**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**FORM 10-Q**

 

**ý****        ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For TheQuarterly Period Ended September 30, 2004**

 

**o****        ****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For The Transition Period From          To          **

 

**Commission File No. 000-30981**

 

**GENAISSANCE PHARMACEUTICALS, INC.**

(Exact Name of Registrant as Specified in its Charter)

 
| **Delaware**                                                      | ** ** | **06-1338846**                         |
|-------------------------------------------------------------------|------------|----------------------------------------|
| (State or other  jurisdiction of   incorporation or organization) |       | (I.R.S. Employer   Identification No.) |
|                                                              |       |                                   |
| **Five Science Park, New Haven, Connecticut  06511**         |
| (Address of principal executive office and zip code)              |
|                                                              |       |                                   |
| **(203) 773-1450**                                                |
| (Registrant’s telephone number, including area code)         |

 

Indicateby check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days:

 

Yes ý       No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inrule 12b-2 of the Exchange Act):

 

Yes o       No ý

 

Thenumber of shares of the registrant’s outstanding common stock as of November 11,2004, was 31,132,084 shares.

 

 

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

For the quarter ended September 30, 2004

**Index**

 
| **PART I – FINANCIAL  INFORMATION**                                                                               |   |
|------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                   |   |
| Item 1 – Financial  statements (unaudited)                                                                        |   |
|                                                                                                                   |   |
| Condensed  Consolidated Balance Sheets as of September 30, 2004 and December 31,  2003                       |   |
|                                                                                                                   |   |
| Condensed  Consolidated Statements of Operations for the three and nine months ended September 30,  2004 and 2003 |   |
|                                                                                                                   |   |
| Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2004 and 2003           |   |
|                                                                                                                   |   |
| Notes  to the Unaudited Condensed Consolidated Financial Statements                                                    |   |
|                                                                                                                   |   |
| Item  2 – Management’s Discussion and Analysis of Financial Condition and Results  of Operations             |   |
|                                                                                                                   |   |
| Item  3 – Quantitative and Qualitative Disclosures About Market Risk                                              |   |
|                                                                                                                   |   |
| Item 4 – Controls and  Procedures                                                                                 |   |
|                                                                                                                   |   |
| **PART II – OTHER INFORMATION**                                                                                   |   |
|                                                                                                                   |   |
| Item  2 – Unregistered Sales of Equity Securities and Use of Proceeds                                             |   |
|                                                                                                                   |   |
| Item 6 – Exhibits                                                                                                 |   |
|                                                                                                                   |   |
| Signature                                                                                                              |   |

 

 

*The Genaissance name and logo, and DecoGen**â**,HAPTM and FAMILIONTM are either registeredtrademarks or trademarks of Genaissance Pharmaceuticals, Inc. in the UnitedStates and/or other countries.  All othertrademarks, servicemarks or trade names referred to in this Quarterly Report onForm 10-Q are the property of their respective owners.*

 

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**PART I –Financial Information**

**Item 1 – Financial Statements.**

 

**GENAISSANCE PHARMACEUTICALS, INC.**

Condensed Consolidated Balance Sheets

(Unaudited)

(In thousands, except per share data)

 
| ** **                                                                                                                                                                                                                                                                        | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                        | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                        | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current Assets:                                                                                                                                                                                                                                                                   |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                         |       | $                            | 6,911      |                        | $          | 8,033 |   |
| Marketable securities                                                                                                                                                                                                                                                             |       | —                       |       | 8,771                       |       |
| Accounts receivable and unbilled revenue, net                                                                                                                                                                                                                                     |       | 5,237                        |       | 2,573                       |       |
| Taxes receivable                                                                                                                                                                                                                                                                  |       | 718                          |       | 1,442                       |       |
| Inventory                                                                                                                                                                                                                                                                         |       | 680                          |       | 1,278                       |       |
| Other current assets                                                                                                                                                                                                                                                              |       | 1,040                        |       | 645                         |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Total current assets                                                                                                                                                                                                                                                              |       | 14,586                       |       | 22,742                      |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Property and equipment, net                                                                                                                                                                                                                                                       |       | 8,343                        |       | 8,776                       |       |
| Deferred financing costs, net                                                                                                                                                                                                                                                     |       | 242                          |       | 317                         |       |
| Investment in affiliate                                                                                                                                                                                                                                                           |       | 1,186                        |       | 2,531                       |       |
| Goodwill                                                                                                                                                                                                                                                                          |       | 11,181                       |       | —                      |       |
| Other intangibles, net                                                                                                                                                                                                                                                            |       | 11,301                       |       | 794                         |       |
| Other assets                                                                                                                                                                                                                                                                      |       | 101                          |       | 429                         |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Total assets                                                                                                                                                                                                                                                                      |       | $                            | 46,940     |                        | $          | 35,589 |   |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED  STOCK, WARRANT AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current Liabilities:                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Current portion of long-term debt                                                                                                                                                                                                                                                 |       | $                            | 4,319      |                        | $          | 2,088 |   |
| Accounts payable                                                                                                                                                                                                                                                                  |       | 879                          |       | 898                         |       |
| Accrued expenses                                                                                                                                                                                                                                                                  |       | 2,845                        |       | 2,925                       |       |
| Accrued dividends                                                                                                                                                                                                                                                                 |       | 1,208                        |       | 1,181                       |       |
| Current portion of deferred revenue                                                                                                                                                                                                                                               |       | 1,956                        |       | 1,455                       |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Total current liabilities                                                                                                                                                                                                                                                         |       | 11,207                       |       | 8,547                       |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Long-Term Liabilities:                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Long-term debt, net of current portion                                                                                                                                                                                                                                            |       | 3,839                        |       | 7,030                       |       |
| Deferred revenue, net of current portion                                                                                                                                                                                                                                          |       | 2,972                        |       | 4,090                       |       |
| Other long-term liabilities                                                                                                                                                                                                                                                       |       | 1,852                        |       | 1,593                       |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Total long-term liabilities                                                                                                                                                                                                                                                       |       | 8,663                        |       | 12,713                      |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Series A Redeemable Convertible Preferred                                                                                                                                                                                                                                         |       |                         |       |                        |       |
| Stock $.001 par value:  460 authorized shares at September 30, 2004 and December 31, 2003;  460 and 270 shares issued and outstanding at September 30, 2004 and December 31,  2003, respectively (liquidation preference $10,350 at September 30,  2004) |       | 9,615                        |       | 5,097                       |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Warrant to purchase Series A Redeemable Convertible Preferred  Stock                                                                                                                                                                                                              |       | —                       |       | 835                         |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Commitments and Contingencies (Note 13)                                                                                                                                                                                                                                           |       |                         |       |                        |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Stockholders’ Equity:                                                                                                                                                                                                                                                        |       |                         |       |                        |       |
| Preferred stock, 540 authorized shares at September 30,  2004 and December 31, 2003; no shares issued or outstanding except for  Series A included above                                                                                                                |       | —                       |       | —                      |       |
| Common stock, 58,000 authorized shares, $.001 par  value, 31,123 and 22,847 shares issued and outstanding at September 30,  2004 and December 31, 2003, respectively                                                                                                    |       | 31                           |       | 23                          |       |
| Additional paid-in capital                                                                                                                                                                                                                                                        |       | 248,326                      |       | 220,541                     |       |
| Deferred compensation                                                                                                                                                                                                                                                             |       | (502                         | )          | —                      |       |
| Accumulated deficit                                                                                                                                                                                                                                                               |       | (230,373                     | )          | (212,160                    | )          |
| Accumulated other comprehensive loss                                                                                                                                                                                                                                              |       | (27                          | )          | (7                          | )          |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Total stockholders’ equity                                                                                                                                                                                                                                                   |       | 17,455                       |       | 8,397                       |       |
|                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                   |       | $                            | 46,940     |                        | $          | 35,589 |   |

 

*Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.*

 

1

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Condensed Consolidated Statements of Operations

(Unaudited)

(In thousands, except per share data)

 
| ** **                                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                           | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Revenue:                                                             |       |                                       |       |                                      |       |   |   |   |   |
| License and research                                                 |       | $                                          | 2,840      |                                      | $          | 1,946 |   | $ | 8,261 |   | $ | 6,811 |   |
| Laboratory services                                                  |       | 2,787                                      |       | 625                                       |       | 6,449 |   | 1,012 |   |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Total revenue                                                        |       | 5,627                                      |       | 2,571                                     |       | 14,710 |   | 7,823 |   |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Operating expenses:                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Cost of laboratory services                                          |       | 2,040                                      |       | 686                                       |       | 4,887 |   | 1,033 |   |
| Research and development                                             |       | 4,723                                      |       | 5,411                                     |       | 15,863 |   | 14,859 |   |
| Selling, general and administrative                                  |       | 3,522                                      |       | 2,080                                     |       | 9,546 |   | 6,200 |   |
| Loss on leased equipment                                             |       | —                                     |       | 368                                       |       | — |   | 368 |   |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Total operating expenses                                             |       | 10,285                                     |       | 8,545                                     |       | 30,296 |   | 22,460 |   |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Loss from operations                                                 |       | (4,658                                     | )          | (5,974                                    | )          | (15,586 | ) | (14,637 | ) |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Other income                                                         |       | 39                                         |       | 52                                        |       | 123 |   | 276 |   |
| Interest expense                                                     |       | (168                                       | )          | (122                                      | )          | (523 | ) | (514 | ) |
| Write-down of investment in affiliate                                |       | (1,003                                     | )          | —                                    |       | (1,003 | ) | — |   |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Loss before income taxes and equity in loss of  affiliate            |       | (5,790                                     | )          | (6,044                                    | )          | (16,989 | ) | (14,875 | ) |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Income tax benefit                                                   |       | 47                                         |       | 200                                       |       | 60 |   | 520 |   |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Equity in loss of affiliate                                          |       | (150                                       | )          | —                                    |       | (450 | ) | — |   |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                                             |       | (5,893                                     | )          | (5,844                                    | )          | (17,379 | ) | (14,355 | ) |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Warrant issuance expense                                             |       | —                                     |       | —                                    |       | (833 | ) | — |   |
| Preferred stock dividends and accretion                              |       | (134                                       | )          | —                                    |       | (355 | ) | — |   |
| Beneficial conversion feature of warrant                             |       | —                                     |       | —                                    |       | (46 | ) | — |   |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Net loss attributable to common stockholders                         |       | $                                          | (6,027     | )                                         | $          | (5,844 | ) | $ | (18,613 | ) | $ | (14,355 | ) |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Net loss per common share, basic and diluted                         |       | $                                          | (0.20      | )                                         | $          | (0.25 | ) | $ | (0.66 | ) | $ | (0.63 | ) |
|                                                                 |       |                                       |       |                                      |       |   |   |   |   |   |   |   |   |
| Weighted average shares used  in computing net loss per common share |       | 30,739                                     |       | 23,044                                    |       | 28,012 |   | 22,937 |   |
|                                                                      |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |

 

*Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.*

 

2

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**GENAISSANCE PHARMACEUTICALS, INC.**

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(In thousands)

 
| ** **                                                                   | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                    | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                                         | (17,379    | ) | $ | (14,355 | ) |
| Adjustment to reconcile net  loss to net cash used in operating activities:  |       |                                      |       |   |   |
| Depreciation and amortization                                                |       | 4,264                                     |       | 5,400 |   |
| Stock based compensation                                                     |       | 440                                       |       | 176 |   |
| Non-cash research and  development expense paid with equity                  |       | 1,276                                     |       | — |   |
| Loss on leased equipment                                                     |       | —                                    |       | 368 |   |
| Write-down of investment and  equity in loss of affiliate                    |       | 1,453                                     |       | — |   |
| Changes in assets and  liabilities:                                          |       |                                      |       |   |   |
| Accounts receivable                                                          |       | (1,121                                    | )          | (232 | ) |
| Taxes receivable                                                             |       | 728                                       |       | (808 | ) |
| Inventory and other current  assets                                          |       | 672                                       |       | (564 | ) |
| Other assets                                                                 |       | 371                                       |       | 910 |   |
| Accounts payable                                                             |       | (590                                      | )          | 118 |   |
| Accrued expenses                                                             |       | (1,055                                    | )          | 909 |   |
| Deferred revenue                                                             |       | (1,138                                    | )          | (1,749 | ) |
| Net cash used in operating  activities                                       |       | (12,079                                   | )          | (9,827 | ) |
|                                                                         |       |                                      |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                   |       |                                      |       |   |   |
| Cash received through (paid  for) acquisition, including transaction costs   |       | 300                                       |       | (1,668 | ) |
| Purchases of property and  equipment                                         |       | (1,291                                    | )          | (840 | ) |
| Proceeds from the sale of  property and equipment                            |       | —                                    |       | 30 |   |
| Investment in affiliate                                                      |       | (108                                      | )          | — |   |
| Investments in marketable  securities                                        |       | —                                    |       | (13,299 | ) |
| Proceeds from sales of  marketable securities                                |       | 8,751                                     |       | 22,091 |   |
| Net cash provided by investing  activities                                   |       | 7,652                                     |       | 6,314 |   |
|                                                                         |       |                                      |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                   | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Net proceeds from issuance of  common stock and exercise of warrant          |       | 5,133                                     |       | 105 |   |
| Repayment of long-term debt                                                  |       | (1,744                                    | )          | (9,804 | ) |
| Proceeds from long-term debt                                                 |       | —                                    |       | 5,000 |   |
| Financing costs                                                              |       | —                                    |       | (33 | ) |
| Preferred stock dividends paid                                               |       | (84                                       | )          | — |   |
| Net cash provided by (used in)  financing activities                         |       | 3,305                                     |       | (4,732 | ) |
|                                                                         |       |                                      |       |   |   |
| NET DECREASE IN CASH AND CASH  EQUIVALENTS                                   |       | (1,122                                    | )          | (8,245 | ) |
|                                                                         |       |                                      |       |   |   |
| CASH AND CASH EQUIVALENTS,  beginning of period                              |       | 8,033                                     |       | 16,578 |   |
|                                                                         |       |                                      |       |   |   |
| CASH AND CASH EQUIVALENTS, end  of period                                    |       | $                                         | 6,911      |   | $ | 8,333 |   |
|                                                                         |       |                                      |       |   |   |
| **SUPPLEMENTAL DISCLOSURE AND  NON-CASH ACTIVITIES:**                        | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Interest paid                                                                |       | $                                         | 422        |   | $ | 944 |   |
| Foreign income taxes paid                                                    |       | $                                         | 504        |   | $ | — |   |
| Issuance of restricted shares                                                |       | $                                         | —     |   | $ | 296 |   |
| Issuance of common stock for services and licenses                           |       | $                                         | 1,306      |   | $ | — |   |
| Issuance of stock, options and  warrants in connection with the acquisitions |       | $                                         | 23,403     |   | $ | 110 |   |
| Issuance of warrants in  connection with term loan                           |       | $                                         | —     |   | $ | 209 |   |

 

*Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.*

 

3

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**GENAISSANCE PHARMACEUTICALS, INC**.

 

# **Notes to Unaudited CondensedConsolidated Financial Statements**

For the Quarter Ended September 30, 2004

(Amounts in thousands, except per share data)

 

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

 

Genaissance Pharmaceuticals, Inc. (together with itssubsidiary, Lark Technologies, Inc., “Genaissance” or the “Company”) developsinnovative products based on its proprietary pharmacogenomic technology and hasa revenue-generating business in DNA and pharmacogenomic products andservices.  The Company also markets its proprietary *FAMILION* Test, a genetic test for cardiacchannelopathies that is compliant with the Clinical Laboratory ImprovementAmendments, or CLIA, which is designed to detect mutations responsible forcausing Familial Long QT and Brugada Syndromes, two causes of sudden cardiacdeath.  The Company’s product development strategy is focused on drugcandidates with promising clinical profiles and finding genetic markers toidentify a responsive patient population.  This strategy is designed toenable the Company to leverage existing clinical data and, thus, reduce thecosts and risks associated with traditional drug development and increase theprobability of clinical success and commercialization.  The Company’s leadtherapeutic product, vilazodone for depression, is in Phase II of development.

