# **UNITEDSTATES**

# **SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC  20549**

 

# **FORM10-Q**

 

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

 

## **ForThe Quarterly Period Ended June 30, 2005**

 

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

 

**ForThe Transition Period From               To               **

 

**Commission File No. 000-30981**

 

**GENAISSANCEPHARMACEUTICALS, INC.**

(Exact Name ofRegistrant as Specified in its Charter)

 
| **Delaware**                                               | ** ** | **06-1338846**       |
|------------------------------------------------------------|------------|----------------------|
| (State or other  jurisdiction of                           |       | (I.R.S. Employer     |
| incorporation or  organization)                            |       | 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) |

 

Indicate by check markwhether the registrant:  (1) has filedall reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days:

Yes ý      Noo

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in rule 12b-2 of theExchange Act):

Yes ý      Noo

 

The number of shares ofthe registrant’s outstanding common stock as of August 3, 2005, was 35,412,044shares.

 

 

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**GENAISSANCEPHARMACEUTICALS, INC.**

 

For the Quarter Ended June 30, 2005

 

**Index**

 
| **PART I – FINANCIAL INFORMATION**                                                                     |   |
|-------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                        |   |
| Item 1 – Financial  Statements (unaudited)                                                             |   |
|                                                                                                        |   |
| Condensed Consolidated  Balance Sheets as of June 30, 2005 and December 31, 2004                            |   |
|                                                                                                        |   |
| Condensed Consolidated  Statements of Operations for the Three and Six Months Ended June 30, 2005 and  2004 |   |
|                                                                                                        |   |
| Condensed Consolidated  Statements of Cash Flows for the Six Months Ended June 30, 2005 and 2004            |   |
|                                                                                                        |   |
| Notes to 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 4 –  Submission of Matters to a Vote of Security Holders                                          |   |
|                                                                                                        |   |
| Item 6 – Exhibits                                                                                      |   |
|                                                                                                        |   |
| Signature                                                                                                   |   |

 

*The Genaissance nameand logo, the Lark name and logo, and DecoGen**â**,HAP**â**,HAPTM and FAMILION**â**are either registered trademarks or trademarks of Genaissance Pharmaceuticals,Inc. in the United States and/or other countries.  All other trademarks, servicemarks or tradenames referred to in this Quarterly Report on Form 10-Q are the property oftheir respective owners.*

 

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**PART I –Financial Information**

**Item 1 –Financial Statements (unaudited).**

 

**GENAISSANCEPHARMACEUTICALS, INC.**

 

CondensedConsolidated Balance Sheets

(Unaudited)

(In thousands,except per share data)

 
| ** **                                                                                                                                                                                                   | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|------------|------------------|------------|
| ** **                                                                                                                                                                                                   | ** ** | **2005**     | ** ** | **2004**         | ** ** |
|                                                                                                                                                                                                         |       |         |       |             |       |
| **ASSETS**                                                                                                                                                                                                   | ** ** | ** **   | ** ** | ** **       | ** ** |
| CURRENT ASSETS:                                                                                                                                                                                              |       |         |       |             |       |
| Cash and cash  equivalents                                                                                                                                                                                   |       | $            | 4,086      |             | $          | 9,174 |   |
| Restricted cash                                                                                                                                                                                              |       | 224          |       | 213              |       |
| Accounts  receivable, net                                                                                                                                                                                    |       | 4,753        |       | 4,251            |       |
| Taxes receivable                                                                                                                                                                                             |       | 697          |       | 652              |       |
| Inventory                                                                                                                                                                                                    |       | 638          |       | 606              |       |
| Other current  assets                                                                                                                                                                                        |       | 1,006        |       | 1,020            |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| Total current  assets                                                                                                                                                                                        |       | 11,404       |       | 15,916           |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| PROPERTY AND  EQUIPMENT, net                                                                                                                                                                                 |       | 8,274        |       | 9,182            |       |
| DEFERRED  FINANCING COSTS, net                                                                                                                                                                               |       | 170          |       | 216              |       |
| INVESTMENT IN  AFFILIATE                                                                                                                                                                                     |       | 1,186        |       | 1,186            |       |
| GOODWILL                                                                                                                                                                                                     |       | 12,286       |       | 12,286           |       |
| OTHER  INTANGIBLES, net                                                                                                                                                                                      |       | 10,853       |       | 11,153           |       |
| OTHER ASSETS                                                                                                                                                                                                 |       | 95           |       | 99               |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| Total assets                                                                                                                                                                                                 |       | $            | 44,268     |             | $          | 50,038 |   |
|                                                                                                                                                                                                         |       |         |       |             |       |
| **LIABILITIES,  REDEEMABLE CONVERTIBLE PREFERRED STOCK, AND STOCKHOLDERS’ EQUITY**                                                                                                                      | ** ** | ** **   | ** ** | ** **       | ** ** |
| CURRENT  LIABILITIES:                                                                                                                                                                                        |       |         |       |             |       |
| Current portion  of long-term debt                                                                                                                                                                           |       | $            | 735        |             | $          | 3,648 |   |
| Accounts payable                                                                                                                                                                                             |       | 1,816        |       | 1,472            |       |
| Accrued expenses                                                                                                                                                                                             |       | 2,464        |       | 2,929            |       |
| Accrued  dividends                                                                                                                                                                                           |       | 1,259        |       | 1,260            |       |
| Current portion  of deferred revenue                                                                                                                                                                         |       | 1,330        |       | 1,789            |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| Total current  liabilities                                                                                                                                                                                   |       | 7,604        |       | 11,098           |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| LONG-TERM  LIABILITIES:                                                                                                                                                                                      |       |         |       |             |       |
| Long-term debt,  net of current portion and discount                                                                                                                                                         |       | 6,663        |       | 3,692            |       |
| Deferred  revenue, net of current portion                                                                                                                                                                    |       | 2,433        |       | 2,791            |       |
| Deferred tax  liabilities                                                                                                                                                                                    |       | 1,327        |       | 1,327            |       |
| Other long-term  liabilities                                                                                                                                                                                 |       | 2,700        |       | 2,330            |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| Total long-term  liabilities                                                                                                                                                                                 |       | 13,123       |       | 10,140           |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| COMMITMENTS AND  CONTINGENCIES (Note 17)                                                                                                                                                                     |       |         |       |             |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| SERIES A  REDEEMABLE CONVERTIBLE PREFERRED STOCK:                                                                                                                                                            |       |         |       |             |       |
| 460 authorized  shares at June 30, 2005 and December 31, 2004; $.001 par value; 460 shares issued  and outstanding at June 30, 2005 and December 31, 2004 (liquidation  preference $11,139 at June 30, 2005) |       | 9,869        |       | 9,698            |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                                                  |       |         |       |             |       |
| Preferred stock,  540 authorized shares at June 30, 2005 and December 31, 2004; no shares  issued or outstanding except for series A included above                                                          |       | —       |       | —           |       |
| Common stock,  58,000 authorized shares at June 30, 2005 and December 31, 2004; $.001 par  value; 35,412 and 34,708 shares issued and outstanding at June 30, 2005 and  December 31, 2004, respectively      |       | 35           |       | 35               |       |
| Additional  paid-in capital                                                                                                                                                                                  |       | 255,326      |       | 252,945          |       |
| Accumulated  deficit                                                                                                                                                                                         |       | (240,836     | )          | (233,522         | )          |
| Deferred  compensation                                                                                                                                                                                       |       | (796         | )          | (374             | )          |
| Accumulated  other comprehensive (loss) income                                                                                                                                                               |       | (57          | )          | 18               |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| Total  stockholders’ equity                                                                                                                                                                             |       | 13,672       |       | 19,102           |       |
|                                                                                                                                                                                                         |       |         |       |             |       |
| Total  liabilities, redeemable convertible preferred stock, and stockholders’ equity                                                                                                                    |       | $            | 44,268     |             | $          | 50,038 |   |

