**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC  20549**

 

 

**FORM 10-Q**

 
| **o**                                                                                                                                                                         | **Quarterly report pursuant to  Section 13 or 15(****d) of the Securities Exchange  Act of 1934** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------|
|                                                                                                                                                                          |
|                                                                                                                                                                          | **For The  Quarterly Period Ended September 30, 2002**                                            |
|                                                                                                                                                                          |
| **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 ofRegistrant 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)       |

 

Indicate by check markwhether the registrant:  (1) has filedall reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days:

Yes  ý           No o

 

The number of shares of the registrant’s outstanding common stock as ofNovember 11, 2002 was 22,827,353 shares.

 

 

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**GENAISSANCEPHARMACEUTICALS, INC.**

 

For the quarter endedSeptember 30, 2002

**Index**

 
| **PART I – FINANCIAL  INFORMATION**                                                                  |
|-----------------------------------------------------------------------------------------------------------|
|                                                                                                      |
| Item 1 – Financial  statements (unaudited)                                                           |
|                                                                                                      |
| Balance Sheet as of September 30, 2002  and December 31, 2001                                             |
|                                                                                                      |
| Statements of Operations for  the three and nine months ended September 30, 2002 and 2001                 |
|                                                                                                      |
| Statements of Cash Flows for  the nine months ended September 30, 2002 and 2001                           |
|                                                                                                      |
| Notes to the  Unaudited 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 – Changes in  Securities and Use of Proceeds                                                  |
|                                                                                                      |
| Item 6 – Exhibits and  Reports on Form 8-K                                                           |
|                                                                                                      |
| Signature                                                                                                 |
|                                                                                                      |
| Certifications                                                                                            |

 

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Part 1: FinancialInformation

Item 1 – Financial Statements:

**GENAISSANCE PHARMACEUTICALS, INC.**

Balance Sheets

(Unaudited)

(In thousands,except per share data)

 
|                                                                                                                                                   |   | **September  30,  2002** |   | **December  31,  2001** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-------------------------|--------|
|                                                                                                                                                   |   |                     |   |                    |   |
| **ASSETS**                                                                                                                                             |   |                     |   |                    |   |
| Current  Assets:                                                                                                                                       |   |                     |   |                    |   |
| Cash  and cash equivalents                                                                                                                             |   | $                        | 28,026 |                    | $      | 25,204 |   |
| Marketable  securities                                                                                                                                 |   | 8,329                    |   | 34,469                  |   |
| Accounts  receivable                                                                                                                                   |   | 310                      |   | 359                     |   |
| Other  current assets                                                                                                                                  |   | 506                      |   | 2,891                   |   |
|                                                                                                                                                   |   |                     |   |                    |   |
| Total  current assets                                                                                                                                  |   | 37,171                   |   | 62,923                  |   |
|                                                                                                                                                   |   |                     |   |                    |   |
| Property  and equipment, net (Note 4)                                                                                                                  |   | 16,299                   |   | 28,508                  |   |
|                                                                                                                                                   |   |                     |   |                    |   |
| Other  assets                                                                                                                                          |   | 1,199                    |   | 846                     |   |
|                                                                                                                                                   |   |                     |   |                    |   |
| Total  assets                                                                                                                                          |   | $                        | 54,669 |                    | $      | 92,277 |   |
|                                                                                                                                                   |   |                     |   |                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                          |   |                     |   |                    |   |
|                                                                                                                                                   |   |                     |   |                    |   |
| Current  Liabilities:                                                                                                                                  |   |                     |   |                    |   |
| Current  portion of long-term debt, including amounts due to a shareholder of $391 and  $187 at September 30, 2002 and December 31, 2001, respectively |   | $                        | 391    |                    | $      | 672 |   |
| Current  portion of capital lease obligations                                                                                                          |   | 6,918                    |   | 6,759                   |   |
| Accounts  payable                                                                                                                                      |   | 885                      |   | 2,607                   |   |
| Accrued  expenses                                                                                                                                      |   | 2,392                    |   | 4,899                   |   |
| Accrued  dividends                                                                                                                                     |   | 1,159                    |   | —                  |   |
| Royalty  Obligation                                                                                                                                    |   | 300                      |   | —                  |   |
| Current  portion of deferred revenue                                                                                                                   |   | 247                      |   | 211                     |   |
|                                                                                                                                                   |   |                     |   |                    |   |
| Total  current liabilities                                                                                                                             |   | 12,292                   |   | 15,148                  |   |
|                                                                                                                                                   |   |                     |   |                    |   |
| Long-Term  Liabilities:                                                                                                                                |   |                     |   |                    |   |
| Long-term  debt, due to a shareholder                                                                                                                  |   | 4,603                    |   | 4,929                   |   |
| Capital  lease obligations, less current portion                                                                                                       |   | 4,691                    |   | 9,834                   |   |
| Deferred  revenue, less current portion                                                                                                                |   | 1,773                    |   | 1,928                   |   |
| Royalty  obligations                                                                                                                                   |   | —                   |   | 300                     |   |
| Accrued  dividends                                                                                                                                     |   | —                   |   | 1,159                   |   |
|                                                                                                                                                   |   |                     |   |                    |   |
| Total  long-term liabilities                                                                                                                           |   | 11,067                   |   | 18,150                  |   |

 

*The accompanying notes are an integral part of thesefinancial statements.*

 

1

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**GENAISSANCE PHARMACEUTICALS, INC.**

Balance Sheets

(Unaudited)

(In thousands,except per share data)

 
|                                                                                                                                                                  |   | **September  30,  2002** |   | **December  31,  2001** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-------------------------|--------|
|                                                                                                                                                                  |   |                     |   |                    |   |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                                                            |   |                     |   |                    |   |
| (Continued)                                                                                                                                                           |   |                     |   |                    |   |
|                                                                                                                                                                  |   |                     |   |                    |   |
| STOCKHOLDERS’  EQUITY:                                                                                                                                           |   |                     |   |                    |   |
| Common  stock, 58,000 authorized shares, $.001 par value, 22,827 and 22,783 shares  issued and outstanding at September 30, 2002 and December 31, 2001,  respectively |   | 23                       |   | 23                      |   |
| Additional  paid-in capital                                                                                                                                           |   | 219,493                  |   | 219,348                 |   |
| Accumulated  deficit                                                                                                                                                  |   | (188,243                 | )      | (160,509                | )      |
| Net  unrealized investment gains                                                                                                                                      |   | 37                       |   | 117                     |   |
|                                                                                                                                                                  |   |                     |   |                    |   |
| Total  stockholders’ equity                                                                                                                                      |   | 31,310                   |   | 58,979                  |   |
|                                                                                                                                                                  |   |                     |   |                    |   |
| Total  liabilities and stockholders’ equity                                                                                                                      |   | $                        | 54,669 |                    | $      | 92,277 |   |
|                                                                                                                                                                       |        |                          |        |                         |        |  |  |

 

*The accompanying notes are anintegral part of these financial statements.*

 

2

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Statements of Operations

(Unaudited)

(In thousands,except per share data)

 
|                                                                 |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |       |
|----------------------------------------------------------------------|--------|----------------------------------------|--------|---------------------------------------|------------|
|                                                                 |   | **2002**                               |   | **2001**                              | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| License  and service revenue                                         |   | $                                      | 1,754  |                                  | $          | 1,083 |   | $ | 5,539 |   | $ | 3,149 |   |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Operating  Expenses:                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Research  and development(a)                                         |   | 4,767                                  |   | 12,637                                |       | 19,557 |   | 34,046 |   |
| General  and administrative(a)                                       |   | 2,001                                  |   | 2,896                                 |       | 6,930 |   | 8,901 |   |
| Impairment  of fixed assets (Note 4)                                 |   | —                                 |   | —                                |       | 6,000 |   | — |   |
| Stock  based compensation expense/ (benefit)                         |   | (100                                   | )      | 96                                    |       | 107 |   | 381 |   |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Total  operating expenses                                            |   | 6,668                                  |   | 15,629                                |       | 32,594 |   | 43,328 |   |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Loss  from operations                                                |   | (4,914                                 | )      | (14,546                               | )          | (27,055 | ) | (40,179 | ) |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Interest  (expense) income                                           |   | (268                                   | )      | 171                                   |       | (651 | ) | (1,403 | ) |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Net  loss before income tax (expense) benefit                        |   | $                                      | (5,182 | )                                     | $          | (14,375 | ) | (27,706 | ) | (38,776 | ) |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Income  tax (expense) benefit                                        |   | (28                                    | )      | 2,574                                 |       | (28 | ) | 2,574 |   |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Net  loss attributable to common stockholders                        |   | $                                      | (5,210 | )                                     | $          | (11,801 | ) | (27,734 | ) | (36,202 | ) |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Net  loss per common share, basic and diluted                        |   | $                                      | (.23   | )                                     | $          | (.52 | ) | (1.22 | ) | (1.59 | ) |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Weighted average shares used in computing net  loss per common share |   | 22,827                                 |   | 22,773                                |       | 22,802 |   | 22,746 |   |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| (a)  Excludes non-cash, stock-based compensation expense as follows: |   |                                   |   |                                  |       |   |   |   |   |
|                                                                 |   |                                   |   |                                  |       |   |   |   |   |
| Research  and development                                            |   | $                                      | (55    | )                                     | $          | 70 |   | $ | 67 |   | $ | 278 |   |
| General  and administrative                                          |   | (45                                    | )      | 26                                    |       | 40 |   | 103 |   |
|                                                                 |   | $                                      | (100   | )                                     | $          | 96 |   | $ | 107 |   | $ | 381 |   |

 

*The accompanying notes are an integral part of thesefinancial statements.*

 

3

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Statements of Cash Flows

(Unaudited)

