# ** **

# **UNITED STATES**

# **SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, DC  20549**

 

# **FORM 10-Q**

# ** **

| **ý** |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**  |
|------------|--------|-----------------------------------------------------------------------------------------------|
|       |   |                                                                                          |
|       |   | **For The  Quarterly Period Ended March 31, 2004**                                            |
|       |   |                                                                                          |
| **o**      |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |

 

**ForThe Transition PeriodFrom               To               **

 

**CommissionFile No. 000-30981**

 

**GENAISSANCE PHARMACEUTICALS, INC.**

(Exact Name of Registrantas Specified 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 principalexecutive office and zip code)

 

**(203)773-1450**

(Registrant’s telephonenumber, 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 during thepreceding 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     Noo

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in rule 12b-2 of the Exchange Act):

 

Yes o     Noý

 

The number of shares of the registrant’s outstandingcommon stock as of May 14, 2004, was 30,196,772 shares.

 

 

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**GENAISSANCEPHARMACEUTICALS, INC.**

 

For the quarterended March 31, 2004

**Index**

 
|                                                                                                       | **Page** |
|------------------------------------------------------------------------------------------------------------|----------|
|                                                                                                       |     |
| **PART I – FINANCIAL  INFORMATION**                                                                   |     |
|                                                                                                       |     |
| Item 1 – Financial  statements (unaudited)                                                            |     |
|                                                                                                       |     |
| Condensed  Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003                          | 1        |
|                                                                                                       |     |
| Condensed  Consolidated Statements of Operations for the three months ended March 31,  2004 and 2003       | 2        |
|                                                                                                       |     |
| Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2004 and 2003       | 3        |
|                                                                                                       |     |
| Notes  to the Unaudited Condensed Consolidated Financial Statements                                        | 4        |
|                                                                                                       |     |
| Item  2 – Management’s Discussion and Analysis of Financial Condition and Results  of Operations | 11       |
|                                                                                                       |     |
| Item  3 – Quantitative and Qualitative Disclosures About Market Risk                                  | 30       |
|                                                                                                       |     |
| Item 4 – Controls and  Procedures                                                                     | 30       |
|                                                                                                       |     |
| **PART II – OTHER INFORMATION**                                                                       |     |
|                                                                                                       |     |
| Item 2 – Changes in Securities,  Use of Proceeds and Issuer Purchases of Equity Securities            | 31       |
|                                                                                                       |     |
| Item 6 –  Exhibits and Reports on Form 8-K                                                            | 31       |
|                                                                                                       |     |
| Signatures                                                                                                 | 32       |

 

DecoGenâ,  HAPâand HAPTM are either registered trademarks or trademarks ofGenaissance Pharmaceuticals, Inc. in the United States and/or othercountries.  All other trademarks ortrade names referred to in this Quarterly Report on Form 10-Q are the propertyof their respective owners.

 

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**PART I – Financial Information**

**Item 1 – Financial Statements.**

 

**GENAISSANCE PHARMACEUTICALS, INC.**

Condensed ConsolidatedBalance Sheets

(In thousands, except pershare data)

 
|                                                                                                                                                                                                                                 |   | **March 31,  2004** |       | **December  31,  2003** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|-------------------------|------------|
|                                                                                                                                                                                                                                 |   | **(Unaudited)**     |       |                    |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| **ASSETS**                                                                                                                                                                                                                           |   |                | ** ** |                    | ** ** |
| Current Assets:                                                                                                                                                                                                                      |   |                |       |                    |       |
| Cash and cash  equivalents                                                                                                                                                                                                           |   | $                   | 5,302      |                    | $          | 8,033 |   |
| Marketable  securities                                                                                                                                                                                                               |   | 6,129               |       | 8,771                   |       |
| Accounts  receivable and unbilled revenue, net                                                                                                                                                                                       |   | 2,325               |       | 2,573                   |       |
| State taxes  receivables                                                                                                                                                                                                             |   | 1,497               |       | 1,442                   |       |
| Inventory                                                                                                                                                                                                                            |   | 1,340               |       | 1,278                   |       |
| Other current  assets                                                                                                                                                                                                                |   | 908                 |       | 645                     |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Total current  assets                                                                                                                                                                                                                |   | 17,501              |       | 22,742                  |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Property and  equipment, net                                                                                                                                                                                                         |   | 7,689               |       | 8,776                   |       |
| Deferred  financing costs, net                                                                                                                                                                                                       |   | 292                 |       | 317                     |       |
| Investment in  affiliate                                                                                                                                                                                                             |   | 2,419               |       | 2,531                   |       |
| Other assets                                                                                                                                                                                                                         |   | 1,920               |       | 1,223                   |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Total assets                                                                                                                                                                                                                         |   | $                   | 29,821     |                    | $          | 35,589 |   |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| **LIABILITIES,  REDEEMABLE CONVERTIBLE PREFERRED STOCK, WARRANT AND STOCKHOLDERS’ EQUITY**                                                                                                                                      |   |                | ** ** |                    | ** ** |
| Current  Liabilities:                                                                                                                                                                                                                |   |                |       |                    |       |
| Current portion  of long-term debt                                                                                                                                                                                                   |   | $                   | 2,109      |                    | $          | 2,088 |   |
| Accounts payable                                                                                                                                                                                                                     |   | 1,363               |       | 898                     |       |
| Accrued expenses                                                                                                                                                                                                                     |   | 1,523               |       | 2,925                   |       |
| Accrued  dividends                                                                                                                                                                                                                   |   | 1,188               |       | 1,181                   |       |
| Current portion  of deferred revenue                                                                                                                                                                                                 |   | 1,774               |       | 1,455                   |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Total current  liabilities                                                                                                                                                                                                           |   | 7,957               |       | 8,547                   |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Long-Term  Liabilities:                                                                                                                                                                                                              |   |                |       |                    |       |
| Long-term debt,  net of current portion                                                                                                                                                                                              |   | 6,504               |       | 7,030                   |       |
| Deferred revenue,  net of current portion                                                                                                                                                                                            |   | 4,038               |       | 4,090                   |       |
| Other long-term  liabilities                                                                                                                                                                                                         |   | 1,593               |       | 1,593                   |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Total long-term  liabilities                                                                                                                                                                                                         |   | 12,135              |       | 12,713                  |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Series A  Redeemable Convertible Preferred Stock:                                                                                                                                                                                    |   |                |       |                    |       |
| 460 authorized shares  at March 31, 2004 and December 31, 2003; $.001 par value; 270 shares issued  and outstanding at March 31, 2004 and December 31, 2003 (liquidation  preference $6,075 at March 31, 2004 and December 31, 2003) |   | 5,177               |       | 5,097                   |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Warrant to  purchase Series A Redeemable Convertible Preferred Stock                                                                                                                                                                 |   | 840                 |       | 835                     |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Stockholders’  Equity:                                                                                                                                                                                                          |   |                |       |                    |       |
| Common stock,  58,000 authorized shares, $.001 par value, 23,387 and 23,301 shares issued  and outstanding at March 31, 2004 and December 31, 2003, respectively                                                                     |   | 23                  |       | 23                      |       |
| Preferred stock,  540 authorized shares at March 31, 2004 and December 31, 2003, no shares  issued or outstanding except for Series A included above                                                                                 |   | —              |       | —                  |       |
| Additional  paid-in capital                                                                                                                                                                                                          |   | 220,558             |       | 220,541                 |       |
| Accumulated  deficit                                                                                                                                                                                                                 |   | (216,869            | )          | (212,160                | )          |
| Accumulated other  comprehensive income (loss)                                                                                                                                                                                       |   | —              |       | (7                      | )          |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Total  stockholders’ equity                                                                                                                                                                                                     |   | 3,712               |       | 8,397                   |       |
|                                                                                                                                                                                                                                 |   |                |       |                    |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                     |   | $                   | 29,821     |                    | $          | 35,589 |   |

 

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

 

1

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Condensed ConsolidatedStatements of Operations

(Unaudited)

(In thousands, except pershare data)

 
|                                                                   |   | **Three  Months Ended  March 31,** |   |
|------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                   |   | **2004**                           |   | **2003** |   |
|                                                                   |   |                               |   |   |   |
| Revenue:                                                               |   |                               |   |   |   |
| License and  service                                                   |   | $                                  | 2,868  |   | $ | 2,139 |   |
| Laboratory  services                                                   |   | 860                                |   | — |   |
|                                                                   |   |                               |   |   |   |
| Total revenue                                                          |   | 3,728                              |   | 2,139 |   |
|                                                                   |   |                               |   |   |   |
| Operating  expenses:                                                   |   |                               |   |   |   |
| Cost of  laboratory services                                           |   | 861                                |   | — |   |
| Research and  development                                              |   | 5,012                              |   | 4,739 |   |
| General and administrative                                             |   | 2,358                              |   | 2,059 |   |
|                                                                   |   |                               |   |   |   |
| Total operating  expenses                                              |   | 8,231                              |   | 6,798 |   |
|                                                                   |   |                               |   |   |   |
| Loss from  operations                                                  |   | (4,503                             | )      | (4,659 | ) |
|                                                                   |   |                               |   |   |   |
| Other income                                                           |   | 75                                 |   | 134 |   |
| Interest expense                                                       |   | (180                               | )      | (201 | ) |
|                                                                   |   |                               |   |   |   |
| Loss before  benefit from income taxes and equity in loss of affiliate |   | (4,608                             | )      | (4,726 | ) |
|                                                                   |   |                               |   |   |   |
| Income tax  benefit                                                    |   | 49                                 |   | — |   |
| Equity in loss  of affiliate, net of tax                               |   | (150                               | )      | — |   |
|                                                                   |   |                               |   |   |   |
| Net loss                                                               |   | (4,709                             | )      | (4,726 | ) |
|                                                                   |   |                               |   |   |   |
| Preferred stock  dividends and accretion                               |   | (110                               | )      | — |   |
| Beneficial  conversion feature of warrant                              |   | (6                                 | )      | — |   |
|                                                                   |   |                               |   |   |   |
| Net loss  attributable to common stockholders                          |   | $                                  | (4,825 | ) | $ | (4,726 | ) |
|                                                                   |   |                               |   |   |   |
| Net loss per  common share, basic and diluted                          |   | $                                  | (0.21  | ) | $ | (0.21 | ) |
|                                                                   |   |                               |   |   |   |
| Weighted average shares used in computing net loss per common  share   |   | 23,194                             |   | 22,865 |   |

 

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

 

2

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Condensed ConsolidatedStatements of Cash Flows

(Unaudited)

(In thousands)

 
|                                                                        |   | **Three  Months Ended  March 31,** |   |
|-----------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                        |   | **2004**                           |   | **2003** |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                   |   |                               |   |   |   |
| Net loss                                                                    |   | $                                  | (4,709 | ) | $ | (4,726 | ) |
| Adjustment to reconcile net loss to net cash used in operating  activities: |   |                               |   |   |   |
| Depreciation and amortization                                               |   | 1,552                              |   | 1,765 |   |
| Stock based compensation                                                    |   | 118                                |   | 59 |   |
| Loss in equity of affiliate                                                 |   | 150                                |   | — |   |
| Changes in assets and liabilities -                                         |   |                               |   |   |   |
| Accounts receivable                                                         |   | 248                                |   | 381 |   |
| Taxes receivable                                                            |   | (55                                | )      | — |   |
| Inventory and other current assets                                          |   | (325                               | )      | (34 | ) |
| Other assets                                                                |   | (727                               | )      | — |   |
| Accounts payable                                                            |   | 464                                |   | 242 |   |
| Accrued expenses                                                            |   | (1,403                             | )      | 191 |   |
| Deferred revenue                                                            |   | 268                                |   | 99 |   |
| Net cash used in operating activities                                       |   | (4,419                             | )      | (2,023 | ) |
|                                                                        |   |                               |   |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                   |   |                               |   |   |   |
| Purchases of property and equipment                                         |   | (410                               | )      | (410 | ) |
| Investment in affiliate                                                     |   | (38                                | )      | — |   |
| Investments in marketable securities                                        |   | —                             |   | (4,583 | ) |
| Proceeds from sale of marketable securities                                 |   | 2,650                              |   | 7,235 |   |
| Net cash provided by investing activities                                   |   | 2,202                              |   | 2,242 |   |
|                                                                        |   |                               |   |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                   |   |                               |   |   |   |
| Net proceeds from issuance of common stock                                  |   | 15                                 |   | — |   |
| Repayment of long-term debt                                                 |   | (506                               | )      | (64 | ) |
| Dividends paid                                                              |   | (23                                | )      | — |   |
| Repayment of capital lease obligations                                      |   | —                             |   | (1,622 | ) |
| Net cash used in financing activities                                       |   | (514                               | )      | (1,686 | ) |
|                                                                        |   |                               |   |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                   |   | (2,731                             | )      | (1,467 | ) |
|                                                                        |   |                               |   |   |   |
| CASH AND CASH EQUIVALENTS, beginning of period                              |   | 8,033                              |   | 16,578 |   |
|                                                                        |   |                               |   |   |   |
| CASH AND CASH EQUIVALENTS, end of period                                    |   | $                                  | 5,302  |   | $ | 15,111 |   |
|                                                                        |   |                               |   |   |   |
| **SUPPLEMENTAL DISCLOSURE AND NON-CASH ACTIVITIES:**                        |   |                               |   |   |   |
| Interest paid                                                               |   | 172                                |   | 175 |   |
| Issuance of  restricted shares                                              |   | —                             |   | 296 |   |
| Issuance of  common stock for services                                      |   | 31                                 |   | — |   |
| Taxes paid                                                                  |   | 6                                  |   | — |   |

 

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

 

3

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**GENAISSANCE PHARMACEUTICALS, INC**.

