**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC  20549**

 

**FORM 10-Q**

 
| **ý** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
|------------|-----------------------------------------------------------------------------------------------------|
|       |                                                                                                |
|       | **For The Quarterly Period Ended  September 30, 2003**                                         |
|       |                                                                                                |
| **o**      | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |

 

**ForThe Transition Period From              To              **

 

**CommissionFile No. 000-30981**

 

**GENAISSANCEPHARMACEUTICALS, INC.**

(Exact Name of Registrant asSpecified in its Charter)

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

 

**FiveScience Park, New Haven, Connecticut 06511**

(Address of principal executiveoffice and zip code)

 

**(203)773-1450**

(Registrant’s telephone number,including area code)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days:
| Yes ý |   | No o |
|-----------------|--------|-----------|

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in rule 12b-2 of the Exchange Act):
| Yes o |   | No ý |
|------------|--------|----------------|

 

The number of shares of the registrant’s outstanding common stock as ofNovember 10, 2003, was 23,052,227 shares.

 

 

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**GENAISSANCEPHARMACEUTICALS, INC.**

 

For the quarter endedSeptember 30, 2003

**Index**

 
| **PART I –  FINANCIAL INFORMATION**                                                                      |   |   |   |
|---------------------------------------------------------------------------------------------------------------|--------|--------|--------|
|                                                                                                          |   |   |   |
| Item 1 **–** Financial statements (unaudited)                                                            |   |   |   |
|                                                                                                          |   |   |   |
| Balance Sheets as  of September 30, 2003 and December 31, 2002                                      |   |   |   |
|                                                                                                          |   |   |   |
| Statements  of Operations for the three and nine months ended September 30, 2003 and  2002               |   |   |   |
|                                                                                                          |   |   |   |
| Statements  of Cash Flows for the nine months ended September 30, 2003 and 2002                          |   |   |   |
|                                                                                                          |   |   |   |
| Notes to the Unaudited Financial  Statements                                                                  |   |   |   |
|                                                                                                          |   |   |   |
| Item 2 **–** Management’s Discussion and Analysis of Financial  Condition and Results of Operations |   |   |   |
|                                                                                                          |   |   |   |
| Item 3 **–** Quantitative and Qualitative Disclosures about Market Risk                                  |   |   |   |
|                                                                                                          |   |   |   |
| Item 4 **–** Controls and Procedures                                                                     |   |   |   |
|                                                                                                          |   |   |   |
| **PART II –  OTHER INFORMATION**                                                                         |   |   |   |
|                                                                                                          |   |   |   |
| Item  2 **–** Changes in Securities and  Use of Proceeds                                                 |   |   |   |
|                                                                                                          |   |   |   |
| Item 6 **–** Exhibits and Reports on Form 8-K                                                            |   |   |   |
|                                                                                                          |   |   |   |
| Signature                                                                                                     |   |   |   |

 

----

 

**PARTI****– FinancialInformation**

**Item1****– FinancialStatements.**

 

**GENAISSANCE PHARMACEUTICALS, INC.**

Balance Sheets

(Unaudited)

(In thousands, except per sharedata)

 
|                                                                                                                                                                            |   | **September 30,  2003** |       | **December 31,  2002** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                            |   |                         |       |                        |       |
| **ASSETS**                                                                                                                                                                      |   |                         | ** ** |                        | ** ** |
| Current Assets:                                                                                                                                                                 |   |                         |       |                        |       |
| Cash and  cash equivalents                                                                                                                                                      |   | $                            | 8,333      |                        | $          | 16,578 |   |
| Restricted  cash                                                                                                                                                                |   | 2,100                        |       | 2,100                       |       |
| Marketable  securities                                                                                                                                                          |   | 6,655                        |       | 15,472                      |       |
| Accounts  receivable                                                                                                                                                            |   | 1,467                        |       | 448                         |       |
| Taxes  receivable                                                                                                                                                               |   | 808                          |       | —                      |       |
| Other  current assets                                                                                                                                                           |   | 1,007                        |       | 407                         |       |
|                                                                                                                                                                            |   |                         |       |                        |       |
| Total  current assets                                                                                                                                                           |   | 20,370                       |       | 35,005                      |       |
|                                                                                                                                                                            |   |                         |       |                        |       |
| Property and  equipment, net                                                                                                                                                    |   | 10,054                       |       | 14,554                      |       |
| Intangible  assets, net                                                                                                                                                         |   | 870                          |       | —                      |       |
| Other assets                                                                                                                                                                    |   | 376                          |       | 1,163                       |       |
|                                                                                                                                                                            |   |                         |       |                        |       |
| Total assets                                                                                                                                                                    |   | $                            | 31,670     |                        | $          | 50,722 |   |
|                                                                                                                                                                            |   |                         |       |                        |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                  |   |                         | ** ** |                        | ** ** |
| Current  Liabilities:                                                                                                                                                           |   |                         |       |                        |       |
| Current  portion of long-term debt, including amounts due to a shareholder of $414 and  $397 at September 30, 2003 and December 31, 2002, respectively                |   | $                            | 2,081      |                        | $          | 397 |   |
| Current  portion of capital lease obligations                                                                                                                                   |   | 1,644                        |       | 11,187                      |       |
| Accounts  payable                                                                                                                                                               |   | 956                          |       | 838                         |       |
| Accrued  expenses                                                                                                                                                               |   | 2,904                        |       | 2,037                       |       |
| Accrued  dividends                                                                                                                                                              |   | 1,159                        |       | 1,159                       |       |
| Current  portion of deferred revenue                                                                                                                                            |   | 1,432                        |       | 3,026                       |       |
|                                                                                                                                                                            |   |                         |       |                        |       |
| Total  current liabilities                                                                                                                                                      |   | 10,176                       |       | 18,644                      |       |
|                                                                                                                                                                            |   |                         |       |                        |       |
| Long-Term  Liabilities:                                                                                                                                                         |   |                         |       |                        |       |
| Long-term  debt, including amounts due to a shareholder of $4,222 and $4,501 at  September 30, 2003 and December 31, 2002, respectively, less  current portion        |   | 7,555                        |       | 4,501                       |       |
| Deferred  revenue, less current portion                                                                                                                                         |   | 1,567                        |       | 1,722                       |       |
|                                                                                                                                                                            |   |                         |       |                        |       |
| Total  long-term liabilities                                                                                                                                                    |   | 9,122                        |       | 6,223                       |       |
|                                                                                                                                                                            |   |                         |       |                        |       |
| Stockholders’  Equity:                                                                                                                                                     |   |                         |       |                        |       |
| Common  stock, 58,000 authorized shares, $.001 par value, 23,212 and 22,847 shares  issued and outstanding at September 30, 2003 and December 31, 2002,  respectively |   | 23                           |       | 23                          |       |
| Additional  paid-in capital                                                                                                                                                     |   | 220,309                      |       | 219,413                     |       |
| Accumulated  deficit                                                                                                                                                            |   | (207,957                     | )          | (193,602                    | )          |
| Accumulated  other comprehensive income (loss)                                                                                                                                  |   | (3                           | )          | 21                          |       |
|                                                                                                                                                                            |   |                         |       |                        |       |
| Total  stockholders’ equity                                                                                                                                                |   | 12,372                       |       | 25,855                      |       |
|                                                                                                                                                                            |   |                         |       |                        |       |
| Total  liabilities and stockholders’ equity                                                                                                                                |   | $                            | 31,670     |                        | $          | 50,722 |   |

 

*The accompanying notes are an integral partof these financial statements.*

 

2

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Statements ofOperations

(Unaudited)

(In thousands, except per sharedata)

 
|                                                                 |   | **Three Months Ended  September 30,** |   | **Nine Months Ended  September 30,** |   |
|----------------------------------------------------------------------|--------|--------------------------------------------|--------|-------------------------------------------|--------|
|                                                                 |   | **2003**                                   |   | **2002**                                  |   | **2003** |   | **2002** |   |
|                                                                 |   |                                       |   |                                      |   |   |   |   |   |
| License  and service revenue                                         |   | $                                          | 2,571  |                                      | $      | 1,754 |   | $ | 7,823 |   | $ | 5,539 |   |
|                                                                 |   |                                       |   |                                      |   |   |   |   |   |
| Operating  expenses:                                                 |   |                                       |   |                                      |   |   |   |   |   |
| Research  and development                                            |   | 6,097                                      |   | 4,712                                     |   | 15,892 |   | 19,624 |   |
| General  and administrative                                          |   | 2,080                                      |   | 1,956                                     |   | 6,200 |   | 6,970 |   |
| Impairment  of fixed assets                                          |   | —                                     |   | —                                    |   | — |   | 6,000 |   |
| Loss  on leased equipment                                            |   | 368                                        |   | —                                    |   | 368 |   | — |   |
|                                                                 |   |                                       |   |                                      |   |   |   |   |   |
| Total  operating expenses                                            |   | 8,545                                      |   | 6,668                                     |   | 22,460 |   | 32,594 |   |
|                                                                 |   |                                       |   |                                      |   |   |   |   |   |
| Loss  from operations                                                |   | (5,974                                     | )      | (4,914                                    | )      | (14,637 | ) | (27,055 | ) |
|                                                                 |   |                                       |   |                                      |   |   |   |   |   |
| Interest  income                                                     |   | 52                                         |   | 219                                       |   | 276 |   | 858 |   |
| Interest  expense                                                    |   | (122                                       | )      | (487                                      | )      | (514 | ) | (1,509 | ) |
|                                                                 |   |                                       |   |                                      |   |   |   |   |   |
| Loss  before benefit from (provision for) income taxes               |   | (6,044                                     | )      | (5,182                                    | )      | (14,875 | ) | (27,706 | ) |
|                                                                 |   |                                       |   |                                      |   |   |   |   |   |
| Income  tax benefit (provision)                                      |   | 200                                        |   | (28                                       | )      | 520 |   | (28 | ) |
|                                                                 |   |                                       |   |                                      |   |   |   |   |   |
| Net  loss attributable to common stockholders                        |   | $                                          | (5,844 | )                                         | $      | (5,210 | ) | $ | (14,355 | ) | $ | (27,734 | ) |
|                                                                 |   |                                       |   |                                      |   |   |   |   |   |
| Net  loss per common share, basic and diluted                        |   | $                                          | (0.25  | )                                         | $      | (0.23 | ) | $ | (0.63 | ) | $ | (1.22 | ) |
|                                                                 |   |                                       |   |                                      |   |   |   |   |   |
| Weighted  average shares used in computing net loss per common share |   | 23,044                                     |   | 22,827                                    |   | 22,937 |   | 22,802 |   |

 

*The accompanying notes are an integral partof these financial statements.*

 

3

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Statements ofCash Flows

(Unaudited)

(In thousands)

