# ** **

# **UNITED STATES**

# **SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, DC 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 March 31, 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 No. 000-30981**

 

**GENAISSANCE PHARMACEUTICALS, INC.**

(Exact Name of Registrant as Specified in its Charter)

 
| **Delaware**                                                     | ** ** | **06-1338846**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**Five Science Park, New Haven, Connecticut  06511**

(Address of principal executive office and zip code)

 

**(203) 773-1450**

(Registrant’s telephone number, including area code)

 

Indicateby check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days:

Yes ý                                     Noo

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inrule 12b-2 of the Exchange Act):

Yes ý                                     Noo

 

Thenumber of shares of the registrant’s outstanding common stock as of May 2,2005, was 35,348,497 shares.

 

 

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

For the Quarter Ended March 31,2005

 

**Index**

 
| **PART I – FINANCIAL  INFORMATION**                                                                   |   |
|------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                       |   |
| Item 1 – Financial Statements  (unaudited)                                                            |   |
|                                                                                                       |   |
| Condensed  Consolidated Balance Sheets as of March 31, 2005 and December 31,  2004               |   |
|                                                                                                       |   |
| Condensed  Consolidated Statements of Operations for the Three Months Ended  March 31, 2005 and 2004  |   |
|                                                                                                       |   |
| Condensed  Consolidated Statements of Cash Flows for the Three Months Ended  March 31, 2005 and 2004  |   |
|                                                                                                       |   |
| Notes to Unaudited  Condensed Consolidated Financial Statements                                            |   |
|                                                                                                       |   |
| Item  2 – Management’s Discussion and Analysis of Financial Condition and Results  of Operations |   |
|                                                                                                       |   |
| Item 3 –  Quantitative and Qualitative Disclosures About Market Risk                                  |   |
|                                                                                                       |   |
| Item 4 –  Controls and Procedures                                                                     |   |
|                                                                                                       |   |
| **PART II – OTHER INFORMATION**                                                                       |   |
|                                                                                                       |   |
| Item 2 –  Unregistered Sales of Equity Securities and Use of Proceeds                                 |   |
|                                                                                                       |   |
| Item 6 –  Exhibits                                                                                    |   |
|                                                                                                       |   |
| Signature                                                                                                  |   |

 

 

*The Genaissance name and logo, the Lark name and logo, and DecoGen**â**, HAP**â**,HAPTM and FAMILIONTM are either registeredtrademarks or trademarks of Genaissance Pharmaceuticals, Inc. in the UnitedStates and/or other countries.  All othertrademarks, servicemarks or trade names referred to in this Quarterly Report onForm 10-Q are the property of their respective owners.*

 

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**PARTI – Financial Information**

**Item 1 –Financial Statements****(unaudited).**

 

**GENAISSANCE PHARMACEUTICALS, INC.**

 

Condensed ConsolidatedBalance Sheets

(Unaudited)

 (In thousands, except per sharedata)

 
| ** **                                                                                                                                                                                                                               | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                               | ** ** | **2005**           | ** ** | **2004**              | ** ** |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| **ASSETS**                                                                                                                                                                                                                               | ** ** | ** **         | ** ** | ** **            | ** ** |
| CURRENT ASSETS:                                                                                                                                                                                                                          |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                |       | $                  | 5,880      |                  | $          | 9,174 |   |
| Restricted cash                                                                                                                                                                                                                          |       | 224                |       | 213                   |       |
| Accounts receivable and unbilled revenue, net                                                                                                                                                                                            |       | 4,256              |       | 4,251                 |       |
| Taxes receivable                                                                                                                                                                                                                         |       | 685                |       | 652                   |       |
| Inventory                                                                                                                                                                                                                                |       | 661                |       | 606                   |       |
| Other current assets                                                                                                                                                                                                                     |       | 935                |       | 1,020                 |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| Total current assets                                                                                                                                                                                                                     |       | 12,641             |       | 15,916                |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| PROPERTY AND EQUIPMENT, net                                                                                                                                                                                                              |       | 8,601              |       | 9,182                 |       |
| DEFERRED FINANCING COSTS, net                                                                                                                                                                                                            |       | 211                |       | 216                   |       |
| INVESTMENT IN AFFILIATE                                                                                                                                                                                                                  |       | 1,186              |       | 1,186                 |       |
| GOODWILL                                                                                                                                                                                                                                 |       | 12,286             |       | 12,286                |       |
| OTHER INTANGIBLES, net                                                                                                                                                                                                                   |       | 11,003             |       | 11,153                |       |
| OTHER ASSETS                                                                                                                                                                                                                             |       | 95                 |       | 99                    |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| Total assets                                                                                                                                                                                                                             |       | $                  | 46,023     |                  | $          | 50,038 |   |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| **LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED  STOCK, AND STOCKHOLDERS’ EQUITY**                                                                                                                                                  | ** ** | ** **         | ** ** | ** **            | ** ** |
| CURRENT LIABILITIES:                                                                                                                                                                                                                     |       |               |       |                  |       |
| Current portion of long-term debt                                                                                                                                                                                                        |       | $                  | 845        |                  | $          | 3,648 |   |
| Accounts payable                                                                                                                                                                                                                         |       | 1,722              |       | 1,472                 |       |
| Accrued expenses                                                                                                                                                                                                                         |       | 2,264              |       | 2,929                 |       |
| Accrued dividends                                                                                                                                                                                                                        |       | 1,207              |       | 1,260                 |       |
| Current portion of deferred revenue                                                                                                                                                                                                      |       | 1,356              |       | 1,789                 |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| Total current liabilities                                                                                                                                                                                                                |       | 7,394              |       | 11,098                |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| LONG-TERM LIABILITIES:                                                                                                                                                                                                                   |       |               |       |                  |       |
| Long-term debt, net of current portion                                                                                                                                                                                                   |       | 6,050              |       | 3,692                 |       |
| Deferred revenue, net of current portion                                                                                                                                                                                                 |       | 2,613              |       | 2,791                 |       |
| Deferred tax liabilities                                                                                                                                                                                                                 |       | 1,327              |       | 1,327                 |       |
| Other long-term liabilities                                                                                                                                                                                                              |       | 2,618              |       | 2,330                 |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| Total long-term liabilities                                                                                                                                                                                                              |       | 12,608             |       | 10,140                |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| COMMITMENTS AND CONTINGENCIES (Note 16)                                                                                                                                                                                                  |       |               |       |                  |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| SERIES A REDEEMABLE CONVERTIBLE PREFERRED STOCK:                                                                                                                                                                                         |       |               |       |                  |       |
| 460 authorized shares at March 31, 2005 and December 31,  2004; $.001 par value; 460 shares Issued and outstanding at March 31,  2005 and December 31, 2004 (liquidation preference $10,350 at March 31,  2005) |       | 9,783              |       | 9,698                 |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                                                               |       |               |       |                  |       |
| Preferred stock, 540 authorized shares at March 31,  2005 and December 31, 2004; no shares issued or outstanding except for  series A included above                                                                           |       | —             |       | —                |       |
| Common stock, 58,000 authorized shares at March 31,  2005 and December 31, 2004; $.001 par value; 35,343 and 34,708 shares  issued and outstanding at March 31, 2005 and December 31, 2004,  respectively            |       | 35                 |       | 35                    |       |
| Additional paid-in capital                                                                                                                                                                                                               |       | 253,992            |       | 252,945               |       |
| Accumulated deficit                                                                                                                                                                                                                      |       | (236,651           | )          | (233,522              | )          |
| Deferred compensation                                                                                                                                                                                                                    |       | (1,119             | )          | (374                  | )          |
| Accumulated other comprehensive income (loss)                                                                                                                                                                                            |       | (19                | )          | 18                    |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| Total stockholders’ equity                                                                                                                                                                                                          |       | 16,238             |       | 19,102                |       |
|                                                                                                                                                                                                                                     |       |               |       |                  |       |
| Total liabilities, redeemable convertible preferred  stock, and stockholders’ equity                                                                                                                                                |       | $                  | 46,023     |                  | $          | 50,038 |   |

 

*Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.*

 

1

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Condensed Consolidated Statements of Operations

(Unaudited)

(In thousands, except per share data)

 
| ** **                                                           | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                           | ** ** | **March 31,**     | ** ** |
| ** **                                                           | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                                                 |       |                   |       |   |   |
| **REVENUES:**                                                        |       |                   |       |   |   |
| License and research                                                 |       | $                      | 2,853      |   | $ | 2,868 |   |
| Laboratory services                                                  |       | 2,735                  |       | 860 |   |
|                                                                 |       |                   |       |   |   |
| Total revenue                                                        |       | 5,588                  |       | 3,728 |   |
|                                                                 |       |                   |       |   |   |
| **OPERATING EXPENSES:**                                              |       |                   |       |   |   |
| Cost of laboratory services                                          |       | 2,027                  |       | 861 |   |
| Research and development                                             |       | 3,301                  |       | 5,012 |   |
| Selling, general and administrative                                  |       | 3,240                  |       | 2,358 |   |
|                                                                 |       |                   |       |   |   |
| Total operating expenses                                             |       | 8,568                  |       | 8,231 |   |
|                                                                 |       |                   |       |   |   |
| Loss from operations                                                 |       | (2,980                 | )          | (4,503 | ) |
|                                                                 |       |                   |       |   |   |
| **OTHER INCOME (EXPENSE):**                                          |       |                   |       |   |   |
| Other income                                                         |       | 34                     |       | 75 |   |
| Interest expense                                                     |       | (157                   | )          | (180 | ) |
|                                                                 |       |                   |       |   |   |
| Loss before income taxes and equity in loss of  affiliate            |       | (3,103                 | )          | (4,608 | ) |
|                                                                 |       |                   |       |   |   |
| Income tax (expense) benefit                                         |       | (26                    | )          | 49 |   |
|                                                                 |       |                   |       |   |   |
| Loss before equity in loss of affiliate                              |       | (3,129                 | )          | (4,559 | ) |
|                                                                 |       |                   |       |   |   |
| Equity in loss of affiliate                                          |       | —                 |       | (150 | ) |
|                                                                 |       |                   |       |   |   |
| Net loss                                                             |       | (3,129                 | )          | (4,709 | ) |
|                                                                 |       |                   |       |   |   |
| **PREFERRED STOCK DIVIDENDS AND ACCRETION**                          |       | (136                   | )          | (110 | ) |
| **BENEFICIAL CONVERSION FEATURE OF PREFERRED STOCK  AND WARRANT**    |       | —                 |       | (6 | ) |
|                                                                 |       |                   |       |   |   |
| Net loss applicable to common stockholders                           |       | $                      | (3,265     | ) | $ | (4,825 | ) |
|                                                                 |       |                   |       |   |   |
| Net loss per common share, basic and diluted                         |       | $                      | (0.09      | ) | $ | (0.21 | ) |
|                                                                 |       |                   |       |   |   |
| Weighted average shares used  in computing net loss per common share |       | 34,629                 |       | 23,194 |   |

 

*The accompanying notes are an integral part ofthese condensed consolidated financial statements.*

 

2

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Condensed Consolidated Statements of CashFlows

(Unaudited)

(In thousands)

 
| ** **                                                                  | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                  | ** ** | **March 31,**     | ** ** |
| ** **                                                                  | ** ** | **2005**               | ** ** | **2004** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                  | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net loss                                                                    |       | $                      | (3,129     | ) | $ | (4,709 | ) |
| Adjustment to reconcile net  loss to net cash used in operating activities: |       |                   |       |   |   |
| Depreciation and amortization                                               |       | 903                    |       | 1,552 |   |
| Stock-based compensation                                                    |       | 396                    |       | 87 |   |
| Non-cash service and license  expense paid with stock                       |       | —                 |       | 31 |   |
| Equity in loss of affiliate                                                 |       | —                 |       | 150 |   |
| Changes in assets and  liabilities:                                         |       |                   |       |   |   |
| Accounts receivable                                                         |       | (5                     | )          | 248 |   |
| Taxes receivable                                                            |       | (33                    | )          | (55 | ) |
| Inventory and other current  assets                                         |       | (20                    | )          | (325 | ) |
| Other assets                                                                |       | —                 |       | (727 | ) |
| Accounts payable                                                            |       | 250                    |       | 464 |   |
| Accrued expenses                                                            |       | (660                   | )          | (1,403 | ) |
| Deferred revenue                                                            |       | (611                   | )          | 268 |   |
| Other long-term liabilities                                                 |       | 288                    |       | — |   |
| Net cash used in operating  activities                                      |       | (2,621                 | )          | (4,419 | ) |
|                                                                        |       |                   |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                  |       |                   |       |   |   |
| Purchases of property and  equipment                                        |       | (98                    | )          | (410 | ) |
| Investment in affiliate                                                     |       | —                 |       | (38 | ) |
| Increase in restricted cash                                                 |       | (11                    | )          | — |   |
| Proceeds from sales of  marketable securities                               |       | —                 |       | 2,650 |   |
| Net cash (used in) provided by  investing activities                        |       | (109                   | )          | 2,202 |   |
|                                                                        |       |                   |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                  | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net proceeds from issuance of  common stock                                 |       | 42                     |       | 15 |   |
| Repayment of long-term debt                                                 |       | (445                   | )          | (506 | ) |
| Financing costs                                                             |       | (20                    | )          | — |   |
| Preferred stock dividends paid                                              |       | (104                   | )          | (23 | ) |
| Net cash used in financing  activities                                      |       | (527                   | )          | (514 | ) |
|                                                                        |       |                   |       |   |   |
| Effect of exchange rate  changes on cash                                    |       | (37                    | )          | — |   |
|                                                                        |       |                   |       |   |   |
| NET DECREASE IN CASH AND CASH  EQUIVALENTS                                  |       | (3,294                 | )          | (2,731 | ) |
|                                                                        |       |                   |       |   |   |
| CASH AND CASH EQUIVALENTS,  beginning of period                             |       | 9,174                  |       | 8,033 |   |
|                                                                        |       |                   |       |   |   |
| CASH AND CASH EQUIVALENTS, end  of period                                   |       | $                      | 5,880      |   | $ | 5,302 |   |
|                                                                        |       |                   |       |   |   |
| **SUPPLEMENTAL DISCLOSURE AND  NON-CASH ACTIVITIES:**                       | ** ** | ** **             | ** ** | ** ** | ** ** |
| Interest paid                                                               |       | $                      | 109        |   | $ | 172 |   |
| Income taxes paid                                                           |       | $                      | —     |   | $ | 6 |   |
| Issuance of restricted shares, net of forfeitures                           |       | $                      | 1,118      |   | $ | — |   |
| Issuance of common stock for services and licenses                          |       | $                      | —     |   | $ | 31 |   |

 

*Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.*

 

3

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**GENAISSANCE PHARMACEUTICALS, INC**.

 

# **Notes to**Unaudited Condensed Consolidated Financial Statements

For the Quarter Ended March 31, 2005

(Amounts in thousands, except per share data)

 

**(1)****                     BASISOF PRESENTATION**

 

Genaissance Pharmaceuticals, Inc., together with itssubsidiary, Lark Technologies, Inc. (Genaissance or the Company), developsinnovative products based on its proprietary pharmacogenomic technology and hasa revenue-generating business in DNA and pharmacogenomic products andservices.  The Company also markets its proprietary *FAMILION* Test, a genetic test for cardiacchannelopathies that is compliant with the Clinical Laboratory ImprovementAmendments, or CLIA.  The *FAMILION* Test is designed to detectmutations responsible for causing familial Long QT (LQT) and Brugada Syndromes,two causes of sudden cardiac death.  The Company’s product developmentstrategy is focused on drug candidates with promising clinical profiles andfinding genetic markers to identify a responsive patient population.  Thisstrategy is designed to enable the Company to leverage existing clinical dataand, thus, reduce the costs and risks associated with traditional drugdevelopment and increase the probability of clinical success andcommercialization.  The Company’s lead therapeutic product, vilazodone fordepression, is in Phase II of development.