(In thousands)

 
|                                                                        |   | **Nine  Months Ended  September 30,** |       |
|-----------------------------------------------------------------------------|--------|---------------------------------------|------------|
|                                                                        |   | **2002**                              |       | **2001** |   |
|                                                                        |   |                                  |       |   |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                   |   |                                  | ** ** |   | ** ** |
| Net loss                                                                    |   | $                                     | (27,734    | ) | $ | (36,202 | ) |
| Adjustment to reconcile net loss to net cash used in  operating activities: |   |                                  |       |   |   |
| Depreciation and amortization                                               |   | 6,422                                 |       | 6,305 |   |
| Impairment of fixed assets                                                  |   | 6,000                                 |       | — |   |
| Stock based compensation                                                    |   | 107                                   |       | 381 |   |
| Changes in assets and liabilities -                                         |   |                                  |       |   |   |
| Accounts receivable                                                         |   | 49                                    |       | 198 |   |
| Other current assets                                                        |   | 2,385                                 |       | (3,260 | ) |
| Other assets                                                                |   | (481                                  | )          | 44 |   |
| Accounts payable                                                            |   | (1,722                                | )          | (1,775 | ) |
| Accrued expenses                                                            |   | (2,507                                | )          | 1,692 |   |
| Deferred revenue                                                            |   | (119                                  | )          | (154 | ) |
|                                                                        |   |                                  |       |   |   |
| Net cash used in operating activities                                       |   | (17,600                               | )          | (32,771 | ) |
|                                                                        |   |                                  |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                   |   |                                  |       |   |   |
| Purchases of property and equipment                                         |   | (85                                   | )          | (4,110 | ) |
| Proceeds from sale of marketable securities                                 |   | 26,060                                |       | 20,872 |   |
|                                                                        |   |                                  |       |   |   |
| Net cash provided by investing activities                                   |   | 25,975                                |       | 16,762 |   |
|                                                                        |   |                                  |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                   |   |                                  | ** ** |   | ** ** |
| Net proceeds from issuance of common stock                                  |   | 38                                    |       | 288 |   |
| Repayment of long-term debt due to related parties,  net                    |   | (122                                  | )          | 338 |   |
| Repayment of long-term debt, net                                            |   | (485                                  | )          | (614 | ) |
| Repayment of capital lease obligations                                      |   | (4,984                                | )          | (4,635 | ) |
|                                                                        |   |                                  |       |   |   |
| Net cash used in financing activities                                       |   | (5,553                                | )          | (4,623 | ) |
|                                                                        |   |                                  |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                        |   | 2,822                                 |       | (20,632 | ) |
|                                                                        |   |                                  |       |   |   |
| CASH AND CASH EQUIVALENTS, beginning of period                              |   | 25,204                                |       | 69,204 |   |
|                                                                        |   |                                  |       |   |   |
| CASH AND CASH EQUIVALENTS, end of period                                    |   | $                                     | 28,026     |   | $ | 48,572 |   |
|                                                                        |   |                                  |       |   |   |
| **SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:**                         |   |                                  | ** ** |   | ** ** |
| Acquisition of equipment pursuant to capital lease  obligations             |   | $                                     | —     |   | $ | 1,855 |   |
| Interest paid                                                               |   | 1,381                                 |       | 1,743 |   |
| Taxes paid                                                                  |   | 28                                    |       | — |   |

 

*The accompanying notes are an integral part of thesefinancial statements.*

 

4

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**GENAISSANCE PHARMACEUTICALS, INC**.

 

Notes to UnauditedFinancial StatementsFor the Quarter Ended September 30, 2002

(In thousands)

 

**(1)        BASIS OFPRESENTATION**

 

GenaissancePharmaceuticals, Inc. is seeking to create personalized medicines through theintegration of gene variation into drug development. We discover inheriteddifferences, or genomic markers, that exist in human genes. We use ourtechnological capabilities and methods as well as our clinical geneticdevelopment skills to identify the genomic markers that appear to define apatient population that responds best to a medication and has a superior safetyprofile.  We market our technology andour predictive genomic markers to the pharmaceutical and biotechnologyindustries as a means to improve the development, marketing and prescribing ofdrugs.

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.

 

We have prepared theaccompanying financial statements without audit, pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to such rules andregulations. These financial statements should be read in conjunction with ouraudited financial statements and related footnotes for the year ended December31, 2001, thereto included in our Annual Report on Form 10-K (File No.000-30981).  The unaudited financialstatements include, in the opinion of management, all adjustments (consistingonly of normal recurring adjustments) necessary to present fairly our financialposition as of September 30, 2002, and the results of our operations for thethree and nine month periods ended September 30, 2002 and 2001. The results ofoperations for such interim periods are not necessarily indicative of theresults to be achieved for the full year.

 

**(2)        EARNINGS PERSHARE**

 

We compute and presentnet loss per share in accordance with SFAS No. 128, *Earnings Per Share*.  For the three and nine months endedSeptember 30, 2002 and 2001, there is no difference in basic and diluted netloss per common share as the effect of stock options and warrants would beanti-dilutive for all periods presented. The outstanding stock options and warrants (prior to application of thetreasury stock method) would entitle holders to acquire 3,822 and 3,238 sharesof common stock at September 30, 2002 and 2001, respectively.

 

**(3)        REVENUE****RECOGNITION**

 

Weearn our revenues primarily through the licensing of our *HAP*TM Technology and byproviding genomic services. We have also entered into agreements which provide for future milestones androyalty payments.  We recognize revenuein accordance with Staff Accounting Bulletin No. 101, *Revenue Recognition in Financial Statements*(SAB 101), and in accordance with Statement of Position 97-2, *Software Revenue Recognition* (SOP 97-2),as amended by Statement of Position 98-9. In accordance therewith, we recognize annual

 

5

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**GENAISSANCE PHARMACEUTICALS, INC**.

 

# **Notes to Unaudited FinancialStatements**

For the QuarterEnded September 30, 2002

(In thousands)

 

licenseand subscription fees over the term of the agreement and service fees as theservices are performed.  Futuremilestones and royalty payments, if any, will be recognized when receivedprovided that the milestone is substantive and a culmination of the earningsprocess has occurred.

 

**(4)        IMPAIRMENT OFFIXED ASSETS**

 

In August 2001, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards No. 144, *Accounting forthe**Impairment or Disposal ofLong-Lived Assets*(SFAS No. 144), effective for fiscal years beginning afterDecember 15, 2001.  SFAS No. 144establishes a single accounting model,based on the framework established in Statement of Financial AccountingStandards No. 121 (SFAS No. 121), for long-lived assets to be held foruse.  SFAS No. 144 retains thefundamental provisions of SFAS No. 121 for recognition and measurement of theimpairment of long-lived assets. We assess the impairment of long-livedassets whenever events or changes in circumstances indicate that the carryingvalue may not be recoverable. Factors we consider important, which couldtrigger an impairment review, include, among others, the following:

 

•                  a significantadverse change in the extent or manner in which a long-lived asset is beingused;

 

•                  a significantadverse change in the business climate that could affect the value of along-lived asset; and

 

•                  a significantdecrease in the market value of assets.

 

If we determine that thecarrying value of long-lived assets may not be recoverable, based upon theexistence of one or more of the above indicators of impairment, we compare thecarrying value of the asset group to the undiscounted cash flows expected to begenerated by the group.  If the carryingvalue exceeds theundiscounted cash flows, an impairment charge may be needed.  To determine the amount of the impairmentcharge, we compare the carrying value of the applicable fixed asset group toits fair value.  We determine the fairvalue of the fixed asset group by discounting expected future cash flow using adiscount rate determined by our management to be commensurate with the riskinherent in our current business.  Ifthe fair value is less than the carrying value, such amount is recognized as animpairment charge.

 

Duringthe quarter ended June 30, 2002, we determined that certain conditions hadarisen which triggered the need to review our long-lived assets for potentialimpairment.  The conditions included,but were not limited to, the overall business climate in which we operate and asignificant change in the manner in which we were utilizing our DNA sequencingfacility and related assets.  Our reviewconcluded that the carrying value of certain long-lived assets exceeded their fairvalue by approximately $6.0 million. The impairment charge includes thewrite-down of sequencing equipment, computer hardware and software andleasehold improvements and has been allocated to the individual assets on apro-rata basis.

 

**(5)        ACCRUEDCLINICAL TRIAL EXPENSE**

 

Accrued clinical trialexpenses are comprised of amounts owed to third party Clinical ResearchOrganizations (CRO) for research and development work performed on behalf ofthe Company.  At each period end theCompany evaluates the accrued clinical trial expense balance based uponinformation received from each CRO and ensures that the balance isappropriately stated.  During the thirdquarter of 2002, based upon current information received from each CRO, theCompany reversed previously recorded accrued clinical trial expense of $627,000by crediting Research and Development expense. Accordingly, the remaining accrued clinical trial expense balance of$629,000 at September 30, 2002, represents the Company’s best estimate ofamounts owed for clinical trial services performed through September 30, 2002based on all information available. Such estimates are subject to changes as additional information becomesavailable.

 

**(6)        SIGNIFICANTCUSTOMERS**

 

For the nine months endedSeptember 30, 2002 and September 30, 2001, Customer A accounted for 27% and 41%of reported revenue.  For the ninemonths ended September 30, 2002 and September 30, 2001, Customer B accountedfor 41% and 51% of reported revenue. The Company’s collaboration agreement with Customer A expires in thefourth quarter of 2002.  The Company’scollaboration agreement with Customer B provides for an early terminationprovision.  In October 2002, the Companyamended its collaboration agreement with Customer B to extend the customer’srights under the termination provision for 30 days, or until November 22,2002.  The amendment was entered into toallow the parties sufficient time to further amend the agreement before theoption to terminate expires.