 
|                                                                                                            |   | **Nine  Months Ended  September 30,** |       |
|-----------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                                                                            |   | **2003**                                   |       | **2002** |   |
| **CASH FLOWS FROM  OPERATING ACTIVITIES:**                                                                      |   |                                       | ** ** |   | ** ** |
| Net  loss                                                                                                       |   | $                                          | (14,355    | ) | $ | (27,734 | ) |
| Adjustment to reconcile net loss to net cash used in operating  activities, net of acquisition of DNA Sciences: |   |                                       |       |   |   |
| Depreciation  and amortization                                                                                  |   | 5,400                                      |       | 6,422 |   |
| Impairment  of fixed assets                                                                                     |   | —                                     |       | 6,000 |   |
| Stock  based compensation                                                                                       |   | 176                                        |       | 107 |   |
| Loss  on leased equipment                                                                                       |   | 368                                        |       | — |   |
| Changes  in assets and liabilities -                                                                            |   |                                       |       |   |   |
| Accounts  receivable                                                                                            |   | (232                                       | )          | 49 |   |
| Taxes  receivable                                                                                               |   | (808                                       | )          | — |   |
| Other  current assets                                                                                           |   | (564                                       | )          | 2,385 |   |
| Other  assets                                                                                                   |   | 910                                        |       | (481 | ) |
| Accounts  payable                                                                                               |   | 118                                        |       | (1,722 | ) |
| Accrued  expenses                                                                                               |   | 909                                        |       | (2,507 | ) |
| Deferred revenue                                                                                                |   | (1,749                                     | )          | (119 | ) |
| Net cash used in operating activities                                                                           |   | (9,827                                     | )          | (17,600 | ) |
|                                                                                                            |   |                                       |       |   |   |
| **CASH FLOWS FROM  INVESTING ACTIVITIES:**                                                                      |   |                                       |       |   |   |
| Acquisition of net assets of DNA Sciences                                                                       |   | (1,668                                     | )          | — |   |
| Purchases of property and equipment                                                                             |   | (840                                       | )          | (85 | ) |
| Proceeds from the sale of property and equipment                                                                |   | 30                                         |       | — |   |
| Investments in marketable securities                                                                            |   | (13,299                                    | )          | — |   |
| Proceeds  from sale of marketable securities                                                                    |   | 22,091                                     |       | 26,060 |   |
| Net  cash provided by investing activities                                                                      |   | 6,314                                      |       | 25,975 |   |
|                                                                                                            |   |                                       |       |   |   |
| **CASH FLOWS FROM  FINANCING ACTIVITIES:**                                                                      |   |                                       | ** ** |   | ** ** |
| Net  proceeds from issuance of common stock                                                                     |   | 105                                        |       | 38 |   |
| Repayment  of long-term debt due to shareholder                                                                 |   | (261                                       | )          | (122 | ) |
| Proceeds  from (repayment of) long-term debt                                                                    |   | 5,000                                      |       | (485 | ) |
| Financing  costs                                                                                                |   | (33                                        | )          | — |   |
| Repayment  of capital lease obligations                                                                         |   | (9,543                                     | )          | (4,984 | ) |
| Net  cash used in financing activities                                                                          |   | (4,732                                     | )          | (5,553 | ) |
|                                                                                                            |   |                                       |       |   |   |
| NET  (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS                                                           |   | (8,245                                     | )          | 2,822 |   |
|                                                                                                            |   |                                       |       |   |   |
| CASH  AND CASH EQUIVALENTS, beginning of period                                                                 |   | 16,578                                     |       | 25,204 |   |
|                                                                                                            |   |                                       |       |   |   |
| CASH  AND CASH EQUIVALENTS, end of period                                                                       |   | $                                          | 8,333      |   | $ | 28,026 |   |
|                                                                                                            |   |                                       |       |   |   |
| **SUPPLEMENTAL DISCLOSURE AND NON-CASH  ACTIVITIES:**                                                           |   |                                       | ** ** |   | ** ** |
| Interest  paid                                                                                                  |   | 944                                        |       | 1,381 |   |
| Issuance  of restricted shares                                                                                  |   | 296                                        |       | — |   |
| Issuance  of stock and warrants in connection with the acquisition of net assets of DNA  Sciences               |   | 110                                        |       | — |   |
| Issuance  of warrants in connection with term loan                                                              |   | 209                                        |       | — |   |
| Taxes  paid                                                                                                     |   | —                                     |       | 28 |   |

 

*The accompanying notes are an integral partof these financial statements.*

 

4

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**GENAISSANCE PHARMACEUTICALS, INC**.

 

Notes to Unaudited FinancialStatementsFor the Quarter Ended September 30, 2003

 

**(1)****                     BASISOF PRESENTATION AND RECENT DEVELOPMENTS**

 

Genaissance Pharmaceuticals, Inc. is a leader in thediscovery and use of human gene variation for the development of a newgeneration of DNA-based diagnostic and therapeutic products. The Company’s technology,services and clinical development expertise are marketed to biopharmaceuticaland diagnostic development companies, as a comprehensive solution to theirpharmacogenomic needs.  The Company’sgoal is to improve drug development, physicians’ ability to prescribe drugs,and patients’ lives by elucidating the role of genetic variation in drugresponse. Additionally, the Company provides Good Laboratory Practices (GLP)compliant DNA banking and research and GLP compliant genotyping and relatedservices to a variety of companies.

 

The Company has prepared the accompanying financialstatements without audit, pursuant to the rules and regulations of theSecurities and Exchange Commission. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed or omitted pursuant to such rules and regulations. Thesefinancial statements should be read in conjunction with the Company’s auditedfinancial statements and related footnotes for the year ended December 31,2002, included in our Annual Report on Form 10-K (File No. 000-30981).  The unaudited financial statements include,in the opinion of management, all adjustments (consisting only of normalrecurring adjustments) necessary to present fairly our financial position as ofSeptember 30, 2003, and the results of our operations for the three andnine-month periods ended September 30, 2003 and 2002, respectively. Theresults of operations for such interim periods are not necessarily indicativeof the results to be achieved for the full year.

 

In September 2003, the Company prepaid its capital lease obligations with FinovaCapital Credit Corp. (Finova) and Newcourt Financial USA, Inc. (Newcourt),including any end of lease buy out provisions for equipment retained.  The aggregate amount paid was $4.4million.  See Note 7 for further detailsof the lease prepayments.  InOctober 2003, the Company prepaid its capital lease obligationswith General Electric Capital Corporation (GE) and paid all outstandingobligations due to GE under the terms of the agreement.  The Company made a payment of$1.7 million to GE which represented all principal and interest through thedate of buyout as well as a prepayment penalty of approximately $126,000.  See Note 14 for further details of the GElease prepayment.

 

In September 2003, the Company entered into a $5.0 million Loan andSecurity Agreement with Comerica Bank (Comerica).  The agreement requires equal monthly payments of principal over a36-month period and bears interest at prime plus 2.5%.  See Note 8 for further discussion of theComerica loan.

 

In October 2003, the Company sold 270,000 sharesof Series A Preferred Stock to an accredited investor for $22.50 per shareresulting in proceeds of approximately $5.9 million, net of issuance costs ofapproximately $175,000.   See Note 14for details of the preferred stock sold.

 

**(2)****                    ****ACQUISITION OF DNA SCIENCES**

 

On May 15, 2003, under order of the United StatesBankruptcy Court, the Company acquired certain assets and liabilities of DNASciences, Inc. for $1.8 million inclusive of related fees and expenses.  Included in the fees and expenses is $74,700which represents the fair value of warrants exercisable for up to 75,000 sharesof the Company’s common stock at an exercise price of $2.00 per share issued inconnection with investment banking services performed, as well as $35,000 whichrepresents the fair value of 25,000 shares issued by the Company to a licensorin connection with a license modification of a license acquired in connectionwith the acquisition.  The primaryassets acquired consisted of a GLP compliant and Clinical LaboratoryImprovement

 

5

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Amendments (CLIA) licensed genotyping servicesbusiness, and licenses and patent estates surrounding Long QT Syndrome and athiopurine S-methyltransferase (TPMT) diagnostic test, as well as certain tradeaccounts receivable and fixed assets.

 

The acquisition has been accounted for using thepurchase method of accounting and, accordingly, the purchase price has beenallocated to the assets purchased and liabilities assumed based upon theestimated fair values on the date of acquisition.  The fair value of the assets received was greater than thepurchase price and,****therefore, thefair value of the long-lived assets was reduced, on a pro-rata basis, by theexcess.  After consideration of suchreduction, included in the accompanying September 30, 2003, balance sheetis $870,000 of acquired intellectual property and other intangible assets, netof accumulated amortization of approximately $45,000.  The intellectual property is being amortized over its estimated usefullife of 5 to 10 years and is estimated to be approximately $120,000 per yearfor each of the next five years.

 

The accompanying statement of operations includes theoperating results of DNA Sciences since the date of the acquisition.  Pro forma results of operations have notbeen presented, as the acquisition is not deemed to be a material businesscombination.

 

In May 2003, subsequent to the closing, theCompany****and PrometheusLaboratories, Inc. (Prometheus) amended a license agreement primarily toprovide certain additional rights to the TPMT test to Prometheus in exchangefor a $675,000 cash payment to the Company. The $675,000 payment is included in License and Service Revenue in theaccompanying statement of operations for the nine months ended September 30,2003, as the Company had no further obligation to provide any additionalinformation or services to Prometheus under the terms of the agreement.

 

**(3)****                     EARNINGSPER SHARE**

 

The Company computes and presents net loss per sharein accordance with Statement of Financial Accounting Standards No. 128, *Earnings PerShare*(SFAS No. 128).  For the three and nine months endedSeptember 30, 2003 and 2002, there is no difference in basic and dilutednet loss per common share as the effect of stock options and warrants would beanti-dilutive for all periods presented. The outstanding stock options and warrants (prior to application of thetreasury stock method) would entitle holders to acquire 4,185,000 and 3,822,000shares of common stock at September 30, 2003 and 2002, respectively.  For the purpose of computing basic net lossper share, the 162,000 shares of restricted common stock issued are notconsidered outstanding until such restrictions lapse.

 

**(4)****                     REVENUERECOGNITION**

 

The Company earns itsrevenues primarily through the licensing of its *HAP*TM Technology, by providing *HAP*TM Typing (genotyping)services and by providing GLP compliant DNA banking and genotyping services.The Company has also entered into agreements which provide for future milestoneand royalty payments.  The Company recognizesrevenue in accordance with Staff Accounting Bulletin No. 101, *Revenue Recognition in Financial Statements*(SAB 101), in accordance with Statement of Position 97-2, *Software Revenue Recognition* (SOP 97-2),as amended by Statement of Position 98-9 (SOP 98-9), and in accordance withEmerging Issues Task Force Issue 00-21 (EITF 00-21), *Accounting for Revenue Arrangements with Multiple Deliverables*.  In accordance therewith, the Companyrecognizes annual license and subscription fees over the term of the agreementand service fees as the services are performed.  For agreements with multiple deliverables, revenue is notrecognized unless the fair value of the undelivered elements can be determinedand the elements delivered have stand-alone value to the customer.   Future milestones and royalty payments, ifany, will be recognized when received provided that the milestone issubstantive and a culmination of the earnings process has occurred.  Amounts received in advance of revenuerecognition are recorded as deferred revenue.

 

6

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**(5)****                     ACCOUNTING FOR STOCK BASED COMPENSATION**

 

In December 2002, the Financial AccountingStandards Board (FASB) issued Statement of Financial Standards No. 148, *Accounting for Stock-Based Compensation - Transitionand Disclosure - an amendment of SFAS No. 123*(SFAS No. 148).  SFAS No. 148 provides additional transitionguidance for those entities that elect to voluntarily adopt the accountingprovisions of SFAS No. 123, *Accounting forStock-Based Compensation*. SFAS No. 148 also mandates certain new disclosures that are incrementalto those required by SFAS No. 123.  TheCompany adopted the disclosure provisions of SFAS No. 148 during the fourthquarter of 2002.

 

AtSeptember 30, 2003, the Company had one stock-based compensation planwhich is accounted for under the recognition and measurement principles ofAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees,* and relatedinterpretations.

 

Thefollowing table illustrates the effect on net income and earnings per share ifthe Company had applied the fair value recognition provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*,to stock-based employee compensation for the quarters ended September 30,2003 and 2002:

 

(In thousands, except per share data)

 
|                                                                                                             |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                                             |   | **2003**                                    |   | **2002**                                   |   | **2003** |   | **2002** |   |
|                                                                                                             |   |                                        |   |                                       |   |   |   |   |   |
| Net loss, as reported                                                                                            |   | $                                           | (5,844 | )                                          | $      | (5,210 | ) | $ | (14,355 | ) | $ | (27,734 | ) |
| Add: Stock-based employee compensation expense  included in reported net loss                                    |   | 59                                          |   | (40                                        | )      | 176 |   | 49 |   |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards |   | (353                                        | )      | (716                                       | )      | (1,130 | ) | (2,026 | ) |
| Pro forma net loss                                                                                               |   | $                                           | (6,138 | )                                          | $      | (5,966 | ) | $ | (15,309 | ) | $ | (29,711 | ) |
|                                                                                                             |   |                                        |   |                                       |   |   |   |   |   |
| Net loss per share:                                                                                              |   |                                        |   |                                       |   |   |   |   |   |
| Basic and diluted - as reported                                                                                  |   | $                                           | (0.25  | )                                          | $      | (0.23 | ) | $ | (0.63 | ) | $ | (1.22 | ) |
|                                                                                                             |   |                                        |   |                                       |   |   |   |   |   |
| Basic and diluted - pro forma                                                                                    |   | $                                           | (0.27  | )                                          | $      | (0.26 | ) | $ | (0.67 | ) | $ | (1.30 | ) |

 

**(6)**                     **SIGNIFICANT CUSTOMERS**

 

For the nine months ended September 30, 2003 andSeptember 30, 2002, customer A accounted for 30% and 45% of the Company’srevenue, respectively.  Customers B andC accounted for 14% and 13% of revenue for the nine months ended September 30,2003, respectively.  Customer Daccounted for 27% of revenue for the nine months ended September 30,2002.  The collaboration agreement withcustomer A expires in the fourth quarter of 2003 and the collaborationagreement with customer D expired in the fourth quarter of 2002.  In addition, the Prometheus license fee androyalty accounted for 10% of revenue for the nine months endedSeptember 30, 2003.  See Note 2 forfurther discussion of this license modification fee.

