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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 June 30, 2002. | 
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------- | 




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.    YesxNo  ̈





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; 25,320,592 shares outstanding at July 31, 2002.





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KOSAN BIOSCIENCES INCORPORATED





Form 10-Q


Quarter Ended June 30, 2002





INDEX





PART I     FINANCIAL INFORMATION

PageItem 1:

Condensed Financial Statements and Notes (unaudited):Condensed Balance Sheets as of June 30, 2002 and December 31, 2001

3Condensed Statements of Operations for the three months and six months ended June 30, 2002 and 2001

4Condensed Statements of Cash Flows for the six months ended June 30, 2002 and 2001

5Notes to Condensed Financial Statements

6Item 2:

Managements Discussion and Analysis of Financial Condition and Results of Operations

11Item 3:

Quantitative and Qualitative Disclosures About Market Risk

24PART II     OTHER INFORMATIONItem 1:

Legal Proceedings

25Item 2:

Changes in Securities and Use of Proceeds

25Item 3:

Defaults Upon Senior Securities

25Item 4:

Submission of Matters to a Vote of Security Holders

25Item 5:

Other Information

25Item 6:

Exhibits and Reports on Form 8-K

26SIGNATURES

27




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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)





June 30, 2002


December 31, 2001(unaudited)


(1)AssetsCurrent assets:Cash and cash equivalents

$
29,166


$
18,561Short-term investments


41,024



58,880Prepaid expenses and other current assets


1,038



617Total current assets


71,228



78,058Property and equipment, net


4,997



3,567Long-term investments


10,910



12,902Notes receivable from related parties


557



1,041Other assets


468



244Total assets

$
88,160


$
95,812Liabilities and Stockholders EquityCurrent liabilities:Accounts payable

$
1,125


$
1,439Accrued liabilities


3,119



1,828Deferred revenue


563



999Current portion of capital lease obligation and equipment loans


1,875



1,387Total current liabilities


6,682



5,653Equipment loans, less current portion


2,036



1,568Stockholders equity:Common stock


25



25Additional paid-in capital


141,865



141,863Notes receivable from stockholders


(1,533
)


(1,541
)Deferred stock-based compensation


(2,206
)


(4,430
)Accumulated other comprehensive gain


157



1,216Accumulated deficit


(58,866
)


(48,542
)Total stockholders equity


79,442



88,591Total liabilities and stockholders equity

$
88,160


$
95,812


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|(1) |  | The balance sheet data at December 31, 2001 has been derived from the audited financial statements at that date.
|--- |  | ----------------------------------------------------------------------------------------------------------------




See accompanying notes.




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KOSAN BIOSCIENCES INCORPORATED





CONDENSED STATEMENTS OF OPERATIONS


(unaudited)


(in thousands, except per share data)





Three Months Ended June 30,


Six Months Ended June
30,2002


2001


2002


2001Revenues:Contract revenue

$
925


$
717


$
1,850


$
1,726Grant revenue


590



261



1,327



481Total revenues


1,515



978



3,177



2,207Operating expenses:Research and development (including charges for stock-based compensation of $835 and $1,319 in the three months ended
June 30, 2002 and 2001, respectively, and $1,634 and $2,831 in the six months ended June 30, 2002 and 2001, respectively)


7,159



6,742



13,106



12,306General and administrative (including charges for stock-based compensation of $165 and $407 in the three months ended
June 30, 2002 and 2001, respectively, and $327 and $651 in the six months ended June 30, 2002 and 2001, respectively)


1,242



1,469



2,502



2,562Total operating expenses


8,401



8,211



15,608



14,868Loss from operations


(6,886
)


(7,233
)


(12,431
)


(12,661
)Other income, net


496



238



2,107



1,743Net loss

$
(6,390
)

$
(6,995
)

$
(10,324
)

$
(10,918
)Basic and diluted net loss per common share

$
(0.26
)

$
(0.29
)

$
(0.42
)

$
(0.46
)Shares used in computing basic and diluted net loss per common share


24,851



24,066



24,742



23,955





See accompanying notes.




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KOSAN BIOSCIENCES INCORPORATED





CONDENSED STATEMENTS OF CASH FLOWS


(unaudited)


(in thousands)





Six Months Ended June 30,2002


2001Operating activitiesNet loss

$
(10,324
)

$
(10,918
)Adjustment to reconcile net loss to net cash used in operating activities:Depreciation and amortization


777



583Amortization of investment premiums and discounts, net


163



(654
)Amortization of stock-based compensation


1,097



3,168Other stock-based compensation


864



314Realized (gain)/loss on investment


(990
)


990Changes in assets and liabilities:Prepaid expenses and other current assets


(421
)


33Other assets and notes receivable from related parties


260



16Accounts payable and accrued liabilities


977



305Deferred revenue


(436
)


(619
)Net cash used in operating activities


(8,033
)