 

The accompanying condensed consolidated financialstatements of the Company were prepared without audit, pursuant to the rulesand regulations of the Securities and Exchange Commission (SEC).  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to such rules and regulations. Thesefinancial statements should be read in conjunction with the Company’s auditedfinancial statements and related footnotes for the year ended December 31,2004, included in its Annual Report on Form 10-K (File No. 000-30981).  The unaudited condensed consolidatedfinancial statements include, in the opinion of management, all adjustments,including the elimination of all significant intercompany transactions, whichare necessary to present fairly the Company’s consolidated financial positionas of March 31, 2005, and the results of its operations for the threemonths ended March 31, 2005 and 2004, respectively. The results ofoperations for such interim periods are not necessarily indicative of theresults to be achieved for the full year.

 

The Company believes that its current cash balance andthe funds generated from operations will be sufficient to cover anticipatedcash needs through at least the next 12 months, except with respect to fundsrequired for the clinical development of vilazodone.  The Company’s current business plan reflectscontinued initiatives to increase revenue, reduce cost of laboratory servicesas a percentage of revenue, reduce research and development expenses andcontrol selling, general and administrative costs.  If the Company is unable to achieve revenueand cost targets within a reasonable range of its operating plan, the Companywill need to raise additional funds through the public or private sale of itsequity or debt securities or from other sources, in order to satisfy itsprojected cash needs. Further, the Company is also reviewing variousalternatives to finance its ongoing operations and meet its obligations,including potentially reorganizing the Company, disposing of some of itsassets, exploring strategic alternatives, such as a potential sale of theCompany, developing strategic alliances and/or joint developmentarrangements.  There is no assurance thatthe Company will be able to obtain sufficient financing on acceptable terms, ifat all.

 

The Companyoperates in an environment of rapid change in technology and has substantialcompetition from companies developing genomic related technologies.  In addition to the normal risks associated witha business venture, there can be no assurance that the Company’s technologieswill be successfully used, that the Company will obtain adequate patentprotection for its technologies and that any of its products will becommercially viable.  The Company hasincurred substantial losses to date and expects to incur substantialexpenditures in the foreseeable future to fund its research and development andcommercialization of its products.

 

4

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**(2)****                     ORGANIZATION,OPERATIONS AND RECENT DEVELOPMENTS**

 

In April 2005,the Company entered into a Note and Warrant Purchase Agreement with XmarkOpportunity Fund, Ltd., Xmark Opportunity Fund, L.P. and Xmark JV InvestmentPartners, LLC (collectively Xmark), pursuant to which, among other things, theCompany issued Notes (collectively Note) to Xmark in the aggregate principalamount of $4,500.  The Note is secured bysubstantially all of the Company’s assets, excluding, among other assets, theCompany’s intellectual property.  Inaddition, the Company issued Xmark warrants to purchase an aggregate of 2,000shares of the Company's common stock at an exercise price of $2.25 per share.  Concurrent with signing the Note, the Companyterminated its Loan and Security Agreement with Comerica Bank N.A. (Comerica)and repaid all outstanding principal and interest due to Comerica.  The Note is payable on April 21,2007.  As a result of these transactions,the Company has classified the Comerica debt as long-term in the accompanyingcondensed consolidated balance sheet as of March 31, 2005.  See Note 17 for further discussion of theNote.

 

In November 2004, the Company reduced itsworkforce by approximately 10% to align better its operating structure with itscurrent and projected revenues and reduced expenses in certain otherareas.  The Company took a charge ofapproximately $400 in the fourth quarter of 2004, primarily relating toseverance obligations in connection with this workforce reduction.

 

In September 2004,the Company entered into a license, development and cooperation agreement withMerck KgaA (Merck) pursuant to which the Company acquired an exclusiveworldwide license from Merck to develop and commercialize vilazodone, a smallmolecule compound.  In consideration forthe rights relating to vilazodone, the Company agreed to pay an initial licensefee in shares of the Company’s common stock and milestone payments upon theachievement of specified development, regulatory and sales milestones. Under the terms of the agreement, the Company can pay the initial license feeand milestone payments, until the first commercial sale of vilazodone, throughthe issuance of its common stock.  TheCompany issued 369 shares of its common stock to Merck in payment of theinitial license fee.  Under the terms ofthe agreement, if Merck and its affiliates’ aggregate ownership of the Company’scommon stock would exceed 19.9% of the number of shares of its common stockthen outstanding, or if the average closing price of the Company’s common stockat the time of the respective payment date is below $2.25 per share, theCompany is required to make milestone payments to Merck in cash.  Inaddition, the agreement requires that the Company demonstrate its ability tofund the initial research and development activities by July 22, 2005 orMerck may terminate the agreement and reacquire rights to vilazodone.  Pursuant to the terms of the agreement, Merckis entitled to royalties on all future product sales and a share of allsub-licensing income from any third party. The Company is reviewing its alternatives in connection with obtainingthe financing required to conduct initial research and development relatedactivities under the Merck agreement.

 

In April 2004,the Company acquired Lark Technologies, Inc. (Lark) in a stock-for-stock mergersuch that Lark became a wholly-owned subsidiary of the Company.  Lark provides Good Laboratory Practices (GLP)compliant and research sequencing and related molecular biology services to thepharmaceutical, biotechnology and agbio industries at its facilities inHouston, Texas and the United Kingdom. Lark’s service portfolio consists of over 100 different molecularbiology services in the areas of nucleic acid extraction, DNA sequencing,genetic stability testing, gene expression and detection as well as othercustom services.  See Note 3 for furtherdiscussion of the Lark acquisition.

 

**(3)**                     **ACQUISITION OF LARK TECHNOLOGIES**

 

On April 1, 2004, Genaissance acquired Lark in astock-for-stock merger accounted for as a purchase transaction.  The total cost of the acquisition wasapproximately $24,486.  The purchaseprice was allocated to the tangible and identifiable intangible assets of Larkacquired by Genaissance and the liabilities assumed by Genaissance on the basisof their fair values on the acquisition date.

 

The results of operations of Lark are included in theCompany’s condensed consolidated statements of operations since the date ofacquisition.  Supplemental pro formadisclosure of results of operations for the three months ended March 31,2004 as though the merger had been completed as of January 1, 2004, are asfollows:

 
| Revenue                                      |   | $      | 5,589 |   |
|----------------------------------------------|--------|--------|-------|--------|
| Operating loss                               |   | (5,349 | )     |
| Net loss attributable to common stockholders |   | (5,697 | )     |
| Earnings per share                           |   | $      | (0.22 | )      |

 

5

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Thefinancial statements of the Company’s U.K. facility are measured using thelocal currency as the functional currency. Assets and liabilities of the U.K. facility are translated at the ratesof exchange at the balance sheet date. The resulting translation adjustments are recorded in a separatecomponent of stockholders’ equity included in other comprehensive income (loss)(see Note 14).  Income and expense itemsare translated at average monthly rates of exchange.

 

Laboratoryservices revenue for the U.K. facility totaled approximately $485 for the threemonths ended March 31, 2005.

 

**(4)****                     EARNINGSPER SHARE**

 

The Company computes and presents net loss per sharein accordance with Statement of Financial Accounting Standards (SFAS) No. 128, *Earnings Per Share*. There is no difference in basic and diluted net loss per common share asthe effect of the convertible preferred stock, stock options and warrants wouldbe anti-dilutive for all periods presented. The outstanding convertible preferred stock, stock options and warrants(prior to application of the treasury stock method) would entitle holders toacquire 14,565 and 9,320 shares of common stock at March 31, 2005 and2004, respectively.

 

**(5)****                     DEFERREDCOMPENSATION**

 

In January 2005, the Company issued 527 shares ofrestricted stock to certain of its employees under its 2000 Amended andRestated Equity Incentive Plan.  Theshares of restricted stock vest fully in February 2006.  The Company recorded deferred compensation basedon the fair market value of the stock on the date of grant and is recognizingthe expense, net of cancellations, ratably over the period from the date ofgrant to the vesting date.

 

**(6)****                    ****REVENUE RECOGNITION**

 

The Company earns its revenues primarily through the licensing of its *HAP* Technology and by providing molecularbiology services.  The Company recognizesrevenue associated with molecular biology services, which are included inlaboratory service revenue in the accompanying condensed consolidated statementsof operations, in accordance with Staff Accounting Bulletin (SAB) No. 104, *Revenue Recognition* (which supercedes SABNo. 101, *Revenue Recognition in FinancialStatements*) as the services are performed provided that persuasiveevidence of an arrangement exists, the price is fixed and determinable andcollectibility is reasonably assured.

 

In accordance with SAB No. 104 and Emerging Issues Task Force Issue00-21, the Company generally recognizes license fees over the term of theagreement and research fees as the research is performed.  For agreements with multiple deliverables,revenue is not recognized unless the fair value of the undelivered elements canbe determined and the elements delivered have stand-alone value to thecustomer.  Future milestones androyalties received under these agreements, if any, will be recognized, providedthat the milestone is substantive and a culmination of the earnings process hasoccurred.

 

Deferred revenueresults when consideration is received or amounts are receivable in advance ofrevenue recognition.  Deferred revenuerelated to license agreements is generally recognized over the licenseperiod.  For license agreements, whichcontain early termination provisions, the Company recognizes revenue upon theexpiration of the termination provision for the period from the originallicense date to the date the early termination provisions expire.

 

6

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**(7)****                    ****RECENTLY ISSUEDACCOUNTING STANDARDS**

 

In December 2004, the FASB issued SFAS No. 123 (Revised 2004),Share-Based Payment.  The new rulerequires that the compensation cost relating to share-based paymenttransactions be recognized in financial statements based on the fair value ofthe equity or liability instruments issued. In April 2005, the SEC announced a deferral of the effective dateof SFAS No. 123(R) to be the first annual reporting period starting after December 15,2005.  The Company routinely usesshare-based payment arrangements as compensation for its employees.  The Company is in the process of evaluatingthe impact the adoption of SFAS No. 123(R) but believes it will have a materialimpact on its condensed consolidated financial statements.  See Note 9 for the effect on net income forthe three months ended March 31, 2005 and 2004.

 

**(8)****                     GOODWILLAND INTANGIBLE ASSETS**

 

Goodwill andidentifiable intangible assets recorded in the condensed consolidated balancesheet of the Company are comprised of the following as of March 31, 2005:

 
| ** **                       | ** ** | **Gross**  | ** ** | **Accumulated**  | ** ** |
|----------------------------------|------------|------------|------------|------------------|------------|
| ** **                       | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Amortizable intangible assets:   |       |       |       |             |       |
| Patents acquired                 |       | $          | 868        |             | $          | (222 | ) |
| Lark customer relationships      |       | 7,200      |       | (480             | )          |
|                             |       |       |       |             |       |
| Unamortizable intangible assets: |       |       |       |             |       |
| Lark trade name                  |       | 3,500      |       | —           |       |
| Lark GLP certification           |       | 137        |       | —           |       |
| Lark goodwill                    |       | 12,286     |       | —           |       |
|                             |       |       |       |             |       |
| Total                            |       | $          | 23,991     |             | $          | (702 | ) |

 

Amortization expense wasapproximately $151 and $30 for the three months ended March 31, 2005 and2004, respectively.

 

The expected amortizationexpense for the current and each of the next four years is as follows:

 

| Fiscal 2005 |   | $   | 599    |   |
|-------------|--------|-----|--------|--------|
| Fiscal 2006 |   | 599 |   |
| Fiscal 2007 |   | 599 |   |
| Fiscal 2008 |   | 559 |   |
| Fiscal 2009 |   | 535 |   |

 

**(9)****                     ACCOUNTING FOR STOCK-BASED COMPENSATION**

 

At March 31,2005, the Company had one stock-based compensation plan, which is accounted forunder the recognition and measurement principles of Accounting Principles BoardOpinion No. 25, *Accounting for Stock Issuedto Employees,* and related interpretations.

 

Thefollowing table illustrates the effect on net income and earnings per share, ifthe Company had applied the fair value recognition provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*,to stock-based employee compensation for the three months ended March 31,2005 and 2004, respectively:

 

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| ** **                                                                                                       | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                       | ** ** | **March 31,**     | ** ** |
| ** **                                                                                                       | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                                                                                             |       |                   |       |   |   |
| Net loss applicable to common shareholders, as  reported                                                         |       | $                      | (3,265     | ) | $ | (4,825 | ) |
| Add: Stock-based employee compensation expense  included in reported net loss                                    |       | 23                     |       | 39 |   |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards |       | (535                   | )          | (449 | ) |
| Pro forma net loss applicable to common shareholders                                                             |       | $                      | (3,777     | ) | $ | (5,235 | ) |
|                                                                                                             |       |                   |       |   |   |
| Net loss per share:                                                                                              |       |                   |       |   |   |
| Basic and diluted - as reported                                                                                  |       | $                      | (0.09      | ) | $ | (0.21 | ) |
|                                                                                                             |       |                   |       |   |   |
| Basic and diluted - pro forma                                                                                    |       | $                      | (0.11      | ) | $ | (0.23 | ) |

 

**(10)**              **SIGNIFICANT CUSTOMERS**

 

For the three months ended March 31, 2005,revenue from Pfizer, Inc. (Pfizer) accounted for 20% of the Company’s totalrevenue.  For the three months ended March 31,2004, revenue from Pfizer, Johnson & Johnson Pharmaceutical Research andDevelopment (J&J PRD) and Millennium Pharmaceuticals, Inc. accounted for38%, 16% and 10% of the Company’s total revenue.  The collaboration agreement with J&J PRDexpired in the first quarter of 2004, which accounted for approximately $600 ofrevenue recognized during the three months ended March 31, 2004.

 

**(11)****             ****INVESTMENT IN AFFILIATE**

 

In November 2003, the Company entered intoseveral agreements with Sciona Inc. (Sciona, formerly known as Sciona Limited),whereby the Company granted a technology license to Sciona (Technology License)in exchange for a 37% equity interest (30% on a fully diluted basis) in Sciona(Investment).  In September 2004, Scionaclosed an equity financing, which diluted the Company’s holdings to 13% (11% ona fully diluted basis).  As a result, theCompany changed its method of accounting for the investment from the equitymethod to the cost method, and the Company no longer records its percentageinterest in the results of operations of Sciona.  In February 2005, Sciona closed anadditional equity financing, which further diluted the Company’s holdings to 9%(7% on a fully diluted basis).  TheTechnology License grants Sciona an exclusive license to the Company’s *HAP* Technology for consumer tests, asdefined in the Technology License, for a period of five years.  Sciona is obligated to pay to the Companyspecified royalties and service fees, subject to minimum payments.  The Company was also granted specified rightsto develop genotyping assays and perform genetic tests.

 

Deferred revenue resulting from the Technology Licenseand the accompanying investment were recorded based upon the approximate $2,600estimated fair value of the equity in Sciona as of the date of the TechnologyLicense.  The excess of the Investment,over the underlying fair value of the net assets of Sciona, is considered to beunamortizable goodwill.  Deferred revenueis being amortized into income over the term of the Technology License.  The accompanying condensed consolidatedstatements of operations include approximately $127 of license and researchrevenue recognized from the amortization of deferred revenue during the threemonths ended March 31, 2005.  Therevenue recognized represents the ratable portion of the Technology License feefor the three months ended March 31, 2005, as a result of Sciona meetingthe Sciona Milestones.  Also, included inthe accompanying condensed consolidated statements of operations, for the threemonths ended March 31, 2005 and 2004, are approximately $375 and $47,respectively, of license and research revenues related to Sciona.