 

Notes to UnauditedCondensed Consolidated Financial StatementsFor the Quarter Ended March 31, 2004

(Amounts in thousands,except per share data)

 

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

 

GenaissancePharmaceuticals, Inc. is a leader in the discovery and use of human genevariation for the development of a new generation of DNA-based diagnostic andtherapeutic products. The Company’s technology, services and clinicaldevelopment expertise are marketed to biopharmaceutical and diagnosticdevelopment companies, as a comprehensive solution to their pharmacogenomicneeds.  The Company’s goal is to improvedrug development, drug therapy prescribed by physicians and the quality of apatient’s life by elucidating the role of genetic variation in drug response.Additionally, the Company provides Good Laboratory Practices (GLP) compliantDNA banking and research and GLP compliant genotyping and related services to avariety of companies.

 

TheCompany has prepared the accompanying condensed consolidated financialstatements without audit, pursuant to the rules and regulations of theSecurities and Exchange Commission (SEC). 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 31,2003, included in its 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 the Company’s financialposition as of March 31, 2004, and the results of the Company's operations forthe three months ended March 31, 2004 and 2003, respectively. The results ofoperations for such interim periods are not necessarily indicative of theresults to be achieved for the full year.

 

OnMay 2003, the Company acquired certain assets and assumed certainliabilities of DNA Sciences, Inc.  Theassets acquired included a GLP compliant DNA banking and a GLP compliantgenotyping services business licensed under the Clinical Laboratory ImprovementAmendments (CLIA).  Revenue associated with this service business isincluded in laboratory services in the accompanying condensed consolidatedstatement of operations.

 

InDecember 2003, the Company entered into a merger agreement with LarkTechnologies, Inc.  The stockholders ofeach company approved the merger on April 1, 2004.  See Note 12 for further discussion of the merger agreement andthe merger.

 

TheCompany has incurred losses since inception and expects to incur losses in thefuture.  Based upon the Company’scurrent activities, the Company plans to fund its operations for at least thenext twelve months with existing cash and marketable securities on-hand,revenue from *HAP* Technologycustomers and pharmacogenomic support service customers and revenue generatedby Lark Technologies which was acquired by the Company on April 1, 2004.

 

**(2)****                     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 months ended March 31, 2004and 2003, there is no difference in basic and diluted net loss per common shareas the effect of stock options and warrants would be anti-dilutive for allperiods presented.  The outstandingpreferred stock (see Note 8), stock options and warrants (prior to applicationof the treasury stock method) would entitle holders to acquire 9,320 and 4,241shares of common stock at March 31, 2004 and 2003, respectively.

 

4

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**(3)****                     REVENUERECOGNITION**

 

The Company earns its revenue primarily through thelicensing of its *HAP* Technologyand by providing research genotyping services and GLP compliant DNA banking andgenotyping services. The Company has also entered into agreements which providefor the Company to receive future milestone and royalty payments.  The Company recognizes revenue in accordancewith Staff Accounting Bulletin No. 104, *RevenueRecognition* (SAB 104) (which supercedes SAB 101, *Revenue Recognition in Financial Statements*),Statement of Position 97-2 (SOP 97-2), *SoftwareRevenue Recognition*, as amended by Statement of Position 98-9 (SOP98-9), and Emerging Issues Task Force Issue 00-21 (EITF 00-21), *Revenue Arrangements with Multiple Deliverables*.  In accordance with SAB 104 and EITF 00-21,the Company recognizes annual license and subscription fees over the term ofthe agreement and service fees as the services are performed.  For agreements with multiple deliverables,revenue is not recognized unless the fair value of the undelivered elements canbe determined and the elements delivered have stand-alone value to thecustomer.  Future milestones and royaltypayments, if any, will be recognized when received, provided that the milestoneis substantive and a culmination of the earnings process has occurred.  Deferred revenue results from cash receivedor amounts receivable in advance of revenue recognition.

 

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

 

In December 2002, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialStandards No. 148, *Accounting for Stock-BasedCompensation - Transition and Disclosure - an amendment of FAS 123*(FAS148).  FAS 148 provides additionaltransition guidance for those entities that elect to voluntarily adopt theaccounting provisions of FAS 123, *Accountingfor Stock-Based Compensation*. FAS 148 also mandates certain new disclosures that are incremental tothose required by FAS 123.  The Companyadopted the disclosure provisions of FAS 148 during the fourth quarter of 2002.

 

At March 31, 2004, theCompany had one stock-based compensation plan which is accounted for under therecognition and measurement principles of Accounting Principles Board (APB)Opinion No. 25, *Accounting for Stock Issuedto Employees,* and related interpretations.

 

The following tableillustrates the effect on net income and earnings per share if the Company hadapplied the fair value recognition provisions of FAS 123, *Accounting for Stock-Based Compensation*,to stock-based employee compensation for the quarters ended March 31, 2004 and2003:

 

(In thousands, except per share data)

 
|                                                                                                              |   | **Three  Months Ended  March 31,** |   |
|-------------------------------------------------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                                                              |   | **2004**                           |   | **2003** |   |
|                                                                                                              |   |                               |   |   |   |
| Net loss  applicable to common stockholders, as reported                                                          |   | $                                  | (4,709 | ) | $ | (4,726 | ) |
| Add: Stock-based  employee compensation expense included in reported net loss                                     |   | 39                                 |   | 58 |   |
| Deduct: Total stock-based  employee compensation expense determined under fair value based method for  all awards |   | (449                               | )      | (408 | ) |
| Pro forma net  loss applicable to common stockholders                                                             |   | $                                  | (5,119 | ) | $ | (5,076 | ) |
|                                                                                                              |   |                               |   |   |   |
| Net loss per  share:                                                                                              |   |                               |   |   |   |
| Basic and  diluted - as reported                                                                                  |   | $                                  | (0.21  | ) | $ | (0.21 | ) |
|                                                                                                              |   |                               |   |   |   |
| Basic and  diluted - pro forma                                                                                    |   | $                                  | (0.22  | ) | $ | (0.22 | ) |

 

**(5)**                     **SIGNIFICANT CUSTOMERS**

 

For the three months ended March 31, 2004 and 2003,Johnson & Johnson Pharmaceutical Research and

 

5

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Development (J&J PRD) accounted for 16% and 35% ofthe Company’s revenue, respectively. Millennium Pharmaceuticals, Inc. accounted for 10% and 15% of revenuefor the three months ended March 31, 2004 and 2003, respectively.  Pfizer Inc. accounted for 38% of revenue forthe three months ended March 31, 2004. The collaboration agreement with J&J PRD expired in the firstquarter of 2004.

 

**(6)****                     INVESTMENTIN AFFILIATE**

 

In November 2003,the Company entered into several agreements with Sciona Limited (Sciona), aprivate company based in England, whereby the Company granted a technologylicense to Sciona (Technology License) in exchange for a 37% equity interest(30% on a fully diluted basis) in Sciona (Investment).  The Technology License grants Sciona an exclusivelicense to the Company’s *HAP*Technology for consumer products, as defined in the Technology License, for aperiod of five years.  Sciona isobligated to pay to the Company specified royalties and service fees subject tominimum annual payments.  The Companywas also granted specified rights to develop genotyping assays and performgenetic tests.

 

The Company agreed tofund certain expenses until Sciona reaches certain levels of financialperformance for up to 18 months (Sciona Milestones).  Since entering into the agreements, the Company has funded $118of Sciona expenses which are included in other current assets in theaccompanying 2004 condensed consolidated balance sheet.  Should Sciona not meet the ScionaMilestones, the Company may terminate the license and the equity interest willrevert back to Sciona (Termination Provision).

 

Deferred revenueresulting from the Technology License and the accompanying investment wereinitially recorded based upon the $2,600 estimated fair value of the equity inSciona as of the date of the Technology License. The excess of the Investmentover the underlying fair value of the net assets of Sciona is considered to beunamortizable goodwill.  Deferredrevenue will be amortized into income over the term of the Technology Licenseonce the Termination Provision has lapsed. The Company also includes, in equityin loss of affiliate in the accompanying condensed consolidated statement ofoperations, its percentage interest in the unaudited losses of Sciona andreduced the investment by a like amount. For the quarter ended March 31, 2004, the Company recorded $150 of suchlosses.  Also included in theaccompanying consolidated statement of operations for the quarter ended March31, 2004 is $47 of revenues for services provided to Sciona.

 

**(7)****                     LONG-TERMDEBT**

 

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 March 31, 2004) plus 2.5%. Borrowings under the agreement are secured by certain assets of theCompany.  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.  In addition, the agreement includes amaterial adverse change clause which provides that all amounts become due uponsuch a change.  The Company was incompliance with these covenants as of March 31, 2004.

 

**(8)****                     PREFERREDSTOCK**

 

In October 2003,the Company sold 270,000 shares of newly designated Series A RedeemableConvertible Preferred Stock (Series A), $0.001 par value per share, to RAMTrading, Ltd. (RAM) for $22.50 per share, resulting in proceeds ofapproximately $5,925, net of issuance costs of approximately $150.  In connection therewith, RAM was issued awarrant to purchase, in whole but not in part, an additional 190,000 shares ofSeries A through December 31, 2005, at $22.50 per share, which if exercisedwould result in gross proceeds to the Company of $4,275.  RAM is required to exercise the warrant ifthe price for the Company’s common stock closes above $4.00 for 23 consecutivebusiness days.

 

The Series A andthe warrant were recorded at their relative fair market values of $5,195 and$880, respectively, net of the issuance costs. As a result of the put rights discussed below, the difference in thestated value and the carrying value of the Series A, resulting from theallocation of the proceeds and the

 

6

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issuance costs, isaccreted to the earliest Put Date (as defined below) using the effectiveinterest rate method.  This accretionresults in a higher effective dividend and is reflected in net loss applicableto common stockholders in the accompanying consolidated statement of operationsfor the quarter ended March 31, 2004.

 

In connection withthe issuance of the Series A, the Company immediately recognized a charge of$2,200 which represents the beneficial conversion feature of the stock on thedate of issuance, which resulted from the difference between the fair value ofthe Company’s common stock and the price paid per common share equivalent. Inaddition, the Company is recognizing a $49 charge for the beneficial conversionfeature of the warrant over the life of the warrant.  If the warrant is exercised prior to its expiration date, anyoutstanding charges will be immediately recognized.  A charge of $6 is included in the accompanying 2004 condensedconsolidated statement of operations in connection with the beneficialconversion feature of the warrant. This beneficial conversion is also reflectedin net loss applicable to common stockholders in the accompanying 2004condensed consolidated statement of operations.