(6,782
)Investing activitiesAcquisition of property and equipment


(2,207
)


(1,045
)Purchase of investments


(19,904
)


(58,107
)Proceeds from maturity of investments


39,520



58,481Net cash provided by (used in) investing activities


17,409



(671
)Financing activitiesProceeds from issuance of common stock, net of repurchases


271



148Proceeds from the repayment of notes receivable from stockholders


2



Proceeds from equipment loans


1,655



Principal payments under capital lease obligation and equipment loans


(699
)


(541
)Net cash provided by (used in) financing activities


1,229



(393
)Net increase (decrease) in cash and cash equivalents


10,605



(7,846
)Cash and cash equivalents at beginning of period


18,561



36,425Cash and cash equivalents at end of period

$
29,166


$
28,579





See accompanying notes.




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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 agreements, equipment financing arrangements and government grant awards. 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 June 30, 2002, and for the three and six months ended June 30, 2002 and 2001, 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, 2001.





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. All investment securities are classified as available-for-sale and 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.
Realized gains and losses and declines in the fair value that are deemed to be other than temporary are reflected in earnings. The cost of securities sold is based on the specific identification method.





The Company holds certain restricted investments consisting of cash. These investments are carried at fair value and are restricted as to
withdrawal under a letter of credit agreement related to a facility lease (see Note 7). These investments are held in the Companys name and are included in long-term investments on the Companys financial statements.




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##### Table of Contents



KOSAN BIOSCIENCES INCORPORATED





NOTES TO CONDENSED FINANCIAL STATEMENTS(Continued)


(unaudited)







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





Revenue Recognition





The Company recognizes license and other up-front fees pursuant to research collaboration agreements over the estimated research term of the respective agreement. Payments related to substantive
performance milestones that are at risk at the initiation of an agreement are recognized upon successful completion of a performance milestone event. Contract revenues related to collaborative research and development efforts are recognized as
revenue on a ratable basis as the related services are performed. Such payments generally are made based on the number of fulltime equivalent researchers assigned to the collaboration project. Revenues related to government grant awards are
recognized at the time a grant is awarded and the related research expenses are incurred. 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 primarily of salaries and other personnel-related expenses, stock-based compensation, facility-related expenses, depreciation
of facilities and equipment, lab consumables and fees paid to outside service providers that conduct certain research activities on behalf of the Company. Research and development expenses under government grant awards and collaborative agreements
approximated the revenue recognized, excluding milestone payments received under such arrangements.





Net Loss per Share





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 potentially dilutive securities in the loss per share computation
would be antidilutive.





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 June 30,


Six Months Ended June
30,2002


2001


2002


2001Net loss

$
(6,390
)

$
(6,995
)

$
(10,324
)

$
(10,918
)Weighted-average shares of common stock outstanding


25,309



25,195



25,268



25,174Less: weighted-average shares subject to repurchase


(458
)


(1,129
)


(526
)


(1,219
)Weighted-average shares used in computing basic and diluted net loss per common share


24,851



24,066



24,742



23,955Basic and diluted net loss per common share

$
(0.26
)

$
(0.29
)

$
(0.42
)

$
(0.46
)




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KOSAN BIOSCIENCES INCORPORATED





NOTES TO CONDENSED FINANCIAL STATEMENTS(Continued)


(unaudited)







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





Stock-Based Compensation





The Company accounts for common stock options granted to employees using the intrinsic value method and, thus, recognizes compensation expense for options granted with exercise prices less than the
fair value of the Companys common stock on the date of the grant. Deferred stock compensation calculated for options granted with exercise prices less than the deemed fair value of the common stock is amortized over the vesting period of the
individual options, generally four years, using the graded vesting method.





Stock-based compensation expense for
options granted to non-employees has been determined in accordance with Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, 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. As such, changes to these measurements could be substantial should the Company experience significant changes in its stock price.





Reclassification





Certain reclassifications of the prior
years balances have been made to conform to the current year presentation. These reclassifications had no effect on the prior years net loss or stockholders equity.





2.    Collaborative Research and Development and License Agreements





Johnson & Johnson Pharmaceutical Research and Development, LLC





In September 1998, the
Company signed a collaborative agreement with The R.W. Johnson Pharmaceutical Research Institute, LLC 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 the research program and funding have been extended until at least December 28, 2002. Effective January 2002, the rights and obligations under the agreement were assigned to Johnson
& Johnson Pharmaceutical Research and Development, LLC, a subsidiary of Ortho-McNeil Pharmaceutical, Inc. 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 six months ended June 30, 2002 and 2001, the Company made payments under these agreements of approximately $495,000 and
$164,000, respectively.





3.    Realized Gain on Investment





At June 30, 2001, the Company determined that an other-than-temporary decline in fair value of its investment in short-term commercial
paper of Southern California Edison, or SoCalEd, a utility company, had occurred. 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.