 

*The accompanying notes are an integral part ofthese condensed consolidated financial statements.*

 

1

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**GENAISSANCEPHARMACEUTICALS, INC.**

 

CondensedConsolidated Statements of Operations

(Unaudited)

(In thousands,except per share data)

 
| ** **                                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                           | ** ** | **June 30,**           | ** ** | **June 30,**         | ** ** |
| ** **                                                           | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| **REVENUES:**                                                        |       |                   |       |                 |       |   |   |   |   |
| License and  research                                                |       | $                      | 2,065      |                 | $          | 2,553 |   | $ | 4,918 |   | $ | 5,421 |   |
| Laboratory  services                                                 |       | 2,965                  |       | 2,802                |       | 5,700 |   | 3,662 |   |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| Total revenue                                                        |       | 5,030                  |       | 5,355                |       | 10,618 |   | 9,083 |   |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| **OPERATING  EXPENSES:**                                             |       |                   |       |                 |       |   |   |   |   |
| Cost of  laboratory services                                         |       | 1,956                  |       | 1,986                |       | 3,982 |   | 2,847 |   |
| Research and  development                                            |       | 2,973                  |       | 6,128                |       | 6,274 |   | 11,140 |   |
| Selling, general  and administrative                                 |       | 3,911                  |       | 3,666                |       | 7,151 |   | 6,024 |   |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| Total operating  expenses                                            |       | 8,840                  |       | 11,780               |       | 17,407 |   | 20,011 |   |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| Loss from  operations                                                |       | (3,810                 | )          | (6,425               | )          | (6,789 | ) | (10,928 | ) |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| **OTHER  INCOME (EXPENSE):**                                         |       |                   |       |                 |       |   |   |   |   |
| Other income,  net                                                   |       | 42                     |       | 9                    |       | 76 |   | 84 |   |
| Interest expense                                                     |       | (411                   | )          | (175                 | )          | (568 | ) | (355 | ) |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| Loss before  income taxes and equity in loss of affiliate            |       | (4,179                 | )          | (6,591               | )          | (7,281 | ) | (11,199 | ) |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| Income tax  (expense) benefit                                        |       | (7                     | )          | (36                  | )          | (33 | ) | 13 |   |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| Equity in loss  of affiliate                                         |       | —                 |       | (150                 | )          | — |   | (300 | ) |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| Net loss                                                             |       | (4,186                 | )          | (6,777               | )          | (7,314 | ) | (11,486 | ) |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| **WARRANT  ISSUANCE EXPENSE**                                        |       | —                 |       | (833                 | )          | — |   | (833 | ) |
| **PREFERRED  STOCK DIVIDENDS AND ACCRETION**                         |       | (138                   | )          | (111                 | )          | (273 | ) | (221 | ) |
| **BENEFICIAL  CONVERSION FEATURE OF PREFERRED STOCK AND WARRANT**    |       | —                 |       | (40                  | )          | — |   | (46 | ) |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| Net loss  attributable to common stockholders                        |       | $                      | (4,324     | )                    | $          | (7,761 | ) | $ | (7,587 | ) | $ | (12,586 | ) |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| Net loss per  common share, basic and diluted                        |       | $                      | (0.12      | )                    | $          | (0.26 | ) | $ | (0.22 | ) | $ | (0.47 | ) |
|                                                                 |       |                   |       |                 |       |   |   |   |   |
| Weighted average shares used in computing net loss per common  share |       | 34,677                 |       | 30,073               |       | 34,653 |   | 26,633 |   |

 

*The accompanying notes are an integral part ofthese condensed consolidated financial statements.*

 

2

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**GENAISSANCEPHARMACEUTICALS, INC.**

 

CondensedConsolidated Statements of Cash Flows

(Unaudited)

