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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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FORM 10-Q

(Mark one)

|      |  |                                                                                                                                            
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|[X]   |  | Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934. For the quarterly period ended September 30,
2001.
|      |  | or                                                                                                                                         
|[   ] |  | Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934. For the transition period from  to               

Commission File Number:

000-31633


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Kosan Biosciences Incorporated

(Exact name of registrant as specified in its charter)


|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 94-3217016                          
|(State or other jurisdiction of
incorporation or organization) |  | (I.R.S. Employer
Identification No.)

3832 Bay Center Place, Hayward, California 94545

(address of principal executive offices)


(510) 732-8400

(Registrants telephone number, including area code)




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Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
filing requirements for the past 90 days.

Yes  [X]    No [   ]

Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date. Common Stock, $.001 par
value; 25,262,403 shares outstanding at October 31, 2001.



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TABLE OF CONTENTS



|                                                  |                                                                                               |                                         |  |  |  |  |  | 
|------------------------------------------------- | --------------------------------------------------------------------------------------------- | --------------------------------------- |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION                    
|                                                  | Item 1: Condensed Financial Statements and Notes                                             
|                                                  |                                                                                               | CONDENSED BALANCE SHEETS               
|                                                  |                                                                                               | CONDENSED STATEMENTS OF OPERATIONS     
|                                                  |                                                                                               | CONDENSED STATEMENTS OF CASH FLOWS     
|                                                  |                                                                                               | NOTES TO CONDENSED 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                           
|PART II.OTHER INFORMATION                        
|                                                  | Item 1. Legal Proceedings                                                                    
|                                                  | Item 2. Changes in Securities and Use of Proceeds                                            
|                                                  | Item 3. Defaults Upon Senior Securities                                                      
|                                                  | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                                                  | Item 5. Other Information                                                                    
|                                                  | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                                       
|Amendmend No. 3 to Research and License Agreement
|Master Loan and Security Agreement no. 84325     



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##### Table of Contents



KOSAN BIOSCIENCES INCORPORATED

Form 10-Q

Quarter Ended September 30, 2001

INDEX

|           |  |                                                                                                           |  |     
|---------- |  | --------------------------------------------------------------------------------------------------------- |  | ----
|           |  |                                                                                                           |  | Page
|           |  |                                                                                                           |  |     
|PART I     |  | FINANCIAL INFORMATION                                                                                     |  | 3   
|          
|Item 1:    |  | Condensed Financial Statements and Notes:                                                                 |  | 3   
|          
|           |  | Condensed Balance Sheets as of September 30, 2001
and December 31, 2000                                   |  | 3   
|          
|           |  | Condensed Statements of Operations for the three months and nine
months ended September 30, 2001 and 2000 |  | 4   
|          
|           |  | Condensed Statements of Cash Flows for the nine
months ended September 30, 2001 and 2000                  |  | 5   
|          
|           |  | Notes to Condensed Financial Statements                                                                   |  | 6   
|          
|Item 2:    |  | Managements Discussion and Analysis of Financial
Condition and Results of Operations                     |  | 11  
|          
|Item 3:    |  | Quantitative and Qualitative Disclosures About Market Risk                                                |  | 21  
|          
|PART II    |  | OTHER INFORMATION                                                                                         |  | 23  
|          
|Item 1:    |  | Legal Proceedings                                                                                         |  | 23  
|          
|Item 2:    |  | Changes in Securities and Use of Proceeds                                                                 |  | 23  
|          
|Item 3:    |  | Defaults Upon Senior Securities                                                                           |  | 23  
|          
|Item 4:    |  | Submission of Matters to a Vote of Security Holders                                                       |  | 23  
|          
|Item 5:    |  | Other Information                                                                                         |  | 23  
|          
|Item 6:    |  | Exhibits and Reports on Form 8-K                                                                          |  | 23  
|          
|SIGNATURES |  |                                                                                                           |  | 25  

2



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##### Table of Contents






PART I. FINANCIAL INFORMATION




Item 1:Condensed Financial Statements and Notes

KOSAN BIOSCIENCES INCORPORATED




CONDENSED BALANCE SHEETS
(in thousands)

|                                                                   |                                           |                                                                 |                      |                                            |         |               |        |              |         |         |         | 
|------------------------------------------------------------------ | ----------------------------------------- | --------------------------------------------------------------- | -------------------- | ------------------------------------------ | ------- | ------------- | ------ | ------------ | ------- | ------- | ------- | 
|                                                                   |                                           |                                                                 |                      |                                            |         | September 30, |        | December 31,
|                                                                   |                                           |                                                                 |                      |                                            |         | 2001          |        | 2000        
|                                                                   |                                           |                                                                 |                      |                                            |         |               |        |             
|                                                                   |                                           |                                                                 |                      |                                            |         | (unaudited)   |        | (1)         
|                                                                   |                                           |                                                                 |                      |                                            |         |               |        |             
|Assets                                                            
|Current assets:                                                    |                                           |                                                                 |                      |                                            |         |               |        |             
|                                                                   | Cash and cash equivalents                 |                                                                 | $                    | 23,504                                     |         |               | $      | 36,425       |        
|                                                                   | Short-term investments                    |                                                                 |                      | 56,096                                     |         |               |        | 49,313       |        
|                                                                   | Other receivables                         |                                                                 |                      | 789                                        |         |               |        | 21           |        
|                                                                   | Prepaid expenses and other current assets |                                                                 |                      | 337                                        |         |               |        | 515          |        
|                                                                   |                                           |                                                                 |                      |                                            |         |               |        |             
|                                                                   |                                           |                                                                 | Total current assets |                                            |         | 80,726        |        |              |         | 86,274  |        
|Property and equipment, net                                        |                                           |                                                                 | 3,593                |                                            |         |               | 3,133  |             
|Long-term investments                                              |                                           |                                                                 | 13,858               |                                            |         |               | 17,003 |             
|Notes receivable from related parties                              |                                           |                                                                 | 1,066                |                                            |         |               | 917    |             
|Other assets                                                       |                                           |                                                                 | 244                  |                                            |         |               | 244    |             
|                                                                   |                                           |                                                                 |                      |                                            |         |               |        |             
|                                                                   |                                           |                                                                 | Total assets         |                                            | $       | 99,487        |        |              | $       | 107,571 |        
|                                                                   |                                           |                                                                 |                      |                                            |         |               |        |             
|Liabilities and Stockholders Equity                              
|Current liabilities:                                               |                                           |                                                                 |                      |                                            |         |               |        |             
|                                                                   |                                           | Accounts payable                                                |                      | $                                          | 1,673   |               |        | $            | 980     |        
|                                                                   |                                           | Accrued liabilities                                             |                      |                                            | 1,271   |               |        |              | 1,597   |        
|                                                                   |                                           | Deferred revenue                                                |                      |                                            | 717     |               |        |              | 619     |        
|                                                                   |                                           | Current portion of capital lease obligation and equipment loans |                      |                                            | 1,339   |               |        |              | 1,035   |        
|                                                                   |                                           |                                                                 |                      |                                            |         |               |        |             
|                                                                   |                                           |                                                                 |                      | Total current liabilities                  |         |               | 5,000  |              |         |         | 4,231   | 
|Capital lease obligation and equipment loans, less current portion |                                           |                                                                 | 1,930                |                                            |         |               | 1,975  |             
|Stockholders equity:                                              |                                           |                                                                 |                      |                                            |         |               |        |             
|                                                                   |                                           | Common stock                                                    |                      |                                            | 25      |               |        |              | 25      |        
|                                                                   |                                           | Additional paid-in capital                                      |                      |                                            | 141,909 |               |        |              | 141,590 |        
|                                                                   |                                           | Notes receivable from stockholders                              |                      |                                            | (1,705  | )             |        |              | (2,079  | )      
|                                                                   |                                           | Deferred stock-based compensation                               |                      |                                            | (5,998  | )             |        |              | (11,122 | )      
|                                                                   |                                           | Accumulated other comprehensive income/(loss)                   |                      |                                            | 1,059   |               |        |              | (380    | )      
|                                                                   |                                           | Accumulated deficit                                             |                      |                                            | (42,733 | )             |        |              | (26,669 | )      
|                                                                   |                                           |                                                                 |                      |                                            |         |               |        |             
|                                                                   |                                           |                                                                 |                      | Total stockholders equity                 |         |               | 92,557 |              |         |         | 101,365 | 
|                                                                   |                                           |                                                                 |                      |                                            |         |               |        |             
|                                                                   |                                           |                                                                 |                      | Total liabilities and stockholders equity |         | $             | 99,487 |              |         | $       | 107,571 | 
|                                                                   |                                           |                                                                 |                      |                                            |         |               |        |             

See accompanying notes.