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KOSAN BIOSCIENCES INCORPORATED





NOTES TO CONDENSED FINANCIAL STATEMENTS(Continued)


(unaudited)




3.    Realized Gain on Investment (Continued)





The security matured on April 18, 2001, and SoCalEd defaulted on payment. The amortized 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. In March 2002, the security was fully repaid. Thus, the Company recorded a realized gain on the investment of
$990,000 in the quarter ended March 31, 2002.





4.    Comprehensive Loss





For the three and six months ended June 30, 2002 and 2001, comprehensive loss was as follows (in thousands):





Three Months Ended June 30,


Six Months Ended June 30,2002


2001


2002


2001Net loss

$
(6,390
)

$
(6,995
)

$
(10,324
)

$
(10,918
)Unrealized gain/(loss) on available-for-sale securities


171



(519
)


(69
)


(222
)Reclassification of realized (gain)/loss on available-for-sale securities






990



(990
)


990Comprehensive loss

$
(6,219
)

$
(6,524
)

$
(11,383
)

$
(10,150
)





5.    Equipment Financing





The Company finances certain equipment and facility improvements under debt obligations. In April 2002, the Company entered into a $3.0
million equipment line of credit agreement. As of June 30, 2002, the Company had utilized approximately $1.7 million of the line of credit.





The terms of the loan obligations range from 42 to 49 months. Some of the loans have a balloon payment at the end of the term. The interest rates of each of the loans are fixed at the time of the draw
down, with the interest rates ranging from 8.71% to 13.86%. Obligations under the loans are secured by the assets financed under the loans.





6.    Accrued Liabilities





Accrued liabilities consisted of the
following (in thousands):





June 30, 2002

December 31, 2001Facilities-related

$
405

$
349Compensation-related


954


827Professional services


541


289Research & development-related


903


Other


316


363$
3,119

$
1,828




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KOSAN BIOSCIENCES INCORPORATED





NOTES TO CONDENSED FINANCIAL STATEMENTS(Continued)


(unaudited)







7.    Facility Leases





In June 2002, the Company expanded its facilities by entering into an assignment of a non-cancelable operating lease, which commenced in
June 2002 and expires in 2008, with an option to renew. The Company also extended the terms of its existing facility lease to 2013, with an option to renew. Minimum annual rental commitments at June 30, 2002 are as follows (in thousands):





Year ended December 31,2002

$
8932003


1,7082004


1,5882005


1,6092006


1,624Thereafter


7,635Total minimum payments

$
15,057





In June 2002, the Company obtained a stand-by letter of
credit for approximately $903,000 from a commercial bank as security for the Companys obligation under one of its facility leases. The letter of credit is secured by $904,000 of cash in an investment account that the Company must maintain for
the term of the lease. The investment account is classified within long-term investments on the balance sheet.




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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, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. 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 (KOS-862), a potential anti-cancer agent, in
Phase I human clinical trials. In infectious disease, we have a collaboration with Johnson & Johnson Pharmaceutical Research and Development, LLC, focusing on the development of a next generation antibiotic. We have additional product
development and research programs.





We have incurred significant losses since our inception. As of June 30, 2002,
our accumulated deficit was approximately $58.9 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.





Critical Accounting Policies





Revenue Recognition





We recognize license and other up-front fees over the
estimated research term of each respective agreement. If an agreement does not have a specified term, we must apply judgment in determining the appropriate level of recognition. Milestone payments are recognized upon successful completion of a
performance milestone event. We apply judgment as to the timing of recognizing milestone payments and whether such payments represent the culmination of a separate earnings process. Contract revenues related to collaborative research and development
agreements are recognized on a ratable basis as services are performed. Revenues related to government grants are recognized at the time a grant is awarded and the related research expenses are incurred. Any amounts received in advance of
performance are recorded as deferred revenue until earned.





Stock-Based Compensation





We account for common stock options granted to employees using the intrinsic value method and, thus, recognize compensation
expense for options granted with exercise prices less than the fair value of our common stock on the date of the grant. We recorded total deferred stock-based compensation of approximately $15.6 million in 2000 and $2.9 million in 1999, which
amounts are being amortized to expense using the graded vesting method over the vesting periods of the underlying options, generally four years. We recognized stock-based compensation of approximately $1.1 million and $3.2 million for the six months
ended June 30, 2002 and 2001, respectively. Based on deferred stock-based compensation recorded as of June 30, 2002, we expect to record amortization of deferred stock-based compensation approximately as follows: $1.0 million in the remaining six
months of 2002, $973,000 in 2003 and $233,000 in 2004.




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Stock-based compensation expense for options granted to non-employees has been
determined as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. We recognized other stock-based compensation for non-employees of approximately $864,000 and $314,000
in the six months ended June 30, 2002 and 2001, respectively. In addition, assuming no changes, we expect to recognize other stock-based compensation in connection with stock options granted to non-employees of approximately $889,000 in the
remaining six months of 2002, $714,000 in 2003, $529,000 in 2004 and $318,000 in 2005. The measurement of stock-based compensation to non-employees is subject to periodic adjustment as the underlying securities vest. As such, changes to these
measurements could be substantial should we experience significant changes in our stock price. See Note 1 of our financial statements.