 

The rights of theSeries A holders are as follows:

 

Voting Rights –the holders of Series A are entitled to vote on all matters and shall beentitled to .88 votes per share of common stock into which each share of SeriesA is convertible.

 

Dividend Rights - theSeries A earns a dividend at the rate of 2% per annum payable in cash inarrears semi-annually in January and July. Included in accrued dividends in the accompanying 2004 balance sheet is$29 related to the Series A dividends.

 

Conversion Rights- Each share of Series A is convertible into ten shares of common stock at theoption of the holder.  On or afterOctober 29, 2006, the Company can require the conversion of the Series A if thecommon stock has traded above $7.00 for 23 consecutive business days.

 

Redemption Rights - Underthe terms of the Series A, the Company is required to redeem, unless theholders of at least 66 2/3%of the Series A elect otherwise, all of the outstanding shares of Series A if asignificant event, as defined, occurs or the Company breaches certaincovenants.  The redemption value is theoriginal stated purchase price of $22.50 per share, plus accrued but unpaiddividends.  A significant event is generallydefined as a dissolution of the Company or the sale of the Company or substantiallyall of its assets.  If the significantevent or breach occurs prior to October 29, 2008, the face value plus all ofthe unpaid cash dividends through October 29, 2008 also become payable ($6,660at March 31, 2004).  In addition, RAMhas the option to require that the Company redeem all of the outstanding sharesof Series A on either October 29, 2006, 2007 or 2008 (Put Dates). The Companymay delay such payment for up to one year, in which case the dividend ratewould increase to 10% per annum.

 

In connection with theissuance of the Series A, the Company is required to maintain certaincovenants.  The****most significant of thesecovenants restricts the Company from: (i) incurring indebtedness in excess of$11,000 ($7,000 if the warrant is exercised); (ii) paying dividends on itscommon stock; and (iii) redeeming any equity securities.  The Company was in compliance with thesecovenants as of March 31, 2004.

 

**(9)****                     COMPREHENSIVELOSS**

 

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 transactions and other economic events during the period other thantransactions with owners.  The Company’sother comprehensive income (loss) arises from net unrealized gains (losses) onmarketable securities. 

 

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

 
|                      |   | **Three  Months Ended  March 31,** |   |
|---------------------------|--------|------------------------------------|--------|
|                      |   | **2004**                           |   | **2003** |   |
|                      |   |                               |   |   |   |
| Net loss                  |   | $                                  | (4,709 | ) | $ | (4,726 | ) |
| Other  comprehensive loss |   | 7                                  |   | (17 | ) |
| Total  comprehensive loss |   | $                                  | (4,702 | ) | $ | (4,743 | ) |

 

**(10)****              COMMITMENTSAND CONTINGENCIES**

 

In November 2002, theFASB issued FASB Interpretation No. 45 (FIN 45), *Guarantor’s Accounting and Disclosure Requirements for Guarantees,including Indirect Guarantees of Indebtedness of Others*, aninterpretation of SFAS Nos. 5, 57 and 107 and Rescission of FIN 34.  FIN 45 clarifies the requirements of SFASNo. 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.

 

Inthe ordinary course of its business, the Company enters into agreements withthird parties that include indemnification provisions which, in the Company’sjudgment, are normal and customary for companies in its industry sector. Theseagreements are typically with business partners, clinical sites, and suppliers.Pursuant to these agreements, the Company generally agrees to indemnify, holdharmless and reimburse the indemnified parties for losses suffered or incurredby the indemnified parties with respect to the Company’s products or productcandidates, use of such products or other actions taken or omitted by theCompany. The maximum potential amount of future payments the Company could berequired to make under these indemnification provisions is unlimited, and theCompany may have insurance coverage related to any potential loss. The Companyhas not incurred any costs to defend lawsuits or settle claims related to theseindemnification provisions. As a result, the current estimated fair value ofliabilities relating to these provisions is minimal. Accordingly, the Companyhas not recorded a liability for these provisions as of March 31, 2004.

 

**(11)****              RECENTLYISSUED ACCOUNTING PRONOUNCEMENTS**

 

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In May 2003, the FASB issuedStatement No. 150 (SFAS No. 150),*Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity*. SFAS No. 150 specifies that instruments within its scopeembody obligations of the issuer and that the issuer must classify them asliabilities. SFAS No. 150 requires issuers to classify as liabilities thefollowing three types of freestanding financial instruments: (1) mandatorilyredeemable financial instruments, (2) obligations to repurchase the issuer’sequity shares by transferring assets, and (3) certain obligations to issue avariable number of shares. SFAS No. 150 defines a “freestanding financialinstrument” as a financial instrument that (1) is entered into separately andapart from any of the entity’s other financial instruments or equitytransactions or (2) is entered into in conjunction with some other transactionand can be legally detached and exercised on a separate basis. For allfinancial instruments entered into or modified after May 31, 2003, SFASNo. 150 is effective immediately. For all other instruments of publiccompanies, SFAS No. 150 went into effect at the beginning of the first interimperiod beginning after June 15, 2003. The adoption of SFAS No. 150 did nothave a material impact on the Company's financial statements. In November 2003,the FASB deferred the effective date for selected provisions of SFAS No. 150,limited to mandatorily redeemable, noncontrolling interests associated withfinite-lived subsidiaries. The deferral of those selected provisions is notexpected to have a material impact on the Company's financial statements.

 

**(12)****              SUBSEQUENTEVENT**

 

On April 1, 2004 thestockholders of the Company and the stockholders of Lark Technologies, Inc.(Lark) voted to approve the plan of merger the two companies entered into inDecember 2003, and the merger closed that day. Under the terms of the agreement, the Company acquired Lark in astock-for-stock exchange accounted for as a purchase transaction.  Lark provides contract molecular biologyservices to the pharmaceutical, biotechnology and agbio industries.

 

Lark stockholders received1.81 shares of the Company’s common stock in exchange for each Lark share ofcommon stock, or an aggregate of approximately 7,111 shares of the Company’scommon stock.  In addition, options topurchase approximately 800 shares of Lark common stock were converted intooptions to purchase approximately 1,450 shares of the Company’s commonstock.  The total cost of theacquisition is $25,758 consisting of the following:

 
|                                                                                                   |   | **(Unaudited)** |   |
|--------------------------------------------------------------------------------------------------------|--------|-----------------|--------|
| Market value of  the Company’s common stock issued in exchange for outstanding Lark common  stock |   | $               | 21,120 |   |
| Fair value of  Lark stock options assumed                                                              |   | 3,524           |   |
| Direct  transaction costs of the Company                                                               |   | 1,114           |   |
|                                                                                                   |   | $               | 25,758 |   |

 

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The purchase price will beallocated to the tangible and identifiable intangible assets of Lark acquiredby the Company and the liabilities assumed by the Company on the basis of theirfair values on the acquisition date. Based on the financial statements of Lark as of December 31, 2003, theCompany has preliminarily allocated the total costs of the acquisition to thenet assets of Lark as follows:

 
|                                     |   | **(Unaudited)** |   |
|------------------------------------------|--------|-----------------|--------|
| Tangible assets  acquired                |   | $               | 5,795  |   |
| Identifiable  intangible assets acquired |   | 11,037          |   |
| Goodwill                                 |   | 11,783          |   |
| Liabilities  assumed                     |   | (2,857          | )      |
| Total purchase  price                    |   | $               | 25,758 |   |

 

The allocation of thepurchase price is preliminary and will remain as such until the closing balancesheet of Lark is obtained.  The finalamounts allocated to assets and liabilities acquired could differ materiallyfrom the amounts presented above. Identifiable intangible assets include backlog of $200 with an estimateduseful life of one year, customer relationships of $7,200 with an estimateduseful life of 15 years, and GLP certification of $137 and trade name of $3,500that have indefinite useful lives.  Theamount allocated to goodwill will not be deductible for tax purposes.  Commencing on April 1, 2004, the date ofacquisition, the Company will include the results of operations from Lark inits consolidated financial statements.

 

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**Item2 – Management’s Discussion and Analysis of Financial Condition and Results ofOperations.**

 

*The following discussion andanalysis of our financial condition and the results of operations should beread in conjunction with the financial statements and related notes appearingelsewhere in this Quarterly Report on Form 10-Q.  This Quarterly Report on Form 10-Q contains forward-lookingstatements within the meaning of Section 21E of the Securities Exchange Act of1934, as amended, that involve risks and uncertainties, including, but notlimited to, statements about management’s expectations as to our revenue, costsand liquidity position.  Theseexpectations are based on certain assumptions regarding our research anddevelopment activities, projected expenditures, the ability of our technologiesto improve the drug development process, success of our commercializationefforts and growth in our revenue and other factors relating to ourbusiness.  These expectations may notmaterialize if development efforts are delayed or suspended or if otherassumptions prove incorrect.  Thesefactors are more fully discussed below under the heading “Factors AffectingFuture Operating Results” and in our other filings with the Securities andExchange Commission.  Readers arecautioned not to place undue reliance on these or other forward-lookingstatements, which reflect management’s analysis, judgment, belief orexpectation only as of the date on which they are made.  While we may elect to update forward-lookingstatements at some time in the future, we specifically disclaim any obligationto do so, even if our estimates change.*

 

**CommonTerms**

 

We use the following terms in this Management’sDiscussion and Analysis of Financial Condition and Results of Operations:

 

*HAP*Technology – the key components of our *HAP* Technology are:  a database of highly-informative,proprietary measures of genomic variation, or haplotypes, which we call *HAP*Markers, for pharmaceutically relevant genes; a proprietary informatics system,which we call *DecoGen*, includingunique algorithms, for defining patient populations with different drugresponses; a cost-effective, efficient process for measuring genomic variationin clinical DNA samples, which we call *HAP* Typing; Good Laboratory Practices(GLP) compliant DNA banking and genotyping services and clinical geneticsdevelopment skills.

 

STRENGTH program (Statin Response Examined by Genetic *HAP*Markers) – this program was designed to apply our *HAP* Technology and ourclinical genetics development skills to the statin class of drugs, whichdoctors use to treat patients with high cholesterol and lipid levels and whoare, therefore, at risk for cardiovascular disease.

 

CARING program (Clozapine and Agranulocytosis Relationshipsinvestigated by Genetics (*HAP*Markers)) – this program was designed to identify which of our *HAP*Markers define the patients who are most likely to develop agranulocytosis, apotentially life-threatening depletion of white blood cells, if treated withclozapine.

 

Cardiac Channelopathies program – this program was designed to developa genetic test compliant under the Clinical Laboratory Improvement Amendments(CLIA) for detecting cardiac ion channel mutations. Cardiac channelopathies,including familial Long QT (LQT) and Brugada Syndromes, are conditions thataffect the electrical system of the heart. These conditions are caused bygenetic mutations that result in structural abnormalities in the potassium andsodium channels of the heart and predispose affected individuals to an abnormalheart rhythm (arrhythmia). Familial LQT and Brugada Syndromes are commonly seenin apparently healthy, active adolescent patients.  If left undiagnosed and untreated, these conditions can be fatal.We will also seek to discover genetic markers that are predictive of QTprolongation and arrhythmias, which are drug induced and occur in patients withother disorders, such as congestive heart failure.

 

Proprietary Programs – The three programs described above are referredto collectively as our Proprietary Programs.

 

**Overview**

 

We are a leader inthe discovery and use of human gene variation for the development of a newgeneration of DNA-based diagnostic and therapeutic products. Our technology,services and clinical development expertise are marketed to pharmaceutical,biotechnology and diagnostic companies, as a comprehensive solution to theirpharmacogenomic needs.  Our goal is toimprove drug development, drug therapy prescribed by physicians and the

 

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quality of a patient’slife by elucidating the role of genetic variation in drug response.Additionally, we provide DNA banking and research, and genotyping and relatedservices, to a variety of companies in accordance with GLP.