 

The accompanying condensed consolidated financialstatements of the Company were prepared without audit, pursuant to the rulesand regulations of the Securities and Exchange Commission (SEC).  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen 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 condensed consolidatedfinancial statements include, in the opinion of management, all adjustments,including the elimination of all significant intercompany transactions, whichare necessary to present fairly the Company’s consolidated financial positionas of September 30, 2004, and the results of its operations for the threeand nine months ended September 30, 2004 and 2003, respectively. Theresults of operations for such interim periods are not necessarily indicativeof the results to be achieved for the full year.  Certain reclassifications of prior periodamounts have been made to conform with the current period presentation.

 

**The Company believes its existingcash reserves, together with expected future revenues, will not be sufficientto fund its expected net losses, debt service obligations and capitalexpenditures beyond March 31, 2005, based upon its current activities.*** *The Company operates in anenvironment of rapid change in technology and has substantial competition fromcompanies developing genomic related technologies.  In addition to the normal risks associatedwith a business venture, there can be no assurance that the Company’stechnologies will be successfully used, that the Company will obtain adequatepatent protection for its technologies, and that any of its products will becommercially viable.  The Company hasincurred substantial losses to date, has an accumulated deficit ofapproximately $230,400 as of September 30, 2004 and expects to incursubstantial expenditures in the foreseeable future to fund its research and developmentand commercialization of its products.

 

In September 2003, the Company entered into a$5,000 Loan and Security Agreement with Comerica Bank (Comerica).  Borrowings under the agreement arecollateralized by certain assets of the Company.  The terms of the agreement include certainaffirmative, negative and financial covenants, including requirements tomaintain a minimum cash balance and a minimum quick ratio, as defined.  In addition, the agreement also includes amaterial adverse change clause.  Non-compliancewith any of these conditions constitutes an event of default, and the failureto remedy the non-compliance may result in the borrowing becoming immediatelydue and payable or require the Company to maintain restricted cash in an amountequal to 105% of the outstanding debt balance. The Company was not in compliance with the minimum cash requirement atvarious times during the third quarter of 2004 and in October 2004.  The Company was also not in compliance withthe quick ratio requirement.  The Companyhas received waivers of such non-compliance. As a result of the uncertainty surrounding future debt covenantcompliance, the Company has classified the

 

4

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debt with Comerica as a current liability in theaccompanying condensed consolidated balance sheet.

 

The Company is completing a strategic review of itsfinancing needs and its operations, including reducing its operatingcosts.  Further, the Company is alsoreviewing various alternatives to financing its ongoing operations and meetingits obligations, including potentially reorganizing the Company, disposing ofsome of its assets, exploring strategic alternatives such as a potential saleof the Company, developing strategic alliances and/or joint developmentarrangements.  There is no assurance thatthe Company will be able to obtain sufficient financing on acceptable terms, ifat all, or cure or waive any future non-compliance with the terms of its borrowingarrangements.  These circumstances raisesubstantial doubt about the Company’s ability to continue as a going concernand the Company's ability to meet its obligations under certain of its materialagreements, including the Merck agreement described in the next paragraph.  These financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

 

In September 2004, the Company entered into alicense, development and cooperation agreement with Merck KGaA (Merck) pursuantto which the Company acquired an exclusive worldwide license from Merck todevelop and commercialize vilazodone, a small molecule compound.  In consideration for the rights relating tovilazodone, the Company agreed to pay an initial license fee and milestonepayments upon the achievement of specified development, regulatory and salesmilestones.  Under the terms of the agreement, the Company can pay theinitial license fee and milestone payments, until the first commercial sale,through the issuance of its common stock. The Company issued 369 shares of its common stock to Merck in payment ofthe initial license fee.  The full valueof the shares issued is included in research and development expenses in theaccompanying condensed consolidated statements of operations for the ninemonths ended September 30, 2004. Under the terms of the agreement, if Merck and its affiliates’ aggregateownership of the Company’s common stock would exceed 19.9% of the number ofshares of its common stock then outstanding, or if the average closing price ofthe Company’s common stock at the time of the respective payment date is below$2.25 per share, the Company will pay milestone payments to Merck incash.  In addition, the agreement requires that the Company demonstrateits ability to fund the initial research and development activities by July 2005or Merck may terminate the agreement. Pursuant to the terms of the agreement, Merck is entitled to royaltieson all future product sales and a share of all sub-licensing income from anythird party.  The Company is reviewingits alternatives in connection with obtaining the financing required to conductinitial research and development related activities under the Merck agreement.

 

In June 2004, the holder of the Company’s SeriesA Redeemable Convertible Preferred Stock (Series A) exercised its warrant topurchase an additional 190 shares of Series A. See Note 10 for further discussion of the warrant exercise.

 

In April 2004, the Company acquired LarkTechnologies, Inc. (Lark) in a stock-for-stock exchange such that Lark became awholly-owned subsidiary of the Company. Lark provides GLP compliant and research sequencing and relatedmolecular biology services to the pharmaceutical, biotechnology and agbioindustries at its facilities in Houston, Texas and the United Kingdom.  Lark’s 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 other customservices.  See Note 2 for furtherdiscussion of the acquisition.

 

In May 2003, the Company acquired certain assetsand assumed certain liabilities of DNA Sciences, Inc.   The assetsacquired included a GLP compliant DNA banking and a GLP compliant and CLIAlicensed genotyping services business.

 

**(2)**                     **MERGERWITH LARK TECHNOLOGIES**

 

On April 1, 2004, Genaissance acquired Larkin a stock-for-stock exchange accounted for as a purchase transaction.

 

Lark stockholders received 1.81 shares ofGenaissance’s common stock in exchange for each share of Lark common stock foran aggregate of approximately 6,693 shares of Genaissance’s common stock.  In addition,

 

5

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options to purchase Lark common stock were convertedinto options to purchase approximately 1,448 shares of Genaissance’s commonstock.  The total cost of the acquisitionwas approximately $24,486 consisting of the following:

 
| ** **                                                                                            | ** ** | **(Unaudited)** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------|------------|
| Market value of the Company’s common stock issued in  exchange for outstanding Lark common stock |       | $               | 19,879     |   |
| Fair value of Lark stock options assumed                                                              |       | 3,524           |       |
| Direct transaction costs of Genaissance                                                               |       | 1,083           |       |
|                                                                                                  |       | $               | 24,486     |   |

 

The purchase price was allocated to the tangibleand identifiable intangible assets of Lark acquired by Genaissance and theliabilities assumed by Genaissance on the basis of their fair values on theacquisition date.  Genaissance hasallocated the total costs of the acquisition to the net assets of Lark asfollows:

 
| ** **                              | ** ** | **(Unaudited)** | ** ** |
|-----------------------------------------|------------|-----------------|------------|
| Tangible assets acquired                |       | $               | 5,750      |   |
| Identifiable intangible assets acquired |       | 11,037          |       |
| Goodwill                                |       | 10,799          |       |
| Liabilities assumed                     |       | (3,100          | )          |
| Total purchase price                    |       | $               | 24,486     |   |

 

Identifiableintangible assets include backlog of $200, with an estimated useful life of oneyear, customer relationships of $7,200, with an estimated useful life of 15years, and GLP certification of $137 and trade name of $3,500, with indefiniteuseful lives (see Note 5).  Theindefinite lived intangible assets will not be amortized and will be tested forimpairment at least annually.  Goodwillrepresents the excess of the purchase price over the fair value of the nettangible and intangible assets acquired less liabilities assumed.  Amortization of all of the intangible assetsis not deductible for income tax purposes. A federal deferred tax liability of approximately $2,516 has beenestablished for the tax effects of temporary differences resulting from thepurchase price allocation.  This federaldeferred tax liability has been offset by the recognition of deferred taxassets for the tax effects of the carryforward losses of the Company.  As a result, these federal deferred taxliabilities had no net impact on goodwill. The Company recognized a state deferred tax liability of approximately $222as a result of the tax effects of temporary differences arising from thepurchase price allocation.

 

The results of operations of Lark are included in theCompany’s condensed consolidated statements of operations since the date ofacquisition.  Supplemental pro formadisclosure of results of operations for the three months ended September 30,2003, and nine-month periods ended September 30, 2004 and 2003,respectively, as though the merger had been completed as of January 1,2003, are as follows:

 
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **2003**                                   | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
|                                         |       |                                       |       |                                      |       |   |   |
| Revenue                                      |       | $                                          | 4,928      |                                      | $          | 16,571 |   | $ | 14,851 |   |
| Operating loss                               |       | (5,455                                     | )          | (16,432                                   | )          | (13,073 | ) |
| Net loss attributable to common stockholders |       | (5,601                                     | )          | (19,486                                   | )          | (13,142 | ) |
| Earnings per share                           |       | $                                          | (0.19      | )                                         | $          | (0.62 | ) | $ | (0.44 | ) |

 

Thefinancial statements of the Company’s U.K. facility are measured using thelocal currency as the functional currency. Assets and liabilities of the U.K. facility are translated at the ratesof exchange at the balance sheet date. The resulting translation adjustments are recorded in a separatecomponent of stockholders’ equity included in other comprehensive income (loss)(see Note 11).  Income and expense itemsare translated at average monthly rates of exchange.

 

6

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Laboratoryservices revenue for the U.K. facility totaled approximately $882 for the threemonths ended September 30, 2004.

 

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

 

TheCompany computes and presents net loss per share in accordance with Statementof Financial Accounting Standards No. 128, *Earnings Per Share*(SFAS No. 128).  For the three and nine months ended September 30,2004 and 2003, respectively, there is no difference in basic and diluted netloss per common share as the effect of Series A, stock options and warrantswould be anti-dilutive for all periods presented.  The outstanding Series A, stock options andwarrants (prior to application of the treasury stock method) would entitleholders to acquire 10,986 and 4,185 shares of common stock at September 30,2004 and 2003, respectively.

 

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

 

The Company earnsits revenue primarily through the licensing of its *HAP* Technology and by providing molecular biologyservices.  The Company has also enteredinto agreements that entitle the Company to receive future milestone androyalty payments.  The Company recognizesrevenue in accordance with Staff Accounting Bulletin No. 104, *Revenue Recognition* (SAB 104) (whichsupercedes SAB 101, *Revenue Recognition inFinancial Statements*), Statement of Position 97-2 (SOP 97-2), *Software Revenue Recognition*, as amendedby Statement of Position 98-9 (SOP 98-9), and Emerging Issues Task Force Issue00-21 (EITF 00-21), * Revenue Arrangements with MultipleDeliverables*.  In accordancewith SAB 104 and EITF 00-21, the Company generally recognizes license fees overthe term of the agreement and service fees as the services are performed.  Revenue associated with GLP compliant DNAbanking and genotyping services and Lark’s molecular biology services areincluded in laboratory services in the accompanying condensed consolidatedstatements of operations.  For agreementswith multiple deliverables, revenue is not recognized unless the fair value ofthe undelivered elements can be determined and the elements delivered havestand-alone value to the customer. Future milestones and royalty payments, if any, will be recognized,provided that the milestone is substantive and a culmination of the earningsprocess has occurred.

 

Deferred revenueresults when consideration is received or amounts are receivable in advance ofrevenue recognition.  Deferred revenuerelated to license agreements is recognized over the license period.  The Company does not record revenue fromlicense agreements that include early termination provisions until thetermination provisions expire.  Upon theexpiration of the termination provisions, the Company’s policy is to recognizerevenue for the period from the original license date to the date the earlytermination provisions expire.

 

**(5)****                     GOODWILLAND INTANGIBLE ASSETS**

 

Goodwill andidentifiable intangible assets recorded in the condensed consolidated balancesheet of the Company are comprised of the following as of September 30,2004:

 
| ** **                       | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
|----------------------------------|------------|-------------------|------------|-------------------------------|------------|
|                             |       |              |       |                          |       |
| Amortizable intangible assets:   |       |              |       |                          |       |
| Patents acquired                 |       | $                 | 868        |                          | $          | (164 | ) |
| Lark customer relationships      |       | 7,200             |       | (240                          | )          |
|                             |       |              |       |                          |       |
| Unamortizable intangible assets: |       |              |       |                          |       |
| Lark trade name                  |       | 3,500             |       | —                        |       |
| Lark GLP certification           |       | 137               |       | —                        |       |
| Lark goodwill                    |       | 11,181            |       | —                        |       |
|                             |       |              |       |                          |       |
| Total                            |       | $                 | 22,886     |                          | $          | (404 | ) |

 

The expectedamortization expense for the current and each of the next four years is asfollows:

 

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| Fiscal 2004 |   | $   | 479    |   |
|-------------|--------|-----|--------|--------|
| Fiscal 2005 |   | 599 |   |
| Fiscal 2006 |   | 599 |   |
| Fiscal 2007 |   | 598 |   |
| Fiscal 2008 |   | 559 |   |

 

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

 

At September 30, 2004, the Company had onestock-based compensation plan, which is accounted for under the recognition andmeasurement principles of Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees,*and related interpretations.

 

The following table illustrates the effect on netincome and earnings per share, if the Company had applied the fair valuerecognition provisions of FAS 123, *Accountingfor Stock-Based Compensation*, to stock-based employee compensationfor the three and nine months ended September 30, 2004 and 2003,respectively:

 
| ** **                                                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Net loss applicable to common stockholders, as  reported                          |       | $                                          | (6,027     | )                                         | $          | (5,844 | ) | $ | (18,613 | ) | $ | (14,355 | ) |
| Add: Stock-based employee compensation expense  included in reported net loss     |       | 23                                         |       | 59                                        |       | 87 |   | 176 |   |
| Deduct: Total stock-based employee compensation  expense determined under FAS 123 |       | (1,810                                     | )          | (353                                      | )          | (3,984 | ) | (1,130 | ) |
| Pro forma net loss applicable to common stockholders                              |       | $                                          | (7,814     | )                                         | $          | (6,138 | ) | $ | (22,510 | ) | $ | (15,309 | ) |
|                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Net loss per share:                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Basic and diluted - as reported                                                   |       | $                                          | (0.20      | )                                         | $          | (0.25 | ) | $ | (0.66 | ) | $ | (0.63 | ) |
|                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Basic and diluted - pro forma                                                     |       | $                                          | (0.25      | )                                         | $          | (0.27 | ) | $ | (0.80 | ) | $ | (0.67 | ) |

 

**(7)**                     **SIGNIFICANTCUSTOMERS**

 

Forthe nine months ended September 30, 2004 and 2003, Customer A accountedfor 17% and 13% of the Company’s revenue, respectively. Customer B accountedfor 11% of revenue for the nine months ended September 30, 2004.  Customers C and D accounted for 30% and 14%of the Company’s revenue for the nine months ended September 30, 2003,respectively.  The collaborationagreement with Customer C expired in the first quarter of 2004.  Customer A and Customer B accounted for 10%and 33%, respectively, of the Company’s accounts receivable balance as of September 30,2004. No other customer accounted for 10% or more of the Company’s accountsreceivable balance as of September 30, 2004.

 

**(8)****                     INVESTMENT INAFFILIATE**

 

In November 2003, the Company entered intoseveral agreements with Sciona Limited (Sciona), a private company based in theU.K., whereby the Company granted a technology license to Sciona (TechnologyLicense) in exchange for a 37% equity interest (30% on a fully diluted basis)in Sciona (Investment).  The TechnologyLicense grants Sciona an exclusive license to the Company’s *HAP* Technology for consumer tests, asdefined in the Technology License, for a period of five years.  Sciona is obligated to pay to the Companyspecified royalties and service fees, subject to minimum annual payments.  The Company was also granted specified rightsto develop genotyping assays and perform genetic tests.

 

TheCompany agreed to fund certain expenses of Sciona for up to 18 months or untilSciona reaches certain levels of financial performance (ScionaMilestones).  In September 2004,Sciona met the Sciona Milestones and subsequently paid the majority of theexpenses funded by the Company.  Theremaining amount due to

 

8

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theCompany is included in other current assets in the accompanying condensedconsolidated balance sheet as of September 30, 2004.