(In thousands)

 
| ** **                                                                   | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                       | ** ** | **2004** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                    | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                              | (7,314     | ) | $ | (11,486 | ) |
| Adjustment to reconcile net loss to net cash used in operating  activities:  |       |                           |       |   |   |
| Depreciation and amortization                                                |       | 2,007                          |       | 3,257 |   |
| Stock-based compensation                                                     |       | 767                            |       | 318 |   |
| Non-cash service and license expense paid with stock                         |       | —                         |       | 345 |   |
| Equity in loss of affiliate                                                  |       | —                         |       | 300 |   |
| Changes in assets and liabilities:                                           |       |                           |       |   |   |
| Accounts receivable                                                          |       | (502                           | )          | 118 |   |
| Taxes receivable                                                             |       | (45                            | )          | (115 | ) |
| Inventory and other current assets                                           |       | (68                            | )          | 652 |   |
| Other assets                                                                 |       | 4                              |       | 352 |   |
| Accounts payable                                                             |       | 344                            |       | (446 | ) |
| Accrued expenses                                                             |       | (465                           | )          | (1,291 | ) |
| Deferred revenue                                                             |       | (817                           | )          | (455 | ) |
| Other long-term liabilities                                                  |       | 370                            |       | — |   |
| Net cash used in operating activities                                        |       | (5,719                         | )          | (8,451 | ) |
|                                                                         |       |                           |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                    |       |                           |       |   |   |
| Cash received through acquisition, net of transaction costs                  |       | —                         |       | 300 |   |
| Purchases of property and equipment                                          |       | (440                           | )          | (930 | ) |
| Investment in affiliate                                                      |       | —                         |       | (74 | ) |
| Increase in restricted cash                                                  |       | (11                            | )          | — |   |
| Proceeds from sales of marketable securities                                 |       | —                         |       | 4,168 |   |
| Net cash (used in) provided by investing activities                          |       | (451                           | )          | 3,464 |   |
|                                                                         |       |                           |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                    | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net proceeds from issuance of common stock and exercise of warrant           |       | 62                             |       | 5,103 |   |
| Proceeds from long-term debt                                                 |       | 4,500                          |       | — |   |
| Repayment of long-term debt                                                  |       | (3,178                         | )          | (1,147 | ) |
| Financing costs                                                              |       | (123                           | )          | — |   |
| Preferred stock dividends paid                                               |       | (104                           | )          | (23 | ) |
| Net cash provided by financing activities                                    |       | 1,157                          |       | 3,933 |   |
|                                                                         |       |                           |       |   |   |
| Effect of exchange rate changes on cash                                      |       | (75                            | )          | — |   |
|                                                                         |       |                           |       |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                    |       | (5,088                         | )          | (1,054 | ) |
|                                                                         |       |                           |       |   |   |
| CASH AND CASH EQUIVALENTS, beginning of period                               |       | 9,174                          |       | 8,033 |   |
|                                                                         |       |                           |       |   |   |
| CASH AND CASH EQUIVALENTS, end of period                                     |       | $                              | 4,086      |   | $ | 6,979 |   |
|                                                                         |       |                           |       |   |   |
| **SUPPLEMENTAL DISCLOSURE AND NON-CASH ACTIVITIES:**                         | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Interest paid                                                                |       | $                              | 283        |   | $ | 351 |   |
| Income taxes paid                                                            |       | $                              | 48         |   | $ | 67 |   |
| Issuance of  restricted shares, net of forfeitures                           |       | $                              | 1,166      |   | $ | — |   |
| Issuance of warrants in connection with debt financing                       |       | $                              | 1,405      |   | $ | — |   |
| Issuance of  common stock for services and licenses                          |       | $                              | —     |   | $ | 59 |   |
| Issuance of stock, options and warrants in connection with the  acquisitions |       | $                              | —     |   | $ | 23,403 |   |

 

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

* *

3

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**GENAISSANCEPHARMACEUTICALS, INC**.

 

# **Notes to Unaudited CondensedConsolidated Financial Statements**

For the QuarterEnded June 30, 2005

(Amounts inthousands, except per share data)

 

**(1)****                     BASIS OFPRESENTATION**

 

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.  The *FAMILION* Test is designed to detectmutations responsible for causing familial Long QT (LQT) and Brugada Syndromes,two causes of sudden cardiac death.  The Company’s 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 the Company to leverage existing clinical dataand, thus, reduce the costs and risks associated with traditional drugdevelopment and increase the probability of clinical success andcommercialization.  The Company’s lead therapeutic product, vilazodone fordepression, 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 31,2004, 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 June 30, 2005, and the results of its operations for the three and six monthsended June 30, 2005 and 2004, respectively. The results of operations for suchinterim periods are not necessarily indicative of the results to be achievedfor the full year.

 

The Company believes that its current cash balance andthe funds generated from operations will not be sufficient to fund its expectednet losses, debt service obligations and capital expenditures for the nexttwelve months based on its current activities.  The pending merger withClinical Data, Inc. (Clinical Data) (see Note 3) would obviate the need foradditional liquidity.  However, there can be no assurance that the mergerwill be consummated in the expected time frame.  Should the merger not occur, the Company wouldbe required to review other alternatives to raise capital including, but notlimited to, the sale of certain assets or raising private or public equity ordebt.  There can be no assurance that the Company will be able to obtainsufficient financing on acceptable terms, if at all.  These circumstances raise substantial doubtabout the Company’s ability to continue as a going concern.  These financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

 

The Company operates inan environment of rapid change in technology and has substantial competitionfrom companies 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 has or would obtain adequateprotection for intellectual property or that any of its products would becommercially viable.  The Company hasincurred substantial losses to date and expects to incur substantial expendituresin the foreseeable future to fund its research and development and commercializeits products.