 

Since our inception, wehave incurred significant operating losses, and, as of March 31, 2004, we hadan accumulated deficit of $216.9 million. The majority of our operating losses have resulted from costs weincurred developing our *HAP* Technology, in our clinical trials andfrom administrative costs associated with operations.  As part of our *HAP*Technology platform, we continue to populate our database with *HAP* Marker information for pharmaceuticallyrelevant genes.  As of March 31, 2004,we had a total of 7,895 genes in our database with 279 of these genes havingbeen added during the quarter ended March 31, 2004, and 528 genes having beenadded during the quarter ended March 31, 2003. There is not necessarily any correlation between the costs incurred inany period and the number of genes added to the database in that period.  This is due to the fact that the size of thegene and, therefore, the amount of work involved varies from gene to gene.  In addition, after a gene is sequenced itmust be analyzed and go through an internal quality assurance check before itis added to the database.  This processmay cause a gene sequenced in one period to be added to the database in adifferent period.  Furthermore, sinceadditional information about genes continues to be discovered, we mayresequence genes previously included in the database and do further qualityassurance analysis.  We expect todedicate a significant portion of our resources for the foreseeable future toservicing our *HAP* Technologycustomers and STRENGTH program customers, our pharmacogenomics support servicescustomers, to develop our CARING and Cardiac Channelopathies programs, and tomaintain our *HAP* Technology.  Todate, our revenue has been primarily from licensing and service fees from ouragreements with AstraZeneca UK Limited, Biogen Idec, Inc., Gene Logic, Inc.,Johnson & Johnson Pharmaceutical Research & Development (J&J PRD),Millennium Pharmaceuticals, Inc. (Millennium) and Pfizer Inc., as well as asublicensing agreement with Visible Genetics, Inc. and, to a lesser extent,government grants.

 

**Acquisitions**

 

*Lark Technologies, Inc.*

 

On April 1, 2004, ourstockholders and the stockholders of Lark Technologies, Inc. (Lark) voted toapprove the Agreement and Plan of Merger (Merger Agreement) we entered into inDecember 2003, and the transaction closed that day.  Under the terms of the Merger Agreement, we acquired Lark in astock-for-stock exchange. Each Lark stockholder received 1.81 shares of ourcommon stock for each share of Lark held. As of the closing date, the former Lark stockholders held approximately19.2 % of total outstanding shares of Genaissance assuming the conversion ofour Series A preferred stock and the exercise and conversion of a Series Apreferred stock warrant.

 

Lark provides contractmolecular biology services to the pharmaceutical, biotechnology and agbioindustries at its facilities in Houston and England.  Lark’s contract research service portfolio consists of over onehundred different molecular biology services in the areas of nucleic acidextraction services, DNA sequencing services, genetic stability testingservices, gene expression and detection services, and custom molecular biologyservices.

 

We will record thetransaction as a purchase for accounting purposes and allocate the purchaseprice of approximately $25.8 million to the assets purchased and liabilitiesassumed based upon their respective fair values.  We will allocate the excess of the purchase price over theestimated fair market value of the net tangible assets acquired to identifiedintangibles with estimated useful lives as follows: backlog – 1 year; customerrelationships – 15 years; and GLP certification and trade name – indefinite. Wecurrently estimate the resulting goodwill will be approximately $11.8 million;however, the actual amount will be dependent upon the closing balance sheet ofLark.  Based on our initial estimates ofacquired intangibles, we would expect to incur charges for amortization ofintangibles of approximately $680,000 in the first twelve months post-closingand approximately $480,000 per year thereafter.

 

Our consolidated financialstatements will include the results of operations and cash flows of Lark from theclosing date.  We expect that althoughLark will contribute positive operating results, we will still incur net lossesin the foreseeable future.  The extentof the benefits received from the acquisition will depend upon how quickly weare able to integrate Lark’s operations with our operations including salesforces and operational efficiencies.

 

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*DNASciences, Inc.*

 

On May 15, 2003, under order of the United StatesBankruptcy Court, we acquired certain assets and assumed certain liabilities ofDNA Sciences, Inc. for $1.8 million, inclusive of related fees andexpenses.  The primary assets acquired consisted of a GLP compliant DNAbanking and a GLP compliant and CLIA licensed genotyping services business andlicenses and patent estates surrounding Long QT Syndrome and a thiopurineS-methyltransferase (TPMT) test, as well as certain trade accounts receivableand fixed assets.  By combining DNA Sciences’ offerings of GLP compliantDNA banking and GLP compliant genotyping services with our *HAP* Technology and high-throughputresearch genotyping capabilities, we provide a broader range of offerings forthe application of pharmacogenomics to the clinical development and marketingof drugs.

 

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

###### ** **

Our financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (GAAP).  The preparation offinancial statements in accordance with GAAP requires management to makeestimates and assumptions that affect the amounts reported in our financialstatements and accompanying footnotes. We base our estimates on historical experience and on various otherassumptions that we believe to be reasonable under the circumstances, theresults of which form our basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from othersources.  Actual results may differ fromestimates, sometimes materially. Critical accounting policies and estimates are defined as those that areboth most important to the portrayal of our financial condition and results andrequire management’s most subjective judgments.

 

Our critical accounting policies are as follows:

 

•                       revenuerecognition;

 

•                       valuationof long-lived assets; and 

 

•                       researchand development expenses.

 

Revenue recognition. We earn our revenue primarily through the licensing of our *HAP* Technology and by providing researchgenotyping services and GLP compliant DNA banking and genotyping services.  We have also entered into agreements whichprovide for us to receive future milestones and royalty payments.  We recognize revenue in accordance withStaff Accounting Bulletin No. 104, *RevenueRecognition* (SAB 104) (which supercedes Staff Accounting BulletinNo. 101, *Revenue Recognition in FinancialStatements*), Statement of Position 97-2, *Software Revenue Recognition* (SOP 97-2), as amended byStatement of Position 98-9, and Emerging Issues Task Force Issue 00-21, *Arrangements with Multiple Deliverables*(EITF00-21).  In accordance with SAB 104 andEITF 00-21, 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,revenue is not recognized unless the fair value of the undelivered elements canbe determined and the elements delivered have stand-alone value to thecustomer.  Future milestones and royaltypayments, if any, will be recognized when received provided that the milestone issubstantive and a culmination of the earnings process has occurred.  Deferred revenue results from cash receivedor amounts receivable in advance of revenue recognition.  The timing of revenue recognition isdependent on when contracts are signed and data is delivered and can fluctuatesignificantly between periods.

 

Valuation of long-livedassets. We assessthe impairment of long-lived assets whenever events or changes in circumstancesindicate that the carrying value of the assets may not be recoverable.  Factors which could trigger an impairmentreview, include:

 

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

 

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

 

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•                                asignificant decrease in the market value of assets.

 

If we determine that the carrying value of thelong-lived assets may not be recoverable, based upon the existence of one ormore of the above indicators of impairment, we compare the carrying value ofthe asset group to the undiscounted cash flows expected to be generated by thegroup.  If the carrying value exceedsthe undiscounted cash flows, an impairment charge may be needed.  To determine the amount of the impairmentcharge, we compare the carrying value of the applicable fixed asset group toits fair value.  We determine the fairvalue of the fixed asset group by discounting expected future cash flow using adiscount rate determined by us to be commensurate with the risk inherent in ourcurrent business.  If the fair value isless than the carrying value, such amount is recognized as an impairmentcharge.  If an impairment charge isrequired in future periods, it could result in a material, non-cash charge inour statement of operations.

 

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

 

**Results of Operations**

 

***Three Months Ended March 31, 2004 and 2003***

 

Revenue consists primarily of revenue recognized inconnection with the licensing of our *HAP*Technology and from *HAP* Typingand GLP compliant DNA banking and genotyping services.  Revenue increased to $3.7 million for the threemonths ended March 31, 2004 from $2.1 million for the same period in 2003. Theincrease in revenue is attributable to $860,000 in laboratory services revenuerecognized for services provided by our GLP compliant and CLIA licensedlaboratory which we acquired through the purchase of certain of the net assetsof DNA Sciences in May 2003.  Theincrease is also due to increased commercialization of our *HAP* Technology.  Revenue from J&J PRD, Millennium and Pfizer Inc. accountedfor 64% of our total revenue for the three months ended March 31, 2004.  Revenue from J&J PRD and Pfizer Inc.accounted for 54% of our total revenue for the same period in 2003.  The contract with J&J PRD, whichaccounted for 16% of our revenue for the three months ended March 31, 2004,expired in January 2004.

 

Cost of laboratory services consists of payroll andbenefits for personnel, materials and reagent costs, depreciation andmaintenance and facility-related costs incurred by our GLP compliant facilitywhich we acquired through the acquisition of certain of the assets of DNASciences in May 2003.  The cost oflaboratory services is $861,000 for the three months ended March 31, 2004.  Due to the high fixed cost nature of thisfacility, we expect the cost of laboratory services to decrease as a percentageof sales as we grow our revenue in our GLP operation.

 

Research and development expenses consist primarily ofpayroll and benefits for research and development personnel, materials andreagent costs, costs incurred in connection with clinical trials, depreciationexpense and maintenance costs for equipment used for *HAP* Marker discovery and *HAP*Typing, technology license fees and facility-related costs.  We expense our research and developmentcosts as incurred.  Research and developmentcosts increased to $5.0 million for the three months ended March 31, 2004 from$4.7 million for the same period in 2003. Substantially all of our research and development expenditures areincurred in developing our *HAP*Technology, and in conducting our Proprietary Programs.  The following is a breakdown of research anddevelopment expenses (in thousands):

 
|                           |   | **Three  Months Ended** |   |
|--------------------------------|--------|-------------------------|--------|
|                           |   | **March 31,  2004**     |   | **March 31,  2003** |   |
| Payroll and  benefits          |   | $                       | 2,090  |   | $ | 1,800 |   |
| Depreciation and  amortization |   | 1,335                   |   | 1,590 |   |
| Material and  reagent costs    |   | 550                     |   | 530 |   |
| Technology  license fees       |   | 255                     |   | 90 |   |
| Repairs and  maintenance       |   | 135                     |   | 160 |   |
| Stock-based  compensation      |   | 100                     |   | 40 |   |
| Other                          |   | 547                     |   | 529 |   |
|                           |   |                    |   |   |   |
| Total                          |   | $                       | 5,012  |   | $ | 4,739 |   |

 

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The increase in research and development expenses forthe three months ended March 31, 2004 is primarily attributable to an increaseof approximately $290,000 in payroll and benefits.  The increase in payroll and benefits is due to a minor increasein personnel associated with the growth in our business and a general increasein salaries.  We expect to continue todevote substantial resources to research and development expenses in the nearfuture as we continue to develop our *HAP*Technology, including investments in ongoing product development andimprovements related to our *DecoGen*Informatics System.  One of ourstrategic goals is to in-license a compound for further clinicaldevelopment.  Should that occur, ourresearch and development expenses would substantially increase.

 

General and administrative expenses consist primarilyof payroll and benefits for executive, business development, finance and otheradministrative personnel, as well as facility related costs and outsideprofessional fees incurred in connection with corporate development, generallegal and financial matters.  Generaland administrative expenses increased to approximately $2.4 million for thethree months ended March 31, 2004 from $2.1 million for the same period in2003.  The increase in general andadministrative expenses for the three months ended March 31, 2004 is primarilydue to an increase in professional fees and a general increase in payroll andrelated expenses.

 

Other income decreased to approximately $75,000 forthe three months ended March 31, 2004 from $134,000 for the same period in2003.  The decrease is primarily due toa decrease in interest income as a result of higher cash, cash equivalents andshort-term investment balances in 2003.

 

Interest expense decreased to approximately $180,000for the three months ended March 31, 2004 from $201,000 for the same period in2003.  The decrease is primarily due tolower debt balances in 2004.

 

State income tax benefit increased to $49,000 for thethree months ended March 31, 2004.  Thebenefit represents a net tax benefit from the State of Connecticut (State) as aresult of legislation which allows companies to receive cash refunds from theState at a rate of 65% of their incremental research and development taxcredit, as defined, in exchange for foregoing the carryforward of the researchand development tax credit.  The Statehad allowed the exchange program to lapse for the 2002 tax year, however,during 2003, the State passed legislation to reinstate the program for the 2002through 2004 tax years.

 

Equity in loss ofaffiliate of $150,000 for the three months ended March 31, 2004 represents ourpercentage interest in the unaudited losses of Sciona Limited (Sciona) based onour 37% equity interest in Sciona.  InNovember 2003, we granted Sciona a license to our technology in exchange for anequity interest.  We expect that theloss from Sciona will average approximately $150,000 per quarter for 2004 asSciona develops its products and commercialization plans.