(1)  The balance sheet data at December 31, 2000 has been derived from the
audited financial statements at that date.

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##### Table of Contents



KOSAN BIOSCIENCES INCORPORATED




CONDENSED STATEMENTS OF OPERATIONS

(unaudited)
(in thousands, except per share data)


|                                                                      |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |      |         |        |        |   |         |        |        | 
|--------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------ | ------ | ------------------ | ----- | ----------------- | ------ | ----- | ----- | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                                      |                                                                                                                                                                                                                                                               |                          |        | Three Months Ended |       | Nine Months Ended
|                                                                      |                                                                                                                                                                                                                                                               |                          |        | September 30,      |       | September 30,    
|                                                                      |                                                                                                                                                                                                                                                               |                          |        |                    |       |                  
|                                                                      |                                                                                                                                                                                                                                                               |                          |        | 2001               |       | 2000              |        | 2001  |       | 2000
|                                                                      |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |     
|Revenues:                                                             |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |      |         |        |        |   |         |       
|                                                                      | Contract revenue                                                                                                                                                                                                                                              |                          | $      | 717                |       |                   | $      | 1,025 |       |      | $       | 2,443  |        |   | $       | 3,109  |       
|                                                                      | Grant revenue                                                                                                                                                                                                                                                 |                          |        | 783                |       |                   |        | 170   |       |      |         | 1,264  |        |   |         | 310    |       
|                                                                      |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |      |         |        |        |   |         |       
|                                                                      |                                                                                                                                                                                                                                                               | Total revenues           |        |                    | 1,500 |                   |        |       | 1,195 |      |         |        | 3,707  |   |         |        | 3,419  | 
|Operating expenses:                                                   |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |      |         |        |        |   |         |       
|                                                                      | Research and development (including charges for stock-
based compensation of $1,279 and $1,925 in the three
months ended September 30, 2001 and 2000,
respectively, and $4,110 and $4,522 in the nine months
ended September 30, 2001 and 2000, respectively) |                          |        | 6,478              |       |                   |        | 4,860 |       |      |         | 18,784 |        |   |         | 12,481 |       
|                                                                      | General and administrative (including charges for stock-
based compensation of $316 and $428 in the three
months ended September 30, 2001 and 2000,
respectively, and $967 and $1,136 in the nine months
ended September 30, 2001 and 2000, respectively)     |                          |        | 1,286              |       |                   |        | 1,022 |       |      |         | 3,848  |        |   |         | 2,815  |       
|                                                                      |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |      |         |        |        |   |         |       
|                                                                      |                                                                                                                                                                                                                                                               | Total operating expenses |        |                    | 7,764 |                   |        |       | 5,882 |      |         |        | 22,632 |   |         |        | 15,296 | 
|                                                                      |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |      |         |        |        |   |         |       
|Loss from operations                                                  |                                                                                                                                                                                                                                                               |                          | (6,264 | )                  |       |                   | (4,687 | )     |       |      | (18,925 | )      |        |   | (11,877 | )     
|Other income, net                                                     |                                                                                                                                                                                                                                                               |                          | 1,118  |                    |       |                   | 436    |       |       |      | 2,861   |        |        |   | 947     |       
|                                                                      |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |      |         |        |        |   |         |       
|Net loss                                                              |                                                                                                                                                                                                                                                               |                          | (5,146 | )                  |       |                   | (4,251 | )     |       |      | (16,064 | )      |        |   | (10,930 | )     
|Deemed dividend upon issuance of Series C
convertible preferred stock |                                                                                                                                                                                                                                                               |                          |       |                    |       |                   |       |       |       |      |        |        |        |   | (11,267 | )     
|                                                                      |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |      |         |        |        |   |         |       
|Net loss attributable to common stockholders                          |                                                                                                                                                                                                                                                               | $                        | (5,146 | )                  |       | $                 | (4,251 | )     |       | $    | (16,064 | )      |        | $ | (22,197 | )     
|                                                                      |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |      |         |        |        |   |         |       
|Basic and diluted net loss per common share                           |                                                                                                                                                                                                                                                               | $                        | (0.21  | )                  |       | $                 | (0.79  | )     |       | $    | (0.67   | )      |        | $ | (4.31   | )     
|                                                                      |                                                                                                                                                                                                                                                               |                          |        |                    |       |                   |        |       |       |      |         |        |        |   |         |       
|Shares used in computing basic and diluted net loss per
common share  |                                                                                                                                                                                                                                                               |                          | 24,243 |                    |       |                   | 5,384  |       |       |      | 24,051  |        |        |   | 5,147   |       

See accompanying notes.

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##### Table of Contents



KOSAN BIOSCIENCES INCORPORATED




CONDENSED STATEMENTS OF CASH FLOWS

(unaudited)
(in thousands)


|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                   |        |         |   |        |         |  
|---------------------------------------------------- | ---------------------------------------------------------------------------- | -------------------------------------------------------------------------- | ----------------------------------------- | -------------------------------------------------------- | - | ----------------- | ------ | ------- | - | ------ | ------- | -
|                                                     |                                                                              |                                                                            |                                           |                                                          |   | Nine Months Ended
|                                                     |                                                                              |                                                                            |                                           |                                                          |   | September 30,    
|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                  
|                                                     |                                                                              |                                                                            |                                           |                                                          |   | 2001              |        | 2000   
|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|Operating activities                                 |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|                                                     | Net loss                                                                     |                                                                            | $                                         | (16,064                                                  | ) |                   | $      | (10,930 | )
|                                                     |                                                                              | Adjustment to reconcile net loss to net cash used in
operating activities: |                                           |                                                          |   |                   |        |         |   |       
|                                                     |                                                                              |                                                                            |                                           | Depreciation                                             |   |                   | 912    |         |   |        | 666     |  
|                                                     |                                                                              |                                                                            |                                           | Amortization of investment premiums and discounts, net   |   |                   | (867   | )       |   |        |        |  
|                                                     |                                                                              |                                                                            |                                           | Amortization of stock-based compensation                 |   |                   | 4,642  |         |   |        | 4,544   |  
|                                                     |                                                                              |                                                                            |                                           | Other stock-based compensation                           |   |                   | 435    |         |   |        | 1,114   |  
|                                                     |                                                                              |                                                                            |                                           | Issuance of convertible preferred stock for license fees |   |                   |       |         |   |        | 30      |  
|                                                     |                                                                              |                                                                            |                                           | Loss on write-down of investment                         |   |                   | 990    |         |   |        |        |  
|                                                     |                                                                              | Changes in assets and liabilities:                                         |                                           |                                                          |   |                   |        |         |   |       
|                                                     |                                                                              |                                                                            |                                           | Other receivables                                        |   |                   | (768   | )       |   |        | 329     |  
|                                                     |                                                                              |                                                                            |                                           | Prepaid expenses and other current assets                |   |                   | 178    |         |   |        | 230     |  
|                                                     |                                                                              |                                                                            |                                           | Other assets and notes receivable from related parties   |   |                   | 187    |         |   |        | (1,913  | )
|                                                     |                                                                              |                                                                            |                                           | Accounts payable                                         |   |                   | 693    |         |   |        | 714     |  
|                                                     |                                                                              |                                                                            |                                           | Accrued liabilities                                      |   |                   | (326   | )       |   |        | 551     |  
|                                                     |                                                                              |                                                                            |                                           | Deferred revenue                                         |   |                   | 98     |         |   |        | (409    | )
|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|                                                     |                                                                              |                                                                            |                                           | Net cash used in operating activities                    |   |                   | (9,890 | )       |   |        | (5,074  | )
|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|Investing activities                                 |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|                                                     | Acquisition of property and equipment, net                                   |                                                                            |                                           | (1,372                                                   | ) |                   |        | (1,210  | )
|                                                     | Purchase of investments                                                      |                                                                            |                                           | (77,525                                                  | ) |                   |        | (15,682 | )
|                                                     | Proceeds from maturity of investments                                        |                                                                            |                                           | 75,203                                                   |   |                   |        |        |  
|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|                                                     |                                                                              |                                                                            |                                           | Net cash used in investing activities                    |   |                   | (3,694 | )       |   |        | (16,892 | )
|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|Financing activities                                 |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|                                                     | Proceeds from issuance of common stock, net                                  |                                                                            |                                           | 404                                                      |   |                   |        | 60      |  
|                                                     | Proceeds from issuance of convertible preferred stock, net of issuance
costs |                                                                            |                                           |                                                         |   |                   |        | 24,600  |  
|                                                     | Proceeds from equipment loans                                                |                                                                            |                                           | 1,092                                                    |   |                   |        | 1,754   |  
|                                                     | Principal payments under capital lease obligation and equipment loans        |                                                                            |                                           | (833                                                     | ) |                   |        | (557    | )
|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|                                                     |                                                                              |                                                                            | Net cash provided by financing activities |                                                          |   | 663               |        |         |   | 25,857 |        
|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|Net (decrease) increase in cash and cash equivalents |                                                                              |                                                                            | (12,921                                   | )                                                        |   |                   | 3,891  |        
|Cash and cash equivalents at beginning of period     |                                                                              |                                                                            | 36,425                                    |                                                          |   |                   | 1,032  |        
|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        
|Cash and cash equivalents at end of period           |                                                                              | $                                                                          | 23,504                                    |                                                          |   | $                 | 4,923  |        
|                                                     |                                                                              |                                                                            |                                           |                                                          |   |                   |        |        

See accompanying notes.