 

6

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**GENAISSANCE PHARMACEUTICALS, INC**.

 

# **Notes to Unaudited FinancialStatements**

For the QuarterEnded September 30, 2002

(In thousands)

 

**(7)        DIVIDENDS**

 

The Company hasclassified accrued dividends as a current liability in the financial statementsfor the quarter ended September 30, 2002, as the Company may be contractuallyrequired to pay such dividends within the next 12 months.

 

**(8)        RECENT ACCOUNTING PRONOUNCEMENTS**

 

InJune 2002, the Financial Accounting Standards Board (FASB) issued Statement ofFinancial Accounting Standards No. 146 (SFAS No. 146), *Accounting for Costs Associated with Exit or DisposalActivities* (“SFAS 146”). This Statement addresses financialaccounting and reporting for costs associated with exit or disposal activitiesand nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, *Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring*). The provisions of SFAS No. 146are effective for exit or disposal activities that are initiated after December31, 2002, with early application encouraged. We believe the adoption of thisnew standard will not have a material impact on either our operating results orfinancial position.

 

InApril 2002, the FASB issued Statement of Financial Accounting Standards No. 145(SFAS No. 145), *Rescission of FASBStatements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and TechnicalCorrections*. This Statement rescinds SFAS No. 4, *Reporting Gains and Losses from Extinguishment ofDebt*, SFAS No. 44, “Accounting for Intangible Assets of MotorCarriers” and SFAS No. 64, *Extinguishmentsof Debt Made to Satisfy Sinking-Fund Requirements*. This statementalso amends SFAS No. 13, *Accounting forLeases* and makes various technical corrections to existingpronouncements. Those corrections are not substantive in nature. The provisionsof SFAS No. 145 were effective as of May 15, 2002. The adoption of the newstandard had no impact on our operating results or financial position.

 

7

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**Item2 – Management’s Discussion****and Analysis of Financial Condition andResults of Operations**

 

The following discussion and analysis of our financial condition andthe results of operations should be read in conjunction with the financialstatements and related notes appearing elsewhere in this quarterly report onForm 10-Q. This report on Form 10-Q contains forward-looking statements withinthe meaning of Section 21E of the Securities Exchange Act of 1934, as amended,that involve risks and uncertainties, including, but not limited to, statementsabout management’s expectations as to costs and our liquidity position. Theseexpectations are based on certain assumptions regarding our research anddevelopment activities, projected expenditures, the ability of our technologiesto improve the drug development process, success of our commercializationefforts and significant growth in our revenues and other factors relating toour business.  These expectations maynot materialize if development efforts are delayed or suspended or if otherassumptions prove incorrect.  Thesefactors are more fully discussed below under the heading “Factors AffectingFuture Operating Results” and in our other filings with the Securities andExchange Commission. Readers are cautioned not to place undue reliance on theseor other forward-looking statements, which reflect management’s analysis,judgment, belief or expectation only as of the date on which they aremade.  While we may elect to updateforward-looking statements at some time in the future, we specifically disclaimany obligation to do so, even if our estimates change.

 

**Overview**

 

Since our inception, we have incurred significant operating losses,and, as of September 30, 2002, we had an accumulated deficit of $188.2million.  The majority of our operatinglosses have resulted from costs we incurred in developing our *HAP*TMTechnology and from our clinical trials. We expect to dedicate a significant portion of our resources for theforeseeable future to maintain our *HAP*TM Technology, to serviceour current and future partners and to expand and intensify ourcommercialization activities.  To date,our revenue has been primarily from licensing and service fees from ouragreements with AstraZeneca UK Limited (AstraZeneca), Biogen, Inc. (Biogen),Gene Logic, Inc. (GLI), Janssen Research Foundation, a Johnson & JohnsonCompany (J&J), and Pfizer, Inc., as well as a sublicensing agreement withVisible Genetics, Inc. and government grants.

 

In October 2002, we amended our collaboration agreement with a customerwhich accounted for 43% and 41% of our revenue for the three and nine monthsended September 30, 2002, respectively. The amendment extends their early termination option for 30 days, untilNovember 22, 2002.  The amendmentprovides additional time for the parties to review the intellectual propertyrights granted pursuant to the agreement before the option to terminateexpires.  A collaboration agreement witha customer which accounted for 29% and 27% of our revenue for the three andnine months ended September 30, 2002, respectively, expires in the fourthquarter of 2002.

 

On August 5, 2002, we announced a restructuring and cost reductionprogram to revise our business focus and to better align our operating coststructure with our current and projected partner needs and projected revenuesfrom our current and projected partners. The cost reduction program included arealignment of management responsibilities, a reduction in our workforce, and adecision to seek partners for all internal product development programs. Theworkforce was reduced by 20 percent to 110 employees in the third quarter, withthe majority of the workforce reductions occurring in the DNA sequencingfacility and related informatics support. We incurred a charge for severance and related costs of approximately$200,000, which was recorded in operating results in the third quarter.

 

As a result of the restructuring and cost reduction program, we expectfuture operating expenses to decrease, primarily in research and developmentexpenses. In addition to reducing expenses, our plans and projections reflectreductions in our negative operating cash flow. These planned reductions in ournegative operating cash flow assume significant year over year increases inrevenues.  There can be no assurancethat revenues will continue to increase or that there will continue to be adecrease in the level of cash used to fund operations.  If we are not successful in increasingrevenues or reducing expenses, as planned, we may not be able to maintain ouroperations at planned levels.

 

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**Critical Accounting Policies**

 

Our critical accounting policies are as follows:

•                  Revenuerecognition

•                  Valuationof long-lived assets

 

Revenuerecognition.  We earn our revenues primarily through thelicensing of our *HAP*TMTechnology and by providing genomic services. We have also entered intoagreements which provide for future milestones and royalty payments.  We recognize revenue in accordance withStaff Accounting Bulletin No. 101, *RevenueRecognition in Financial Statements* (SAB 101), and in accordancewith Statement of Position 97-2, *SoftwareRevenue Recognition* (SOP 97-2), as amended by Statement of Position98-9 (SOP 98-9).  In accordancetherewith, we recognize annual license and subscription fees over the term ofthe agreement and service fees as the services are performed.  Future milestones and royalty payments, ifany, will be recognized when received provided that the milestone issubstantive and a culmination of the earnings process has occurred.

 

Valuation oflong-lived assets. We assess the impairment of long-livedassets whenever events or changes in circumstances indicate that the carryingvalue may not be recoverable. Factors we consider important, which couldtrigger an impairment review, include, among others, the following:

 

•                  asignificant adverse change in the extent or manner in which a long-lived assetis being used;

 

•                  asignificant adverse change in the business climate that could affect the valueof a long-lived asset; and

 

•                  asignificant decrease in the market value of assets.

 

If we determinethat the carrying value of long-lived assets may not be recoverable, based uponthe existence of one or more of the above indicators of impairment, we comparethe carrying value of the asset group to the undiscounted cash flows expectedto be generated by the group.  If thecarrying value 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 fixed assetgroup to its fair value.  We determinethe fair value of the fixed asset group by discounting expected future cashflow using a discount rate determined by our management to be commensurate withthe risk inherent in our current business. If the fair value is less than the carrying value, such amount isrecognized as an impairment charge.

 

**Resultsof Operations**

 

**ThreeMonths Ended September 30, 2002 and 2001**

 

License and service revenue consists primarily of proceeds received inconnection with the licensing of our *HAP*TM Technology and the sublicensing of apatent. Revenue increased to approximately $1.8 million in the three monthsended September 30, 2002 from $1.1 million in the three months ended September30, 2001. The increase in license revenue is primarily attributable to thecommercialization of our *HAP*TMTechnology Partnership program and our *HAP*TMDrug-Specific Partnership program, including agreements entered into withBiogen in 2002, and J&J in 2000. Revenue also includes the amortization, over the remaining life of thesublicensed patent, of upfront payments received in connection with the sublicensingof a patent.

 

Research and development expenses consists primarily of payroll andbenefits for research and development personnel, material and reagent costs,costs incurred in connection with clinical trials, depreciation and maintenancecosts for equipment used for *HAP*TM Marker discovery and *HAP*TMTyping, and facility-related costs. We expense our research and developmentcosts as incurred. Research and development expenses decreased to approximately$4.8 million in the three months ended September 30, 2002 from approximately$12.6 million in the three months ended September 30, 2001.  The decrease in expenses is primarilyattributable to a decrease of approximately $4 million related to our clinicaltrials, a decrease of approximately $1 million in material and reagent costsassociated with the discovery of new *HAP*TM Markers, a decrease ofapproximately $500,000 in payroll and related costs as a result of our workforce reduction in connection with our restructuring program and a decrease ofapproximately $400,000 in

 

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depreciation as a result of the impairment charge incurred in thequarter ended June 30, 2002.  Thedecrease in clinical trial expenses is primarily due to our STRENGTH Trialswhich began in the second quarter of 2001 and were largely completed in thefirst quarter of 2002.  The decrease inmaterial and reagent costs is primarily due to reduced DNA sequencing volumesconsistent with the removal of the majority of our ABI Prism® 3700 DNA Analyzersfrom production in the quarter ended June 30, 2002.

 

General and administrative expenses consists primarilyof payroll and benefits for executive, business development, finance, publicaffairs and other administrative personnel, as well as facility-related costsand outside professional fees incurred in connection with corporate developmentand general legal and financial matters. General and administrative expensesdecreased to approximately $2.0 million in the three months ended September 30,2002 from approximately $2.9 million in the three months ended September 30,2001.  The decrease is primarilyattributable to a decrease in consulting and professional service fees incurredin connection with business development and marketing activities and a generalreduction in expenses as part of our cost reduction program initiated duringthe quarter ended September 30, 2002.