 

**(12)****             ****LONG-TERM DEBT**

 

The Company entered into financing agreements(the Agreements) with Connecticut Innovations, Inc., a stockholder of theCompany, to finance certain leasehold improvements and other costs associatedwith the Company’s facility expansion in New Haven.  The Agreements provide for payments ofprincipal and interest based on a 120-month amortization, with final balloonpayments due in March 2009 through June 2011.  Borrowings under the Agreements arecollateralized by the related leasehold improvements.  Management believes that the Company is incompliance with all covenants under the Agreements as of March 31, 2005and the Agreements do not contain any cross default provisions.

 

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In September 2003,the Company entered into a $5,000 Loan and Security Agreement with Comerica,which was subsequently terminated with all outstanding principal and interestbeing repaid in April 2005 (See Note 17).  Under the terms of theagreement, the Company was required to satisfy certain financial covenants,including a minimum cash balance and a minimum quick ratio, as defined. Due to the uncertainty surrounding future debt covenant compliance at December 31,2004, the Company classified the Comerica debt as current in the accompanyingcondensed consolidated balance sheet as of December 31, 2004.

 

On April 21,2005, the Company entered into a Note and Warrant Purchase Agreement withXmark, pursuant to which, among other things, the Company issued the Note toXmark in the aggregate principal amount of $4,500. The Note, which is payableon April 21, 2007, bears interest at 5% and is secured by substantiallyall of the Company’s assets, excluding, among other assets, the Company’sintellectual property.  Under the termsof the Note, the Company is required to prepay the Note upon the occurrence ofcertain events including the sale of the Company’s assets, as defined.  In addition, the Company issued Xmark warrantsto purchase an aggregate of 2,000 shares of the Company’s common stock at anexercise price of $2.25 per share.  Theprice per share is subject to adjustment in certain circumstances whilethere is a balance outstanding under the Note on or after September 18,2005 and the Company issues specified securities for less than $2.25per share.  The warrants also provide foran adjustment to the exercise price and number and type of securitiespurchasable upon exercise of the warrant in certain circumstances, including****,****withoutlimitation, a split-up or combination of shares or a consolidation or mergerwhere the Company is not the surviving entity. Concurrent with signing the Note, the Company terminated its Loan andSecurity Agreement with Comerica and repaid all outstanding principal andinterest due to Comerica.  As a result ofthese transactions, the Company has classified the Comerica debt as long-termin the accompanying condensed consolidated balance sheet as of March 31,2005.

 

**(13)****             ****PREFERRED STOCK**

 

In October 2003, the Company sold 270 shares ofseries A preferred stock (Series A), $0.001 par value per share, to RAMTrading, Ltd. (RAM) for $22.50 per share, resulting in proceeds ofapproximately $5,925, net of issuance costs of approximately $150.  In connection therewith, the Company issuedRAM a warrant to purchase an additional 190 shares of Series A through December 31,2005, at $22.50 per share, which RAM exercised on June 30, 2004, resultingin gross proceeds to the Company of $4,275. In connection with the exercise of the warrant, the Company granted anaffiliate of RAM a warrant to purchase approximately 262 shares of common stockat the then fair market value of $4.17 per share.

 

The Series A shares and the Series A warrant wereinitially recorded at their relative fair market values of approximately $5,195and $880, respectively.  As a result ofthe put rights discussed below, the difference in the stated value and thecarrying value of the Series A, resulting from the allocation of the proceedsand the issuance costs, is being accreted through the earliest Put Date (asdefined below) using the effective interest rate method.  This accretion results in a higher effectivedividend and is reflected in net loss applicable to common stockholders in theaccompanying condensed consolidated statement of operations for the threemonths ended March 31, 2005.

 

The rights of the Series A holders are as follows:

 

•                  Voting Rights – the holders of Series Aare entitled to vote on all matters and are entitled to 0.88 votes per commonequivalent share to comply with certain NASDAQ Marketplace rules.

 

•                  Dividend Rights – the Series A earns adividend at the rate of 2% per annum payable in cash in arrears semi-annuallyin January and July.  Included inaccrued dividends in the accompanying condensed consolidated balance sheets asof March 31, 2005 and 2004 is approximately $48 and $29, respectively,related to the Series A dividends.

 

•                  Conversion Rights – each share of SeriesA is convertible into ten shares of common stock at the option of theholder.  On or after October 29,2006, the Company can require the conversion of the Series A if the commonstock has traded above $7.00 for 23 consecutive business days.

 

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•                  Redemption Rights – under the terms ofthe Series A, the Company is required to redeem, unless the holders of at least66-2/3% of the Series A elect otherwise, all of the outstanding shares ofSeries A if a significant event, as defined, occurs or the Company breachescertain covenants.  The redemption valueis the original stated purchase price of $22.50 per share, plus accrued butunpaid dividends.  A significant event isgenerally defined as a dissolution of the Company or the sale of the Company orsubstantially all of its assets.  If thesignificant event or breach occurs prior to October 29, 2008, the facevalue plus all of the unpaid cash dividends through October 29, 2008 alsobecome payable (approximately $11,139 at March 31, 2005).  In addition, RAM has the option to requirethat the Company redeem all of the outstanding shares of Series A on either October 29,2006, 2007 or 2008 (the Put Dates). Genaissance may delay such payment for up to one year, in which case thedividend rate would increase to 10% per annum.

 

Inconnection with the issuance of the Series A, the Company is required tomaintain certain covenants.  The****most significant of these covenants restricts the Companyfrom: (i) incurring indebtedness in excess of $9,000; (ii) paying dividends onits common stock; and (iii) redeeming most of its equity securities.  Management believes that the Company was incompliance with these covenants as of March 31, 2005.

 

In June 2004,RAM agreed not to convert its Series A if such conversion would cause RAM,together with RAM’s affiliates, to beneficially own in excess of 9.99% of theCompany’s common stock.

 

**(14)**              **COMPREHENSIVE INCOME (LOSS)**

 

TheCompany reports comprehensive income (loss) in accordance with SFAS No. 130,Reporting Comprehensive Income, which establishes standards for reporting andthe display of comprehensive income (loss) and its components in a full set ofgeneral purpose financial statements. The objective of the statement is to report a measure of all changes inequity of an enterprise that result from transactions and other economic eventsduring the period other than transactions with owners.  The Company’s other comprehensive income(loss) arises from net unrealized gains (losses) on marketable securities andforeign currency translation gains (losses).

 

A summary of total comprehensive loss is as follows:

 
| ** **                                   | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------|------------|------------------------|------------|
| ** **                                   | ** ** | **March 31,**     | ** ** |
| ** **                                   | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                         |       |                   |       |   |   |
| Net loss attributable to common stockholders |       | $                      | (3,265     | ) | $ | (4,825 | ) |
| Other comprehensive income (loss)            |       | (19                    | )          | 18 |   |
| Total comprehensive loss                     |       | $                      | (3,284     | ) | $ | (4,807 | ) |

 

**(15)**              **INCOME TAXES**

 

The State of Connecticut(the State) allows companies conducting business in the State to receive cashrefunds from the State at a rate of 65% of their qualifying research anddevelopment tax credit, as defined, in exchange for foregoing the carryforwardof the research and development tax credit. In the three months ended March 31, 2005 and 2004, the Companyrecorded an estimated benefit of approximately $33 and $55, respectively,related to the State exchange program, which is offset by foreign and state taxexpense.

 

Included in deferred taxliabilities in the accompanying condensed consolidated balance sheets areFederal and state deferred tax liabilities of approximately $1,236 and $91,respectively, which were established as a result of the purchase priceallocation for the tax effects of temporary differences in amortization ofintangible assets acquired in the Lark acquisition.

 

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**(16)****             ****COMMITMENTS AND CONTINGENCIES**

 

In the ordinary course of its business, the Companyenters into agreements with third parties that include indemnificationprovisions, which, in the Company’s judgment, are normal and customary forcompanies in its industry sector.  Theseagreements are typically with business partners, clinical sites and suppliers.Pursuant to these agreements, the Company generally agrees to indemnify, holdharmless, and reimburse the indemnified parties for losses suffered or incurredby the indemnified parties with respect to the Company’s products or productcandidates, use of such products or other actions taken or omitted by theCompany.  The maximum potential amount offuture payments the Company could be required to make under theseindemnification provisions is unlimited. Since the date of its incorporation, the Company has not incurred anycosts to defend lawsuits or settle claims related to these indemnificationprovisions.  As a result, the currentestimated fair value of liabilities relating to these provisions isminimal.  Accordingly, the Company hasnot recorded a liability for these provisions as of March 31, 2005.

 

The Company periodicallyenters into agreements with third parties to obtain exclusive or non-exclusivelicenses for certain technologies.  Theterms of certain of these agreements require the Company, among other items, todemonstrate the ability to fund certain research and development andcommercialization activities, pay future royalty payments and pay certainmilestone payments based on product sales or sublicense income generated fromapplicable technologies, if any.  Thetiming of such events and the amount of such payments will depend uponsuccessful commercialization of applicable technologies, if any.

 

Under the terms of the license, developmentand cooperation agreement the Company signed with Merck in September 2004,the Company agreed to pay milestone payments upon the achievement of specifieddevelopment, regulatory and sales milestones and royalties on all futureproduct sales and a share of all sub-licensing income from any third party onthe commercialization of vilazodone.  To date the Company has not made anymilestone or royalty payments to Merck.  Underthe agreement, the Company is required to demonstrate that by no later than July 22,2005, it will have at least $8,000 in financing or have shown the capacity tofund such levels of research and development activities in 2005 relating tovilazodone.  If the Company is unable to meet this requirement, Merck canterminate the agreement and reacquire the compound.  In addition, if Merck and its affiliates’aggregate ownership of the Company’s common stock would exceed 19.9% of thenumber of shares of the Company’s common stock then outstanding, or if theaverage closing price of the common stock at the time of the respective paymentdate is below $2.25 per share, the Company will pay milestone payments to Merckin cash.

 

**(17)**              **SUBSEQUENT EVENT**

 

On April 21, 2005, the Company entered into aNote and Warrant Purchase Agreement with Xmark, pursuant to which, among otherthings, the Company issued the Note to Xmark in the aggregate principal amountof $4,500.  The Note, which is payable onApril 21, 2007, bears interest at 5% and is secured by substantially allof the Company’s assets, excluding, among other assets, the Company’sintellectual property.  Under the termsof the Note, the Company is required to prepay the Note upon the occurrence ofcertain events including the sale of the Company’s assets, as defined.  In addition, the Company issued Xmark warrantsto purchase an aggregate of 2,000 shares of the Company’s common stock at anexercise price of $2.25 per share.  Theprice per share is subject to adjustment in certain circumstances whilethere is a balance outstanding under the Note on orafter September 18, 2005 and the Company issues specifiedsecurities for less than $2.25 per share. The warrants also provide for an adjustment to the exercise price andnumber and type of securities purchasable upon exercise of the warrant incertain circumstances, including****,****without limitation, a split-up orcombination of shares or a consolidation or merger where the Company is not thesurviving entity.  Concurrent withsigning the Note, the Company terminated its Loan and Security Agreement withComerica and repaid all outstanding principal and interest due to Comerica.  As a result of these transactions, theCompany has classified the Comerica debt as long-term in the accompanyingcondensed consolidated balance sheet as of March 31, 2005.

 

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**Item 2 – Management’s Discussion and Ana****lysis of Financial Condition and Results of Operations.**

 

                   *You should read thefollowing discussion and analysis of our financial condition and results ofoperations together with our financial statements and accompanying notesincluded elsewhere in this Quarterly Report on Form 10-Q.  In addition to the historical information,the discussion in this Quarterly Report contains certain forward-lookingstatements that involve risks and uncertainties.  Our actual results could differ materiallyfrom those anticipated by the forward-looking statements due to the factors setforth under “Factors Affecting Future Operating Results” below and elsewhere inthis Quarterly Report.*

 

**CommonTerms**

 

We use the followingterms in this Management’s Discussion and Analysis of Financial Condition andResults of Operations:

 

*HAP*Technology – the key components of our *HAP* Technologyare:

 

•      a proprietaryinformatics system, which we call DecoGen, including unique algorithms fordefining patient populations with different drug responses;

 

•      a database, whichwe call the *HAP* Database, of highly informative,proprietary measures of genetic variation, or haplotypes, which we call *HAP* Markers, for pharmaceutically relevant genes;

 

•      acost-effective, efficient process for determining genomic variation in clinicalDNA samples, genotyping;

 

•      and clinicalgenetics development skills.

 

Cardiac Channelopathiesprogram – this program was designed to develop a CLIA compliant, genetic testfor detecting cardiac ion channel mutations. Cardiac channelopathies, including familial LQT and Brugada Syndromes,are conditions that affect the electrical system of the heart.  These conditions are caused by geneticmutations that result in structural abnormalities in the potassium and sodiumchannels of the heart and predispose affected individuals to abnormal heartrhythm, or arrhythmia.  Familial LQT andBrugada Syndromes are commonly seen in apparently healthy, active adolescentpatients.  If left undiagnosed anduntreated, these conditions can be fatal. In May 2004, we launched our *FAMILION* Test,which is a CLIA compliant genetic test for cardiac channelopathies.  We will also seek to discover genetic markersthat are predictive of drug-induced QT prolongation and arrhythmias, andarrhythmias that occur in patients with other disorders such as congestiveheart failure.

 

CARING program (Clozapineand Agranulocytosis Relationships Investigated by Genetics (*HAP* Markers)) – this program was designed to identify whichof our *HAP* Markers define the patients who aremost likely to develop agranulocytosis, a potentially life-threateningdepletion of white blood cells, if treated with clozapine.  In December 2004, we reported the discoveryof genetic markers that we believe predict who is at risk of developingclozapine-induced agranulocytosis.  Webelieve that the findings may apply to other drugs that also affect white bloodcell counts.

 

STRENGTH program (StatinResponse Examined by Genetic *HAP* Markers) –this program was designed to apply our *HAP* Technologyand our clinical genetics development skills to the statin class of drugs,which doctors use to treat patients with high cholesterol and lipid levels andwho are, therefore, at risk for cardiovascular disease.

 

Vilazodone program – thisprogram is designed to identify genetic markers that define patients who aremost likely to respond to vilazodone, a small molecule compound we licensedfrom Merck KGaA (Merck), which is under development for the treatment ofdepression.

 

Proprietary Programs –the five programs described above are referred to collectively as ourproprietary programs.

 

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MolecularBiology Services – these DNA-based analytical services include Good LaboratoryPractices (GLP) compliant DNA isolation and banking and research and GLPcompliant sequencing, genotyping and related services.

###### ** **

###### **Overview**

 

Wedevelop innovative products based on our proprietary pharmacogenomic technologyand have a revenue-generating business in DNA and pharmacogenomic products andservices.  We also market our proprietary *FAMILION*Test, a CLIA compliant genetic test for cardiac channelopathies, which isdesigned to detect mutations responsible for causing familial LQT and BrugadaSyndromes, two causes of sudden cardiac death.  Our product developmentstrategy is focused on drug candidates with promising clinical profiles andfinding genetic markers to identify a responsive patient population.  Thisstrategy is designed to enable us to leverage existing clinical data and, thus,reduce the costs and risks associated with traditional drug development andincrease the probability of clinical success and commercialization.  The Company’s lead therapeutic product,vilazodone for depression, is in Phase II of development.

