**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                      |
|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                        |
|       |       | **For the  quarterly period ended June 30, 2005**                                                                                                                      |
|       |       |                                                                                                                                                                        |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                     |
|       |       |                                                                                                                                                                        |
|       |       | **For the  transition period  from           to           .** |

 

**Commission File Number 000-31275**

 

**LARGE SCALE BIOLOGY CORPORATION**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                    | ** ** | **77-0154648**                           |
|-----------------------------------------------------------------|------------|------------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. employer  identification number) |
| ** **                                                      | ** ** | ** **                               |
| **3333 Vaca Valley Parkway, Vacaville, CA   95688**   |
| (Address of principal executive offices and zip  code)          |
| ** **                                                      |       |                                     |
| **(707) 446-5501**                                              |
| (Registrant’s telephone number, including area code)       |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes ý No o

 

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

 

The number of sharesoutstanding of registrant’s common stock, $0.001 par value, as of August 8,2005:  32,165,223

 

 

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*Some ofthe statements contained in this report constitute forward-looking statementsthat involve substantial risks and uncertainties. In some cases, you canidentify these statements by forward-looking words such as “may,” “will,” “expect,”“plan,” “anticipate,” “believe,” “forecast,” “project,” or “continue” andvariations of these words or comparable words. In addition, any statementswhich refer to expectations, projections or other characterizations of futureevents or circumstances are forward-looking statements. Our Management’sDiscussion and Analysis of Financial Condition and Results of Operations containmany such forward-looking statements. These forward-looking statements involveknown and unknown risks, uncertainties and situations that may cause our or ourindustry’s actual results, level of activity, performance or achievements to bematerially different from any future results, levels of activity, performanceor achievements expressed or implied by these statements. The risk factorscontained in this report, under the heading Factors That May Affect OurBusiness, as well as any other cautionary language in this report, provideexamples of risks, uncertainties and events that may cause our actual resultsto differ from the expectations described or implied in our forward-lookingstatements.*

 

*Althoughwe believe that the expectations reflected in the forward-looking statementsare reasonable, we cannot guarantee future results, levels of activity,performance or achievements. You should not place undue reliance on theseforward-looking statements, which apply only as of the date of this report. Exceptas required by law, we do not undertake to update or revise any forward-lookingstatement, whether as a result of new information, future events, or otherwise.*

 

*LargeScale Biology Corporation, LSBC, our logo,*GENEWAREÒ, BAMFTM,GRAMMRTM*and other product and trade names aretrademarks of or registered trademarks of Large Scale Biology Corporation inthe United States and/or other countries. Other product and trade namesmentioned herein may be trademarks and/or registered trademarks of theirrespective companies. References in this report to “the Company,” “our,” “we”and “us” refer collectively to Large Scale Biology Corporation, a Delawarecorporation, and its predecessors and subsidiaries.*

 

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**Large Scale Biology Corporation**

**Form 10-Q**

**For the Quarter Ended June 30, 2005**

**Table of Contents**

 
| ** **                                | **Page**                                                                                                                     |
|-------------------------------------------|------------------------------------------------------------------------------------------------------------------------------|
| PART I – FINANCIAL  INFORMATION |                                                                                                                         |
|                                      |                                                                                                                         |   |
| Item 1.                                   | Financial Statements                                                                                                         |   |
|                                      |                                                                                                                         |   |
|                                      | Condensed Consolidated  Balance Sheets as of June 30, 2005 and December 31, 2004 (Unaudited)                       | 1 |
|                                      |                                                                                                                         |   |
|                                      | Condensed Consolidated  Statements of Operations for the three and six months ended June 30,  2005 and 2004 (Unaudited) | 2 |
|                                      |                                                                                                                         |   |
|                                      | Condensed Consolidated  Statements of Cash Flows for the six months ended June 30, 2005 and 2004  (Unaudited)           | 3 |
|                                      |                                                                                                                         |   |
|                                      | Notes to Condensed  Consolidated Financial Statements (Unaudited)                                                            | 4 |
|                                      |                                                                                                                         |   |
| Item 2.                                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                  | 8 |
|                                      |                                                                                                                         |   |
| Item 3.                                   | Quantitative  and Qualitative Disclosures About Market Risk                                                                  | 20 |
|                                      |                                                                                                                         |   |
| Item 4.                                   | Controls  and Procedures                                                                                                     | 20 |
|                                      |                                                                                                                         |   |
| PART II – OTHER  INFORMATION    |                                                                                                                         |
|                                      |                                                                                                                         |   |
| Item 2.                                   | Unrestricted Sales  of Equity Securities and Use of Proceeds                                                                 | 21 |
|                                      |                                                                                                                         |   |
| Item 4.                                   | Submission of  Matters to a Vote of Security Holders                                                                         | 21 |
|                                      |                                                                                                                         |   |
| Item 6.                                   | Exhibits                                                                                                                     | 22 |
|                                      |                                                                                                                         |   |
| SIGNATURE                                 | 23                                                                                                                           |

 

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**PART I– FINANCIAL INFORMATION**

** **

**Item 1.  Financial Statements**

 

**Large Scale Biology Corporation**

**Condensed Consolidated BalanceSheets**

**(Unaudited)**

 
| ** **                                                                                    | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| **Assets**                                                                                    | ** ** | ** **             | ** ** | ** **                 | ** ** |
| Current assets:                                                                               |       |                   |       |                       |       |
| Cash and cash equivalents                                                                     |       | $                      | 362,000    |                       | $          | 1,112,000 |   |
| Accounts receivable, net                                                                      |       | 253,000                |       | 133,000                    |       |
| Prepaid expenses                                                                              |       | 474,000                |       | 521,000                    |       |
| Total current assets                                                                          |       | 1,089,000              |       | 1,766,000                  |       |
| Property, plant, and equipment, net                                                           |       | 7,029,000              |       | 7,798,000                  |       |
| Intangible assets, net                                                                        |       | 1,895,000              |       | 2,194,000                  |       |
| Other assets                                                                                  |       | 1,245,000              |       | 1,037,000                  |       |
|                                                                                          |       | $                      | 11,258,000 |                       | $          | 12,795,000 |   |
|                                                                                          |       |                   |       |                       |       |
| **Liabilities and Stockholders’ Equity**                                                 | ** ** | ** **             | ** ** | ** **                 | ** ** |
| Current liabilities:                                                                          |       |                   |       |                       |       |
| Accounts payable                                                                              |       | $                      | 1,112,000  |                       | $          | 735,000 |   |
| Accrued employee compensation                                                                 |       | 317,000                |       | 343,000                    |       |
| Accrued expenses                                                                              |       | 134,000                |       | 24,000                     |       |
| Current portion of debt                                                                       |       | 5,374,000              |       | —                     |       |
| Deferred revenue and customer advances                                                        |       | —                 |       | 28,000                     |       |
| Total current liabilities                                                                     |       | 6,937,000              |       | 1,130,000                  |       |
| Long-term debt                                                                                |       | —                 |       | 1,000,000                  |       |
| Accrued stock compensation                                                                    |       | 394,000                |       | 898,000                    |       |
| Deferred rent                                                                                 |       | 363,000                |       | 336,000                    |       |
| Total liabilities                                                                             |       | 7,694,000              |       | 3,364,000                  |       |
| Stockholders’ equity:                                                                    |       |                   |       |                       |       |
| Common stock; issued and outstanding:                                                         |       |                   |       |                       |       |
| June 30, 2005 — 32,142,720 shares; December 31,  2004 — 31,382,813 shares |       | 203,497,000            |       | 201,074,000                |       |
| Stockholders’ notes receivable                                                           |       | (4,000                 | )          | (20,000                    | )          |
| Accumulated deficit                                                                           |       | (199,929,000           | )          | (191,623,000               | )          |
| Total stockholders’ equity                                                               |       | 3,564,000              |       | 9,431,000                  |       |
|                                                                                          |       | $                      | 11,258,000 |                       | $          | 12,795,000 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

1

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**Large Scale Biology Corporation**

**Condensed Consolidated Statementsof Operations**

**(Unaudited)**

 
| ** **                                               | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                               | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                                                 |       | $                                    | 680,000    |                               | $          | 362,000 |   | $ | 1,113,000 |   | $ | 681,000 |   |
| Costs and expenses:                                      |       |                                 |       |                               |       |   |   |   |   |
| Development agreements                                   |       | 1,255,000                            |       | 535,000                            |       | 1,925,000 |   | 1,022,000 |   |
| Research and development                                 |       | 1,591,000                            |       | 2,280,000                          |       | 3,822,000 |   | 4,519,000 |   |
| General and administrative                               |       | 1,697,000                            |       | 1,638,000                          |       | 3,146,000 |   | 3,564,000 |   |
| Total costs and expenses                                 |       | 4,543,000                            |       | 4,453,000                          |       | 8,893,000 |   | 9,105,000 |   |
| Loss from operations                                     |       | (3,863,000                           | )          | (4,091,000                         | )          | (7,780,000 | ) | (8,424,000 | ) |
| Interest income (expense), net                           |       | (368,000                             | )          | 20,000                             |       | (526,000 | ) | 29,000 |   |
| Net loss                                                 |       | $                                    | (4,231,000 | )                                  | $          | (4,071,000 | ) | $ | (8,306,000 | ) | $ | (8,395,000 | ) |
| Net loss per share - basic and diluted                   |       | $                                    | (0.13      | )                                  | $          | (0.13 | ) | $ | (0.26 | ) | $ | (0.29 | ) |
| Weighted average shares outstanding - basic and  diluted |       | 31,507,393                           |       | 31,186,663                         |       | 31,454,156 |   | 29,253,478 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

2

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**Large Scale Biology Corporation**