Investments





We invest in debt and equity securities. The price of these
securities is subject to significant volatility. We record an impairment charge when we believe that an investment has experienced a decline in value that is other than temporary. Generally, we review an investment for impairment if its market value
has been below its carrying value for each trading day in a six-month period. Changes in the market price of these securities may impact our profitability.





Results of Operations





Revenues





Our revenues were approximately $1.5 million and $3.2 million for the three and six months ended June 30, 2002, respectively, compared to
approximately $1.0 million and $2.2 million, respectively, for the same periods in 2001. Grant revenue was $1.3 million for the six months ended June 30, 2002, compared to $481,000 for the same period last year. Total contract revenues under our
collaboration with Johnson & Johnson Pharmaceutical Research and Development, LLC, or J&J, were approximately $981,000 for the six months ended June 30, 2002, compared to approximately $1.7 million for the same period in 2001. Included in
2001 contract revenue was a non-recurring $250,000 milestone received in connection with this collaboration. The initial term of the collaboration with J&J has been extended to December 28, 2002. If we do not maintain or further extend this
agreement, our revenues will significantly decrease thereafter, unless we enter into additional collaborations.





Research and Development Expenses





Our research and development expenses consist
primarily of salaries and other personnel-related expenses, fees paid to outside service providers, stock-based compensation, facility-related expenses, lab consumables and depreciation of facilities and equipment. Research and development expenses
increased to approximately $7.2 million and $13.1 million for the three and six months ended June 30, 2002, respectively, from $6.7 million and $12.3 million, respectively, for the same periods in 2001. These increases were primarily attributable to
our expanded research and development efforts, including three Phase I studies of KOS-862 (Epothilone D) and continued investment in our internally funded programs and technologies. Additionally, the increase was partially offset by the decrease in
stock-based compensation expense for the three and six months ended June 30, 2002, compared to the same periods in 2001. We expect our research and development expenses will increase substantially to advance Epothilone D through clinical
development, fund the expansion of our technology platform, support our collaborative research programs, advance other in-house research programs into later stages of development and fund the expansion and improvement of our facilities as we
continue to expand our laboratory capabilities.




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General and Administrative Expenses





General and administrative expenses decreased in the three and six months ended June 30, 2002 to approximately $1.2 million and $2.5
million, respectively, from $1.5 million and $2.6 million, respectively, for the same periods in 2001. These decreases were primarily due to lower stock-based compensation. We expect our general and administrative expenses will increase in the
future to support the continued growth of our research and development efforts and expansion and improvement of our facilities.





Interest Income





Interest income decreased to approximately $591,000 and $1.3
million for the three and six months ended June 30, 2002, respectively, from $1.3 million and $2.9 million, respectively, for the same periods in 2001. These decreases were attributable to lower average investment balances and lower investment
yields associated with the declining interest rate environment.





Interest Expense





Interest expense increased to $95,000 for the three months ended June 30, 2002 from $80,000 for the same period in 2001
and decreased to $173,000 for the six months ended June 30, 2002 from $174,000 for the same period in 2001. The increase for the quarter ended June 30, 2002 from the same period in 2001 resulted from additional debt financing during 2002.





Realized Gain on Investment





At June 30, 2001, we determined that an other-than-temporary decline in the fair value of our investment in short-term commercial paper of Southern California Edison, or
SoCalEd, a utility company, had occurred. 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 SoCalEd defaulted on payment. The amortized cost of the security was $3.0 million, and the security was valued at approximately 67% of cost at June 30, 2001. Accordingly, for the quarter ended June 30, 2001, we
recorded a write-down on the carrying value of the investment of $990,000. In March 2002, the security was fully repaid. Thus, we recorded a realized gain on the investment of $990,000 in the three months ended March 31, 2002.





Liquidity and Capital Resources





We have financed our operations from inception primarily through sales of convertible preferred stock and common stock, totaling $119.9 million in net proceeds, contract payments under our collaboration agreement, equipment
financing arrangements and government grants. As of June 30, 2002, we had approximately $81.1 million in cash, cash equivalents and investments, compared to approximately $90.3 million as of December 31, 2001. Our funds are currently invested in
U.S. Treasury and government agency obligations and corporate obligations.





Our operating activities used cash of
$8.0 million for the six months ended June 30, 2002, compared to $6.8 million for the same period in 2001. Our net loss of approximately $10.3 million for the six months ended June 30, 2002 included a $990,000 non-cash realized gain on a
previously written-down investment, and was partially offset by non-cash expenses of $2.9 million related to stock-based compensation, depreciation and amortization of investment premiums and discounts. Cash used for the same period in 2001 was used
primarily to fund our net operating loss of approximately $10.9 million, that included a $990,000 non-cash write-down of an investment, partially offset by non-cash expenses of $3.4 million related to stock-based compensation, depreciation and
amortization of investment premiums and discounts.