 

**(7)**                     **CAPITAL LEASES**

 

In December 2002, theCompany announced it had received a notice from GE claiming that an event ofdefault had occurred under the lease agreement as a result of an allegedmaterial adverse change in the Company’s business.  GE also filed a complaint in the Superior Court of the State ofConnecticut, demanding payment of all amounts due under the leaseagreement.  The Company also received anotice from Finova stating that, as a result of the alleged default claim byGE, there had been a cross-default under the Company’s agreement withFinova.  To remedy the cross-default,Finova declared that all principal and future interest obligations were due andpayable immediately.  In March 2003,the Company settled the claim with GE and simultaneously amended its lease agreementwith GE (GE Amendment).  In connectionwith the GE Amendment, and as additional security for its payment obligation toGE, the Company delivered to GE a $2.0

 

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million irrevocable letterof credit and agreed to additional covenants in the GE Amendment.  The letter of credit was collateralized bycash at 105% of the outstanding letter of credit balance.  In connection with the GE Amendment, GEretroactively rescinded its default claim. The GE Amendment and letter of credit have been reflected in theaccompanying balance sheet as of December 31, 2002.  The Company recorded an additional charge tointerest expense during the fourth quarter of 2002 for future interest dueunder the capital lease agreement with Finova to reflect the fact that allfuture interest and principal could be currently due and payable under theFinova capital lease agreement as a result of the default claim.  As of December 31, 2002, the amountsdue to GE and Finova were classified as current obligations.

 

In September 2003, theCompany prepaid its capital lease obligations with Finova and Newcourt (SeeNote 1) and paid all amounts due, including any end of lease buy out provisionsfor equipment retained.  In connectionwith the Finova agreement, the Company paid a total of $4.2 million, whichincluded a prepayment discount of approximately $88,000 that was credited tointerest expense during the quarter ended September 30, 2003.  Under their original terms, the leaseschedules covered by the Finova agreement would have expired betweenNovember 2003 and August 2004. In connection with the Newcourt agreement, the Company paid a total ofapproximately $173,000, which represented all future interest and principal dueunder the leases schedules which, by their original terms, would have expiredin November and December 2003. The Company disposed of certain equipment financed under certain of thelease schedules and recorded an additional charge of approximately $368,000related to this equipment.  Inconnection with the buyout, Finova and Newcourt released their liens on allpurchased equipment.

 

In October 2003, theCompany prepaid its capital lease obligations with GE and paid all amounts dueunder the agreement.  See Note 14 forfurther discussion of the GE lease buy out.

 

**(8)**                     **LONG-TERM DEBT**

 

In September 2003, theCompany entered into a $5.0 million Loan and Security Agreement withComerica.  The agreement requires equalmonthly payments of principal over a 36-month period and bears interest atprime (4.0% at September 30, 2003) plus 2.5%.  Borrowings under the agreement are secured by certain assets ofthe Company.  Under the terms of theagreement, the Company is required to satisfy certain financial covenants,including a minimum cash balance and a minimum quick ratio, as defined.  The Company was in compliance with suchfinancial covenants as of September 30, 2003.  In addition, the agreement includes a material adverse changeclause which provides that all amounts become due upon such a change.  In connection with the agreement, theCompany issued a warrant to Comerica, which is exercisable throughSeptember 30, 2010, for the purchase of up to 131,579 shares of commonstock at an exercise price of $1.90 per share. The fair value of the warrant on the date of issue, approximately$209,000, is being amortized into interest expense over the life of the loan.

 

Long-term debt consists ofthe following (dollars in thousands):

 
|                                                                      |   | **September 30,****2003** |   | **December 31,****2002** |   |
|---------------------------------------------------------------------------|--------|--------------------------------|--------|-------------------------------|--------|
|                                                                      |   |                           |   |                          |   |
| Notes payable to Connecticut Innovations, Inc.  bearing interest at 6.5%, |   | $                              | 4,636  |                          | $      | 4,898 |   |
| Term loan payable to Comerica Bank                                        |   | 5,000                          |   | —                        |   |
|                                                                      |   |                           |   |                          |   |
| Total long-term debt                                                      |   | $                              | 9,636  |                          | $      | 4,898 |   |
| Less – current portion                                               |   | (2,081                         | )      | (397                          | )      |
| Long-term debt                                                            |   | $                              | 7,555  |                          | $      | 4,501 |   |

 

**(9)**                     **COMPREHENSIVE LOSS**

 

The Company reports andpresents comprehensive income (loss) in accordance with SFAS No. 130, *Reporting Comprehensive Income,* whichestablishes standards for reporting and the display of comprehensive income(loss) and its components in a full set of general purpose financialstatements.  The objective of thestatement is to report a measure of all changes in equity of an enterprise thatresult from

 

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transactions and othereconomic events during the period other than transactions with owners.  The Company’s other comprehensive income(loss) arises from net unrealized gains (losses) on marketable securities. TheCompany has elected to display comprehensive income (loss) as a component ofthe statements of stockholders’ equity and comprehensive loss.

 

A summary of totalcomprehensive loss is as follows (dollars in thousands):

 
|                      |   | **Three months ended  September 30,** |   | **Nine months ended****September 30,** |   |
|---------------------------|--------|--------------------------------------------|--------|---------------------------------------------|--------|
|                      |   | **2003**                                   |   | **2002**                                    |   | **2003** |   | **2002** |   |
|                      |   |                                       |   |                                        |   |   |   |   |   |
| Net loss                  |   | $                                          | (5,844 | )                                           | $      | (5,210 | ) | $ | (14,355 | ) | $ | (27,734 | ) |
| Other comprehensive loss  |   | (1                                         | )      | (18                                         | )      | (24 | ) | (80 | ) |
| Total  comprehensive loss |   | $                                          | (5,845 | )                                           | $      | (5,228 | ) | $ | (14,379 | ) | $ | (27,814 | ) |

 

**(10)**              **INCOME TAX BENEFIT**

 

Recentlegislation enacted by the State of Connecticut reinstated its research anddevelopment tax credit exchange program. The program allows companies to receive a cash payment from the State inexchange for foregoing certain research and development tax creditcarryforwards.  The State exchanges theresearch and development tax credit carryforwards, at the rate of 65% of theannual research and development tax credit, as defined.  The legislation to reinstate the exchangeprogram for the 2002 tax year was passed during the second quarter of 2003.  The legislation to reinstate the exchangeprogram for the 2003 and 2004 tax years was passed during the third quarter of2003.  The Company elected toparticipate in the exchange program.  Asa result, the Company recorded a benefit of approximately $200,000 in thequarter ended September 30, 2003, and has recognized a benefit of $520,000for the nine months ended September 30, 2003.

 

**(11)****              COMMITMENTS ANDCONTINGENCIES**

 

InNovember 2002, the FASB issued FASB Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, including Indirect Guarantees of Indebtedness of Others*(FIN45), an interpretation of SFAS Nos. 5, 57 and 107 and Rescission of FIN34.  FIN 45 clarifies the requirementsof SFAS No. 5, *Accounting for Contingencies*,relating to the guarantor’s accounting for, and disclosure of, the issuance ofcertain types of guarantees.  Adoptionof FIN 45 did not have a material impact on either the operating results orfinancial position of the Company.

 

TheCompany has entered into indemnification provisions under certain of itsagreements with other companies in the ordinary course of business, typicallywith business partners.  Pursuant tothese agreements, the Company may indemnify, hold harmless and/or reimburse theindemnified parties for certain stipulated losses suffered or incurred by theindemnified parties in connection with the Company’s products or services.  The term of these indemnification agreementsis generally perpetual.  The Companyalso agreed to indemnify the purchaser of the Company’s Series A PreferredStock in connection with the issuance and registration of such securities.  The maximum potential amount of futurepayments the Company could be required to make under these indemnificationagreements is unlimited.  The Companyhas not incurred any costs to defend lawsuits or settle claims related to theseindemnification agreements.  As aresult, the estimated fair value of these agreements is minimal.  Accordingly, the Company has no liabilityrecorded for these agreements as of September 30, 2003.

 

**(12)**              **RECENTLY ISSUED ACCOUNTINGPRONOUNCEMENTS**

 

InMay 2003, the FASB issued SFAS No. 150, *Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity*.  SFAS No. 150 establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity.  The standard is effective for new ormodified contracts after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003.  The adoption of SFAS No. 150 was notmaterial to the Company’s operating results or financial position.

 

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**(13)**              **IMPAIRMENT OF FIXED ASSETS**

 

Duringthe second quarter of 2002, the Company recorded a $6.0 million charge for theimpairment of fixed assets.  This chargewas related to sequencing equipment, computer hardware and software andleasehold improvements in the Company’s DNA sequencing facility that theCompany determined needed to be reviewed for potential impairment.  As a result of this review, the Companydetermined that the carrying value of the assets was in excess of expecteddiscounted future cash flows to be generated by the asset group and a writedown of $6.0 million was recorded.

 

**(14)**              **SUBSEQUENT EVENTS**

 

InOctober 2003, the Company terminated its capital lease obligations with GEand paid all outstanding obligations due, including end of lease buy outprovisions.  Under their original terms,the lease schedules covered by the GE agreement would have expired betweenOctober 2003 and February 2005.  The Company made a payment of$1.7 million to GE, which represented all principal and interest through thedate of buyout as well as a prepayment penalty of approximately $126,000.  As a result of the termination of the lease,the $2.1 million of restricted cash (See Note 7) was released and the Companyreceived full title to the equipment. During the fourth quarter, the Company will record a charge of $60,000in connection with the termination.

 

InOctober 2003, the Company sold 270,000 shares of newly designated Series Aredeemable convertible preferred stock (Preferred Stock) to an accreditedinvestor for $22.50 per share resulting in proceeds of approximately $5.9million, net of issuance costs of approximately $175,000.  In addition, the investor was granted awarrant to purchase an additional 190,000 shares of Preferred Stock throughDecember 31, 2005 at $22.50 per share. The Company will record the warrant at its estimated fair market valueas a discount to the Preferred Stock carrying value.  The discount will be accreted over the period from date ofissuance to the redemption date and will result in a higher recorded dividend charge.  The investor is required to exercise thewarrant if the Company’s stock closes above $4.00 for 23 consecutive businessdays.  The Preferred Stock earnsdividends at the rate of 2% per annum payable in cash semi-annually inJanuary and July.  Each share ofPreferred Stock is convertible into ten shares of common stock at the option ofthe shareholder.  On or afterOctober 29, 2006, the Company can require the conversion of the PreferredStock if the Company’s stock has traded above $7.00 for 23 consecutive businessdays.  Under the terms of the agreement,the Company will be required to redeem, unless the holders of at least 66 2/3%of the Preferred Stock elect otherwise, all of the outstanding shares if a significantevent, as defined, occurs.  If thesignificant event occurs prior to October 29, 2008, all unpaid cashdividends through October 29, 2008 also become payable.  In addition, the shareholder has the optionto require the Company to redeem all of the outstanding shares on eitherOctober 29, 2006, 2007 or 2008. The Company may delay such payment for up to one year, in which case thedividend rate would increase to 10% per annum. During the fourth quarter of 2003, the Company will recognize thebeneficial conversion features embedded in the Preferred Stock.  The valuation of the warrant, coupled withthe accounting for the beneficial conversion feature, could have a materialeffect on the Company’s results and earnings available to common stockholders infuture periods.

 

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**Item 2****–Management’s Discussion and Analysis of Financial Condition and Results ofOperations.**

 

*The following discussion and analysis of ourfinancial condition and the results of operations should be read in conjunctionwith the financial statements and related notes appearing elsewhere in thisQuarterly Report on Form 10-Q.  ThisQuarterly Report on Form 10-Q contains forward-looking statements within themeaning of Section 21E of the Securities Exchange Act of 1934, as amended,that involve risks and uncertainties, including, but not limited to, statementsabout management’s expectations as to revenues, costs and our liquidityposition.  These expectations are basedon certain assumptions regarding our research and development activities,projected expenditures, the ability of our technologies to improve the drugdevelopment process, success of our commercialization efforts and growth in ourrevenues and other factors relating to our business.  These expectations may not materialize if development efforts aredelayed or suspended or if other assumptions prove incorrect.  These factors are more fully discussed belowunder the heading “Factors Affecting Future Operating Results” and in our otherfilings with the Securities and Exchange Commission.  Readers are cautioned not to place undue reliance on these orother forward-looking statements, which reflect management’s analysis,judgment, belief or expectation only as of the date on which they aremade.  While we may elect to updateforward-looking statements at some time in the future, we specifically disclaimany obligation to do so, even if our estimates change.*

 

**CommonTerms**

 

*HAP*TM Technology – the key components of our *HAP*TM Technology are:  a database of highly-informative, proprietary measures of genomicvariation, or haplotypes, which we call *HAP*TM Markers, for pharmaceutically relevantgenes; a proprietary informatics system, which we call *DecoGen*®, including unique algorithms, for defining patient populations withdifferent drug responses; a cost-effective, efficient process for measuringgenomic variation in clinical DNA samples, which we call *HAP*TM Typing; GLP compliant DNA banking andgenotyping services and clinical genetics development skills.