**Condensed Consolidated Statementsof Cash Flows**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                        |       |                               |       |   |   |
| Net loss                                                                     |       | $                                  | (8,306,000 | ) | $ | (8,395,000 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                               |       |   |   |
| Depreciation of property, plant and equipment                                |       | 779,000                            |       | 686,000 |   |
| Amortization of intangible assets                                            |       | 299,000                            |       | 265,000 |   |
| Stock compensation expense                                                   |       | 409,000                            |       | 446,000 |   |
| Vesting of warrant issued with debt and accretion of  interest               |       | 370,000                            |       | — |   |
| Loan forgiveness                                                             |       | 15,000                             |       | — |   |
| Changes in assets and liabilities:                                           |       |                               |       |   |   |
| Accounts receivable                                                          |       | (120,000                           | )          | 160,000 |   |
| Prepaid expenses                                                             |       | 47,000                             |       | (25,000 | ) |
| Other assets                                                                 |       | (208,000                           | )          | (245,000 | ) |
| Accounts payable                                                             |       | 503,000                            |       | (16,000 | ) |
| Accrued employee compensation                                                |       | (26,000                            | )          | (410,000 | ) |
| Accrued expenses                                                             |       | 110,000                            |       | 61,000 |   |
| Deferred revenue and customer advances                                       |       | (28,000                            | )          | 3,000 |   |
| Deferred rent                                                                |       | 27,000                             |       | — |   |
| Net cash used in operating activities                                        |       | (6,129,000                         | )          | (7,470,000 | ) |
| Cash flows from investing activities:                                        |       |                               |       |   |   |
| Capital expenditures                                                         |       | (136,000                           | )          | (325,000 | ) |
| Increase in patents and intellectual property  licenses                      |       | —                             |       | (12,000 | ) |
| Net cash used in investing activities                                        |       | (136,000                           | )          | (337,000 | ) |
| Cash flows from financing activities:                                        |       |                               |       |   |   |
| Proceeds from issuance of common stock                                       |       | 14,000                             |       | 7,604,000 |   |
| Proceeds from issuance of debt and related warrants                          |       | 5,500,000                          |       | — |   |
| Proceeds from stockholder loan payments                                      |       | 1,000                              |       | 4,000 |   |
| Change in restricted cash                                                    |       | —                             |       | 144,000 |   |
| Principal payments on long-term debt                                         |       | —                             |       | (26,000 | ) |
| Net cash provided by financing activities                                    |       | 5,515,000                          |       | 7,726,000 |   |
| Net decrease in cash and cash equivalents                                    |       | (750,000                           | )          | (81,000 | ) |
| Cash and cash equivalents at beginning of period                             |       | 1,112,000                          |       | 7,737,000 |   |
| Cash and cash equivalents at end of period                                   |       | $                                  | 362,000    |   | $ | 7,656,000 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

3

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**Large Scale Biology Corporation**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

**1.**              The Company and Summary of Significant AccountingPolicies

** **

LargeScale Biology Corporation and its subsidiaries (collectively, the “Company”, “we”or “our”) is a product-focused biotechnology company using proprietarytechnologies to develop and manufacture recombinant biologics.  Our biomanufacturing opportunities includevaccines, complex proteins and follow-on off-patent therapeutics.  We are focusing our efforts on the followingproducts:

 

**•**                  Certain follow-on off-patentbiologics and proprietary products, including Lysosomal acid lipase fortreatment of certain lipid storage disorders and reduction of plaque inarteries, Interferon alpha 2a and 2b, and Alpha-galactosidase A for treatmentof Fabry disease

**•**                  Recombinant Aprotinin, a proteaseinhibitor used in medical, research and manufacturing applications

**•**                  Vaccines for human and animalhealthcare, including antiviral and anticancer applications

 

Thetechnology employed in our product development and biomanufacturing operationsincludes our proprietary GENEWARE transient gene expression system and GRAMMRsystem to shuffle and improve gene sequences. Our manufacturing processes can be used to produce follow-on therapeuticproducts.  We believe that ourcombination of proprietary technologies and existing manufacturinginfrastructure enables us to rapidly and economically develop partner-specifiedproducts and to participate in market opportunities in major diseasecategories.

 

Ourwholly-owned subsidiary, Predictive Diagnostics, Inc. (“PDI”) is adiagnostics company established for the commercial development of a proprietaryapproach to early diagnosis of life-threatening diseases.  PDI’s products are supported by ourtechnology developed in the course of our past genomics and medical productdevelopment programs.  PDI’s initialproduct focus is in the field of oncology. Our Biomarker Amplification Filter, or BAMF technology, potentiallyprovides low-cost and rapid analysis of multiple biomarkers derived fromprofiling thousands of individual proteins, peptides and other metabolitesfound in clinical blood samples.  Currenttypical diagnostic tests rely on measuring the variations from the normalamount of a single protein or biomarker. Our BAMF technology finds multiple proteins or biomarkers in bloodsamples and creates a disease “fingerprint,” potentially leading to an accurateand early detection of disease.

 

TheCompany’s proprietary systems are supported by patents and patentapplications.  The Company’s corporateoffices, research and development, and its subsidiary company, PredictiveDiagnostics, Inc. are headquartered in Vacaville, California.  The Company’s biomanufacturing operation islocated in Owensboro, Kentucky.

 

TheCompany incurred net losses of $8,306,000 and $17,425,000, and negativeoperating cash flows of $6,129,000 and $14,566,000 in the six months ended June 30, 2005and the year ended December 31, 2004, respectively.  Thesenegative cash flows were financed primarily by proceeds from the Company’s IPOin 2000, a private placement of our common stock during the first quarter of2004 and loans received during December 2004 and the first six months of2005.  The Company’s history of negativecash flows and its cash and cash equivalents balance of $362,000 at June 30, 2005raise substantial doubt about the Company’s ability to continue as a goingconcern.  The financial statements do notinclude any adjustments relating to the recoverability and classification ofassets or the amounts and classification of recorded liabilities that might benecessary should the Company be unable to continue as a going concern.  In an effort to mitigate this near-termconcern, the Company secured $1,000,000 in short-term debt financing and a$15,000,000 private equity agreement on August 5, 2005 (seeNote 5).  Prior to selling commonstock under the private equity agreement, the Company must file a registrationstatement on SEC Form S-1 and this registration statement must becomeeffective, which is expected within 90 to 120 days of August 5, 2005subject to the SEC Staff’s review schedule. However, we cannot assure you as to the amount that the Company willreceive under the private equity agreement because such amount will depend uponour stock price and trading volume, and is subject to uncertainties related toobtaining shareholder approval to sell more than 19.99% of outstanding stockand filing an SEC Form S-1 registration statement.  In addition, the Company is seeking to securefunds for its subsidiary, PDI, and the Company, through a sale of PDI stockheld by the Company.  The Company mayalso sell fixed assets and technology to obtain funds.  In addition, the Company is seeking toincrease collaborative related cash flows by expanding existing relationshipsbased on product opportunities.  However,we cannot assure you that we will successfully obtain funds through the sale ofassets or PDI, or product related revenues, as such events are subject tofactors beyond the Company’s control.

 

4

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*Basis ofPresentation* — The unaudited condensed consolidated financialstatements have been prepared by the Company in accordance with the rules andregulations of the Securities and Exchange Commission regarding interimfinancial information.  Accordingly,these financial statements and notes thereto do not include certain disclosuresnormally associated with financial statements prepared in accordance withaccounting principles generally accepted in the United States of America.  This interim financial information should beread in conjunction with the Company’s audited consolidated financialstatements and notes thereto for the year ended December 31, 2004 includedin the Company’s Annual Report on Form 10-K.

 

Theunaudited condensed consolidated financial statements include the accounts ofLarge Scale Biology Corporation and its subsidiaries.  All intercompany balances and transactionshave been eliminated.  In the opinion ofthe Company’s management, the unaudited condensed consolidated financialstatements include all adjustments (consisting of only normal recurringadjustments) and disclosures considered necessary for a fair presentation ofthe results of the interim periods presented. This interim financial information is not necessarily indicative of theresults of any future interim periods or for the Company’s full year ending December 31,2005.

 

*SegmentReporting* — The Company operates in one reportablesegment.

 

*IntangibleAssets* — The following table presents the carryingvalues and accumulated amortization of intangible assets as of June 30,2005:

 
| Capitalized patent costs       |   | $          | 1,852,000 |   |
|--------------------------------|--------|------------|-----------|--------|
| Intellectual property licenses |   | 3,264,000  |      |
|                           |   | 5,116,000  |      |
| Accumulated amortization       |   | (3,221,000 | )         |
|                           |   | $          | 1,895,000 |   |

 

*Stock-BasedCompensation* — The Company adopted Statement ofFinancial Accounting Standards No. 123 (“SFAS 123”), “Accounting forStock-Based Compensation” effective January 1, 2003 for its stock-basedemployee compensation plans using the prospective recognition method underStatement of Financial Accounting Standards No. 148 (“SFAS 148”), “Accountingfor Stock-Based Compensation-Transition and Disclosure, an amendment of SFAS123.”  This method applies therecognition provisions of SFAS 123 to all employee stock awards granted,modified, or settled after January 1, 2003 and accordingly, recognizedcompensation expense for those issuances under our stock-based employeecompensation plans.  The fair values ofstock options were estimated at the date of grant using the Black-Scholesoption-pricing model and are being amortized over the vesting period ofgenerally 3 years.  For stock awardsgranted prior to January 1, 2003, compensation expense has not beenrecognized under SFAS 123, unless those stock awards were modified after January 1,2003.  During December 2004,Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS123R”), “Share Based Payment,” was issued requiring the expensing of allstock-based compensation.  The Company isevaluating the effects of SFAS 123R but believes its implementation will nothave a material effect on the Company’s financial statements since the Companyhad already adopted FASB 123 for its stock-based employee compensation plans asdescribed above.

 

Priorto January 1, 2003, the Company accounted for stock options granted toemployees and directors and other stock-based employee compensation plans usingthe intrinsic value method of accounting in accordance with AccountingPrinciples Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issuedto Employees” and related interpretations. As such, the Company recognized compensation expense for stock optionsonly if the quoted market value of the Company’s common stock exceeded theexercise price of the option on the grant date. Any compensation expense realized using this intrinsic value method isbeing amortized over the vesting period of the option.

 

5

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Thefollowing table presents the effect on net loss and net loss per share if wehad always applied the fair value recognition provisions of SFAS 123 tostock-based awards to employees:

 
| ** **                                                                                                        | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss as reported                                                                                              |       | $                                    | (4,231,000 | )                                  | $          | (4,071,000 | ) | $ | (8,306,000 | ) | $ | (8,395,000 | ) |
| Stock-based employee compensation expense included  in reported net loss for awards issued from 2003 through 2005 |       | 176,000                              |       | 215,000                            |       | 416,000 |   | 391,000 |   |
| Stock-based employee compensation expense determined  using the fair value method for all awards                  |       | (224,000                             | )          | (573,000                           | )          | (665,000 | ) | (1,119,000 | ) |
| Pro forma net loss                                                                                                |       | $                                    | (4,279,000 | )                                  | $          | (4,429,000 | ) | $ | (8,555,000 | ) | $ | (9,123,000 | ) |
| Net loss per share:                                                                                               |       |                                 |       |                               |       |   |   |   |   |
| Basic and diluted – as reported                                                                              |       | $                                    | (0.13      | )                                  | $          | (0.13 | ) | $ | (0.26 | ) | $ | (0.29 | ) |
| Basic and diluted – pro forma                                                                                |       | $                                    | (0.14      | )                                  | $          | (0.14 | ) | $ | (0.27 | ) | $ | (0.31 | ) |

 

Thefair values of stock options are estimated at the date of grant using theBlack-Scholes option-pricing model and amortized over the vesting period oftypically 3 or 4 years for the calculation of stock-based employee compensationin the above table.  The Company granted78,000 and 539,000 stock options to employees and directors during the sixmonths ended June 30, 2005 and 2004, respectively.

 

Stockoptions issued to non-employees as consideration for services provided to theCompany have been and continue to be accounted for under the fair value methodin accordance with SFAS 123, which requires that compensation expense berecognized for all such options.

