our co-development arrangement with Genentech, we
will forego U.S. development and drug approval milestones and royalty payments on potential future U.S. sales. We will now 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 to incur approximately $20,000,000 in development expenses through phase II clinical trials, of which $4,879,000 was paid through the third quarter of 2005
and an additional $820,000 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. The basal cell
carcinoma product candidate is currently being tested in a phase I clinical trial. Assuming 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.



Effective June 9, 2005, we entered into a loan agreement with the
Boston Private Bank & Trust Company to finance up to $1,450,000 in purchases of equipment and facility leasehold improvements. Under the terms of the loan agreement, we can request periodic financings for qualifying purchases of equipment
and leasehold improvements during the period from June 9, 2005 until December 9, 2005. Until December 9, 2005, we will pay interest only on any borrowings on a monthly basis in arrears. On or before December 9, 2005, we will
convert the then outstanding balance into a 36-month term note that bears interest at either a variable rate (7.75% as of September 30, 2005) or a fixed rate (7.66% as of September 30, 2005) for the repayment period. The loan will be
secured by any equipment and leasehold improvements financed thereunder. As of September 30, 2005, we have financed $866,000 in equipment purchases under this loan agreement.



Effective January 7, 2005, we entered into an amendment with the Boston Private Bank & Trust Company to extend
the drawdown date under which we can request periodic financings up to $2,250,000 for qualifying purchases of equipment and facility leasehold improvements 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 plus any accrued interest 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
fixtures and those that are purchased after March 23, 2005 under purchase money arrangements with equipment lenders. As of September 30, 2005, we were in compliance with the sole covenant under this agreement. This covenant requires us to
maintain a minimum working capital ratio. 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. 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 September 30, 2005, there was approximately $2,597,000, including approximately $597,000 in accrued interest, outstanding under the note.



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Since August 2002, we have sublet 11,980 of the 17,600 square fee of our facility at 61 Moulton Street in
Cambridge, Massachusetts. Under the terms of our sublease, as amended, we receive sublease payments which total $365,000 per year. In addition, we receive approximately $50,000 for facilities-related services and a pro-rata portion of the 61 Moulton
Street facility overhead, including real estate taxes and utilities. In July 2005, our subtenant informed us that it would like to amend the terms of our sublease to reduce its sublease rate and that it would likely vacate the space in December
2005. Our lease obligation on our 61 Moulton Street facility extends to April 2007 and our lease obligation from October 2005 to April 2007 is approximately $750,000. Should our current subtenant vacate the 61 Moulton facility, as expected, we will
seek to sublet all or part of the facility. There is no guarantee that we will be able to sublease the premises or on terms that are similar to our current sublease.



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 September 30, 2005:



|                                           |  |                    |       |      |   |       |  |      |       |      |   |            |  |       |     |  |   |     |  |   |       
|------------------------------------------ |  | ------------------ | ----- | ---- | - | ----- |  | ---- | ----- | ---- | - | ---------- |  | ----- | --- |  | - | --- |  | - | ------
|                                           |  | (amounts in 000s)
|                                           |  | Remainderof 2005   |       | 2006 |   | 2007  |  | 2008 |       | 2009 |   | Thereafter |  | Total
|Convertible subordinated long-term debt(2) |  | $                  |      |      | $ | 2,805 |  | $    |      |      | $ |           |  | $     |    |  | $ |    |  | $ | 2,805 
|Debt obligations under note payable        |  |                    | 1,095 |      |   | 853   |  |      | 798   |      |   | 254        |  |       |    |  |   |    |  |   | 3,000 
|Operating lease obligations                |  |                    | 203   |      |   | 1,323 |  |      | 1,105 |      |   | 948        |  |       | 948 |  |   | 948 |  |   | 5,475 
|Outside service obligations(3)             |  |                    | 662   |      |   | 163   |  |      |      |      |   |           |  |       |    |  |   |    |  |   | 825   
|Licensing obligations                      |  |                    | 99    |      |   | 146   |  |      |      |      |   |           |  |       |    |  |   |    |  |   | 245   
|                                           |  |                    |       |      |   |       |  |      |       |      |   |            |  |       |     |  |   |     |  |   |       
|Total future obligations(4)                |  | $                  | 2,059 |      | $ | 5,290 |  | $    | 1,903 |      | $ | 1,202      |  | $     | 948 |  | $ | 948 |  | $ | 12,350
|                                           |  |                    |       |      |   |       |  |      |       |      |   |            |  |       |     |  |   |     |  |   |       