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##### Table of Contents



KOSAN BIOSCIENCES INCORPORATED




NOTES TO CONDENSED FINANCIAL STATEMENTS

(unaudited)


1. Organization and Summary of Significant Accounting Policies

Overview

Kosan Biosciences Incorporated (Kosan or the Company) was incorporated
under the laws of the State of California on January 6, 1995 and commenced
operations in 1996. In July 2000, the Company was reincorporated under the
laws of the state of Delaware. Kosan has proprietary gene-engineering
technologies for the manipulation and production of polyketides, a rich source
of pharmaceutical products.

The Company has funded its operations primarily through sales of common
stock, convertible preferred stock, contract payments under its collaboration
agreement, equipment financing arrangements and government grants. Prior to
achieving profitable operations, the Company intends to fund operations through
the additional sale of equity securities, strategic collaborations, government
grant awards and debt financing.

Basis of Presentation

The accompanying unaudited condensed financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information. The information as of
September 30, 2001, and for the three months and nine months ended September
30, 2001 and 2000, reflects all adjustments (including normal recurring
adjustments) that the management of the Company believes are necessary for a
fair presentation of the results for the periods presented. Results for any
interim period are not necessarily indicative of results for any future interim
period or for the entire year. The accompanying condensed financial statements
should be read in conjunction with the financial statements and notes thereto
included in the Companys Annual Report on Form 10-K for the year ended
December 31, 2000.

Use of Estimates

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and the accompanying notes. Actual results could differ from those
estimates.

Cash Equivalents and Investments

The Company considers all highly liquid investments with a maturity from
date of purchase of three months or less to be cash equivalents. The Company
limits its concentration of risk by diversifying its investments among a
variety of issuers. The Company classifies all investment securities as
available-for-sale in accordance with Statement of Financial Accounting
Standards No. 115, Accounting for Certain Investments in Debt and Equity
Securities (SFAS 115). Available-for-sale investments are recorded at fair
value based on quoted market prices, with unrealized gains and losses excluded
from earnings and reported in other comprehensive income (loss). Purchase
premiums and discounts are recognized in interest income using the interest
method over the terms of the securities. Declines in the fair value of
available-for-sale securities below their cost that are deemed to be other than
temporary are reflected in earnings as realized losses. Gains and losses on
the sale of securities are recorded on the trade date and are determined using
the specific identification method.

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##### Table of Contents



KOSAN BIOSCIENCES INCORPORATED

NOTES TO CONDENSED FINANCIAL STATEMENTS
(unaudited)

1. Organization and Summary of Significant Accounting Policies (Continued)

Revenue Recognition

The Company recognizes license and other up-front fees on a ratable basis
over the term of the respective agreement. Milestone payments are recognized
upon successful completion of a performance milestone event. Contract revenues
related to collaborative research and development agreements and government
grants are recognized on a ratable basis as services are performed. Any
amounts received in advance of performance are recorded as deferred revenue
until earned.

Research and Development

Research and development expenses consist of costs incurred for
Company-sponsored and collaborative research and development activities. These
costs consist of direct and indirect internal costs related to specific
projects as well as fees paid to other entities that conduct certain research
activities on behalf of the Company. Research and development expenses under
the government grants and collaborative agreements approximated the revenue
recognized, less milestone payments received under such arrangements.

Net Loss per Share

Basic and diluted net loss per common share is presented in conformity
with the Statement of Financial Accounting Standards No. 128, Earnings per
Share (SFAS 128), for all periods presented. Following the guidance given
by the Securities and Exchange Commission (SEC) Staff Accounting Bulletin No.
98, common stock and convertible preferred stock that has been issued or
granted for nominal consideration prior to the anticipated effective date of
the initial public offering must be included in the calculation of the basic
and diluted net loss per common share as if these shares had been outstanding
for all periods presented. To date, the Company has not issued or granted
shares for nominal consideration.

In accordance with SFAS 128, basic and diluted net loss per common share
has been computed using the weighted-average number of shares of common stock
outstanding during the period, less shares subject to repurchase. Diluted net
loss is not presented separately as the Company is in a net loss position, and
including common stock equivalents in the loss per share computation would be
antidilutive. Pro forma net loss per common share has been computed to give
effect to the automatic conversion of preferred stock into common stock
immediately prior to the completion of the Companys initial public offering
(using the if-converted method) from the original date of issuance.

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KOSAN BIOSCIENCES INCORPORATED

NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
(unaudited)

1. Organization and Summary of Significant Accounting Policies (Continued)

The following table presents the calculation of basic, diluted and pro
forma basic and diluted net loss per share (in thousands, except per share
data):

|                                                                                             |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|-------------------------------------------------------------------------------------------- |  | ------------------ | ------ | ----------------- |  | ---- | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                             |  | Three Months Ended |        | Nine Months Ended
|                                                                                             |  | September 30,      |        | September 30,    
|                                                                                             |  |                    |        |                  
|                                                                                             |  | 2001               |        | 2000              |  | 2001 |        | 2000
|                                                                                             |  |                    |        |                   |  |      |        |     
|Net loss attributable to common stockholders                                                 |  | $                  | (5,146 | )                 |  | $    | (4,251 | )    |  | $ | (16,064 | ) |  | $ | (22,197 | )
|                                                                                             |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Weighted-average shares of common
stock outstanding                                          |  |                    | 25,192 |                   |  |      | 6,706  |      |  |   | 25,180  |   |  |   | 6,400   |  
|Less: weighted-average shares subject
to repurchase                                          |  |                    | (949   | )                 |  |      | (1,322 | )    |  |   | (1,129  | ) |  |   | (1,253  | )
|                                                                                             |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Weighted-average shares used in computing
basic and diluted net loss per common share        |  |                    | 24,243 |                   |  |      | 5,384  |      |  |   | 24,051  |   |  |   | 5,147   |  
|                                                                                             |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Basic and diluted net loss per common share                                                  |  | $                  | (0.21  | )                 |  | $    | (0.79  | )    |  | $ | (0.67   | ) |  | $ | (4.31   | )
|                                                                                             |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Pro forma:                                                                                   |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Shares used above                                                                            |  |                    | 24,243 |                   |  |      | 5,384  |      |  |   | 24,051  |   |  |   | 5,147   |  
|Pro forma adjustment to reflect weighted
effect of conversion of convertible
preferred stock |  |                    |       |                   |  |      | 12,221 |      |  |   |        |   |  |   | 11,426  |  
|                                                                                             |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Shares used in computing pro forma basic and
diluted net loss per common share               |  |                    | 24,243 |                   |  |      | 17,605 |      |  |   | 24,051  |   |  |   | 16,573  |  
|                                                                                             |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Pro forma basic and diluted net loss per share                                               |  | $                  | (0.21  | )                 |  | $    | (0.24  | )    |  | $ | (0.67   | ) |  | $ | (1.34   | )
|                                                                                             |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  

Stock-Based Compensation

The Company accounts for common stock options granted to employees using
the intrinsic value method and thus recognizes no compensation expense for
options granted with exercise prices equal to or greater than the deemed fair
value of the Companys common stock on the date of the grant.

Stock-based compensation expense for options granted to non-employees has
been determined in accordance with Statement of Financial Accounting Standards
No. 123, Accounting for Stock-Based Compensation (SFAS 123) and Emerging
Issues Task Force (EITF) Consensus No. 96-18 as the fair value of the
consideration received or the fair value of the equity instruments issued,
whichever is more reliably measured. The measurement of stock-based
compensation to non-employees is subject to periodic adjustment as the
underlying securities vest.

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KOSAN BIOSCIENCES INCORPORATED

NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
(unaudited)

2. Collaborative Research and Development and License Agreements

The R.W. Johnson Pharmaceutical Research Institute

In September 1998, the Company signed a collaborative agreement with The
R.W. Johnson Pharmaceutical Research Institute and Ortho-McNeil Pharmaceutical,
Inc., both Johnson & Johnson companies. In September 2001, the Company amended
its collaborative research and development agreement. Under the terms of the
amended agreement, subject to termination provisions, the research program and
funding have been extended until December 28, 2002. In February 2001, the
Company received, and recognized in full, a $250,000 milestone in connection
with this agreement.