 

*Net LossPer Share* — Basic net loss per share is computed by dividingthe net loss for the period by the weighted average number of common sharesoutstanding during the period.  Dilutednet loss per share is computed by dividing the net loss for the period by theweighted average number of common shares outstanding during the period, plusthe potential dilutive effect of common shares issuable upon exercise orconversion of outstanding stock options and warrants during the period.  The weighted average number of potentiallydilutive common shares were 66,648 and 674,472 for the three months ended June 30,2005 and 2004, respectively, and 174,881 and 832,132 for the six months ended June 30,2005 and 2004, respectively.  Theseshares are excluded from diluted net loss per share because of theiranti-dilutive effect.

 

**2.**              Debt

** **

On April 15,2005, the Company received $3,000,000 in cash in exchange for a promissory note(“Promissory Note”) and warrant issued to Kevin J. Ryan, the Company’sPresident and Chief Executive Officer and a member of the Company’s Board ofDirectors (“CEO”).  The Promissory Notebears interest at the prime rate plus two percent per annum initially at 7.75%due monthly starting May 15, 2005 with a rate not less than 7.25%.  The Promissory Note is due on April 17,2006.  Borrowings under the loan aresecured by certain intellectual property related to PDI.  The Promissory Note may be prepaid by theCompany without penalty at any time.  OurCEO may elect to be repaid up to $1,500,000 as a result of any Companyfinancing event with net proceeds of $4,000,000 or more.

 

Thewarrant may either be used to purchase 903,614 shares of the Company’s commonstock at $0.83 per share or common stock of the Company’s PDI subsidiary, andexpires on April 15, 2011.  The PDIexercise price would be the lowest price per share of the PDI stock in any PDIfinancing event of no less than $1,500,000. The number of warrant shares would be determined by dividing $3,000,000by the PDI exercise price.  PDI commonstock issuable pursuant to the warrant would be subject to exchange andunderwriter’s holding period restrictions, or “lock-ups”.  The fair value of the warrant was estimatedon April 15, 2005 assuming the purchase of the Company’s common stock,using the Black-Scholes option-pricing model with the followingweighted-average assumptions: expected volatility of 109%, risk-free interestrate of 4.2%, initial expected life of six years and no expected dividend yield.**** The resulting fairvalue of $664,000 was recorded as equity and the remaining $2,336,000 wasrecorded as debt.  The debt discount of$664,000 due to the issuance of the warrant is accreted as interest over theloan period on a straight-line basis and resulted in $138,000 of interestexpense being recorded during the second quarter of 2005 in the condensedconsolidated statements of operations.

 

6

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Thecarrying value of debt as presented in the condensed consolidated balance sheetat June 30, 2005 is:

 
| ** **                           | ** ** | **Maturity Value** | ** ** | **Discounted Value** | ** ** |
|--------------------------------------|------------|--------------------|------------|----------------------|------------|
| Note payable due June 17, 2006  |       | $                  | 2,900,000  |                 | $          | 2,900,000 |   |
| Note payable due April 17, 2006 |       | 3,000,000          |       | 2,474,000            |       |
| Total debt                           |       | 5,900,000          |       | 5,374,000            |       |
| Less current portion                 |       | (5,900,000         | )          | (5,374,000           | )          |
| Long-term debt                       |       | $                  | —     |                 | $          | — |   |

 

**3.**              Note Conversion

** **

On March 3,2005, the Company issued aconvertible promissory note (“Note”) maturing on July 1, 2005 to its CEO, in exchange for$600,000.  The Note was converted into 631,579shares of the Company’s common stock on June 29, 2005 at a conversionprice of $.95 per share according to the terms of the Note.

 

**4.**              Supplemental Cash flow Disclosures

** **

Theconversion of the Note into 631,579 shares of the Company’s common stock on June 29,2005 resulted in debt decreasing and stockholder’s equity increasing by$600,000 as presented in the condensed consolidated balance sheet as of June 30,2005.

 

Approximately$15,000 of an employee loan that has been presented as stockholders notesreceivable in the condensed consolidated balance was forgiven by the Board ofDirectors and resulted in a non-cash charge to operating activities.

 

**5.**              Subsequent Events

** **

***EquityAgreement*** - On August 5,2005, the Company entered into a three-year private equity agreement withSouthridge Capital Management LLC’s advised fund, Brittany Capital ManagementLimited, which permits the Company to require Brittany Capital to purchase upto $15,000,000 of the Company’s common stock. The Company has a right to periodically put common shares to BrittanyCapital for which it will pay the Company cash at a seven percent (7%) discountto the then market price calculated over a 10 trading day period.  Each put transaction must have a minimumpurchase price of $25,000 and the number of shares issuable is limited to amaximum of five hundred percent (500%) of the weighted average volume for thetwenty (20) trading days immediately preceding the put date, up to 4.99% of allof the Company’s outstanding common stock on a transaction closing date.  The agreement commits the Company to putshares having a minimum aggregate purchase price of $2,000,000 and a maximumaggregate purchase price of $15,000,000 over the term of the agreement.  The maximum aggregate number of shares put toBrittany Capital may not exceed 19.99% of the Company’s currently outstandingcommon stock, or approximately 6,430,000 shares, unless the Company obtainsstockholder approval.  The Company mustfile a registration statement on SEC Form S-1 with respect to the resaleof the securities by Brittany Capital, and the registration statement must beeffective prior to the first put date. The Company expects an S-1 registration to be effective within 90 to 120days from August 5, 2005, subject to the SEC Staff’s review schedule.

*** ***

*Term Loan Financing* - On August 5, 2005, theCompany issued secured promissory notes (“Notes”) beneficially to Kevin J.Ryan, the Company’s President and Chief Executive Officer and a member of theBoard of Directors, and Robert L. Erwin, Chairman of the Board of Directors (“Investors”),and accompanying warrants, in exchange for loans to the Company in the amountsof $750,000 and $250,000, respectively. The Notes bear interest at the prime rate plus two percent per annuminitially at 8.25% due monthly starting September 15, 2005 with a rate notless than 7.25%.  The Notes are due on January 31,2006.  Borrowings under these loans aresecured by the Company’s real property located in Owensboro, Kentucky.  The Notes may be prepaid by the Companywithout penalty at any time.  The Notesprovide the Investors with the option to accelerate payment of the unpaidprincipal balance upon certain financing transactions by the Company.

 

**The common stock purchase warrants may be exercisedcommencing on February 5, 2006 and expire on February 5, 2011.  Mr. Ryan and Mr. Erwin may purchaseup to 462,963 and 154,321 shares, respectively, of the Company’s common stockat  $0.81 per share, the closing bidprice of the Company’s common stock on August 4, 2005.  The Company’s stock issued to the Investorsupon exercise of their warrants is subject to piggyback registration rights ifthe Company should file certain registration statements with the SEC.**

** **

**7**

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** **

**Item2.**                                   Management’sDiscussion and Analysis of Financial Condition and Results of Operations

** **

The following discussionof our financial condition and results of operations should be read inconjunction with our unaudited condensed consolidated financial statements andrelated notes included in this Report and our audited consolidated financialstatements and related notes for the year ended December 31, 2004 includedin our Annual Report on Form 10-K.

 

**Overview**

 

Ourcurrent efforts are focused on improving cash flows, developing andmanufacturing products and entering into relationships to market and sell ourproducts.  Management’s objective is tomanufacture and sell products in order to generate sufficient cash flows tosustain our operations.  An example of theseefforts is demonstrated by our lead candidate molecule, Lysosomal acid lipase,or LAL, which is a naturally occurring human enzyme for treatment of certainlipid storage disorders and reduction of plaque in arteries.  We have done extensive process developmentand we now have a scalable method of manufacturing LAL to pharmaceuticalspecifications and are currently evaluating the quality and stability of theproduct.  Our strategy is to develop LALfirst for certain smaller specialty markets that fall within the FDA’s OrphanDrug definition and subsequently move into larger, mainstream markets with anappropriate commercial partner.  We wereawarded Orphan Drug Designation for our recombinant human LAL from theFDA.  In terms of partnering, we hadentered into a paid collaboration with Bayer BioScience N.V., a division of thecrop science unit within Bayer Holdings A.G., or Bayer BioScience.  Bayer BioScience and the Company haveco-funded the initial phases of the LAL program and we have met or exceeded allthe program milestones on time and within budget.  The next step for Bayer BioScience is tocommit itself to the clinical development portion of the program, a decisionthat we anticipate them making sometime this fall.

 

Ourcash balance was $362,000 at June 30, 2005, and we have incurrednegative operating cash flows of $6,129,000 during the first six months of 2005and $14,566,000 during 2004.  The currentrate of cash usage raises substantial doubt about the Company’s ability tocontinue as a going concern.  Thefinancial statements do not include any adjustments relating to therecoverability and classification of assets or the amounts and classificationof recorded liabilities that might be necessary should the Company be unable tocontinue as a going concern.  In aneffort to mitigate this near-term concern, we secured $1,000,000 in short-termdebt financing and a $15,000,000 private equity agreement on August 5,2005.  Prior to selling common stockunder the private equity agreement, we must file a registration statement onSEC Form S-1 and this registration statement must become effective, whichis expected within 90 to 120 days of August 5, 2005 subject to the SECStaff’s review schedule.  However, wecannot assure you as to the amount that we will receive under the privateequity agreement because such amount will depend upon our stock price andtrading volume, and is subject to uncertainties related to obtainingshareholder approval to sell more than 19.99% of outstanding stock and filingan SEC Form S-1 registration statement. In addition, we are seeking to secure funds for our subsidiary, PDI, andthe Company, through a sale of PDI stock held by the Company.  We may also sell fixed assets and technologyto obtain funds.  In addition, we areseeking to increase collaborative related cash flows by expanding existingrelationships based on product opportunities. However, we cannot assure you that we will successfully obtain fundsthrough the sale of assets or PDI, or product related revenues, as such eventsare subject to factors beyond our control.

 

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**Recent Developments**

 

Weentered an agreement to manufacture and supply one of the Company’s proprietaryprotein products for distribution by EMD Biosciences, Inc., part of MerckKGaA’s Life Science and Analytics division. In addition, we entered a collaborative research and developmentagreement with Bayer BioScience to investigate the potential application of theCompany’s proprietary pharmaceutical product, Lysosomal acid lipase, or LAL,for an important orphan and other therapeutic disease applications.  We applied for and were subsequently grantedOrphan Drug Designation from U.S. Food and Drug Administration for our LALtherapeutic enzyme.  We achievedpreclinical milestones in the development of LAL in collaboration with Dr. GregoryA. Grabowski, M.D. at Cincinnati Children’s Hospital Medical Center.  We and Planet Biotechnology, Inc.(Planet) expanded the companies’ biomanufacturing program to extract and purifyPlanet’s lead product, CaroRx(TM), a plant-made antibody to control dentalcaries.