 

As of March 31,2005, we had a total of 7,777 genes in our database, with 34 of these geneshaving been added during the three months ended March 31, 2005, and 31genes having been added during the three months ended March 31, 2004.  There is not necessarily any correlationbetween the costs incurred in any period and the number of genes added to thedatabase in that period.  This is due tothe fact that the size of the gene and, therefore, the amount of work involvedvaries from gene to gene.  In addition,after a gene is sequenced, it must be analyzed and go through an internalquality assurance check before it is added to the database.  This process may cause a gene sequenced inone period to be added to the database in a different period.  Furthermore, since additional informationabout genes continues to be discovered, we may resequence genes previouslyincluded in the database and/or perform further quality assurance analysis.

 

Sinceour inception, we have incurred significant operating losses, and, as of March 31,2005, we had an accumulated deficit of approximately $236.7 million.  The majority of our operating losses haveresulted from costs we incurred developing our *HAP*Technology, in our clinical trials and from administrative costsassociated with operations.  As part ofour *HAP* Technology program, wecontinue to populate our database with *HAP*Marker information for pharmaceutically relevant genes, but we do so only wheninformation that we need is not then currently available in our *HAP* Database.  We expect to dedicate a significant portionof our resources for the foreseeable future to continue the development of ourproprietary programs and service our proprietary programs and molecular biologyservices customers.  To date, our revenuehas been primarily from licensing and service fees from our agreements withBiogen Idec, Inc., Gene Logic, Inc., Johnson & Johnson PharmaceuticalResearch & Development (J&J PRD), Millennium Pharmaceuticals, Inc.(Millennium), Pfizer, Inc. (Pfizer) and Wayne State University and from themolecular biology services that we offer. The collaboration agreement with J&J PRD expired in the firstquarter of 2004.

 

We arecompleting a strategic review of our operations, including reducing ouroperating costs.  Further, we are alsoreviewing various alternatives to finance our ongoing operations and meet ourobligations, including a potential reorganization, disposing of some of ourassets, exploring strategic alternatives, such as a potential sale of theCompany, developing strategic alliances and/or joint developmentarrangements.  There is no assurance thatwe will be able to obtain sufficient financing on acceptable terms, if at all,or cure or waive any future non-compliance with the terms of our financingarrangements.

 

**Financing Activities**

 

On April 21,2005, we entered into a Note and Warrant Purchase Agreement with XmarkOpportunity Fund, Ltd., Xmark Opportunity Fund, L.P. and Xmark JV InvestmentPartners, LLC (collectively Xmark), pursuant to which, among other things, weissued Notes (collectively Note) to Xmark in the aggregate principal amount of$4.5 million.  The Note, which is payableon April 21, 2007, bears interest at 5% and is secured by substantiallyall of our assets, excluding, among other assets, our intellectual property.  Under the terms of the Note, we are requiredto prepay the Note upon the occurrence of certain events including the sale ofour assets, as defined.  In addition, weissued Xmark warrants to purchase an aggregate of 2,000,000 shares of our commonstock at an exercise price of $2.25 per share. The price per share is subject to adjustment in certain circumstanceswhile there is a balance outstanding under the Note on or after September 18,2005 and we issue specified securities for less than $2.25 pershare.  The warrants also provide for anadjustment to the exercise price and number and type of securities purchasableupon exercise of the warrant in

 

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certain circumstances,including****,****without limitation, a split-up orcombination of shares or a consolidation or merger where we are not thesurviving entity.  Concurrent withsigning the Note, we terminated our Loan and Security Agreement with ComericaBank N.A. (Comerica) and repaid all outstanding principal and interest due toComerica. As a result of these transactions, we have classified the Comericadebt as long-term in our condensed consolidated balance sheet as of March 31,2005.

 

On November 19,2004, we sold an aggregate of 3,550,294 shares of our common stock in a privateplacement for an aggregate price of $6.0 million and net proceeds ofapproximately $5.4 million, net of issuance costs of approximately $580,000, tocertain accredited investors.  Inaddition, we issued the investors warrants, exercisable through November 18,2009, to purchase an aggregate of 3,550,294 additional shares of common stockat an exercise price of $1.69 per share.

 

**Acquisitions**

 

*Lark Technologies, Inc.*

 

Weacquired Lark in a stock-for-stock merger that closed on April 1,2004.  In the merger, each Larkstockholder received 1.81 shares of our common stock for each share of Larkcommon stock held.  Immediately followingthe closing, the former Lark stockholders held approximately 19.2% of our totaloutstanding shares, assuming the conversion of our preferred stock and theexercise and conversion of our preferred stock warrant then outstanding.

 

Larkprovides contract, GLP compliant and research sequencing and associatedmolecular services to the pharmaceutical, biotechnology and agricultural industriesthrough its GLP compliant facility in Houston, Texas and its research facilityin Takeley, U.K.

 

Werecorded the transaction as a purchase transaction for accounting purposes andallocated the purchase price of approximately $24.5 million to the assetspurchased and liabilities assumed based upon their respective fair values.  We allocated the excess of the purchase priceover the estimated fair market value of the net tangible assets acquired toidentified intangibles with estimated useful lives as follows: backlog – oneyear; customer relationships – 15 years; and GLP certification and trade name –indefinite.  The resulting goodwill wasapproximately $10.8 million.  We expectto incur charges for amortization of intangibles of approximately $120,000 perquarter after March 31, 2005.

 

Ourcondensed consolidated financial statements include the results of operationsand cash flows of Lark from the closing date. Although Lark is contributing positive operating cash flows, we willstill incur net losses in the foreseeable future as we continue to develop ourproprietary programs.  The extent of thebenefits received from the acquisition will depend upon how well we are able toobtain operational efficiencies and increased sales from the integration ofLark’s operations and sales force.

 

*DNA Sciences, Inc.*

 

OnMay 15, 2003, under order of the United States Bankruptcy Court, weacquired certain assets and assumed certain liabilities of DNA Sciences, Inc.for approximately $1.8 million, inclusive of related fees and expenses. The primary assets acquired consisted of:

 

•                  a GLP compliant DNA isolation andbanking and a GLP compliant and CLIA licensed genotyping services business;

 

•                  licenses and patent estatessurrounding LQT Syndrome and a TPMT test; and

 

•                  certain trade accounts receivable andfixed assets.

 

Bycombining DNA Sciences’ offerings of GLP compliant DNA banking and GLPcompliant genotyping services with our *HAP*Technology and high-throughput research genotyping capabilities as well as theservices 

 

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from Lark, we now providea broader range of offerings for the application of pharmacogenomics to theclinical development and marketing of drugs.

 

###### **Critical Accounting Policies and Estimates**

 

Our financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States of America (GAAP).  The preparation of financial statements inaccordance with GAAP requires management to make judgments, assumptions andestimates that affect our reported assets and liabilities, revenue andexpenses, and other information reported in our financial statements andaccompanying footnotes.  We base ourestimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, the results of which form ourbasis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources.  Actual results may differ from estimates, sometimesmaterially.  We regard an accountingestimate or assumption underlying our financial statements as a “criticalaccounting estimate” where:

 

•                  the nature of the estimate orassumption is material due to the level of subjectivity and judgment necessaryto account for highly uncertain matters or the susceptibility of such mattersto change; and

 

•                  the impact of the estimates andassumptions on financial condition or operating performance is material.

 

Our significantaccounting policies are more fully described in the Notes to UnauditedCondensed Consolidated Financial Statements section of this QuarterlyReport on Form 10-Q and in Note 2 of the Notes to Consolidated FinancialStatements in our Annual Report on Form 10-K for the year ended December 31,2004.  Not all of these significant accounting policies, however, fit thedefinition of “critical accounting estimates.” We have discussed our accounting policies with the audit committee ofour board of directors, and we believe that our estimates relating to:

 

•                  revenue recognition;

 

•                  valuation of long-lived assets;

 

•                  research and development expenses;and

 

•                  goodwill and identifiable intangibleassets

 

described below fit the definition of “criticalaccounting estimates.”

 

Revenue recognition. We earn our revenues primarily through the licensing of our HAPTechnology and by providing molecular biology services.  We recognize revenue associated withmolecular biology services in accordance with Staff Accounting Bulletin (SAB)No. 104, Revenue Recognition (which supercedes SAB No. 101, Revenue Recognitionin Financial Statements) as the services are performed provided that persuasiveevidence of an arrangement exists, the price is fixed and determinable andcollectibility is reasonably assured.  Inaccordance with SAB No. 104 and Emerging Issues Task Force Issue 00-21, wegenerally recognize license fees over the term of the agreement and researchfees as the research is performed.  Foragreements with multiple deliverables, revenue is not recognized unless thefair value of the undelivered elements can be determined and the elementsdelivered have stand-alone value to the customer.  Future milestones and royalties receivedunder these agreements, if any, will be recognized, provided that the milestoneis substantive and a culmination of the earnings process has occurred.  Deferred revenue results when considerationis received or amounts are receivable in advance of revenue recognition.  Deferred revenue related to licenseagreements is generally recognized over the license period.  For license agreements, which contain earlytermination provisions, we recognize revenue upon the expiration of thetermination provision for the period from the original license date to the datethe early termination provisions expire.

 

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Valuation of long-lived assets. We assess the impairment of long-lived assets whenever events or changesin circumstances indicate that the carrying value of the assets may not befully recoverable.  Factors, which couldtrigger an impairment review, include:

 

•                  a significant adverse change in the extent or manner in which along-lived asset is being used;

 

•                  a significant adverse change in the business climate that could affectthe value of a long-lived asset; and

 

•                  a significant decrease in the market value of assets.

 

If we determine that the carrying value ofthe long-lived assets may not be fully recoverable, based upon the existence ofone or more of the above indicators of impairment, we compare the carryingvalue of the asset group to the undiscounted cash flows we expect to begenerated by the group.  If the carryingvalue exceeds the undiscounted cash flows, an impairment charge may beneeded.  To determine the amount of theimpairment charge, we compare the carrying value of the applicable asset groupto its fair value.  We determine the fairvalue of the asset group by discounting expected future cash flow using adiscount rate that we determined to be commensurate with the risk inherent inour current business.  If the fair valueis less than the carrying value, such amount is recognized as an impairmentcharge.  If an impairment charge isrequired in future periods, it could result in a material, non-cash charge inour statement of operations.

 

Research and development expenses.  We record research and development expenseswhen they are incurred.  Research anddevelopment expenses include the following major types of costs: salaries andbenefits, material and reagent costs, research license fees, clinical trialexpenses, depreciation and amortization of laboratory equipment and leaseholdimprovements and building and utility costs related to research space.  We expense clinical trial costs as incurredbased on information we receive from third parties and estimates that wemake.  Our estimates may change asadditional information becomes available, which could cause results to varyfrom period to period.

 

Goodwill and identifiable intangible assets. We record business combinations under the provisions of Statement ofFinancial Accounting Standards (SFAS) No. 141, *BusinessCombinations,* and SFAS No. 142, *Goodwilland Other Intangible Assets*. These standards require the use of the purchase method of accounting forbusiness combinations, set forth the accounting for the initial recognition ofacquired intangible assets and goodwill and describe the accounting subsequentto initial recognition. Under the provisions of these standards, goodwill andintangible assets deemed to have indefinite lives are not subject toamortization.  All other intangible assetsare amortized over their estimated useful lives. Goodwill and intangible assetsare subject to annual impairment tests and will also be tested for impairmentbetween annual tests, if changes in circumstances indicate that the carryingamount may be impaired.  This testingcompares carrying values to fair values and, if the carrying value of theseassets is less than the fair value, an impairment loss is recognized for theamount of the difference.  Our evaluationof fair value is based on various analyses including undiscounted cash flowprojections.

 

**Results of Operations**

 

***Three Months Ended March 31, 2005 and 2004***

 

License and research revenue consistsprimarily of revenue recognized in connection with the licensing of our *HAP* Technology and by providing molecularbiology services.  License and researchrevenue was approximately $2.9 million for the three months ended March 31,2005 and 2004.  Revenue from licensingour *HAP* Technology decreasedapproximately $1.5 million, due mainly to the expiration of our agreement withJ&J PRD and a reduction in the data provided under our agreements withMillennium and Pfizer.  The collaborationagreement with J&J PRD expired in the first quarter of 2004, which accountedfor approximately $600,000 of revenue recognized during the three months ended March 31,2004.  The decrease was offset byincreases of approximately $740,000 and $455,000 in revenue recognized fromresearch genotyping and our collaboration with Sciona Inc. (Sciona),respectively, during the three months ended March 31, 2005.  In addition, during the three months ended March 31,2005, we recognized approximately $201,000 in revenue from our *FAMILION* Test, which we launched in May2004.

 

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Laboratory services revenue consists ofrevenue recognized from services provided by our GLP compliant DNA banking andgenotyping facility in Morrisville, North Carolina, and GLP compliantsequencing and related molecular biology services provided by Lark, which weacquired in April 2004.  Laboratoryservices revenue increased to approximately $2.7 million for the three monthsended March 31, 2005 from approximately $860,000 for the same period in2004.  The increase in laboratoryservices revenue is attributable to the inclusion of approximately $1.9 millionof revenue from Lark during the three months ended March 31, 2005.

 

Cost of laboratory services consists ofpayroll and benefits for personnel, materials and reagent costs, depreciationand maintenance and facility-related costs incurred in providing the laboratoryservices.  The cost of laboratoryservices increased to approximately $2.0 million for the three months ended March 31,2005 compared to approximately $861,000 for the same period in 2004.  The increase is due to the inclusion ofapproximately $1.2 million of expenses incurred by Lark in the three monthsended March 31, 2005.  We expect thecost of laboratory services to decrease as a percentage of revenues as ourrevenues increase because a substantial portion of these costs are fixed costsfor operating these facilities.

 

Research and development expenses consistprimarily of payroll and benefits for research and development personnel,materials and reagent costs, depreciation expense and maintenance costs forequipment used for *HAP* Markerdiscovery and research genotyping, technology license fees and facility-relatedcosts.  We expense our research anddevelopment costs as incurred.  Researchand development costs decreased to approximately $3.3 million for the threemonths ended March 31, 2005 from approximately $5.0 million for the sameperiod in 2004.  A substantial portion ofour research and development expenditures are incurred in developing andconducting our proprietary programs.  Thefollowing is a breakdown of research and development expenses (in thousands):

 
| ** **                     | ** ** | **Three Months Ended** | ** ** |
|--------------------------------|------------|------------------------|------------|
| ** **                     | ** ** | **March 31,**     | ** ** | **March 31,** | ** ** |
| ** **                     | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                           |       |                   |       |   |   |
| Payroll and  benefits          |       | $                      | 1,420      |   | $ | 2,090 |   |
| Depreciation  and amortization |       | 320                    |       | 1,340 |   |
| Material and  reagent costs    |       | 790                    |       | 550 |   |
| Technology  license fees       |       | 190                    |       | 250 |   |
| Repairs and  maintenance       |       | 160                    |       | 140 |   |
| Stock-based  compensation      |       | 10                     |       | 100 |   |
| Other                          |       | 411                    |       | 542 |   |
|                           |       |                   |       |   |   |
| Total                          |       | $                      | 3,301      |   | $ | 5,012 |   |

 

The decrease in research and developmentexpenses for the three months ended March 31, 2005 is primarilyattributable to a decrease of approximately $1.0 million in depreciation andamortization and a decrease of approximately $670,000 in payroll and benefits,which were partially offset by an increase of approximately $240,000 inmaterial and reagent costs.  The decreasein depreciation and amortization was primarily due to the fact that themajority of our DNA sequencing machines and the related assets became fullydepreciated during the quarter ended June 30, 2004.  The decrease in payroll and benefits wasprimarily due to the fact that in November 2004, we reduced our work forceby approximately 10% to align better our operating structure with our currentand projected revenues and reduced expenses in certain other areas.  The majority of the workforce reductionsoccurred in research and development.  The increase in material andreagent costs was primarily due to an increase in research services provided byour research facility and increases related to our *FAMILION* Test.  The development of our proprietaryprograms will require us to continue to devote substantial resources toresearch and development expenses in the near future.  We currently do not have sufficient resourcesto continue the development of all of our proprietary programs.  Further development of these programs willdepend upon our ability to secure sufficient funds in a financingtransaction.  See “Factors AffectingFuture Operating Results” for further discussion.