 

STRENGTH program (Statin Response Examined byGenetic *HAP*TM Markers) – this program is designed to apply our *HAP*TM Technology and our clinical geneticsdevelopment skills to the statin class of drugs, which doctors use to treatpatients with high cholesterol and lipid levels and who are, therefore, at riskfor cardiovascular disease.

 

CARING program (Clozapine *HAP*TM Marker Discovery Study) – this program isdesigned to identify which of our *HAP*TM Markers define the patients who are most likely to developagranulocytosis, a potentially life-threatening depletion of white blood cells,if treated with clozapine.

 

Long QT program – This program is designed todevelope a CLIA compliant diagnostic test for familial Long QT syndrome, whichis responsible for heart arrhythmias and sudden death.  This DNA-based test utilizes intellectualproperty that we acquired when we purchased substantially all of the assets ofDNA Sciences.  We will also seek todiscover genetic markers that are predictive of QT prolongation andarrhythmias, that are drug induced and result from heart disease.

 

**Overview**

 

Since our inception, we have incurred significant operating losses and,as of September 30, 2003, we had an accumulated deficit of $208.0million.  The majority of our operatinglosses have resulted from costs we incurred in developing our *HAP*TMTechnology, including our clinical trials and administrative costs associatedwith operations.  We expect to dedicatea significant portion of our resources for the foreseeable future to servicingour *HAP*TMPartnership program partners, our pharmacogenomic support service customers,our CARING and Long QT programs and to maintain our *HAP*TM Technology.  To date, our revenue has been primarily from licensing andservice fees from our agreements with Biogen, Inc. (Biogen), Gene Logic, Inc.(GLI), Johnson & Johnson Pharmaceutical Research & Development, adivision of Janssen Pharmaceuticals, N.V., (J&J PRD), MillenniumPharmaceuticals, Inc. (Millennium) and Pfizer, Inc., as well as a sublicensingagreement with Visible Genetics, Inc. (a part of Bayer AG), a one timelicensing fee from Prometheus Laboratories, Inc. and government grants.

 

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In October 2003, we sold 270,000 shares of newly designated SeriesA redeemable convertible preferred stock (Preferred Stock), $.001 par value pershare, to an accredited investor for $22.50 per share resulting in proceeds ofapproximately $5.9 million, net of issuance costs of approximately $175,000.  In addition, the investor was granted awarrant to purchase an additional 190,000 shares of Preferred Stock throughDecember 31, 2005 at $22.50 per share. We will record the warrant at its estimated fair market value as adiscount to the Preferred Stock carrying value.  The discount will be amortized over the period from the date ofissuance to the redemption date and will result in a higher recorded dividendcharge.  The investor is required toexercise the warrant if our stock closes above $4.00 for 23 consecutivebusiness days.  The Preferred Stockearns dividends at the rate of 2% per annum payable in cash semi-annually inJanuary and July.  Each share ofPreferred Stock is convertible into ten shares of common stock at the option ofthe shareholder.  On or afterOctober 29, 2006, we can require the conversion of the Preferred Stock ifour stock has traded above $7.00 for 23 consecutive business days.  Under the terms of the agreement we will berequired to redeem, unless the holders of at least 66 2/3% of the PreferredStock elect otherwise, all of the outstanding shares if a significant event, asdefined, occurs.  If the significantevent occurs prior to October 29, 2008, all of the unpaid cash dividendsthrough October 29, 2008 also become payable.  In addition, the investor has the option to require that weredeem all of the outstanding shares of Preferred Stock on eitherOctober 29, 2006, 2007 or 2008.  Wemay delay such payment for up to one year, in which case the dividend ratewould increase to 10% per annum.  Duringthe fourth quarter of 2003, we will recognize the beneficial conversionfeatures embedded in the Preferred Stock. The valuation of the warrant, coupled with the accounting for thebeneficial conversion feature, could have a material effect on our results andearnings available to common shareholders in future periods.

 

In September 2003, weentered into a $5.0 million Loan and Security Agreement with Comerica.  The agreement requires equal monthlypayments of principal over a 36-month period and bears interest at prime (4.0%at September 30, 2003) plus 2.5%. Borrowings under the agreement are secured by certain of ourassets.  Under the terms of theagreement, we are required to satisfy certain financial covenants, includingmaintenance of a minimum unrestricted cash balance and a minimum quick ratio,as defined.  We were in compliance withsuch financial covenants as of September 30, 2003.

 

Prior to closing the loanagreement with Comerica, we elected to prepay certain capital lease obligationswith Finova and Newcourt and paid all amounts due, including any end of leasebuy out provisions for equipment retained. In connection with the Finova agreement, we paid a total of $4.2million, which included a prepayment discount of approximately $88,000 that wascredited to interest expense during the quarter ended September 30,2003.  Under their original terms, thelease schedules covered by the Finova agreement would have expired betweenNovember 2003 and August 2004. In connection with the Newcourt agreement, we paid a total ofapproximately $173,000 which represented all future interest and principal dueunder the lease schedules which, by their original terms, would have expired inNovember and December 2003. We disposed of certain equipment financed under certain of the leaseschedules and recorded an additional charge of approximately $368,000 relatedto this equipment.  In connection withthe buyout, Finova and Newcourt released their liens on all purchasedequipment.  In October 2003, asrequired under the Comerica agreement, we terminated our capital leaseobligations with GE and paid all outstanding obligations due to GE, includingthe end of lease buy out provisions. Under their original terms, the lease schedules covered by the GEagreement would have expired between October 2003 andFebruary 2005.  We made a paymentof $1.7 million to GE, which represented all principal and interest through thedate of buyout as well as a prepayment penalty of approximately $126,000.  As a result of the termination of the lease,the $2.1 million of restricted cash was released and we received full title tothe equipment.  During the fourthquarter we will record a charge of approximately $60,000 in connection with thetermination.  As a result of thetermination of the GE lease and the issuance of the Preferred Stock inOctober 2003, our cash and cash equivalents and marketable securitiesincreased by $4.2 million, after expenses, as compared to the amounts shown inthe accompanying unaudited financial statements as of September 30, 2003.

 

On May 15, 2003, under order of the United States BankruptcyCourt, we acquired certain assets and liabilities of DNA Sciences, Inc. for$1.8 million, inclusive of related fees and expenses.  Included in the fees and expenses is $74,700 which represents thefair value of warrants exercisable for up to an aggregate of 75,000 shares ofour common stock at an exercise price of $2.00 per share issued in connectionwith investment banking services performed, as well as $35,000 which representsthe fair value of 25,000 shares we issued to a licensor in connection with alicense modification.  The primaryassets acquired consisted of a GLP compliant DNA banking and a GLP

 

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compliant and CLIA licensed genotyping services business and licensesand patent estates surrounding Long QT Syndrome and a thiopurineS-methyltransferase (TPMT) diagnostic test as well as certain trade accountsreceivable and fixed assets.  Subsequentto the closing, we entered into an amendment to an existing****license agreement (the TPMT Amendment)with Prometheus under which we provide certain additional rights to the TPMTtest for a $675,000 cash payment, which is included in License and ServiceRevenue in the accompanying statement of operations for the nine months endedSeptember 30, 2003.  By combining DNA Sciences’ offerings of GLPcompliant DNA Banking and GLP compliant genotyping services with our *HAP*TM Technology and high-throughputresearch genotyping capabilities, we seek to provide a complete range ofofferings for the application of DNA tests to the clinical development andmarketing of drugs.

 

In August 2002, we announced a restructuring and cost reductionprogram to revise our business focus and to better align our operating coststructure with our current and projected partner needs and projected revenuesfrom our current and projected partners. The cost reduction program included arealignment of management responsibilities, a reduction in our workforce and adecision at that time to seek partners for all internal product developmentprograms. The workforce was reduced by 20 percent to 110 employees in the thirdfiscal quarter of 2002, with the majority of the workforce reductions occurringin our DNA sequencing facility and related informatics support.  We incurred a charge for severance andrelated costs of approximately $200,000, which was recorded in operatingresults in the third fiscal quarter of 2002. All severance obligations associated with this workforce reduction hadbeen paid by December 31, 2002.

 

During the second quarter of 2002, we recorded a $6.0 million chargefor the impairment of fixed assets. This charge was related to sequencing equipment, computer hardware andsoftware and leasehold improvements in our DNA sequencing facility that wedetermined needed to be reviewed for potential impairment.  As a result of our review, we determined thatthe carrying value of the assets was in excess of expected discounted futurecash flows to be generated by the asset group and we recorded a write down of$6.0 million.

 

**Critical Accounting Policies**

 

The preparation of financial statements in conformity with generallyaccepted accounting principles requires management to make certain estimatesand assumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingent liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during the reporting period.

 

We believe the following critical accounting policies affect the moresignificant judgments and estimates used in the preparation of our financialstatements:

•                  revenuerecognition;

•                  valuationof long-lived assets; and

•                  researchand development expenses

 

Revenue recognition.  Weearn our revenues primarily through the licensing of our *HAP*TM Technology and byproviding *HAP*TM Typingservices and GLP compliant DNA banking and genotyping services.  We have also entered into agreements whichprovide for future milestones and royalty payments.  We recognize revenue in accordance with Staff Accounting BulletinNo. 101, *Revenue Recognition in FinancialStatements* (SAB 101), in accordance with Statement of Position 97-2,*Software Revenue Recognition* (SOP97-2), as amended by Statement of Position 98-9 (SOP 98-9), and in accordancewith Emerging Issues Task Force Issue 00-21 (EITF 00-21), *Accounting for Revenue Arrangements with MultipleDeliverables*.  In accordancetherewith, we recognize annual license and subscription fees over the term ofthe agreement and service fees as the services are performed.  For agreements with multiple deliverables,we do not recognize revenue unless the fair value of the undelivered elementscan be determined and the elements delivered have stand-alone value to thecustomer.  Future milestones and royaltypayments, if any, will be recognized when received provided that the milestoneis substantive and a culmination of the earnings process has occurred.  Revenues derived from the achievement ofmilestones or recognition of related work performed under the terms of acontract, as well as the access period of the license agreement, may cause ouroperating results to vary considerably from period to period.  Deferred revenue results from cash receivedor amounts receivable in advance of revenue

 

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recognition.

 

Valuationof long-lived assets. We assess the impairment of long-livedassets whenever events or changes in circumstances indicate that the carryingvalue may not be recoverable.  Factorswe consider important, which could trigger an impairment review, include, amongothers, the following:

 

•                  a significant adverse change in theextent or manner in which a long-lived asset is being used;

 

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

 

•                  a significant decrease in the marketvalue of assets.

 

If wedetermine that the carrying value of long-lived assets may not be recoverable,based upon the existence of one or more of the above indicators of impairment,we compare the carrying value of the asset group to the undiscounted cash flowsexpected to be generated by the group. If the carrying value exceeds the undiscounted cash flows, an impairmentcharge may be needed.  To determine theamount of the impairment charge, we compare the carrying value of theapplicable fixed asset group to its fair value.  We determine the fair value of the fixed asset group bydiscounting expected future cash flow using a discount rate determined by us tobe commensurate with the risk inherent in our current business.  If the fair value is less than the carryingvalue, such amount is recognized as an impairment charge.

 

Research and development expenses. We record research and development expenseswhen they are incurred or, in the case of clinical trial expenses, based uponinformation we receive from third party clinical research organizations.  Research and development expenses includethe following major types of costs: salaries and benefits, material and reagentcosts, research license fees, clinical trial expenses, depreciation andamortization of laboratory equipment and leasehold improvements and buildingand utility costs related to research space. We expense clinical trial costs as incurred based on information wereceive from third parties and estimates that we make.  Our estimates may change as additionalinformation becomes available, which could cause results to vary from period toperiod.