Our investing activities, excluding changes in our
investments, for the six months ended June 30, 2002 used cash of approximately $2.2 million, compared to $1.0 million for the same period in 2001, reflecting capital expenditures related to the expansion and improvement of our facilities as we
continued to expand our laboratory capabilities.




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Cash provided by financing activities was approximately $1.2 million for the six
months ended June 30, 2002, compared to cash used in financing activities of $393,000 for the same period in 2001. Financing activities for 2002 included approximately $1.7 million in proceeds from equipment loans, partially offset by normal
payments on existing debt.





In April 2002, we entered into a $3.0 million equipment line of credit agreement for
facility improvements and capital purchases. As of June 30, 2002, we had utilized approximately $1.7 million of the line of credit. See Note 5 to our financial statements.





We believe our existing cash and investments and anticipated cash flow from existing collaborations will be sufficient to support our current operating plan through the
first half of 2004. 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 scope of revenues received under, any new collaborations;
| | - |  | -------------------------------------------------------------------------------------------




| |  |  | the progress and number of research programs carried out by us;
| | - |  | ---------------------------------------------------------------




| |  |  | the progress and success of preclinical testing and clinical trials of our drug candidates;
| | - |  | -------------------------------------------------------------------------------------------




| |  |  | our ability to maintain or extend our existing collaboration with Johnson & Johnson Pharmaceutical Research and Development, LLC;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------




| |  |  | the costs and timing of obtaining, enforcing and defending our patent and intellectual rights;
| | - |  | ----------------------------------------------------------------------------------------------




| |  |  | the costs and timing of our facilities expansion;
| | - |  | -------------------------------------------------




| |  |  | the costs and timing of regulatory approvals; and
| | - |  | -------------------------------------------------




| |  |  | expenses associated with unforeseen litigation.
| | - |  | -----------------------------------------------




In addition, we review from time to time potential opportunities to expand our technologies or add to our portfolio of drug candidates. In the future, we may need further capital in order to acquire or
invest in technologies, products or businesses.





We expect that additional financing will be required in the
future to fund operations. We expect to finance future cash needs through the sale of equity securities, strategic collaborations, government grant awards 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. In addition, see Factors That May Affect Results of Operations and Financial Condition.





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.




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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 June 30, 2002, we had an accumulated deficit of approximately $58.9 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 $10.3 million for the six months ended June
30, 2002. 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 successfully is long and uncertain, and successful commercialization may not occur at all. As a result, we may never become profitable.





If our current corporate collaboration or license agreements are unsuccessful or if conflicts develop with these relationships, our research and development efforts could be delayed.





Our collaboration with Johnson & Johnson Pharmaceutical Research and Development, LLC, is scheduled to expire on December 28, 2002. We
may not be able to maintain or extend this collaboration on acceptable terms, if at all. If we do not maintain or extend this collaboration, our research and development efforts could be delayed.





We do not control the amount and timing of resources that our corporate collaborator devotes to our program or potential products. As a result, we do not know if our
corporate collaborator will dedicate sufficient resources or if the development or commercialization efforts by our corporate collaborator will be successful. We also do not know whether our current collaborative partner or future collaborative
partners, if any, might pursue alternative technologies or develop alternative products either on their own or in collaboration with others, including our competitors, as a means for developing treatments for the diseases targeted by collaborative
arrangements with us. In addition, if a business combination involving our existing corporate collaborator were to occur, the effect could diminish, terminate or cause delays in our corporate collaboration. Should our collaborative partner fail to
develop or commercialize a compound or product for which it has rights from us, we may not receive any future milestone payments and will not receive any royalties associated with such compound or product. Conflicts might also arise with
collaborative partners concerning proprietary rights to particular compounds. If our corporate collaborator were to breach or terminate its agreement with us or otherwise fail to conduct the collaborative activities successfully and in a timely
manner, the preclinical or clinical development or commercialization of the affected product candidates or research program could be delayed or terminated.





We are also a party to various license agreements that give us rights to use specified technologies in our research and development processes. The agreements, pursuant to which we have in-licensed
technology, permit our licensors to terminate the agreement under certain circumstances. If we are not able to continue to license these future technologies on commercially reasonable terms, our product development and research may be delayed.





If we fail to enter into new collaborative agreements in the future, our business and operations would be negatively impacted.