 

Deferredrevenue resulting from the Technology License and the accompanying investmentwere recorded based upon the approximate $2,600 estimated fair value of theequity in Sciona as of the date of the Technology License.  The excess of the Investment, over theunderlying fair value of the net assets of Sciona, is considered to beunamortizable goodwill.  Deferred revenueis being amortized into income over the term of the Technology License.  The accompanying condensed consolidatedstatements of operations include $448 of license and research revenuerecognized in the current period due to the expiration of the early terminationprovision contained in the Technology License. The revenue recognized represents the ratable portion from the date ofthe Technology License through September 30, 2004 as a result of Scionameeting the Sciona Milestones.  Also,included in the accompanying condensed consolidated statements of operations, forthe three and nine months ended September 30, 2004, are $108 and $192,respectively, of license and research revenues for services provided to Sciona.

 

Inconjunction with the Sciona Milestones being met by means of an equityinvestment from third parties, the Company’s equity interest in Scionadecreased to 13% (11% on a fully diluted basis).  As a result, the Company changed its methodof accounting for the investment from the equity method to the cost method asnone of the criteria for equity method accounting were now met.  During the three months ended September 30,2004, the Company recorded a $1,003 charge to write-down the investment to itscurrent estimated fair value based on the price at which securities weresold.  Prior to changing its method ofaccounting for the impairment to the cost method, the Company recorded itsshare of Sciona’s losses in equity in loss of affiliate in the accompanyingcondensed consolidated statements of operations.  For the three and nine months ended September 30,2004, the Company recorded $150 and $450, respectively, of such losses.  The Company has reduced the investment inaffiliate in the accompanying condensed consolidated balance sheet for thewrite-down of the Investment as well as the recording of its share of theSciona losses.

 

**(9)****                     LONG-TERMDEBT**

 

In September 2003,the Company entered into a $5,000 Loan and Security Agreement withComerica.  The agreement requires equalmonthly payments of principal over a 36-month period and bears interest atprime (4.75% as of September 30, 2004) plus 2.5%.  Borrowings under the agreement, which totaledapproximately $3,333 at September 30, 2004, are collateralized by certainassets of the Company.  Under the termsof the agreement, the Company is required to satisfy certain financialcovenants, including a minimum cash balance and a minimum quick ratio, asdefined.  In addition, the agreementincludes a clause, which provides that all amounts become immediately due andpayable upon a material adverse change in the business.  The Company was not in compliance with theminimum cash requirement at various times during the third quarter of 2004 andin October 2004.  The Company hasreceived a waiver of such non-compliance. In addition, the Company was not in compliance with the quick ratiorequirement and has received a waiver through November 30, 2004.  If the Company does not comply with its debtcovenants, and if future waivers are not obtained, Comerica will have certainremedies available which include demanding immediate repayment of the amountsoutstanding under the agreement, plus interest, or requiring the Company tomaintain restricted cash in an amount equal to 105% of the outstanding debtbalance.  Due to the uncertainty surroundingfuture debt covenant compliance, the Company has classified the Comerica debtas current in the accompanying condensed consolidated balance sheet. Thisincludes approximately $1,700 of debt that, under the terms of the agreement,is not due within the next twelve months.

 

TheCompany also has financing agreements with Connecticut Innovations, Inc.(CII).  The Company is in compliance withall covenants under the CII agreements as of September 30, 2004 and theagreements do not contain any cross default provisions.

 

9

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**(10)****              PREFERRED STOCK**

 

In October 2003, the Company sold 270 shares ofSeries A, $0.001 par value per share, to RAM Trading, Ltd. (“RAM”) for $22.50per share, resulting in proceeds of approximately $5,925, net of issuance costsof approximately $150.  In connectiontherewith, the Company issued RAM a warrant to purchase an additional 190shares of Series A through December 31, 2005, at $22.50 per share, whichRAM exercised on June 30, 2004, resulting in gross proceeds to the Companyof $4,275.  In connection with theexercise of the warrant, the Company granted an affiliate of RAM a warrant topurchase approximately 262 shares of common stock at the then fair market valueof $4.17 per share.  The fair value ofthe warrant, as determined under the Black-Scholes model, of approximately$833, is included in warrant issuance expense in the accompanying condensedconsolidated statements of operations for the nine months ended September 30,2004.

 

The Series A shares and the Series A warrant wereinitially recorded at their relative fair market values of $5,195 and $880,respectively.  As a result of the putrights discussed below, the difference in the stated value and the carryingvalue of the Series A, resulting from the allocation of the proceeds and theissuance costs, is being accreted through the earliest Put Date (as definedbelow) using the effective interest rate method.  This accretion results in a higher effectivedividend and is reflected in net loss applicable to common stockholders in theaccompanying condensed consolidated statements of operations for the three andnine months ended September 30, 2004.

 

Under the terms of the Series A, the Company isrequired to redeem, unless the holders of at least 66-2/3% of the Series Aelect otherwise, all of the outstanding shares of Series A if asignificant event, as defined, occurs or the Company breaches certaincovenants.  Among these significantevents is the issuance of shares of the Company’s common stock or securitiesconvertible into common stock, with a purchase price of less than $2.25 pershare, other than in limited circumstances. The redemption value of the Series A is the original stated purchaseprice of $22.50 per share, plus accrued but unpaid dividends.  A significant event is generally defined as adissolution of the Company or the sale of the Company or substantially all ofits assets.  If the significant event orbreach occurs prior to October 29, 2008, the face value of the Series Aplus all of the unpaid cash dividends through October 29, 2008 also becomepayable ($11,240 at September 30, 2004). In addition, RAM has the optionto require that the Company redeem all of the outstanding shares ofSeries A on either October 29, 2006, 2007 or 2008 (the Put Dates).Genaissance may delay such payment for up to one year, in which case thedividend rate would increase to 10% per annum.

 

Inconnection with the issuance of the Series A, the Company is required tomaintain certain covenants.  The****most significant of these covenants restricts the Companyfrom: (i) incurring indebtedness in excess of $9,000; (ii) paying dividends onits common stock; and (iii) redeeming most of its equity securities.  The Company was in compliance with thesecovenants as of September 30, 2004.

 

In June 2004,RAM agreed not to convert its Series A if such conversion would cause RAM,together with RAM’s affiliates, to beneficially own in excess of 9.99% of theCompany’s common stock.

 

**(11)**              **COMPREHENSIVEINCOME (LOSS)**

 

TheCompany reports 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 and foreign currency translation gains (losses). 

Asummary of total comprehensive loss is as follows:

 

10

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| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                         |       |                                       |       |                                      |       |   |   |   |   |
| Net loss attributable to common stockholders |       | $                                          | (6,027     | )                                         | $          | (5,844 | ) | $ | (18,613 | ) | $ | (14,355 | ) |
| Other comprehensive income (loss)            |       | (9                                         | )          | (1                                        | )          | (20 | ) | (24 | ) |
| Total comprehensive loss                     |       | $                                          | (6,036     | )                                         | $          | (5,845 | ) | $ | (18,633 | ) | $ | (14,379 | ) |

 

**(12)**              **INCOMETAXES**

 

The State of Connecticut(the State) allows companies conducting business in the State to receive cashrefunds from the State at a rate of 65% of their incremental qualifyingresearch and development tax credit, as defined, in exchange for foregoing thecarryforward of the research and development tax credit.  The State had allowed the exchange program tolapse for the 2002 tax year, however, during the second quarter of 2003, theState passed legislation to reinstate the program for the 2002 tax year.  The legislation to reinstate the exchangeprogram for the 2003 and 2004 tax years was passed during the third quarter of2003.  The Company recorded the fiscal2003 tax benefit of approximately $200 in the quarter ended September 30,2003.  In addition, the Company recordedthe fiscal 2002 tax benefit of approximately $320 during the nine months ended September 30,2003.  In the nine months ended September 30,2004, the Company has recorded an estimated benefit of approximately $175related to the State exchange program which is offset by foreign and state taxexpense.

 

**(13)****              COMMITMENTS ANDCONTINGENCIES**

 

In the ordinary course of its business, the Companyenters into agreements with third parties that include indemnificationprovisions, which, in the Company’s judgment, are normal and customary forcompanies in its industry.  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 and servicesor product candidates, use of such products and services or other actions takenor omitted by the Company. The maximum potential amount of future payments thatthe Company could be required to make under these indemnification provisions isunlimited, and the Company may have insurance coverage related to any potentialloss.  The Company has not incurred anycosts to defend lawsuits or settle claims related to these indemnificationprovisions.  As a result, the currentestimated fair value of liabilities relating to these provisions isminimal.  Accordingly, the Company hasnot recorded a liability for these provisions as of September 30, 2004.

 

The Company periodicallyenters into agreements with third parties to obtain exclusive or non-exclusivelicenses for certain technologies.  Theterms of certain of these agreements require the Company to, among other items,demonstrate its ability to fund certain research and development andcommercialization activities, pay future royalty payments and pay certainmilestone payments based on product sales or sublicense income generated fromapplicable technologies, if any.  Thetiming of such events and the amount of such payments will depend uponsuccessful commercialization of applicable technologies, if any.

 

On September 22, 2004, the Company enteredinto a license, development and cooperation agreement with Merck pursuant towhich the Company acquired an exclusive worldwide license from Merck to developand commercialize vilazodone, a small molecule compound.  The Company paidan initial license fee, agreed to pay milestone payments upon the achievementof specified development, regulatory and sales milestones and royalties on allfuture product sales and a share of all sub-licensing income from any thirdparty on the commercialization of vilazodone.  Under the agreement, theCompany is required to demonstrate that by no later than July 22, 2005,the Company will have at least $8.0 million in financing or have shown thecapacity to fund such levels of research and development activities in 2005relating to vilazodone.  If the Company is unable to meet thisrequirement, Merck can terminate the agreement and reacquire the compound. Inaddition, if Merck and its affiliates’ aggregateownership of the Company’s common stock would exceed 19.9% of the number ofshares of its common stock then outstanding, or if the average closing price ofits common stock at

 

11

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the time of the respective payment is below$2.25 per share, the Company will be required to make the milestone payments toMerck in cash.

 

**(14)**              **SUBSEQUENTEVENT**

 

On November 9, 2004, the Company, as part of astrategic review of its operations, reduced its workforce by approximately10%.  The majority of the workforcereductions occurred in research and development.  The Company expects to take a charge ofapproximately $400 in the fourth quarter of 2004, primarily for severanceobligations.

 

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**Item 2 – Management’s Discussionand Analysis of Financial Condition and Results of Operations.**

 

*Thefollowing discussion and analysis of our consolidated financial condition andresults of operations should be read in conjunction with the financialstatements and related notes appearing elsewhere in this Quarterly Report onForm 10-Q.  This Quarterly Report on Form10-Q contains forward-looking statements within the meaning of Section 21Eof the Securities Exchange Act of 1934, as amended, that involve risks anduncertainties, including, but not limited to, statements about management’sexpectations as to our revenue, costs and liquidity position.  These expectations are based on certainassumptions regarding our ability to attract additional sources of financing,our efforts to build a pharmacogenomic franchise around ion channel mutations,the timing and outcome of our genetic testing programs, 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 we do not obtain additional financing, if development effortsare delayed or suspended or if other assumptions prove incorrect.  These factors are more fully discussed belowunder the heading “Factors Affecting Future Operating Results” and in our otherfilings with the Securities and Exchange Commission.  Readers are cautioned not to place unduereliance on these or other forward-looking statements, which reflect management’sanalysis, judgment, belief or expectation only as of the date on which they aremade.  While we may elect to updateforward-looking statements at some time in the future, we specifically disclaimany obligation to do so, even if our estimates change.*

 

**CommonTerms**

 

We usethe following terms in this Management’s Discussion and Analysis of FinancialCondition and Results of Operations:

 

*HAP* Technology – the key components of our *HAP* Technology are:a database of highly-informative, proprietary measures of genomic variation, orhaplotypes, which we call *HAP* Markers, for pharmaceutically relevantgenes; a proprietary informatics system, which we call *DecoGen*, including unique algorithms, fordefining patient populations with different drug responses; a cost-effective,efficient process for measuring genomic variation in clinical DNA samples,which we call *HAP* Typing; and clinical genetics developmentskills.

 

STRENGTHprogram (Statin Response Examined by Genetic *HAP* Markers) – this program was designed to applyour *HAP* Technology and our clinical genetics development skills to the statinclass of drugs, which doctors use to treat patients with high cholesterol andlipid levels and who are, therefore, at risk for cardiovascular disease.

 

CARINGprogram (Clozapine and Agranulocytosis Relationships Investigated by Genetics (*HAP* Markers)) – this program was designedto identify which of our *HAP* Markers define the patients who are mostlikely to develop agranulocytosis, a potentially life-threatening depletion ofwhite blood cells, if treated with clozapine.

 

CardiacChannelopathies program – this program was designed to develop a genetic testfor detecting cardiac ion channel mutations that is compliant with the ClinicalLaboratory Improvement Amendments, or CLIA. Cardiac channelopathies, including familial Long QT and BrugadaSyndromes, are conditions that affect the electrical system of the heart.  These conditions are caused by geneticmutations that result in structural abnormalities in the potassium and sodium channelsof the heart and predispose affected individuals to an abnormal heart rhythm,or arrhythmia.  Familial Long QT andBrugada Syndromes are commonly seen in apparently healthy, active adolescentpatients.  If left undiagnosed anduntreated, these conditions can be fatal.  We launched our *FAMILION* Test in May 2004, which is a CLIAcompliant genetic test for cardiac channelopathies.  We will also seek to discover genetic markersthat are predictive of drug-induced QT prolongation and arrhythmias, and arrhythmiasthat occur in patients with other disorders such as congestive heartfailure.

 

Vilazodoneprogram – this program is designed to obtain genetic markers to define patientswho are most likely to respond to vilazodone, a small molecule compound in-licensedfrom Merck KGaA (Merck), which is under development for the treatment ofdepression.

 

ProprietaryPrograms – the five programs described above are referred to collectively asour proprietary programs.

 

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MolecularBiology Services – these services include Good Laboratory Practices, or GLP,compliant DNA banking and research and GLP compliant sequencing, genotyping andrelated services.

 

**Overview**

 

Wedevelop innovative products based on our proprietary pharmacogenomic technologyand have a revenue-generating business in DNA and pharmacogenomic products andservices.  We also market our proprietary *FAMILION*Test, a CLIA compliant genetic test for cardiac channelopathies, which is designedto detect mutations responsible for causing Familial Long QT and BrugadaSyndromes, two causes of sudden cardiac death.  Our product developmentstrategy is focused on drug candidates with promising clinical profiles andfinding genetic markers to identify a responsive patient population.  Thisstrategy is designed to enable Genaissance to leverage existing clinical dataand, thus, reduce the costs and risks associated with traditional drugdevelopment and increase the probability of clinical success andcommercialization.  Our lead therapeutic product, vilazodone fordepression, is in Phase II of development.

 

As of September 30,2004, we had a total of 8,079 genes in our database with 71 of these geneshaving been added during the quarter ended September 30, 2004, and 256genes having been added during the quarter ended September 30, 2003.  There is not necessarily any correlationbetween the costs incurred in any period and the number of genes added to thedatabase in that period.  This lack of adirect correlation is due to the fact that the size of the gene 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 portions of genes previously included in the database and do furtherquality assurance analysis.