 

Relatedto our diagnostics subsidiary, PDI and PerkinElmer announced the discovery ofblood biomarkers for Alzheimer’s disease based on the results of a joint studypresented at the American Association for Clinical Chemistry Conference inBaltimore, Maryland.

 

The following financings have funded our operations during the firstsix months of 2005 and may provide continued funding subsequent to June 30,2005:

 

**•**                  We entered into a $2.9 millionloan agreement on December 17, 2004, with an initial advance of $1.0million received on December 20, 2004, and a second advance of$1.9 million received on January 14, 2005.  In connection with this loan agreement, weissued a common stock purchase warrant to purchase a maximum of 700,000 sharesof common stock at $1.42 per share.

 

**•**                  On March 3, 2005, we borrowed $0.6 million from Kevin J. Ryan, our President and ChiefExecutive Officer and a member of the our Board of Directors, or CEO, andissued him a convertible promissory note due on July 1, 2005.  Our CEO converted this promissory note into631,579 shares of common stock of the Company on June 29, 2005 at aconversion price of $.95 per share.

 

**•**                  We borrowed an additional $3.0 million from our CEO on April 15,2005, and issued him apromissory note due on April 17, 2006 and a common stock purchasewarrant.  The holder of the warrant hasthe option either to purchase 903,614 shares of our common stock at $0.83 pershare or common stock of our subsidiary, Predictive Diagnostics, Inc.

 

**•**                  The Company entered into a three-year privateequity agreement with Brittany Capital Management Limited on August 5,2005, which permits the Company to require Brittany Capital to purchase up to$15,000,000 of our common stock.  We havea right to periodically put common shares to Brittany Capital for which it willpay the Company cash at a seven percent (7%) discount to the then market pricecalculated over a 10 trading day period. We must file a registration statement on SEC Form S-1 with respectto the resale of the securities by Brittany Capital, and the registrationstatement must be effective prior to the first put date.  We expect an S-1 registration to be effectivewithin 90 to 120 days from August 5, 2005, subject to the SEC Staff’sreview schedule.

 

**•**                  On August 5, 2005, we issuedsecured promissory notes beneficially to our CEO and Robert L. Erwin, Chairmanof the Board of Directors, and accompanying warrants, in exchange for loans tothe Company in the amounts of $750,000 and $250,000, respectively.

 

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###### **Results of Operations**

###### ** **

*Revenues*—The following table presents the changes in revenues from 2004 to 2005:

 
| ** ** | ** ** | **Three Months ended June 30,** | ** ** | **Six Months ended June 30,** | ** ** |
|------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** ** | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **Increase from 2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Increase from 2004** | ** ** |
| Revenues   |       | $                                    | 680,000    |                               | $          | 362,000 |   | $ | 318,000 |   | 88 | % | $ | 1,113,000 |   | $ | 681,000 |   | $ | 432,000 |   | 63 | % |
|            |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The revenue increase is primarily theresult of the new contracts with Bayer BioScience that started in May 2005and the US Army Medical Research Institute of Infectious Diseases, or USAMRIID,that started in December 2004.  Weexpect quarterly revenues to increase as we expand the LAL product initiativewith Bayer BioScience.  If we are notable to increase revenues during 2005 with an expanded agreement with Bayer BioScienceor other revenue sources, we will not be able to sustain operations, as theypresently exist.

 

*Developmentagreements*and*research and development**expenses* — The following tablepresents the changes in total researchactivity expenses from 2004 to 2005:

 
| ** **                | ** ** | **Three Months ended June 30,** | ** ** | **Six Months ended June 30,** | ** ** |
|---------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **Increase (Decrease)  from 2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Increase (Decrease)  from 2004** | ** ** |
| Development agreements    |       | $                                    | 1,255,000  |                               | $          | 535,000 |   | $ | 720,000 |   | 135 | % | $ | 1,925,000 |   | $ | 1,022,000 |   | $ | 903,000 |   | 88 | % |
| Research and development  |       | 1,591,000                            |       | 2,280,000                          |       | (689,000 | ) | (30 | )% | 3,822,000 |   | 4,519,000 |   | (697,000 | ) | (15 | )% |
| Total research activities |       | $                                    | 2,846,000  |                               | $          | 2,815,000 |   | $ | 31,000 |   | 1 | % | $ | 5,747,000 |   | $ | 5,541,000 |   | $ | 206,000 |   | 4 | % |

 

Development agreements and research and developmentcosts consist mainly of personnel expenses, outside research services,research materials and laboratory overhead costs.*  Development agreement*expenses, as they relate to activities performed under revenue generatingresearch agreements and grants, have and are expected to fluctuate consistentlywith increases or decreases in revenues earned from research agreements andgrants.  The increase in developmentagreement expense from 2004 to 2005 is primarily attributed to increasedefforts under new contracts with Bayer BioScience and USAMRIID.  Developmentagreement expenses related to the Bayer BioScience contract were $0.6million during the second quarter of 2005. Such expenses under the USAMRIIDcontract were $0.1 million and $0.3 million during the three and six monthsended June 30, 2005, respectively. We expect development agreement expense in the third quarter of 2005 tobe consistent with the second quarter of 2005. However, development agreement expense may increase if we enter into anexpanded relationship with Bayer BioScience related to the LAL productinitiative.  *Research anddevelopment* expenses from 2004 to 2005 have decreased by $0.7million for both of the three and six months ended June 30 as researchpersonnel were reassigned to development agreement activities.  We expect research and development expense inthe third quarter of 2005 to be materially consistent with the second quarter,but may decrease if further resources are reassigned to the LAL productinitiative.

 

*Generaland administrative*— The following table presents the changesin general and administrative expenses from 2004 to 2005:

 
| ** **                 | ** ** | **Three Months ended June 30,** | ** ** | **Six Months ended June 30,** | ** ** |
|----------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                 | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **Increase from 2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **(Decrease) from 2004** | ** ** |
| General and administrative |       | $                                    | 1,697,000  |                               | $          | 1,638,000 |   | $ | 59,000 |   | 4 | % | $ | 3,146,000 |   | $ | 3,564,000 |   | $ | (418,000 | ) | (12 | )% |
|                            |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Forthe three months ended June 30, *General and administrative*expenses increased by $0.1million because legal costs related to patents increased by approximately $0.3million, and with other cost increases, exceeded $0.3 million of decreasedcosts related to the closure of the Germantown, Maryland facility in 2004.  Related to the Germantown, Maryland facilitycertain operating and clean-up expenses were only incurred during 2004 andfacility rental expense in 2005 was offset by sublease rental receipts.  Forthe six months ended June 30, *General and administrative*expenses decreased by $0.4million because costs related to the Germantown, Maryland facility decreased byapproximately $0.7 million, and with other cost decreases exceeded $0.5 millionof increased legal costs related to patents.

 

*Interestincome and expense* — Interest income is not significantbecause of our declining cash and marketable securities balances available forinvestment.  Interest expense was notsignificant in 2004 because of the small amount of our long-term debt.  With the addition of debt of$2.9 million in December 2004 and January 2005,$0.6 million in March 2005 and $3.0 million in April 2005,interest expense increased substantially in 2005.  Interest expense includes finance charges of $0.3million and $0.4 million for the three and six months ended June 30, 2005,respectively, related to the accretion of a debt discount due to the issuanceof a warrant and the vesting of another warrant issued in connection withdebt.  We expect interest expense toincrease during the third and fourth quarter of 2005 due to the addition ofdebt on August 5, 2005.

 

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**Liquidityand Capital Resources**

 

Ourhistory of negative cash flows and our cash balance of $362,000 at June 30, 2005,raise substantial doubt about the Company’s ability to continue as a goingconcern, absent any new sources of significant cash flows.  In an effort to mitigate this near-termconcern, we secured $1,000,000 in short-term debt financing and a $15,000,000private equity agreement on August 5, 2005.  Prior to selling common stock under theprivate equity agreement, we must file a registration statement on SEC Form S-1and this registration statement must become effective, which is expected within90 to 120 days of August 5, 2005 subject to the SEC Staff’s reviewschedule.  However, we cannot assure youas to the amount that we will receive under the private equity agreementbecause such amount will depend upon our stock price and trading volume, and issubject to uncertainties related to obtaining shareholder approval to sell morethan 19.99% of outstanding stock and filing an SEC Form S-1 registrationstatement.  In addition, we are seekingto sell stock of our subsidiary, PDI, or other technology and fixed assets, andto increase collaborative related cash flows by expanding existingrelationships based on product opportunities. However, we cannot assure you that we will successfully obtain fundsthrough the sale of assets or PDI, or product related revenues, as such eventsare subject to factors beyond our control.

 

*Net cashused in operating activities* — The following table presentscash flows from operating activities for the first six months of 2005 and 2004:

 
| ** **                                 | ** ** | **Six Months Ended June 30** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|
| ** **                                 | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Cash paid to employees                     |       | $                                 | (3,169,000 | ) | $ | (3,587,000 | ) |
| Cash paid to suppliers                     |       | (3,769,000                        | )          | (4,756,000 | ) |
| Total cash paid to employees and suppliers |       | (6,938,000                        | )          | (8,343,000 | ) |
| Cash received from customers               |       | 965,000                           |       | 844,000 |   |
| Net interest received (paid)               |       | (156,000                          | )          | 29,000 |   |
| Net cash used in operating activities      |       | $                                 | (6,129,000 | ) | $ | (7,470,000 | ) |

 

Thedecrease in *cash paid to employees*is the result of severance benefits paid during the first six months of 2004 toemployees affected by our closure of our Germantown, Maryland facility.  The decrease in *cash paid to suppliers* is primarily the result of subleaserental receipts of $0.3 million that offset rental expense and decreasedcash expenditures of $0.1 million related to our Germantown, Marylandfacility, and $0.6 million of increased accounts payable and accruedexpenses for the six months ended June 30, 2005.

 

Themodest increase in cash received from customers is related to newcontracts.  The interest paid in 2005 isrelated to the increased debt load.  Weexpect the negative operating cash flows to decrease in the third and fourthquarters of 2005 from the rate of the first six months of 2005, due toincreased cash receipts from our collaborators related to current product initiatives,or reduced disbursements as operations are further restructured.

 

*Net cashused in investing activities*— We spent $0.1 million oncapital expenditures during the first six months of 2005.  We have no material capital expenditurecommitments at June 30, 2005.  Weanticipate that our biomanufacturing facility in Owensboro, Kentucky, mayrequire capital expenditures to support our business objectives if we signrevenue-generating contracts.

 

*Net cashprovided by financing activities*— In 2000 we received netproceeds of $88.8 million from our initial public offering, whichsustained our operations through 2003. Financing activities have not provided significant cash flows from 2001through 2003.  On March 8, 2004,we received net proceeds of approximately $7.5 million in a privateplacement of common stock.