 

**(2)****                     ORGANIZATION,OPERATIONS AND RECENT DEVELOPMENTS**

 

On June 21, 2005,the Company entered in to a merger agreement with Clinical Data (see Note3).  The accompanying condensedconsolidated financial statements do not reflect any effects of this agreement.

 

In April 2005, theCompany entered into a Note and Warrant Purchase Agreement with XmarkOpportunity Fund, Ltd., Xmark Opportunity Fund, L.P. and Xmark JV InvestmentPartners, LLC (collectively, Xmark), pursuant to which, the Company issuedNotes (collectively, the Note) to Xmark in the aggregate principal amount of$4,500.  The Note is

 

4

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secured by substantiallyall of the Company’s assets, excluding, among other assets, the Company’sintellectual property.  In addition, theCompany issued Xmark warrants to purchase an aggregate of 2,000 shares of theCompany’s common stock at an exercise price of $2.25 per share.  The Note is payable in full on April 21,2007.  Concurrent with signing the Note,the Company terminated its Loan and Security Agreement with Comerica Bank N.A.(Comerica) and repaid all outstanding principal and interest due to Comerica.

 

In September 2004, theCompany entered into a license, development and cooperation agreement withMerck KGaA (Merck) pursuant to which the Company acquired an exclusiveworldwide license from Merck to develop and commercialize vilazodone, a smallmolecule compound.  In consideration forthe rights relating to vilazodone, the Company agreed to pay an initial licenseand milestone payments upon the achievement of specified development,regulatory and sales milestones.  Under the terms of the agreement, theCompany paid the initial license fee and will pay milestone payments, until thefirst commercial sale of vilazodone, through the issuance of its commonstock.  The Company issued 369 shares ofits common stock to Merck in payment of the initial license fee.  Under the terms of the agreement, if Merckand its affiliates’ aggregate ownership of the Company’s common stock wouldexceed 19.9% of the number of shares of its common stock then outstanding, orif the average closing price of the Company’s common stock at the time of therespective payment date is below $2.25 per share, the Company is required tomake milestone payments to Merck in cash.  Pursuant to the terms of theagreement, Merck is entitled to royalties on all future product sales and ashare of all sub-licensing income from any third party.  In addition, the agreement requires that theCompany have demonstrated its ability to fund the initial research anddevelopment activities by July 22, 2005 or Merck may terminate the agreementand reacquire rights to vilazodone.  TheCompany believes that the planned merger with Clinical Data (see Note 3)fulfills the requirements of the July 22, 2005 deadline.

 

In April 2004, theCompany acquired Lark Technologies, Inc. (Lark) in a stock-for-stock mergersuch that Lark became a wholly-owned subsidiary of the Company.  Lark provides Good Laboratory Practices (GLP)compliant and research sequencing and related molecular biology services to thepharmaceutical, biotechnology and agbio industries at its facilities in Houston,Texas and the United Kingdom (U.K.). Lark’s service portfolio consists of over 100 different molecularbiology services in the areas of nucleic acid extraction, DNA sequencing,genetic stability testing, gene expression and detection as well as other customservices.  See Note 4 for furtherdiscussion of the Lark acquisition.

 

**(3)**                     **MERGER WITH CLINICALDATA**

 

On June 21, 2005,the Company entered in to a merger agreement with Clinical Data and a whollyowned subsidiary of Clinical Data, pursuant to which Genaissance would become awholly owned subsidiary of Clinical Data in a stock-for-stock merger to beaccounted for as a purchase transaction whereby each Genaissance common stockholderwould receive 0.065 shares of Clinical Data common stock for each share ofGenaissance common stock held and Genaissance series A preferred stock wouldconvert into a new class of Clinical Data preferred stock.  The transaction is valued at approximately $65,400,including the assumption of debt, and is expected to close in the fourthquarter of 2005.  The closing of thetransaction is conditioned upon the approval of the respective stockholders ofboth companies and certain other customary items.  Reference is made to the joint proxystatement/prospectus, which forms a part of the Registration Statement on FormS-4 filed by Clinical Data on August 5, 2005, for a full description of thebackground, reasons for and terms of the proposed merger with Clinical Data.

 

**(4)**                     **ACQUISITION OF LARKTECHNOLOGIES**

 

On April 1, 2004, Genaissance acquired Lark in astock-for-stock merger accounted for as a purchase transaction.  The total cost of the acquisition wasapproximately $24,486.  The purchaseprice was allocated to the tangible and identifiable intangible assets of Larkacquired by Genaissance and the liabilities assumed by Genaissance on the basisof their fair values on the acquisition date.

 

Theresults of operations of Lark are included in the Company’s condensedconsolidated statements of operations since the date of acquisition.  Supplemental pro forma disclosure of resultsof operations for the six months ended June 30, 2004 as though the merger hadbeen completed as of January 1, 2004, are as follows:

 
| Revenue                                       |   | $       | 10,945 |   |
|-----------------------------------------------|--------|---------|--------|--------|
| Operating loss                                |   | (11,773 | )      |
| Net loss  attributable to common stockholders |   | (13,459 | )      |
| Earnings per  share                           |   | $       | (0.40  | )      |

 

5

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The financialstatements of the Lark’s U.K. facility are measured using the local currency asthe functional currency.  Assets andliabilities of the U.K. facility are translated at the rates of exchange at thebalance sheet date.  The resultingtranslation adjustments are recorded as a separate component of stockholders’equity and are included in other comprehensive income (loss) (see Note 15).  Income and expense items are translated ataverage monthly rates of exchange.

 

Laboratoryservices revenue for the U.K. facility totaled approximately $526 and $1,011for the three and six months ended June 30, 2005, respectively.

 

**(5)****                     EARNINGS PERSHARE**

 

The Companycomputes and presents net loss per share in accordance with Statement ofFinancial Accounting Standards (SFAS) No. 128, *Earnings PerShare*.  There is no differencein basic and diluted net loss per common share because the effect of theconvertible preferred stock, stock options and warrants would be anti-dilutivefor all periods presented.  Theoutstanding series A convertible preferred stock, stock options and warrants(prior to application of the treasury stock method) would entitle holders toacquire 16,640 and 10,022 shares of common stock at June 30, 2005 and 2004,respectively.