 

**Financing Arrangements**

 

Sinceour inception, we have incurred significant operating losses, and, as of September 30,2004, we had an accumulated deficit of $230.4 million.  The majority of our operating losses haveresulted from costs we incurred developing our HAP Technology, in our clinicaltrials and from administrative costs associated with operations.  As part of our HAP Technology program, wecontinue to populate our database with HAP Marker information forpharmaceutically relevant genes.  Weexpect to dedicate a significant portion of our resources for the foreseeablefuture to continuing the development of our proprietary programs and servicingour proprietary programs and molecular biology services customers.  To date, our revenue has been primarily fromlicensing and service fees from our agreements with Biogen Idec, Inc., GeneLogic, Inc., J&J PRD, Millennium Pharmaceuticals, Inc. Pfizer, Inc. andWayne State University, as well as a sublicensing agreement with VisibleGenetics, Inc. and from the molecular biology services that we offer.

 

We arecompleting a strategic review of our operations, including reducing ouroperating costs.  Further, we are alsoreviewing various alternatives to financing our ongoing operations and meetingour obligations, including potentially reorganizing the Company, disposing ofsome of our assets, exploring strategic alternatives such as a potential saleof the Company, developing strategic alliances and/or joint developmentarrangements.  There is no assurance thatwe will be able to obtain sufficient financing on acceptable terms, if at all,or cure or waive any future non-compliance with the terms of our borrowingarrangements.  These circumstances raisesubstantial doubt about our ability to continue as a going concern and ourability to meet our obligations under certain of our material agreements,including the Merck agreement.

 

**Acquisitions**

 

*Lark Technologies, Inc.*

 

Weacquired Lark Technologies, Inc. in a stock-for-stock exchange that closed on April 1,2004.  In the exchange, each Larkstockholder received 1.81 shares of our common stock for each share of Larkcommon stock held.  Immediately followingthe closing, the former Lark stockholders held approximately 19.2% of totaloutstanding shares of Genaissance, assuming the conversion of our preferredstock and the exercise and conversion of our preferred stock warrant thenoutstanding.

 

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Larkprovides GLP compliant and research sequencing, genetic stability testingservices, gene expression and detection services, and related molecular biologyservices to the pharmaceutical, biotechnology and agbio industries at itsfacilities in Houston, Texas, and the U.K.

 

Werecorded the transaction as a purchase transaction for accounting purposes andallocated the purchase price of approximately $24.5 million to the assetspurchased and liabilities assumed based upon their respective fair values.  We allocated the excess of the purchase priceover the estimated fair market value of the net tangible assets acquired toidentified intangibles with estimated useful lives as follows: backlog – oneyear; customer relationships – 15 years; and GLP certification and trade name –indefinite.  The resulting goodwill wasapproximately $10.8 million.  We expectto incur charges for amortization of intangibles of approximately $680,000 inthe first 12 months post-closing and approximately $480,000 per yearthereafter.

 

Ourconsolidated financial statements include the results of operations and cashflows of Lark from the closing date. Although Lark is contributing positive operating results, we will stillincur net losses in the foreseeable future as we continue to develop ourproprietary programs.  The extent of thebenefits received from the acquisition will depend upon how quickly we are ableto obtain operational efficiencies and increased sales from the integration ofLark’s operations and sales force.

 

*DNA Sciences, Inc.*

 

OnMay 15, 2003, under order of the United States Bankruptcy Court, weacquired certain assets and assumed certain liabilities of DNA Sciences, Inc.for $1.8 million, inclusive of related fees and expenses.  The primaryassets acquired consisted of a GLP compliant DNA banking and a GLP compliantand CLIA licensed genotyping services business and licenses and patent estatessurrounding cardiac channelopathies and a thiopurine S-methyltransferase, orTPMT, test as well as certain trade accounts receivable and fixed assets. By combining these service offerings with our proprietary programs andmolecular biology services, we increased our offerings for the application ofpharmacogenomics to the clinical development and marketing of drugs.

 

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

 

Ourfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America, or GAAP.  The preparation of financial statements inaccordance with GAAP requires management to make estimates, assumptions andjudgments that affect our reported assets and liabilities, revenues andexpenses, and other information reported in our financial statements andaccompanying footnotes.  We base ourestimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, the results of which form ourbasis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources.  Actual results may differ from estimates,sometimes materially.  We regard anaccounting estimate or assumption underlying our financial statements as a “criticalaccounting estimate” where:

 

•                  the nature of the estimate orassumption is material due to the level of subjectivity and judgment necessaryto account for highly uncertain matters or the susceptibility of such mattersto change; and

 

•                  the impact of the estimates andassumptions on financial condition or operating performance is material.

 

Oursignificant accounting policies are more fully described in the Notes toUnaudited Condensed Consolidated Financial Statements section of thisQuarterly Report on Form 10-Q and in Note 2 of the Notes to ConsolidatedFinancial Statements in our Annual Report on Form 10-K for the year ended December 31,2003.  Not all of these significantaccounting policies, however, fit the definition of “critical accountingestimates.”  We have discussed ouraccounting policies with the audit committee of our board of directors, and webelieve that our estimates relating to:

 

•                  revenue recognition;

 

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•                  valuation of long-lived assets;

 

•                  research and development expenses;and

 

•                  goodwill and identifiable intangibleassets

 

fit the definition of “critical accounting estimates.”  The first three estimates above are describedunder the caption “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations – Critical Accounting Policies andEstimates” in our Annual Report on Form 10-K for the year ended December 31,2003.  In addition, we believe that ourestimates relating to goodwill and identifiable intangible assets, which aredescribed below, now fit the definition of “critical accounting estimates.”

 

Goodwill and Identifiable Intangible Assets. We record business combinations underthe provisions of Statement of Financial Accounting Standards (“SFAS”) No. 141,*Business Combinations,* and SFASNo. 142, *Goodwill and Other IntangibleAssets*. These standards require the use of the purchase method ofaccounting for business combinations, set forth the accounting for the initialrecognition of acquired intangible assets and goodwill and describe theaccounting subsequent to initial recognition. Under the provisions of thesestandards, goodwill and intangible assets deemed to have indefinite lives arenot subject to amortization. All other intangible assets are amortized overtheir estimated useful lives. Goodwill and intangible assets are subject toannual impairment tests and will also be tested for impairment between annualtests, if changes in circumstances indicate that the carrying amount may beimpaired. This testing compares carrying values to fair values and, if thecarrying value of these assets is less than the fair value, an impairment lossis recognized for the amount of the difference.

 

**Resultsof Operations**

 

***Three Months Ended September 30,2004 and 2003***

 

Licenseand research revenue consists primarily of revenue recognized in connectionwith the licensing of our *HAP* Technologyand related research services.  Licenseand research revenue increased to $2.8 million for the three months ended September 30,2004 from $1.9 million for the same period in 2003.  The increase was primarily due to an $800,000increase in revenue from research genotyping and a $448,000 increase in revenuerecognized from Sciona due to the expiration of the early termination provisionin the agreement.  The increase waspartially offset by the expiration of the J&J PRD contract, which accountedfor $750,000 of revenue in the three months ended September 30, 2003.

 

Laboratoryservices revenue consists of revenue recognized from services provided by ourGLP compliant DNA banking and genotyping facility, which we acquired in May2003, and GLP compliant sequencing and molecular biology services provided byLark, which we acquired in April 2004. Laboratory services revenue increased to $2.8 million for the threemonths ended September 30, 2004 from $625,000 for the same period in 2003.The increase in laboratory services revenue is primarily attributable to theinclusion of $2.1 million of revenue from Lark customers during the threemonths ended September 30, 2004.

 

Costof laboratory services consists of payroll and benefits for personnel,materials and reagent costs, depreciation and maintenance and facility-relatedcosts incurred in providing the laboratory services.  The cost of laboratory services was $2.0million for the three months ended September 30, 2004 compared to $686,000for the same period in 2003.  Theincrease is primarily due to the inclusion of approximately $1.2 million ofexpenses incurred by Lark in the quarter ended September 30, 2004.  We expect the cost of laboratory services todecrease as a percentage of revenues as our revenues increase because asubstantial portion of these costs are fixed costs that relate to our operatingfacilities.

 

Researchand development expenses consist primarily of payroll and benefits for researchand development personnel, materials and reagent costs, depreciation expenseand maintenance costs for equipment used for *HAP*Marker discovery and *HAP* Typing,technology license fees and facility-related costs.  We expense our research and development costsas incurred.  Research and developmentcosts decreased to $4.7 million for the three months ended September 30,2004 from $5.4 million for the same period in 2003.  A substantial portion of our research and

 

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development expendituresare incurred in developing and conducting our proprietary programs.  The following is a breakdown of research anddevelopment expenses (in thousands):

 
| ** **                    | ** ** | **Three Months Ended**       | ** ** |
|-------------------------------|------------|------------------------------|------------|
| ** **                    | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|                          |       |                         |       |   |   |
| Payroll and benefits          |       | $                            | 1,790      |   | $ | 2,250 |   |
| Depreciation and amortization |       | 440                          |       | 1,560 |   |
| Material and reagent costs    |       | 690                          |       | 630 |   |
| License fees                  |       | 1,010                        |       | 290 |   |
| Repairs and maintenance       |       | 140                          |       | 160 |   |
| Other                         |       | 653                          |       | 521 |   |
|                          |       |                         |       |   |   |
| Total                         |       | $                            | 4,723      |   | $ | 5,411 |   |

 

Thedecrease in research and development expenses for the three months ended September 30,2004 is primarily attributable to a decrease of approximately $1.1 million indepreciation and amortization expenses and a decrease of approximately $460,000in payroll and benefits expenses, which were partially offset by an increase of$720,000 in license fees.  The decreasein depreciation and amortization expenses is primarily due to the fact that themajority of our DNA sequencing machines and the related assets became fully depreciatedduring the quarter ended June 30, 2004. The decrease in payroll and benefits expenses is primarily due to theresignation of our Chief Scientific Officer during the quarter ended September 30,2003 who received one year of salary as severance in accordance with hisemployment agreement.  The increase in license fees is primarily due to anapproximate $929,000 non-cash charge incurred in connection with our issuanceof common stock as a license payment under a license agreement entered intowith Merck for in-licensing of vilazodone, a drug candidate in clinicaldevelopment. We reduced our work force by approximately 10% in November 2004,to better align our operating structure with our current and projected revenuesand reduced expenses in certain other areas. The majority of the workforce reductions occurred in research anddevelopment.  We expect to take a chargeof approximately $400,000 in the fourth quarter of 2004, primarily relating toseverance obligations in connection with this workforce reduction. We expect tocontinue to devote substantial resources to research and development expensesin the near future as we continue to develop our proprietary programs.  We currently do not have sufficient resourcesto continue development under our proprietary programs.  Further development under these programs willdepend upon our ability to secure sufficient funds in a financingtransaction.  See “Financing Arrangements”and “Factors Affecting Future Operating Results” for further discussion.

 

Selling,general and administrative expenses consist primarily of payroll and benefitsfor executive, business development, finance and other administrativepersonnel, as well as facility related costs and outside professional feesincurred in connection with corporate development, general legal and financialmatters.  Selling, general andadministrative expenses increased to approximately $3.5 million for the threemonths ended September 30, 2004 from $2.1 million for the same period in2003.  The increase is primarily due tothe inclusion of $701,000 in expenses incurred by Lark in the third quarter of2004 as well as amortization of intangible assets of $170,000 and $67,000 ofdeferred compensation, recognized from the purchase of Lark.  In addition, professional fees increased by approximately$600,000 in the three months ended September 30, 2004, primarily due to anincrease in professional and consulting fees incurred in connection with theevaluation of our internal controls as required under Section 404 of theSarbanes-Oxley Act of 2002 and fees incurred in connection with thein-licensing of vilazodone.

 

Other income decreased toapproximately $39,000 for the three months ended September 30, 2004 fromincome of $52,000 for the same period in 2003. The decrease is primarily due to a decrease in interest income as aresult of higher cash, cash equivalents and short-term investment balances in2003.

 

Interestexpense increased to approximately $168,000 for the three months ended September 30,2004 from $122,000 for the same period in 2003. The increase is primarily the result of recording all of the futureinterest associated with the capital leases that we entered into with FinovaCapital Corporation (Finova) in the quarter ended December 31, 2002 whichresulted in lower interest expense during 2003.

 

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Write-down of investment in affiliate of $1.0 millionfor the three months ended September 30, 2004 represents a charge to write downour equity interest in Sciona Limited (Sciona) to its estimated current fairvalue.  In November 2003, we grantedSciona a license to our *HAP*Technologyin exchange for an equity interest in Sciona.

 

Income tax benefit decreased to approximately $47,000for the three months ended September 30, 2004 from approximately $200,000 forthe same period in 2003.  The State ofConnecticut (the State) allows companies conducting business in the State toreceive cash refunds from the State at a rate of 65% of their incrementalqualifying research and development tax credit, as defined, in exchange forforegoing the carryforward of the research and development tax credit.  The State had allowed the exchange program tolapse for the 2003 tax year, however, in August 2003, the State passedlegislation to reinstate the program for the 2003 and 2004 tax years.  We recorded the year-to-date 2003 tax benefitin the quarter ended September 30, 2003. In 2004, we are recording the estimated benefit as earned during theyear.  For the quarter ended September30, 2004, this benefit was offset by foreign and state taxes recorded duringthe period as a result of the acquisition of Lark.

 

Equity in loss ofaffiliate of $150,000 for the three months ended September 30, 2004 representsour percentage interest in the unaudited losses of Sciona.  In November 2003, we granted Sciona a licenseto our *HAP*Technology in exchangefor an equity interest.  Due to thechange in method of accounting for the investment from the equity method to thecost method, we will no longer record our percentage interest in the results ofoperations of Sciona.

 

***Nine Months Ended September 30, 2004 and 2003***

 

License and research revenue increased toapproximately $8.3 million in the nine months ended September 30, 2004 from$6.8 million in the nine months ended September 30, 2003.  The increase in license and research revenueis primarily attributable to a $1.8 million increase in research genotypingservice revenue, which was partially offset by a one-time $675,000 license feereceived from Prometheus Laboratories, Inc. for expanded rights to the TPMTtest during the nine months ended September 30, 2003.

 

Laboratory services revenue increased to approximately$6.4 million in the nine months ended September 30, 2004 from $1.0 million inthe nine months ended September 30, 2003. The increase in laboratory services revenue is attributable to theinclusion of $4.4 million of revenue from Lark since the date ofacquisition.  In addition, revenue fromour GLP compliant DNA banking and genotyping facility is included for a fullnine months in 2004 as opposed to 2003 which only included revenue earned fromthe date of acquisition on May 15, 2003.

 

The cost of laboratoryservices was $4.9 million for the nine months ended September 30, 2004 comparedto $1.0 million for the same period in 2003. The increase is due to the inclusion of $2.4 million of expensesincurred by Lark since the date of acquisition and an increase of approximately$1.5 million in expenses incurred by our GLP compliant DNA banking andgenotyping facility in North Carolina. The expenses for 2003 included only those expenses incurred since weacquired the facility from DNA Sciences on May 15, 2003.

 

Research and development expenses increased toapproximately $15.9 million in the nine months ended September 30, 2004 fromapproximately $14.9 million for the same period in 2003.  The following is a breakdown of research anddevelopment expenses (in thousands):

 

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| ** **                     | ** ** | **Nine Months Ended**   | ** ** |
|--------------------------------|------------|-------------------------|------------|
| ** **                     | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|                           |       |                    |       |   |   |
| Payroll and  benefits          |       | $                       | 5,940      |   | $ | 6,030 |   |
| Depreciation and  amortization |       | 2,970                   |       | 4,730 |   |
| Material and  reagent costs    |       | 2,590                   |       | 1,630 |   |
| License fees                   |       | 1,720                   |       | 430 |   |
| Repairs and  maintenance       |       | 420                     |       | 420 |   |
| Stock based  compensation      |       | 200                     |       | — |   |
| Other                          |       | 2,023                   |       | 1,619 |   |
|                           |       |                    |       |   |   |
| Total                          |       | $                       | 15,863     |   | $ | 14,859 |   |

 

The increase in research and development expenses isprimarily attributable to an increase of approximately $960,000 in material andreagent costs, an increase of approximately $1.3 million in license fees and anincrease of approximately $404,000 in other expenses, which were partiallyoffset by a decrease of $1.8 million in depreciation and amortization expenses.The increase in the material and reagent costs is primarily due to an increasein research services provided by our research facility, costs incurred inadvance of the related revenue and increases in internal research activitiesrelated to our *FAMILION*Test.  The increase in license fees isprimarily due to an approximate $1.2 million non-cash charge for shares ofcommon stock that we issued to Merck in connection with the in-licensing ofvilazodone, a drug candidate in clinical development.  The increasein other expense is primarily due to an increase in consulting fees related toour *FAMILION* Test and inconnection with the in-licensing of vilazodone. The decrease in depreciation and amortization expense is primarily dueto the full depreciation of many of our DNA sequencing machines and the relatedassets during the quarter ended June 30, 2004.