 

On December 17,2004, we entered into a $2.9 million loan agreement, with an initialadvance of $1.0 million received on December 20, 2004, and a secondadvance of $1.9 million received on January 14, 2005.  Borrowings under the loan bear interest at 8%and are secured by our assets located at our Owensboro, Kentucky facility; andcertain patented intellectual property and related know-how.

 

On March 3,2005, we issued a $600,000convertible promissory note, or Note, to our CEO.  The Note wasconverted into 631,579 shares of our Common Stock on June 29, 2005 at aconversion price of $.95 per share according to the terms of the Note.

 

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On April 15,2005, we received $3,000,000 incash in exchange for a promissory note, or Promissory Note, and warrant issuedto our CEO.  The Promissory Note bears interest at theprime rate plus two percent per annum initially at 7.75% due monthly starting May 15,2005 with a rate not less than 7.25%. The Promissory Note is due on April 17, 2006.  Borrowings under the loan are secured bycertain intellectual property related to PDI. The Promissory Note may be prepaid by us without penalty at anytime.  Our CEO may elect to be repaid upto $1,500,000 as a result of any Company financing event with net proceeds of$4,000,000 or more.  The warrant mayeither be used to purchase 903,614 shares of our common stock at $0.83 pershare or common stock of our PDI subsidiary and expires on April 15, 2011.

 

On August 5, 2005,we entered into a three-year private equity agreement with Brittany CapitalManagement Limited, which permits us to deliver from time to time putsrequiring Brittany Capital to purchase up to $15,000,000 of our commonstock.  We have a right to periodicallyput common shares to Brittany Capital for which it will pay the Company cash ata seven percent (7%) discount to the then market price calculated over a 10trading day period.  We must file aregistration statement on SEC Form S-1 with respect to the resale of thesecurities by Brittany Capital, and the registration statement must beeffective prior to the first put date. We expect an S-1 registration to be effective within 90 to 120 days fromAugust 5, 2005, subject to the SEC Staff’s review schedule.

 

On August 5,2005, we issued secured promissory notes beneficially to our CEO and Robert L.Erwin, Chairman of the Board of Directors, and accompanying warrants, inexchange for loans to the Company in the amounts of $750,000 and $250,000,respectively.

 

###### **Critical Accounting Policies**

###### ** **

Weconsider the following accounting policies to be critical given they involveestimates and judgments made by management and are important for our investors’understanding of our operating results and financial condition.

 

*Long-LivedAssets* — Our long-lived assets include capitalized costs offiling patent applications, capitalized licenses and property andequipment.  We evaluate our long-livedassets for impairment in accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets” whenever events or changes incircumstances indicate that the carrying amount of such assets may not berecoverable.  Estimates of future cashflows and timing of events for evaluating long-lived assets for impairment arebased upon management’s judgment.  If anyof our intangible or long-lived assets are considered to be impaired, theamount of impairment to be recognized is the excess of the carrying amount overthe fair value of the assets.

 

Alllong-lived assets are amortized or depreciated over the shorter of theirestimated useful lives, the estimated period that the assets will generaterevenue, or the statutory or contractual term in the case of patents andintellectual property licenses. Estimates of useful lives and periods of expected revenue generation arereviewed periodically for appropriateness and are based upon management’sjudgment.

 

*Stock-BasedCompensation*— We adopted Statement of Financial Accounting StandardsNo. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation” effective January 1,2003 for its stock-based employee compensation plans using the prospectiverecognition method under Statement of Financial Accounting Standards No. 148(“SFAS 148”), “Accounting for Stock-Based Compensation-Transition andDisclosure, an amendment of SFAS 123.” This method applies the recognition provisions of SFAS 123 to allemployee stock awards granted, modified or settled after January 1, 2003and accordingly, recognized compensation expense for those issuances under ourstock-based employee compensation plans. Methodologies used for calculations such as the Black-Scholesoption-pricing model and variables such as volatility and expected life arebased upon management’s judgment.  Suchmethodologies and variables are reviewed and updated periodically forappropriateness and affect the amount of recorded charges.

 

DuringDecember 2004 Statement of Financial Accounting Standards No. 123(revised 2004) (“SFAS 123R”), “Share Based Payment,” was issued requiring theexpensing of all stock-based compensation. The Company is evaluating the effects of SFAS 123R but believes itsimplementation will not have a material effect on the Company’s financialstatements since the Company had already adopted FASB 123 for its stock-basedemployee compensation plans as described above.

 

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**FactorsThat May Affect Our Business**

 

# ***RisksRelated To Our Business***

# * *

*The Company’s recurring losses from operations and currentcash and cash equivalents balance raise substantial doubt about its ability tocontinue as a going concern.*

 

Ourcash balance was $362,000 at June 30, 2005, and we have incurrednegative operating cash flows of $6,129,000 during the first half of 2005 and$14,566,000 during 2004.  We haverealized significant net losses in recent years and in the six months ended June 30, 2005.  Based upon our current cash balance, ourcurrent rate of negative operating cash flows and the expected cost to completethe development of our products, we cannot assure you that the Company will beable to continue as a going concern.  Thefinancial statements do not include any adjustments relating to the recoverabilityand classification of assets or the amounts and classification of recordedliabilities that might be necessary should the Company be unable to continue asa going concern.

 

Our revenues were $1,767,000 for the year ended December 31, 2004and $1,113,000 for the six months ended June 30, 2005.  We may be required to further reduce ouroperating costs by further restructuring our operations or reducing the scopeof our development programs.  Theseactions would adversely affect our ability to generate new sources ofrevenue.  If we are unable tosignificantly increase our revenues and cash received from customers, we willnot be able to sustain operations as they presently exist, and our businesswill suffer.

 

Our product development programs need substantial additional funding tobe commercialized.  Our recombinantAprotinin, Alpha-galactosidase A, and Interferon alpha 2a and 2b requireclinical trials to prove their efficacy and safety for pharmaceuticalapplications.  We do not have sufficientworking capital to complete all phases of clinical trials.  Our PDI subsidiary requires funding for itsstart-up activities.  If we are unable toraise sufficient financing or collaborative funding, we may delay or abandonsome of our product development initiatives, which would likely harm our business.

 

*Our workingcapital is not sufficient to fund our operations or all of our productdevelopment initiatives.*

 

Werequire substantial working capital to continue our product developmentprograms and to fund our operations.  Inaddition, the risks inherent in developing innovative products or platforms,such as recombinant Aprotinin, Alpha-galactosidase A, Interferon alpha 2a and2b, Lysosomal acid lipase and BAMF technology diagnostic tests make itdifficult to forecast with certainty the capital required to commercialize ourproducts.  We may raise this capitalthrough public or private equity financings or through collaborations orstrategic partnerships.  We cannot assureyou that we will be able to obtain additional financing on commercially reasonableterms, if at all.  Our recent operatingresults and our current stock price may limit our ability to raise capital byselling and issuing additional equity securities.  If additional funds are raised through theissuance of equity securities or convertible debt securities, the percentageownership of our then-current stockholders would be reduced and the value oftheir investments might decline. In addition, any new securities issued mighthave rights, preferences or privileges senior to those securities held by ourexisting stockholders.  If we raiseadditional funds through the issuance of debt, we might become subject torestrictive covenants or high rates of interest, and our assets could becomeencumbered, which would limit our ability to borrow in the future.  We may be unsuccessful in entering into anynew collaboration or strategic partnership that results in significant workingcapital or revenue.  Further, any significantrevenues we generate from such collaborations or partnerships may not be realizedfor several quarters or years, as regulatory approval and other matters couldimpede commercialization of these products. If we are unable to raise sufficient additional capital, we may have tocurtail or cease operations.

 

*Our stock could be delisted from the Nasdaq SmallCap Marketif it does not meet its continued listing requirements.*

 

On June 16,2005, we received notice from the Staff of the Nasdaq Stock Market that theCompany does not currently comply with Marketplace Rule 4450(a)(5), whichis a requirement for continued listing on the Nasdaq SmallCap Market, orNasdaq, because the bid price of the Company’s common stock had closed belowthe minimum $1.00 per share requirement for the previous 30 consecutivebusiness days.  We have a 180-day cureperiod during which our stock must meet the $1.00 minimum bid pricerequirement.  If our stock price does nottrade above $1.00 for at least ten consecutive days during the 180-day cureperiod, we are entitled to a hearing. However, we cannot assure you that our common stock will not be delistedfrom Nasdaq following such hearing. Delisting from Nasdaq may, among other things, limit liquidity.  If our stock is potentially subject todelisting from Nasdaq, we may have the ability to increase our stock pricethrough certain capital transactions including a reverse stock split.

 

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*We may not be able to enter into collaborationsnecessary to fully develop and commercialize our products and technologies, andwe will be dependent on our collaborators if we do.*

* *

We areindependently pursuing some therapeutic product applications into thedevelopment stage.  However, we expect todevelop and commercialize most of our future products in collaboration withpharmaceutical, biotechnology and other companies.  For example, our strategy concerning ourrecombinant Aprotinin, Alpha-galactosidase A, Interferon alpha 2a and 2b,Lysosomal acid lipase and BAMF technology diagnostic tests involves seekingpartners to complete the development and commercialization of theseproducts.  We cannot assure you that suchcollaborative arrangements will be available to us on acceptable terms, or atall.  If our cash flows continue todeteriorate or we take significant steps to reduce our expenses, potentialpartners may question our ability to perform and choose not to do business withus, which would make it harder for us to find a partner and would harm ourability tocommercialize our products.  Our successwill depend in large part on our ability to enter into future collaborationswith other companies for the financing of development and/or regulatoryapproval and commercialization of our products. Our reliance upon these companies for these capabilities will reduce ourcontrol over such activities and could make us dependent upon them.  Furthermore, obtaining funds througharrangements with collaborative partners or others may require us to relinquishour rights to certain technologies, product candidates or products that we wouldotherwise seek to develop or commercialize on our own, or to sell or licenseour rights to certain products or technologies on terms that are worse than wemight have been able to obtain in a different environment.  To date, we have entered into only a limitednumber of collaborations.  Some of ourexisting agreements provide us with rights to participate financially in thecommercial development of products resulting from the use of our technologies.  We may be unable to obtain such rights infuture collaborations.  In addition,unforeseen delays or complications could arise and result in the breach of ourcontractual obligations with our collaborators and others, or us not being ableto perform at the quality and capacity levels required for success.

 

*We may beunable to recruit and retain senior management and other key scientificpersonnel on whom we are dependent.*

 

The loss of a number of our senior management or other key scientificpersonnel could significantly harm our business, cause collaborators to ceasedoing business with us, cause potential collaborators to decline to do businesswith us, or inhibit our research and development and commercializationefforts.  None of our key personnel aresubject to employment agreements that prevent them from leaving ouremployment.  We face competition forresearch scientists and technical staff from other companies, academicinstitutions, government entities, nonprofit laboratories and otherorganizations.  We have implemented 10%cash salary reductions substituting non-cash stock compensation for our highestpaid employees to conserve cash.  Inaddition, we adhere to an eighteen-month salary review process for seniorpersonnel.  Our compensation practicesmay be less attractive compared to our competition.  Failure to recruit and retain seniormanagement and scientific personnel on acceptable terms may prevent us fromachieving our business objectives.