License Agreements

The Company has collaborative and license agreements with several academic
and medical institutions. For the nine months ended September 30, 2001 and
2000, the Company made payments under these agreements of approximately
$371,000 and $316,000, respectively. At September 30, 2001, the Company
estimated its non-cancelable commitments under these agreements to be
approximately $375,000.

3. Comprehensive Income/(Loss)

For the three and nine months ended September 30, 2001 and 2000,
comprehensive loss is as follows (in thousands):

|                                                                |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------- |  | ------------------ | ------ | ----------------- |  | ---- | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                |  | Three Months Ended |        | Nine Months Ended
|                                                                |  | September 30,      |        | September 30,    
|                                                                |  |                    |        |                  
|                                                                |  | 2001               |        | 2000              |  | 2001 |        | 2000
|                                                                |  |                    |        |                   |  |      |        |     
|Net loss                                                        |  | $                  | (5,146 | )                 |  | $    | (4,251 | )    |  | $ | (16,064 | ) |  | $ | (22,197 | )
|Unrealized gain on
available-for-sale securities                |  |                    | 671    |                   |  |      | 53     |      |  |   | 449     |   |  |   | 59      |  
|Reclassification of write-down on
available-for-sale securities |  |                    |       |                   |  |      |       |      |  |   | 990     |   |  |   |        |  
|                                                                |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Comprehensive loss                                              |  | $                  | (4,475 | )                 |  | $    | (4,198 | )    |  | $ | (14,625 | ) |  | $ | (22,138 | )
|                                                                |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  

4. Loss on Write-Down of Investment

In accordance with SFAS 115, the Company determined that an
other-than-temporary decline in fair value of its investment in short-term
commercial paper of Southern California Edison (So Cal Ed), a utility
company, had occurred at June 30, 2001. At the time of purchase, the security
was a high investment-grade security, but was subsequently downgraded due to
the financial uncertainty that resulted from the California energy crisis. The
security matured on April 18, 2001, and So Cal Ed defaulted on payment. The
initial cost of the security was $3.0 million, and the security was valued at
approximately 67% of cost at June 30, 2001. Accordingly, the Company recorded
a $990,000 loss on the related write-down in the carrying value of the
investment. Subsequent to the maturity date, So Cal Ed has made interest
payments on a monthly basis at the stated interest rate of 6.64%. At September
30, 2001, the security remained outstanding and was valued at approximately 83%
of cost. The unrealized gain of $480,000 is included in accumulated other
comprehensive income (loss).

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KOSAN BIOSCIENCES INCORPORATED

NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
(unaudited)

5. Capital Leases and Equipment Financing

The Company leases certain equipment and facility improvements under
non-cancelable capital leases and debt obligations. Some of the equipment
loans have a balloon payment at the end of the term. The interest rates of
each of the leases and loans are fixed at the time of the draw down, with the
interest rates ranging from 9.02% to 16.96%. In July 2001, the Company entered
into a $2.5 million equipment line of credit agreement (the Line of Credit).
Each draw down has a repayment period of 42 months and an interest rate that is
fixed at the time of draw down. As of September 30, 2001, the Company utilized
approximately $1.1 million of the Line of Credit, which carries with it an
interest rate of 9.02%. Obligations under the Line of Credit are payable in
monthly installments of principal and interest and are secured by the assets
financed under the Line of Credit.

6. Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

|                      |  |               |       |              |  |   |       | 
|--------------------- |  | ------------- | ----- | ------------ |  | - | ----- | 
|                      |  | September 30, |       | December 31,
|                      |  | 2001          |       | 2000        
|                      |  |               |       |             
|Facilities-related    |  | $             | 325   |              |  | $ | 415   | 
|Compensation-related  |  |               | 306   |              |  |   | 451   | 
|Professional services |  |               | 373   |              |  |   | 250   | 
|Other                 |  |               | 267   |              |  |   | 481   | 
|                      |  |               |       |              |  |   |       | 
|                      |  | $             | 1,271 |              |  | $ | 1,597 | 
|                      |  |               |       |              |  |   |       | 

7. Subsequent Event

On October 5, 2001, the Board of Directors of the Company adopted a
Stockholder Rights Plan under which all stockholders of record as of October
29, 2001 will receive rights (the Rights) to purchase shares of a new series
of Preferred Stock. The Rights will be distributed as a non-taxable dividend
and will expire on October 29, 2011. As set forth in the Stockholder Rights
Plan, each Right entitles the holder to purchase one one-hundredth of a share
of newly created Series A Junior Participating Preferred Stock of the Company
at an exercise price of $70.00 per one-one hundredth of a share, if a person
acquires more than 20% of the Companys Common Stock. The Rights holder will
generally be entitled to redeem the Rights for $0.001 per share prior to the
time a person acquires more than 20% of the Companys Common Stock.

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Item 2:Managements Discussion and Analysis of Financial Condition and Results
of Operations

Forward-Looking Statements

The following discussion of our financial condition and results of
operations contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange
Act of 1934. These statements relate to future events or our future financial
performance. In some cases, you can identify forward-looking statements by
terminology such as may, will, should, expect, plan, anticipate, believe,
estimate, predict, potential or continue, the negative of terms like these or
other comparable terminology. Actual events or results may differ materially
from those anticipated in these forward-looking statements. All
forward-looking statements included in this document are based on information
available to us on the date hereof, and we assume no obligation to update any
such forward-looking statements. In evaluating these statements, you should
specifically consider various factors, including the risks outlined under the
caption Factors that May Affect Results of Operations and Financial Condition
set forth at the end of this Item 2, the Risk Factors set forth in our Annual
Report on Form 10-K filed with the SEC and those contained from time to time in
our other filings with the SEC. We caution investors that our business and
financial performance are subject to substantial risks and uncertainties.

Overview

We have proprietary gene-engineering technologies for the manipulation and
production of polyketides, a rich source of pharmaceutical products. We use
our platform technologies to develop product candidates that target large
pharmaceutical markets. We are testing Epothilone D, a potential anti-cancer
agent in Phase I human clinical trials. In infectious disease, we have a
collaboration with The R.W. Johnson Pharmaceutical Research Institute, a
Johnson & Johnson company, focusing on the development of a next generation
antibiotic.

We have incurred significant losses since our inception. As of September
30, 2001, our accumulated deficit was $42.7 million. We expect to incur
additional operating losses over the next several years as we continue to
develop our technologies and fund internal product research and development.

Stock-Based Compensation

Stock-based compensation represents the difference between the exercise
price of an option and the deemed fair value of our common stock on the date of
the option grant calculated in accordance with Accounting Principles Board
Opinion No. 25 and its related interpretations. Such amounts are included as a
reduction of stockholders equity and are being amortized to expense using the
graded vesting method over the vesting periods of the underlying options, which
generally are four years. Amortization of stock-based compensation has been
allocated to research and development expense and general and administrative
expense, as appropriate. We recognized stock-based compensation expense of
$4.6 million and $4.5 million for the nine months ended September 30, 2001 and
2000, respectively. Based on deferred stock-based compensation recorded as of
September 30, 2001, we expect to record amortization for deferred stock-based
compensation approximately as follows: $1.4 million for the three months
remaining in 2001, $3.0 million in 2002, $1.3 million in 2003 and $298,000 in
2004.

In connection with the grants of stock options and restricted stock to
non-employees, we recognize compensation on a ratable basis over the related
service period. We recognized other stock-based compensation for non-employees
of $435,000 and $1.1 million in the nine months ended September 30, 2001 and
2000, respectively. In addition, we expect to recognize other stock-based
compensation in connection with stock options and restricted stock granted to
non-employees of $568,000 for the three months remaining in 2001, $431,000 in
2002, $197,000 in 2003, $121,000 in 2004 and $34,000 in 2005. The measurement
of stock-based compensation to our non-employees is subject to periodic
adjustment as

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our stock price changes and as the underlying securities vest. As such,
changes to these measurements could be substantial should we experience
significant changes in our stock price.