 

**Resultsof Operations**

 

**ThreeMonths Ended September 30, 2003 and 2002**

 

License and service revenue consists primarily of revenue recognized inconnection with the licensing of our *HAP*TM Technology and from *HAP*TM Typing and GLP compliantDNA banking and genotyping services. Revenue increased to approximately $2.6million in the three months ended September 30, 2003, from $1.8 million inthe three months ended September 30, 2002.  Approximately $625,000 of the increase in revenue is attributableto the revenue recognized for services provided by our GLP and CLIA compliantlaboratory which we acquired through the purchase of certain of the assets ofDNA Sciences on May 15, 2003.  Theincrease is also due to the increased commercialization of our *HAP*TM Technology Partnershipprogram and our *HAP*TM Drug-SpecificPartnership program, including agreements entered into with Millennium in 2003,which was partially offset by the expiration of a contract with a customer inthe fourth quarter of 2002.  Theagreement with a customer who accounted for 32% of our revenue for the threemonths ended September 30, 2003, will expire in November 2003 underits original term.

 

Research and development expenses consist primarily of payroll andbenefits for research and development personnel, material and reagent costs,costs incurred in connection with depreciation and maintenance costs forequipment used for *HAP*TM Marker discovery and *HAP*TMTyping and facility-related costs.  Weexpense our research and development costs as incurred.  Research and development expenses increasedto approximately $6.1 million in the three months ended September 30,2003, from approximately $4.7 million in the three months ended September 30,2002.  The increase in expenses isattributable to an increase of approximately $580,000 in payroll and payrollrelated expenses for research and development personnel who joined us inconnection with the DNA Sciences acquisition for a full quarter and due to theresignation of our Chief Scientific Officer during the quarter who will receiveone year of salary as severance in accordance with his employmentagreement.  In addition, there was an

 

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increase of approximately $510,000 in consumables and supplies used inour laboratories primarily as a result of an increase in production in our *HAP*TMTyping and sequencing laboratories. Expenses in the third quarter of 2003 also increased over the sameperiod last year as a result of the reversal of accrued expenses related to ourclinical trials of approximately $580,000 recorded in the third quarter of2002.  These increases were partiallyoffset by a decrease of approximately $610,000 in technology license fees.  This decrease is primarily attributable tothe expiration of a license agreement in December 2002.

 

General andadministrative expenses consist primarily of payroll and benefits forexecutive, business development, finance and other administrative personnel aswell as facility-related costs and outside professional fees incurred inconnection with corporate development and general legal and financialmatters.  General and administrativeexpenses increased to approximately $2.1 million in the three months endedSeptember 30, 2003, from approximately $2.0 million in the three monthsended September 30, 2002.  Theincrease is primarily attributable to an increase in payroll related to theinclusion for a full quarter of personnel at our North Carolina facility, whichwe acquired in the DNA Sciences acquisition.

 

Loss on leased equipment was approximately $368,000 in the three monthsended September 30, 2003, as a result of our disposition of certain assetsupon termination of the capital lease agreements.

 

Interest income decreased to approximately $52,000 in the three monthsended September 30, 2003, from approximately $219,000 for the same periodin 2002.  The decrease is the result ofhigher cash, cash equivalent and short-term investment balances in 2002 andlower interest rates on investments during 2003.

 

Interest expense decreased to approximately $122,000 in the threemonths ended September 30, 2003, from approximately $487,000 in the threemonths ended September 30, 2002. The decrease is primarily the result of the recording of all futureinterest associated with the Finova capital leases in the quarter endedDecember 31, 2002.  We recordedthis charge to reflect the fact that all future interest could be due andpayable under the Finova lease agreement as a result of their defaultclaim.  In September 2003, weprepaid certain outstanding capital lease obligations, including Finova.  Please see the “Overview” section of“Management’s Discussion and Analysis of Financial Condition” and Note 7 of“Notes to Unaudited Financial Statements” included herein for further details.

 

Income tax benefit increased to $200,000 for the three months endedSeptember 30, 2003, from an expense of approximately $28,000 for the threemonths ended September 30, 2002. The benefit is the result of legislation passed in August 2003 bythe State of Connecticut that reinstated the research and development taxcredit exchange program for the 2003 and 2004 tax years.  The legislation allows companies to exchangeresearch and development tax credits earned in the tax year for a cash refundfrom the State at a rate of 65% of the research tax credit, as defined.

 

**NineMonths Ended September 30, 2003 and 2002**

 

Revenue increased to approximately $7.8 million in the nine months endedSeptember 30, 2003, from $5.5 million in the nine months endedSeptember 30, 2002.  The increasein revenue is primarily attributable to the $675,000 license fee received fromPrometheus for their expanded rights to the TPMT test under the TPMT Amendmentand approximately $1.0 million of revenue recognized for services which wereprovided by our GLP compliant laboratory, which we acquired through thepurchase of certain of the assets of DNA Sciences on May 15, 2003.  The increase is also due to the increasedcommercialization of our *HAP*TM Technology Partnershipprogram and our *HAP*TM Drug-Specific Partnership program,including agreements entered into with Millennium in 2003 and Pfizer in 2002,which was partially offset by the expiration of a contract with a customer inthe fourth quarter of 2002.  Theagreement with the customer who accounted for 30% of our revenue for the ninemonths ended September 30, 2003, will expire in November 2003 underits original term.

 

Research and development expenses decreased to approximately $15.9million in the nine months ended September 30, 2003, from approximately$19.6 million in the nine months ended September 30, 2002.  The decrease in expenses is primarily attributableto a decrease of approximately $2.2 million in technology license fees and adecrease of approximately $1.5 million in depreciation and repair andmaintenance expenses.  The decrease in

 

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technology license fees is primarily due to alicense agreement that expired in the fourth quarter of 2002.  The decreases in depreciation and repair andmaintenance expenses are primarily due to a reduction in DNA sequencing,consistent with the removal of the majority of our DNA analyzers fromproduction and the asset impairment charge recorded in the quarter ended June 30, 2002. Payroll expense remained constant during the two periods due to theadditional personnel associated with the DNA Sciences acquisition and theresignation of our Chief Scientific Officer in the third quarter of 2003, whichwas offset by our workforce reduction as part of our restructuring program inthe third quarter of 2002.

 

General and administrative expenses decreased to approximately $6.2million in the nine months ended September 30, 2003, from approximately$7.0 million in the nine months ended September 30, 2002.  The decrease is primarily attributable to a$288,000 sales and use tax refund recorded in the second quarter of 2003 and ageneral reduction in expenses as part of our cost reduction program initiatedduring the quarter ended September 30, 2002.

 

The impairment of fixed assets charge relates to sequencing equipment,computer hardware and software and leasehold improvements used in our DNAsequencing facility.  During the quarterended June 30, 2002, we determined that certain conditions had arisenduring the quarter that triggered the need for a review of our long-livedassets for potential impairment.  Theseconditions included, but were not limited to, the overall business climate inwhich we were operating and a significant change in the manner in which we wereutilizing our DNA sequencing facility and related assets.  In particular, during the quarter endedJune 30, 2002, we determined that our production capacity significantlyexceeded our forecasted demand for the foreseeable future, which resulted inour decision to remove from production the majority of our DNA analyzers, theprimary asset of the group. Accordingly, we performed an impairment review on our sequencing long-livedassets.  As a result of our review, wedetermined that the carrying value of the assets was in excess of the projectedundiscounted cash flows to be generated by the asset group.  To determine the impairment charge wecompared the carrying value of the applicable fixed assets to their fairvalue.  We determined the fair value ofthe fixed assets by discounting expected future cash flows using a discountrate determined by us to be commensurate with the risk inherent in our currentbusiness.  As a result of our analysis,we determined that the carrying value of the assets was in excess of discountedfuture cash flow to be generated by the asset group and we recorded awrite-down of $6.0 million.  The impairmentcharge was allocated to the individual assets on a pro-rata basis.  The revised carrying value of each of theassets is being depreciated over the remaining life of the primary asset of thegroup.

 

Loss on leased equipment was approximately $368,000 in the nine monthsended September 30, 2003, as a result of our disposition of certain assetsupon termination of the capital lease agreements.

 

Interest income decreased to approximately $276,000 in the nine monthsended September 30, 2003, from $858,000 in the nine months endedSeptember 30, 2002.  The decreaseis the result of higher cash, cash equivalent and short-term investmentbalances in 2002 and lower interest rates on investments during 2003.

 

Interest expense decreased to approximately $514,000 in the nine monthsended September 30, 2003, from an expense of approximately $1.5 million inthe nine months ended September 30, 2002. The decrease is primarily the result of the recording of all futureinterest associated with the Finova capital leases in the quarter endedDecember 31, 2002.  We recordedthis charge to reflect the fact that all future interest could be due andpayable under the Finova lease agreement as a result of their defaultclaim.  Please see the “Overview”section of “Management’s Discussion and Analysis of Financial Condition”and Note 7 of “Notes to Unaudited Financial Statements” included herein forfurther.

 

Income tax benefit increased to $520,000 for the nine months endedSeptember 30, 2003 from an expense of approximately $28,000 for the nine monthsended September 30, 2002.  The benefitis the result of legislation passed by the State of Connecticut in June 2003that reinstated the research and development tax credit exchange program forthe 2002 tax year.  In addition, inAugust 2003 the state passed legislation to reinstate the research anddevelopment tax credit exchange program for the 2003 and 2004 tax years.  The legislation allows companies to exchangeresearch and development tax credits earned in the year for a cash refund fromthe state at a rate of 65% of the research tax credit, as defined.

 

**Liquidityand Capital Resources**

 

We have financed our operations primarily through the sale of commonand preferred stock, payments received under licensing and service agreements,loans and capital leases.  From inceptionthrough September 30, 2003, we have received aggregate gross proceeds ofapproximately $163.2 million from issuance of common and preferred stock.  In addition, through September 30,2003, we have received $24.7 million from license and service fees, royaltiesand research contracts.  We have alsoreceived $26.2 million****from capital lease financing arrangementsand $13.2 million from other loans.  Wehave acquired, through September 30, 2003, $42.9 million of property and

 

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equipment.  The majority ofthese assets were financed through capital lease financing arrangements andother loans.

 

In October 2003, the Company sold 270,000 shares of PreferredStock to an accredited investor for $22.50 per share resulting in proceeds ofapproximately $5.9 million, net of issuance costs of approximately$175,000.  Please see Note 14 of the“Notes to the Unaudited Financial Statements” and “Management’s Discussion andAnalysis of Financial Condition” for further details of this transaction.

 

For the next 18 months, we expect to continue to finance our operationsfrom cash we received in 2000 and in October 2003 from the sale of ourcommon and preferred stock and revenue from our *HAP*TM Technology Partnership program and our pharmacogenomicsupport service customers.  During thisperiod, we expect to expend substantialfunds to conduct research and development activities and other general andadministrative activities. Our expenditures for these activities will includerequired payments under operating leases and licensing and service agreementsas noted in the table below.

 

For periods beyond 18 months, we may seek to raise additional fundsthrough the issuance of debt and/or equity securities.  Our business strategy depends on, amongother things, entering into partnership agreements with pharmaceutical andbiotechnology companies and growing the revenue from our pharmacogenomicsupport services business.  If we areunsuccessful in entering into new partnership programs, growing the revenuefrom our pharmacogenomic support services business, or obtaining additionalfinancing funds, we may not generate sufficient funds to sustain our operationsat planned levels.

 

Cash used in operations for the nine months ended September 30,2003, was $9.8 million compared with $17.6 million for the same period in2002.  The cash used in operations forthe nine months ended September 30, 2003, resulted primarily from a netloss of $14.4 million and a decrease in deferred revenue of $1.7 million,partially offset by $5.9 million of non-cash charges for depreciation andamortization expense, stock-based compensation and the loss on disposal ofequipment.  Cash used in operations forthe nine months ended September 30, 2002 resulted primarily from a netloss of $27.7 million and a $4.2 million decrease in accounts payable andaccrued liabilities, partially offset by $12.5 million of non-cash charges fordepreciation and amortization expense, stock-based compensation and impairmentof fixed assets as well as a $2.4 million decrease in other currentassets.  The decrease in other currentassets for the nine months ended September 30, 2002 includes the receiptof $1.0 million from the State of Connecticut for the research and developmenttax credit exchange program.

 

Cash provided by investing activities for the nine months endedSeptember 30, 2003, was $6.3 million compared with $26.0 million for thesame period in 2002.  Net proceeds fromthe sale of marketable securities totaled $8.8 million for the nine monthsended September 30, 2003, compared to $26.1 million for the same period in2002.  During the nine months endedSeptember 30, 2003, we used $1.7 million of cash for the purchase ofcertain net assets of DNA Sciences.  Inaddition, during the nine months ended September 30, 2003, we used$840,000 of cash for the purchase of property and equipment compared to $85,000for the same period in 2002.