Our strategy depends upon the formation and sustainability of multiple collaborative arrangements and license
agreements with third parties in the future. We expect to rely on these arrangements for not only financial resources, but also for expertise that we expect to need in the future relating to clinical trials, manufacturing, sales and marketing, and
for license and technology rights. Although we have established a collaborative arrangement and various license agreements, we do not know if we will be able to establish additional arrangements on favorable terms, or whether current or any future
collaborative arrangements will ultimately be successful. There have been, and may continue to be, a significant number of recent business combinations among large pharmaceutical companies that have resulted, and may continue to result, in a reduced
number of potential future corporate collaborators, which may limit our ability to find partners who will work with us in developing and commercializing our drug candidates. If we do not enter into new collaborative agreements, then our revenues
will be reduced, and our drug candidates may not be developed, manufactured or marketed.




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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 products
that we are currently developing will require significant development and investment, including extensive preclinical and clinical testing, before we can submit any application for regulatory approval.





Our products must satisfy rigorous standards of safety and efficacy before they can be approved by the U.S. Food and Drug Administration
and international regulatory authorities for commercial use. We will need to conduct significant additional research, preclinical testing and clinical trials, before we can file applications with the FDA for product approval. Clinical trials are
expensive and have a high risk of failure. In addition, to compete effectively, our products must be easy to use, cost-effective and economical to manufacture on a commercial scale. We may not achieve any of these objectives. Any of our products may
not attain market acceptance. Typically, there is a high rate of attrition for products in preclinical testing and clinical trials. Also, third parties may develop superior products or have proprietary rights that preclude us from marketing our
products. If research and testing is not successful or we fail to obtain regulatory approval, we will be unable to market and sell our future product candidates.





The progress and results of our animal and human testing are uncertain.





We must
provide the FDA and foreign regulatory authorities with clinical data that demonstrates the safety and efficacy of our products before they can be approved for commercial sale. As a result, commercialization of our product candidates depends upon
successful completion of clinical trials. Preclinical testing and clinical development are long, expensive and uncertain processes. It may take us several years to complete our testing, and failure can occur at any stage of testing. Success in
preclinical testing and early clinical trials does not ensure that later clinical trials will be successful, and interim results of trials do not necessarily predict final results. A number of companies in the pharmaceutical industry, including
biotechnology companies, have suffered significant setbacks in advanced clinical trials, even after promising results in earlier trials. None of the product candidates that we have internally developed or licensed have advanced beyond the stage of
human testing designed to determine safety, known as Phase I clinical trials.





We do not know whether planned
clinical trials will begin on time or whether any of our clinical trials will be completed on schedule, or at all. Negative or inconclusive results or adverse medical events during a clinical trial could cause a clinical trial to be repeated or a
program to be terminated. In October 2001, we initiated clinical trials of Epotholine D (KOS-862), which is directed to the treatment of cancer. Anti-cancer drugs generally have a narrow therapeutic window between efficacy and toxicity. If
unacceptable toxicity is observed in clinical trials, the trials may be terminated at an early stage. Drug-related deaths may occur in clinical trials with anti-cancer drugs, because drugs for the treatment of cancer are typically dangerous and
cancer patients are critically ill.





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 FDA




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believe the patients participating in our studies are exposed to unacceptable health risks. Our commencement and rate of completion of clinical trials may be delayed by many factors, including:





| |  |  | ineffectiveness or toxicity of the study compound, or perceptions by physicians that the compound is not safe or 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;
| | - |  | -------------------------------------------------




| |  |  | the death of patients during a clinical trial;
| | - |  | ----------------------------------------------




| |  |  | inconclusive or negative results experienced during the clinical trial;
| | - |  | -----------------------------------------------------------------------




| |  |  | third-party clinical investigators may not perform our clinical trials on our anticipated schedule or consistent with a clinical trial protocol, and other
third-party organizations may not perform data collection and analysis in a timely or accurate manner; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | government or regulatory delays.
| | - |  | --------------------------------




Any clinical trial may fail to produce results satisfactory to the FDA. Preclinical and clinical data can be interpreted in different ways, which could delay, limit or prevent regulatory approval.





Our product development costs will increase if we have delays in testing or approvals or if we need to perform
more or larger clinical trials than planned. If the delays are significant, our financial results and the commercial prospects for our products will be harmed, and our ability to become profitable will be delayed.





We do not know whether our existing or any future clinical trials will demonstrate safety and efficacy sufficient to obtain the requisite
regulatory approvals or will result in marketable products. Our failure to adequately demonstrate the safety and efficacy of our products under development will prevent receipt of FDA approval and, ultimately, commercialization of our products. 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 ability to successfully commercialize product candidates.





Our commercial 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 any competitive advantage we may have. 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 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.