 

Selling, general and administrative expensesconsist primarily of payroll and benefits for executive, sales, finance andother administrative personnel, as well as facility related costs and outsideprofessional fees incurred in connection with corporate development, generallegal and financial matters.  Selling,general and administrative expenses increased to approximately $3.2 million forthe three months ended March 31, 2005 from approximately 

 

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$2.4 million for the same period in 2004.  The increase was primarily due to an increaseof approximately $555,000 due to the inclusion of Lark in our operations duringthe three months ended March 31, 2005. Amortization of the intangible assets recognized from the Lark purchaseaccounted for an additional $170,000 in expense in the three months ended March 31,2005.  Professional fees increased byapproximately $111,000 in the three months ended March 31, 2005, primarilydue to an increase in professional and consulting fees incurred in connection withthe evaluation of our internal controls as required under Section 404 ofthe Sarbanes-Oxley Act of 2002.

 

Other income decreased to approximately $34,000 for the three monthsended March 31, 2005 from income of approximately $75,000 for the sameperiod in 2004.  The decrease wasprimarily due to a decrease in interest income as a result of higher cash, cashequivalents and short-term investment balances in 2004.

 

Interest expense decreased to approximately$157,000 for the three months ended March 31, 2005 from approximately$180,000 for the same period in 2004. The decrease was primarily due to lower debt balances in 2005.

 

Income tax (expense) benefit decreased to an expense of approximately$26,000 for the three months ended March 31, 2005 from a benefit ofapproximately $49,000 for the same period in 2004.  We recorded estimated foreign and state taxesof approximately $59,000 and $6,000 recorded in the three months ended March 31,2005 and 2004, respectively.  The expenseis offset by a net tax benefit from the State of Connecticut (the State) as aresult of legislation, which allows companies conducting business in the Stateto receive cash refunds from the State at a rate of 65% of their qualifyingresearch and development tax credit, as defined, in exchange for foregoing thecarryforward of the research and development tax credit.

 

Equity in loss of affiliate represents ourpercentage interest in the losses of Sciona. The loss was $150,000 in the three months ended March 31,2004.  In November 2003, we grantedSciona a license to our *HAP*Technologyin exchange for a 37% equity interest (30% on a fully diluted basis).  In September 2004, Sciona closed anequity financing, which diluted our holdings to 13% (11% on a fully dilutedbasis).  As a result, we changed ourmethod of accounting for the investment from the equity method to the costmethod, and we no longer record our percentage interest in the results ofoperations of Sciona.   In February 2005,Sciona closed an additional equity financing, which further diluted ourholdings to 9% (7% on a fully diluted basis).

 

**Liquidity and Capital Resources**

 

Our liquidity requirements have historicallyconsisted, and we expect that they will continue to consist, of capitalexpenditures, working capital, debt service, research and development expenses,general corporate expenses and expenses related to acquisitions.

 

We have financed our operations primarilythrough the private and public sale of common and preferred stock, loans,payments under licensing agreements, government research grants and capitalleases.  From inception through March 31,2005, we have received aggregate gross proceeds of approximately $180.0 millionfrom the issuance of common and preferred stock.  In addition, through March 31, 2005, wehave received approximately $51.1 million from license and service fees,royalties and research contracts.  Wealso have received approximately $26.2 million from capital lease financingarrangements and approximately $13.2 million from other loans. Through March 31,2005, we have acquired approximately $45.2 million of property andequipment.  These assets were largelyfinanced through capital lease financing arrangements and other loans.

 

We entered into a $5.0 million loan andsecurity agreement with Comerica in September 2003, which was subsequentlyterminated with all outstanding principal and interest being repaid in April 2005(See “Financing Activities” section above).  Under the terms of the agreement, we wererequired to satisfy certain financial covenants, including a minimum cashbalance and a minimum quick ratio, as defined. Due to the uncertainty surrounding future debt covenant compliance at December 31,2004, we classified the Comerica debt as current in our condensed consolidatedbalance sheet as of December 31, 2004.

 

We have also entered into financingagreements (the Agreements) with Connecticut Innovations, Inc. (CII), one ofour stockholders, to finance certain leasehold improvements and other costsassociated with our facility expansion in New Haven.  The Agreements provide for payments ofprincipal and interest based on a 120-month 

 

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amortization, with final balloon payments due in March 2009through June 2011.  Borrowings underthe Agreements are collateralized by the related leasehold improvements.  Management believes that we are in compliancewith all covenants under the Agreements as of March 31, 2005 and theAgreements do not contain any cross default provisions.

 

We operate in an environment of rapid changein technology and have substantial competition from companies developinggenomic related technologies and offering molecular biology services.  In addition to the normal risks associatedwith a business venture, there can be no assurance that our technologies andour molecular biology services offerings will be successfully used, that wewill obtain adequate patent protection for our technologies or that any of ourproducts will be commercially viable.  Wehave incurred substantial losses to date, have an accumulated deficit ofapproximately $236.7 million as of March 31, 2005 and expect to incursubstantial expenditures in the foreseeable future to fund our research,development and commercialization of our products and to maintain our molecularbiology services.

 

We believe that our current cash and cashequivalents balance and the funds generated from operations will be sufficientto cover anticipated cash needs through at least the next 12 months, other thanwith respect to funds required for the clinical development of vilazodone.  Our current business plan reflects continuedinitiatives to increase revenue, reduce cost of goods sold as a percentage ofrevenue, reduce research and development expenses and control selling, generaland administrative costs.  If we areunable to achieve revenue and cost targets within a reasonable range of ouroperating plan, we will need to raise additional funds through the public orprivate sale of our equity or debt securities or from other sources, in orderto satisfy our projected cash needs. Furthermore, we are also reviewing various alternatives to financing ourongoing operations and meeting our obligations, including a potentialreorganization, disposing of some of our assets, exploring strategicalternatives, such as a potential sale of the Company, developing strategicalliances and/or joint development arrangements.  There is no assurance that we will be able toobtain sufficient financing on acceptable terms, if at all, or cure or waiveany future non-compliance with the terms of our financing arrangements.  On November 9, 2004, as part of ourstrategy to decrease our operating expenses, we reduced our workforce byapproximately 10%.  The majority of theworkforce reductions occurred in research and development.

 

On November 19, 2004, we closed aprivate placement with certain institutional and other accredited investors for3,550,294 shares of our common stock together with warrants to purchase anadditional 3,550,294 shares of our common stock at $1.69 per share.  We received proceeds of approximately $5.4million net of issuance costs of approximately $580,000.

 

On April 21, 2005, we entered into aNote and Warrant Purchase Agreement with Xmark, pursuant to which, among otherthings, we issued the Note to Xmark in the aggregate principal amount of $4.5million.  The Note, which is payable on April 21,2007, bears interest at 5% and is secured by substantially all of our assets, excluding,among other assets, our intellectual property. Under the terms of the Note, we are required to prepay the Note upon theoccurrence of certain events including the sale of our assets, as defined.  In addition, we issued Xmark warrants topurchase an aggregate of 2,000,000 shares of our common stock at an exerciseprice of $2.25 per share.  The price pershare is subject to adjustment in certain circumstances while there is abalance outstanding under the Note on or after September 18,2005 and we issue specified securities for less than $2.25 per share.  The warrants also provide for an adjustmentto the exercise price and number and type of securities purchasable uponexercise of the warrant in certain circumstances, including****,****withoutlimitation, a split-up or combination of shares or a consolidation or mergerwhere we are not the surviving entity. Concurrent with signing the Note, we terminated our Loan and SecurityAgreement with Comerica and repaid all outstanding principal and interest dueto Comerica. As a result of these transactions, we have classified the Comericadebt as long-term in our condensed consolidated balance sheet as of March 31,2005.

 

***Cash and CashEquivalents***

 

At March 31, 2005, cash, cashequivalents and short-term investments totaled approximately $5.9 millioncompared to approximately $9.2 million at December 31, 2004.  Our cash reserves are held ininterest-bearing, high-grade corporate bonds and money market accounts.

 

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***CashFlows***

 

Cash used in operations was approximately $2.6million in the three months ended March 31, 2005 compared withapproximately $4.4 million for the same period in 2004.  The cash used in operations for the threemonths ended March 31, 2005 resulted primarily from a net loss ofapproximately $3.1 million and a decrease of approximately $660,000 in accruedexpenses, partially offset by approximately $1.3 million of non-cash chargesfor depreciation and amortization expense and stock-based compensation.  The cash used in operations for the threemonths ended March 31, 2004 resulted primarily from a net loss ofapproximately $4.7 million and a decrease of approximately $1.4 million inaccrued expenses, partially offset by approximately $1.8 million of non-cashcharges for depreciation and amortization expense, stock-based compensation,non-cash research and development expense and the loss in the equity of anaffiliate.

 

Cash used in investing activities wasapproximately $109,000 in the three months ended March 31, 2005 comparedwith cash provided by investing activities of approximately $2.2 million forthe same period in 2004.  During thethree months ended March 31, 2005, we used approximately $98,000 millionfor the purchase of property and equipment. During the three months ended March 31, 2004, we used approximately$410,000 for the purchase of property and equipment and received net proceedsof approximately $2.7 million from the maturity of investments in marketablesecurities.

 

Cash used in financing activities wasapproximately $527,000 in the three months ended March 31, 2005 comparedwith approximately $514,000 for the same period in 2004.  During the three months ended March 31,2005, we used cash of approximately $445,000 for the repayment of long-termdebt and approximately $104,000 for the payment of preferred stockdividends.  During the three months endedMarch 31, 2004, we used cash of approximately $506,000 for the repaymentof long-term debt.

 

***ContractualObligations***

 

In April 2005, we entered into a Noteand Warrant Purchase Agreement with Xmark, pursuant to which, among otherthings, we issued the Note to Xmark in the aggregate principal amount of $4.5million (See “Financing Activities” section above).  Concurrently, we terminated our Loan andSecurity Agreement with Comerica and repaid all outstanding principal andinterest due to Comerica.  As such, $2.6million of long-term debt, including interest, shown in the contractualobligations table in our 2004 Annual Report on Form 10-K (File No. 000-30981)as due in fiscal 2005 is now due in fiscal 2006 and 2007.

 

***Short-Term FundingRequirements***

 

We believe that our existing cash reserveswill be sufficient to fund our expected net losses, debt service obligationsand capital expenditures for at least the next 12 months based upon our currentactivities.  We are reviewing variousalternatives to fund the development of vilazodone without utilizing ourcurrent resources.

 

We expect to continue to finance ouroperations from cash we received in October 2003 and June 2004 fromthe sale of our series A preferred stock and the related exercise of a warrantto purchase shares of our series A preferred stock, cash we received in November 2004from our private placement of common stock, cash we received from our debtfinancing in April 2005 and future revenue from our proprietary programsand molecular biology services customers. Factors affecting our funding requirements are described below.  In particular, if we are unsuccessful inmarketing our proprietary programs and growing our molecular biology servicesrevenue, we may not generate sufficient revenue to sustain our operations atplanned levels.  We expect to expendsubstantial funds to conduct research and development activities and othergeneral and administrative activities. Our expenditures for these activities will include required paymentsunder operating leases and long-term debt agreements and licensing,collaboration and service agreements. Capital expenditures are not currently expected to exceed $1.0 millionfor fiscal 2005 and 2006.  We expect tofund our capital expenditures through our current cash and cash equivalentsreserves and expect our capital expenditures to be for equipment used in ourservices business and in our research activities.

 

***Long-Term FundingRequirements***

 

In addition to our short-term fundingrequirements, for periods beyond 12 months, even if we market our proprietaryprograms and grow our molecular biology services revenue significantly, we mayneed to seek additional funding through public or private equity financings,debt financings or commercial customers. We cannot assure you that we will be able to obtain additional financingor new customers for our molecular biology services and our proprietaryprograms, or generate the increased revenue to support our operations.

 

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Our cash requirements in both the short-termand the long-term could vary depending upon a number of factors, many of whichmay be beyond our control, including:

 

•                  ourability to obtain additional financing and our level of indebtedness;

 

•                    our ability toretain and find new customers for our proprietary programs;

 

•                  ourability to grow profitably our molecular biology services business;

 

•                  ourability to commercialize molecular tests;

 

•                  howwe finance any clinical trials for our in-licensed compound, if at all;

 

•                  oursuccess in entering into strategic alliances and/or joint developmentarrangements;

 

•                  thecommercialization of intellectual property derived from our proprietaryprograms;

 

•                  thelevel of competition we face;

 

•                  acquisitioncosts or other non-recurring charges in connection with the acquisition ofcompanies, products or technologies;

 

•                  ourability to maintain and develop our proprietary programs; and

 

•                  ourability to manage effectively our operating expenses and reduce costs.

 

If our existing resources are insufficient tosatisfy our liquidity requirements, we may need to sell additional equity ordebt securities or seek additional financing through other arrangements.  Any sale of additional equity or debtsecurities may result in additional dilution to our stockholders, and debtfinancing may involve covenants limiting or restricting our ability to takespecific actions, such as incurring additional debt or making capital expenditures.  We cannot be certain that additional publicor private financing will be available in amounts or on terms acceptable to us,if at all.  In addition, we cannot incurindebtedness above certain levels or issue any capital stock or other equity securitieshaving rights, preferences, privileges or priorities pari passu with or seniorto the series A preferred stock without the vote or written consent of holdersof at least 66-2/3% of the series A preferred stock then outstanding.  If we are unable to obtain additionalfinancing, we will be required to delay, reduce the scope of, or eliminate oneor more of our planned research, development and commercialization activities,which could harm our financial condition and operating results.  In addition, failure to obtain additionalcapital may preclude us from developing or enhancing our products, takingadvantage of future opportunities, growing our business or responding tocompetitive pressures.

 

**Collaborative Research Agreements**

 

In September 2004, we entered into alicense, development and cooperation agreement with Merck pursuant to which weacquired an exclusive worldwide license from Merck to develop and commercializevilazodone, a small molecule compound.  Webelieve that previous preclinical and clinical studies of vilazodone provide abasis for further development of the product for use in the treatment ofdepressive illness.  In light of published studies suggesting anassociation between antidepressant response and genetics, we intend to evaluatevilazodone in a Phase II clinical trial, which would include a pharmacogenomiccharacterization of patients suffering from depression.  We believe that genetic markers predictive ofdrug response can be discovered, which could lead to a novel therapy targetinga population of patients suffering from depression, who will respond to thedrug.  We currently do not havesufficient resources to commence this Phase II clinical trial.  We will need to secure additional sources offinancing to meet our requirements under the Merck agreement and we areconsidering our options in this regard.