 

Selling, general and administrative expenses increasedto approximately $9.5 million in the nine months ended September 30, 2004 fromapproximately $6.2 million in the nine months ended September 30, 2003.  The increase is primarily due an increase of$1.5 million due to the inclusion of Lark since April 2004.  Amortization of the intangible assetsrecognized from the Lark purchase accounted for an additional $340,000 inexpense over the prior year. Professional fees increased by approximately $1.2million in the nine months ended September 30, 2004, primarily due to anincrease in professional and consulting fees incurred in connection with theevaluation of our internal controls as required under Section 404 of theSarbanes-Oxley Act of 2002 and fees incurred in connection with the in-licensingof vilazodone.  In addition, a sales anduse tax refund of $288,000 was recorded during the nine months ended September30, 2003.

 

Other income decreased to approximately $123,000 inthe nine months ended September 30, 2004 from $276,000 in the nine months endedSeptember 30, 2003.  The decrease isprimarily due to a decrease in interest income as a result of higher cash, cashequivalent and short-term investment balances in 2003.

 

Interest expense increased to approximately $523,000in the nine months ended September 30, 2004 from approximately $514,000 in thenine months ended September 30, 2003. The increase is primarily the result of recording all of the futureinterest associated with the Finova capital leases in the quarter endedDecember 31, 2002 which resulted in lower interest expense during 2003.

 

Write-down of investment in affiliate of approximately$1.0 million for the nine months ended September 30, 2004 represents a chargein the three months ended September 30, 2004 to write down our equity interestin Sciona to its estimated current fair value.

 

Income tax benefit decreased to approximately $60,000for the nine months ended September 30, 2004 from a benefit of approximately$520,000 for the same period in 2003. The benefit represents a net tax benefit from the State of Connecticutas a result of legislation which allows companies conducting business in theState to receive cash refunds from the State at a rate of 65% of theirincremental qualifying research and development tax credit, as defined, inexchange for foregoing the carryforward of the research and development taxcredit.  The State had allowed theexchange program to lapse for the 2002 tax year, however, during the secondquarter of 2003, the State

 

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passed legislationto reinstate the program for the 2002 tax year. The legislation to reinstate the exchange program for the 2003 and 2004tax years was passed during the third quarter of 2003.  This benefit is offset by estimated foreignand state taxes of approximately $115,000 recorded during the nine months endedSeptember 30, 2004.

 

Equity in loss ofaffiliate of approximately $450,000 for the nine months ended September 30,2004 represents our percentage interest in the unaudited losses of Sciona.

 

During the fourth quarter of 2003, in connection withour issuance of Series A preferred stock, we granted a warrant to purchaseadditional shares of Series A preferred stock. We were required to recognize, over the life of the warrant, a charge ofapproximately $49,000 for the beneficial conversion feature embedded in thewarrant.  The warrant was exercised onJune 30, 2004, and, therefore, we recognized the remaining unamortizedbeneficial conversion charge of approximately $40,000.  A total of $46,000 was recognized for the ninemonths ended September 30, 2004.  Inaddition, we recognized a charge of $833,000 representing the Black-Scholesvalue of a common stock warrant issued in connection with the warrant exercise.

 

**Liquidity and Capital Resources**

 

Our liquidity requirements have historicallyconsisted, and we expect that they will continue to consist, of capitalexpenditures, working capital, business development expenses, debt service,research and development expenses, clinical trials, general corporate expensesand acquisitions.

 

We have financed our operations primarily through theprivate and public sale of common and preferred stock, revenue from servicingcustomers, payments under licensing agreements, loans and capital leases.  From inception through September 30, 2004, wehave received aggregate gross proceeds of approximately $174.4 million from theissuance of common and preferred stock. In addition, through September 30, 2004, we have received $39.2 millionfrom license and service fees, royalties and research contracts.  We have also received $26.2 million fromcapital lease financing arrangements and $13.2 million from other loans.Through September 30, 2004, we have acquired $44.2 million of property andequipment.  These assets were largelyfinanced through capital lease financing arrangements and other loans.

 

We entered into a $5.0 million Loan and Security Agreement with Comerica Bank in September2003.  The agreement requires equalmonthly payments of principal over a 36-month period and bears interest atprime (4.75% as of September 30, 2004) plus 2.5%.  Borrowings under the agreement arecollateralized by certain of our assets. Under the terms of the agreement, we are required to satisfy certainfinancial covenants, including a minimum cash balance and a minimum quickratio, as defined.  Non-compliance withthese conditions constitutes an event of default and the failure to remedy thenon-compliance may result in the borrowing becoming immediately due and payableor require us to maintain restricted cash in an amount equal to 105% of theoutstanding debt balance.  In addition,the agreement includes a material adverse change clause, which provides thatall amounts become due upon such a change. We were not in compliance with the minimum cash requirement at varioustimes during the third quarter of 2004 and in October 2004 and we received awaiver of such non-compliance.  Inaddition, we were not in compliance with the quick ratio requirement and havereceived a waiver through November 30, 2004. We have also entered into financing agreements with ConnecticutInnovations, Inc. (CII).  We are incompliance with all covenants under the CII agreements and the agreements donot contain any cross default provisions. Due to the uncertainty surroundingfuture debt covenant compliance, we have classified the debt as current in theaccompanying condensed consolidated balance sheet. This includes approximately$1.7 million of debt that, under the terms of the agreement, is not due withinthe next twelve months.

 

We operate in an environment of rapid change intechnology and have substantial competition from companies developing genomicrelated technologies.  In addition to thenormal risks associated with a business venture, there can be no assurance thatour technologies will be successfully used, that we will obtain adequate patentprotection for our technologies, and that any of our products will becommercially viable.  We have incurredsubstantial losses to date, have an accumulated deficit of approximately $230.4million as of September 30, 2004 and expect to incur substantial expendituresin the foreseeable future to fund our research and development andcommercialization of our products.

 

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We are completing a strategic review of ouroperations, including reducing our operating costs.  Further, we are also reviewing variousalternatives to financing our ongoing operations and meeting our obligations,including potentially reorganizing the Company, disposing of some of ourassets, exploring strategic alternatives such as a potential sale of theCompany, developing strategic alliances and/ or joint developmentarrangements.  There is no assurance thatwe will be able to obtain sufficient financing on acceptable terms, if at all,or cure or waive any future non-compliance with the terms of our borrowingarrangements.  These circumstances raisesubstantial doubt about our ability to continue as a going concern and ourability to meet our obligations under certain of our material agreements,including the Merck agreement.  Thefinancial statements included in this Quarterly Report on Form 10-Q do notinclude any adjustments that might result from the outcome of this uncertainty.

 

On November 9, 2004, we, as part of a strategic reviewof our operations, reduced our workforce by approximately 10%.  The majority of the workforce reductionsoccurred in research and development.  Weexpect to take a charge of approximately $400,000 in the fourth quarter of2004, primarily for severance obligations.

 

***Cash and Cash Equivalents***

 

At September 30, 2004, cash, cash equivalents andshort-term investments totaled $6.9 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 nine months endedSeptember 30, 2004, was $12.1 million compared with $9.8 million for the sameperiod in 2003. The cash used in operations, for the nine months endedSeptember 30, 2004, resulted primarily from a net loss of $17.4 million, a $1.1million increase in accounts receivable and a $1.1 million decrease in deferredrevenue, partially offset by $7.4 million of non-cash charges for depreciationand amortization expense, stock based compensation, non-cash research anddevelopment expense and the write-down of investment and equity in loss ofaffiliate.  The cash used in operations,for the nine months ended September 30, 2003, resulted primarily from a netloss of $14.4 million, partially offset by $5.6 million of non-cash charges fordepreciation and amortization expense and stock based compensation.

 

Cash provided by investing activities was $7.7 millionfor the nine months ended September 30, 2004 compared to $6.3 million for thesame period in 2003.  For the nine monthsended September 30, 2004, we used $1.3 million for the purchase of property andequipment and received net proceeds of $8.8 million from the maturity ofinvestments in marketable securities. For the nine months ended September 30, 2003, we used $1.7 million ofcash for the purchase of certain assets and liabilities of DNA Sciences,$840,000 to purchase property and equipment and received net proceeds of $22.1million from the liquidation of investments in marketable securities.

 

Cash provided by financing activities, for the ninemonths ended September 30, 2004, was $3.3 million compared to cash used infinancing activities of $4.7 million for the same period in 2003.  For the nine months ended September 30, 2004,we received cash of approximately $5.1 million from the sale of common stockand the exercise of a preferred stock warrant and used cash of approximately$1.7 million for the repayment of long-term debt and capital leaseobligations.  During the same period in2003, we repaid capital lease obligations and long-term debt of approximately$9.8 million.

 

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***Contractual Obligations***

 

Our contractual cash obligations as of September 30,2004, are as follows:

 
| ** **                          | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------|------------|----------------------------|------------|
| ** **                          | ** ** | **(in thousands)**         | ** ** |
| **Contractual Obligations**         | ** ** | **Total**                  | ** ** | **Total for  remaining  Fiscal 2004** | ** ** | **Total for  Fiscal Years  2005 and 2006** | ** ** | **Total for  Fiscal Years  2007 and 2008** | ** ** | **Total for  Fiscal Year  2009 and later** | ** ** |
| Long-Term Debt,  including interest |       | $                          | 8,857      |   | $ | 3,735 |   | $ | 1,409 |   | $ | 1,408 |   | $ | 2,305 |   |
| Capital lease  obligations          |       | 576                        |       | 119 |   | 457 |   | — |   | — |   |
| Operating Leases                    |       | 13,938                     |       | 354 |   | 3,255 |   | 3,493 |   | 6,836 |   |
| Minimum License  Obligations        |       | 1,357                      |       | — |   | 215 |   | 215 |   | 927 |   |
| Total  Contractual Cash Obligations |       | $                          | 24,728     |   | $ | 4,208 |   | $ | 5,336 |   | $ | 5,116 |   | $ | 10,068 |   |

 

Long-term debt consists primarily of three financingagreements with Connecticut Innovations, Inc. (CII), and an agreement withComerica. The funds received from CII were used to finance certain leaseholdimprovements and related costs associated with our New Haven facility.  Each CII agreement provides for monthlypayments of principal and interest, based on a 120-month amortization, withfinal balloon payments due in March 2009 through June 2011.  Borrowings under the agreements bear interestat 6.5% and are secured by the related leasehold improvements.  We were in compliance with the covenantsunder the CII agreements at September 30, 2004. Funds received from Comerica were used to refinance certain of theamounts due under several capital lease agreements.  The Comericaagreement requires ratable repayment of principal over a 36-month period andbears interest at the prime rate plus 2.5%.  Borrowings under theagreement are collateralized by certain of our assets. We were not incompliance with the minimum cash requirement at various times during the thirdquarter of 2004 and in October 2004 and have received a waiver of such non-compliance.  In addition, we were not in compliance withthe quick ratio requirement and have received a waiver through November 30,2004.

 

Capital lease obligations consists of four agreementsLark entered into with three different leasing companies.  The agreements require monthly payments ofprincipal and interest, at varying rates and have termination dates betweenSeptember 2005 and May 2006.

 

We lease our operating facilities located in NewHaven, Connecticut; Morrisville, North Carolina; Houston, Texas; and Takeley,England.  The Connecticut leaseagreements require annual lease payments of $1.1 million per year over theoriginal term which expires in 2006.  Wehave two five-year renewal options to extend the lease agreements beyond theinitial term and we have assumed that one five-year renewal option will beexercised, which is reflected in the table above.  In April 2004, we signed a new 10-year andfour month lease agreement for our North Carolina facility.  We expect to move to the new facility in NorthCarolina which triggers the lease commencement in November 2004.  Upon commencement of the lease, no paymentswill be due during the first year of the lease. Beginning in the second year of the agreement, the annual lease paymentwill be approximately $427,000 increasing to approximately $517,000 in thefinal year of the lease.  In the secondquarter of 2004, we signed a 10-year lease agreement for our facility inTakeley, England, which requires annual lease payments of approximately$115,000 for the first five years with an annual review of rentthereafter.  For purposes of the abovetable we have assumed a constant rent for the 10-year period.  In addition, we lease space in Houston, Texasunder a lease agreement that expires in December 2009, which requires annuallease payments of approximately $134,000. We are recording the expense associated with the leases on astraight-line basis over the expected term of the leases. In addition to theoperating lease agreements for our current facilities, we also have operatingleases for various office equipment.

 

We periodically enter into agreements with thirdparties to obtain exclusive or non-exclusive licenses for certaintechnologies.  The terms of certain ofthese agreements require us, among other items, to demonstrate the ability tofund certain research and development and commercialization activities, payfuture royalty payments and pay certain milestone payments based on productsales or sublicense income generated from applicable

 

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technologies, if any.  The timingof such events and the amount of such payments will depend upon successfulcommercialization of applicable technologies, if any.

 

Under the terms of the license, development andcooperation agreement we signed with Merck in September 2004, we agreed to paymilestone payments upon the achievement of specified development, regulatoryand sales milestones and royalties on all future product sales and a share ofall sub-licensing income from any third party on the commercialization ofvilazodone.  Under the agreement, we are required to demonstrate that byno later than July 22, 2005, we will have at least $8.0 million in financing orhave shown the capacity to fund such levels of research and developmentactivities in 2005 relating to vilazodone.  If we are unable to meet thisrequirement, Merck can terminate the agreement and reacquire the compound. Inaddition, if Merck and its affiliates’ aggregate ownership of our common stockwould exceed 19.9% of the number of shares of our common stock thenoutstanding, or if the average closing price of the common stock at the time ofthe respective payment date is below $2.25 per share, we will pay milestonepayments to Merck in cash.

 

***Short-Term Funding Requirements***

 

We believe our existing cash reserves, together withexpected future revenues, will not be sufficient to fund our expected netlosses, debt service obligations and capital expenditures beyond March 31,2005, based upon our current activities. We are completing a strategic review of our operations, includingreducing our operating costs.  Further,we are also reviewing various alternatives to financing our ongoing operationsand meeting our obligations, including potentially reorganizing the Company,disposing of some of our assets, exploring strategic alternatives such as apotential sale of the Company, developing strategic alliances and/or jointdevelopment arrangements.  There is noassurance that we will be able to obtain sufficient financing on acceptableterms, if at all.

 

We expect to continue to finance our operations fromcash we received from the sale of our Series A preferred stock, any additionalequity financings, any future strategic alliance and/or joint developmentarrangement,  and future revenue from ourproprietary programs and molecular biology services customers.  Factors affecting our funding requirementsare described below.  In particular, ifwe are unsuccessful in marketing our proprietary programs and growing our servicerevenues, we may not generate sufficient revenue to sustain our operations atplanned levels. We expect to expend substantial funds to service our customers,conduct our proprietary programs, comply with certain of our materialagreements and maintain our HAP Technology, including for the conduct ofresearch and development activities and other general and administrativeactivities. Our expenditures for these activities will include requiredpayments under operating leases and long-term debt agreements and licensing,collaboration and service agreements. Capital expenditures are not currently expected to exceed $2.5 millionfor each of fiscal 2004 and 2005.

 

***Long-Term Funding Requirements***

 

In addition to our short term funding requirements,even if we receive additional financing and grow our revenue significantly, wemay need to seek additional funding through public or private equityfinancings, debt financings or commercial customers.