 

Stock based non-cash compensation expense relates to options granted toemployees and options granted to scientific advisory board members andconsultants. Stock options granted to employees are accounted for in accordancewith APB No. 25. The accounting for scientific advisory board members requiresus to record periodic charges for unvested options based on an increase in thefair value of our common stock and the related vesting of the options. Stockbased compensation decreased to income of approximately $100,000 in the threemonths ended September 30, 2002 from expense of approximately $96,000 in thethree months ended September 30, 2001. The decrease is primarily due to the reversal of charges previouslyincurred on vested options issued to former employees of the company who didnot exercise their vested options upon termination.

 

Interest income (expense), net, decreased to an expense ofapproximately $268,000 in the three months ended September 30, 2002 from incomeof approximately $171,000 in the three months ended September 30, 2001. Thedecrease is primarily the result of higher cash, cash equivalents andshort-term investment balances in 2001 and the lower interest rates oninvestments after the third quarter of 2001.

 

**Nine Months Ended September 30, 2002and 2001**

 

Revenue increased to approximately $5.5 million in the nine monthsended September 30, 2002 from $3.1 million in the nine months ended September30, 2001. The increase in license revenue is attributable to thecommercialization of our *HAP*TMTechnology Partnership program and our *HAP***TM**Drug-Specific Partnership program, including agreements entered into withBiogen in 2002, Pfizer and AstraZeneca in 2001, as well as the agreemententered into with J&J in 2000.

 

Research and development expenses decreased to approximately $19.6million in the nine months ended September 30, 2002 from approximately $34.0million in the nine months ended September 30, 2001.  The decrease in expenses is primarily attributable to a decreaseof approximately $6 million related to our clinical trials, a decrease ofapproximately $4 million in material and reagent costs associated with thediscovery of new *HAP***TM**Markersand a decrease of approximately $1 million in payroll and related costs as aresult of our restructuring program. The decrease in clinical trial expenses isprimarily due to our STRENGTH Trials which began in the second quarter of 2001and were largely completed in the first quarter of 2002.  The decrease in material and reagent costsis primarily due to reduced DNA sequencing volumes consistent with the removalof the majority of our ABI Prism®3700 DNA Analyzers from production in the quarter ended June 30, 2002.

 

General and administrative expenses decreased toapproximately $6.9 million in the nine months ended September 30, 2002 fromapproximately $8.9 million in the nine months ended September 30, 2001. Thedecrease is primarily attributable to a decrease of approximately $1 million inconsulting and professional service fees incurred in connection with businessdevelopment and marketing activities and a general reduction in expenses aspart of our cost reduction program initiated during the quarter ended September30, 2002.

 

The $6.0 million impairment of fixed assets charge relates to sequencingequipment, computer hardware and software and leasehold improvements in our DNAsequencing facility.  During the quarterended June 30, 2002, our management determined that certain conditions hadarisen during the quarter that triggered the need for a review of ourlong-lived assets for potential impairment. These conditions included, but were not limited to, the overall businessclimate in which we operate and a significant change in the manner in which wewere utilizing our DNA

 

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sequencing facility and related assets. In particular, during the quarter ended June 30, 2002, we determinedthat our sequencing production capacity significantly exceeded our forecasteddemand for the foreseeable future, which resulted in our decision to removefrom production the majority of our ABI Prism® 3700 DNA Analyzers,the primary asset of the group. Accordingly, we performed an impairment review on our sequencinglong-lived assets.  As a result of ourreview, we determined that the carrying value of the assets was in excess ofthe projected undiscounted cash flows to be generated by the asset group.  To determine the impairment charge, wecompared the carrying value of the applicable fixed assets to their fairvalue.  We determined the fair value ofthe fixed assets by discounting expected future cash flows using a discountrate determined by our management to be commensurate with the risk inherent inour current business.  As a result of our analysis, we determinedthat the carrying value of the assets was in excess of discounted future cashflow to be generated by the asset group and we recorded a write-down of $6.0million.  The impairment charge has beenallocated to the individual assets on a pro-rata basis.  The revised carrying value of theassets will be depreciated over two years, the average remaining life of theprimary asset of the group.

 

Stock based compensation expense decreased to approximately $107,000 inthe nine months ended September 30, 2002 from approximately $381,000 in thenine months ended September 30, 2001.

 

Interest income (expense), net, decreased to an expense ofapproximately $651,000 in the nine months ended September 30, 2002 from incomeof approximately $1.4 million in the nine months ended September 30, 2001.

 

**Liquidityand Capital Resources**

 

We have financed our operations primarily through the sale of commonand preferred stock, government research grants, payments under licensingagreements, loans and capital leases. From inception through September 30,2002, we have received aggregate gross proceeds of approximately $163.1 millionfrom issuance of common and preferred stock. In addition, through September 30,2002, we have received $4.5 million of government research grants and $15.3million from license and service fees, royalties and research contracts. Wehave also received $26.2 million****from capital lease financing arrangementsand $8.2 million from other loans. We have acquired, through September 30,2002, $41.8 million of property and equipment. The majority of these assets were financed through capital leasefinancing arrangements and other loans.

 

We expect to continue to finance our operations in the short-term fromcash we received in 2000 from the sale of our common and preferred stock andrevenue from our *HAP***TM**Technology Partnership program and our *HAP***TM**Drug-SpecificPartnership program.  Our businessstrategy depends on entering into partnership agreements with pharmaceuticaland biotechnology companies.  If we areunsuccessful in marketing our partnership programs, we may not generatesufficient revenues to sustain our operations at planned levels.

 

Cash used in operations for the nine months ended September 30, 2002was $17.6 million compared with $32.8 million for the same period in 2001. Thecash used in operations for the nine months ended September 30, 2002 resultedprimarily from a net loss of $27.7 million and a $4.2 million decrease inaccounts payable and accrued liabilities, partially offset by $12.5 million ofnon-cash charges for depreciation and amortization expense, stock basedcompensation and impairment of fixed assets as well as a $2.4 million decreasein other current assets. The decrease in other current assets includes thereceipt of $1.0 million from the State of Connecticut for the sale of researchand development tax credits.  Cash usedin operations for the nine months ended September 30, 2001 resulted primarilyfrom a net loss of $36.2 million and a $3.3 million increase in other currentassets, partially offset by $6.7 million of non-cash charges for depreciationand amortization expense and stock based compensation.

 

Cash provided by investing activities for the nine months endedSeptember 30, 2002 was $26.0 million compared with $16.8 million for the sameperiod in 2001.  Proceeds from the saleof marketable securities totaled $26.1 million for the nine months ended September30, 2002 compared to $20.9 million for the same period in 2001.  During the nine months ended September 30,2002, we used $85,000 of cash for the purchase of property and equipmentcompared to $4.1 million for the same period in 2001.

 

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Cash used for financing activities for the nine months ended September30, 2002 was $5.6 million compared with $4.6 million for the same period in2001.  The primary use of cash fromfinancing activities for the nine months ended September 30, 2002 and 2001 wasthe repayment of long-term debt and capital lease obligations.

 

Our contractual cash obligations as ofSeptember 30, 2002, are as follows:

 
| **Contractual  Obligations***                 |                          | **Payments Due by Period********(in  thousands)** |            |
|-----------------------------------------------|-------------------------------|---------------------------------------------------|-----------------|
|                                          | **Total  Amounts  Committed** |                                              | **Fiscal 2002** |   | **Fiscal Years  2003 and 2004** |   | **Fiscal Years  2005 and 2006** |   | **Fiscal Year  2007 and later** |   |
| Long-Term Debt, including interest            |                          | $                                                 | 6,637           |   | $ | 117 |   | $ | 1,414 |   | $ | 1,414 |   | $ | 3,692 |   |
| Capital Lease Obligations, including interest |                          | 12,600                                            |            | 1,908 |   | 10,637 |   | 55 |   | — |   |
| Operating Leases                              |                          | 9,521                                             |            | 298 |   | 2,324 |   | 2,096 |   | 4,803 |   |
| Minimum License Obligations                   |                          | 1,591                                             |            | 1,165 |   | 200 |   | 226 |   | — |   |
| Total Contractual Cash Obligations            |                          | $                                                 | 30,349          |   | $ | 3,488 |   | $ | 14,575 |   | $ | 3,791 |   | $ | 8,495 |   |

 

*Payment of our long-term debt and capitallease obligations could be accelerated if we fail to maintain compliance withcertain non-financial covenants, including absence of material adverse changeand other covenants.

 

Long-term debt consists primarily of threefinancing agreements with Connecticut Innovations Inc. (CII), a stockholder,used to finance certain leasehold improvements and other costs associated withour facility expansion.  The agreementsbear interest at 6.5%.  The agreementsprovide for interest only for a certain period. Principal and interest payments,based on a 120-month amortization, beginning in April 2001 through October2002, with final balloon payments due in April 2009 through June 2011.  Borrowings under the agreements arecollateralized by the related leasehold improvements.  We have borrowed all available amounts under these agreements.

 

Capital lease obligations, related toequipment, consist principally of arrangements with four equipment leasingcompanies.  The leases have termsranging from two to four years with installments ending between August 2003 andFebruary 2005, and bear interest at rates ranging from 8.15% to 12.46%.  Borrowings under these agreements aresecured by the underlying leased equipment. We have borrowed all available amounts under these agreements.  The capital lease arrangements allow for thepurchase of the related equipment at the completion of the lease term, asdefined in the agreements.

 

We lease our operating facilities located inNew Haven, Connecticut.  The leaseagreements currently require annual lease payments of approximately $980,000per year, increasing to $1.1 million per year over the original term, whichexpires in 2004.  We have two five-yearrenewal options to extend the lease agreements beyond the initial term.  We are recording the expense associated withthe leases on a straight-line basis over the expected term of the leases.  In addition to the operating leaseagreements for our current facility, we also have operating leases for certainof our office equipment.