 

Cash used for financing activities for the nine months endedSeptember 30, 2003, was $4.7 million compared with $5.6 million for thesame period in 2002.  The cash used infinancing activities for the nine months ended September 30, 2003,primarily resulted from the repayment of capital lease obligations of $9.5million, which was partially offset by proceeds received from long-term debt of$5.0 million.  The primary use of cashfrom financing activities for the nine months ended September 30, 2002 wasthe repayment of long-term debt and capital lease obligations.

 

Our contractual cash obligations as of September 30,2003, are as follows:

 
| **Contractual  Obligations**                 |   | **Payments Due by Period  (in thousands)** |   |
|----------------------------------------------|--------|--------------------------------------------|--------|
| **Total  Amounts  Committed**                |   | **Total for  remainder of  Fiscal 2003**   |   | **Total for  Fiscal Years  2004 and 2005** |   | **Total for  Fiscal Years  2006 and 2007** |   | **Total for  Fiscal Year  2008 and later** |   |
| Long-Term Debt, including interest           |   | $                                          | 11,445 |   | $ | 672 |   | $ | 5,130 |   | $ | 2,692 |   | $ | 2,951 |   |
| Capital Lease Obligation, including interest |   | 1,716                                      |   | 1,716 |   | — |   | — |   | — |   |
| Operating Leases                             |   | 8,345                                      |   | 293 |   | 2,235 |   | 2,025 |   | 3,792 |   |
| Minimum License Obligations                  |   | 490                                        |   | 78 |   | 206 |   | 206 |   | — |   |
| Total Contractual Cash Obligations           |   | $                                          | 21,996 |   | $ | 2,759 |   | $ | 7,571 |   | $ | 4,923 |   | $ | 6,743 |   |

 

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Long-term debt consists of three financingagreements with a stockholder, Connecticut Innovations Inc. (CII), and anagreement with Comerica.  The fundsreceived from CII were used to finance certain leasehold improvements and othercosts associated with our facility expansion. Each CII agreement provided for interest only with principal payments,based on a 120-month amortization beginning April 2001 throughOctober 2002, with final balloon payments due in March 2009 throughJune 2011.  Borrowings under theagreements bear interest at 6.5% and are collateralized by the relatedleasehold improvements.  We are incompliance with all debt covenants as of September 30, 2003.  The funds received from Comerica were usedto refinance certain of the amounts due under several capital leaseagreements.  The agreement requiresratable repayment of the amounts due over a 36-month period and bears interestat prime plus 2.5%.  Borrowings underthe agreement are secured by certain of our assets.

 

Capitallease obligation relates to equipment purchased under an agreement with GE..  All outstanding balances due underthis agreement were repaid in October 2003.  Borrowings under the agreement were secured by the underlyingleased equipment.

 

We lease our operating facilities located in New Haven, Connecticut andMorrisville, North Carolina.  TheConnecticut lease agreements currently require annual lease payments ofapproximately $1.1 million per year over the original term, which expires in2006.  We have two five-year renewaloptions to extend the lease agreements beyond the initial term.  We are recording the expense associated withthe leases on a straight-line basis over the expected term of the leasesthrough September 2011.  We arecurrently a tenant-at-will in the North Carolina facility and we are in theprocess of negotiating a new lease agreement. In addition to the operating lease agreements for our currentfacilities, we also have operating leases for certain of our office equipment.

 

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

 

Based on our current business plans, capitalexpenditures are not expected to exceed $1.5 million for each of fiscal 2003and 2004.

 

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

 

•                  thedemand for our *HAP* TM Technology;

 

•                  theefforts and success of our *HAP* TM partnership program;

 

•                  thecommercialization of intellectual property derived from our associations;

 

•                  thegrowth of our pharmacogenomic support services business;

 

•                  thelevel of competition we face;

 

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

 

•                  ourability to effectively manage our operating expenses.

 

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At September 30, 2003, our cash and cash equivalents andshort-term investments totaled $17.1 million compared to approximately $34.2million at December 31, 2002.  As aresult of the termination of the GE lease and the issuance of the PreferredStock in October 2003, our cash and cash equivalents and marketablesecurities increased by $4.2 million, after expenses, as compared to theamounts shown in the accompanying unaudited financial statements as ofSeptember 30, 2003.  Our cashreserves are held in interest-bearing high-grade corporate bonds and moneymarket accounts.  We believe that ourexisting cash reserves will be sufficient to support our expected net losses,debt obligations and capital expenditures for at least 18 months.  To execute our long-term business plan, wewill need to grow our revenues significantly each year and we may need to seekadditional funding through public or private equity offerings or debtfinancings or through commercial partners. We cannot assure you that we will obtain additional partners or capitalfunding on acceptable terms, if at all.

 

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**FactorsAffecting Future Operating Results**

 

*This Quarterly Report on Form 10-Q contains “forward-lookingstatements” within the meaning of Section 21E of the Securities ExchangeAct of 1934, as amended.  Thesestatements are subject to risks and uncertainties and are based on the beliefsand assumptions of our management based on information currently available toour management.  Use of words, such as“believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,”“should,” “likely” or similar expressions, indicate a forward-lookingstatement.  Forward-looking statementsinvolve risks, uncertainties and assumptions. Certain of the information contained in this Quarterly Report on Form10-Q consists of forward-looking statements. Important factors that could cause actual results to differ materiallyfrom the forward-looking statements include the following:*

 

**We are an early stage company with ahistory of losses and we expect to incur net losses for the foreseeable futuresuch that we may never be profitable**.

 

We have incurred substantial operating lossessince our inception.  As ofSeptember 30, 2003, we have generated only minimal revenue from our *HAP*TM Partnership program and ourpharmacogenomic support services, and we do not expect to generate significantrevenues for several years, if ever. From inception through September 30, 2003, we had an accumulateddeficit of approximately $208.0 million. Our losses to date have resulted principally from costs we incurred inthe development of our *HAP*TMTechnology, in our clinical trials and from general and administrative costsassociated with operations. We expect to devote substantially all of ourresources to service our *HAP*TMPartnership program and STRENGTH program partners, our pharmacogenomic supportservices customers and our CARING and Long QT programs and to maintain our *HAP*TM Technology.

 

We expect to incur additional losses thisyear and in future years, and we may never achieve profitability.  In addition, pharmaceutical andbiotechnology companies are only now beginning to use products such as ours intheir drug and diagnostic development or marketing efforts and, accordingly,they may not choose to use our *HAP*TMTechnology. We do not expect our losses to be substantially mitigated byrevenues from our *HAP*TMPartnership and STRENGTH programs and our CARING and Long QT programs, if any,or from our pharmacogenomic support services for a number of years.

 

**We currently rely on a limited numberof licensing and service arrangements for substantially all of ourrevenues.  As a result, the loss of onemajor customer or our inability to secure additional significant customersduring a given period would have an adverse effect on our business andoperating results.**

 

We are dependent upon a limited number oflicensing and service arrangements that represent substantially all of ourrevenues. In the quarter ended September 30, 2003, two of our customersaccounted for 47% of our total revenues. The agreement with the one of the two customers expires in the fourthquarter of 2003.  If we are unable toreplace, upon substantially similar terms, the agreement that expires in thefourth quarter of 2003, or if we lose any of our other remaining significantcustomers, it would have a material adverse effect on our revenues and on ourbusiness in general and could cause volatility or a decline in our stock price.

 

**To generate significant revenues, wemust obtain additional customers for our *HAP*TMPartnership program and our STRENGTH, CARING and Long QT programs and for ourpharmacogenomic support services.**

 

Our strategy depends on entering intoagreements with pharmaceutical and biotechnology companies for our *HAP*TM Partnership program and our STRENGTH,CARING and Long QT programs and obtaining additional customers for ourpharmacogenomic support services.  Wecurrently have a *HAP*TM Partnershipprogram with five pharmaceutical and biotechnology companies as well as anagreement with a major diagnostic company to commercialize exclusively thediagnostic rights and non-exclusively the product development rights from ourSTRENGTH program.  Our contracts for ourpharmacogenomic support services are specific limited-term projects.  We may not be successful in obtainingadditional partners for our *HAP*TMPartnership program and our STRENGTH program or obtaining any partners for ourCARING or Long QT programs or obtain sufficient new customers for ourpharmacogenomic support services to replace our current projects.  If we are unsuccessful in finding additionalpartners for our *HAP*TM Partnershipprogram and our STRENGTH program or in finding any partners for our CARING orLong QT programs or new customers for our pharmacogenomic support services, wemay never generate sufficient revenues to sustain our operations.  In addition, we expect that some of ourfuture *HAP*TM

 

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Partnership program collaborations, like some of our current *HAP*TM Partnership programcollaborations, will be limited to specific, limited-term projects or that someof these collaborations may not be renewed. Accordingly, we must continually obtain new customers to besuccessful.  To date, the integration ofpharmacogenomics into drug development and marketing has not achievedwidespread market acceptance.

 

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

 

Our financial statements have been preparedin accordance with accounting principles generally accepted in the UnitedStates of America.  The preparation ofthese financial statements requires us to make estimates and judgments thataffect the reported amounts of our assets, liabilities, revenues and expenses,the amounts of charges accrued by us and related disclosure of contingentassets and liabilities.  We base ourestimates on historical experience and on various other assumptions that webelieve to be reasonable at that time under the circumstances.  There can be no assurance, however, that ourestimates or the assumptions underlying our estimates will be correct.

 

**We may require additional funding tofund operations and repay debt and we may not be able to obtain any.**

 

We have used substantial amounts of cash tofund our research and development activities. We will continue to spend funds to service our *HAP*TM Partnership program andSTRENGTH program partners, our pharmacogenomic support services customers andour CARING and Long QT programs and to maintain our *HAP*TM Technology.  We plan to pay for these activities with funds from:

 

•                  ourexisting cash and investment securities; and

 

•                  incomethat we may receive from our *HAP*TMPartnership program and STRENGTH program partners and pharmacogenomic supportservices customers.

 

We intend to rely on our current *HAP*TM Partnership program andSTRENGTH program partners and future partners, if any, and our currentpharmacogenomic support services customers and future customers, if any, forsignificant funding in the future to support our development efforts.  To execute our business plans, we will needto grow our revenues significantly each year. We cannot be certain when we will begin to receive additional income, ifat all, from our *HAP*TMPartnership and STRENGTH programs and our pharmacogenomic support services andincome, if any, from our CARING and Long QT programs.  If we do not receive this income or do not receive it as rapidlyas we expect, we would spend our existing cash and investment securities morerapidly than we currently plan.

 

We believe that our existing cash reserveswill be sufficient to support our expected net losses, debt obligations andcapital expenditures for at least 18 months. We cannot assure you that we will be able to obtain new partners or togenerate the increased revenues required to meet our business planobjectives.  In addition, to execute ourbusiness plans, we may need to seek additional funding through public orprivate equity offerings, debt financings or through commercial partners.  We cannot assure you that we will obtainadditional partners or capital funding on acceptable terms, if at all.  If we are unable to generate sufficientrevenues or access capital on acceptable terms, we may be required to obtainfunds on unfavorable terms that may require us to relinquish rights to certainof our technologies or that would significantly dilute our stockholders and/orsignificantly scale back current operations. Either of these two possibilities would have a material adverse effecton our business.

 

**Our *HAP*TMTechnology may not allow our partners to develop commercial products or toincrease sales of their marketed products.**

 

We developed our *HAP*TM Technology on the assumption thatinformation about gene variation and gene variation associated with drugresponse may help drug development professionals better understand the drugresponse of particular populations and complex disease processes.  Although the pharmaceutical and biotechnologyindustries are increasing their use of genomics in analyzing drug response anddiseases, we are aware of only one successful drug program applying populationgenomics.

 

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We discover *HAP*TMMarkers for pharmaceutically relevant genes. If we are unable to find *HAP*TMMarkers for pharmaceutically relevant genes in a timely manner, our potentialpartners may lose confidence in our *HAP*TMTechnology and our company, which could decrease our ability to generaterevenues.  Even if we are able to discover*HAP*TM Markers forpharmaceutically relevant genes, this information may not prove to be superiorto genomic variation information discovered by our competitors.  Furthermore, pharmaceutical andbiotechnology companies may not choose our *HAP*TMTechnology over competing technologies.

 

Our *DecoGen*®Informatics System may also be less effective than we expect or may not allowour partners or us to determine a correlation between drug response and genomicvariation.  Furthermore, even if ourpartners or we are successful in identifying such a correlation, our partnersmay not be able to develop or sell commercially viable products nor may ourpartners be able to increase the sales of their marketed products using thiscorrelation.  Accordingly, our *HAP*TM Markers and *HAP*TM Technology may notimprove the development, marketing and prescribing of drugs or the developmentand marketing of diagnostics developed by our *HAP*TMPartnership program and STRENGTH program partners.