 

*We are inthe early or middle stages of product commercialization, and we may not be ableto successfully develop our products and technologies nor sustain commercialuse of our technology.*

 

We are in the early or middle stages of commercializing our productsunder development, and we are subject to all of the risks inherent in thedevelopment of a business enterprise, including the need for substantialcapital to support the development of our products and technologies.  Our anticipated products most likely willrequire that we enter into new collaborations before we can manufacture and/ormarket them.  For instance, we believethat our NHL vaccine, which is ready for Phase II trials, cannot be furtherdeveloped without collaboration.  Theprospects for development of our Alpha-galactosidase A, recombinant Aprotinin,Interferon alpha 2a and 2b, and Lysosomal acid lipase products are limitedwithout collaboration or partnering support. Because we are in new and developing fields such as diagnostic tests fordisease, and our research focuses on new and unproven products, our therapeuticvaccines, proteins and other therapeutics under development may not beeffective for their intended purpose, or may not meet regulatory requirementsfor safety and efficacy.  In addition,even if we successfully develop a product, there may not be a substantialcommercial market for that product at commercially viable prices.

 

*We are in new and developing fields and there may not be a market forour technologies.*

 

Our technologies, including our GENEWARE and BAMF technology, havelimited commercial precedent.  Much ofour research is fundamentally unique, and we cannot assure the acceptance ofits scientific merit or the benefits of products produced by it, nor that thepublic will react favorably to it.  Theusefulness of the information and products generated by our proteomics, functionalgenomics and bioinformatics technologies is unproven, and our collaborators andpotential collaborators may determine that they are not useful, cost-effective,or otherwise unacceptable to them.  Wegenerate large amounts of data from our research with genes and proteins and wemay not be able to mine or integrate this data in a timely manner or turn itinto commercially viable information.  Inaddition, because our fields are characterized by rapid innovation, we mustcomplete development of our technologies in time to meet market demand, ifany.  If we fail to do so, it is likelythat other technologies and companies will predominate and we will not be ableto earn a sufficient return on our investment.

 

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*Alternative technologies may supersede our technologies or make themnoncompetitive.*

 

Genomics, proteomics, biomanufacturing and bioinformatics are intenselycompetitive fields.  They arecharacterized by extensive research efforts, which result in rapidtechnological progress that can render existing technologies obsolete oreconomically noncompetitive.  If ourcompetitors succeed in developing more effective technologies or render ourtechnologies obsolete or noncompetitive, our business will suffer.  Many universities, public agencies andestablished pharmaceutical, biotechnology, health care, chemical and other lifesciences companies with substantially greater resources than we have aredeveloping and using technologies and are actively engaging in the developmentof products similar to or competitive with our products and technologies.  Like us, our competitors are using proteomicsand genomics technologies to identify potential drug targets, therapeutic proteinsand diagnostic marker proteins.  Toremain competitive, we must continue to invest in new technologies and improveexisting technologies.  If our revenuesand cash flows do not improve significantly, we will not have the resources tocontinue such investment.

 

Our competitors may devise faster, more complete or more accuratemethods to obtain proteomic and functional genomic information than ourtechnologies and systems, including our GENEWARE systems and BAMFtechnology.  There has been and continuesto be substantial academic and commercial research effort devoted to thedevelopment of such methods.  Ifsuccessful competitive methods were developed, it would undermine thecommercial basis for the products and technologies we intend to provide.

 

*Generaleconomic conditions may cause uncertainty with respect to other companies andentities collaborating with us or otherwise dealing with us, and this can havean adverse effect on our revenues and cash flows.*

 

To a large extent, decisions by businesses and other entities tocollaborate or otherwise do business with us are discretionary, and thedecision making process typically takes many months to complete.  We believe that the previous slowdown in theU.S. and global economies, and the biotechnology and pharmaceutical industriesin particular, has caused potential collaborators and customers to deferdecisions to work with us or to access our technologies.  As a result, revenues and cash flows havebeen uncertain.  Future results aredifficult to predict, as it is difficult to accurately assess and predict thefuture demand for our products, technologies and services.  General economic conditions are expected toimprove as the economy grows.  However,we cannot assure you that any such improvement will cause our results ofoperations to improve.  If economicconditions decline or stagnate, our revenues and operating results could beadversely affected.

 

*Conflictswith collaborators or licensees could harm our business.*

 

Conflicts with collaborators could have a negative impact on ourrelationships with them, and our revenues to be derived from theserelationships, and impair our ability to enter into future collaborations, allof which could adversely affect our business. Collaborators could develop competing products, preclude us fromentering into collaborations with their competitors or terminate theiragreements with us prematurely. Moreover, disagreements could arise with collaborators or licensees overrights to our intellectual property, our rights to share in any of the futurerevenues from products or technologies resulting from use of our technologies,our rights to payments for achievement of milestones or our performance ofresearch and development activities on behalf of collaborators, or ouractivities in separate fields may conflict with other business plans of ourcollaborators or licensees.

 

*We mustenter into agreements with third parties to provide sales and marketingservices, or develop these capabilities on our own, if we are to successfullycommercialize our products and technologies.*

 

Although we plan to enter into sales and marketing arrangements withthird parties, we may not be able to enter into these arrangements on favorableterms, if at all.  We must also expandour business development force with sufficient technical expertise to generatedemand for our products and technologies. Our possible inability to hire business development personnel orcontract for effective sales and marketing capabilities would significantlyimpair our ability to commercialize our products and technologies.

 

*We may notbe able to successfully manufacture products in commercial quantities or atacceptable costs.*

 

The failure of our technologies to provide safe, effective, useful orcommercially viable approaches to the discovery, development and/or productionof drug targets and proteins which can be used as therapeutics and diagnostictests for diseases, such as cancer, would significantly limit our business planand future growth.

 

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*Concentrationof ownership among our existing executive officers, directors and principalstockholders may enable them to collectively influence significant corporatetransactions that require stockholder approval.*

 

Our directors, our executive officers and principal stockholdersaffiliated with our directors and executive officers beneficially own, in theaggregate, approximately 22% of our outstanding common stock as of August 8, 2005.  The concentration of ownership in combinationwith other common stockholders may collectively influence significant corporatetransactions such as mergers, changes in control, consolidation or sale of someor all of our assets, and other significant corporate transactions requiringshareholder approval.

 

*Ourstockholder rights plan and provisions of our charter documents and Delawarelaw may inhibit a takeover, which could adversely affect our stock price.*

 

We have adopted a stockholder rights plan and declared a dividenddistribution of one right for each outstanding share of common stock tostockholders of record as of May 4, 2001. Subject to certain specified exceptions and limitations under the rightsplan, we will continue to issue one right for each share of common stock thatbecomes outstanding after May 4, 2001. Each right entitles the holder to purchase one unit consisting of oneone-hundredth of a share of our Series A Junior Participating PreferredStock for $45 per unit.  Under certaincircumstances, if a person or group acquires 15% or more of our outstandingshares of common stock, holders of the rights (other than the person or groupcausing their exercisability) will be able to purchase, in exchange for the $45exercise price, shares of our common stock or of any company into which we aremerged having a value of $90.  Inaddition, the board of directors has the option, under certain circumstances,to exchange each right (other than rights held by the person or grouptriggering the board of directors’ option) for a share of common stock for noadditional consideration on the part of the holder of the right.  The rights expire on April 27,2011.  Our rights plan could make it moredifficult for a third party to acquire us (or a significant percentage of ouroutstanding capital stock) by causing substantial dilution of the stockownership of a person or group attempting to acquire control of us.  Our rights plan may have the effect ofdiscouraging takeover attempts because a potential acquirer would have tonegotiate with our board of directors to avoid suffering dilution.

 

Provisions in our charter and bylaws and applicable provisions of theDelaware General Corporation Law may also make it more difficult for a thirdparty to acquire control of us without the approval of our board of directors.  These provisions may make it more difficultor expensive for a third party to acquire a majority of our common stock ordelay, prevent or deter a merger, acquisition, tender offer or proxy contest,which may adversely affect our stock price.

 

**Risks Related to Our Industry**

 

*If companiesin the pharmaceutical, biotechnology, healthcare, and life sciences industriesdo not succeed or their demand for our products and technologies decreases,then our revenues could be reduced.*

 

We expect to derive our revenues primarily from products and technologiesprovided to the pharmaceutical, biotechnology, healthcare and life sciencesindustries.  Accordingly, our successwill depend directly on the success of companies in these industries and theirdemand for our products, services and technologies.  Our operating results may fluctuatesubstantially due to reductions and delays in expenditures by companies inthose industries, or their unwillingness or inability to use our products andtechnologies.  These reductions anddelays may result from factors that are not within our control, such as:

 

**•**                  changes ineconomic conditions generally;

**•**                  the extentto which companies in these industries conduct research and developmentinvolving diagnostics, proteomics and functional genomics in-house or throughindustry consortia;

**•**                  the extentto which genomic information is or is not made publicly available;

**•**                  consolidationwithin one or more of these industries;

**•**                  changes inthe regulatory environment affecting these industries;

**•**                  pricingpressures;

**•**                  market-drivenpressures on companies to consolidate and reduce costs; and/or

**•**                  otherfactors affecting spending in these industries.

 

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*Ifcompetitive products are better than our products, then our business may fail.*

 

Our human and veterinary therapeutics and vaccines are included in thehighly competitive markets for protein development and production.  We face significant competition in ourprotein product development and production efforts from entities using alternative,and in some cases, higher volume and larger scale, approaches for the samepurpose.  Competitors with substantiallygreater resources are actively developing products similar to or competitivewith our products and potential products. Our competitors may succeed in developing products or obtainingregulatory approval before we do or in developing products that are moreeffective than those we develop or propose to develop.  A large number of universities and othernot-for-profit institutions, many of which are funded by the U.S. and foreigngovernments, are also conducting research to discover genes and theirfunctions.  Any one or more of theseentities may discover and establish a patent position in one or more of thegenes or proteins that we wish to commercialize.

 

Several pharmaceutical, biotechnology, chemical and other life sciencescompanies engage in research and development in the use of unique geneexpression systems to produce therapeutic proteins.  These competitors may develop products earlieror obtain regulatory approvals faster than we may be able to, or developproducts that are more effective than ours. New developments are expected to continue, and discoveries by others mayrender our products and technologies noncompetitive, which could lead to thefailure of our business.

 

Diagnostics companies in the health care industry with more resourcesthan us constitute varied competition for our diagnostic technology, which isearly stage.  Competing diagnostictechnologies may be developed and marketed that may be competitively superiorto ours.