 

In consideration for the rights relating tovilazodone, we agreed to pay Merck an initial license fee and milestonepayments upon the achievement of specified development, regulatory and salesmilestones.  Under the 

 

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terms of the agreement, we paid the initial license fee through theissuance of 369,280 shares of our common stock. Pursuant to the terms of the agreement, Merck is entitled to royaltieson all future product sales and a share of all sub-licensing income from anythird party.

 

**Income Taxes**

 

We have not generated any taxable income todate and, therefore, have not paid any federal income taxes sinceinception.  On December 31, 2004, wehad available unused net operating loss carryforwards of approximately $153.8million and approximately $140.5 million, which may be available to offsetfuture federal and state taxable income, respectively.  Use of our federal and state net operatingloss carryforwards, which will begin to expire in 2007 and 2005, respectively,may be subject to limitations.  Thefuture utilization of these carryforwards may be limited due to changes withinour current and future ownership structure. We have recorded a full valuation allowance against our deferred taxassets, which consists primarily of net operating loss carryforwards, becauseof uncertainty regarding their recoverability, as required by SFAS No. 109, *Accounting for Income Taxes*.

 

**Off-Balance Sheet Arrangements**

 

During the year ended December 31, 2004and through March 31, 2005, we have not engaged in off-balance sheetactivities, including the use of structured finance or specific purposeentities.

 

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**Factors Affecting Future Operating Results**

 

*This Quarterly Report on Form 10-Q containsforward-looking statements within the meaning of Section 21E of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”).  For this purpose, statements contained hereinregarding our strategy, future operations, financial position, future revenues,projected costs, prospects, plans and objectives of management, other thanstatements of historical fact may be forward-looking statements.  The words “believes,” “anticipates,” “plans,”“expects” and similar expressions are intended to identify forward-lookingstatements, although not all forward-looking statements contain theseidentifying words. We cannot guarantee that we will actually achieve the plans,intentions or expectations expressed or implied in our forward-lookingstatements. There are a number of important factors that could cause actualresults, levels of activity, performance or events to differ materially fromthose expressed or implied.  Theseimportant factors include our “critical accounting estimates” and the factorsset forth below.*

 

**Risks Related to Our Need for Financing and Financial Results**

 

**Weare an early stage company with a history of losses, and we expect to incur netlosses for the foreseeable future such that we may never be profitable.**

 

We have incurred substantial operating losses in every year since ourinception.  As of March 31, 2005, wehad generated only minimal revenues from our proprietary programs and our molecularbiology services.  From inception throughMarch 31, 2005, we had an accumulated deficit of approximately$236.7 million.  Our losses to datehave resulted principally from costs we incurred in the development and conductof our proprietary programs and from general and administrative costsassociated with operations.

 

We expect to devote substantially all of our resources for theforeseeable future to service our molecular biology services and proprietaryprograms customers and continue the development of our proprietaryprograms.  We will need to generatesignificantly higher revenues and attract external capital in the form of debtor equity financing, or a third party collaboration, to fund our spending.  Pharmaceutical and biotechnology companiesare only beginning to use services such as ours in their drug and diagnosticdevelopment or marketing efforts and, accordingly, they may not choose to useour *HAP* Technology or ourmolecular biology services.  We cannot becertain whether we will be able to attract external capital in the form of debtor equity financing, or a third party collaboration, because of significantuncertainties with respect to our ability to generate revenues from the sale ofproducts and covenants with existing shareholders.  As a result, even if we obtain additionalfinancing, we expect to incur additional losses this year and in future years,and we may never achieve profitability.

 

**Additionalfinancing may be difficult to obtain. Our failure to obtain necessary financing or doing so on unattractiveterms could adversely affect our ability to fund operations, repay debt anddevelop vilazodone and, thereby, negatively impact our value.**

 

If we are unable to obtain additional financing, we will be required todelay, reduce the scope of, or eliminate one or more of our planned research,development and commercialization activities, which could harm our financialcondition and operating results.  In November 2004,we reduced our workforce by approximately 10%, and the majority of theworkforce reductions occurred in our research and development department.

 

We may be forced to seek funds through arrangements with collaboratorsor others that require us to relinquish rights to certain of our technologiesor therapeutic products, which we would otherwise pursue on our own, or grantlicenses on terms that may not be favorable to us.  For example, in September 2004, weentered into a license, development and cooperation agreement with Merck,pursuant to which we acquired an exclusive world-wide license to develop andcommercialize vilazodone, a small molecule compound.  We agreed to pay milestone payments upon theachievement of specified development, regulatory and sales milestones androyalties on all future product sales and a share of all sub-licensing incomefrom any third party on the commercialization of vilazodone.  Under theagreement, we are required to demonstrate that, by no later than July 22,2005, we will have at least $8.0 million in financing or have shown thecapacity to fund such levels of research and development activities in 2005relating to vilazodone.  If we are unable to meet this requirement, Merckcan terminate the agreement and reacquire the compound.  In addition, if the average closing price ofour common stock at the time of the respective milestone payment is below $2.25per share, we will be required to make the milestone payments to Merck in cashrather than in shares of our common stock. If Merck and its affiliates’ aggregate ownership of our common stockwould exceed 19.9% of the number of shares of our 

 

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commonstock then outstanding, we would also be required to make payments in cashrather than in shares of our common stock. We will need to seek alternate means to finance the development ofvilazodone or raise additional capital to do so.  We do not currently have sufficient resourcesto meet our obligations with respect to vilazodone.

 

Any sale of additional equity or debt securities may result in additionaldilution to our stockholders, and such financing may involve covenants limitingor restricting our ability to take specific actions, such as incurringadditional debt or making capital expenditures. We cannot be certain that additional public or private financing will beavailable in amounts or on terms acceptable or favorable to us, if at all.  In addition, we cannot incur indebtednessabove certain levels or issue any capital stock or other equity securitieshaving rights, preferences, privileges or priorities pari passu with or seniorto our series A preferred stock without the vote or written consent of holdersof at least 66-2/3% of the series A preferred stock then outstanding.  Failure to obtain additional capital maypreclude us from developing or enhancing our products, taking advantage offuture opportunities, growing our business or responding to competitivepressures.

 

**Ourredemption obligations under our series A preferred stock could have a materialadverse effect on our financial condition.**

 

Under the terms of our series A preferred stock, we are required,unless the holders of at least 66-2/3% of our outstanding series A preferredstock elect otherwise, to redeem all then outstanding shares of our series Apreferred stock if one or more of the following events occurs:

 

•                  ourcommon stock is delisted from The NASDAQ National Market;

 

•                  weissue shares of our common stock or securities convertible into common stock,with a purchase price of less than $2.25 per share, other than in limitedcircumstances;

 

•                  webreach any representation or warranty contained in the series A purchaseagreement or the registration rights agreement that has a material adverseeffect on the holders of our series A preferred stock;

 

•                  webreach any covenant or fail to perform any of our obligations under the seriesA purchase agreement or the registration rights agreement, each entered into inconnection with the sale of our series A preferred stock, that has a materialadverse effect on the holders of our series A preferred stock;

 

•                  aninvoluntary case is commenced against us under any bankruptcy, insolvency orother similar law or we commence a voluntary case under any bankruptcy,insolvency or other similar law or consent to any receivership, liquidation orassignment for the benefit of creditors;

 

•                  wedefault under any agreement entered into on or after October 7, 2003,under which we have incurred indebtedness for borrowed money in excess of$500,000; and

 

•                  we,prior to October 29, 2008, liquidate, dissolve or windup, transfer all orsubstantially all of our assets or are party to a merger or other change incontrol transaction, in which our stockholders do not own a majority of ouroutstanding voting securities after such transaction.

 

If we are required to redeem our series A preferred stock due to any ofthe foregoing events, we are required to pay each holder of our series Apreferred stock the original purchase price, plus an amount equal to thedividends that would otherwise have accrued and been payable on such sharesthrough October 29, 2008 that have not otherwise been paid as of theredemption date.  As of March 31,2005, the aggregate redemption price we would be required to pay isapproximately $11.1 million.  As of March 31,2005, we had aggregate cash and cash equivalents of approximately $5.9 million.

 

In addition, the holders of at least 66-2/3% of the outstanding sharesof our series A preferred stock may elect to require us to redeem alloutstanding shares of our series A preferred stock for the original purchaseprice, plus all accrued but unpaid dividends as of the redemption date, oneither October 29, 2006, 2007 or 2008.

 

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A redemption of the series A preferred stock would deplete the cash wehave available to fund operations, research and product development, capitalexpenditures and other general corporate purposes.  In addition, we have incurred net losses inthe past and expect to incur losses in the future, which may impair our abilityto generate the cash required to meet our obligations under our series Apreferred stock.  If we cannot generatesufficient cash to meet these obligations, we will be required to incuradditional indebtedness or raise additional capital, which would negativelyimpact our stockholders.

 

In addition, under the terms of the Note in the aggregate principalamount of $4.5 million issued in a private placement on April 21, 2005, aredemption of the series A preferred stock would result in an event of defaultunder the Note.  Upon the occurrence andduring the continuance of such an event of default, the outstanding principalamount of the Note will bear interest at a maximum rate of 15% per annum.

 

**Thepurchaser of our series A preferred stock owns a substantial portion of ourcapital stock, which may afford the purchaser significant influence over ouraffairs.**

 

As of March 31, 2005, the holder of our series A preferred stock,together with its affiliates, held or had the right to acquire and/or vote14.07% of our outstanding common stock, assuming the conversion of series Apreferred stock to common stock and the exercise of a common stock purchasewarrant, including shares of our common stock which the holder previouslypurchased in the open market.  The seriesA holder has agreed not to convert its series A if such conversion would causethe holder to beneficially own in excess of 9.99% of our common stock.  Nevertheless, this stockholder hassignificant influence over our ability to offer securities for sale at apurchase price of less than $2.25 per share, incur additional indebtedness andaffect any change in control of the Company that may be favored by otherstockholders.  Additionally, thisstockholder could otherwise exercise significant influence over all corporateactions requiring stockholder approval, including the approval of some mergersand other significant corporate transactions, such as a sale of substantiallyall of our assets or the defeat of any non-negotiated takeover attempt thatmight otherwise benefit the public stockholders.  Consequently, this stockholder may approve atransaction that, in its judgment, enhances the value of its investment, butwhich nonetheless may diverge from the interests of our other stockholders.

 

**Theagreements and instruments governing the rights and preferences of our series Apreferred stock impose restrictions on our business and limit our ability toundertake certain corporate actions, including with respect to financings.**

 

Our amended and restated certificate of incorporation, which we referto as our charter, and the series A purchase agreement govern the terms of ourseries A preferred stock and impose significant restrictions on ourbusiness.  These restrictions may limitour ability to obtain additional financing, operate our business and to takeadvantage of potential business opportunities as they arise.  Without the consent of the holders of atleast 66-2/3% of the outstanding shares of our series A preferred stock, wecannot:

 

•                  alteror change the rights, preferences or privileges of our series A preferredstock, including any increase in the number of authorized shares of our seriesA preferred stock;

 

•                  issueshares of our common stock, or securities convertible into shares of our commonstock, with a purchase price of less than $2.25 per share, other than inlimited circumstances;

 

•                  incurmore than $9,000,000 of indebtedness at any time;

 

•                  create,incur or assume specified liens; or

 

•                  declareor pay dividends, redeem stock or make other distributions to stockholders,other than in limited circumstances.

 

Events beyond our control, including prevailing economic, financial andindustry conditions, may affect our ability to comply with theserestrictions.  In addition, the holder ofour series A preferred stock has the right to participate in any of our futurecapital raising transactions.  Theexistence of this right may substantially reduce our ability to establish termswith respect to, or enter into, any financing with parties other than theseries A preferred stockholder.  Theterms of any additional financing, which we may enter into, may imposeconstraints on our ability to operate our business as we deem appropriate.  These restrictions and covenants could limitour ability to take advantage of financings, mergers and acquisitions or othercorporate opportunities, which could adversely affect our business andfinancial condition and your investments in our common stock.

 

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**Theissuance and sale of our securities could have the effect of substantiallydiluting the interests of our current stockholders.**

 

In connection with the Note in the aggregate amount of $4.5 millionissued in a private placement on April 21, 2005, we issued Xmark warrantsto purchase an aggregate of 2,000,000 shares of our common stock at an exerciseprice of $2.25 per share.  The price pershare is subject to adjustment in certain circumstances while there is abalance outstanding under the Note on or after September 18,2005 and we issue specifiedsecurities for less than $2.25 per share. The warrants also provide for an adjustment to the exercise price and number andtype of securities purchasableupon exercise of the warrant in certain circumstances, including****,****withoutlimitation, a split-up or combination of shares or a consolidation ormerger where we are not thesurviving entity. In connection with our private placement in November 2004, weissued warrants to purchase an aggregate of 3,550,294 shares of our commonstock at an exercise price of $1.69 per share. On October 29, 2003, we issued and sold an aggregate of 270,000shares of our series A preferred stock and granted the purchaser of suchshares a warrant to purchase an additional 190,000 shares of our series Apreferred stock at $22.50 per share, which the purchaser exercised on June 30,2004.  In connection with the exercise ofthe warrant, we granted an affiliate of the series A holder a warrant topurchase 261,500 shares of our common stock at an exercise price of $4.17 pershare.  Each share of our series Apreferred stock is currently convertible into ten shares of our commonstock.  Consequently, on an as-convertedand as-exercised basis, an aggregate of 4,861,500 shares of our common stockmay be issued to the series A purchaser or its affiliate.  Any issuance of shares of our common stockupon conversion of shares of our series A preferred stock, or upon exercise ofoutstanding warrants, could have the effect of substantially diluting theinterests of our current stockholders, as well as the interests of holders ofour outstanding options and warrants.  Asof March 31, 2005, we had outstanding options and warrants exercisable foran aggregate of 9,964,637 shares of our common stock, which does not includethe warrant to purchase an aggregate of 2,000,000 shares of our common stockissued to Xmark in April 2005.

 

Moreover, any sale of the shares of our common stock issued uponconversion of the series A preferred stock, as well as any of the outstandingshares of our common stock issued upon exercise of options or warrants, intothe public market could cause a decline in the trading price of our commonstock.  In financing transactions, forcompensatory purposes or in other types of transactions, we may issue additionalequity securities, including options and warrants, that could dilute theinterests of our current and future stockholders.

 

**Ouroperating results may fluctuate significantly, and any failure to meetfinancial expectations may disappoint securities analysts or investors andresult in a decline of our common stock price.**

 

Our operating results have fluctuated in the past and we expect theywill fluctuate in the future.  Thesefluctuations could cause our common stock price to decline.  Some of the factors that could cause ouroperating results to fluctuate include:

 

•                  ourability to pay our obligations as they become due;

 

•                  recognitionof non-recurring revenue due to receipt of license fees, achievement ofmilestones, completion of contracts or other revenue;

 

•                  demandfor, and market acceptance of, our molecular biology services and ourproprietary programs;

 

•                  timingof the execution of agreements relating to our molecular biology services andproprietary programs, and other material contracts;

 

•                  ourdependence on a limited number of customers for a substantial portion of ourrevenue;

 

•                  ourcompetitors’ announcements or introduction of new products, services ortechnological innovations;

 

•                  acquisitioncosts or other non-recurring charges in connection with the acquisition ofcompanies, products or technologies;

 

•                  ourability to control operating expenses;

 

•                  disputesregarding patents or other intellectual property rights;

 

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•                  securitiesclass actions or other litigation;

 

•                  adversechanges in the level of economic activity in the United States and other majorregions, in which we conduct business; and

 

•                  generaland industry-specific economic conditions, which may affect our customers’ useof our *HAP* Technology and ourmolecular biology services.