 

**(6)****                     DEFERREDCOMPENSATION**

 

In January 2005,the Company issued 527 shares of restricted stock to certain of its employeesunder its 2000 Amended and Restated Equity Incentive Plan.  The shares of restricted stock vest fully inFebruary 2006.  The Company recordeddeferred compensation based on the fair market value of the stock on the date ofgrant and is recognizing the expense, net of cancellations, ratably over theperiod from the date of grant to the vesting date.

 

**(7)****                     REVENUE RECOGNITION**

 

The Company earnsits revenues primarily through the licensing of its *HAP* Technology and by providing molecular biologyservices.  The Company recognizes revenueassociated with molecular biology services, which are included in laboratoryservice revenue in the accompanying condensed consolidated statements ofoperations, in accordance with Staff Accounting Bulletin (SAB) No. 104, *Revenue Recognition* (which supercedes SABNo. 101, *Revenue Recognition in FinancialStatements*) as the services are performed provided that persuasiveevidence of an arrangement exists, the price is fixed and determinable andcollectibility is reasonably assured.

 

In accordance withSAB No. 104 and Emerging Issues Task Force Issue 00-21, the Company generallyrecognizes license fees over the term of the agreement and research fees as theresearch is performed.  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 royalties received under these agreements, if any,will be recognized, provided that the milestone is substantive and a culminationof the earnings process has occurred.

 

Deferred revenue resultswhen consideration is received or amounts are receivable in advance of revenuerecognition.  Deferred revenue related tolicense agreements is generally recognized over the license period.  For license agreements, which contain earlytermination provisions, the Company recognizes revenue upon the expiration ofthe termination provisions for the period from the original license date to thedate the early termination provisions expire.

 

**(8)****                     RECENTLY ISSUED ACCOUNTINGSTANDARDS**

 

In May 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections*, which replacesAccounting Principles Board Opinions No. 20, *AccountingChanges*, and SFAS No. 3, *ReportingAccounting Changes in Interim Financial Statements-An Amendment of APB OpinionNo. 28*.  SFAS No. 154 providesguidance on the accounting for and reporting of accounting changes and errorcorrections.  It establishesretrospective application, or the latest practicable date, as the requiredmethod for reporting a change in accounting principle and the reporting of acorrection of an error.  SFAS No. 154 iseffective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005.  The Company is currentlyevaluating the effect that the adoption of SFAS No. 154 will have on itsconsolidated financial statements but does not expect it to have a materialimpact.

 

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In December 2004,the FASB issued SFAS No. 123 (Revised 2004),*Share-Based Payment*.  The new rule requires that the compensationcost relating to share-based payment transactions be recognized in financialstatements based on the fair value of the equity or liability instrumentsissued.  In April 2005, the SEC announceda deferral of the effective date of SFAS No. 123(R) to be the first annualreporting period starting after December 15, 2005.  The Company routinely uses share-basedpayment arrangements as compensation for its employees.  The Company is in the process of evaluatingthe impact of the adoption of SFAS No. 123(R) but believes it will have amaterial impact on its consolidated financial statements.  At the present time, we have not yetdetermined which valuation method we will use.

 

**(9)****                     GOODWILL ANDINTANGIBLE ASSETS**

 

Goodwill and identifiableintangible assets, recorded in the condensed consolidated balance sheet of theCompany, are comprised of the following as of June 30, 2005:

 
| ** **                        | ** ** | **Gross**  | ** ** | **Accumulated**  | ** ** |
|-----------------------------------|------------|------------|------------|------------------|------------|
| ** **                        | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Amortizable  intangible assets:   |       |       |       |             |       |
| Patents acquired                  |       | $          | 868        |             | $          | (252 | ) |
| Lark customer  relationships      |       | 7,200      |       | (600             | )          |
|                              |       |       |       |             |       |
| Unamortizable  intangible assets: |       |       |       |             |       |
| Lark trade name                   |       | 3,500      |       | —           |       |
| Lark GLP  certification           |       | 137        |       | —           |       |
| Lark goodwill                     |       | 12,286     |       | —           |       |
|                              |       |       |       |             |       |
| Total                             |       | $          | 23,991     |             | $          | (852 | ) |

 

Amortization expense wasapproximately $150 for each of the three months ended June 30, 2005 and 2004and $300 and $59 for the six months ended June 30, 2005 and 2004, respectively.

 

The expected amortizationexpense for the current and each of the next four years is as follows:

 
| Fiscal 2005  (remaining) |   | $   | 299    |   |
|--------------------------|--------|-----|--------|--------|
| Fiscal 2006              |   | 599 |   |
| Fiscal 2007              |   | 599 |   |
| Fiscal 2008              |   | 559 |   |
| Fiscal 2009              |   | 535 |   |

 

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

 

At June30, 2005, the Company had one stock-based compensation plan, which is accountedfor under the recognition and measurement principles of Accounting PrinciplesBoard Opinion No. 25, *Accounting for StockIssued to Employees,* and related interpretations.