 

*Ourcollaborators and we may not obtain FDA and other approvals for our products ina timely manner, or at all.*

 

Drugs and certain diagnostic products and tests are subject to anextensive and uncertain regulatory approval process by the FDA and comparableagencies in other countries.  Theregulation of new products and certain diagnostic products and tests isextensive, and the required process of laboratory testing and human studies islengthy, expensive and uncertain.  Theburden of these regulations will fall on us to the extent we are developingproprietary products.  We may not be ableto obtain the clearances and approvals necessary for the clinical testing,field-testing, manufacturing or marketing of our products.  If the products or diagnostic tests are theresult of a collaborative effort, these burdens may fall on our collaboratorsor we may share these burdens with them. We may not obtain FDA or other approvals for those products or tests ina timely manner, or at all.  We mayencounter significant delays or excessive costs in our efforts to securenecessary approvals or licenses.  Even ifwe obtain FDA regulatory approvals, the FDA extensively regulatesmanufacturing, labeling, marketing, promotion and advertising after productapproval.  Further, once a manufacturerobtains regulatory approval, a marketed product and its manufacturer aresubject to continual review, and discovery of previously unknown problems witha product, test or manufacturer may result in restrictions on the product,test, manufacturer or manufacturing facility, including withdrawal of theproduct or test from the market.  In somecountries, regulatory agencies also set or approve the sale prices for drug anddiagnostic products and tests. Additionally, several of our product development areas may involverelatively new technology that has not been the subject of extensive producttesting in humans.  The regulatoryrequirements governing these drug and diagnostic products, tests, and relatedclinical procedures remain uncertain and the products and tests themselves maybe subject to substantial review by the FDA and foreign governmental regulatoryauthorities that could prevent or delay approval.  Regulatory requirements ultimately imposed onour products could limit our ability to test, manufacture and commercialize ourproducts and tests.

 

*USDA rules couldadversely affect us or our collaborators.*

 

We must comply with USDA regulations for outdoor releases of geneticallyengineered organisms as well as other products designed for use on or withagricultural products.  In addition, theUSDA prohibits growing and transporting genetically modified plants exceptpursuant to an exemption or under special permits.  We may use genetically modified plants asscreening or production hosts.  Changesin USDA policy regarding the movement or field release of genetically modifiedplant hosts could adversely affect our business by increasing the cost of ourproducts and technologies or decreasing consumer demand for those products andtechnologies or causing the government to prohibit their sale or use.  If we fail to comply with such rules orpolicies, we may be subject to financial loss or be liable for costs incurredas a result of non-compliance.

 

*If there isnegative public reaction to the use of genetically engineered products andtechnologies, then the market for certain products and technologies we developwill be adversely affected.*

 

Future commercial success of some of our products and of the productsof some of our collaborators will depend in part on public acceptance of theuse of genetically engineered products including drugs, plants and plantproducts.  Claims that genetically engineeredproducts are unsafe for consumption or pose a danger to the environment mayinfluence public attitudes.  Negativepublic reaction to genetically modified organisms and products could result ingreater government regulation of genetic research and resultant products,including stricter labeling requirements, and could cause a decrease in thedemand for our products, even if such products do not result from GMOorganisms.

 

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*We may be sued for product liability and our product liability insurancemay not be adequate.*

 

The testing, marketing and sale of our and our collaborators’ productsand diagnostic tests will entail a risk of allegations of product liability,and third parties may assert substantial product liability claims againstus.  While we have limited productliability insurance to protect against this risk, adequate insurance coveragemay not be available at an acceptable cost, if at all, in the future and aproduct liability claim or product recall could materially and adversely affectour business.  Inability to obtainsufficient insurance coverage at an acceptable cost or otherwise to protectagainst potential product liability claims could prevent or inhibit thecommercialization of the products and diagnostic tests developed by ourcollaborators or us.  If we are sued forany injury allegedly caused by our products or our collaborators’ products, ourliability could exceed our total assets and our ability to pay the liability.

 

*If we usehazardous materials in our business in a manner that causes injury or violateslaws, we may be liable for substantial damages.*

 

Our research and development processes involve the use of hazardousmaterials, including chemicals and radioactive and biological materials.  Our operations also produce hazardous wasteproducts.  The chemicals we use include,but are not limited to, flammable solvents such as methanol and ethanol;ethidium dye, which is a commonly used fluorescent dye for visualizing DNA;buffer solutions used in the purification of DNA; and various organic solvents,acids and bases.  We also use severalradioisotopes including phosphorous-32, carbon-14, sulfur-35, phosphorous-33,iodine-125 and hydrogen-3.  We cannoteliminate the risk of accidental contamination or discharge and any resultantinjury from these materials.  Federal,state and local laws and regulations govern the use, manufacture, storage,handling and disposal of these materials. We could be subject to civil damages and criminal penalties in the eventof an improper or unauthorized release of, or exposure of individuals to,hazardous materials.  Further, it ispossible that the materials we use could contaminate another party’sproperty.  In addition, claimants may sueus for injury or contamination that results from our use or the use by thirdparties of these materials, and our liability may exceed our total assets andour ability to pay the liability.  Inaddition, compliance with environmental laws and regulations is expensive, andcurrent or future environmental regulations may impair our research anddevelopment and production efforts. Although we have general liability insurance, these policies do notcover claims arising from pollution from chemical, radioactive or biologicalmaterials.  Our collaborators may also beworking with various types of hazardous materials in connection with ourcollaborations.  In the event of alawsuit or investigation, we could be held responsible for any injury we or ourcollaborators cause to persons or property by exposure to, or release of, anyhazardous materials.

 

*Healthcarereform and restrictions on reimbursements may limit the financial returns fromour products and diagnostic tests.*

 

Our ability and that of our collaborators to commercialize therapeuticsand diagnostic products and tests may depend in part on the extent to whichgovernment health administration authorities, private health insurers and otherorganizations will pay the cost of these products and tests.  These third parties are increasinglychallenging both the need for and the price of new medical products, tests andservices.  Significant uncertainty existsas to the reimbursement status of newly approved therapeutics and diagnostics,and adequate third party reimbursement may not be available for any product toenable us to maintain price levels sufficient to realize an appropriate returnon our investment in research and product development.

 

# ***Risks Related to Our IntellectualProperty***

# * *

*Patentprotection in the biotechnology, pharmaceutical, and healthcare industries isuncertain, which may result in a decrease in the value of our products andtechnologies.*

 

We are involved in overlapping and rapidly evolving areas ofbiotechnology, pharmaceutical development, healthcare, and diagnostics andbasic research involving viral vectors, plant transgenics, proteomics,functional genomics, protein transformation, and immunotherapy.  Each of these areas has been the subject ofintense research and patenting activity throughout the world by our commercialcompetitors, actual and potential collaborators, academic institutions andgovernment researchers.  We cannotdetermine whether or not there are patents currently pending that, if issued,would prevent us from practicing our core technologies, commercializing them ordeveloping commercially viable products and diagnostic tests based upon them.

 

The patent positions of biotechnology firms generally are highlyuncertain and involve complex legal and factual questions that will determinewho has the right to develop a particular product.  Changes in, or different interpretations of,patent laws in the United States and other countries might allow others to useour discoveries or to develop and commercialize products and technologiessimilar to our products and technologies without any compensation to us.  Our potential collaborators or customers mayconclude that uncertainties about patent protection decrease the value of ourdatabases, products and services.

 

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Throughout the world there are numerous issued patents, as well aspublished foreign patent applications which may be issued as patents, many ofwhich relate to our current operations, our anticipated future operations andthe products we are likely to develop. The scope of these patents is a matter of legal interpretation and issubject to uncertainty.  We have notobtained, but we may in the future obtain, opinions from our patent counselthat we have freedom to conduct our commercial activities free of claims ofpatent infringement from third parties. From time to time, we receive letters from third parties offering tonegotiate a license to LSBC based on a perception that our processes orproducts might infringe a patent owned by the third party.  Disagreements could arise from these letters,and could result in costly and time-consuming litigation and divert ourfinancial and managerial resources.  Inaddition, if we are ever determined to infringe the patent of any third party,we may be required to obtain a license to use this patent, which would increaseour cost of doing business.

 

*Our patentapplications may not result in issued patents that are enforceable.*

 

Our disclosures in our patent applications may not be sufficient tomeet the statutory requirements for patentability in all cases.  As a result, we do not know which of ourpatent applications will result in enforceable patents.  Our patent applications may not be issued aspatents, and any patents that are issued to us may not provide commerciallymeaningful protection against competitors. Any issued patent may not provide us with competitive advantages.  Others may challenge our patents orindependently file patent applications that could result in an interferenceproceeding in the U.S. Patent and Trademark Office.  Others may be able to design around ourissued patents or develop products similar to our products.  In addition, others may discover uses forgenes or proteins other than those uses covered in our patents, and these otheruses may be separately patentable.

 

*Publicdisclosure and patents relating to our proprietary products, processes, anddiagnostic products and tests held by others may limit our proprietary rights.*

 

We are aware of issued patents and patent applications containingsubject matter such that we or our licensees or collaborators may require alicense or rights in order to research, develop or commercialize some of ourproducts, diagnostic tests and technologies. We may find that licenses relating to such subject matter will not beavailable on acceptable terms, or at all.

 

*Patentinfringement or enforcement litigation or interference proceedings could becostly and disrupt our business and may prevent us from commercializing ourproducts and diagnostic tests.*

 

The technology that we use to develop our products, diagnostic testsand key resources, and those that we incorporate into our products, diagnostictests and technologies, may be subject to claims by third parties, includingour collaborators, that they infringe the patents or proprietary rights ofothers.  Technologies of ourcollaborators may also be subject to infringement or similar claims which couldimpair our collaborative product and diagnostic test development andcommercialization efforts.  We also mayneed to enforce our patent rights in actions against others, which could beexpensive.  The risk of such eventsoccurring will tend to increase as the fields of generic drug, vaccine,diagnostic, health care and the biotechnology industry expand, more patents areissued and other companies engage in other generic drug, vaccine, diagnosticsand biotechnology-related businesses.

 

With respect to identifying proteins uniquely associated with diseasestates or as targets for drug therapy, we are aware that companies havepublished patent applications relating to nucleic acids encoding specificproteins.  We are also aware of issuedand pending patent applications covering certain aspects of bioinformatic-baseddiagnostic testing.  The issued patentsby the U.S. Patent and Trademark Office to these companies may limit ourability and the ability of our collaborators to practice under any patents thatmay be issued to us.  Also, even if theU.S. Patent and Trademark office issues us a patent, the scope of coverage orprotection afforded to the patent may be limited.

 

*We may notbe able to protect our know-how and trade secrets.*

 

We generally control the disclosure and use of our know-how and tradesecrets using confidentiality agreements. It is possible, however, that:

 

**•**                  Some or allconfidentiality agreements will not be honored without our knowledge;

**•**                  Thirdparties will independently develop equivalent technology;

**•**                  Disputesmight arise with our consultants, collaborators or others concerning theownership of intellectual property; and/or

**•**                  Unauthorizeddisclosure of our know-how or trade secrets will occur without our knowledge.

 

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###### **Item3.  Quantitative and QualitativeDisclosures About Market Risk**

###### ** **

Information regardingour exposures to market risks is provided in Item 7A of our Annual Report on Form 10-Kfor the year ended December 31, 2004. There have been no material changes to our exposures to market risksince December 31, 2004.