 

Our cash requirements in both the short-term and thelong term could vary depending upon a number of factors, many of which may bebeyond our control, including:

 

•                  ourability to obtain additional financing and our level of indebtedness;

•                  ourability to retain and find new customers for our proprietary programs;

•                  ourability to grow profitably our molecular biology services business;

•                  ourability to successfully commercialize molecular tests;

•                  howwe finance any clinical trials for our in-licensed compound;

•                  oursuccess in entering into strategic alliances and/or joint developmentarrangements;

•                  thecommercialization of intellectual property derived from our proprietaryprograms;

•                  thelevel of competition we face;

 

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

•                  ourability to maintain and develop our proprietary programs; and

•                  ourability to manage effectively our operating expenses and reduce costs.

 

If our existing resources are insufficient to satisfyour liquidity requirements, we may need to sell additional equity or debtsecurities or seek additional financing through other arrangements. Any sale ofadditional equity or debt securities may result in additional dilution to ourstockholders, and debt financing may involve covenants limiting or restrictingour ability to take specific actions, such as incurring additional debt ormaking capital expenditures. We cannot be certain that additional public orprivate financing will be available n amounts or on terms acceptable to us, ifat all. In addition, we cannot incur indebtedness above certain levels or issueany capital stock or other equity securities having rights, preferences,privileges or priorities pari passu with or senior to the Series A preferredstock without the vote or written consent of holders of at least 66-2/3% of theSeries A preferred stock then outstanding. If we are unable to obtain additional financing, we will be required todelay, reduce the scope of, or eliminate one or more of our planned research,development and commercialization activities, which could harm our financialcondition and operating results.  Inaddition, failure to obtain additional capital may preclude us from developingor enhancing our products, taking advantage of future opportunities, growingour business or responding to competitive pressures.

 

**Collaborative Research Agreements**

 

In September 2004, we entered into a license,development and cooperation agreement with Merck pursuant to which we acquiredan exclusive worldwide license from Merck to develop and commercializevilazodone, a small molecule compound. We believe that previous preclinical and clinical studies of vilazodoneprovide a basis for further development of the product for use in the treatmentof depressive illness.  In light of published studies suggesting anassociation between antidepressant response and genetics, we had intended toevaluate vilazodone in a Phase II clinical trial to include a pharmacogenomiccharacterization of patients suffering from depression.  We believe that genetic markers predictive ofdrug response can be discovered, which could lead to novel therapies targetinga population of patients suffering from depression who will respond to thedrug.  We currently do not havesufficient resources to commence a Phase II clinical trial of vilazodone.  We will need to secure additional sources offinancing to meet our requirements under the Merck agreement and we are consideringour options in this regard.  See “FinancingArrangements” for further discussion.

 

In consideration for the rights relating tovilazodone, we agreed to pay Merck an initial license fee and milestonepayments upon the achievement of specified development, regulatory and salesmilestones.  Under the terms of the agreement, we paid the initial licensefee through the issuance of 369,280 shares of our common stock.  The full value of the shares issued isincluded in research and development expenses in the condensed statements ofoperations for the nine months ended September 30, 2004.  Pursuant to the terms of the agreement, Merckis entitled to royalties on all future product sales and a share of allsub-licensing income from any third party.

 

**Income Taxes**

 

We have not generated any federal taxable income todate and, therefore, have not paid any federal income taxes sinceinception.  On December 31, 2003, we hadavailable unused net operating loss carryforwards of approximately $133.6million and $131.8 million, which may be available to offset future federal andstate taxable income, respectively.  Useof our federal and state net operating loss carryforwards, which will begin toexpire in 2007 and 2004, respectively, may be subject to limitations.  The future utilization of these carryforwardsmay be limited due to changes within our ownership structure.  We have recorded a full valuation allowanceagainst our deferred tax assets, which consists primarily of net operating losscarryforwards, because of uncertainty regarding their recoverability, asrequired by Statement of Financial Accounting Standards No. 109, *Accounting for Income Taxes*.

 

**Off-Balance Sheet Arrangements**

 

During the year ended December 31, 2003, and throughSeptember 30, 2004, we have not engaged in off-balance sheet activities,including the use of structured finance or specific purpose entities.

 

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**Factors Affecting Future OperatingResults**

 

*This Quarterly Report on Form 10-Qcontains forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended.  For this purpose, statements contained hereinregarding management’s expectations as to our future revenues, costs andliquidity position, our strategy for to operating on existing capital resourcesand attracting additional sources of financing, our future operations andlevels of activities, our financial position, any future strategic alliancesand/or joint development arrangements, our, ability to fund the development ofvilazodone, prospects for the growth and development of our business, timing ofregulatory actions, and the plans and objectives of management, other thanstatements of historical fact, may be forward-looking statements.  The words “believes,” “anticipates,” “plans,”“expects,” “intends” and similar expressions are intended to identifyforward-looking statements, although not all forward-looking statements containthese identifying words.  We cannotguarantee that we will actually achieve the plans, intentions or expectationsexpressed or implied in our forward-looking statements.  There are a number of important factors,risks and uncertainties that could cause actual results, levels of activity,performance or events to differ materially from those expressed or implied.  These important factors include our “criticalaccounting estimates” and the factors set forth below.*

 

**RisksRelated to Our Need for Financing and Financial Results**

 

**Unlesswe obtain additional financing, we may not be able to continue as a going concern.**

 

Our ability to continueas a going concern is dependent on our ability to obtain additional funding andreduce costs.  We will need to continueto spend substantial funds to service our customers, conduct our proprietaryprograms, comply with certain of our material agreements and maintain our *HAP*Technology, including for the conductof research and development activities and other general and administrativeactivities.  Our existing cash andinvestment securities, and future revenue that we may receive from ourcustomers, will be insufficient to fund our operations in the short term andrepay our indebtedness.  We believe thatour existing cash reserves, together with expected future revenue, will not besufficient to support our expected net losses, debt obligations and capitalexpenditures beyond March 31, 2005 based upon our current activities, evenafter the 10% workforce reduction we announced in November 2004.

 

We are completing a strategic review of ouroperations, including reducing our operating costs.  Further, we are also reviewing variousalternatives to financing our ongoing operations and meeting our obligations,including potentially reorganizing the Company, disposing of some of ourassets, exploring strategic alternatives such as a potential sale of theCompany, developing strategic alliances and/or joint developmentarrangements.  There is no assurance thatwe will be able to obtain sufficient financing on acceptable terms, if at all.These circumstances raise substantial doubt about our ability to continue as agoing concern and our ability to meet our obligations under certain of ourmaterial agreements, including the Merck agreement.

 

Our actual cashrequirements in the short term and the long term could vary depending upon anumber of factors, many of which may be beyond our control, including:

 

•                  ourability to obtain additional financing and the level of our indebtedness;

 

•                  ourability to retain and find new customers for our proprietary programs;

 

•                  ourability to grow profitably our molecular biology services business;

 

•                  ourability to successfully commercialize molecular tests;

 

•                  howwe finance any clinical trials for our in-licensed compound;

 

•                  oursuccess in entering into strategic alliances and/or joint development agreements;

 

•                  thecommercialization of intellectual property derived from our proprietaryprograms;

 

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•                  thelevel of competition we face;

 

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

 

•                  ourability to maintain and develop our proprietary programs; and

 

•                  ourability to manage effectively our operating expenses and reduce costs.

 

In the short term, toexecute our business plans, we will need to obtain additional financing.  In the longer term, we will need to grow ourrevenue significantly each year and, even then, we will need to seek additionalfunding through public or private equity financings, debt financings orcommercial customers.  We cannot assureyou that we will be able to obtain additional financing or new customers forour molecular biology services and our proprietary programs, or generate theincreased revenue to support our operations. If we do not receive additional financing,or additional income, or if we do not receive either as rapidly as we expect,we would spend our existing cash and investment securities more rapidly than wecurrently plan and will be unable to continue as a going concern.

 

**We maydefault under our loan agreement with Comerica Bank.**

 

Our loan and securityagreement with Comerica Bank, which provides us with the ability to borrow upto $5.0 million, is a significant source of liquidity for us.  The terms of the agreement include certainaffirmative, negative and financial covenants, including requirements tomaintain a minimum cash balance and a minimum quick ratio, as defined.  In addition, the agreement also includes amaterial adverse change clause.  We werenot in compliance with the minimum cash requirement at various times during thethird quarter of 2004 and in October 2004. We were also not in compliance with the quick ratio requirement.  We received waivers of such non-compliance.

 

Under the terms of theComerica agreement, non-compliance with any of the terms and conditionsconstitutes an event of default, and the failure to remedy the non-compliancemay result in our borrowing becoming immediately due and payable or require usto maintain restricted cash in an amount equal to 105% of the outstanding debtbalance.  In particular, upon an event of default, Comerica may, at itselection, without notice of its election and without demand, take any of thefollowing actions:

 

•                  declareall amounts outstanding under the Comerica Agreement immediately due andpayable;

 

•                  ceaseadvancing money or extending credit to or for our benefit;

 

•                  settleor adjust disputes and claims directly with our account debtors for amounts,upon terms and in whatever order that Comerica reasonably considers advisable;

 

•                  makeany payments and take any actions as Comerica considers necessary or reasonableto protect its security interest in its collateral, which consists of certainof our assets; and

 

•                  setoff against our obligations any (i) company balances and deposits held byComerica, or (ii) indebtedness at any time owing to or for the credit or ouraccount held by Comerica.

 

We are uncertain that wewill be able to comply with our covenants under the Comerica agreement in thefuture. We are also uncertain whether we would be able to cure or obtain awaiver from Comercia for any future non-compliance.  Any default under our agreement with Comericawould have a material adverse effect on our business operations, liquidity,cash flows and ability to continue as a going concern.

 

**We arean early stage company with a history of losses and we expect to incur netlosses for the foreseeable future such that we may never be profitable.**

 

We have incurredsubstantial operating losses in every year since our inception.  As of September 30, 2004, we had generatedonly minimal revenues from our proprietary programs and our molecular biologyservices. From

 

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inception through September 30, 2004, we had anaccumulated deficit of approximately $230.4 million. Our losses to datehave resulted principally from costs we incurred in the development of and inconducting our proprietary programs and from general and administrative costsassociated with operations.

 

We expect to devotesubstantially all of our resources for the foreseeable future to service ourmolecular biology services and proprietary programs customers and continue thedevelopment of our proprietary programs. We will need to generate significantlyhigher revenues and to attract external capital in the form of debt or equityfinancing, or a third party collaboration, to fund our spending.  Pharmaceutical and biotechnology companiesare only beginning to use services such as ours in their drug and diagnosticdevelopment or marketing efforts and, accordingly, they may not choose to useour *HAP* Technology.  In October 2004, we revised downward ourrevenue guidance for the year ending December 31, 2004, from $25 million to arange of $20 million to $21 million.  Inaddition, we cannot be certain whether we will be able to attract externalcapital in the form of debt or equity financing, or a third partycollaboration, because of significant uncertainties with respect to our abilityto generate revenues from the sale of products and covenants with existingshareholders.  As a result, even if weobtain additional financing, we expect to incur additional losses this year andin future years, and we may never achieve profitability.

 

**Additionalfinancing may be difficult to obtain. Our failure to obtain necessary financingor doing so on unattractive terms could adversely affect our ability to fundoperations, repay debt and develop vilazodone and thereby negatively impact ourvalue.**

 

In October 2004, weannounced that we were proposing to issue securities in a privateplacement.  We expected to use proceedsfrom the financing for working capital and other corporate purposes.  We have not completed such a proposedfinancing and may be unable to do so.  Asa result, we are reviewing various alternatives to financing our ongoingoperations and meeting our obligations, including potentially reorganizing theCompany, disposing of some of our assets, exploring strategic alternatives suchas a potential sale of the Company, developing strategic alliances and/or jointdevelopment arrangements.  If we areunable to obtain additional financing, we will be required to delay, reduce thescope of, or eliminate one or more of our planned research, development and commercializationactivities, which could harm our financial condition and operatingresults.   For example, in November 2004,we reduced our workforce by approximately 10%, and the majority of theworkforce reductions occurred in our research and development department.

 

We may be forced to seekfunds through arrangements with collaborators or others that require us torelinquish rights to certain of our technologies or therapeutic products whichwe would otherwise pursue on our own, or grant licenses on terms that may notbe favorable to us. For example, in September 2004, we entered into a license,development and cooperation agreement with Merck KGaA pursuant to which weacquired an exclusive world license to develop and commercialize vilazodone, asmall molecule compound.  We agreed topay milestone payments upon the achievement of specified development,regulatory and sales milestones and royalties on all future product sales and ashare of all sub-licensing income from any third party on the commercializationof vilazodone.  Under the agreement, we are required to demonstrate thatby no later than July 22, 2005, we will have at least $8.0 million in financingor have shown the capacity to fund such levels of research and developmentactivities in 2005 relating to vilazodone.  If we are unable to meet thisrequirement, Merck can terminate the agreement and reacquire the compound. Inaddition, if the average closing price of our common stock at the time of therespective milestone payment is below $2.25 per share, we will be required tomake the milestone payments to Merck in cash rather than in shares of ourcommon stock.  If Merck and itsaffiliates’ aggregate ownership of our common stock would exceed 19.9% of thenumber of shares of our common stock then outstanding, we would also berequired to make payments in cash rather than in shares of our common stock.  We will need to seek alternative means tofinance the development of vilazodone or raise additional capital to doso.  We do not currently have sufficientresources to meet of obligations with respect to vilazodone.

 

Any sale of additionalequity or debt securities may result in additional dilution to ourstockholders, and debt financing may involve covenants limiting or restrictingour ability to take specific actions, such as incurring additional debt ormaking capital expenditures. We cannot be certain that additional public orprivate financing will be available in amounts or on terms acceptable orfavorable to us, if at all. In addition, we cannot incur indebtedness abovecertain levels or issue any capital stock or other equity securities havingrights, preferences, privileges or priorities pari passu with or senior to theSeries A preferred stock without the vote or written consent of holders of at

 

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least 66-2/3% of the Series A preferred stock thenoutstanding.  Failure to obtainadditional capital may preclude us from developing or enhancing our products,taking advantage of future opportunities, growing our business or responding tocompetitive pressures.

 

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

 

Under the terms of ourSeries A preferred stock, we are required, unless the holders of at least 66-2/3% of our outstanding Series Apreferred stock elect otherwise, to redeem all then outstanding shares of ourSeries A preferred stock if one or more of the following events occurs:

 

•                  ourcommon stock is delisted from the NASDAQ National Market;

 

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

 

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

 

•                  webreach any covenant or fail to perform any of our obligations under the SeriesA purchase agreement or the registration rights agreement each entered into inconnection with the sale of our Series A preferred stock, that has a materialadverse effect on the holders of our Series A preferred stock;

 

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

 

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

 

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

 

If we are required toredeem our Series A preferred stock due to any of the foregoing events, we arerequired to pay each holder of our Series A preferred stock the originalpurchase price, plus an amount equal to the dividends that would otherwise haveaccrued and been payable on such shares through October 29, 2008 that havenot otherwise been paid as of the redemption date.  As of September 30, 2004, the aggregateredemption price we would be required to pay is approximately $11.2million.  As of September 30, 2004, wehad aggregate cash and cash equivalents of approximately $6.9 million.

 

In addition, the holdersof at least 66-2/3%of the outstanding shares of our Series A preferred stock may elect to requireus to redeem all outstanding shares of our Series A preferred stock for theoriginal purchase price, plus all accrued but unpaid dividends as of theredemption date, on either October 29, 2006, October 29, 2007 orOctober 29, 2008.

 

A redemption of theSeries A preferred stock would deplete the cash we have available to fundoperations, research and product development, capital expenditures and othergeneral corporate purposes. In addition, we have incurred net losses in thepast and expect to incur losses in the future, which may impair our ability togenerate the cash required to meet our obligations under our Series A preferredstock and our loan agreement with Comerica Bank. If we cannot generatesufficient cash to meet these obligations, we will be required to incuradditional indebtedness or raise additional capital, which would negativelyimpact our stockholders.