 

During the fourth quarterof 2003, in connection with our issuance of Series A preferred stock, wegranted a warrant to purchase additional shares of Series A preferred stock andwill recognize a charge of approximately $49,000 for the beneficial conversionfeature embedded in the warrant over the life of the warrant.  The total charge recognized for the threemonths ended March 31, 2004 is $6,000. If the warrant is exercised prior to its expiration, we will immediatelyrecognize any remaining charges associated with this beneficial conversionfeature.

 

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**Liquidity and Capital Resources**

 

Our liquidityrequirements have historically consisted, and we expect that they will continueto consist, of capital expenditures, working capital, business developmentexpenses, debt service, research and development expenses, general corporateexpenses and acquisitions.

 

We have financed our operations primarily through theprivate and public sale of common and preferred stock, government researchgrants, payments under licensing agreements, loans and capital leases.  From inception through March 31, 2004, wehave received aggregate gross proceeds of approximately $169.3 million from theissuance of common and preferred stock. In addition, through March 31, 2004, we have received $4.5 million ofgovernment grant funding and $30.5 million from license and service fees,royalties and research contracts.  Wehave also received $26.2 million from capital lease financing arrangements and$13.2 million from other loans. Through March 31, 2004, we have acquired $43.3million of property and equipment. These assets were largely financed through capital lease financingarrangements and other loans.

 

***Cash and Cash Equivalents***

 

At March 31, 2004, cash, cash equivalents andshort-term investments totaled $11.4 million compared to approximately $16.8million at December 31, 2003.  Our cashreserves are held in interest-bearing, high-grade corporate bonds and moneymarket accounts.

 

***Cash Flow***

 

Cash used in operations for the three months endedMarch 31, 2004, was $4.4 million compared with $2.0 million for the same periodin 2003. The cash used in operations for the three months ended March 31, 2004resulted primarily from a net loss of $4.7 million and a $1.4 million decreasein accrued expenses, partially offset by $1.8 million of non-cash charges fordepreciation and amortization expense, stock-based compensation and the loss inequity of affiliate.  The cash used inoperations for the three months ended March 31, 2003 resulted primarily from anet loss of $4.7 million, partially offset by $1.8 million of non-cash chargesfor depreciation and amortization expense and stock-based compensation, a$433,000 increase in accounts payable and accrued expenses and a $381,000decrease in accounts receivable.

 

Cash provided by investing activities was $2.2 millionfor the quarter ended March 31, 2004 compared with $2.2 million for the sameperiod in 2003.  For the three monthsended March 31, 2003, we used $410,000 for the purchase of property andequipment and received net proceeds of $2.7 million from the maturity ofinvestments in marketable securities. For the three months ended March 31, 2003, we used cash to purchase$410,000 of property and equipment and received net proceeds of $2.7 millionfrom the liquidation of investments in marketable securities.

 

Cash used in financing activities for the three monthsended March 31, 2004 was $514,000 compared to $1.7 million for the same periodin 2003.  For the three months endedMarch 31, 2004, we used cash of approximately $506,000 for the repayment oflong-term debt.  During the firstquarter of 2003, we repaid capital lease obligations and long-term debt ofapproximately $1.7 million.

 

***Short-Term Funding Requirements***

 

We believe that our existing cash reserves will besufficient to fund our expected net losses, debt obligations and capitalexpenditures for at least the next 12 months based upon our current activities.We expect to continue to finance our operations from cash we received inOctober 2003 from the sale of our Series A preferred stock, revenue from our *HAP* Technology customers and ourpharmacogenomic support service customers and revenue generated by Lark whichwe acquired effective April 1, 2004.  Ourbusiness strategy depends on, among other things, entering into *HAP* Technology agreements withpharmaceutical and biotechnology companies. If we are unsuccessful in marketing our programs and growing our servicerevenues, we may not generate sufficient revenue to sustain our operations atplanned levels. We expectto expend substantial funds to conduct research and development activities andother general and administrative activities. Our expenditures for theseactivities will include required payments under operating leases and long-termdebt agreements and licensing, collaboration and

 

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service agreements.  Capital expenditures are not currentlyexpected to exceed $1.5 million for each of fiscal 2004 and 2005.

 

***Long-Term Funding Requirements***

 

For periods beyond 12 months, even if we grow ourrevenue significantly, we will need to seek additional funding through publicor private equity financings, debt financings or commercial customers.  Our business strategy depends on, amongother things, entering into partnership agreements with pharmaceutical andbiotechnology companies and growing the revenue from our pharmacogenomicsupport services business.  We cannot assureyou that we will obtain additional customers or capital funding on acceptableterms, if at all.  If we areunsuccessful in obtaining new customers for our *HAP* Technology, growing the revenue from our pharmacogenomicsupport services business, or obtaining additional financing funds, we may notgenerate sufficient funds to sustain our operations at planned levels, and wemay have to delay, reduce the scope of, or eliminate one or more aspects of ourbusiness development activities.  Inaddition, we cannot incur indebtedness above certain levels or issue anycapital stock or other equity securities having rights, preferences, privilegesor priorities pari passu with or senior to our Series A preferred stock withoutthe vote or written consent of holders of at least 66-2/3% of our Series A preferredstock then outstanding.

 

Our cash requirements in the long term will varydepending upon a number of factors, many of which may be beyond our control,including:

•                       our abilityto retain and find new customers for our *HAP* Technology;

•                       our abilityto grow profitably our pharmacogenomic support services business;

•                       our abilityto successfully commercialize diagnostic tests;

•                       whether wesuccessfully in-license a drug candidate;

•                       thecommercialization of intellectual property derived from our *HAP*Technology;

•                       the levelof competition we face;

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

•                       our abilityto maintain and develop our *HAP*Technology;and

•                       our abilityto manage effectively our operating expenses.

 

**IncomeTaxes**

 

We have not generated anytaxable income to date and, therefore, have not paid any federal income taxessince inception.  On December 31, 2003,we had available unused net operating loss carryforwards of approximately$133.6 million and $131.8 million, which may be available to offset futurefederal and state taxable income, respectively.  Use of our federal and state net operating loss carryforwards,which will begin to expire in 2007 and 2004, respectively, may be subject tolimitations.  The future utilization ofthese carryforwards may be limited due to changes within our current and futureownership structure.  We have recorded afull valuation allowance against our deferred tax assets, which consists primarilyof net operating loss carryforwards, because of uncertainty regarding theirrecoverability, as required by Statement of Financial Accounting Standards No.109, *Accounting for Income Taxes*.

 

**Off-Balance Sheet Financing**

 

During the year ended December 31, 2003, we have not engaged in materialoff-balance sheet activities, including the use of structured finance orspecific purpose entities.

 

**Recent Accounting Pronouncements**

 

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In May 2003, the FASB issuedStatement No. 150 (SFAS No. 150),*Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity*. SFAS No. 150 specifies that instruments within its scopeembody obligations of the issuer and that the issuer must classify them asliabilities. SFAS No. 150 requires issuers to classify as liabilities thefollowing three types of freestanding financial instruments: (1) mandatorilyredeemable financial instruments, (2) obligations to repurchase the issuer’sequity shares by transferring assets, and (3) certain obligations to issue avariable number of shares. SFAS No. 150 defines a “freestanding financialinstrument” as a financial instrument that (1) is entered into separately andapart from any of the entity’s other financial instruments or equitytransactions or (2) is entered into in conjunction with some other transactionand can be legally detached and exercised on a separate basis. For allfinancial instruments entered into or modified after May 31, 2003, SFASNo. 150 is effective immediately. For all other instruments of publiccompanies, SFAS No. 150 went into effect at the beginning of the first interimperiod beginning after June 15, 2003. The adoption of SFAS No. 150 did nothave a material impact on our financial statements. In November 2003, the FASBdeferred the effective date for selected provisions of SFAS No. 150, limited tomandatorily redeemable, noncontrolling interests associated with finite-livedsubsidiaries. The deferral of those selected provisions is not expected to havea material impact on our financial statements.

 

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**Factors Affecting Future OperatingResults**

 

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

 

**We are anearly stage company with a history of losses and we expect to incur net lossesfor the foreseeable future such that we may never be profitable.**

 

We have incurred substantialoperating losses since our inception. As of March 31, 2004, we havegenerated only minimal revenue from our *HAP*Technology and our pharmacogenomic support services, and we do not expect togenerate significant revenue for several years. From inception throughMarch 31, 2004, we had an accumulated deficit of approximately$216.9 million. Our losses to date have resulted principally from costs weincurred in the development of our *HAP*Technology, in conducting our Proprietary Programs and from general andadministrative costs associated with operations. We expect to devotesubstantially all of our resources to service our *HAP* Technology customers and STRENGTH program customers, ourpharmacogenomic support services customers and conduct our other ProprietaryPrograms and to maintain our *HAP*Technology.

 

We expect to incuradditional losses this year and in future years, and we may never achieveprofitability. In addition, pharmaceutical and biotechnology companies are onlynow beginning to use products such as ours in their drug and diagnosticdevelopment or marketing efforts and, accordingly, they may not choose to useour *HAP* Technology. We do notexpect our losses to be substantially mitigated by revenue from our *HAP* Technology customers and STRENGTHprograms, and our CARING and Cardiac Channelopathies programs, if any, or fromour pharmacogenomic support services for a number of years.

 

**We currently rely on a limitednumber of licensing and service arrangements for substantially all of ourrevenue. As a result, the loss of one major customer or our inability to secureadditional significant customers during a given period would have an adverseeffect on our business and operating results.**

 

We are dependent upon alimited number of licensing and service arrangements that representsubstantially all of our revenue. In the quarter ended****March 31, 2004, three of our customers,J&J PRD, Millennium and Pfizer Inc., accounted for 64% of our revenue andeach accounted for more than 10% of our revenue. The agreement with J&J PRDwhich accounted for 16% of the revenue for the first quarter of 2004 expired inJanuary 2004. No other customer accounted for 10% or more of our revenue in thequarter ended****March 31, 2004.If we are unable to replace in a timely fashion, upon substantially similarfinancial terms, the agreement that expired in the first quarter of 2004, or ifwe lose and are not able to replace customers that provide us with significantrevenue, it could have a material adverse effect on our revenue and on ourbusiness in general and could cause volatility or a decline in our stock price.

 

**To generate significant revenue, wemust obtain additional customers for our *HAP*Technology and our Proprietary Programs and for our pharmacogenomic supportservices.**

 

Our strategy depends onentering into agreements with pharmaceutical and biotechnology companies forour *HAP* Technology and ourProprietary Programs and obtaining additional customers for our pharmacogenomicsupport services. Our contracts with many of our *HAP* Technology customers and for our pharmacogenomic supportservices are for specific limited-term projects. We may not be successful inobtaining additional customers for our *HAP*Technology and our STRENGTH program or obtaining any customers for ourProprietary Programs or obtain sufficient new customers for our pharmacogenomicsupport services to replace our current projects. If we are unsuccessful infinding additional customers for our *HAP*Technology and our STRENGTH program or in finding any customers for our otherProprietary Programs or new customers for our pharmacogenomic support services,we

 

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may never generatesufficient revenue to sustain our operations. In addition, we expect that someof our future *HAP* Technologycollaborations, like some of our current *HAP*Technology collaborations, will be limited to specific, limited-term projectsor that some of these collaborations may not be renewed. Accordingly, we mustcontinually obtain new customers to be successful. To date, the integration ofpharmacogenomics into drug development and marketing has not achievedwidespread market acceptance.

 

**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 havefluctuated in the past and we expect they will fluctuate in the future. Thesefluctuations could cause our common stock price to decline. Some of the factorsthat could cause our operating results to fluctuate include:

 

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

•                  demand for andmarket acceptance of our *HAP*Technology, Proprietary Programs and for our pharmacogenomic support services;

•                  timing of theexecution of agreements on our *HAP*Technology, Proprietary Programs and other material contracts;

•                  our competitors’announcements or introduction of new products, services or technologicalinnovations;

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

•                  our ability tocontrol operating expenses;

•                  disputesregarding patents or other intellectual property rights;

•                  securities classactions or other litigation;

•                  adverse changesin the level of economic activity in the United States and other major regionsin which we conduct business; and

•                  general andindustry-specific economic conditions, which may affect our customers’ use ofour *HAP* Technology.