 

###### **Item4.  Controls and Procedures**

###### ** **

(a)          *Disclosure controls and procedures*.  Our Chief Executive Officer and ChiefFinancial Officer, after evaluating the effectiveness of our “disclosurecontrols and procedures” (as defined in the Exchange Act Rules 13a-15(e) and15d-15(e)) as of the end of the period covered by this report on Form 10-Q,have concluded that as of the end of the period covered by this report, ourdisclosure controls and procedures were effective.

 

(b)         *Changes in internal control over financial reporting*.  There were no changes in our internal controlover financial reporting identified in connection with the evaluation requiredby paragraph (d) of Exchange Act Rule 13a-15 that occurred during thesecond fiscal quarter that have materially affected, or are reasonably likelyto materially affect, our internal control over financial reporting.

 

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**PART II– OTHER INFORMATION**

 

###### **Item2.  Unregistered Sales of EquitySecurities and Use of Proceeds**

###### ** **

On April 15,2005, we received $3,000,000 in cash in exchange for a promissory note, orPromissory Note, issued to Kevin J. Ryan, our President and Chief ExecutiveOfficer and a member of our Board of Directors, or CEO.  The Promissory Note bears interest at theprime rate plus two percent per annum initially at 7.75% due monthly starting May 15,2005 with a rate not less than 7.25%. The Promissory Note is due on April 17, 2006.  Borrowings under the loan are secured bycertain intellectual property related to PDI. The Promissory Note may be prepaid by us without penalty at anytime.  The holder of the Promissory Notemay elect to be repaid up to $1,500,000 as a result of any Company financingevent with net proceeds of $4,000,000 or more.

 

Inconnection with the Promissory Note, we issued a common stock purchase warrantthat expires on April 15, 2011.  Theholder of the warrant has the option either to purchase 903,614 shares of theCompany’s common stock at $0.83 per share or common stock of our subsidiary,Predictive Diagnostic, Inc, or PDI.  ThePDI exercise price would be the lowest price per share of the PDI stock in anyPDI financing event of no less than $1,500,000. The number of warrant shares would be determined by dividing $3,000,000by the PDI exercise price.  PDI commonstock issuable pursuant to the warrant would be subject to exchange andunderwriter’s holding period restrictions, or “lock-ups”.  The warrant was issued in reliance on theexemption from registration provided by Section 4(2) of the Act, onthe basis that its issuance did not involve a public offering, no underwritingfees or commissions were paid by us in connection with such sale and CEO is an “accreditedinvestor,” as defined in the Act.

 

On March 3,2005, we issued a convertible promissory note (“Note”) to our CEO, in return for a loan inprincipal amount of $600,000.  The Notewas converted into 631,579 shares of our Common Stock on June 29, 2005 ata conversion price of $.95 per share according to the terms of the Note.  The Note and converted shares were issuedunder Section 4(2) of the Securities Act of 1933 in reliance upon theprovisions of Regulation D promulgated thereunder and was made without generalsolicitation or advertising.  Our CEO is an accredited investor andhas access to all relevant information to evaluate the investment andrepresented to us that the shares were being acquired for investment.

 

On August 5, 2005,the Company entered into a three-year private equity agreement with SouthridgeCapital Management LLC’s advised fund, Brittany Capital Management Limited,which permits the Company to require Brittany Capital to purchase up to$15,000,000 of LSBC common stock.  TheCompany has a right to periodically put common shares to Brittany Capital forwhich it will pay LSBC cash at a seven percent (7%) discount to the then marketprice calculated over a 10 trading day period. Each put transaction must have a minimum purchase price of $25,000 andthe number of shares issuable is limited to a maximum of five hundred percent (500%)of the weighted average volume for the twenty (20) trading days immediatelypreceding the put date, up to 4.99% of all of the Company’s outstanding commonstock on a transaction closing date.  Theagreement commits LSBC to put shares having a minimum aggregate purchase priceof $2,000,000 and a maximum aggregate purchase price of $15,000,000 over theterm of the agreement.  The maximumaggregate number of shares put to Brittany Capital may not exceed 19.99% of theCompany’s currently outstanding common stock, or approximately 6,430,000 shares,unless the Company seeks and obtains stockholder approval in accordance with rules andrequirements of the NASD and the Nasdaq SmallCap Market.  The Company must file a registrationstatement on SEC Form S-1 with respect to the resale of the securities byBrittany Capital, and the registration statement must be effective prior to thefirst put date.  The private equityagreement was issued in reliance on the exemption from registrationprovided by Section 4(2) of the Act, on the basis that its issuance didnot involve a public offering, no underwriting fees or commissions were paid byus in connection with such sale and Brittany Capital Management Limited is an “accreditedinvestor,” as defined in the Act.

 

Inconnection with the secured promissory notes issued on August 5, 2005, theCompany issued common stock purchase warrants that may be exercised commencingon February 5, 2006 and which expire on February 5, 2011. Mr. Ryanand Mr. Erwin, the holders of the warrants, may purchase up to 462,963 and154,321 shares, respectively, of the Company’s common stock at the exerciseprice of $0.81 per share, the closing bid price of the Company’s common stockon August 4, 2005.  The Investorshave the piggyback registration rights for the Company’s stock issued to theInvestors upon exercise of their warrants. The warrants were issued under Section 4(2) of the SecuritiesAct of 1933 in reliance upon the provisions of Regulation D promulgatedthereunder and were made without general solicitation or advertising.  The Investors are accredited investors andhave access to all relevant information to evaluate the investment andrepresented to us that the shares were being acquired for investment.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

We held our AnnualMeeting of Stockholders on June 24, 2005. Set forth below is a summary of each matter voted upon at the meetingand the number of votes cast for, against, withheld or abstained.

 

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*Proposal1*:  The election ofRobert L. Erwin, Ulrich M. Grau, Ph.D., Bernard I. Grosser, M.D., Sol Levineand Kevin J. Ryan as directors of the Company, to serve until the 2006 AnnualMeeting of Stockholders or until their successors are duly elected andqualified.

 
| **Nominee**              | ** ** | **Total Votes For all Nominees** | ** ** | **Total Votes Withheld From All  Nominees** | ** ** |
|--------------------------|------------|----------------------------------|------------|---------------------------------------------|------------|
| Robert L. Erwin          |       | 23,404,862                       |       | 375,524                                     |       |
| Ulrich M. Grau, Ph.D.    |       | 23,661,949                       |       | 118,437                                     |       |
| Bernard I. Grosser, M.D. |       | 23,549,639                       |       | 230,747                                     |       |
| Sol Levine               |       | 23,488,561                       |       | 291,825                                     |       |
| Kevin J. Ryan            |       | 23,414,573                       |       | 365,813                                     |       |

 

*Proposal2*:  Ratification ofMacias Gini & Company LLP as the Company’s independent registeredpublic accounting firm for the year ending December 31, 2005.

 
| **Total Votes For** | ** ** | **Total Votes Against** | ** ** | **Abstained** | ** ** |
|---------------------|------------|-------------------------|------------|---------------|------------|
| 23,659,465          |       | 96,976                  |       | 23,945        |       |

 

###### **Item 6.  Exhibits**

###### ** **

*List ofExhibits:*

 
| **Exhibit** | ** ** | **Exhibit**                                                                                                                                                                      | ** ** | **Incorporated by Reference** | ** ** | **Filed** |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|-----------|
| **Number**  | ** ** | **Description**                                                                                                                                                                  | ** ** | **Form**                      | ** ** | **Date**  | ** ** | **Number** | ** ** | **Herewith** |
| 4.1         |       | Warrant to  Purchase Common Stock, dated as of April 15, 2005, issued by Large Scale  Biology Corporation and Predictive Diagnostics, Inc. in favor of Kevin  J. Ryan. |       | 8-K                           |       | 04/21/05  |   | 4.1 |   |   |
| 4.2         |       | Amended and  Restated Rights Agreement dated June 29, 2005 between the Registrant and  American Stock Transfer and Trust Company                                            |       | 8-K                           |       | 07/6/05   |   | 4.1 |   |   |
| 10.1        |       | Note and Warrant  Purchase Agreement, dated as of April 15, 2005, executed by Large Scale  Biology Corporation, Predictive Diagnostics, Inc. and Kevin J. Ryan.        |       | 8-K                           |       | 04/21/05  |   | 10.1 |   |   |
| 10.2        |       | Secured  Promissory Note, dated as of April 15, 2005, issued by Large Scale  Biology Corporation in favor of Kevin J. Ryan.                                                 |       | 8-K                           |       | 04/21/05  |   | 10.2 |   |   |
| 10.3        |       | Security  Agreement, dated as of April 15, 2005, executed by Large Scale Biology  Corporation in favor of Kevin J. Ryan.                                                    |       | 8-K                           |       | 04/21/05  |   | 10.3 |   |   |
| 10.4        |       | Patent Security  Agreement, dated as of April 15, 2005, executed by Large Scale Biology  Corporation in favor of Kevin J. Ryan.                                             |       | 8-K                           |       | 04/21/05  |   | 10.4 |   |   |
| 31.1        |       | Certification of  the Principal Executive Officer pursuant to Rule 13a-14(a)/15d-14(a), as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.         |       |                          |       |      |   |   |   | X |
| 31.2        |       | Certification of  the Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a), as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.         |       |                          |       |      |   |   |   | X |
| 32.1        |       | Certification of  the Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.           |       |                          |       |      |   |   |   | X |
| 32.2        |       | Certification of  the Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.           |       |                          |       |      |   |   |   | X |

** **

**22**

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** **

**SIGNATURE**

** **

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

** **
| ** **                                  | **Large Scale Biology Corporation** |
|---------------------------------------------|-------------------------------------|
| ** **                                  | ** **                          |
| **Date:   August 15,  2005** | **By:**                             | **/s/ Ronald J. Artale** | ** ** |
| ** **                                  | ** **                          | **Ronald J. Artale** |
| ** **                                  | ** **                          | **Senior Vice President, Chief Operating Officer** |
| ** **                                  | ** **                          | **and Chief Financial Officer** |
| ** **                                  | ** **                          | **(Principal Financial Officer)** |

** **

**23**

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** **

**Exhibit Index**

** **
| **Exhibit  Number** | ** ** | **Exhibit Title or  Description**                                                                                                                                   |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                |       | Certification of  the Principal Executive Officer pursuant to Rule 13a-14(a)/15d-14(a), as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 31.2                |       | Certification of  the Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a), as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 32.1                |       | Certification of  the Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.   |
| 32.2                |       | Certification of  the Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.   |

 

24

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