Results of Operations

Revenues. Our revenues were $1.5 million and $3.7 million for the three
and nine months ended September 30, 2001, compared to $1.2 million and $3.4
million for the same periods in 2000. Grant revenue was $1.3 million for the
nine months ended September 30, 2001, compared to $310,000 for the same period
last year. In addition, during the nine months ended September 30, 2001, we
recognized a non-recurring $250,000 milestone received in connection with the
anti-infective collaboration with The R.W. Johnson Pharmaceutical Research
Institute. Included in the year-to-date 2000 revenues was $375,000 in
amortization of the up-front fee received in connection with this
collaboration. The initial term of the collaboration with The R.W. Johnson
Pharmaceutical Research Institute has been extended to December 28, 2002,
subject to early termination. If we do not maintain or further extend this
agreement, or if it is terminated early, our revenues will significantly
decrease thereafter, unless we enter into additional collaborations.

Research and Development Expenses.Our research and development expenses
consist primarily of stock-based compensation, salaries and other
personnel-related expenses, facility-related expenses and fees paid to outside
service providers. Research and development expenses increased to $6.5 million
and $18.8 million for the three and nine months ended September 30, 2001 from
$4.9 million and $12.5 million for the same periods in 2000. These increases
were primarily attributable to our expanded research and development efforts,
including advancing Epothilone D toward the clinic and continued investment in
our internally funded programs and technologies. Stock-based compensation
decreased in the three months ended September 30, 2001 to $1.3 million from
$1.9 million for the same period in 2000 and decreased for the nine months
ended September 30, 2001 to $4.1 million from $4.5 million for the same period
in 2000. We expect our research and development expenses will increase
substantially to advance our Epothilone D program through clinical trials, fund
the expansion of our technology platform, support our collaborative research
programs and advance other in-house research programs into later stages of
development.

General and Administrative Expenses. General and administrative expenses
increased to $1.3 million and $3.8 million for the three and nine months ended
September 30, 2001 from $1.0 million and $2.8 million for the same periods in
2000. This increase was primarily due to higher employee-related costs to
support our expanding research and development activities and added public
company-related expenses. We expect our general and administrative expenses
will increase in the future to support the continued growth of our research and
development efforts and to fulfill our obligations associated with being a
publicly held company.

Interest Income.Interest income increased to $1.2 million and $3.1
million for the three and nine months ended September 30, 2001 from $530,000
and $1.2 million for the same periods in 2000. This increase was due to higher
average investment balances due to aggregate net proceeds of $98.0 million
received in connection with our October 2000 initial public offering of common
stock and the issuance of Series C convertible preferred stock in March 2000.

Interest Expense. Interest expense decreased to $88,000 for the three
months ended September 30, 2001 from $94,000 for the same period in 2000 and
increased to $262,000 for the nine months ended September 30, 2001 from
$261,000 for the same period in 2000. The decrease for the quarter ended
September 30, 2001 from the quarter ended September 30, 2000 resulted from
normal amortization of our existing debt.

Write-down of Investment.At September 30, 2001, we had approximately
$3.0 million invested in short-term commercial paper of Southern California
Edison (So Cal Ed), a utility company. The security matured on April 18,
2001 and So Cal Ed defaulted on payment. At June 30, 2001, the security

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was valued at approximately 67% of cost, and we recorded a write-down on
the carrying value of the investment of $990,000. Due to the continuing
uncertainty associated with the California energy crisis, additional
write-downs in the carrying value of the security may be required in the event
So Cal Ed experiences further adverse material changes in its financial
condition. As of September 30, 2001, the security remained outstanding and was
valued at approximately 83% of cost. The $480,000 increase in the carrying
value is included in accumulated other comprehensive gain (loss).

Beneficial Conversion Feature.In March 2000, we sold 804,196 shares of
Series C convertible preferred stock (which converted into 2,412,588 shares of
common stock at the closing of our initial public offering) for net proceeds of
approximately $24.6 million. After evaluating the fair value of our common
stock in contemplation of our initial public offering, we determined that the
issuance of the Series C convertible preferred stock resulted in a beneficial
conversion feature calculated in accordance with EITF Consensus No. 98-5,
Accounting for Convertible Securities with Beneficial Conversion Features.
The beneficial conversion feature was reflected as a deemed dividend of $11.3
million in our financial statements for the six months ended June 30, 2000.

Liquidity and Capital Resources

We have financed our operations from inception primarily through sales of
convertible preferred stock and common stock, totaling $119.5 million in net
proceeds, contract payments under our collaboration agreement, equipment
financing arrangements and government grants. As of September 30, 2001, we had
$93.5 million in cash, cash equivalents and investments, compared to $102.7
million as of December 31, 2000. Our funds are invested in U.S. Treasury and
government agency obligations, investment-grade asset-backed securities and
corporate obligations.

Our operating activities used cash of $9.9 million for the nine months
ended September 30, 2001, compared to $5.1 million for the same period in 2000.
Our net loss of $16.1 million for the nine months ended September 30, 2001 was
partially offset by non-cash expenses of $6.1 million related to stock-based
compensation, depreciation and amortization and the write-down of our
investment in So Cal Ed. Cash used for the same period in 2000 was used
primarily to fund our net operating losses of $10.9 million, partially offset
by non-cash expenses of $6.4 million related to stock-based compensation and
depreciation.

Our investing activities, excluding changes in our investments, for the
nine months ended September 30, 2001 used cash of $1.4 million, compared to
$1.2 million for the same period in 2000, reflecting capital expenditures and
facility improvements.

Cash provided by financing activities was $663,000 for the nine months
ended September 30, 2001, compared to cash provided by financing activities of
$25.9 million for the same period in 2000. Financing activities included $1.1
million in net proceeds from our equipment loan financing in July 2001 and
$24.6 million in net proceeds from the issuance of our Series C convertible
preferred stock in March 2000. In July 2001, we secured a $2.5 million
equipment line of credit. As of September 30, 2001, $1.1 million had been
utilized leaving approximately $1.4 million available to be drawn upon.

For periods subsequent to September 30, 2001, we have estimated our
non-cancelable commitments under our collaborative and license agreements to be
approximately $375,000.

We believe our existing cash and investments will be sufficient to meet
our anticipated cash requirements for at least 24 months. Our future capital
uses and requirements depend on numerous forward-looking factors. These
factors include, but are not limited to, the following:



| |  |  | our ability to establish, and the amount of revenues received under, any new collaborations;
| | - |  | --------------------------------------------------------------------------------------------
|
| |  |  | the progress and number of research programs carried out by us;                             

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| |  |  | the progress and success of pre-clinical and clinical trials of our drug candidates;                       
| | - |  | -----------------------------------------------------------------------------------------------------------
|
| |  |  | our ability to maintain our existing collaboration with The R.W.
Johnson Pharmaceutical Research Institute;
|
| |  |  | the costs and timing of obtaining, enforcing and defending our
patent and intellectual property rights;    
|
| |  |  | the costs and timing of regulatory approvals; and                                                          
|
| |  |  | expenses associated with unforeseen litigation.                                                            

For the next several years, we do not expect our operations to generate
the amounts of cash required for our future cash needs. In order to fulfill
our cash requirements, we expect to finance future cash needs through the sale
of equity securities, strategic collaborations and debt financing. We cannot
assure you that additional financing or collaboration and licensing
arrangements will be available when needed or that, if available, will be on
terms favorable to us or our stockholders. Insufficient funds may require us
to delay, scale back or eliminate some or all of our research or development
programs, to lose rights under existing licenses or to relinquish greater or
all rights to product candidates at an earlier stage of development or on less
favorable terms than we would otherwise choose or may adversely affect our
ability to operate as a going concern. If additional funds are obtained by
issuing equity securities, substantial dilution to existing stockholders may
result.

Factors That May Affect Results of Operations and Financial Condition.

You should carefully consider the risks described below, together with all
of the other information included in this report, in considering our business
and prospects. The risks and uncertainties described below are not the only
ones facing us. Additional risks and uncertainties not presently known to us
or that we currently deem immaterial also may impair our business operations.
The occurrence of any of the following risks could harm our business, financial
condition or results of operations.

We have a history of net losses and may never become profitable.

We commenced operations in 1996 and are still in an early stage of
development. We have not commercialized any products, and we have incurred
significant losses to date. As of September 30, 2001, we had an accumulated
deficit of approximately $42.7 million. To date, our revenues have been solely
from collaborations and government grants. Our expenses have consisted
principally of costs incurred in research and development and from general and
administrative costs associated with our operations. We have incurred net
losses since our inception, including a net loss of approximately $16.1 million
for the nine months ended September 30, 2001. We expect our expenses to
increase and to continue to incur operating losses for at least the next
several years as we continue our research and development efforts for our drug
candidates. The amount of time necessary to commercialize any of our drug
candidates is long and uncertain, and successful commercialization may not
occur at all. As a result, we may never become profitable.

If we do not establish and maintain collaborations with other parties, the
development of our products may be delayed or stopped.