---

|(1) |  | Obligations do not include amounts we will owe Genentech under our co-development arrangement.
|--- |  | ----------------------------------------------------------------------------------------------



|(2) |  | Convertible subordinated debt is convertible into either shares of our common stock or cash at our option.
|--- |  | ----------------------------------------------------------------------------------------------------------



|(3) |  | Outside service obligations consist of agreements we have with outside labs, consultants and various other service organizations.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------



|(4) |  | In the future, we may owe royalties and other contingent payments to our licensees based on the achievement of developmental milestones, product sales and specified other
objectives. These potential future obligations are not included in the above table.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We anticipate that existing capital resources at September 30, 2005, together with the payment of all contractually-defined payments under our
collaborations and research programs with Genentech, Wyeth, P&G and the SMA Foundation, assuming these programs continue as planned, should enable us to maintain current and planned operations into the second half of 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 into the second half of 2007 is dependent upon the success of our collaborations, our ability to control 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 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



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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 September 30, 2005.



Inflation



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



Forward-Looking Statements



This Quarterly Report on Form 10Q includes forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, which we refer to as the Exchange Act. For this purpose, any statements contained herein regarding our strategy, future operations, financial position, future
revenues, projected costs, prospects, plans and objectives of management, other than statements of historical facts, are forward-looking statements. The words anticipates, believes, estimates, expects,
intends, may, plans, projects, will, would, and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain
these identifying words. We cannot guarantee that we actually will achieve the plans, intentions or expectations disclosed in our forward-looking statements. There are a number of important factors that could cause actual results or events to differ
materially from those disclosed in the forward-looking statements we make. These important factors include the risk factors set forth below under the caption Factors That May Affect Future Results. Although we may elect to update
forward-looking statements in the future, we specifically disclaim any obligation to do so, even if our estimates change, and readers should not rely on those forward-looking statements as representing our views as of any date subsequent to the date
of this quarterly report.



Factors That May Affect Future 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 September 30, 2005, we had an accumulated deficit of approximately $676,391,000. Other than
OP-1, which we and Stryker discovered under a former collaboration and Stryker has subsequently commercialized, 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, including the various risks described in this section Factors That May Affect Results. 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.



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We will require additional financing, which may be difficult to obtain and may dilute our existing shareholder
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 U.S. development costs for a basal cell carcinoma drug candidate pursuant to our equal cost-sharing co-development arrangement with Genentech;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | support our research and development activities for our internal programs, including our program in cardiovascular disease and any unfunded portion of our small molecule discovery
screening programs;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | expand our infrastructure; 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 planned future capital requirements and accelerate our need for additional financing. These factors, many of which are outside our control, include the following:



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



| |  |  | the time and cost, including unplanned cost, involved in advancing clinical trials for the basal cell carcinoma product candidate being co-developed with Genentech;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the cost of additional facilities requirements;
| | - |  | -----------------------------------------------



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



| |  |  | the timing, receipt and amount of research funding and milestone, license, royalty, profit-sharing 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 of debt or equity and may seek additional funding from additional strategic collaborators or additional foundations, such as the funding that we were awarded under our Spinal Muscular Atrophy Foundation research grant.
However, the biotechnology market in general, and the market for our common stock, in particular, is highly volatile. Due to various factors, including 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.



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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. Such estimates and judgments include the carrying value of our property, equipment and intangible assets, revenue recognition and the value of certain
liabilities. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. However, these estimates and judgments, or the assumptions underlying them, may
prove to be incorrect. Accordingly, our actual financial results may vary significantly from the estimates contained in our financial statements. For a further discussion of the estimates and judgments that we make and the critical accounting
policies that affect these estimates and judgments, see Critical Accounting Policies and Estimates above.



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, Wyeth, P&G, and Ortho Biotech Products. Through the third quarter of 2005 and for the year ended December 31, 2004, $7 million and $4.4
million, or 83% and 88%, respectively, of our gross revenue was derived from licensing and research and development payments received from 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.



We have recently determined that certain accounting errors in our financial statements did not have a material impact on our previously reported financial information. If our determination is found to have been incorrect then we may be
required to restate such previously reported financial information which could cause our stock price to decline and could subject us to securities litigation.