 

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

 

Our success depends, in part, on our abilityto protect our *HAP*TMTechnology, any associations that we find between clinical outcomes and geneticvariation and any other proprietary software, methods and technologies that wedevelop, either as a trade secret or under the patent and other intellectualproperty laws of the United States and other countries, so that we can preventunauthorized entities from using our inventions and proprietaryinformation.  Because patentapplications that were filed prior to November 29, 2000 in the UnitedStates are confidential until patents issue, third parties may have filedpatent applications for technology covered by our pending patent applicationswithout our being aware of those applications, and our patent applications maynot have priority over any patent applications of others.  We are aware that there are other firms orindividuals who have discovered, or are currently discovering, informationsimilar to the information we are discovering, who may have filed, and in thefuture are likely to file, patent applications that are similar or identical toour *HAP*TM Technologypatent applications.

 

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

 

**We may be unable to develop orcommercialize our *HAP*TMTechnology if we cannot establish additional collaborative relationships and wewill depend on our partners to develop or to co-develop products.**

 

Wecurrently have a *HAP*TM Partnership program with five pharmaceutical and biotechnologycompanies as well as an agreement with a major diagnostic company tocommercialize exclusively the diagnostic rights and non-exclusively the productdevelopment rights from our STRENGTH program. We do not currently have any partners for our CARING or Long QTprograms.  As a result, part of ourcurrent and future revenues will depend on payments from our current *HAP*TM Partnership program andSTRENGTH program partners and our future *HAP*TMPartnership, STRENGTH, CARING and Long QT program partners, if any, for eitherthe new products they may develop, or for increased sales of their existingproducts, made possible through the use of our *HAP*TMTechnology.  If we are unable to attractnew *HAP*TM Partnershipprogram and STRENGTH program partners or any partners for our CARING and LongQT programs, we may never generate sufficient revenues to sustain ouroperations.

 

Our partners for our *HAP*TM Partnership program andSTRENGTH program and our partners, if any, for our CARING and Long QT programs,will be responsible for pre-clinical study and clinical development oftherapeutic and diagnostic products and for regulatory approval, manufacturingand marketing of any products or enhanced marketing claims that result from theapplication of our *HAP*TMTechnology.  Our current agreements withthese partners, and we anticipate that any future agreements with partners,will allow them significant discretion in pursuing these activities.  We cannot control the amount and timing ofresources that any such current or potential partners will devote to ourprograms or potential products.  Our *HAP*TM Partnership program andSTRENGTH

 

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program arrangements and our CARING and Long QT program arrangements,if any, may also have the effect of limiting the areas of research that we maypursue either alone or with others. Because part of our revenues will be dependent on the successfulcommercialization or development of our partners’ products, if, for any reason,a *HAP*TM Partnershipprogram partner or our STRENGTH program partner delays or abandons itsdevelopment or commercialization of a product developed using our *HAP*TM Technology, we mayreceive reduced royalty or other payments or no royalty or other payments atall.  In addition, because part of ourfuture revenues will be dependent on the successful commercialization ofadditional aspects of our *HAP*TMPartnership and STRENGTH programs with partners and the successfulcommercialization of our CARING and Long QT programs with partners, if, for anyreason, a partner delays or abandons its development or commercialization ofthese additional aspects of our *HAP*TMPartnership program or STRENGTH program or its development or commercializationof our CARING and Long QT programs, we may receive reduced royalty or otherpayments or no royalty or other payments at all.

 

Although we intend to retain the rights toall *HAP*TM Markers,which we discover as well as to any *HAP*TMMarkers discovered jointly with our *HAP*TMPartnership and STRENGTH program partners and with our CARING and Long QTprogram partners, if any, we have not always and may not always be able tonegotiate the retention of these rights. Furthermore, disputes may arise in the future over the ownership ofrights to *HAP*TMMarkers as well as any other technology we develop with our *HAP*TM Partnership and STRENGTHprogram partners or with our CARING and Long QT program partners, if any.  These and other possible disagreementsbetween our *HAP*TMPartnership and STRENGTH program partners and us or between our CARING and LongQT program partners, if any, and us could lead to delays in the research,development or commercialization of their products.  These disagreements could also result in litigation or requirearbitration to resolve.  Any of theseevents could prevent us from effectively marketing our *HAP*TM Technology.

 

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

 

Our ability to obtain partners for our *HAP*TM Partnership program andour STRENGTH, CARING and Long QT programs will depend in significant part uponthe pharmaceutical and biotechnology industries’ acceptance that our *HAP*TM Technology can helpaccelerate or improve their drug and diagnostic development and marketingefforts.  To achieve market acceptance,we must continue to educate the pharmaceutical and biotechnology industries andthe public in general as to the potential benefits of our *HAP*TM Partnership, STRENGTH,CARING and Long QT programs.  Mostimportantly, we must convince the research and development, clinical andmarketing departments of pharmaceutical and biotechnology companies that our *HAP*TM Technology can accelerateand improve the processes for developing, marketing and prescribing drugs andfor developing and marketing diagnostics and that our *HAP*TM Partnership, STRENGTH,CARING and Long QT programs will be commercially viable.  If we fail to gain this acceptance, we maynever generate sufficient revenues to sustain our operations.  We may expend substantial funds andmanagement effort to market our *HAP*TMPartnership, STRENGTH, CARING and Long QT programs, without any resultingrevenues.

 

**Our ability to make any acquisitionis dependent on the availability of adequate cash and the attractiveness of ourstock price.**

 

We anticipate that any future acquisitions ofbusinesses or technologies will be financed through cash from operations, theissuance of shares of our common stock and/or seller financing.  We cannot assure you that we will havesufficient existing capital resources or that we will be able to raisesufficient additional capital resources on terms satisfactory to us, if at all,in order to meet our capital requirements for such acquisitions.

 

We also believe that a significant factor in ourability to close acquisitions using stock as consideration will be theattractiveness of our common stock for potential acquisition candidates.  This attractiveness may, in large part, bedependent upon the relative market price and capital appreciation prospects ofour common stock compared to the equity securities of our competitors.  The trading price of our common stock on theNASDAQ National Market  could in thefuture materially adversely affect our acquisition program.

 

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**Integration or acquisitions orstrategic investments could interrupt our business and our financial conditioncould be harmed.**

 

From time to time,we may acquire or make strategic investments in other businesses ortechnologies.  For example, onMay 15, 2003, pursuant to the approval of the United States BankruptcyCourt, we purchased substantially all of the assets and assumed certainliabilities of DNA Sciences.  The DNASciences acquisition, as well as any other acquisitions or strategicinvestments we may make in the future, entail numerous risks that include thefollowing:

 

•                  difficultiesintegrating any acquired operations, personnel, technologies or products;

•                  diversionof management’s focus from our core business concerns;

•                  enteringmarkets in which we have no or limited prior experience or knowledge;

•                  exposureto litigation from stockholders or creditors of, or other parties affiliatedwith, the target company or companies;

•                  dilutionto existing stockholders and earnings per share; and

•                  incurrenceof substantial debt.

 

Any such difficultiesencountered as a result of a merger, acquisition or strategic investment couldadversely affect our business, operating results and financial condition.

 

**If we are unable to prevent othersfrom unauthorized use of, or are unable to defend our use of, our *HAP*TM Technology, trade secretsor know how, we may not be able to operate our business profitably.**

 

Despite ourefforts to protect our proprietary rights, unauthorized parties may be able toobtain and use information that we regard as proprietary.  The issuance of a patent does not guaranteethat it is valid or enforceable.  Thus,even if we obtain patents, they may not be valid or enforceable against thirdparties.

 

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

 

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

 

If any party should successfully claim thatthe creation or use of our *HAP*TMTechnology or *HAP*TMMarker association data infringe upon their intellectual property rights, inaddition to any damages we might have to pay, a court could require us to stopthe infringing activity or obtain a license on unfavorable terms.  Moreover, any legal action against us or anyof our program partners claiming damages or seeking to enjoin commercialactivities relating to the affected products and processes could, in additionto subjecting us to potential liability for damages, require us or our *HAP*TM Partnership and STRENGTHprogram partners or any CARING and Long QT program partners, if any, to obtaina license in order to continue to manufacture or market the affected productsand processes.  Any license requiredunder any patent may not be made available on commercially acceptable terms, ifat all.  In addition, some licenses maybe non-exclusive and, therefore, our competitors may have access to the sametechnology licensed to us.  If we failto obtain a required license or are unable to design around a patent, we may beunable to market effectively some of our *HAP*TMTechnology, which could limit our profitability and possibly prevent us fromgenerating revenue sufficient to sustain our operations.

 

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**Regulatory oversight of our *HAP*TM Technology and publicopinion regarding ethical issues surrounding the use of genetic information mayadversely affect our ability to market our products and services.**

 

Currently, there is limited Food and DrugAdministration (FDA) regulation of genetic tests.  The Secretary’s Advisory Committee on Genetic Testing, anadvisory panel to the Secretary of the U.S. Department of Health and HumanServices, has recommended that the FDA expand its regulation of genetic testingto require FDA approval for all new genetic tests and labeling of genetictests.  If the FDA adopts thisrecommendation, it may require that we, or our partners, apply for FDA approvalas a prerequisite to marketing genetic tests that incorporate our products andservices.  If the FDA were to deny anyapplication of this kind, it could adversely affect our business and we may beunable to generate sufficient revenues to sustain our operations.

 

The FDA has only once required that aphysician must have genomic variation information determined about a patientbefore the doctor prescribes a drug.  Inthis one instance, the FDA has stipulated that this requirement can befulfilled with either gene expression information or genomic variationinformation.  On November 3, 2003, the FDA issueddraft guidance that encourages drug and biologic developers to conductpharmacogenomic tests during drug development and clarified how the FDA willevaluate the resulting data.  The guidanceprovides specific criteria and recommendations on the submission ofpharmacogenomic data in connection with Investigational New Drug Applications,New Drug Applications and Biological License Applications.  The guidance includes information on thetype of data needed and how the FDA will or will not use such data inregulatory decisions.  The FDA asked forvoluntary submissions of research information in order to gain experience asthe field of pharmacogenomics evolves. The FDA advised that the agency would not use information from voluntaryreports for regulatory decisions on the drug or biologic with which thevoluntary data is associated.  Inaddition, the FDA held a workshop on November 13 and 14, 2003 to discuss itsdraft guidance and stated that the agency plans in the near future to issuefurther guidance on the co-development of a pharmacogenomic test and adrug.  Our success will depend, in part,on how rapidly the pharmaceutical and biotechnology industry implements theguidance and, accordingly, the validity of our products and services as a basisfor identifying genomic variation and for correlating drug response withgenomic variation.  Without thisimplementation by the pharmaceutical and biotechnology industry, we may beunable to market effectively any products we may have as well as any of ourservices and we may not generate sufficient revenues to sustain our operations.

 

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

 

Additionally, public opinion on ethicalissues related to the confidentiality and appropriate use of genetic testingresults may influence governmental authorities to call for limits on, orregulation of the use of, genetic testing. In addition, governmental authorities or other entities may call forlimits on, or regulation of the use of, genetic testing or prohibit testing forgenetic predisposition to certain conditions, particularly for those that haveno known cure.  The occurrence of any ofthese events could reduce the potential markets for our products and services,which could prevent us from generating sufficient revenues to sustain ouroperations.

 

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

 

**If our partners do not seek, or donot receive, marketing approval for products developed, if any, using our *HAP*TM Technology, we mayreceive delayed royalty or other payments or no royalty or other payments atall.**

 

Any new drug, biologic or new drug orbiologic indication our partners develop using our *HAP*TM Technology must undergo an extensiveregulatory review process in the United States and other countries before a newproduct or indication of this kind could be marketed.  This regulatory process can take many years and requiresubstantial expense.  Changes in FDApolicies and the policies of similar foreign regulatory bodies can prolong theregulatory review of each new drug or biologic license application or preventapproval of the application.  We expectsimilar delays and risks in the regulatory review process for any diagnosticproduct developed by our partners, whenever this regulatory review is required.  Even if a product obtains marketing clearance,a marketed

 

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product and its manufacturer are subject to continuing review.  A manufacturer may be forced to withdraw aproduct from the market if a previously unknown problem with a product becomesapparent.  Because our future revenueswill be dependent on the successful commercialization or development ofproducts using our *HAP*TMTechnology, any delay of our partners in obtaining, failing to obtain, orfailing to maintain regulatory approval for a product developed using our *HAP*TM Technology may delay ourreceipt of royalty or other payments or prevent us from receiving royalty orother payments sufficient to recover our expenses.