 

Due to volatile andunpredictable revenue and operating expenses, we believe that period-to-periodcomparisons of our results of operations may not be a good indication of ourfuture performance. It is possible that our operating results may be below theexpectations of securities analysts or investors. In this event, the marketprice of our common stock could fluctuate significantly or decline.

 

**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 statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofour assets, liabilities, revenue and expenses, the amounts of charges we accrueand related disclosure of contingent assets and liabilities. For example, wehave recorded certain patent estates as long-term intangible assets based ontheir value at the date of acquisition. Events could occur that would cause usto re-evaluate the life of those assets and, therefore, whether those assetshave been impaired, resulting in an impairment charge. We based the estimates wemake on historical experience and on various other assumptions that we believedto be reasonable at the time and under the circumstances. If the estimatesrelating to our patent estate are determined to be incorrect, a write-down maybe required, which could have a material adverse effect on our financialcondition. There can be no assurance that any of our estimates or theassumptions underlying our estimates will be correct.

 

**We may require additional fundingto fund operations and repay debt and we may not be able to obtain any suchfunding.**

 

We have used substantialamounts of cash to fund our research and development activities. We willcontinue to spend funds to service our *HAP*Technology customers and STRENGTH program customers, our

 

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pharmacogenomic supportservices customers, to conduct our CARING and Cardiac Channelopathies programsand to maintain our *HAP*Technology. We plan to pay for these activities with funds from:

 

•                  our existingcash and investment securities;

•                  income that wemay receive from our *HAP*Technology customers and STRENGTH program customers and pharmacogenomic supportservices customers; and

•                  proceeds that wemay receive from the exercise of our outstanding Series A preferred stockwarrant.

 

We intend to rely on ourcurrent *HAP* Technology customersand STRENGTH program customers and future program customers, if any, and ourcurrent pharmacogenomic support services customers and future customers, ifany, for significant funding in the future to support our development efforts.To execute our business plans, we will need to grow our revenue significantlyeach year. We cannot be certain when we will begin to receive additionalincome, if at all, from our *HAP*Technology and STRENGTH programs and our pharmacogenomic support services andincome, if any, from our CARING and Cardiac Channelopathies programs. If we donot receive this income or do not receive it as rapidly as we expect, we wouldspend our existing cash and investment securities more rapidly than wecurrently plan.

 

We believe that our existingcash reserves will be sufficient to support our expected net losses, debtobligations and capital expenditures for at least 12 months. We cannotassure you that we will be able to obtain new customers or to generate theincreased revenue required to meet our business plan objectives. In addition,to execute our business plans, we may need to seek additional funding throughpublic or private equity offerings, debt financings or through commercialcustomers. We cannot assure you that we will obtain additional customers orcapital funding on acceptable terms, if at all. If we are unable to generatesufficient revenue or access capital on acceptable terms, we may be required toobtain funds on unfavorable terms that may require us to relinquish rights tocertain of our technologies or that would significantly dilute our stockholdersand/or significantly scale back current operations. Either of these twopossibilities would have a material adverse effect on our business.

 

**Our *HAP* Technology and Proprietary Programs may not allow ourcommercial customers to develop commercial products or to increase sales oftheir marketed products.**

 

We developed our *HAP* 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 thepharmaceutical and biotechnology industries are increasing their use ofgenomics in analyzing drug response and diseases, we are aware of only onesuccessful drug program applying population genomics.

 

We discover *HAP* Markers for pharmaceutically relevantgenes. If we are unable to find *HAP*Markers for pharmaceutically relevant genes in a timely manner, our potentialcustomers may lose confidence in our *HAP*Technology and in our company, which could decrease our ability to generaterevenue. Even if we are able to discover *HAP*Markers for pharmaceutically relevant genes, this information may not prove tobe superior to genomic variation information discovered by our competitors.Furthermore, pharmaceutical and biotechnology companies may not choose our *HAP* Technology over competing technologies.

 

Our *DecoGen* Informatics System may also beless effective than we expect or may not allow us or our commercial customersto determine a correlation between drug response and genomic variation.Furthermore, even if we or our customers are successful in identifying such acorrelation, our customers may not be able to develop or sell commerciallyviable products nor may our customers be able to increase the sales of theirmarketed products using this correlation. Accordingly, our *HAP* Markers and *HAP* Technology may not improve the development, marketingand prescribing of drugs or the development and marketing of diagnosticsdeveloped by our *HAP* Technologycustomers and Proprietary Programs customers.

 

**We may be unable to develop orcommercialize our HAP Technology or Proprietary Programs if we cannot establishadditional customers and we will depend on our customers to develop or toco-develop products.**

 

We currently have a numberof customers for our *HAP*Technology 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 anycustomers for our CARING or

 

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Cardiac Channelopathiesprograms. As a result, part of our current and future revenue will depend onpayments from our current *HAP*Technology customers and STRENGTH program customers and our future *HAP* Technology customers if any, andfuture Proprietary Programs customers, if any, for either the new products theymay develop, or for increased sales of their existing products, made possiblethrough the use of our *HAP*Technology. If we are unable to attract new *HAP*Technology customers and STRENGTH program customers or any customers for ourCARING and Cardiac Channelopathies programs, we may never generate sufficientrevenue to sustain our operations.

 

Our customers for our *HAP* Technology and our customers from ourSTRENGTH program and our customers, if any, for our CARING and CardiacChannelopathies programs, will be responsible for pre-clinical study andclinical development of therapeutic and diagnostic products and for regulatoryapproval, manufacturing and marketing of any products or enhanced marketing claimsthat result from the application of our *HAP*Technology and Proprietary Programs. Our current agreements with thesecustomers, and we anticipate that any future agreements with customers, willallow them significant discretion in pursuing these activities. We cannotcontrol the amount and timing of resources that any such current or potentialcustomers will devote to our programs or potential products. Our *HAP* Technology and STRENGTH programarrangements and our CARING and Cardiac Channelopathies 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 revenue will bedependent on the successful commercialization or development of our customers’products, if, for any reason, a *HAP*Technology or a Proprietary Program customer delays or abandons its developmentor commercialization of a product developed using our *HAP* Technology, we may receive reducedroyalty or other payments or no royalty or other payments at all. In addition,because part of our future revenue will be dependent on the successfulcommercialization by our customers of any therapeutic and diagnostic productsthat may result from our *HAP*Technology and STRENGTH programs as well as the successful commercialization ofour CARING and Cardiac Channelopathies programs with customers, if, for anyreason, a customer delays or abandons its development or commercialization ofproducts resulting from our *HAP*Technology or Cardiac Channelopathies programs, we may receive reduced royaltyor other payments or no royalty or other payments at all.

 

Although we intend to retainthe rights to all *HAP* Markerswhich we discover as well as to any *HAP*Markers discovered jointly with current customers and future customers, if any,of our *HAP* Technology customersand Proprietary Programs customers, if any, we have not always and may notalways be able to negotiate the retention of these rights. Furthermore,disputes may arise in the future over the ownership of rights to *HAP* Markers as well as any othertechnology we develop with current and future customers of our *HAP* Technology and Proprietary Programs,if any. These and other possible disagreements between us and our *HAP* Technology customers and STRENGTHprogram customers or between us and our CARING and Long QT genetic programcustomers, if any, could lead to delays in the research, development orcommercialization of their products. These disagreements could also result inlitigation or require arbitration to resolve. Any of these events could preventus from effectively marketing our *HAP*Technology and our Proprietary Programs.

 

**We invest considerable amounts oftime, effort, and money to license our HAP Technology and Proprietary Programsand, if we fail in these licensing efforts, we may not generate sufficientrevenue to sustain our operations.**

 

Our ability to obtaincustomers for our *HAP* Technologyand our Proprietary Programs will depend in significant part upon thepharmaceutical and biotechnology industries’ acceptance that our *HAP* Technology and Proprietary Programscan help accelerate or improve their drug and diagnostic development andmarketing efforts. To achieve market acceptance, we must continue to educatethe pharmaceutical and biotechnology industries and the public in general as tothe potential benefits of our *HAP*Technology and Proprietary Programs. Most importantly, we must convince theresearch and development, clinical and marketing departments of pharmaceuticaland biotechnology companies that our *HAP*Technology can accelerate and improve the processes for developing, marketingand prescribing drugs and for developing and marketing diagnostics and that our*HAP* Technology and ProprietaryPrograms will be commercially viable. If we fail to gain this acceptance, wemay never generate sufficient revenue to sustain our operations. We may expendsubstantial funds and management effort to market our *HAP* Technology and Proprietary Programs,without any resulting revenue.

 

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**Our ability to make any acquisitionis dependent upon the availability of adequate cash and the attractiveness ofour stock price.**

 

We anticipate that anyfuture acquisitions of businesses or technologies will be financed through cashfrom operations, the issuance of shares of our common stock and/or sellerfinancing. We cannot assure you that we will have sufficient existing capitalresources or that we will be able to raise sufficient additional capitalresources on terms satisfactory to us, if at all, in order to meet our capitalrequirements for such acquisitions.

 

We also believe that asignificant factor in our ability to close acquisitions using stock asconsideration will be the attractiveness of our common stock for potentialacquisition candidates. This attractiveness may, in large part, be dependentupon the relative market price and capital appreciation prospects of our commonstock compared to the equity securities of our competitors. The trading priceof our common stock on The NASDAQ National Market could in the futurematerially adversely affect our acquisition program. Because our strategyenvisions that a part of our future revenue growth will come from making futureacquisitions of businesses or technologies, if we are unable to identifysuitable acquisition candidates or unable to negotiate successfully theiracquisition at a price or on terms and conditions favorable to us, our futurerevenue may be adversely impacted and we may experience slower revenue growth.

 

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

 

From time totime, we may acquire or make strategic investments in other businesses ortechnologies. For example, in May  2003, pursuant to the approval of theUnited States Bankruptcy Court, we purchased substantially all of the assetsand assumed certain liabilities of DNA Sciences. In addition, on April 1 2004,we received stockholder approval for our merger agreement to acquire Lark. Theacquisitions of DNA Sciences and Lark, as well as any other acquisitions orstrategic investments we may make in the future, entail numerous risks thatinclude the following:

 

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

•                  diversion ofmanagement’s focus from our core business concerns;

•                  entering marketsin which we have no or limited prior experience or knowledge;

•                  exposure tolitigation from stockholders or creditors of, or other parties affiliated with,the target company or companies;

•                  dilution toexisting stockholders and earnings per share; and

•                  incurrence ofsubstantial 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 their use of, our *HAP* Technology and Proprietary Programs,patents, trade secrets or know how, we may not be able to operate our businessprofitably.**

 

Despite our efforts toprotect our proprietary rights, unauthorized parties may be able to obtain anduse information that we regard as proprietary. The issuance of a patent doesnot guarantee that it is valid or enforceable. Thus, even if we obtain patents,they may not be valid or enforceable against third parties. 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 us being aware of those applications, and our patent applications maynot have priority over any patent applications of others. We are aware thatthere are other firms and individuals who have discovered, or are currentlydiscovering, information similar to the information we are discovering, who mayhave filed, and in the future are likely to file, patent applications that aresimilar or identical to our *HAP*Technology patent applications. In addition, some interest groups are lobbyingfor restrictions on patenting of genetic tests.

 

Further, a patent does notprovide the patent holder with freedom to operate in a way that infringes thepatent rights of others. A third party may sue us for infringing on its patentrights. Likewise, we may need to resort to litigation to enforce a patentissued to us or to determine the scope and validity of third party proprietaryrights. The cost to us of any litigation or other proceeding relating tointellectual property rights, even if resolved in our favor, could besubstantial, and the litigation would divert our management’s focus from ourcore business concerns.

 

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Some of our competitors maybe able to sustain the costs of complex patent litigation more effectively thanwe can because they have substantially greater resources. Uncertaintiesresulting from the initiation and continuation of any litigation could limitour ability to continue our operations.