 

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**The purchaserof our Series A preferred stock owns a substantial portion of our capitalstock, which may afford the purchaser significant influence over our affairs.**

 

As of September 30, 2004,the holder of our Series A preferred stock, together with its affiliates, heldor had the right to acquire and/or vote 15.72% of our outstanding common stockassuming the conversion of Series A preferred stock to common stock and theexercise of a common stock purchase warrant, including shares of our commonstock which the holder previously purchased in the open market. The Series Aholder has agreed not to convert its Series A if such conversion would causethe holder to beneficially own in excess of 9.99% of our common stock.  Nevertheless, this stockholder hassignificant influence over our ability to offer securities for sale at apurchase price of less than $2.25 per share, incur additional indebtedness andany change in control of the company that may be favored by other stockholders,and could otherwise exercise significant influence over all corporate actionsrequiring stockholder approval, including the approval of some mergers andother significant corporate transactions, such as a sale of substantially allof our assets or the defeat of any non-negotiated takeover attempt that mightotherwise benefit the public stockholders. Consequently, this stockholder mayapprove a transaction that in its judgment enhances the value of itsinvestment, but which nonetheless may diverge from the interests of our otherstockholders.

 

**Theagreements and instruments governing the rights and preferences of our Series Apreferred stock impose restrictions on our business and limit our ability toundertake certain corporate actions, including with respect to financings.**

 

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 obtain additional financing, operate our business and to takeadvantage of potential business opportunities as they arise. Without theconsent of the holders of at least 66-2/3% of the outstanding shares of our Series A preferred stock, wecannot:

 

•                  alteror change the rights, preferences or privileges of our Series A preferredstock, including any increase in the number of authorized shares of our SeriesA preferred stock;

 

•                  issueshares of our common stock, or securities convertible into shares of our commonstock, with a purchase price of less than $2.25 per share, other than inlimited circumstances;

 

•                  incurmore than $9,000,000 of indebtedness at any time;

 

•                  create,incur or assume specified liens; or

 

•                  declareor pay dividends, redeem stock or make other distributions to stockholders,other than in limited circumstances.

 

Events beyond ourcontrol, including prevailing economic, financial and industry conditions, mayaffect our ability to comply with these restrictions. In addition, the holderof our Series A preferred stock has the right to participate in future capitalraising transactions of the company. The existence of this right maysubstantially reduce our ability to establish terms with respect to, or enterinto, any financing with parties other than the Series A preferred stockholder.The terms of any additional financing we may enter into may impose constraintson our ability to operate our business as we deem appropriate. Theserestrictions and covenants could limit our ability to take advantage offinancings, mergers and acquisitions or other corporate opportunities, whichcould adversely affect our business and financial condition and yourinvestments in our common stock.

 

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

 

On October 29, 2003,we issued and sold an aggregate of 270,000 shares of our Series Apreferred stock and granted the purchaser of such shares a warrant to purchasean additional 190,000 shares of our Series A preferred stock at $22.50 pershare, which the purchaser exercised on June 30, 2004. In connection with theexercise of the warrant, we granted an affiliate of the Series A holder awarrant to purchase 261,500 shares of our common stock at $4.17 per share. Eachshare of our Series A preferred stock is currently convertible into ten sharesof our common stock. Consequently, on an as-converted and as-exercised basis,an aggregate of 4,861,500 shares of our common stock may be issued to the SeriesA purchaser or its affiliate. Any issuance of shares of our common stock uponconversion of shares of our Series A

 

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preferred stock, or upon exercise of the warrant heldby the affiliate of the Series A holder, could have the effect of substantiallydiluting the interests of our current stockholders, as well as the interests ofholders of our outstanding options and warrants. As of September 30, 2004, wehad outstanding options and warrants exercisable for an aggregate of 6,385,500shares of our common stock.

 

Moreover, any sale of theshares of common stock issued upon conversion of the Series A preferred stock,as well as any of the outstanding shares of our common stock issued uponexercise of options or warrants, into the public market could cause a declinein the trading price of our common stock. In financing transactions, forcompensatory purposes or in other types of transactions, we may issueadditional equity securities, including options and warrants, that could dilutethe interests of our current and future stockholders.

 

**Ouroperating results may fluctuate significantly and any failure to meet financialexpectations may disappoint securities analysts or investors and result in adecline in our common stock price.**

 

Our operating resultshave fluctuated in the past and we expect they will fluctuate in the future.These fluctuations could cause our common stock price to decline. Some of thefactors that could cause our operating results to fluctuate include:

 

•                  ourability to pay our obligations as they become due;

 

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

 

•                  demandfor and market acceptance of our molecular biology services and our proprietaryprograms;

 

•                  timingof the execution of agreements relating to our molecular biology services andproprietary programs, and other material contracts;

 

•                  ourdependence on a limited number of customers for a substantial portion of ourrevenue;

 

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

 

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

 

•                  ourability to control operating expenses;

 

•                  disputesregarding patents or other intellectual property rights;

 

•                  securitiesclass actions or other litigation;

 

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

 

•                  generaland industry-specific economic conditions, which may affect our customers’ useof our *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.

 

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**RisksRelated to Commercialization and Development**

 

**Wecurrently rely on a limited number of customers for a substantial portion of ourrevenue. As a result, our revenues may fluctuate based on the buying patternsof our customers, and 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 customers for substantially all of our revenue. In the ninemonths ended****September 30, 2004,one of our customers accounted for 17% of our revenues and another customeraccounted for 11% of our revenues.  Ourreliance on a small number of customers could cause our revenues to fluctuatefrom quarter to quarter based on the buying patterns of these customers.  For example, we revised our revenue annualguidance downward in October 2004 primarily as a result of a shift in thetiming of certain anticipated contracts and the receipt of samples associatedwith some of these contracts.  If we loseand are not able to replace customers that provide us with significantrevenues, it could have a material adverse effect on our revenues and on ourbusiness in general and could cause volatility or a decline in our stockprice.  In addition, if any of thesecustomers fails to pay us on a timely basis or at all, our financial positionand results of operations could be materially adversely affected.

 

**Togenerate significant revenue, we must obtain additional customers for ourmolecular biology services and our proprietary programs.**

 

Our strategy depends onobtaining additional customers for our molecular biology services and enteringinto agreements with pharmaceutical and biotechnology companies for our *HAP* Technology and our other proprietaryprograms. Our contracts for our molecular biology services and with many of our*HAP* Technology customers are forspecific limited-term projects. We may not be successful in obtainingsufficient new customers for our molecular biology services, additionalcustomers for our *HAP* Technology,or obtaining any significant customers for our other proprietary programs to replaceour current customers and projects. If we are unsuccessful in finding such newcustomers, we may never generate sufficient revenue to sustain our operations.In addition, we expect that some of our future *HAP*Technology collaborations, like some of our current *HAP* Technology collaborations, will be limited to specific,limited-term projects or that some of these collaborations may not be renewed.Accordingly, we must continually obtain new customers to be successful. Todate, the integration of pharmacogenomics into drug development and marketinghas not achieved widespread market acceptance.

 

**We mayneed to establish collaborative relationships in order to succeed.**

 

In order to satisfy ourobligations under our license, development and cooperation agreement relatingto vilazodone, we will likely need to enter into a collaborative relationshipwith a third party.  We face significantcompetition in seeking appropriate collaborators. Moreover, these arrangementsare complex to negotiate and time-consuming to document. We may not besuccessful in our efforts to identify potential collaborators and establishcollaborative relationships or other alternative arrangements, especially sincewe do not have experience with these types of collaborations.

 

Reliance on collaborativerelationships poses a number of risks, including the following:

 

•                  wecannot effectively control whether our collaborator will devote sufficientresources to our programs or products;

 

•                  disputesmay arise in the future with respect to the ownership of rights to technologydeveloped with a collaborator;

 

•                  disagreementswith a collaborator could delay or terminate the research, development orcommercialization of products, or result in litigation or arbitration;

 

•                  contractswith a collaborator may fail to provide sufficient protection;

 

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•                  wemay have difficulty enforcing the contracts if a collaborator fails to perform;

 

•                  collaboratorshave considerable discretion in electing whether to pursue the development ofany additional drugs and may pursue technologies or products either on theirown or in collaboration with our competitors; and

 

•                  collaboratorswith marketing rights may choose to devote fewer resources to the marketing ofour products than they do to products that they develop.

 

Given these risks, evenif we are able to identify a potential collaborator and negotiate and enterinto a collaborative arrangement, it is possible that any collaborativearrangement into which we enter may not be successful. Failure of our effortscould cause us to breach covenants in our license agreement relating tovilazodone, delay our drug development or impair commercialization of ourproducts.  In particular, we mustdemonstrate to the licensor’s satisfaction, by no later than July 2005, that wewill have the financial resources to fund the anticipated budget for researchand development activities relating to vilazodone for 2005.  We will likely not be able to satisfy thisrequirement, or other milestone obligations with respect to vilazodone, unlesswe obtain significant additional funding or entering into a collaborationarrangement with a third party.

 

**Ourproprietary programs may not allow our commercial customers to developcommercial products or to increase sales of their marketed products.**

 

We developed our *HAP* Technology and other proprietaryprograms on the assumption that information about gene variation and genevariation associated with drug response may help drug development professionalsbetter understand the drug response of particular populations and complexdisease processes. Although the pharmaceutical and biotechnology industries areincreasing their use of genomics in analyzing drug response and diseases, weare aware of only two successful drug program applying genomics.

 

We discover *HAP* Markers for pharmaceutically relevantgenes. This information may not prove to be superior to genomic variationinformation discovered by our competitors. Furthermore, pharmaceutical andbiotechnology 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 program customers.

 

**We maybe unable to develop or commercialize our proprietary programs if we cannotestablish additional customers and we may depend on our customers to develop orto co-develop products.**

 

Part of our current andfuture revenue will depend on payments from our current proprietary programcustomers and our future proprietary program customers, if any, for either thenew products they may develop or for increased sales of their existingproducts, made possible through the use of our *HAP*Technology. If we are unable to attract new proprietary program customers, wemay never generate sufficient revenue to sustain our operations.

 

Our customers for certainof our proprietary programs may be responsible for pre-clinical study andclinical development of therapeutic and diagnostic products and for regulatoryapproval, manufacturing and marketing of any product or enhanced marketingclaims that result from the application of our proprietary programs. Ourcurrent agreements with these customers allow them significant discretion inpursuing these activities and future agreements, if any, may allow similardiscretion. We cannot control the amount and timing of resources that any suchcurrent or potential customers will devote to our programs or potential products.Our current proprietary program arrangements and our future proprietary programarrangements, if any, may also have the effect of limiting the areas ofresearch or commercialization that we may pursue either alone or with others.Because part of our revenue could be dependent on the successfulcommercialization or development of our customers’ products, if, for

 

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any reason, a proprietary program customer delays orabandons its development or commercialization of a product developed using our *HAP* Technology, we may receive reducedroyalty or other payments or no royalty or other payments at all.

 

**Weinvest considerable amounts of time, 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 proprietary programs will depend in significant part upon thepharmaceutical and biotechnology industries’ acceptance that our *HAP* Technology can help accelerate orimprove their drug and diagnostic development and marketing efforts. To achievemarket acceptance, we must continue to educate the pharmaceutical andbiotechnology industries and the public in general as to the potential benefitsof our *HAP* Technology.  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 ourproprietary programs will be commercially viable. If we fail to gain thisacceptance, we may never generate sufficient revenue to sustain our operations.We may expend substantial funds and management effort to market our proprietaryprograms without any resulting revenue.

 

**If we donot successfully distinguish and commercialize our proprietary programs, we maybe unable to compete successfully with our competitors or to generate revenuesignificant to sustain our operations.**

 

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 genomicsbefore us or our customers for our proprietary programs that are more effectivethan those technologies which we develop or which our customers for ourproprietary programs develop.  Additionally,these competitors may obtain regulatory approvals for their drugs anddiagnostics more rapidly than our customers for our proprietary programs do,any of which could limit our ability to market effectively our proprietaryprograms.

 

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 databases containing gene sequence, genomic variation or othergenomic information and are marketing their data to pharmaceutical andbiotechnology companies or are making their databases freely available to thepublic. In addition, numerous pharmaceutical and biotechnology companies, suchas GlaxoSmithKline plc, either alone or in collaboration with our competitors,are developing genomic research programs that involve the use of informationthat can be found in these databases. Furthermore, companies, such as deCODEgenetics, Inc., have technologies for using genomic variation indiagnostics and in the drug development process and have collaborations withcompanies 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 test or technologies becoming obsoletebefore we recover the expenses that we incur in connection with the developmentof these products. Our proprietary programs could become obsolete if ourcompetitors offer less expensive or more effective drug discovery and developmenttechnologies, including technologies that may be unrelated to genomics.

 

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**Our *FAMILION* Test may not gain marketacceptance.**

 

Themarket for genetic tests is relatively undeveloped.  We are marketing our test to physicians whodid not currently have a genetic test available for cardiacchannelopathies. The success ofour test depends on its acceptance by the medical community, patients andthird-party payors as medically useful. If we are not able to gain market acceptance for our test, we may not beable to generate sufficient revenue to sustain our operations.

 

**RisksRelated to Our Intellectual Property**

 

**If weare unable to prevent others from unauthorized use of, or are unable to defendtheir use of, our patents, trade secrets or know how, we may not be able tooperate our business profitably.**

 

Despite our efforts to protect our proprietary rights,unauthorized parties may be able to obtain and use information that weregard as proprietary. The issuance of a patent does not guarantee that it isvalid or enforceable. Thus, even if we obtain patents, they may be challenged,narrowed, invalidated or unenforceable against third parties, which could limitour ability to stop competitors from marketing similar technologies orproducts, or limit the length of term of patent protection we may have for anyof our technologies or products.  Changesin patent laws or in interpretations of patent laws in the United States andother countries may diminish the value of our intellectual property or narrowthe scope of our patent protection. Because patent applications that were filed prior to November 29,2000 in the United States are confidential until patents issue, third partiesmay have filed patent applications for technology covered by our pending patentapplications without us being aware of those applications, and our patentapplications may not have priority over any patent applications of others. Weare aware that there are other firms and individuals who have discovered, orare currently discovering, information similar to the information we arediscovering, who may have filed, and in the future are likely to file, patentapplications that are similar or identical to our proprietary program patentapplications.  In addition, some interestgroups are lobbying for restrictions on patenting of genetic tests.

 

Further, a patent doesnot provide the patent holder with freedom to operate in a way that infringesthe patent rights of others. A third party may sue us for infringing on itspatent rights. Likewise, we may need to resort to litigation to enforce apatent issued to us or to determine the scope and validity of third partyproprietary rights. The cost to us of any litigation or other proceedingrelating to intellectual property rights, even if resolved in our favor, couldbe substantial, and the litigation would divert our management’s focus from ourcore business concerns. Some of our competitors may be able to sustain thecosts of complex patent litigation more effectively than we can because theyhave substantially greater resources. Uncertainties resulting from theinitiation and continuation of any litigation could limit our ability tocontinue our operations.

 

We also rely uponunpatented trade 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 proprietary programsinfringes upon their intellectual property rights, in addition to any damageswe might have to pay, a court could require us to stop the infringing activityor obtain a license on unfavorable terms. Moreover, any legal action threatenedor commenced against us or any of our program customers claiming damages orseeking to enjoin commercial activities relating to the affected test andprocesses could, in addition to subjecting us to potential liability fordamages, require us or current and any future customers of our proprietaryprograms, if any, to obtain a license in order to continue to manufacture ormarket the affected test and processes. Any license required under any patentmay not be made available on commercially acceptable terms, if at all. Inaddition, some licenses may be non-exclusive and, therefore, our competitorsmay have access to the same technology licensed to us. If we fail to obtain arequired

 

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license or are unable to design around a patent, wemay be unable to market effectively some of our proprietary programs, whichcould limit our profitability and possibly prevent us from generating revenuesufficient to sustain our operations.