 

Due to volatile and unpredictable revenue and operating expenses, webelieve that period-to-period comparisons of our results of operations may notbe a good indication of our future performance. It is possible that our operating results may be below the expectationsof securities analysts or investors.  Inthis event, the market price of our common stock could fluctuate significantlyor decline.

 

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**Risks Related to Commercialization and Development**

 

**Wecurrently rely on a limited number of customers for a substantial portion ofour revenue.  As a result, our revenuesmay fluctuate based on the buying patterns of our customers, and the loss ofone major customer or our inability to secure additional significant customers,during a given period, would have a material adverse effect on our business andoperating results.**

 

We are dependent upon a limited number of customers for substantiallyall of our revenue.  In the three monthsended March 31, 2005, one of our customers accounted for 20% of ourrevenues.  Our reliance on a small numberof customers could cause our revenues to fluctuate from quarter to quarter,based on the buying patterns of these customers.  For example, we revised our guidance for ourannual revenue downward in October 2004, primarily as a result of a shiftin the timing of certain anticipated contracts and the receipt of samplesassociated with some of these contracts. If we lose and are not able to replace customers that provide us withsignificant revenues, it could have a material adverse effect on our revenuesand on our business in general and could cause volatility or a decline in ourstock price.  In addition, if any ofthese customers fails to pay us on a timely basis, or at all, our financialposition and results of operations could be materially and adversely affected.

 

**Togenerate significant revenue, we must obtain additional customers for ourmolecular biology services and our proprietary programs.**

 

Our strategy depends on obtaining additional customers for ourmolecular biology services and entering into new agreements with pharmaceuticaland biotechnology companies for our *HAP*Technology and our other proprietary programs. Our contracts for our molecular biology services and with many of our *HAP* Technology customers are for specificlimited-term projects.  We may not besuccessful in obtaining a sufficient number of new customers for our molecularbiology services, additional customers for our *HAP*Technology, or in obtaining significant customers for our other proprietaryprograms to replace our current customers and projects.  If we are unsuccessful in finding such newcustomers, we may never generate sufficient revenue to sustain ouroperations.  In addition, we expect thatsome of our future *HAP* Technologycollaborations, like some of our current *HAP*Technology collaborations, will be limited to specific, limited-term projectsor that some of these collaborations may not be renewed.  Accordingly, we must continually obtain newcustomers to be successful.  To date, theintegration of pharmacogenomics into drug development and marketing has notachieved widespread market acceptance.

 

**Wemay need to establish collaborative relationships in order to succeed.**

 

In order to satisfy our obligations under our license, development andcooperation agreement relating to vilazodone, we will likely need to enter intoa collaborative relationship with a third party.  We face significant competition in seekingappropriate collaborators.  Moreover,these arrangements are complex to negotiate and time-consuming todocument.  We may not be successful inour efforts to identify potential collaborators and establish collaborativerelationships or other alternative arrangements, especially since we do nothave experience with these types of collaborations.

 

Reliance on collaborative relationships poses a number of risks,including the following:

 

•                  wecannot effectively control whether a collaborator will devote sufficientresources to a program or product;

 

•                  disputesmay arise in the future with respect to the ownership of rights to technologydeveloped with a collaborator;

 

•                  disagreementswith a collaborator could delay or terminate the research, development orcommercialization of products, or result in litigation or arbitration;

 

•                  contractswith a collaborator may fail to provide sufficient protection;

 

•                  wemay have difficulty enforcing the contracts, if a collaborator fails toperform;

 

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•                  collaboratorshave considerable discretion in electing whether to pursue the development ofany additional drugs and may pursue technologies or products, either on theirown or in collaboration with our competitors; and

 

•                  collaboratorswith marketing rights may choose to devote fewer resources to the marketing ofour products than they do to products that they develop.

 

Given these risks, even if we are able to identify a potentialcollaborator and negotiate and enter into a collaborative arrangement, it ispossible that any collaborative arrangement into which we enter may not besuccessful.  Failure of our efforts couldcause us to breach covenants in our license agreement relating to vilazodone,delay our drug development or impair commercialization of our products.  In particular, we must demonstrate to Merck’ssatisfaction, by no later than July 22, 2005, that we will have thefinancial resources to fund the anticipated budget for research and developmentactivities relating to vilazodone for 2005. We will likely not be able to satisfy this requirement, or othermilestone obligations with respect to vilazodone, unless we obtain significantadditional funding or enter into a collaboration arrangement with a third party.

 

**Ourproprietary programs may not allow our commercial customers to developcommercial products or to increase sales of their marketed products.**

 

We developed our *HAP*Technology and other proprietary programs on the assumption that informationabout gene variation and gene variation associated with drug response may helpdrug development professionals better understand the drug response ofparticular populations and complex disease processes.  Although the pharmaceutical and biotechnologyindustries are increasing their use of genomics in analyzing drug response anddiseases, we are aware of only two successful drug program applying genomics.

 

We discover *HAP* Markersfor pharmaceutically relevant genes. This information may not prove to be superior to genomic variationinformation discovered by our competitors or to genomic information availablein public databases.  Furthermore,pharmaceutical and biotechnology companies may not choose our *HAP* Technology over competingtechnologies.

 

Our *DecoGen* InformaticsSystem may also be less effective than we expect or may not allow us or ourcommercial customers to determine a correlation between drug response andgenomic variation.  Furthermore, even ifour customers or we are successful in identifying such a correlation, ourcustomers may not be able to develop or sell commercially viable products, normay our customers be able to increase the sales of their marketed productsusing this correlation.  Accordingly, our*HAP* Markers and *HAP* Technology may not improve thedevelopment, marketing and prescribing of drugs or the development andmarketing of diagnostics developed by our *HAP*Technology customers and proprietary program customers.

 

**Wemay be unable to develop or commercialize our proprietary programs if we cannotestablish additional customers, and we may depend on our customers to developor to co-develop products.**

 

Part of our current and future revenue will depend on payments from ourcurrent proprietary program customers and our future proprietary programcustomers, if any, for either the new products they may develop or forincreased sales of their existing products, made possible through the use ofour *HAP* Technology.  If we are unable to attract new proprietaryprogram customers, we may never generate sufficient revenue to sustain ouroperations.

 

Our customers for certain of our proprietary programs may beresponsible for pre-clinical study and clinical development of therapeutic anddiagnostic products and for regulatory approval, manufacturing and marketing ofany product or enhanced marketing claims that result from the application ofour proprietary programs.  Our currentagreements with these customers allow them significant discretion in pursuingthese activities and future agreements, if any, may allow similardiscretion.  We cannot control the amountand timing of resources that any such current or potential customers willdevote to our programs or potential products. Our current proprietary program arrangements and our future proprietaryprogram arrangements, if any, may also have the effect of limiting the areas ofresearch or commercialization that we may pursue either alone or withothers.  Because part of our revenuecould be dependent on the successful commercialization or development of ourcustomers’ products, if, for any reason, a proprietary program customer delaysor abandons its development or commercialization of a product developed usingour *HAP* Technology, we mayreceive reduced royalty or other payments or no royalty or other payments atall.

 

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**Weinvest considerable amounts of time, effort, and money to license our *HAP* Technology and proprietary programsand, if we fail in these licensing efforts, we may not generate sufficient revenueto sustain our operations.**

 

Our ability to obtain customers for our proprietary programs willdepend in significant part upon the pharmaceutical and biotechnology industries’acceptance that our *HAP*Technology can help accelerate or improve their drug and diagnostic developmentand marketing efforts.  To achieve marketacceptance, we must continue to educate the pharmaceutical and biotechnologyindustries and the public in general as to the potential benefits of our *HAP* Technology.  Most importantly, we must convince theresearch and development, clinical and marketing departments of pharmaceuticaland biotechnology companies that our *HAP*Technology can accelerate and improve the processes for developing, marketingand prescribing drugs and for developing and marketing diagnostics, and thatour proprietary programs will be commercially viable.  If we fail to gain this acceptance, we maynever generate sufficient revenue to sustain our operations.  We may expend substantial funds andmanagement effort to market our proprietary programs without any resultingrevenue.

 

**If wedo not successfully distinguish and commercialize our proprietary programs, wemay be unable to compete successfully with our competitors or to generaterevenue significant to sustain our operations.**

 

Numerous entities are attempting to identify genomic variationpredictive of specific diseases and drug response and to develop products andservices based on these discoveries.  Weface competition in these areas from pharmaceutical, biotechnology anddiagnostic companies, academic and research institutions and government andother publicly funded agencies, both in the United States and abroad, most ofwhich have substantially greater capital resources, research and developmentstaffs, facilities, manufacturing and marketing experience, distributionchannels and human resources than do we.

 

These competitors may discover, characterize or develop importanttechnologies applying genomics before our customers or us for our proprietaryprograms that are more effective than those technologies, which our customersor which we develop for our proprietary programs.  Additionally, these competitors may obtainregulatory approval for their drugs and diagnostics more rapidly than ourcustomers for our proprietary programs do, any of which could limit our abilityto market effectively our proprietary programs.

 

Some companies and governments are marketing or developing a number ofdatabases and informatics tools to assist participants in the healthcare industryand academic researchers in the management and analysis of genomic data.  Entities such as Perlegen Sciences and theInternational HapMap Project have developed databases containing gene sequence,genomic variation or other genomic information and are marketing their data topharmaceutical and biotechnology companies or are making their databases freelyavailable to the public.  In addition,numerous pharmaceutical and biotechnology companies, such as GlaxoSmithKlineplc, either alone or in collaboration with our competitors, are developinggenomic research programs that involve the use of information that can be foundin these databases.  Furthermore,companies, such as deCODE genetics, Inc., have technologies for usinggenomic variation in diagnostics and in the drug development process and havecollaborations with companies employing these technologies.

 

Genomic technologies have undergone, and are expected to continue toundergo, rapid and significant change. Our future success will depend in large part on maintaining acompetitive position in the genomics field. Others may rapidly develop new technologies that may result in ourmolecular tests or technologies becoming obsolete before we recover theexpenses that we incur in connection with the development of theseproducts.  Our proprietary programs couldbecome obsolete if our competitors offer less expensive or more effective drugdiscovery and development technologies, including technologies that may be unrelatedto genomics.

 

**Our *FAMILION* Test may not gain marketacceptance.**

 

The market for genetic tests is relatively undeveloped.  We are marketing our *FAMILION* Test to physicians, who did notpreviously have a genetic test available for cardiac channelopathies.  The success of our test depends on itsacceptance by the medical community, patients and third-party payers as beingmedically useful.  If we are not able togain market acceptance for our test, we may not be able to generate sufficientrevenue to sustain our operations.

 

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**Risks Related to Our Intellectual Property**

 

**If weare unable to prevent others from the unauthorized use of, or are unable todefend their use of, our patents, trade secrets or know how, we may not be ableto operate our business profitably.**

 

Despite our efforts to protect our proprietary rights, unauthorizedparties may be able to obtain and use information that we regard asproprietary.  The issuance of a patentdoes not guarantee that it is valid or enforceable.  Thus, even if we obtain patents, they may bechallenged, narrowed, invalidated or unenforceable against third parties, whichcould limit our ability to stop competitors from marketing similar technologiesor products, or limit the length of term of patent protection we may have forany of our technologies or products. Changes in patent laws or in interpretations of patent laws in theUnited States and other countries may diminish the value of our intellectualproperty or narrow the scope of our patent protection.  Because patent applications that were filedprior to November 29, 2000 in the United States are confidential untilpatents issue, third parties may have filed patent applications for technologycovered by our pending patent applications without us being aware of thoseapplications, and our patent applications may not have priority over any patentapplications of others.  We are awarethat there are other firms and individuals who have discovered, or arecurrently discovering, information similar to the information we arediscovering, who may have filed, and in the future are likely to file, patentapplications that are similar or identical to our proprietary program patentapplications.   In addition, some interestgroups are lobbying for restrictions on patenting of genetic tests.

 

Further, a patent does not provide the patent holder with freedom tooperate in a way that infringes the patent rights of others.  A third party may sue us for infringing onits patent rights.  Likewise, we may needto resort to litigation to enforce a patent issued to us or to determine thescope and validity of third party proprietary rights.  The cost to us of any litigation or otherproceeding relating to intellectual property rights, even if resolved in ourfavor, could be substantial, and the litigation would divert our management’sfocus from our core business concerns. Some of our competitors may be able to sustain the costs of complexpatent litigation more effectively than we can because they have substantiallygreater resources.  Uncertaintiesresulting from the initiation and continuation of any litigation could limitour ability to continue our operations.

 

We also rely upon unpatented trade secrets and improvements, unpatentedknow-how and continuing technological innovation to develop and maintain ourcompetitive position.  We generallyprotect this information with reasonable security measures, includingconfidentiality agreements signed by our employees, academic collaborators andconsultants that provide that all confidential information developed or madeknown to others during the course of the employment, consulting or businessrelationship will be kept confidential, except in specified circumstances.  Agreements with employees, consultants andcollaborators generally provide that all inventions conceived by the individualwhile employed by us are our exclusive property.  If employees, consultants or collaborators donot honor these agreements, we may not have adequate remedies for breach.  Furthermore, our trade secrets may otherwisebecome known or be independently discovered by competitors.

 

If any party should successfully claim that the creation or use of ourproprietary programs infringes upon their intellectual property rights, inaddition to any damages we might have to pay, a court could require us to stopthe infringing activity or obtain a license on unfavorable terms.  Moreover, any legal action threatened orcommenced against us or any of our proprietary program customers claimingdamages or seeking to enjoin commercial activities relating to the affectedtest and processes could, in addition to subjecting us to potential liabilityfor damages, require us or our current and future customers of our proprietaryprograms, if any, to obtain a license in order to continue to manufacture ormarket the affected test and processes. Any license required under any patent may not be made available oncommercially acceptable terms, if at all. In addition, some licenses may be non-exclusive and, therefore, our competitorsmay have access to the same technology licensed to us.  If we fail to obtain a required license orare unable to design around a patent, we may be unable to market effectivelysome of our proprietary programs, which could limit our profitability andpossibly prevent us from generating revenue sufficient to sustain ouroperations.

 

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**Regulatory Risks**

 

**Regulatoryoversight of our proprietary programs and public opinion regarding ethicalissues surrounding the use of genetic information may adversely affect ourability to market our products and services.**

 

Currently, there is limited FDA regulation of genetic tests.  The Secretary’s Advisory Committee on GeneticTesting, an advisory panel to the Secretary of the U.S. Department of Healthand Human Services, has recommended that the FDA expand its regulation ofgenetic testing to require FDA approval for all new genetic tests and labelingof genetic tests.  If the FDA adopts thisrecommendation, it may require that we, or our customers, apply for FDAapproval as a prerequisite to marketing genetic tests that incorporate ourintellectual property.  If the FDA wereto deny any application of this kind, it could adversely affect our businessand we may be unable to generate sufficient revenue to sustain our operations.