 

In addition, we periodically enter intoagreements with third parties to obtain exclusive or non-exclusive licenses forcertain technologies.  The terms ofcertain of these agreements require us to make future royalty payments andcertain milestone payments based on product sales or sublicense incomegenerated from applicable technologies, if any and include provisions requiringfuture minimum license payments, whether or not the technology iscommercialized.  The amount of suchpayments will depend upon successful commercialization of applicabletechnologies, if any.  The futureminimum payments (assuming non-termination of these agreements) are included inthe minimum license obligations above.

 

Based on our current business plans, capitalexpenditures are not expected to exceed $250,000 for each of fiscal 2002 and2003.

 

Our cash requirements will vary depending upon a number of factors,many of which are beyond our control, including:

 

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•                  thedemand for our *HAP* TM Technology Partnership program and our *HAP***TM**Drug-Specific Partnership program;

 

•                  theefforts and success of our partnership program;

 

•                  thecommercialization of intellectual property derived from our internal programs;

 

•                  thelevel of competition we face;

 

•                  ourability to maintain our *HAP*TM Technology; and

 

•                  ourability to effectively manage operating expenses.

 

On September 30, 2002, cash, cash equivalents and short-terminvestments totaled $36.4 million compared to approximately $59.7 million atDecember 31, 2001. Our cash reserves are held in interest-bearing high-gradecorporate bonds and money market accounts. We believe that our existing cash reserves will be sufficient to supportour expected net losses, debt obligations and capital expenditures for at least18 months.  To execute our long-termbusiness plans, we will need to grow our revenues significantly each year.  There can be no assurance that we will beable to obtain new partners or to generate the increased revenues required tomeet our business plan objectives.  Inaddition, to execute our business plan, we may need to consider seekingadditional funding through public or private equity offerings, debt financingsor commercial partners.  We cannotassure you that we will obtain additional partners or capital funding onacceptable terms, if at all.  If we areunable to generate sufficient revenues or access capital on acceptable terms,we may not be able to achieve our objectives under our business plan or sustainour operations at planned levels.

 

On September 19, 2002, we received a letter from The Nasdaq StockMarket, Inc., notifying us that during the preceding 30 consecutive tradingdays, the bid price of our common stock had closed below the minimum bid priceof $1.00 per share as required by the Nasdaq National Market under NasdaqMarketplace Rule 4450(a)(5). The letter stated that we have until December 18,2002 to demonstrate compliance with such rule and that, if we are not incompliance by that date, Nasdaq will notify us that our securities will bedelisted from the Nasdaq National Market. If such event occurs, we may appealthe decision to a Nasdaq Listing Qualifications Panel. We have not made a finaldetermination as to whether we would appeal any such decision.

 

**RecentAccounting Pronouncements**

 

In June 2002, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No.146 (SFAS No. 146), “Accounting for Costs Associated with Exit or DisposalActivities” (“SFAS 146”). This Statement addresses financial accounting andreporting for costs associated with exit or disposal activities and nullifiesEmerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition forCertain Employee Termination Benefits and Other Costs to Exit an Activity(including Certain Costs Incurred in a Restructuring).” The provisions of SFASNo. 146 are effective for exit or disposal activities that are initiated afterDecember 31, 2002, with early application encouraged. We believe the adoptionof this new standard will not have a material impact on either our operatingresults or financial position.

 

In April 2002, the FASB issued Statement ofFinancial Accounting Standards No. 145 (SFAS No. 145), “Rescission of FASBStatements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and TechnicalCorrections”. This Statement rescinds SFAS No. 4, “Reporting Gains and Lossesfrom Extinguishment of Debt”, SFAS No. 44, “Accounting for Intangible Assets ofMotor Carriers” and SFAS No. 64, “Extinguishments of Debt Made to Satisfy Sinking-FundRequirements”. This statement also amends SFAS No. 13, “Accounting for Leases”and makes various technical corrections to existing pronouncements. Thosecorrections are not substantive in nature. The provisions of SFAS No. 145 wereeffective as of May 15, 2002. The adoption of the new standard had no impact onour operating results or financial position.

 

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**FactorsAffecting Future Operating Results**

 

*This Quarterly Report on Form 10-Q contains “forward-lookingstatements” within the meaning of Section 21E of the Securities Exchange Act of1934, as amended.  These statements aresubject to risks and uncertainties and are based on the beliefs and assumptionsof our management based on information currently available to ourmanagement.  Use of words, such as**“believes,” “expects,”“anticipates,” “intends,” “plans,” “estimates,” “should,” “likely” or similarexpressions, indicate a forward-looking statement.  Forward-looking statements involve risks, uncertainties andassumptions.  Certain of the informationcontained in this Quarterly Report on Form 10-Q consists of forward-lookingstatements.  Important factors thatcould cause actual results to differ materially from the forward-lookingstatements include the following:*

 

***We are 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 since our inception.  As of September 30, 2002, we have generatedonly minimal revenue from our *HAP***TM** Technology Partnership program andour *HAP***TM** Drug-Specific Partnership program,and we do not expect to generate significant revenues for several years, ifever.  From inception through September30, 2002, we had an accumulated deficit of approximately $188.2 million.  Our losses to date have resulted principallyfrom costs we incurred in the development of our *HAP***TM**Technology, in our clinical trials and from general and administrative costsassociated with operations.  We expectto devote our resources to service our *HAP***TM** Technology Partnership program andour *HAP***TM** Drug-Specific Partnership programand to maintain our *HAP*TMTechnology.

 

We expect to incur additional losses thisyear and in future years, and we may never achieve profitability.  In addition, pharmaceutical andbiotechnology companies are only now beginning to use products such as ours intheir drug development or marketing efforts and, accordingly, they may notchoose to use our *HAP*TMTechnology.  We do not expect our lossesto be substantially mitigated by revenues from our *HAP*TM Technology Partnership program, our *HAP***TM**Drug-Specific Partnership program, or from our STRENGTH and CARING programs fora number of years, if ever.

 

***We currently relyon a limited number of licensing and service arrangements for a significantportion of our revenues.  As a result,the loss of one major customer or our inability to secure additionalsignificant customers during a given period would have an adverse affect on ourbusiness and operating results.***

 

We are dependent upon a limited number oflicensing and service arrangements that are represent a significant portion ofour total revenues. For example,  thenine months ended September 30, 2002, two of our customers accounted for 27% and 41% of our total revenues,respectively.  The agreements with thesecustomers terminate by their terms in the fourth quarter of 2002 and the fourthquarter of 2003, respectively.  Theagreement that terminates in 2003 may be terminated by the customer as ofNovember 22, 2002 if we receive notice of such termination by such date.  The loss of either of these three customerswould have an adverse affect on our business and operating results and couldcause volatility or a decline in our stock price.

 

***To generate significant revenues, wemust obtain customers for our*****HAP***TM****Technology Partnership Program and our*****HAP***TM****Drug-Specific Partnership Program******.***

 

Our strategy depends on entering intoagreements with pharmaceutical and biotechnology companies for our *HAP*TM Technology Partnershipprogram and our *HAP***TM** Drug-Specific Partnershipprogram.  To date, we have threepartners for our *HAP***TM** Technology Partnership program andone partner for our *HAP***TM** Drug-Specific Partnership program,and we may not obtain additional partners for our *HAPTM* Technology Partnership program or our *HAP***TM**Drug-Specific Partnership program or find partners for our STRENGTH and CARINGprograms.  We currently do not have anypartners for our STRENGTH and CARING programs. If we are unsuccessful in marketing our *HAP*TMTechnology and finding partners for our STRENGTH and CARING programs, we maynever generate sufficient revenues to sustain our operations.  In addition, we expect that some of our future*HAP*TM TechnologyPartnership program collaborations and that some of our *HAP***TM**Drug-Specific Partnership program collaborations will be limited to specific,limited-term projects or that some of these collaborations may not berenewed.  Accordingly, we mustcontinually obtain new customers to be successful.

 

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***If the estimates we make, and theassumptions on which we rely, in preparing our financial statements proveinaccurate, our actual results may vary from these reflected in our projectionsand accruals.***

 

Our financial statements have been preparedin accordance with accounting principles generally accepted in the UnitedStates of America.  The preparation ofthese financial statements requires us to make estimates and judgments thataffect the reported amounts of our assets, liabilities, revenues and expenses,the amounts of charges accrued by us, such as those made in connection with ourrestructuring, and related disclosure of contingent assets andliabilities.  We base our estimates onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances. There can be no assurance, however, that our estimates or theassumptions underlying our estimates will be correct.

 

***If we are unable tocomply with the continued listing requirements of the Nasdaq National Market,our common stock could be delisted from the Nasdaq National Market.***

 

Our common stock trades on the Nasdaq National Market.  In order to continue trading on the NasdaqNational Market, we must satisfy the continued listing requirements for thatmarket. On September 19, 2002, we received a letter from the Nasdaq StockMarket, notifying us that during the preceding 30 consecutive trading days, thebid price of our common stock had closed below the minimum bid price of $1.00per share as required by the Nasdaq National Market under Nasdaq MarketplaceRule 4450(a)(5). The letter stated that we have until December 18, 2002 todemonstrate compliance with such rule and that, if we are not in compliance bythat date, Nasdaq will notify us that our common stock will be delisted fromthe Nasdaq National Market. If such event occurs, we may appeal the decision toa Nasdaq Listing Qualifications Panel.

 

A delisting of our common stock from the Nasdaq National Market wouldmaterially reduce the liquidity of our common stock and result in acorresponding material reduction in the price of our common stock.  In addition, any such delisting wouldmaterially adversely affect our ability to raise capital through alternativefunding sources on terms acceptable to us, or at all.