 

Thefollowing table illustrates the effect on net income and earnings per share, ifthe Company had applied the fair value recognition provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*,to stock-based employee compensation for the three and six months ended June 30,2005 and 2004, respectively:

 
| ** **                                                                                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                        | ** ** | **June 30,**           | ** ** | **June 30,**         | ** ** |
| ** **                                                                                                        | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                              |       |                   |       |                 |       |   |   |   |   |
| Net loss  applicable to common stockholders, as reported                                                          |       | $                      | (4,324     | )                    | $          | (7,761 | ) | $ | (7,587 | ) | $ | (12,586 | ) |
| Add: Stock-based  employee compensation expense included in reported net loss                                     |       | 360                    |       | 125                  |       | 767 |   | 164 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based method  for all awards |       | (822                   | )          | (1,725               | )          | (1,641 | ) | (2,175 | ) |
| Pro forma net  loss applicable to common stockholders                                                             |       | $                      | (4,786     | )                    | $          | (9,361 | ) | $ | (8,461 | ) | $ | (14,597 | ) |
|                                                                                                              |       |                   |       |                 |       |   |   |   |   |
| Net loss per  share:                                                                                              |       |                   |       |                 |       |   |   |   |   |
| Basic and  diluted - as reported                                                                                  |       | $                      | (0.12      | )                    | $          | (0.26 | ) | $ | (0.22 | ) | $ | (0.47 | ) |
|                                                                                                              |       |                   |       |                 |       |   |   |   |   |
| Basic and  diluted - pro forma                                                                                    |       | $                      | (0.14      | )                    | $          | (0.31 | ) | $ | (0.24 | ) | $ | (0.55 | ) |
|                                                                                                                   |            |                        |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |

 

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**(11)**              **SIGNIFICANT CUSTOMERS**

 

For the six months ended June 30, 2005, revenue fromPfizer, Inc. (Pfizer) accounted for 17% of the Company’s total revenue.  For the six months ended June 30, 2004,revenue from Pfizer and Millennium Pharmaceuticals, Inc. accounted for 28% and11%, respectively, of the Company’s total revenue.  Pfizer accounted for 11% of the Company’saccounts receivable balance as of June 30, 2005.

 

**(12)****             ****INVESTMENT IN AFFILIATE**

 

In November 2003, the Company entered into severalagreements with Sciona Inc. (Sciona, formerly known as Sciona Limited), wherebythe Company granted a technology license (Technology License) to Sciona inexchange for a 37% equity interest (30% on a fully diluted basis) in Sciona(Investment).  In September 2004, Scionaclosed an equity financing, which diluted the Company’s holdings to 13% (11% ona fully diluted basis).  As a result, theCompany changed its method of accounting for the investment from the equitymethod to the cost method, and the Company no longer records its percentageinterest in the results of operations of Sciona.  In February 2005, Sciona closed an additionalequity financing, which further diluted the Company’s holdings to 9% (7% on afully diluted basis).  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 payments.  The Company was also granted specified rightsto develop genotyping assays and perform genetic tests.

 

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 approximately $128 and $255 of license revenuerecognized from the amortization of deferred revenue during the three and six monthsended June 30, 2005, respectively.  Therevenue recognized represents the ratable portion of the Technology License feefor the three and six months ended June 30, 2005, respectively, as a result ofSciona meeting the specified milestones. The accompanying condensed consolidated statements of operations alsoinclude license and research revenues for the three months ended June 30, 2005 and2004, of approximately $375 and $38, respectively, and for the six months endedJune 30, 2005 and 2004, of approximately $750 and $85, respectively.

 

**(13)****              LONG-TERM DEBT**

 

TheCompany entered into financing agreements (the Agreements) with ConnecticutInnovations, Inc., a stockholder of the Company, to finance certain leaseholdimprovements and other costs associated with the Company’s facility in NewHaven.  The Agreements provide forpayments of principal and interest based on a 120-month amortization, withfinal balloon payments due in March 2009 through June 2011.  Borrowings under the Agreements arecollateralized by the related leasehold improvements.  Management believes that the Company is incompliance with all covenants of the Agreements as of June 30, 2005.

 

In April 2005, theCompany entered into a Note and Warrant Purchase Agreement with Xmark, pursuantto which, the Company issued the Note to Xmark in the aggregate principalamount of $4,500.  The Note, which ispayable on April 21, 2007, bears interest at 5% and is secured by substantiallyall of the Company’s assets, excluding among other assets, the Company’sintellectual property.  Under the termsof the Note, the Company is required to prepay the Note upon the occurrence ofcertain events, including the sale of the Company’s assets, as defined.  In addition, the Company issued Xmarkwarrants to purchase an aggregate of 2,000 shares of the Company’s common stockat an exercise price of $2.25 per share. The fair value of the warrants was estimated to be approximately $1,405and was recorded as a discount on the amount borrowed.  The discount will be accreted over therepayment term.  Accordingly, the Companyrecorded

 

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approximately $141 ininterest expense in the accompanying condensed consolidated statement ofoperations.  The exercise price per shareis subject to adjustment in certain circumstances if there is a balanceoutstanding under the Note on or after September 18, 2005 andthe Company issues securities for less than $2.25 per share.  The warrants also provide for an equitable adjustmentto the exercise price and number and type of securities purchasable uponexercise of the warrant in certain circumstances, including****the proposed mergertransaction with Clinical Data.****  Concurrent with signing the Note, the Companyterminated its Loan and Security Agreement with Comerica and repaid alloutstanding principal and interest due to Comerica.

 

InSeptember 2003, the Company entered into a $5,000 Loan and SecurityAgreement with Comerica, which was subsequently terminated with all outstandingprincipal and interest being repaid in April 2005.  Under the terms of theagreement, the Company was required to satisfy certain financial covenants,including a minimum cash balance and a minimum quick ratio, as defined. Due to the uncertainty surrounding future debt covenant compliance at December31, 2004, the Company classified the Comerica debt as current in theaccompanying condensed consolidated balance sheet as of December 31, 2004.

 

**(14)****              PREFERRED STOCK**

 

In October 2003, the Company sold 270 shares of seriesA preferred stock (Series A), $0.001 par value per share, to RAM Trading, Ltd.(RAM) for $22.50 per share, resulting in proceeds of approximately $5,925, netof issuance costs of approximately $150. In connection therewith, the Company issued RAM a warrant to purchase anadditional 190 shares of Series A through December 31, 2005, at $22.50 pershare, which RAM exercised on June 30, 2004, resulting in gross proceeds to theCompany of $4,275.  In connection withthe exercise of the warrant, the Company granted an affiliate of RAM a warrantto purchase approximately 262 shares of common stock at the then fair marketvalue of $4.17 per share.