As discussed in Notes 4 and 6 of the notes to financial statements included elsewhere in this quarterly report on Form 10-Q,
we have recently concluded that we made accounting errors in prior periods including the following: (1) we prematurely recorded accounts receivable within the assets section of our Balance Sheet as well as an offsetting amount to our deferred
revenues within the liabilities section of our Balance Sheet in connection with a collaboration agreement executed in 2003; and (2) we used the contractually negotiated price rather than the closing market price to calculate the value of common
shares sold in connection with two of our collaboration agreements. These errors were discovered in connection with an ordinary review of our most recent annual report on Form 10-K for the year ended December 31, 2004 and Quarterly Report on Form
10-Q for the Quarter ended March 31, 2005 by the Staff of the Corporation Finance Division of the SEC, referred to herein as the Staff.



The first error occurred when we mistakenly treated two $2 million annual maintenance payments payable under our June 2003 Genentech collaboration as
Accounts Receivable. We have determined that there were contingencies relating to our receipt of each payment and, therefore, these amounts should not have been reflected in our Balance Sheet until the cash payments were received. As a result of the
error, our Balance Sheet reflected excess Accounts Receivable in the amount of $4 million in Q3 2003. As the contingencies expired, the receivable balances were paid and the overstatement of Accounts Receivable declined to $2 million in Q2 2004 and
to $0 at year-end 2004. By the end of 2004, therefore, this error had corrected itself and our balance sheet was correct with respect to these contingent payments. Our Balance Sheet also reflected excess Deferred



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Revenue during those periods in like amounts. This error had no effect on our Statement of Operations. The errors did not impact cash, cash flow, revenue or
income in any period.



The other errors were caused by our
allocation of up-front payments that we received under our June 2003 Genentech collaboration agreement and January 2004 Wyeth collaboration agreement. In both of these collaborations, we received contractually specified payments in consideration for
granting to each such collaborator an exclusive license to specific technologies and issuing to each such collaborator shares of our common stock. In both cases, we initially were required to allocate this aggregate up-front payment for common stock
and license fees to the Equity and Deferred Revenue line items in our Balance Sheet. In each case, we calculated the value of the common stock using the negotiated price (which was less than the closing market price on the agreement date). Because
of this, we allocated too little of the payment to Equity and too much to Deferred Revenue. These errors did have some effect on both our Statement of Operations and our Balance Sheet because, in each case, we amortized Deferred Revenue over the
life of the agreement to Revenues in our Statement of Operations. Because the amount of Deferred Revenue was too high, the amount recognized as revenue also was too high. These errors did not impact cash or cash flow. As a result of these errors,
our Statement of Operations and Balance Sheet overstated revenue, understated additional paid-in capital, referred to as APIC in the table below, and overstated deferred revenue by the following amounts:



|                                  |  |            |   |  |        |   |  |                  |  
|--------------------------------- |  | ---------- | - |  | ------ | - |  | ---------------- | -
|                                  |  | (in $000s) |  
|                                  |  | 2003       |   |  | 2004   |   |  | ThroughJune 2005 |  
|Statement of Operations:          |  |            |   |  |        |   |  |                  |  
|      overstated Revenue         |  | 124        |   |  | 233    |   |  | 104              |  
|                                  |  |            |  
|Balance Sheet:                    |  |            |   |  |        |   |  |                  |  
|      understated APIC           |  | (1,491     | ) |  | (1,629 | ) |  | (1,629           | )
|      overstatedDeferred Revenue |  | 1,367      |   |  | 1,217  |   |  | 1,167            |  



We have determined
that the impact of these errors, if recorded in the prior periods to which they related, would not have a material impact on previously reported financial information. We also determined that the impact of the adjustments in the financial statements
in the quarter ended September 30, 2005 resulting from these errors was immaterial to the financial statements for the quarter ended September 30, 2005 or to the projected results of operations for the year ended December 31, 2005.



There are no general standards or formulas for judging the materiality of the
errors in our financial statements. In evaluating the materiality of these errors, we are required to consider all relevant facts and circumstances, including the quantitative impact of the errors as well as a number of qualitative factors. We then
have to make a judgment concerning materiality on the basis of that analysis. Based on our assessment of all factors that we believed to be relevant, we concluded that the errors were immaterial. In connection with the Staffs review, we have
recently advised the Staff of such conclusion. If the Staff disagrees with our judgment that these errors are immaterial then we will be required to restate our financial statements for the years ended December 31, 2003 and 2004 and for the quarters
ended March 30, 2005, June 30, 2005 and September 30, 2005. Any such restatement could result in a decline in our stock price and securities class action litigation. In the past, securities class action litigation has often been brought in
connection with restatements of financial statements. Defending against such potential litigation relating to a restatement of our financial statements will be expensive and will require significant attention and resources of our management.
Moreover, our insurance to cover our obligations with respect to the ultimate resolution of any such litigation may be inadequate. As a result of these factors, any such potential litigation could have a material adverse effect on our business,
results of operations and financial condition.