 

***We may requireadditional funding to fund operations and repay debt and we may not be able toobtain any.***

 

We believe that our existing cash reserves will be sufficient tosupport our expected net losses, debt obligations and capital expenditures forat least 18 months.  To execute ourlong-term business plans, we will need to grow our revenues significantly eachyear.  In the past, we have had limitedsuccess growing our revenues.  We cannotassure you that we will be able to obtain new partners or to generate theincreased revenues required to meet our business plan objectives.  In addition, to execute our business plan,we may need to consider seeking additional funding through public or privateequity offerings, debt financings or commercial partners.  We cannot assure you that we will obtainadditional partners or capital funding on acceptable terms, if at all.  If we are unable to generate sufficientrevenues or access capital on acceptable terms, including because of adelisting of our common stock from the Nasdaq National Market, we may berequired to (a) obtain funds on unfavorable terms that may require us torelinquish rights to certain of our technologies or that would significantlydilute our stockholders, and/or  (b)significantly scale back current operations. Either of which cases would have a material adverse effect on ourbusiness.

 

***Our HAPTM Technology maynot allow our partners or us to develop commercial products or to increasesales of their marketed products.***

 

We developed our *HAP*TM Technology on the assumption thatinformation about gene variation and gene variation associated with drugresponse may help drug development professionals better understand the drugresponse of particular populations and complex disease processes.  Although the pharmaceutical andbiotechnology industries are increasing their use of genomics in analyzing drugresponse and diseases, we are unaware of any successful drug developmentprogram applying population genomics.

 

We discover *HAP*TMMarkers for pharmaceutically relevant genes. If we are unable to find *HAP*TMMarkers for pharmaceutically relevant genes in a timely manner, our potentialpartners may lose confidence in our *HAP*TM

 

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Technology and our company, and this loss inconfidence could decrease our ability to generate revenues.  Even if we are able to discover the *HAP*TM Markers for pharmaceuticallyrelevant genes, this information may not prove to be superior to genomicvariation information discovered by our competitors.  Furthermore, pharmaceutical and biotechnology companies may notchoose our *HAP*TMTechnology over competing technologies.

 

Our *DecoGen*®Informatics System may also be less effective than we expect or may not allowour partners or us to determine a correlation between drug response and genomicvariation.  Furthermore, even if ourpartners or we are successful in identifying a specific correlation betweendrug response and genomic variation based on our *HAP*TM Technology, neither our partners or us maybe able to develop or sell commercially viable products nor may our partners beable to increase the sales of their marketed products using thiscorrelation.  Accordingly, our *HAP*TM Markers and *HAP*TM Technology may notimprove the development, marketing and prescribing of drugs developed by our *HAP*TM Technology Partnershipprogram customers and our *HAP***TM** Drug-Specific Partnership programcustomers.

 

***We may not be able to obtainsufficient additional funding to meet our capital requirements.***

 

We have used substantial amounts of cash tofund our research and development activities. We will continue to spend funds to service our *HAP*TM Technology Partnershipprogram and our *HAP***TM** Drug-Specific Partnership programand to maintain our *HAP*TMTechnology.  We plan to pay for theseactivities with funds from:

•              ourexisting cash and investment securities; and

•                                          income that we may receive from our *HAP*TM Technology Partnershipprogram, our *HAP***TM** Drug-Specific Partnership programand genomic service fees.

 

We intend to rely on current *HAP*TM Technology Partnershipprogram customers and future customers, if any, and our current *HAP***TM**Drug-Specific Partnership program customer and future customers, if any, forsignificant funding in the future to support our development efforts.  We cannot be certain when we will begin toreceive additional income, if at all, from our *HAP*TMTechnology Partnership program, our *HAP***TM** Drug-Specific Partnership program,our genomic services and income, if any, from our STRENGTH and CARINGprograms.  If we do not receive thisincome or do not receive it as rapidly as we expect, we would spend our existingcash and investment securities more rapidly than we currently plan.

 

To service our *HAP*TM Technology Partnership program and our *HAP***TM**Drug-Specific Partnership program and to support the maintenance of our *HAP*TM Technology, we may need to seek additional fundingthrough public or private equity offerings, debt financings or commercialpartners.  Additional financing may notbe on terms favorable to our stockholders or us.  Stockholders’ ownership will be diluted if we raise additionalcapital by issuing equity securities.  Ifwe raise additional funds through partnership or other licensing arrangements,we may have to relinquish rights to some of our technologies or grant licenseson unfavorable terms.

 

We believe that our existing cash reserves will be sufficient tosupport our expected net losses, debt obligations and capital expenditures forat least 18 months.  To execute ourlong-term business plans, we will need to grow our revenues significantly eachyear.  There can be no assurance that wewill be able to obtain new partners or to generate the increased revenuesrequired to meet our business plan objectives. In addition, to execute our business plan, we may need to considerseeking additional funding through public or private equity offerings, debtfinancings or commercial partners.  Wecannot assure you that we will obtain additional partners or capital funding onacceptable terms, if at all.  If we areunable to generate sufficient revenues or access capital on acceptable terms,we may not be able to achieve our objectives under our business plan or sustainour operations at planned levels.

 

***If we are unable to obtain intellectualproperty protection for our*****HAP*TMTechnology, trade secrets or know how, we may not be able to operate ourbusiness profitably.***

 

Our success depends, in part, on our abilityto protect our *HAP***TM** Technology, any associations thatwe find between clinical outcomes and genetic variation and any otherproprietary software, methods and technologies that we develop, either as atrade secret or under the patent and other intellectual property laws of theUnited States and other countries, so that we can prevent unauthorized entitiesfrom using our inventions and proprietary information.

 

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Because patent applications that were filedprior to November 29, 2000 in the United States are confidential until patentsissue, third parties may have filed patent applications for technology coveredby our pending patent applications without our being aware of thoseapplications, and our patent applications may not have priority over any patentapplications of others.  We are awarethat there are other firms or individuals who have discovered, or are currentlydiscovering, information similar to the information we are discovering, who mayhave filed, and in the future are likely to file, patent applications that aresimilar or identical to our *HAP***TM** Technology patent applications.

 

Our pending patent applications may notresult in issued patents.  The patentpositions of pharmaceutical and biotechnology companies, including ours, aregenerally uncertain as a result of the uncertain state of the patent law in thebiotechnology field.  There is nouniform, worldwide policy regarding the subject matter and scope of claimsgranted or allowable in biotechnology patents, particularly those involvinggenomics.  In addition, some interestgroups are lobbying for restrictions on patenting of genetic tests.

 

***We may be unable to develop orcommercialize our*****HAP***TM****Technology if we cannot establishcollaborative relationships, and we will depend on our partners to develop orto co-develop products.***

 

We currently have three *HAP***TM**Technology Partnership program customers, one *HAP***TM**Drug-Specific Partnership program customer and no partners for ourSTRENGTH or CARING programs.  Under ourcurrent strategy, and for the foreseeable future, we do not expect to developor market pharmaceutical products on our own. As a result, our current and future revenues, in part will depend onpayments from our current *HAP***TM** Technology Partnership programcustomers, our current *HAP***TM**Drug-Specific Partnership program customer, and our future *HAP***TM**Technology Partnership program customers, our future *HAP***TM****Drug-Specific Partnership programcustomers and the future STRENGTH and CARING program partners, if any, foreither the new products they may develop, or for increased sales of theirexisting products, made possible through the use of our *HAP***TM**Technology, or from STRENGTH or CARING program partners, if any, for theproducts that these partners may develop and sell.  If we are unable to attract new *HAP***TM** Technology Partnership programcustomers, new *HAP***TM**Drug-Specific Partnership program customers or any partners for ourSTRENGTH and CARING programs, we may never generate sufficient revenues tosustain our operations.

 

Our customers forour *HAP*TM Technology Partnership program and our *HAP***TM****Drug-Specific Partnership program and our partners, if any, for our STRENGTHand CARING programs, will be responsible for pre-clinical study and clinicaldevelopment of therapeutic and diagnostic products and for regulatory approval,manufacturing and marketing of any products or enhanced marketing claims thatresult from the application of our *HAP***TM** Technology.  We anticipate that our agreements withcustomers for our *HAP***TM** Technology Partnership program,our *HAP***TM**Drug-Specific Partnership program and with partners, if any, for our STRENGTH or CARING programs willallow them significant discretion in pursuing these activities.  We cannot control the amount and timing ofresources that any such current or potential customers will devote to our programs or potentialproducts.  Our *HAP*TM Technology Partnership program and our *HAP*TM**Drug-Specific Partnership program arrangements may also have the effect of limiting the areas of researchthat we may pursue either alone or with others.  Because part of our revenues will be dependent on the successfulcommercialization or development of our customers’ products, if, for any reason,a *HAP*TM Technology Partnership program customer or a*HAP*TM**Drug-Specific Partnership programcustomer delays or abandons itsdevelopment or commercialization of a product developed using our *HAP*TM Technology, we may receive reduced royaltyor other payments or no royalty or other payments at all.  In addition, because part of our futurerevenues will be dependent on the successful commercialization of our STRENGTHand CARING programs with partners, if, for any reason, a partner delays orabandons its development or commercialization of our STRENGTH or CARINGprograms, we may receive reduced royalty or other payments or no royalty orother payments at all.