 

The Series A shares and the Series A warrant wereinitially recorded at their relative fair market values of approximately $5,195and $880, respectively.  As a result ofthe put rights discussed below, the difference in the stated value and thecarrying value of the Series A, resulting from the allocation of the proceedsand the issuance costs, is being accreted through the earliest Put Date (asdefined below) 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 statement of operations.

The rights of the Series A holders are as follows:

 

•                  Voting Rights – the holders of Series A are entitledto vote on all matters and are entitled to 0.88 votes per common equivalentshare to comply with certain NASDAQ Marketplace rules.

 

•                  Dividend Rights – the Series A earns a dividend at therate of 2% per annum payable in cash in arrears semi-annually in January andJuly.  Included in accrued dividends inthe accompanying condensed consolidated balance sheets as of June 30, 2005 and December31, 2004 is approximately $100 and $102, respectively, related to the Series Adividends.

 

•                  Conversion Rights – each share of Series A isconvertible into ten shares of common stock at the option of the holder.  On or after October 29, 2006, the Company canrequire the conversion of the Series A if the common stock has traded above$7.00 for 23 consecutive business days.

 

•                  Redemption Rights – under the terms of the Series A,the Company is required to redeem, unless the holders of at least 66-2/3% ofthe Series A elect otherwise, all of the outstanding shares of Series A if asignificant event, as defined, occurs or the Company breaches certaincovenants.  The redemption value is theoriginal stated purchase price of $22.50 per share, plus accrued but unpaiddividends.  A significant event isgenerally defined as a dissolution of the Company or the sale of the Company orsubstantially all of its assets.  If thesignificant event or breach occurs prior to October 29, 2008, the face valueplus all of the unpaid cash dividends through October 29, 2008 also becomepayable (approximately $11,139 at June 30, 2005).  In addition, RAM has the option to requirethat the Company redeem all of the outstanding shares of Series A on eitherOctober 29, 2006, 2007 or 2008 (the Put Dates). The Company may delay such payment for up to one year, in which case thedividend rate would increase to 10% per annum.

 

9

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In connection withthe issuance of the Series A, the Company is required to maintain certaincovenants.  The****mostsignificant of these covenants restricts the Company from: (i) incurringindebtedness in excess of $9,000; (ii) paying dividends on its common stock;and (iii) redeeming most of its equity securities.  Management believes that the Company was incompliance with these covenants as of June 30, 2005.

 

In June 2005, theCompany entered in to a merger agreement with Clinical Data whereby, among otherthings, Genaissance series A preferred stock would convert into a new class ofClinical Data preferred stock.  See Note3 for further discussion of the merger with Clinical Data.

 

In June 2004, RAMagreed not to convert its Series A if such conversion would cause RAM, togetherwith RAM’s affiliates, to beneficially own in excess of 9.99% of the Company’scommon stock.

 

**(15)**              **COMPREHENSIVE INCOME (LOSS)**

 

The Companyreports comprehensive income (loss) in accordance with SFAS No. 130, *Reporting Comprehensive Income*, which establishes standardsfor reporting and the display of comprehensive income (loss) and its componentsin a full set of general purpose financial statements.  The objective of the statement is to report ameasure of all changes in equity of an enterprise that result from transactionsand other economic events during the period, other than transactions withowners.  The Company’s othercomprehensive income (loss) arises from net unrealized gains (losses) onmarketable securities and foreign currency translation gains (losses).

 

A summary of totalcomprehensive loss is as follows:

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **June 30,**           | ** ** | **June 30,**         | ** ** |
| ** **                                    | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                          |       |                   |       |                 |       |   |   |   |   |
| Net loss  attributable to common stockholders |       | $                      | (4,324     | )                    | $          | (7,761 | ) | $ | (7,587 | ) | $ | (12,586 | ) |
| Other  comprehensive income (loss)            |       | (38                    | )          | (18                  | )          | (75 | ) | (11 | ) |
| Total  comprehensive loss                     |       | $                      | (4,362     | )                    | $          | (7,779 | ) | $ | (7,662 | ) | $ | (12,597 | ) |
|                                               |            |                        |            |                      |            |  |  |  |  |  |  |  |  |  |

 

**(16)**              **INCOME TAXES**

 

The State of Connecticut (the State) allows companiesconducting business in the State to receive cash refunds from the State at arate of 65% of their qualifying research and development tax credit, asdefined, in exchange for foregoing the carryforward of the research anddevelopment tax credit.  In the sixmonths ended June 30, 2005 and 2004, the Company recorded an estimated benefitof approximately $45 and $115, respectively, related to the State exchangeprogram, which is offset by foreign and state tax expense.

 

Included in deferred tax liabilities in theaccompanying condensed consolidated balance sheets are federal and statedeferred tax liabilities of approximately $1,236 and $91, respectively, whichwere established as a result of the purchase price allocation for the taxeffects of temporary differences in amortization of intangible assets acquiredin the Lark acquisition.

 

**(17)****              COMMITMENTS AND CONTINGENCIES**

 

In the ordinarycourse of its business, the Company enters into agreements with third partiesthat include indemnification provisions, which, in the Company’s judgment, arenormal and customary for companies in its industry sector.  These agreements are typically with businesspartners and suppliers. Pursuant to these agreements, the Company generallyagrees to indemnify, hold harmless and reimburse the indemnified parties forlosses suffered or incurred by the indemnified parties with respect to theCompany’s products or product candidates, use of such products or other actionstaken or omitted by the Company.  Themaximum potential amount of future payments the Company could be required tomake under these indemnification provisions is unlimited.  Since the date of its incorporation, theCompany has not incurred any costs to defend lawsuits or settle claims relatedto these indemnification provisions.  Asa result, the current estimated fair value of liabilities relating to theseprovisions is minimal.  Accordingly, theCompany has not recorded a liability for these provisions as of June 30,2005.