The degree of future protection for
our proprietary rights is uncertain, and we cannot ensure that:





| |  |  | we were the first to make the inventions covered by each of our pending patent applications;
| | - |  | --------------------------------------------------------------------------------------------




| |  |  | we were the first to file patent applications for these inventions;
| | - |  | -------------------------------------------------------------------



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| |  |  | others will not independently develop similar or alternative technologies or duplicate any of our technologies;
| | - |  | ---------------------------------------------------------------------------------------------------------------




| |  |  | any of our pending patent applications will result in issued patents;
| | - |  | ---------------------------------------------------------------------




| |  |  | any patents issued to us or our licensors will provide a basis for commercially viable products or will provide us with any competitive advantages or will not
be challenged by third parties;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | we will develop additional proprietary technologies that are patentable; or
| | - |  | ---------------------------------------------------------------------------




| |  |  | the patents of others will not have an adverse effect on our business.
| | - |  | ----------------------------------------------------------------------




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. 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. 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 our own.





We rely upon trade secret protection for our confidential information. We have taken measures to protect our confidential information.
However, these measures may not provide adequate protection for our trade secrets. We seek to protect our confidential information by entering into confidentiality agreements with employees, collaborators and consultants. Nevertheless, we may not be
able to protect adequately 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 drug candidates that we are developing and genes, gene fragments, compounds and technologies we use or may wish
to use. If we wish to use the claimed technology in issued and unexpired patents owned by others, 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 based on the drug candidates that we are developing.
We cannot be sure that other parties have not filed for or 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 or in an administrative proceeding 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 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 agency or court 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 may be
declared between patents and applications we own or have exclusively licensed and patents and applications owned by Novartis relating to epothilone biosynthetic genes and Epothilone D and one or more patent applications owned by Gesellschaft
für Biotechnologische Forschung mbH relating to Epothilone D; and patents and applications owned by Abbott Laboratories and Biotica Ltd. relating to erythromycin polyketide synthase genes, methods for altering polyketide synthase genes and
erythromycin analogs and derivatives. 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, at 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 a license would be available to us on satisfactory terms, if at all.




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Other parties may obtain patents in the future and 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 that could effectively block our ability to 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 substantial damages;
| | - |  | ------------------------




| |  |  | stop using certain products and methods;
| | - |  | ----------------------------------------




| |  |  | develop non-infringing products and methods; and
| | - |  | ------------------------------------------------




| |  |  | obtain one or more licenses from other parties.
| | - |  | -----------------------------------------------




We may not be able to obtain licenses from other parties 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 and products, which we may not be able to accomplish.





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





We rely on third parties to conduct our clinical trials, and those
third parties may not perform satisfactorily.





If third parties do not successfully carry out their
contractual duties or meet expected deadlines, we will not be able to obtain regulatory approvals for our product candidates and will not be able to successfully commercialize our product candidates for targeted diseases. We do not have the ability
to independently conduct clinical trials for our product candidates, and we rely on third parties such as contract research organizations, medical institutions and clinical investigators to perform this function. If these third parties do not
perform satisfactorily, our clinical trials may be extended or delayed. We may not be able to locate any necessary acceptable replacements or enter into favorable agreements with them, if at all.





If we are unable to manage our growth effectively through recruiting and retaining skilled employees and expand our management and facilities 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 88 on June
30, 2001 to 104 on June 30, 2002. 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.




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Our facilities consist of approximately 118,000 square feet of research and
office space located in Hayward, California, of which approximately 44,000, 69,000 and 5,000 square feet are leased to us until 2013, 2008 and 2005, respectively. We have an option to renew our lease on the 44,000 square foot facility for one
additional period of five years and an option to renew our lease on the 79,000 square foot facility for two additional periods of five years.





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.





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, that 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 liability 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.




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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 the use by third parties or our collaborators 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 have a stockholders rights plan and 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 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 rights agreement 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 our 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 38% 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, they could cause us to enter into transactions or agreements which 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 by us or our
competitors;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | 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, has 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 anticipated levels of revenues could therefore significantly harm our operating results for a particular fiscal period.




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





If we fail to obtain the capital necessary to fund our operations, we will be unable to successfully
develop products.





We expect that additional financing will be required in the future to fund operations. We
do not know whether additional financing will be available when needed, or that, if available, we will obtain financing on terms favorable to our stockholders or us. 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. We have consumed substantial amounts of cash to date and expect capital outlays and operating expenditures to increase over the next several years as we expand our infrastructure and research and
development activities.





We believe that existing cash and investment securities and anticipated cash flow from
existing collaborations will be sufficient to support our current operating plan through the first half of 2004. We have based this estimate on assumptions that may prove to be wrong. Our future capital requirements depend on many factors that
affect our research, development, collaboration and sales and marketing activities. See Managements Discussion and Analysis of Financial Condition and Results of Operations.





We may raise additional financing through public or private equity offerings, debt financings or additional corporate collaboration and licensing arrangements. To the
extent we raise additional capital by issuing equity securities, our stockholders may experience dilution. To the extent that we raise additional funds through collaboration and licensing arrangements, it may be necessary to relinquish some rights
to our technologies or product candidates, or grant licenses on terms that are not favorable to us. If adequate funds are not available, we will not be able to continue developing our products.