 

Although we intend to retain the rights toall *HAP***TM** Markers, which we discover as wellas to *HAP***TM** Markers discovered jointly withour *HAP***TM** Technology Partnership programcustomers and our *HAP***TM**Drug-Specific Partnership program customers, we may not always beable to negotiate the retention of these rights.  Furthermore, disputes may arise in the future over the ownershipof rights to *HAP***TM** Markers as well as any othertechnology we develop with our *HAP***TM** Technology Partnership programcustomers and our *HAP***TM**Drug-Specific Partnership program customers.  These and other possible disagreements betweenour *HAP***TM** Technology Partnership program

 

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customers and us and between our *HAP***TM**Drug-Specific Partnership program customers and us could lead todelays in the research, development or commercialization of theirproducts.  These disagreements couldalso result in litigation or require arbitration to resolve.  Any of these events could prevent us fromeffectively marketing our *HAP***TM** Technology.

 

***We invest considerable amounts of time,effort, and money to license our*****HAP***TM****Technology; and if we are unable to license our technology, we may not generatesufficient revenue to sustain our operations.***

 

Our ability to obtain customers for our *HAP***TM**Technology and our STRENGTH and CARING programs will depend insignificant part upon the pharmaceutical and biotechnology industries’acceptance that our *HAP***TM** Technology can help accelerate orimprove their drug development and marketing efforts.  To achieve market acceptance, we must continue to educate thepharmaceutical and biotechnology industries and the public in general as to thepotential benefits of our *HAP***TM** Technology and our STRENGTH andCARING programs.  Most importantly, wemust convince the research and development, clinical and marketing departmentsof pharmaceutical and biotechnology companies that our *HAP***TM**Technology can accelerate and improve the processes for developing, marketingand prescribing drugs and that our STRENGTH and CARING programs will becommercially viable. If we fail to gain this acceptance, we may never generatesufficient revenues to sustain our operations. We may expend substantial funds and management effort to market our *HAP***TM**Technology and STRENGTH and CARING programs, without any resulting revenues.

 

***If we are unable to prevent others fromunauthorized use of, or are unable to defend our use of, our*****HAP*TM Technology, trade secrets or knowhow, we may not be able to operate our business profitably.***

 

Despite our efforts to protect ourproprietary rights, unauthorized parties may be able to obtain and useinformation that we regard as proprietary. The mere issuance of a patent does not guarantee that it is valid orenforceable; thus even if we obtain patents, they may not be valid or enforceableagainst third parties.

 

We also rely upon unpatented trade secretsand improvements, unpatented know-how and continuing technological innovationto develop and maintain our competitive position.  We generally protect this information with reasonable securitymeasures, including confidentiality agreements signed by our employees,academic collaborators and consultants that provide that all confidentialinformation developed or made known to others during the course of theemployment, consulting or business relationship will be kept confidentialexcept in specified circumstances. Agreements with employees, consultants and collaborators generallyprovide that all inventions conceived by the individual while employed by usare our exclusive property.  Ifemployees, consultants or collaborators do not honor these agreements, we maynot have adequate remedies for breach. Furthermore, our trade secrets may otherwise become known or beindependently discovered by competitors.

 

Further, a patent does not provide thepatent holder with freedom to operate in a way that infringes the patent rightsof others.  A third party may sue us forinfringing on its patent rights. Likewise, we may need to resort to litigation to enforce a patent issuedto us or to determine the scope and validity of third party proprietaryrights.  The cost to us of anylitigation or other proceeding relating to intellectual property rights, evenif resolved in our favor, could be substantial, and the litigation would divertour management’s efforts.  Some of ourcompetitors may be able to sustain the costs of complex patent litigation moreeffectively than we can because they have substantially greater resources.  Uncertainties resulting from the initiationand continuation of any litigation could limit our ability to continue ouroperations.

 

If any party should successfully claim thatthe creation or use of our *HAP***TM** Technology or *HAP***TM**Marker association data 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 against us or our*HAP***TM** Technology Partnership programcustomers, our *HAP***TM** Drug-Specific Partnership programcustomers or any STRENGTH or CARING program partners claiming damages orseeking to enjoin commercial activities relating to the affected products andprocesses could, in addition to subjecting us to potential liability fordamages, require us or our *HAP***TM** Technology Partnership programcustomers, our*HAP***TM** Drug-Specific Partnership programcustomers or any STRENGTH or CARING program partners to obtain a license inorder to

 

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continue to manufacture or market theaffected products and processes.  Anylicense required under any patent may not be made available on commerciallyacceptable terms, if at all.  Inaddition, 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 *HAP***TM** Technology, which could limit ourprofitability and possibly prevent us from generating revenue sufficient tosustain our operations.

 

 

***Regulatory oversight of our*****HAP***TM****Technology and public opinion regarding ethical issues surrounding the use ofgenetic information may adversely affect our ability to market our*****HAP***TM****Technology.***

 

Currently, there is limited FDA regulationof genetic tests.  The Secretary’sAdvisory Committee on Genetic Testing, an advisory panel to the Secretary ofthe U.S. Department of Health and Human Services, has recommended that the FDAexpand its regulation of genetic testing to require FDA approval for all newgenetic tests and labeling of genetic tests. If the FDA adopts this recommendation, it may require that we, or ourpartners, apply for FDA approval as a prerequisite to marketing genetic teststhat incorporate our *HAP***TM** Technology.  If the FDA were to deny any application ofthis kind, it could adversely affect our business and we may be unable togenerate sufficient revenues to sustain our operations.

 

Moreover, our success will depend in part onthe FDA’s and other regulatory agencies’ acceptance of genomic variationanalysis as part of the drug approval process and, more specifically, thevalidity of our *HAP***TM** Technology as a basis foridentifying genomic variation and for correlating drug response with genomicvariation.  Without this acceptance, wemay be unable to market effectively our *HAP***TM** Technology and we may not generatesufficient revenues to sustain our operations. To date, the FDA has not required, in connection with approving anydrug, that a physician must have genomic variation information determined abouta patient before the doctor prescribes a drug. However, the FDA, in one instance, has required that a physician musthave gene expression information about a patient before the doctor prescribesthe drug.

 

Within the field of personalized health andmedicine, governmental and other entities may enact patient privacy andhealthcare laws and regulations that may limit the use of genomic variationdata.  To the extent that these laws andregulations limit the use of our *HAP***TM**Technology or impose additionalcosts on our partners, we may be unable to market effectively our *HAP***TM**Technology and STRENGTH and CARING programs and we may not generate sufficientrevenues to sustain our operations.

 

Additionally, public opinion on ethical issuesrelated to the confidentiality and appropriate use of genetic testing resultsmay influence governmental authorities to call for limits on, or regulation ofthe use of, genetic testing.  Inaddition, governmental authorities or other entities may call for limits on, orregulation of the use of, genetic testing or prohibit testing for geneticpredisposition to certain conditions, particularly for those that have no knowncure.  The occurrence of any of theseevents could reduce the potential markets for our *HAP***TM**Technology, which could prevent us from generating sufficient revenues tosustain our operations.

 

Furthermore, we may be directly subject toregulations as a provider of diagnostic information.  To the extent that these regulations restrict the sale of our *HAP***TM**Technology or impose other costs, we may be unable to provide our *HAP***TM**Technology to our customers on terms sufficient to recover our expenses.

 

***If our partners do not seek, or do notreceive, marketing approval for products developed, if any, using our*****HAP***TM****Technology, we may receive delayed royalty or other payments or no royalty orother payments at all.***

 

Any new drug, biologic, or new drug orbiologic indication our partners or we develop using our *HAP***TM**Technology must undergo an extensive regulatory review process in the UnitedStates and other countries before a new product or indication of this kindcould be marketed.  This regulatoryprocess can take many years and require substantial expense.  Changes in FDA policies and the policies ofsimilar foreign regulatory bodies can prolong the regulatory review of each newdrug or biologic license application or prevent approval of theapplication.  We expect similar

 

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delays and risks in the regulatory reviewprocess for any diagnostic product, whenever this regulatory review isrequired.  Even if a product obtainsmarketing clearance, a marketed product and its manufacturer are subject tocontinuing review.  A manufacturer maybe forced to withdraw a product from the market if a previously unknown problemwith a product becomes apparent. Because our future revenues will be largely dependent on the successfulcommercialization or development of products using our *HAP***TM**Technology, any delay in obtaining, failing to obtain, or failing to maintainregulatory approval for a product developed using our *HAP***TM**Technology may delay our receipt of royalty or other payments or prevent usfrom receiving royalty or other payments sufficient to recover our expenses.

 

***If our partners or we are unable to obtainFDA approval for therapeutic or diagnostic products developed using our*****HAP*TM Technology, the lack of regulatoryapproval will diminish the value of our*HAP*TM Technology****.*

 

To date, no one has developed orcommercialized any therapeutic or diagnostic products using our *HAP***TM**Technology.  We expect to rely on ourcustomers for our *HAP***TM** Technology Partnership program andour *HAP***TM**Drug-Specific Partnership program and our partners, if any, for ourSTRENGTH and CARING programs to file applications for regulatory approval andgenerally direct the regulatory review process and obtain FDA acceptance of our*HAP***TM** Technology and our STRENGTH andCARING programs.  Our customers for our *HAP***TM**Technology Partnership program and our *HAP***TM**Drug-Specific Partnership program or our partners, if any, for ourSTRENGTH and CARING programs, may not submit an application for regulatoryreview.  Even if they do submitapplications, they may not be able to obtain marketing clearance for anyproducts on a timely basis, if at all. If our partners fail to obtain required governmental clearances fortherapeutic or diagnostic products, they will not be able to market theseproducts unless and until they obtain these clearances.  As a result, we may not receive royalty orother payments from our customers.  Theoccurrence of any of these events may prevent us from generating revenuessufficient to sustain our operations.

 

***If we do not successfully distinguish andcommercialize our*****HAP*TMTechnology, we may be unable to compete successfully with our competitors or togenerate revenue significant to sustain our operations.***

 

Numerous entities are attempting to identifygenomic variation predictive of specific diseases and drug response and todevelop products and services based on these discoveries.  We face competition in these areas frompharmaceutical, biotechnology and diagnostic companies, academic and researchinstitutions and government or other publicly-funded agencies, both in theUnited States and abroad, most of which have substantially greater capitalresources, research and development staffs, facilities, manufacturing andmarketing experience, distribution channels and human resources than we do.