Because we do not currently possess the financial and other resources
necessary to develop potential products that may result from our technologies,
or the financial and other resources to complete any approval processes that
may be required for these products, we must enter into collaborative
arrangements to develop many of our drug candidates. If we do not maintain or
further extend our current collaboration with The R.W. Johnson Pharmaceutical
Research Institute and Ortho-McNeil Pharmaceutical, Inc., both Johnson &
Johnson companies, which expires on December 28, 2002, subject to termination
provisions,

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or if we do not enter into new collaborative agreements, then our revenues
will be significantly reduced, and our drug candidates may not be developed,
manufactured or marketed.

Our potential products are in an early stage of development, and substantial
additional effort will be necessary for development.

Our technologies are new, and our drug candidates are in early stages of
research and development. We may not develop products that prove to be safe
and effective, meet applicable regulatory standards, are capable of being
manufactured at reasonable costs or can be marketed successfully. All of the
potential proprietary products that we are currently developing will require
significant development and investment, including extensive pre-clinical and
clinical testing, before we can submit any application for regulatory approval.
Before obtaining regulatory approvals for the commercial sale of any of our
products, we must demonstrate through pre-clinical testing and clinical trials
that our drug candidates are safe and effective in humans. In October 2001, we
initiated clinical trials of Epothilone D. Conducting clinical trials is a
lengthy, expensive and uncertain process. Completion of clinical trials may
take several years or more. The length of time generally varies substantially
according to the type, complexity, novelty and intended use of the drug
candidate. Our clinical trials may be suspended at any time, if we or the U.S.
Food and Drug Administration, or the FDA, believe the patients participating in
our studies are exposed to unacceptable health risks. We may encounter
problems in our studies that will cause us or the FDA to delay or suspend the
studies.

Our commencement and rate of completion of clinical trials may be delayed
by many factors, including:



| |  |  | ineffectiveness of the study compound, or perceptions by physicians
that the compound is not effective for a particular indication;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | inability to manufacture sufficient quantities of compound for use in clinical trials;                                             
|
| |  |  | failure of the FDA to approve our clinical trial protocols;                                                                        
|
| |  |  | slower than expected rate of patient recruitment;                                                                                  
|
| |  |  | unforeseen safety issues; or                                                                                                       
|
| |  |  | government or regulatory delays.                                                                                                   

If any current or future clinical trials are not successful, our business,
financial condition and results of operations will be harmed.

Any inability to protect our proprietary technologies adequately could harm our
competitive position.

Our success will depend in part on our ability to obtain patents and
maintain adequate protection of other intellectual property for our
technologies and products in the United States and other countries. If we do
not adequately protect our intellectual property, competitors may be able to
use our technologies and erode or negate our competitive advantage. The laws
of some foreign countries do not protect our proprietary rights to the same
extent as the laws of the United States, and we may encounter significant
problems in protecting our proprietary rights in these foreign countries.

The patent positions of biotechnology companies, including our patent
position, involve complex legal and factual questions and, therefore, validity
and enforceability cannot be predicted with certainty. Patents may be
challenged, deemed unenforceable, invalidated or circumvented. We will be able
to protect our proprietary rights from unauthorized use by third parties only
to the extent that our proprietary technologies are covered by valid and
enforceable patents or are effectively maintained as trade secrets.

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We apply for patents covering both our technologies and drug candidates as
we deem appropriate. However, we may fail to apply for patents on important
technologies or products in a timely fashion or at all, and in any event, the
applications we do file may not result in issued patents or, if issued, may be
challenged. Our existing patents and any future patents we obtain may not be
sufficiently broad to prevent others from practicing our technologies or from
developing competing products. Furthermore, others may independently develop
similar or alternative technologies or design around our patented technologies.
In addition, others may challenge or invalidate our patents, or our patents
may fail to provide us with any competitive advantages. If the use or validity
of any of our patents is ever challenged, resulting in litigation or
administrative proceedings, we would incur substantial costs and the diversion
of management in defending the patent. In addition, we generally do not
control the patent prosecution of technology that we license from others.
Accordingly, we are unable to exercise the same degree of control over this
intellectual property as we would over technology we own.

We also rely upon trade secret protection for our confidential and
proprietary information. We have taken measures to protect our proprietary
information. These measures may not provide adequate protection for our trade
secrets or other proprietary information. We seek to protect our proprietary
information by entering into confidentiality agreements with employees,
collaborators and consultants. Nevertheless, employees, collaborators or
consultants may still disclose our proprietary information, and we may not be
able to protect our trade secrets effectively. In addition, others may
independently develop substantially equivalent proprietary information or
techniques or otherwise gain access to our trade secrets.

Litigation or other proceedings or third-party claims of intellectual property
infringement would require us to spend time and money and could prevent us from
developing or commercializing products.

Our commercial success depends in part on not infringing the patents and
proprietary rights of other parties and not breaching any licenses that we have
entered into with regard to our technologies and products. Others have filed
patent applications and issued patents, and in the future are likely to
continue to file patent applications and issue patents, claiming genes, gene
fragments, compounds or other technologies that we used or may wish to use. If
we use the claimed technology in issued and unexpired patents, then we may need
to obtain a license from another party, enter into litigation or incur the risk
of litigation.

The biotechnology industry is characterized by extensive litigation
regarding patents and other intellectual property rights. We are aware of
patents and published patent applications that, if valid, and if we are
unsuccessful in circumventing or acquiring the rights to these patents, may
block our ability to commercialize products. We cannot be sure that other
parties have not been issued relevant patents that could affect our ability to
obtain patents or to operate as we would like to. Others may sue us in the
future to challenge our patent rights or claim infringement of their patents.
An adverse determination in litigation to which we may become a party could
subject us to significant liabilities to others, require us to license disputed
rights from others or require us to cease using the disputed technology.

We are aware of a significant number of patents and patent applications
relating to aspects of our technologies and families of compounds filed by, and
issued to, other parties. Others have filed patent applications or have been
granted patents claiming inventions also claimed by us, and we may have to
participate in an interference proceeding declared by the relevant patent
regulatory agency to determine priority of invention and, thus, the right to a
patent for these inventions in the United States. For example, we believe one
or more interferences or other legal proceedings to determine priority of
invention may be declared between patents and patent applications we own or
have exclusively licensed and patents owned by Novartis relating to epothilone
biosynthetic genes and Epothilone D and related compounds and patents owned by
Abbott Laboratories relating to erythromycin polyketide synthase genes and
methods

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for altering polyketide synthase genes. Such a proceeding or a lawsuit in
which we are alleged to have infringed an issued patent could result in
substantial cost to us even if the outcome is favorable, and if the outcome is
unfavorable, we could be required to license the other partys rights, on terms
that may be unfavorable to us, or cease using the technology. Even if
successful on priority grounds, an interference may result in loss of claims
based on patentability grounds raised in the interference. Although patent and
intellectual property disputes in the biotechnology area are often settled
through licensing or similar arrangements, costs associated with these
arrangements may be substantial and could include ongoing royalties.
Furthermore, we cannot be certain that the necessary license would be available
to us on satisfactory terms, if at all.

Other parties have obtained or may obtain patents and then claim that the
use of our technologies infringes these patents or that we are employing their
proprietary technology without authorization. We could incur substantial costs
and diversion of management and technical personnel in defending ourselves
against any of these claims or enforcing our patents against others.
Furthermore, parties making claims against us may be able to obtain injunctive
or other equitable relief, which could effectively block our ability to further
develop, commercialize and sell products, and could result in the award of
substantial damages against us. In the event of a successful claim of
infringement against us, we may be required to:



| |  |  | pay damages;                                   
| | - |  | -----------------------------------------------
|
| |  |  | stop using our products or methods;            
|
| |  |  | develop non-infringing products or methods; and
|
| |  |  | obtain one or more licenses from other parties.

We may not be able to obtain these licenses at a reasonable cost, if at
all. In that event, we could encounter substantial delays in product
introductions while we attempt to develop alternative methods or products,
which we may not be able to accomplish.

Litigation or failure to obtain licenses could prevent us from
commercializing available products.

If we are unable to manage our growth effectively through recruiting and
retaining skilled employees and expand our management and improve our controls
and systems, we may not be able to manage our day-to-day operations.

We have experienced a period of rapid and substantial growth that has
placed, and if this growth continues will further place, a strain on our human
and capital resources. If we are unable to manage this growth effectively,
then our losses could increase. The number of our employees increased from 65
on September 30, 2000 to 94 on September 30, 2001. Retaining our current
employees and recruiting qualified scientific personnel to perform future
research and development work will be critical to our success. Competition is
intense for experienced scientists, and we may not be able to retain or recruit
sufficient skilled personnel to allow us to pursue collaborations and develop
our products and core technologies to the extent otherwise possible.
Additionally, we are highly dependent on the principal members of our
management and scientific staff, such as our two co-founders, the loss of whose
services would adversely impact the achievement of our objectives. Although we
maintain and are the beneficiary of $1.0 million key-man life insurance
policies for the lives of each of our two co-founders, Dr. Daniel Santi, our
chief executive officer, and Dr. Chaitan Khosla, a director and consultant, we
do not believe the proceeds would be adequate to compensate us for their loss.