 

We also rely upon unpatentedtrade secrets and improvements, unpatented know-how and continuingtechnological innovation to develop and maintain our competitive position. Wegenerally protect this information with reasonable security measures, includingconfidentiality agreements signed by our employees, academic collaborators andconsultants that provide that all confidential information developed or madeknown to others during the course of the employment, consulting or businessrelationship will be kept confidential except in specified circumstances.Agreements with employees, consultants and collaborators generally provide thatall inventions conceived by the individual while employed by us are ourexclusive property. If employees, consultants or collaborators do not honorthese agreements, we may not have adequate remedies for breach. Furthermore,our trade secrets may otherwise become known or be independently discovered bycompetitors.

 

If any party shouldsuccessfully claim that the creation or use of our *HAP* Technology or genetic markers from one of ourProprietary Programs infringes upon their intellectual property rights, inaddition to any damages we might have to pay, a court could require us to stopthe infringing activity or obtain a license on unfavorable terms. Moreover, anylegal action against us or any of our program customers claiming damages orseeking to enjoin commercial activities relating to the affected products andprocesses could, in addition to subjecting us to potential liability fordamages, require us or current and any future customers of our *HAP* Technology and Proprietary Programs,if any, to obtain a license in order to continue to manufacture or market theaffected products and processes. Any license required under any patent may notbe made available on commercially acceptable terms, if at all. In addition,some licenses may be non-exclusive and, therefore, our competitors may haveaccess to the same technology licensed to us. If we fail to obtain a requiredlicense or are unable to design around a patent, we may be unable to marketeffectively some of our *HAP*Technology or our Proprietary Programs, which could limit our profitability andpossibly prevent us from generating revenue sufficient to sustain our operations.

 

**Regulatory oversight of our *HAP* Technology and Proprietary Programsand public opinion regarding ethical issues surrounding the use of geneticinformation may adversely affect our ability to market our products andservices.**

 

Currently, there is limitedFood and Drug Administration (FDA) regulation of genetic tests. The Secretary’sAdvisory Committee on Genetic Testing, an advisory panel to the Secretary ofthe U.S. Department of Health and Human Services, has recommended that the FDAexpand its regulation of genetic testing to require FDA approval for all newgenetic tests and labeling of genetic tests. If the FDA adopts thisrecommendation, it may require that we, or our customers, apply for FDAapproval as a prerequisite to marketing genetic tests that incorporate ourproducts and services. If the FDA were to deny any application of this kind, itcould adversely affect our business and we may be unable to generate sufficientrevenue to sustain our operations.

 

The FDA has only oncerequired that a physician must have genomic variation information determinedabout a patient before the doctor prescribes a drug. In this one instance, theFDA has stipulated that this requirement can be fulfilled with either geneexpression information or genomic variation information. On November 3,2003, the FDA issued draft guidance that encourages drug and biologicdevelopers to conduct pharmacogenomic tests during drug development andclarified how the FDA will evaluate the resulting data. The guidance provides specificcriteria and recommendations on the submission of pharmacogenomic data inconnection with Investigational New Drug Applications, New Drug Applicationsand 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 for voluntary submissions of researchinformation in order to gain experience as the field of pharmacogenomicsevolves. The FDA advised that the agency would not use information fromvoluntary reports for regulatory decisions on the drug or biologic with whichthe voluntary data is associated. In addition, the FDA held a workshop inNovember 2003 to discuss its draft guidance and stated that the agencyplans in the near future to issue further guidance on the co-development of apharmacogenomic test and drug. Our success will depend, in part, on how rapidlythe pharmaceutical and biotechnology industry implements the guidance and,accordingly, the validity of our products and services as a basis foridentifying genomic variation and for correlating drug response with genomicvariation. Without this implementation by the pharmaceutical and biotechnologyindustry, we may be unable to market effectively any products we may have aswell as any of our services and we may not generate sufficient revenue tosustain our operations.

 

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Within the field ofpersonalized health and medicine, governmental and other entities may enact patientprivacy and healthcare laws and regulations that may limit the generation anduse of genomic variation data. To the extent that these laws and regulationslimit the use of our products and services or impose additional costs on ourcustomers, we may be unable to market effectively our *HAP* Technology and Proprietary Programsand we may not generate sufficient revenue to sustain our operations.

 

Additionally, public opinionon ethical issues related to the confidentiality and appropriate use of genetictesting results may influence governmental authorities to call for limits on,or regulation of the use of, genetic testing. In addition, governmentalauthorities or other entities may call for limits on, or regulation of the useof, genetic testing or prohibit testing for genetic predisposition to certainconditions, particularly for those that have no known cure. The occurrence ofany of these events could reduce the potential markets for our products andservices, which could prevent us from generating sufficient revenue to sustainour operations.

 

Furthermore, we may bedirectly subject to regulations as a provider of diagnostic information. To theextent that these regulations restrict the sale of our products and services orimpose other costs, we may be unable to provide our products and services toour customers on terms sufficient to recover our expenses.

 

**If our customers do not seek, or donot receive, marketing approval for products developed, if any, using our *HAP* Technology or our genetic markers fromour Proprietary Programs, we may receive delayed royalty or other payments orno royalty or other payments at all.**

 

Any new drug, biologic ornew drug or biologic indication our customers develop using our *HAP* Technology or Proprietary Programsgenetic markers must undergo an extensive regulatory review process in theUnited States and other countries before a new product or indication of thiskind could be marketed. This regulatory process can take many years and requiresubstantial expense. Changes in FDA policies and the policies of similarforeign regulatory bodies can prolong the regulatory review of each new drug orbiologic license application or prevent approval of the application. We expectsimilar delays and risks in the regulatory review process for any diagnosticproduct developed by our customers, whenever this regulatory review isrequired. Even if a product obtains marketing clearance, a marketed product andits manufacturer are subject to continuing review. A manufacturer may be forcedto withdraw a product from the market if a previously unknown problem with aproduct becomes apparent. Because our future revenue will be dependent on thesuccessful commercialization or development of products using our *HAP* Technology or Proprietary Programsgenetic markers, any delay of our customers in obtaining, failing to obtain, orfailing to maintain regulatory approval for a product developed using our *HAP* Technology or Proprietary Programsgenetic markers may delay our receipt of royalty or other payments or preventus from receiving royalty or other payments sufficient to recover our expenses.

 

**If our customers are unable toobtain FDA approval for therapeutic or diagnostic products developed using our *HAP* Technology or genetic markers from ourProprietary Programs, the lack of regulatory approval will diminish the valueof our *HAP* Technology andProprietary Programs.**

 

To date, no one hasdeveloped or commercialized any therapeutic product or commercialized anydiagnostic product using our *HAP*Technology or Proprietary Programs genetic markers. We expect to rely on ourcustomers to file applications for regulatory approval and generally direct theregulatory review process and obtain FDA acceptance of any products theydevelop with our *HAP* Technology orProprietary Programs, if any. Our customers may not submit an application forregulatory review. Even if they do submit applications, they may not be able toobtain marketing clearance for any products on a timely basis, if at all. Ifour customers fail to obtain required governmental clearances for therapeuticor diagnostic products, they will not be able to market these products unlessand until they obtain these clearances. As a result, we may not receive royaltyor other payments from our customers. The occurrence of any of these events mayprevent us from generating revenue sufficient to sustain our operations.

 

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**If we do not successfullydistinguish and commercialize our *HAP*Technology and Proprietary Programs, we may be unable to compete successfullywith our competitors or to generate revenue significant to sustain ouroperations.**

 

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

 

These competitors maydiscover, characterize or develop important technologies applying populationgenomics before us or our customers for our *HAP*Technology and Proprietary Programs that are more effective than thosetechnologies which we develop or which our customers for our *HAP* Technology and Proprietary Programsdevelop, or these competitors may obtain regulatory approvals of their drugsand diagnostics more rapidly than our customers for our *HAP* Technology and Proprietary Programsdo, any of which could limit our ability to market effectively our *HAP* Technology and Proprietary Programs.

 

Some companies andgovernments are marketing or developing a number of databases and informaticstools to assist participants in the healthcare industry and academicresearchers in the management and analysis of genomic data. Entities such asPerlegen Sciences, Celera Genomics Group and the International HapMap Projecthave developed or plan to develop databases containing gene sequence, genomicvariation or other genomic information and are marketing or plan to markettheir data to pharmaceutical and biotechnology companies or plan to make freelyavailable their databases. In addition, numerous pharmaceutical andbiotechnology companies, such as GlaxoSmithKline plc, either alone or incollaboration with our competitors, are developing genomic research programsthat involve the use of information that can be found in these databases.Furthermore, companies, such as deCODE genetics, Inc., have technologiesfor using genetic variation in diagnostics and in the drug development processand have collaborations with companies employing these technologies.

 

Genomic technologies haveundergone, and are expected to continue to undergo, rapid and significantchange. Our future success will depend in large part on maintaining acompetitive position in the genomics field. Others may rapidly develop newtechnologies that may result in our products or technologies becoming obsoletebefore we recover the expenses that we incur in connection with the developmentof these products. Our *HAP*Technology could become obsolete if our competitors offer less expensive ormore effective drug discovery and development technologies, includingtechnologies that may be unrelated to genomics.

 

**The current technology labor market is very competitive, and our business may suffer if we are not able to hire and retain sufficient personnel.**

 

Our future success depends on the continued service of our key technical, marketing, executive and administrative personnel. The loss of the services of any of these individuals could have a material adverse effect on our product development and commercialization efforts. In addition, research, product development and commercialization may require additional skilled personnel. Competition for qualified personnel in the technology area is intense, and we operate in geographic locations where labor markets are particularly competitive, including New Haven, Connecticut and Morrisville, North Carolina, where key product development laboratories are located. If we are unable to attract and retain a sufficient number of qualified employees on acceptable terms, our business, financial condition and results of operations could be seriously harmed. The inability to retain and hire qualified personnel could also hinder the future expansion of our business.

 

**We depend on third-party productsand services and limited sources of supply for our sequencing and genotypinglaboratories.**

 

We rely on outside vendors to supply certainsoftware, products and materials used in our laboratories. Some of theseproducts and materials are obtained from a single supplier or a limited groupof suppliers. For example, we have a written agreement with Sequenom, Inc.pursuant to which it is contractually the sole provider of silicon chips forone-time use on their MassARRAYTM System, which is our primarygenotyping platform in our New Haven facility. Under the terms of the agreementand subject to specific conditions, we have the authority to reuse thesechips should Sequenom be unableto supply new chips to us. While we believe that we could prepare for reuse therequisite supply of chips without unreasonable cost or delay, we may be unableto do so. We have no other written long-term supply agreements with oursuppliers. Our reliance on outside vendors generally and a sole or a limitedgroup of suppliers in particular involves several other risks, including:

 

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•                  the inability toobtain an adequate supply of required software, products and materials due tocapacity constraints, product defects, a discontinuance of a product by asupplier or other supply constraints;

•                  reduced controlover quality and pricing of software, products and materials; and

•                  delays and longlead times in 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, revenue and market acceptance.**

 

Because our businessrequires manipulating and analyzing large amounts of data, we depend on thecontinuous, effective, reliable and secure operation of our computer hardware,software and related infrastructure. To the extent that any of these elementsmalfunction, we will experience reduced productivity. We protect our computerhardware through physical and software safeguards. However, our computerhardware is still vulnerable to fire, weather, earthquake, or other naturaldisaster and power loss, telecommunications failures, physical or softwarebreak-ins and similar events. In addition, the software and algorithmiccomponents of our *DecoGen*Informatics System are complex and sophisticated, and as such, could containdata, design or software errors that could be difficult to detect and correct.Users of our system may find software defects in current or future products. Ifwe fail to maintain the necessary computer capacity and data to support ourcomputational needs and our customers’ drug and diagnostic discovery anddevelopment efforts, we could experience a loss in revenue, or a delay inreceiving revenue and a delay in obtaining market acceptance for ourtechnology.