 

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

 

To date, no one has developed orcommercialized any therapeutic product or commercialized any diagnostic productusing our *HAP*TMTechnology.  We expect to rely on ourprogram partners to file applications for regulatory approval and generallydirect the regulatory review process and obtain FDA acceptance of productsdeveloped with our *HAP*TMPartnership and STRENGTH programs and our CARING and Long QT programs, ifany.  Our program partners may notsubmit an application for regulatory review. Even if they do submit applications, they may not be able to obtainmarketing clearance for any products on a timely basis, if at all.  If our partners fail to obtain requiredgovernmental clearances for therapeutic or diagnostic products, they will notbe able to market these products unless and until they obtain these clearances.  As a result, we may not receive royalty orother payments from our customers.  Theoccurrence of any of these events may prevent us from generating revenuessufficient to sustain our operations.

 

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

 

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

 

These competitors may discover, characterizeor develop important technologies applying population genomics before us or ourpartners for our *HAP*TMPartnership and STRENGTH programs that are more effective than thosetechnologies which we develop or which our partners for our *HAP*TM Partnership and STRENGTHprograms develop, or these competitors may obtain regulatory approvals of theirdrugs and diagnostics more rapidly than our partners for our *HAP*TM Partnership and STRENGTHprograms do, any of which could limit our ability to market effectively our *HAP*TM Technology.

 

**Some companiesand governments are marketing or developing a number of databases andinformatics tools to assist participants in the healthcare industry andacademic researchers in the management and analysis of genomic data.  Entities such as Perlegen Sciences, CeleraGenomics Group and the International HapMap Project have developed or plan todevelop databases containing gene sequence, genomic variation or other genomicinformation and are marketing or plan to market their data to pharmaceuticaland biotechnology companies or plan to make freely available theirdatabases.  In addition, numerouspharmaceutical and biotechnology companies, such as GlaxoSmithKline plc, eitheralone or in partnership with our competitors, are developing genomic researchprograms that involve the use of information that can be found in thesedatabases.  Furthermore, companies, suchas deCODE genetics, Inc., have technologies for using genetic variation indiagnostics and in the drug development process and have partnerships withcompanies employing these technologies.**

 

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

 

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**Wedepend on third-party products and services and limited sources of supply forour sequencing and genotyping laboratories.**

 

We rely on outsidevendors to supply certain software, products and materials used in ourlaboratories. Some of these products and materials are obtained from a singlesupplier or a limited group of suppliers. Our reliance on outside vendors generally and a sole or a limited groupof suppliers in particular involves several risks, including:

 

•                  the inability to obtain anadequate supply of required software, products and materials due to capacityconstraints, product defects, a discontinuance of a product by a supplier orother supply constraints;

•                  reduced control over qualityand pricing of software, products and materials; and

•                  delays and long lead timesin receiving software, products, or materials from vendors.

 

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

 

Because our business requires manipulatingand analyzing large amounts of data, we depend on the continuous, effective,reliable and secure operation of our computer hardware, software and relatedinfrastructure.  To the extent that ourhardware or software malfunctions, we will experience reducedproductivity.  We protect our computerhardware through physical and software safeguards.  However, our computer hardware is still vulnerable to fire,weather, earthquake, or other natural disaster and power loss,telecommunications failures, physical or software break-ins and similarevents.  In addition, the software andalgorithmic components of our *DecoGen*®Informatics System are complex and sophisticated, and as such, could containdata, design or software errors that could be difficult to detect andcorrect.  Users of our system may findsoftware defects in current or future products.  If we fail to maintain the necessary computer capacity and datato support our computational needs and our customers’ drug and diagnosticdiscovery and development efforts, we could experience a loss in revenues, or adelay in receiving revenues and a delay in obtaining market acceptance for ourtechnology.

 

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

On October 29, 2003, weissued and sold an aggregate of 270,000 shares of our series A preferredstock and granted the purchaser of such shares a warrant, exercisable at anytime until December 31, 2005, to purchase an additional 190,000 shares of ourseries A preferred stock at $22.50 per share. Under specified circumstances, the purchaser is required to exercise thepreferred stock warrant.  Each share ofour series A preferred stock is currently convertible into ten shares ofour common stock.  Consequently,assuming the exercise of the preferred stock warrant, on an as-converted basis,an aggregate of 4,600,000 shares of our common stock may be issued to theseries A purchaser.  Any issuance ofshares of our common stock upon conversion of shares of our series A preferredstock could have the effect of substantially diluting the interests of ourcurrent stockholders.  Moreover, anysale of these shares of common stock into the public market could cause adecline in the trading price of our common stock.

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

Underthe terms of our series A preferred stock, we are required, unless the holdersof at least 66 2/3% of our outstanding series A preferred stock electotherwise, to redeem all then outstanding shares of our series A preferredstock if one or more of the following events occurs:

•      ourcommon stock is delisted from The NASDAQ National Market;

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

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

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

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

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

•      wefail in good faith to attempt to cause this registration statement to becomeeffective by February 26, 2004; or

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

 

If we are required toredeem our series A preferred stock due to any of the foregoing events, we arerequired to pay each holder of our series A preferred stock the originalpurchase price, plus an amount equal to the dividends that would otherwise haveaccrued and been payable on such shares through October 29, 2008 that have nototherwise been paid as of the redemption date.

In addition, the holders of at least 66 2/3% of theoutstanding shares of our series A preferred stock may elect to require us toredeem all outstanding shares of our series A preferred stock for the originalpurchase price, plus all accrued but unpaid dividends as of the redemptiondate, on either October 29, 2006, 2007 or 2008.

A redemption of the series A preferred stock will reduce the cash wehave available to fund operations, research and product development, capitalexpenditures and other general corporate purposes.  In addition, we have incurred net losses in the past and expectto incur losses in the future, which may impair our ability to generate thecash required to meet our obligations under our series A preferred stock.  If we cannot generate sufficient cash tomeet these obligations, we may be required to incur additional indebtedness orraise additional capital, which may negatively impact our stockholders.

 

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**Thepurchaser of our series A preferred stock owns a substantial portion ofour capital stock, which may afford the purchaser significant influence overour affairs.**

As of November 10, 2003,the purchaser of our series A preferred stock held or had the right toacquire 19.7%of our outstanding common stock (as converted to common stock), includingshares of our common stock which the purchaser previously purchased in the openmarket.  As a result, this stockholderhas significant influence over any change in control of us that may be favoredby other stockholders and could otherwise exercise significant influence overall corporate actions requiring stockholder approval, including the approval ofsome mergers and other significant corporate transactions, such as a sale ofsubstantially all of our assets or the defeat of any non-negotiated takeoverattempt that might otherwise benefit the public stockholders.

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

                Our charter and the series Apurchase agreement govern the terms of our series A preferred stock and imposesignificant restrictions on our business. These restrictions may limit our ability to operate our business and totake advantage of potential business opportunities as they arise.  Our charter places restrictions on ourability to, without the consent of the holders of at least 66 2/3% of theoutstanding shares of our series A preferred stock, among other things:

 

•       alter orchange the rights, preferences or privileges of our series A preferred stock,including any increase in the number of authorized shares of our series Apreferred stock;

•       incur morethan a specified level of indebtedness;

•       create,incur or assume specified liens; or

•       declare orpay dividends, redeem stock or make other distributions to stockholders, otherthan in limited circumstances.

Events beyond our control, including prevailingeconomic, financial and industry conditions, may affect our ability to complywith these restrictions.  In addition,the holders of our series A preferred stock have the right to participate infuture capital raising transactions of ours. The existence of this right may substantially reduce our ability toestablish terms with respect to, or enter into, any financing with partiesother than the series A purchaser.  Theterms of any additional financing we may enter into may impose constraints onour ability to operate our business as we deem appropriate.  These restrictions and covenants could limitour ability to take advantage of financing, merger and acquisitions or othercorporate opportunities, which could adversely affect our business andfinancial condition and your investments in our common stock.

 

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

 

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

 

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

•                  demandfor and market acceptance of our *HAP*TMPartnership, STRENGTH, CARING and Long QT programs;

•                  timingof the execution of agreements on our *HAP*TMPartnership, STRENGTH, CARING and Long QT programs and other materialcontracts;

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

•                  disputesregarding patents or other intellectual property rights;

•                  securitiesclass actions or other litigation;

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

•                  generaland industry-specific economic conditions, which may affect our partners’ useof our *HAP*TM Technology.

 

Due to volatile and unpredictable revenuesand operating expenses, we believe that period-to-period comparisons of ourresults of operations may not be a good indication of our futureperformance.  It is possible that ouroperating results may be below the expectations of securities analysts orinvestors.  In this event, the marketprice of our common stock could fluctuate significantly or decline.

 

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**Item3****– Quantitative and Qualitative Disclosures aboutMarket Risk.**

 

Our exposure to market risk is principally confined to our cashequivalents and investments, all of which have maturities of less than oneyear.  We maintain a non-tradinginvestment portfolio of investment grade, liquid debt securities that limit theamount of credit exposure to any one issue, issuer or type of instrument.  In view of the nature and mix of our totalportfolio, a 10% movement in market interest rates would not have a significantimpact on the total value of our investment portfolio as of September 30,2003.

 

**Item 4** – Controls and Procedures.

** **

**The Company’s management, with theparticipation of the Company’s chief executive officer and chief financialofficer, evaluated the effectiveness of the Company’s disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act)as of September 30, 2003.  Based onthis evaluation, the Company’s chief executive officer and chief financialofficer concluded that, as of September 30, 2003, the Company’s disclosurecontrols and procedures were (1) designed to ensure that material informationrelating to the Company is made known to the Company’s chief executive officerand chief financial officer by others within the Company, particularly duringthe period in which this report was being prepared, and (2) effective, in thatthey provide reasonable assurance that information required to be disclosed bythe Company in the reports that it files or submits under the Exchange Act isrecorded, processed, summarized and reported within the periods specified inthe SEC’s rules and forms.**

** **

**No change in the Company’s internalcontrol over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f)under the Exchange Act) occurred during the fiscal quarter endedSeptember 30, 2003, that has materially affected, or is reasonably likelyto materially affect, the Company’s internal control over financial reporting.**

 

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**PART II****- OtherInformation**

 

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

 

**Changesin Securities**

 

Not applicable.

 

**Useof Proceeds**

 

The proceeds from our initial public offering have been invested ininterest-bearing high-grade corporate bonds and money market accounts.

 

From the closing of our initial public offering throughSeptember 30, 2003, we have used the proceeds for research and developmentactivities, capital expenditures, working capital and other general corporatepurposes.  We will continue to spendfunds to service our *HAP*TMTechnology Partnership program and our STRENGTH program partners, ourpharmacogenomic support services customers, our CARING and Long QT programs andto maintain our *HAP*TMTechnology.  As of September 30,2003, $17.1 million of the net proceeds remain available and are primarilyinvested in short-term marketable securities.

 

 

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

 

(a) Exhibits

See Index to Exhibits attached hereto.

 

(b) Reports on Form 8-K

 

OnAugust 13, 2003, we furnished a Current Report on Form 8-K, containing acopy of our earnings release for the period ended June 30, 2003 (includingfinancial statements) pursuant to Item 12 (Results of Operations and FinancialCondition).

 

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

**SIGNATUR****E**

 

 

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

 
|                         |   | GENAISSANCE PHARMACEUTICALS, INC.                  |           |
|------------------------------|--------|----------------------------------------------------|----------------|
|                         |   |                                               |           |
|                         |   |                                               |           |
| Date: November 14, 2003 |   | By:                                                | /s/ Ben Kaplan |   |   |
|                         |   | Ben Kaplan                                         |           |
|                         |   | Senior Vice President and Chief Financial  Officer |           |
|                         |   | (Principal Financial and Accounting  Officer)      |           |
|                              |        |                                                    |                |  |  |

 

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**EXHIBIT INDEX**

 
| **Exhibit  No.** |   | **Description of Document**                                                                                                                  |
|------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------|
|             |   |                                                                                                                                         |
| 10.1             |   | Loan and Security Agreement entered into as  of September 30, 2003, by and between Comerica Bank and Genaissance  Pharmaceuticals, Inc. |
| 31.1             |   | Certification pursuant to Rules  13a-14(a)/15d-14(a) promulgated under the Securities Exchange Act of 1934, as  amended.                     |
| 31.2             |   | Certification pursuant to Rules  13a-14(a)/15d-14(a) promulgated under the Securities Exchange Act of 1934, as  amended.                     |
| 32.1             |   | Certification pursuant to 18 U.S.C.  Section 1350.                                                                                      |
| 32.2             |   | Certification pursuant to 18 U.S.C.  Section 1350.                                                                                      |

 

 

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