 

The FDA has twice required that a physician must have genomic variationinformation determined about a patient before the doctor prescribes adrug.  In April 2005, the FDA issuedguidance that encourages drug and biologic developers to conductpharmacogenomic tests during drug development and clarified how the FDA willevaluate the resulting data.  Theguidance provides specific criteria and recommendations on the submission ofpharmacogenomic data in connection with Investigational New Drug Applications,New Drug Applications and Biological License Applications.  The guidance includes information on the typeof data needed and how the FDA will or will not use such data in regulatorydecisions.  The FDA asked for voluntarysubmissions of research information in order to gain experience as the field ofpharmacogenomics evolves.  The FDAadvised that the agency would not use information from voluntary reports forregulatory decisions on the drug or biologic, with which the voluntary data isassociated.  In addition, the FDA held aworkshop in April 2005 to discuss its guidance and gain further industrycomment on implications of voluntary data submissions and joint development ofdrug-diagnostic combination products. Our success will depend, in part, on how rapidly the pharmaceutical andbiotechnology industry implements the guidance and, accordingly, the validityof our test and services as a basis for identifying genomic variation and forcorrelating drug response with genomic variation.  Without this implementation by thepharmaceutical and biotechnology industry, we may be unable to marketeffectively any test we may have, as well as any of our services, and we maynot generate sufficient revenue to sustain our operations.

 

Within the field of personalized health and medicine, governmental andother entities may enact patient privacy and healthcare laws and regulationsthat may limit the generation and use of genomic variation data.  To the extent that these laws and regulationslimit the use of our products and services or impose additional costs on ourcustomers, we may be unable to market effectively our proprietary programs, andwe may not generate sufficient revenue to sustain our operations.

 

Additionally, public opinion on ethical issues related to theconfidentiality and appropriate use of genetic testing results may influencegovernmental authorities to call for limits on, or regulation of the use of,genetic testing.  In addition, governmentalauthorities or other entities may call for limits on, or regulation on the useof, genetic testing or prohibit testing for genetic predisposition to certainconditions, particularly for those that have no known cure.  The occurrence of any of these events couldreduce the potential markets for our products and services, which could preventus from generating sufficient revenue to sustain our operations.

 

Furthermore, we are subject to laws and regulations as a provider ofinformation that a doctor can use to make a therapeutic decision.  To the extent that these laws and regulationsrestrict the sale of our products and services or impose other costs, we may beunable to provide our products and services to our customers on termssufficient to recover our expenses.

 

**Ifour customers or we do not seek, or do not receive, marketing approval forproducts developed, if any, from our proprietary programs, we may receivedelayed royalty or other payments or no royalty or other payments at all.**

 

Any new drug, biologic, or new drug or biologic indication we or ourcustomers develop using genetic markers from our proprietary programs mustundergo an extensive regulatory review process in the United States and othercountries before a new product or indication of this kind could bemarketed.  This regulatory process cantake many years, requires substantial expense and is uncertain as tooutcome.  Changes in FDA policies and thepolicies of similar foreign regulatory bodies can prolong the regulatory reviewof each new drug or biologic license application or prevent 

 

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approvalof the application.  We expect similardelays and risks in the regulatory review process for any diagnostic productdeveloped by us or our customers, whenever this regulatory review isrequired.  Even if a product obtainsmarketing clearance, a marketed product and its manufacturer are subject tocontinuing review.  A manufacturer may beforced to withdraw a product from the market if a previously unknown problemwith a product becomes apparent.  Becauseour future revenue will be dependent on the successful commercialization ordevelopment of products using genetic markers from our proprietary programs, anydelay in obtaining, failing to obtain, or failing to maintain regulatoryapproval for a product developed using genetic markers from our proprietaryprograms may delay our receipt of royalty or other payments or prevent us fromreceiving royalty or other payments sufficient to recover our expenses.

 

**Ifour customers are unable to obtain FDA approval for therapeutic or diagnosticproducts developed using our *HAP*Technology or genetic markers from our proprietary programs, the lack ofregulatory approval will diminish the value of our *HAP* Technology and proprietary programs.**

 

To date, none of our customers has developed or commercialized anytherapeutic product or commercialized any diagnostic product using our geneticmarkers from our proprietary programs. We expect to rely on our customers to file applications for regulatoryapproval and generally direct the regulatory review process and obtain FDAacceptance of any product they develop with our genetic markers from ourproprietary programs, if any.  Our customersmay not submit an application for regulatory review.  Even if they do submit applications, they maynot be able to obtain marketing clearance for any product on a timely basis, ifat all.  If our customers fail to obtainrequired governmental clearances for any therapeutic or diagnostic product,they will not be able to market these products. As a result, we may not receive royalty or other payments from ourcustomers.  The occurrence of any ofthese events may prevent us from generating revenue sufficient to sustain ouroperations.

 

**If weare unable to obtain reimbursement from health insurers and other organizationsfor our *FAMILION* Test, our testmay be too costly for regular use and our ability to generate revenues would beharmed.**

 

Our future revenues and profitability will be adversely affected if wecannot depend on governmental and private third-party payers to defray the costof our test to patients.  If theseentities refuse to provide reimbursement for our test or provide aninsufficient level of reimbursement, our test may be too costly for generaluse.  Our profitability may be adverselyimpacted if we choose to offer our test at a reduced price.  Any limitation on the use of our test or anydecrease in the price of our test, without a corresponding decrease in therelated costs, could have a material adverse effect on our ability to generaterevenues.

 

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**Additional Risks Related to Our Business**

 

**Wedepend on third-party products and services and limited sources of supply for ourhigh-throughput genotyping laboratory.**

 

We rely on outside vendors to supply certain software, products andmaterials used in our laboratories.  Someof these products and materials are obtained from a single supplier or alimited group of suppliers.  For example,we have a written agreement with Sequenom, Inc., pursuant to which it iscontractually the sole provider of silicon chips for one-time use on theirMassARRAYTM System, which is our primary genotyping platform in ourNew Haven facility.  Under the terms ofthe agreement and subject to specific conditions, we have the authority toreuse these chips should Sequenom be unable to supply new chips to us.  While we believe that we could prepare forreuse the requisite supply of chips without unreasonable cost or delay, we maybe unable to do so.  We have no otherwritten long-term supply agreements with our suppliers.  Our reliance on outside vendors generally anda sole or a limited group of suppliers in particular involves several otherrisks, including:

 

•                  theinability to obtain an adequate supply of required software, products andmaterials due to capacity constraints, product defects, a discontinuance of aproduct by a supplier or other supply constraints;

 

•                  reducedcontrol over quality and pricing of software, products and materials; and

 

•                  delaysand long lead times in receiving software, products, or materials from vendors.

 

**If wefail to maintain our computer hardware, software and related infrastructure, wecould experience loss of, or delay in, revenue and market acceptance.**

 

Because our business requires manipulating and analyzing large amountsof data, we depend on the continuous, effective, reliable and secure operationof our computer hardware, software and related infrastructure.  To the extent that any of these elementsmalfunction, we will experience reduced productivity.  We protect our computer hardware throughphysical and software safeguards. However, our computer hardware is still vulnerable to fire, weather,earthquake, or other natural disaster and power loss, telecommunicationsfailures, physical or software break-ins and similar events.  In addition, the software and algorithmiccomponents of our *DecoGen*Informatics System are complex and sophisticated, and as such, could containdata, design or software errors that could be difficult to detect andcorrect.  Users of our system may findsoftware defects in current or future tests. We have developed a proprietary Laboratory Information Management System(LIMS) to operate our high-throughput genotyping facilities.  Software defects in the LIMS could adverselyeffect our operations and have a significant impact on our ability to generaterevenue from this facility.  If we failto maintain the necessary computer capacity and data to support ourcomputational needs and our customers’ drug and diagnostic discovery anddevelopment efforts, we could experience a loss in revenue, or a delay inreceiving revenue and a delay in obtaining market acceptance for ourtechnology.

 

**Thecurrent labor markets are very competitive, and our business may suffer if weare not able to hire and retain key personnel.**

 

Our futuresuccess depends on the retention of our key technical, marketing and executivemanagement to assist in formulating our business strategies.  The loss of the services of any of theseindividuals could have a material adverse effect on our product development andcommercialization efforts.  In addition,research, product development and commercialization may require additionalskilled personnel.  Competition forqualified personnel in the technology area is intense, particularly given thecompetition among biotechnology, pharmaceutical and health-care companies,universities and non-profit research institutions for experienced scientists.  In addition, and we operate in geographiclocations where labor markets are particularly competitive, including NewHaven, Connecticut; Morrisville, North Carolina; Houston, Texas; and Takeley,England, where our service facilities are located.  If we are unable to attract and retain asufficient number of qualified personnel on acceptable terms, our business,financial condition and results of operations could be seriously harmed.  The inability to retain and hire qualifiedpersonnel could also hinder the future expansion of our business.

 

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**Integration effortsor strategic investments could interrupt our business and our financialcondition could be harmed.**

 

On April 1, 2004,we acquired Lark Technologies, Inc. Our integration activities with respect to the acquisition are ongoingand entail numerous risks that include the following:

 

•                  difficulties integrating any acquired operations,personnel, technologies or products;

 

•                  diversion of management’s focus from our corebusiness concerns;

 

•                  entering markets, in which we have no or limitedprior experience or knowledge; and

 

•                  any difficulties encountered as a result of ourrecent acquisition could adversely affect our business, operating results andfinancial condition.

 

**Risks Relating to Financial Reporting**

 

**Underregulations required by the Sarbanes-Oxley Act of 2002, an adverse opinion oninternal controls could be issued by our independent registered publicaccounting firm, and this could have a negative impact on our stock price.**

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires that weestablish and maintain an adequate internal control structure and proceduresfor financial reporting and assess on an ongoing basis the design and operatingeffectiveness of our internal control structure and procedures for financialreporting. Our independent registered public accounting firm is required toaudit both the design and operating effectiveness of our internal controls andmanagement’s assessment of the design and the effectiveness of its internalcontrols. Although no known material weaknesses exist at this time, this willbe the first year that we have undergone an audit of our internal controls andprocedures of the operating facilities at our subsidiary, Lark Technologies,Inc., the integration of which was not required under the assessment of ourinternal control structure and procedures for the year ended December 31,2004.  It is possible that materialweaknesses could be found through our own evaluation, or that of ourindependent registered public accounting firm. If such weaknesses are found, wemay not be able to remediate such weaknesses in time to meet the deadlinesimposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404.If we do not effectively complete our assessment or if our internal controlsare not designed or operating effectively, our independent registered publicaccounting firm may either disclaim an opinion as it relates to management’sassessment of the effectiveness of our internal controls or may issue aqualified opinion on the effectiveness of our internal controls. Any suchdisclaimer or qualified opinion could have a material adverse effect on ourstock price.

 

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**Item 3****– Quantitative and Qualitative Disclosures About Market Risk.**

 

Our exposure to market risk is principallyconfined to our cash equivalents and investments, all of which have maturitiesof less than one year.  We have maintained a non-trading investmentportfolio of investment grade, liquid debt securities that limit the amount ofcredit exposure to any one issue, issuer or type of instrument.  In viewof the nature and mix of our total portfolio, a 10% movement in market interestrates would not have any impact on the total value of our investment portfolioas of March 31, 2005.

 

**Wemaintain an operating facility in Takeley, England.  If the U.S. dollar weakens relative to aforeign currency, any losses generated in the foreign currency will, in effect,increase when converted into U.S. dollars and vice versa. We do not speculatein the foreign exchange market and do not manage exposures that arise in thenormal course of business related to fluctuations in foreign currency exchange ratesby entering into offsetting positions through the use of foreign exchangeforward contracts. We also do not engage in derivative activities.**

** **

**Item 4** – Controls andProcedures.

** **

**Evaluation of DisclosureControls and Procedures**

 

Our management, with the participation of ourchief executive officer and chief financial officer, evaluated theeffectiveness of our disclosure controls and procedures as of March 31,2005.  The term “disclosure controls andprocedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the ExchangeAct, means controls and other procedures of a company that are designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is recorded, processed, summarizedand reported, within the time periods specified in the SEC’s rules andforms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is accumulated and communicatedto the company’s management, including its principal executive and principalfinancial officers, as appropriate to allow timely decisions regarding requireddisclosure.  Management recognizes thatany controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving their objectives and managementnecessarily applies its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures. Based on the evaluation of our disclosurecontrols and procedures as of March 31, 2005, our chief executive officerand chief financial officer concluded that, as of such date, our disclosurecontrols and procedures were effective at the reasonable assurance level.

 

**Changes in Internals ControlOver Financial Reporting**

** **

**No change in our internal controlover financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) occurred during the fiscal quarter ended March 31, 2005 thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.**

** **

**36**

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** **

**PART II****- Other Information**

 

**Item 2****– Unregistered Sales of Equity Securities and Use of Proceeds.**

 

Thefollowing table provides information about purchases made by us of our commonstock for each month included in our first quarter:

 
| **ISSUER PURCHASES OF EQUITY SECURITIES** |
|-------------------------------------------|

 
| **Period**         | ** ** | **(a)  Total Number  of Shares (or  Units)  Purchased** | ** ** | **(b)  Average Price  Paid per Share  (or Unit)** | ** ** | **(c)  Total Number  of Shares (or  Units)  Purchased as  Part of Publicly  Announced  Plans or  Programs** | ** ** | **(d)  Maximum  Number (or  Approximate  Dollar Value)  of Shares (or  Units) that May  Yet Be  Purchased  Under the Plans  or Programs** | ** ** |
|--------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **         | ** ** | ** **                                              | ** ** | ** **                                        | ** ** | ** **                                                                                                  | ** ** | ** **                                                                                                                                | ** ** |
| 1/1/2005-1/31/2005 |       | —                                                  |       | —                                            |       | —                                                                                                      |       | —                                                                                                                                    |       |
|               |       |                                                    |       |                                              |       |                                                                                                        |       |                                                                                                                                      |       |
| 2/1/2005-2/28/2005 |       | 5,040                                                   | (1)        | $                                                 | 0.001      |                                                                                                        | —     |                                                                                                                                      | —     |   |
|               |       |                                                    |       |                                              |       |                                                                                                        |       |                                                                                                                                      |       |
| 3/1/2005-3/31/2005 |       | —                                                  |       | —                                            |       | —                                                                                                      |       | —                                                                                                                                    |       |
|               |       |                                                    |       |                                              |       |                                                                                                        |       |                                                                                                                                      |       |
| Total              |       | 5,040                                                   | (1)        | $                                                 | 0.001      |                                                                                                        | —     |                                                                                                                                      | —     |   |

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(1)          The5,040 shares are shares of our common stock repurchased pursuant to restrictedstock agreements that we had entered into with certain of our employees.

 

**Item 6********– Exhibits.**

** **

See Index toExhibits attached hereto, which Exhibit Index is incorporated herein by reference.

 

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**SIGNATURE**

 

 

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

 
|              | GENAISSANCE PHARMACEUTICALS, INC.                                                                           |
|-------------------|-------------------------------------------------------------------------------------------------------------|
|              |                                                                                                        |   |
|              |                                                                                                        |   |
| Date: May 5, 2005 | By:                                                                                                         |    /s/ Ben Kaplan |   |
|              | Ben Kaplan  Senior Vice President and Chief Financial Officer  (Principal Financial and Accounting Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit  No.** | ** ** | **Description  of Document**                                                                                             |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------|
| ** **       | ** ** | ** **                                                                                                               |
| 31.1             |       | Certification pursuant to Rules  13a-14(a)/15d-14(a) promulgated under the Securities Exchange Act of 1934, as  amended. |
|             |       |                                                                                                                     |
| 31.2             |       | Certification pursuant to Rules  13a-14(a)/15d-14(a) promulgated under the Securities Exchange Act of 1934, as  amended. |
|             |       |                                                                                                                     |
| 32.1             |       | Certification pursuant to 18 U.S.C. Section 1350.                                                                   |
|             |       |                                                                                                                     |
| 32.2             |       | Certification pursuant to 18 U.S.C. Section 1350.                                                                   |

 

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