 

**The issuance and sale of oursecurities could have the effect of substantially diluting the interests of ourcurrent 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 ofour Series A preferred stock at $22.50 per share. Under specifiedcircumstances, the purchaser is required to exercise the Series A preferredstock warrant. Each share of our Series A preferred stock is currentlyconvertible into ten shares of our common stock. Consequently, assuming theexercise of the Series A preferred stock warrant, on an as-converted basis, anaggregate of 4,600,000 shares of our common stock may be issued to the Series Apurchaser. Any issuance of shares of our common stock upon conversion of sharesof our Series A preferred stock could have the effect of substantially dilutingthe interests of our current stockholders, as well as the interests of holdersof our outstanding options and warrants which, as of March 31, 2004, areexercisable for an aggregate of 4,720,062 shares of our common stock, assumingthey elect to exercise such securities. Moreover, any sale of the shares ofcommon stock issued upon conversion of the Series A preferred stock, as well asany of the outstanding shares of our common stock issued upon exercise ofoptions or warrants, into the public market could cause a decline in thetrading price of our common stock. In acquisition transactions, in financingtransactions, for compensatory purposes or in other types of transactions,additional issuances of equity securities could dilute the interests of ourcurrent and future stockholders.

 

**Our redemption obligations underour Series A preferred stock could have a material adverse effect on ourfinancial condition.**

 

Under the terms of ourSeries A preferred stock, we are required, unless the holders of at least 662/3% of our outstanding Series A preferred stock elect otherwise, to redeem allthen outstanding shares of our Series A preferred stock if one or more of thefollowing events occurs:

 

•                  our common stockis delisted from The NASDAQ National Market;

•                  we issue sharesof our common stock or securities convertible into common stock, with apurchase price of less than $2.25 per share, other than in limitedcircumstances;

•                  we breach anyrepresentation or warranty contained in the Series A purchase agreement or theregistration rights agreement that has a material adverse effect on the holdersof our Series A preferred stock;

•                  we breach anycovenant or fail to perform any of our obligations under the Series A purchaseagreement or the registration rights agreement each entered into in connectionwith the sale of our Series A preferred stock, that has a material adverseeffect on the holders of our Series A preferred stock;

 

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•                  an involuntarycase is commenced against us under any bankruptcy, insolvency or other similarlaw or we commence a voluntary case under any bankruptcy, insolvency or othersimilar law or consent to any receivership, liquidation or assignment for thebenefit of creditors;

•                  we default underany agreement entered into on or after October 7, 2003 under which we haveincurred indebtedness for borrowed money in excess of $500,000; and

•                  we, prior toOctober 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 to redeemour 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 havenot otherwise been paid as of the redemption date.  As of March 31, 2004, the aggregate redemption price we would berequired to pay is approximately $6,659,500.

 

In addition, the holders ofat least 66 2/3% of the outstanding shares of our Series A preferred stock mayelect to require us to redeem all outstanding shares of our Series A preferredstock for the original purchase price, plus all accrued but unpaid dividends asof the redemption date, on either October 29, 2006, October 29, 2007or October 29, 2008.

 

A redemption of the Series Apreferred stock would reduce the cash we have available to fund operations,research and product development, capital expenditures and other generalcorporate purposes. In addition, we have incurred net losses in the past andexpect to incur losses in the future, which may impair our ability to generatethe cash required to meet our obligations under our Series A preferred stock.If we cannot generate sufficient cash to meet these obligations, we may berequired to incur additional indebtedness or raise additional capital, whichmay negatively impact our stockholders.

 

**The purchaser of our Series Apreferred stock owns a substantial portion of our capital stock, which mayafford the purchaser significant influence over our affairs.**

 

As of March 31, 2004, thepurchaser of our Series A preferred stock held or had the right to acquire19.3% of our outstanding common stock (assuming the exercise of the Series Apreferred stock warrant and the conversion of Series A preferred stock tocommon stock), including shares of our common stock which the purchaserpreviously purchased in the open market. The purchaser of our Series Apreferred stock currently has the right to vote 10.7% of our outstanding commonstock (on an as converted to common stock basis, assuming no exercise of theSeries A preferred stock warrant, based on the number of shares of our capitalstock outstanding as of May 5, 2004). As a result, this stockholder hassignificant influence over any change in control of the company that may befavored by other stockholders and could otherwise exercise significantinfluence over all corporate actions requiring stockholder approval, includingthe approval of some mergers and other significant corporate transactions, suchas a sale of substantially all of our assets or the defeat of anynon-negotiated takeover attempt that might otherwise benefit the publicstockholders. Consequently, this stockholder may approve a transaction that inits judgment enhances the value of its investment, but which nonetheless maydiverge from the interests of our other stockholders.

 

**The agreements and instrumentsgoverning the rights and preferences of our Series A preferred stock imposerestrictions on our business and limit our ability to undertake certaincorporate actions.**

 

Our amended and restatedcertificate of incorporation, which we refer to as our charter, and the SeriesA purchase agreement, govern the terms of our Series A preferred stock andimpose significant restrictions on our business. These restrictions may limitour ability to operate our business and to take advantage of potential businessopportunities as they arise. Our charter places restrictions on our ability,without the consent of the holders of at least 66 2/3%of the outstanding sharesof our Series A preferred stock, to:

 

•                  alter or changethe 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 more than

•                  $7,000,000 ofindebtedness at any time after the Series A preferred stock warrant has beenexercised; or

•                  $11,000,000 ofindebtedness at any time if the Series A preferred stock warrant has not beenexercised;

 

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•                  create, incur orassume specified liens; or

•                  declare or paydividends, redeem stock or make other distributions to stockholders, other thanin limited circumstances.

 

Events beyond our control,including prevailing economic, financial and industry conditions, may affectour ability to comply with these restrictions. In addition, the holders of ourSeries A preferred stock have the right to participate in future capital raisingtransactions of the company. The existence of this right may substantiallyreduce our ability to establish terms with respect to, or enter into, anyfinancing with parties other than the Series A preferred stockholder. The termsof any additional financing we may enter into may impose constraints on ourability to operate our business as we deem appropriate. These restrictions andcovenants could limit our ability to take advantage of financings, mergers andacquisitions or other corporate opportunities, which could adversely affect ourbusiness and financial condition and any investments in our common stock.

 

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**Item3 – Quantitative and Qualitative Disclosures About Market 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 March 31, 2004.

 

**Item 4 – Controls andProcedures.**

** **

**Our management, with the participation of our chiefexecutive officer and chief financial officer, evaluated the effectiveness ofour disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (ExchangeAct)), as of March 31, 2004.  Based onthis evaluation, our chief executive officer and chief financial officerconcluded that, as of March 31, 2004, our disclosure controls and procedureswere (1) designed to ensure that material information relating to us, includingour consolidated subsidiary, is made known to our chief executive officer andchief financial officer by others within those entities, particularly duringthe period in which this report was being prepared, and (2) effective, in thatthey provide reasonable assurance that information required to be disclosed byus in the reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the periods specified in the SEC’srules and forms.**

** **

**No change in our internal control over financial reporting(as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurredduring the fiscal quarter ended March 31, 2004, that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.**

 

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**PART II - Other Information**

 

**Item 2 – Changes in****Securities,Use of Proceeds and Issuer Purchases of Equity Securities.**

 

**Issuanceof Series A Preferred Stock**

 

On October 29,2003, we sold 270,000 shares of Series A preferred stock at a price of $22.50per share in a private placement pursuant to a Series A preferred stockpurchase agreement dated as of October 29, 2003 by and between us and RAMTrading, Ltd. 

 

Each share of ourSeries A preferred stock accrues a dividend of 2% per year, payablesemi-annually in arrears on January 5 and July 5 of each year.  Each share of our Series A preferred stockis entitled to one vote for each share of our common stock issuable uponconversion of our Series A preferred stock. Each share of our Series A preferred stock is currently convertible intoten shares of our common stock.

 

Each share of ourSeries A preferred stock is convertible into shares of our common stock at anytime at the option of the holder of such shares.  We may elect, on or after October 29, 2006, to require theholders of all outstanding shares of our Series A preferred stock to convertsuch shares into our common stock if the per share closing price of our commonstock, as quoted by The NASDAQ National Market, exceeds $7.00 for 23consecutive business days.

 

The holders of atleast 66 2/3% of the outstanding shares of our Series A preferred stock mayelect to require us to redeem all outstanding shares of our Series A preferredstock for the original purchase price, plus all accrued but unpaid dividends asof the redemption date, on either October 29, 2006, 2007 or 2008.  Under the terms of our Series A preferred stock,we are also required to redeem all then outstanding shares of our Series Apreferred stock upon certain other specified events.  If we are required to redeem our Series A preferred stock due tosuch specified events, we are required to pay each holder of our Series Apreferred stock the original purchase price, plus an amount equal to thedividends that would otherwise have accrued and been payable on such sharesthrough October 29, 2008 that have not otherwise been paid as of the redemptiondate.  In certain circumstances, we mayelect to defer payment of the redemption amount, in which case the redemptionprice will be re-calculated such that, with respect to the remaining dividends,the dividend rate is increased to 10% per year for any shares that were notredeemed.

 

We also grantedthe Series A purchaser certain registration rights and certain preemptiverights in connection with future specified issuances of our capital stock.

 

Certain of therights, preferences and privileges of our Series A preferred stock are seniorto the rights, preferences and privileges of our common stock, including,without limitation, the right to receive dividends and the liquidationpreference.

 

 

**IssuerPurchases of Equity Securities**

** **

The followingtable summarizes repurchases of our stock in the quarter ended March 31, 2004:

** **
| **Period**                                 |   | **(a) Total  Number  of Shares (or Units)  Purchased** |   | **(b)  Average Price  Paid per Share (or  Unit)** |   | **(c) Total  Number  of Shares (or Units)  Purchased as Part  of Publicly  Announced Plans  or Programs** |   | **(d)  Maximum  Number (or  Approximate  Dollar Value) of  Shares (or Units)  that May Yet Be  Purchased Under  the Plans or  Programs** |   |
|--------------------------------------------|--------|--------------------------------------------------------|--------|---------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------|--------|
| January 1, 2004 through January 31, 2004   |   | —                                                 |   | —                                            |   | —                                                                                                    |   | —                                                                                                                                   |   |
| February 1, 2004 through February 29, 2004 |   | —                                                 |   | —                                            |   | —                                                                                                    |   | —                                                                                                                                   |   |
| March 1, 2004 through March 31, 2004       |   | 3,900(1)                                               |   | $.001                                             |   | —                                                                                                    |   | —                                                                                                                                   |   |
| Total                                      |   | 3,900(1)                                               |   | $.001                                             |   | —                                                                                                    |   | —                                                                                                                                   |   |

 

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 (1) In March 2004, we exercised our optionto repurchase 3,900 shares of restricted common stock issued toDr. Gualberto Ruaño, our former Vice Chairman and Chief ScientificOfficer, under our 2000 Amended and Restated Equity Incentive Plan, as amended.

 

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

 

(a) Exhibits

 

See Index to Exhibits attached hereto.

 

(b) Reports on Form 8-K

 

On February 12, 2004, we furnished a Current Report onForm 8-K, containing a copy of our earnings release for the quarter and yearended December 31, 2003 (including financial statements) pursuant to Item 12(Results of Operations and Financial Condition).

 

On February 17, 2004, we filed Amendment No. 1 to aCurrent Report on Form 8-K, containing certain financial statements prepared togive effect to the merger of Genaissance and Lark pursuant to Item 5 (OtherEvents and Regulation FD Disclosure) and Item 7 (Financial Statements, ProForma Financial Information and Exhibits).

 

On February 23, 2004, we filed Amendment No. 1 to aCurrent Report on Form 8-K, pursuant to Item 5 (Other Events and Regulation FDDisclosure).

 

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**SIGNATURE****S**

 

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

 
|               | GENAISSANCE PHARMACEUTICALS, INC.                 |
|--------------------|---------------------------------------------------|
|               |                                              |   |
|               |                                              |   |
| Date: May 17, 2004 | By:                                               | /s/ Ben Kaplan |   |
|               | Ben Kaplan                                        |
|               | Senior Vice President and Chief Financial Officer |
|               | (Principal Financial and Accounting Officer)      |
|                    |                                                   |  |  |  |

 

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**EXHIBIT INDEX**

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

 

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