Our ability to manage our operations and growth effectively requires us to
continue to expend funds to expand our management and improve our controls and
systems. If we are unable to implement successfully these expansions and
improvements, then we may not be able to effectively manage our day-to-day
operations.

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We face intense competition from large pharmaceutical companies, biotechnology
companies and academic groups.

We face, and will continue to face, intense competition from
organizations, such as large biotechnology and pharmaceutical companies, as
well as academic and research institutions and government agencies, which are
pursuing competing technologies and products. These organizations may develop
technologies or products that are superior alternatives to ours. Further, our
competitors in the polyketide gene engineering field may be more effective at
implementing their technologies to develop commercial products. Some of these
competitors have entered into collaborations with leading companies within our
target markets to produce polyketides for commercial purposes.

Any products that we develop through our technologies will compete in
multiple, highly competitive markets. Development of pharmaceutical products
requires significant investment and resources. Many of the organizations
competing with us in the markets for such products have greater capital
resources, research and development and marketing staffs, facilities and
capabilities, and greater experience in modifying DNA, obtaining regulatory
approvals and product manufacturing and marketing. Accordingly, our
competitors may be able to develop technologies and products more easily, which
would render our technologies and products and those of our collaborators
obsolete and noncompetitive.

If we face claims in clinical trials of a drug candidate, these claims will
divert our managements time and we will incur litigation costs.

We face an inherent business risk of clinical trial liability claims in
the event that the use or misuse of our potential products results in personal
injury or death. We may experience clinical trial liability claims if our drug
candidates are misused or cause harm before regulatory authorities approve them
for marketing. Even though we have obtained clinical trial liability
insurance, it may not be sufficient to cover claims that may be made against
us. Clinical trial liability insurance is expensive, difficult to obtain and
may not be available in the future on acceptable terms, if at all. Any claims
against us, regardless of their merit, could materially and adversely affect
our financial condition, because litigation related to these claims would
strain our financial resources in addition to consuming the time and attention
of our management. If we are sued for any injuries caused by our products, our
liability could exceed our total assets.

We use hazardous chemicals and radioactive and biological materials in our
business. Any claims relating to improper handling, storage or disposal of
these materials could be time consuming and costly.

Our research and development processes involve the controlled use of
hazardous materials, including hazardous chemicals and radioactive and
biological materials. Some of these materials may be novel, including bacteria
with novel properties and bacteria that produce biologically active compounds.
Our operations also produce hazardous waste products. We cannot eliminate the
risk of accidental contamination or discharge and any resultant injury from
these materials. Federal, state and local laws and regulations govern the use,
manufacture, storage, handling and disposal of these materials. We believe
that our current operations comply in all material respects with these laws and
regulations. We could be subject to civil damages in the event of an improper
or unauthorized release of, or exposure of individuals to, hazardous materials.
In addition, we could be sued for injury or contamination that results from
our use or others or the use by our collaborators or third parties of these
materials, and our liability may exceed our total assets. Compliance with
environmental laws and regulations may be expensive, and current or future
environmental regulations may impair our research, development or
commercialization efforts.

We rely on a continuous power supply to conduct our operations, and
Californias recent energy problems could disrupt our operations and increase
our expenses.

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In the event of an acute power shortage, that is, when power reserves for
the State of California fall below 1.5%, California has on some occasions
implemented, and may in the future continue to implement, rolling blackouts
throughout California. We currently do not have adequate backup generators or
alternate sources of power in the event of a blackout, and our current
insurance does not provide coverage for any damages we may suffer as a result
of any interruption in our power supply. If blackouts interrupt our power
supply, we would be temporarily unable to continue operations at our
facilities, including but not limited to the disruption of laboratory
experiments and product manufacturing cycles. Any such interruption in our
ability to continue operations at our facilities could damage our reputation,
lead to our failure to meet certain time-based milestones and could result in
lost contract revenue, any of which could substantially harm our business and
results of operations.

Furthermore, the deregulation of the energy industry instituted in 1996 by
the California government has caused power prices to increase. Under
deregulation, utilities were encouraged to sell their plants, which
traditionally had produced most of Californias power, to independent energy
companies that were expected to compete aggressively on price. Instead, due in
part to a shortage of supply, wholesale prices have significantly increased
over the past year. If wholesale prices continue to increase, our operating
expenses will likely increase, as all of our facilities are located in
California.

We have anti-takeover provisions in our corporate charter documents that may
result in outcomes with which you do not agree.

Our board of directors has the authority to issue up to 10,000,000 shares
of undesignated preferred stock and to determine the rights, preferences,
privileges and restrictions of those shares without further vote or action by
our stockholders. The rights of the holders of any preferred stock that may be
issued in the future may adversely affect the rights of the holders of common
stock. The issuance of preferred stock could make it more difficult for third
parties to acquire a majority of our outstanding voting stock.

Our certificate of incorporation provides for staggered terms for the
members of the board of directors and prevents our stockholders from acting by
written consent. These provisions and other provisions of our bylaws and of
Delaware law applicable to us could delay or make more difficult a merger,
tender offer or proxy contest involving us. This could reduce the price that
investors might be willing to pay for shares of our common stock and result in
the market price being lower than it would be without these provisions.

We have adopted a Stockholder Rights Plan under which all stockholders of
record as of October 29, 2001 will receive rights to purchase shares of a new
series of preferred stock at an exercise price of $70.00 per one one-hundredth
of a share, if a person acquires more than 20% of the Companys common stock.
The rights plan could make it more difficult for a person to acquire a majority
of our outstanding voting stock. The rights plan could also reduce the price
that investors might be willing to pay for shares of our common stock and
result in the market price being lower than it would be without the rights
plan.

Some of our existing stockholders can exert control over us and may not make
decisions that are in the best interest of all stockholders.

Our officers, directors and affiliates together control approximately 44%
of our outstanding common stock. As a result, these stockholders, if they act
together, are able to exert a significant degree of influence over our
management and affairs and over matters requiring stockholder approval,
including the election of directors and approval of significant corporate
transactions. This concentration of ownership may delay or prevent a change in
control of us and might affect the market price of our common stock, even when
a change may be in the best interests of all stockholders. In addition, the
interests of this concentration of ownership may not always coincide with our
interests or the interests of other stockholders and accordingly, these
stockholders, could cause us to enter into transactions or agreements that we
would not otherwise consider.

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Our stock price has been, and may continue to be, extremely volatile.

The trading price of our common stock has been, and is likely to continue
to be, highly volatile and could be subject to wide fluctuations in price in
response to various factors, many of which are beyond our control, including:



| |  |  | announcements of technological developments in research by us or
our competitors;                                                       
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | delay or failure in initiating, conducting, completing or analyzing
clinical trials or unsatisfactory design or results of these trials;
|
| |  |  | achievement of regulatory approvals;                                                                                                    
|
| |  |  | new products or services introduced or announced by us or our competitors;                                                              
|
| |  |  | changes in financial estimates by securities analysts;                                                                                  
|
| |  |  | announcements of departures or departures of key personnel;                                                                             
|
| |  |  | announcements of litigation or an unfavorable outcome in litigation; and                                                                
|
| |  |  | sales of our common stock.                                                                                                              

In addition, the stock market in general, and the Nasdaq National Market
and the market for biotechnology companies in particular, have experienced
extreme price and volume fluctuations that have often been unrelated or
disproportionate to the operating performance of those companies. These broad
market and industry factors may seriously harm the market price of our common
stock, regardless of our operating performance. In the past, following periods
of volatility in the market price of a companys securities, securities
class-action litigation has often been instituted against that company. If
this type of litigation were instituted against us, we would be faced with
substantial costs and managements attention and resources would be diverted,
which could in turn seriously harm our business, financial condition and
results of operations.

We expect that our quarterly results of operations will fluctuate, and this
fluctuation could cause our stock price to decline, creating investor losses.

Our quarterly operating results have fluctuated in the past and are likely
to do so in the future. These fluctuations could cause our stock price to
fluctuate significantly or decline. Some of the factors that could cause our
operating results to fluctuate include:



| |  |  | expiration of research contracts with collaborators or government
research grants, which may not be renewed or replaced;     
| | - |  | -----------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the success rate of our discovery efforts leading to milestones and royalties;                                               
|
| |  |  | the timing and willingness of collaborators to commercialize our products; and                                               
|
| |  |  | general and industry specific economic conditions, which may affect
our collaborators research and development expenditures.