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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 maximize the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may
cause the principal amount of the investment balance to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and investments in a variety of securities, including commercial paper, money market
funds, government and non-government debt securities and investment-grade corporate obligations.





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 June 30, 2002 (dollars in thousands):





2002


2003


2004Cash and cash equivalents

$
29,166







Average interest rates


1.89
%Short-term investments


22,272


$
18,752



Average interest rates


3.37
%


3.23
%Long-term investments






7,004


$
3,906Average interest rates






3.01
%


3.66
%





We did not hold derivative instruments as of June 30, 2002, and we
have never held such instruments in the past. In addition, we had outstanding debt, consisting of borrowings under equipment financings, of $3.9 million as of June 30, 2002, with a range of interest rates from 8.71% to 13.86%.




24




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##### Table of Contents




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.





Of the net offering proceeds, through June 30, 2002, approximately $1.0 million had been used to purchase property and equipment and approximately $700,000
had been used for general corporate purposes. We intend to use the remaining net proceeds for advancing our drug candidates through preclinical 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. Pending such uses, the balance has 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





a)  The Company held its Annual Meeting of Stockholders on May 23, 2002.





b)  The stockholders elected Bruce Chabner, M.D., Peter Davis, Ph.D. and Christopher Walsh, Ph.D., Class B directors of the Company, to serve until the 2005 Annual Meeting of Stockholders. Directors whose term of
office as a director continued after the meeting are Daniel V. Santi, M.D., Ph.D.; Jean Deleage, Ph.D.; and Chaitan Khosla, Ph.D.





Candidate

Shares Voted In Favor

Shares WithheldBruce Chabner, M.D.

17,099,782

999,106Peter Davis, Ph.D.

16,937,872

1,161,016Christopher Walsh, Ph.D.

16,395,741

1,703,147





c)  The stockholders approved the amendments to the
Companys 2000 Non-Employee Directors Stock Option Plan:





Shares voted in favor

17,779,918Shares voted against

207,730Shares abstaining

111,240Broker nonvote

0





Item 5.Other Information





None.




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##### Table of Contents




Item 6.Exhibits and Reports on Form 8-K





(a)  Exhibits:





Exhibit No.3.1

Amended and Restated Certificate of Incorporation (1)3.2

Bylaws of Registrant (2)4.1

Form of Specimen of Common Stock Certificate (2)10.4

2000 Non-Employee Director Stock Option Plan, as amended10.41

Lease Agreement, dated as of June 7, 2002, by and between EOP-Industrial Portfolio, L.L.C. and
Registrant10.42

Landlord Consent to Assignment and Assumption of Lease, dated as of June 20, 2002, by and among EOP-Industrial
Portfolio, L.L.C., Aventis Pharmaceuticals, Inc. and Registrant99.1

Certification, dated as of August 13, 2002, by Chief Executive Officer and Chief Financial Officer


---

|(1) |  | Filed with Kosans Quarterly Report on Form 10-Q for the quarter ended June 30, 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.
|--- |  | ------------------------------------------------------------------------------------------------------------------------

|(3) |  | The Certification attached as Exhibit 99.1 accompanies the Quarterly Report on Form 10-Q pursuant to § 906 of the Sarbanes-Oxley Act of 2002 and shall not
be deemed filed by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




(b)  Reports on Form 8-K





No Current
Reports on Form 8-K were filed during the quarter ended June 30, 2002.




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##### Table of Contents




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 INCORPORATEDAugust 13, 2002





By:

/s/    DANIEL V. SANTI, M.D.,
PH.D.Daniel V. Santi, M.D., Ph.D. Chairman and Chief Executive OfficerAugust 13, 2002





By:

/s/    SUSAN M.
KANAYASusan M. Kanaya Senior Vice
President, Finance, Chief Financial Officer and Secretary




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##### Table of Contents




EXHIBIT INDEX





Exhibit No.3.1

Amended and Restated Certificate of Incorporation (1)3.2

Bylaws of Registrant (2)4.1

Form of Specimen of Common Stock Certificate (2)10.4

2000 Non-Employee Director Stock Option Plan, as amended10.41

Lease Agreement, dated as of June 7, 2002, by and between EOP-Industrial Portfolio, L.L.C. and
Registrant10.42

Landlord Consent to Assignment and Assumption of Lease, dated as of June 20, 2002, by and among EOP-Industrial
Portfolio, L.L.C., Aventis Pharmaceuticals, Inc. and Registrant99.1

Certification, dated as of August 13, 2002, by Chief Executive Officer and Chief Financial Officer


---

|(1) |  | Filed with Kosans Quarterly Report on Form 10-Q for the quarter ended June 30, 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.
|--- |  | ------------------------------------------------------------------------------------------------------------------------

|(3) |  | The certification attached as Exhibit 99.1 accompanies the Quarterly Report on Form 10-Q pursuant to § 906 of the Sarbanes- Oxley Act of 2002 and shall not
be deemed filed by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



28