 

**RegulatoryRisks**

 

**Regulatoryoversight of our proprietary programs****and public opinion regarding ethical issuessurrounding the use of genetic information may adversely affect our ability tomarket our products and services.**

 

Currently, there islimited Food and Drug Administration, or FDA, regulation of genetic tests. TheSecretary’s Advisory Committee on Genetic Testing, an advisory panel to theSecretary of the U.S. Department of Health and Human Services, has recommendedthat the FDA expand its regulation of genetic testing to require FDA approvalfor all new genetic 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 ourintellectual property. 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 twicerequired that a physician must have genomic variation information determinedabout a patient before the doctor prescribes a drug. On November 3, 2003,the FDA issued draft guidance that encourages drug and biologic developers toconduct pharmacogenomic tests during drug development and clarified how the FDAwill evaluate the resulting data. The draft guidance provides specific criteriaand recommendations on the submission of pharmacogenomic data in connectionwith Investigational New Drug Applications, New Drug Applications andBiological License Applications. The draft 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 final 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 test and services as a basis for identifyinggenomic variation and for correlating drug response with genomic variation.Without this implementation by the pharmaceutical and biotechnology industry,we may be unable to market effectively any test we may have as well as any ofour services and we may not generate sufficient revenue to sustain ouroperations.

 

Within the field ofpersonalized health and medicine, governmental and other entities may enactpatient privacy and healthcare laws and regulations that may limit thegeneration and use of genomic variation data. To the extent that these laws andregulations limit the use of our products and services or impose additionalcosts on our customers, we may be unable to market effectively our proprietaryprograms and we may not generate sufficient revenue to sustain our operations.

 

Additionally, publicopinion on ethical issues related to the confidentiality and appropriate use ofgenetic testing results may influence governmental authorities to call forlimits on, or regulation of the use of, genetic testing. In addition,governmental authorities or other entities may call for limits on, orregulation of the use of, genetic testing or prohibit testing for geneticpredisposition to certain conditions, particularly for those that have no knowncure. The occurrence of any of these events could reduce the potential marketsfor our products and services, which could prevent us from generatingsufficient revenue to sustain our 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.

 

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**If we orour customers do not seek, or do not receive, marketing approval for productsdeveloped, if any, from our proprietary programs, we may receive delayedroyalty or other payments or no royalty or other payments at all.**

 

Any new drug, biologic,or new drug or biologic indication we or our customers develop using geneticmarkers from our proprietary programs must undergo an extensive regulatoryreview process in the United States and other countries before a new product orindication of this kind could be marketed. This regulatory process can takemany years, requires substantial expense and is uncertain as to outcome.Changes in FDA policies and the policies of similar foreign regulatory bodiescan prolong the regulatory review of each new drug or biologic licenseapplication or prevent approval of the application. We expect similar delaysand risks in the regulatory review process for any diagnostic product developedby we or our customers, whenever this regulatory review is required. Even if aproduct obtains marketing clearance, a marketed product and its manufacturerare subject to continuing review. A manufacturer may be forced to withdraw aproduct from the market if a previously unknown problem with a product becomesapparent. Because our future revenue will be dependent on the successfulcommercialization or development of products using genetic markers from ourproprietary programs, any delay in obtaining, failing to obtain, or failing tomaintain regulatory approval for a product developed using genetic markers fromour proprietary programs may delay our receipt of royalty or other payments orprevent us from receiving royalty or other payments sufficient to recover ourexpenses.

 

**If ourcustomers are unable to obtain FDA approval for therapeutic or diagnosticproducts developed using our *HAP*Technology or genetic markers from our other proprietary programs, the lack ofregulatory approval will diminish the value of our *HAP* Technology and other proprietary programs.**

 

To date, none of ourcustomers have developed or commercialized any therapeutic product orcommercialized any diagnostic product using our genetic markers from ourproprietary programs. We expect to rely on our customers to file applicationsfor regulatory approval and generally direct the regulatory review process andobtain FDA acceptance of any product they develop with our genetic markers fromour proprietary programs, if any. Our customers may not submit an applicationfor regulatory review. Even if they do submit applications, they may not beable to obtain marketing clearance for any product on a timely basis, if atall. If our customers fail to obtain required governmental clearances fortherapeutic or diagnostic product, they will not be able to market theseproducts.  As a result, we may notreceive royalty or other payments from our customers. The occurrence of any ofthese events may prevent us from generating revenue sufficient to sustain ouroperations.

 

**If weare unable to obtain reimbursement from health insurers and other organizationsfor our *FAMILION*Test,our test may be too costly for regular use and our ability to generate revenueswould be harmed.**

 

Our future revenues andprofitability will be adversely affected if we cannot depend on governmentaland private third-party payors to defray the cost of our test to patients. Ifthese entities refuse to provide reimbursement for our test or provide aninsufficient level of reimbursement, our test may be too costly for generaluse. Our profitability may be adversely impacted if we choose to offer our testat a reduced price. Any limitation on the use of our test or any decrease inthe price of our test without a corresponding decrease in the related costscould have a material adverse effect on our ability to generate revenues.

 

**AdditionalRisks Related to Our Business**

 

**Wedepend on third-party products and services and limited sources of supply forour high-throughput genotyping laboratory.**

 

We rely on outsidevendors to supply certain software, products and materials used in ourlaboratories. Some of these products and materials are obtained from a singlesupplier or a limited group of suppliers. For example, we have a writtenagreement with Sequenom, Inc. pursuant to which it is contractually thesole provider of silicon chips for one-time use on their MassARRAYTMSystem, which is our primary genotyping platform in our New Haven facility.Under the terms of the agreement and subject to specific conditions, we havethe authority to reuse these chips should Sequenom be unable to supply newchips to us. While we believe that we could prepare for reuse the requisitesupply of chips without unreasonable cost or delay, we may be unable to do so.We have no other written long-term supply agreements with our suppliers. Ourreliance on outside vendors generally and a sole or a limited group ofsuppliers in particular involves several other risks, including:

 

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•                  theinability to obtain an adequate supply of required software, products andmaterials due to capacity constraints, product defects, a discontinuance of aproduct by a supplier or other supply constraints;

 

•                  reducedcontrol over quality and pricing of software, products and materials; and

 

•                  delaysand long lead times in receiving software, products, or materials from vendors.

 

**If wefail to maintain our computer hardware, software and related infrastructure, wecould experience loss of, or delay 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 *DecoGen* are complexand sophisticated, and as such, could contain data, design or software errorsthat could be difficult to detect and correct. Users of our system may findsoftware defects in current or future test. If we fail to maintain thenecessary computer capacity and data to support our computational needs and ourcustomers’ drug and diagnostic discovery and development efforts, we couldexperience a loss in revenue, or a delay in receiving revenue and a delay inobtaining market acceptance for our technology.

 

**Thecurrent technology labor market is very competitive, and our business maysuffer if we are not able to hire and retain sufficient personnel.**

 

Our future successdepends on the continued service of our key technical, marketing, executive andadministrative personnel. The loss of the services of any of these individualscould have a material adverse effect on our product development andcommercialization efforts. In addition, research, product development andcommercialization may require additional skilled personnel. Competition forqualified personnel in the technology area is intense, and we operate ingeographic locations where labor markets are particularly competitive,including New Haven, Connecticut; Morrisville, North Carolina; Houston, Texas;and Takeley, England, where our service facilities are located. If we areunable to attract and retain a sufficient number of qualified employees onacceptable terms, our business, financial condition and results of operationscould be seriously harmed. The inability to retain and hire qualified personnelcould also hinder the future expansion of our business.

 

**Integrationefforts could interrupt our business and our financial condition could beharmed.**

 

On May 15, 2003,pursuant to the approval of the United States Bankruptcy Court, we purchasedsubstantially all of the assets and assumed certain liabilities of DNASciences. In addition, on April 1, 2004, we acquired Lark. Our integrationactivities with respect to the DNA Sciences and Lark acquisitions are ongoingand entail numerous risks that include the following:

 

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

 

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

 

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

 

Any difficultiesencountered as a result of our recent acquisitions could adversely affect ourbusiness, operating results and financial condition.

 

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**RisksRelating to Financial Reporting**

 

**Investorconfidence and our share price may be adversely affected if our independentauditors are unable to provide us with the attestation of the adequacy of ourinternal controls over financial reporting as of December 31, 2004, as requiredby Section 404 of the Sarbanes-Oxley Act of 2002.**

 

As directed by Section404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commissionadopted rules requiring public companies to include a report of management onour internal controls over financial reporting in our annual reports on Form10-K that contains an assessment by management of the effectiveness of ourinternal controls over financial reporting. In addition, our independentauditors must attest to and report on management’s assessment of theeffectiveness of our internal controls over financial reporting. Thisrequirement will first apply to our Annual Report on Form 10-K for the fiscalyear ending December 31, 2004. How companies should be implementing these newrequirements, including internal control reforms, if any, to comply withSection 404’s requirements, and how independent auditors will apply these newrequirements and test companies’ internal controls, are subject touncertainty.  We are diligently andvigorously reviewing our internal controls over financial reporting in order toensure compliance with the new Section 404 requirements.  If our independent auditors are not satisfiedwith our internal controls over financial reporting or the level at which thesecontrols are documented, designed, operated or reviewed, or if the independentauditors interpret the requirements, rules or regulations differently than wedo, then they may decline to attest to management’s assessment or may issue areport that is qualified. This issuance could result in an adverse reaction inthe financial marketplace due to a loss of investor confidence in thereliability of our financial statements, which ultimately could negativelyaffect the market price of our shares.

 

**If theestimates we make, and the assumptions on which we rely, in preparing ourfinancial statements prove inaccurate, our actual results may vary from thosereflected in our projections.**

 

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 long-lived intangible assets based on their value at thedate of acquisition. Events could occur that would cause us to re-evaluate thelife of those assets and, therefore, whether those assets have been impaired,resulting in an impairment charge. We based the estimates we make on historicalexperience and on various other assumptions that we believed to be reasonableat the time and under the circumstances. If the estimates relating to ourintangibles are determined to be incorrect, a write-down may be required, whichcould have a material adverse effect on our financial condition. There can beno assurance that any of our estimates or the assumptions underlying ourestimates, whether relating to intangibles or other aspects of our financialstatements, will be correct.

 

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**Item 3 – Quantitative and Qualitative Disclosuresabout Market Risk.**

 

**Our exposure to market risk isprincipally confined to our cash equivalents and investments, all of which havematurities of less than one year.  Wehave maintained a non-trading investment portfolio of investment grade, liquiddebt securities that limit the amount of credit exposure to any one issue,issuer or type of instrument.  In view ofthe nature and mix of our total portfolio, a 10% movement in market interestrates would not have any impact on the total value of our investment portfolioas of September 30, 2004.**

** **

**Item 4 – Controls andProcedures.**

 

**Evaluationof Disclosure Controls and Procedures**

 

**Our management, with theparticipation of our chief executive officer and chief financial officer,evaluated the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of1934, as amended (Exchange Act)), as of September 30, 2004.  Based on this evaluation, our chief executiveofficer and chief financial officer concluded that, as of September 30, 2004,our disclosure controls and procedures were (1) designed to ensure thatmaterial information relating to us, including our consolidated subsidiary, ismade known to our chief executive officer and chief financial officer by otherswithin those entities, particularly during the period in which this report wasbeing prepared and (2) effective, in that they provide reasonable assurancethat information required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the periods specified in the SEC’s rules and forms.**

** **

**Changesin Internal Control Over Financial Reporting**

** **

**Nochange in our internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscalquarter ended September 30, 2004, that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.**

** **

**Sarbanes-OxleySection 404 Compliance**

** **

**Section404 of the Sarbanes-Oxley Act of 2002 (the “Act”) will require us to include aninternal control report from management in our Annual Report on Form 10-K forthe year ended December 31, 2004 and in subsequent Annual Reports on Form 10-Kthereafter.  The internal control reportmust include the following:  (1) astatement of management’s responsibility for establishing and maintainingadequate internal control over financial reporting, (2) a statement identifyingthe framework used by management to conduct the required evaluation of theeffectiveness of our internal control over financial reporting, (3) management’sassessment of the effectiveness of our internal control over financialreporting as of December 31, 2004, including a statement as to whether or notinternal control over financial reporting is effective, and (4) a statementthat our independent auditors have issued an attestation report on management’sassessment of internal control over financial reporting.**

** **

**Managementacknowledges its responsibility for establishing and maintaining internalcontrols over financial reporting and seeks to continually improve thosecontrols.  In addition, in order toachieve compliance with Section 404 of the Act within the required timeframe,we have been conducting a process to document and evaluate our internalcontrols over financial reporting.  Inthis regard, we have dedicated internal resources, engaged outside consultantsand adopted a detailed work plan to: (i) assess and document the adequacy ofinternal control over financial reporting; (ii) take steps to improve controlprocesses where required; (iii) validate through testing that controls arefunctioning as documented; and (iv) implement a continuous reporting andimprovement process for internal control over financial reporting.  We believe our process for documenting,evaluating and monitoring our internal control over financial reporting isconsistent with the objectives of Section 404 of the Act.**

** **

**Duringthe first nine months of 2004, we commenced testing of our internalcontrols.  Our documentation and testingto date have identified certain gaps in the documentation, design and effectivenessof internal controls over financial reporting that we are in the process ofremediating. Given the risks inherent in the design and**

 

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**operation of internal controls over financial reporting, wecan provide no assurance as to our, or our independent auditor’s conclusions atDecember 31, 2004 with respect to the effectiveness of our internal controlsover financial reporting.**

** **

**Itshould be noted that any system of controls, however well designed andoperated, can provide only reasonable, and not absolute, assurance that theobjectives of the control system are met. In addition, the design of any control system is based in part uponcertain assumptions about the likelihood of future events.  Because of these and other inherentlimitations of control systems, there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions,regardless of how remote.**

 

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**PART II - Other Information**

 

**Item 2 – Unregistered Sales of Equity Securitiesand Use of Proceeds.**

 

On September 22, 2004, weissued 285,121 shares of our common stock in connection with the in-licensingfrom Merck of vilazodone, a drug candidate in clinical development.  We issued the shares to the licensor inconsideration for the exclusive right to develop and commercialize this drugcandidate.

 

Nounderwriters were involved in the foregoing issuance, and the securitiesdescribed were issued to the investors in reliance upon exemptions from theregistration provisions of the Securities Act of 1933, as amended, set forth inSection 4(2) thereof relative to sales by an issuer not involving any publicoffering, to the extent an exemption from registration was required.

 

**Item 6 – Exhibits.**

 

(a)          Exhibits

 

See Index to Exhibitsattached hereto.

 

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**SIGNATURE**

 

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

 
|                    |   |   | GENAISSANCE  PHARMACEUTICALS, INC. |
|-------------------------|--------|--------|------------------------------------|
|                    |   |   |                               |
|                    |   |   |                               |
|                    |   |   | By:                                | /s/  Ben Kaplan |   |
| Date: November 15, 2004 |   |   |                               | Ben Kaplan |   |
|                    |   |   |                               | Senior Vice President  and Chief Financial Officer |
|                    |   |   |                               | (Principal Financial  and Accounting Officer) |

 

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**EXHIBIT INDEX**

** **
| **Exhibit No.** | ** ** | **Description of Document**                                                                                                            |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                   |
| 10.1*           |       | Form  of Nonstatutory Stock Option Agreement under the Registrant’s 2000 Amended  and Restated Equity Incentive Plan, as amended. |
|            |       |                                                                                                                                   |
| 10.2*           |       | Form  of Incentive Stock Option Agreement under the Registrant’s 2000 Amended and  Restated Equity Incentive Plan, as amended.    |
|            |       |                                                                                                                                   |
| 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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*                 Indicatesa management contract or compensatory plan.

 

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