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, profit-sharing and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | 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 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, any such strategic alliances or other arrangements may not result in the successful development and commercialization of 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 from existing and new technologies and 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
Wyeth in the field of neurology, with Procter & Gamble in the field of hair growth regulation, 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 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.



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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.



While many of
our technologies are subject to collaborations, our remaining technologies that are available for internal programs have several potential applications. We have limited resources and are pursuing a strategy of undertaking foundation-funded research
for orphan disease indications. The limited markets that are associated with such indications as well as conditions of funding arrangements may result in our failure to capitalize on other potentially profitable applications of our technologies.



We have limited financial and managerial resources to
devote to new internal programs. These limitations have led us to adopt a strategy where we have undertaken funded research for certain orphan disease indications and to forego the exploration of other product opportunities. While our new
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. In addition, our funded
research includes screening of compounds that are not proprietary to us and may result in identification of a drug candidate that would not result in a commercially viable product and/or may divert resources away from other market opportunities,
which ultimately prove to be more profitable.



If we or any of 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 market acceptance for such products, our expected revenues from sales of these products would be adversely affected.



We could be exposed to significant monetary damages and business harm if we are unable to obtain or maintain adequate product liability 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.



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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.



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 or any of our licensees and assignees breach any of the agreements under which we license or transfer intellectual property to others, 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 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.



We may not be able to obtain patent protection for our technologies and the patent protection we do obtain may not be sufficient to stop
our competitors from using similar technology.



The patent
positions of pharmaceutical and biotechnology companies, including ours, are generally uncertain and involve complex legal, scientific and factual questions. The standards which the United States Patent and Trademark Office uses to grant patents,
and the standards which courts use to interpret patents, are not always applied predictably or uniformly and can change, particularly as new technologies develop. Consequently, the level of protection, if any, that will be provided by our patents if
we attempt to enforce them, and they are challenged, is uncertain. The long-term success of our enterprise depends in significant part on our ability to:



| |  |  | obtain patents to protect our technologies and 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 type and extent of patent claims issued to us
may not be sufficiently broad to protect our technology from



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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.



We may become involved in expensive and unpredictable 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. Any changes in, or unexpected interpretations of, the patent laws may adversely affect our ability to enforce our patent position. 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.



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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 are 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.



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.



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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.



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 and/or obtain regulatory approval to market and sell our product candidates 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 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.



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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.



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 adequate clinical and commercial quantities, in compliance with regulatory requirements, at acceptable quality and cost 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.



Any contract manufacturers that we enter into manufacturing arrangements with
will be 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



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collaborative partners. For example, as part of our agreements with Genentech, Wyeth, Procter & Gamble and Ortho Biotech Products, 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:



| |  |  | 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 September 30, 2005. The stock market, particularly in recent years, has experienced
significant volatility with respect to pharmaceutical- and biotechnology-based company stocks. 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



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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 such shares, could reduce the market price of our common stock. As of September 30,
2005, we had outstanding approximately 49.3 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 and warrants. The exercise of these options and warrants 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.



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 September 30, 2005. The term
disclosure



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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 September 30, 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, as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act, occurred during the fiscal
quarter ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



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PART IIOTHER INFORMATION



|Item 6. | EXHIBITS
|------- | --------



See exhibit index.



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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: November 14, 2005 |  |  |  | By:         |  | /s/    MICHAEL P. GRAY
|                         |  |  |  |             |  |                        |  | Michael P. Gray Vice President of Finance and Chief Financial Officer (Principal Financial and Accounting
Officer)



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EXHIBIT INDEX



|               |  |                                                                                                                                  
|-------------- |  | ---------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                      
|               | 
|10.1          |  | Collaboration, Research and License Agreement dated September 18, 2005 by and between Curis, Inc. and Procter & Gamble
Company.  
|               | 
|31.1           |  | Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Exchange Act.                           
|               | 
|31.2           |  | Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Exchange Act.                           
|               | 
|32.1           |  | Certification of the Chief Executive Officer pursuant to Rule 13a-14(b)/15d-14(b) of the Exchange Act and 18 U.S.C. Section
1350.
|               | 
|32.2           |  | Certification of the Chief Financial Officer pursuant to Rule 13a-14(b)/15d-14(b) of the Exchange Act and 18 U.S.C. Section
1350.

---

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



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