 

These competitors may discover, characterizeor develop important technologies applying population genomics before us or ourcustomers for our *HAP***TM** Technology Partnership program andour HAP**TM** Drug-SpecificPartnership program that are more effective than those technologies which wedevelop or which our customers for our *HAP***TM** Technology Partnership program andour *HAP***TM**Drug-Specific Partnership program develop, or these competitors mayobtain regulatory approvals of their drugs more rapidly than our customers forour *HAP***TM** Technology Partnership program andour *HAP***TM**Drug-Specific Partnership program do, any of which could limit ourability to market effectively our *HAP***TM** Technology.

 

Some companies and governments are marketingor developing a number of databases and informatics tools to assistparticipants in the healthcare industry and academic researchers in themanagement and analysis of genomic data. Entities such as Celera Genomics Group, Incyte Genomics, Inc., NationalHuman Genome Research Institute, Perlegen Sciences and Variagenics, Inc. havedeveloped or plan to develop databases containing gene sequence, geneexpression, genomic variation or other genomic information and are marketing orplan to market their data to pharmaceutical and biotechnology companies or planto make freely available their databases. In addition, numerous pharmaceutical and biotechnology companies, suchas GlaxoSmithKline plc, either alone or in partnership with our competitors,are developing genomic research programs that involve the use of informationthat can be found in these databases.

 

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In order to compete against existing andfuture technologies, we will need to demonstrate to potential *HAP***TM**Technology Partnership program customers and to potential *HAP***TM**Drug-Specific Partnership program customers the value of our *HAP***TM**Technology and that our *HAP***TM** Technology and capabilities aresuperior to competing technologies. Although we believe that our focus on gene-based *HAP***TM**Markers, rather than random genomic SNPs or genome-wide haplotypes,differentiates our *HAP***TM** Technology from other technologiesthat our competitors are developing, any *HAP***TM** Technology improvements we createmay fail to achieve greater market acceptance than the technologies developedby our competitors.

 

Genomic technologies have undergone, and areexpected to continue to undergo, rapid and significant change.  Our future success will depend in large parton maintaining a competitive position in the genomics field.  Others may rapidly develop new technologiesthat may result in our products or technologies becoming obsolete before werecover the expenses we incur in connection with the development of theseproducts.  Our *HAP***TM**Technology could become obsolete if our competitors offer less expensive ormore effective drug discovery and development technologies, includingtechnologies that may be unrelated to genomics.

 

***If we fail to maintain our computerhardware, software and related infrastructure, we could experience loss of, ordelay in, revenues and market acceptance.***

 

Because our business requires manipulatingand analyzing large amounts of data, we depend on the continuous, effective,reliable and secure operation of our computer hardware, software and related infrastructure.  To the extent that our hardware or softwaremalfunctions, 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 andsophisticated, and as such, could contain data, design or software errors thatcould be difficult to detect and correct. Users of our system may find software defects in current or futureproducts.  If we fail to maintain thenecessary computer capacity and data to support our computational needs and ourcustomers’ drug discovery and development efforts, we could experience a lossin revenues, or a delay in receiving revenues, and a delay in obtaining marketacceptance for our technology.

 

***Our operating results may fluctuatesignificantly and any failure to meet financial expectations may disappointsecurities analysts or investors and result in a decline in our common stockprice.***

 

Our operating results have fluctuated in thepast and we expect they will fluctuate in the future. These fluctuations couldcause our common stock price to decline. Some of the factors that could cause our operating results to fluctuateinclude:

•                  recognition of non-recurring revenues due toreceipt of license fees, achievement of milestones, completion of contracts orother revenues;

•                  demand for and market acceptance of our *HAP***TM**Technology Partnership program and our *HAP***TM**Drug-Specific Partnership program;

•                  timing of the execution of agreements on our*HAP***TM** Technology Partnership program andour *HAP***TM**Drug-Specific Partnership program or other material contracts, ifany;

•                  our competitors’ announcements orintroduction of new products, services or technological innovations;

•                  disputes regarding patents or otherintellectual property rights;

•                  securities class actions or otherlitigation;

•                  adverse changes in the level of economicactivity in the United States and other major regions in which we do business;and

•                  general and industry-specific economicconditions, which may affect our partners’ use of our *HAP***TM**Technology.

 

Due to volatile and unpredictable revenuesand operating expenses, we believe that period-to-period comparisons of ourresults of operations may not be a good indication of our futureperformance.  It is possible that, insome future periods, our operating results may be below the expectations ofsecurities analysts or investors.  Inthis event, the market price of our common stock could fluctuate significantlyor decline.

 

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**Item3 – Quantitative and Qualitative****Disclosures about Market Risk.**

 

Our exposure tomarket risk is principally confined to our cash equivalents and investments,all of which have maturities of less than one year. We maintain a non-tradinginvestment portfolio of investment grade, liquid debt securities that limit theamount of credit exposure to any one issue, issuer or type of instrument. Inview of the nature and mix of our total portfolio, a 10% movement in marketinterest rates would not have a significant impact on the total value of ourinvestment portfolio as of September 30, 2002.

 

**Item4 – Controls and Procedures****.**

 

a)     *Evaluation of disclosure controls and procedures*.  Based on their evaluation of the Company’sdisclosure controls and procedures (as defined in Rules 13a —14(c) and15d-14(c) under the Securities Exchange Act of 1934) as of a date within 90days of the filing date of this Quarterly Report on Form 10-Q, the Company’schief executive officer and chief financial officer have concluded that theCompany’s disclosure controls and procedures are designed to ensure thatinformation required to be disclosed by the Company in the reports that itfiles or submits under the Exchange Act is recorded, processed, *summarized* and reported within the timeperiods specified in the SEC’s rules and forms and are operating in aneffective manner

 

b)    *Changes in internal controls*.  There were no significant changes in the Company’s internalcontrols or in other factors that could significantly affect these controlssubsequent to the date of the most recent evaluation.

 

**PARTII - Other Information**

 

**Item2 – Changes in Securities****and Use of Proceeds.**

 

**Changes in Securities**

 

Not applicable

 

**Use of Proceeds**

 

The proceeds from ourinitial public offering have been invested in interest-bearing high-gradecorporate bonds and money market accounts.

 

From the closing of ourinitial public offering through September 30, 2002, we have used the proceedsfor research and development activities, capital expenditures, working capitaland other general corporate purposes. We will continue to spend funds to service our *HAP*TM Technology Partnershipprogram customers and our *HAP*TMDrug-Specific Partnership program customer, to obtain new customers for bothprograms and to maintain our *HAP*TMTechnology.  As of September 30, 2002,$36.4 million of the net proceeds remain available and are primarily investedin cash equivalents and short-term marketable securities.

 

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**Item6 – Exhibits and Reports****on Form 8-K.**

 

(a) Exhibits

 

See Index to Exhibits attached hereto and incorporated by referenceherein.

 

(b) Reports on Form 8-K

 

No reports on Form 8-Khave been filed during the quarter for which this report is filed.

 

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

**SIGNATURE**

 

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                          | GENAISSANCE  PHARMACEUTICALS, INC.            |
|-------------------------------|-----------------------------------------------|
|                          |                                          |   |   |
|                          |                                          |   |   |
|                          |                                          |   |   |
|                          |                                          |   |   |
| Date: November 14,  2002 | By:                                           |   /s/ Joseph Keyes |   |
|                          | Joseph Keyes                                  |
|                          | Vice President and  Chief Financial Officer   |
|                          | (Principal Financial  and Accounting Officer) |

 

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CERTIFICATIONS

 

I, Kevin Rakin, certify that:

 

1.               I have reviewedthis quarterly report on Form 10-Q of Genaissance Pharmaceuticals, Inc.;

 

2.               Based on myknowledge, this quarterly report does not contain any untrue statement of a materialfact or omit to state a material fact necessary to make the statements made, inlight of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.               Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.               The registrant’sother certifying officers and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                   designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b)                  evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                   presented inthis quarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)                   all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                  any fraud,whether or not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.               The registrant’sother certifying officers and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 
|                          | /s/ Kevin Rakin                       |   |
|-------------------------------|---------------------------------------|--------|
| Dated: November 14, 2002 | Kevin Rakin                           |
|                          | President and Chief Executive Officer |

 

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CERTIFICATIONS

 

I, Joseph Keyes, certify that:

 

1.               I have reviewedthis quarterly report on Form 10-Q of Genaissance Pharmaceuticals, Inc.;

 

2.               Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this [annual/quarterly]report;

 

3.               Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.               The registrant’sother certifying officers and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                   designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b)                  evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                   presented inthis quarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)                   all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                  any fraud,whether or not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.               The registrant’sother certifying officers and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 
|                          | /s/ Joseph Keyes                           |   |
|-------------------------------|--------------------------------------------|--------|
| Dated: November 14, 2002 | Joseph Keyes                               |
|                          | Vice President and Chief Financial Officer |

 

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Index to Exhibits

 
| **Exhibit  Number** |   | **Description  of Document**                                                                                                        |
|---------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                |
| 10.1*               |   | Amendment, dated as of May 13, 2002, to the  Agreement, dated as of August 31, 2001 by and between the Registrant and  Pfizer, Inc. |
| 99.1                |   | Statement pursuant to 18 U.S.C. Section 1350                                                                                        |
| 99.2                |   | Statement pursuant to 18 U.S.C. Section 1350                                                                                        |
|                |   |                                                                                                                                |

 

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*          Confidentialtreatment request as to certain portions, which portions have been filedseparately with the commission.

 

 

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