A large portion of our expenses is relatively fixed, including expenses
for facilities, equipment and personnel. Accordingly, if revenues decline or
do not grow due to expiration or termination of research contracts or
government research grants, failure to obtain new contracts or other factors,
we may not be able to reduce our operating expenses correspondingly. In
addition, we expect operating expenses to continue to increase. Failure to
achieve increased levels of revenues could therefore significantly harm our
operating results for a particular fiscal period.

Due to the possibility of fluctuations in our revenues and expenses, we
believe that quarter-to-quarter comparisons of our operating results are not a
good indication of our future performance. Our operating

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results in some quarters may not meet the expectations of stock market
analysts and investors. In that case, our stock price would probably decline.

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Item 3:Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk

The primary objective of our investment activities is to preserve
principal while at the same time maximizing yields without significantly
increasing risk. To achieve this objective, we maintain our portfolio of cash
equivalents, and short-term and long-term investments in a variety of
securities, including corporate obligations and money market funds. As of
September 30, 2001, approximately 85% of our total portfolio will mature in one
year or less, with the remainder maturing in less than two years.

At September 30, 2001, we had approximately $3.0 million invested in
short-term commercial paper of Southern California Edison, a utility company.
At the time of purchase, the security was a high investment-grade security, but
subsequently was downgraded due to the financial uncertainty that has resulted
from the California energy crisis. The security matured on April 18, 2001, and
Southern California Edison defaulted on payment. At June 30, 2001, the
security was valued at approximately 67% of cost. We determined that there had
been an other-than-temporary decline in fair value of the security and recorded
a write-down of $990,000. As of September 30, 2001, the security remained
outstanding and was valued at approximately 83% of cost.

The following table represents the fair value balance of our cash, cash
equivalents and short-term and long-term investments that are subject to
interest rate risk by year of expected maturity and average interest rates as
of September 30, 2001 (dollars in thousands):

|                       |  |      |        |      |  |      |        |   |  |   |       |  
|---------------------- |  | ---- | ------ | ---- |  | ---- | ------ | - |  | - | ----- | -
|                       |  | 2001 |        | 2002 |  | 2003
|                       |  |      |        |      |  |     
|Cash & equivalents     |  | $    | 23,504 |      |  |      |       |   |  |   |      |  
|Average interest rates |  |      | 3.44   | %    |  |      |        |   |  |   |       |  
|Short-term investments |  |      | 20,421 |      |  | $    | 35,675 |   |  |   |      |  
|Average interest rates |  |      | 4.98   | %    |  |      | 4.86   | % |  |   |       |  
|Long-term investments  |  |      |       |      |  |      | 4,520  |   |  | $ | 9,338 |  
|Average interest rates |  |      |        |      |  |      | 3.97   | % |  |   | 4.58  | %

We did not hold derivative instruments as of September 30, 2001, and we
have never held such instruments in the past. In addition, we had outstanding
debt, consisting of borrowings under an equipment financing line of credit and
capital lease obligations, of $3.3 million as of September 30, 2001, with a
range of interest rates from 9.02% to 16.96%.

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PART II.OTHER INFORMATION




Item 1.Legal Proceedings

| |                
| | ---------------
| | Not applicable.




Item 2.Changes in Securities and Use of Proceeds

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | d) Use of Proceeds                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|
| | Our initial public offering of common stock was effected in October
2000, in which we sold 5,750,000 shares of our common stock.                                                                                                                                                                                                                                                                                                                                                                                                                                      
|
| | The net proceeds of the 5,750,000 shares registered and sold were
approximately $73.4 million. We paid a total of approximately $5.6
million in underwriting discounts and commissions and approximately $1.5
million in other costs and expenses in connection with the offering.
None of the expenses were paid, directly or indirectly, to directors,
officers or persons owning ten percent or more of our common stock.                                                                                                                                          
|
| | We intend to continue to use the net proceeds for advancing our
drug candidates through pre-clinical and later stage development,
discovering or acquiring new drug candidates, expanding our technology
platform, capital expenditures, working capital, general corporate
purposes and possible future acquisitions. To date, we have not used
any of the net proceeds from the offering and, pending such use, our
funds have been invested in U.S. Treasury and government agency
obligations, investment-grade asset-backed securities and corporate
obligations.




Item 3.Defaults Upon Senior Securities

| |                
| | ---------------
| | Not applicable.




Item 4.Submission of Matters to a Vote of Security Holders

| |      
| | -----
| | None.




Item 5.Other Information

| |                                                                                                                                                                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In September 2001, Bruce A. Chabner, M.D. was appointed to the Companys
Board of Directors. Dr. Chabner currently serves as the Clinical
Director of the Massachusetts General Hospital Cancer Center and
Professor of Medicine, Harvard Medical School. He is the Associate
Director of Clinical Services of the Dana-Farber Harvard Cancer Center.




Item 6.Exhibits and Reports on Form 8-K

| |               
| | --------------
| | (a)  Exhibits:

|        |  |                                                                                                                                                                                            
|------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                                                                                            
|No.     |  |                                                                                                                                                                                            
|        |  |                                                                                                                                                                                            
|10.36  |  | Amendment No.3 to Research and License Agreement between
Registrant and The R.W. Johnson Pharmaceutical Research Institute
and Ortho-McNeil Pharmaceutical, Inc., dated September 28, 2001.
|       
|10.37   |  | Master Loan and Security Agreement No. 84325 and associated
Prepayment Agreement, by and between the Registrant and Wells
Fargo Equipment Finance, Inc., dated July 9, 2001.               

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|        |  |                                                                                                           
|------- |  | ----------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                           
|No.     |  |                                                                                                           
|        |  |                                                                                                           
|10.38   |  | Rights Agreement, dated as of October 5, 2001, between the
Registrant and Mellon Investor Services LLC.   
|       
|(b)     |  | Reports on Form 8-K
No Current Reports on Form 8-K were filed during the quarter
ended September 30, 2001.



---

| |  | Confidential treatment has been requested with respect to certain
portions of this exhibit. Omitted portions have been separately filed with
the Securities and Exchange Commission.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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SIGNATURES

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

|                  |  |                                |  |                                                                                                                 
|----------------- |  | ------------------------------ |  | ----------------------------------------------------------------------------------------------------------------
|                  |  | Kosan Biosciences Incorporated
|                 
|November 13, 2001 |  | By:                            |  | /s/ Daniel V. Santi, M.D., Ph.D.                                                                                
|                  |  |                                |  |                                                                                                                 
|                  |  |                                |  | Daniel V. Santi, M.D., Ph.D.
Chairman and Chief Executive Officer                                               
|                 
|November 13, 2001 |  | By:                            |  | /s/ Susan M. Kanaya                                                                                             
|                  |  |                                |  |                                                                                                                 
|                  |  |                                |  | Susan M. Kanaya
Vice President, Finance and
Chief Financial Officer
(Principal Financial and Accounting Officer)

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EXHIBIT INDEX

|        |  |                                                                                                                                                                                             
|------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                                                                                             
|Number  |  | Description of Document                                                                                                                                                                     
|        |  |                                                                                                                                                                                             
|3.1     |  | Amended and Restated Certificate of Incorporation, as amended to
date (1)                                                                                                                   
|       
|3.2     |  | Bylaws (2)                                                                                                                                                                                  
|       
|4.1     |  | Form of Specimen Common Stock Certificate (2)                                                                                                                                               
|       
|10.36  |  | Amendment No. 3 to Research and License Agreement between
Registrant and The R.W. Johnson Pharmaceutical Research Institute
and Ortho-McNeil Pharmaceutical, Inc., dated September 28, 2001.
|       
|10.37   |  | Master Loan and Security Agreement No. 84325 and associated
Prepayment Agreement, by and between the Registrant and Wells
Fargo Equipment Finance, Inc., dated July 9, 2001.                
|       
|10.38   |  | Rights Agreement, dated as of October 5, 2001, between the
Registrant and Mellon Investor Services LLC. (1)                                                                                 



---

|(1) |  | Filed with Kosans 10-Q
for the period ending June 30, 2001 and Current
Report on Form 8-K filed on                      October 15, 2001, and incorporated
herein by reference.    
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|   
|   
|   
|(2) |  | Filed with Kosans Registration Statement on Form S-1, as amended (No.
333-33732), and incorporated herein by reference                                                             
|   
|   
|   
|   
|   |  | Confidential treatment has been requested with respect to certain
portions of this exhibit. Omitted portions have been separately filed with
the Securities and Exchange Commission.

26