 

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TheCompany periodically enters into agreements with third parties to obtainexclusive or non-exclusive licenses for certain technologies.  The terms of certain of these agreementsrequire the Company, among other items, to demonstrate the ability to fundcertain research and development activities, pay future royalty payments andpay certain milestone payments based on product sales or sublicense incomegenerated from applicable technologies, if any. The timing of such events and the amount of such payments will dependupon successful commercialization of applicable technologies, if any.

 

Underthe terms of the license, development and cooperation agreement the Companysigned with Merck in September 2004, the Company agreed to pay milestonepayments upon the achievement of specified development, regulatory and salesmilestones and royalties on all future product sales and a share of allsub-licensing income from any third party on the commercialization ofvilazodone.  To date the Company has not made any milestone or royaltypayments to Merck.  Under the terms ofthe agreement, the Company paid the initial license fee and will pay milestonepayments, until the first commercial sale of vilazodone, through the issuanceof its common stock.  If Merck and itsaffiliates’ aggregate ownership of the Company’s common stock would exceed19.9% of the number of shares of the Company’s common stock then outstanding,or if the average closing price of the common stock at the time of therespective payment date is below $2.25 per share, the Company will paymilestone payments to Merck in cash.  Underthe agreement, the Company was required to demonstrate that by no later thanJuly 22, 2005, it has at least $8,000 in financing or has shown the capacity tofund such levels of research and development activities in 2005 relating tovilazodone.  If the Company is unable to meet this requirement, Merck canterminate the agreement and reacquire rights to the compound.  The Company believes that the proposed mergertransaction with Clinical Data (see Note 3) fulfills the requirements of theJuly 22, 2005 deadline.

 

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

 

*Youshould read the following discussion and analysis of our financial conditionand results of operations together with our financial statements andaccompanying notes included elsewhere in this Quarterly Report on Form10-Q.  In addition to the historicalinformation, the discussion in this Quarterly Report contains certainforward-looking statements that involve risks and uncertainties.  Our actual results could differ materiallyfrom those anticipated by the forward-looking statements due to the factors setforth under “Factors Affecting Future Operating Results” below and elsewhere inthis Quarterly Report.*

 

**Common Terms**

 

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

 

*HAP* Technology – the key components of our *HAP* Technology are:

 

•                  a proprietary informatics system, which wecall *DecoGen*,**including unique algorithms for definingpatient populations with different drug responses;

 

•                  a database, which we call the *HAP* Database, of highly informative,proprietary measures of genetic variation, or haplotypes, which we call *HAP* Markers, for pharmaceutically relevantgenes;

 

•                  a cost-effective, efficient process fordetermining genomic variation in clinical DNA samples, genotyping; and

 

•                  clinical genetics development skills.

 

CardiacChannelopathies program – this program was designed to develop a ClinicalLaboratory Improvement Amendments, or CLIA, compliant, genetic test fordetecting cardiac ion channel mutations. Cardiac channelopathies, including familial LQT 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 sodiumchannels of the heart and predispose affected individuals to abnormal heartrhythm, or arrhythmia.  Familial LQT andBrugada Syndromes are commonly seen in apparently healthy, active adolescentpatients.  If left undiagnosed and untreated,these conditions can be fatal.  In May 2004, we launched our *FAMILION* Test, which is a CLIA-compliantgenetic test for cardiac channelopathies. We will also seek to discover genetic markers that are predictive ofdrug-induced QT prolongation and arrhythmias, and arrhythmias that occurin patients with other disorders, such as congestive heart failure.

 

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. In December 2004, we reported the discovery of geneticmarkers that we believe predict who is at risk of developing clozapine-inducedagranulocytosis.  We believe that thefindings may apply to other drugs that also affect white blood cell counts.

 

STRENGTHprogram (Statin Response Examined by Genetic *HAP* Markers) – this program was designed toapply our *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.

 

Vilazodoneprogram – this program is designed to identify genetic markers that define patientswho are most likely to respond to vilazodone, a small molecule compound welicensed from Merck KGaA (Merck), which is under development for the treatmentof depression.

 

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

 

MolecularBiology Services – these DNA-based analytical services include Good LaboratoryPractices (GLP) compliant DNA isolation and banking services and research andGLP compliant sequencing, genotyping and related services.

 

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###### **Overview**

 

We develop innovativeproducts based on our proprietary pharmacogenomic technology and have arevenue-generating business in DNA and pharmacogenomic products andservices.  We also market our proprietary *FAMILION*Test, a CLIA compliant genetic test for cardiac channelopathies, which isdesigned to detect mutations responsible for causing familial LQT 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 us to leverage existing clinical data and, thus,reduce the costs and risks associated with traditional drug development andincrease the probability of clinical success and commercialization.  The Company’s lead therapeutic product,vilazodone for depression, is in Phase II of development.

 

As of June 30, 2005, wehad a total of 7,803 genes in our database, with 26 of these genes having beenadded during the three months ended June 30, 2005, and 32 genes having beenadded during the three months ended June 30, 2004.  There is not necessarily any correlationbetween the costs incurred in any period and the number of genes added to thedatabase in that period.  This is due tothe fact that the size of the gene and, therefore, the amount of work involvedvaries from gene to gene.  In addition,after a gene is sequenced, it must be analyzed and go through an internalquality assurance check before it is added to the database.  This process may cause a gene sequenced inone period to be added to the database in a different period.  Furthermore, since additional informationabout genes continues to be discovered, we may resequence genes previouslyincluded in the database and/or perform a further quality assurance analysis.

 

Since our inception, wehave incurred significant operating losses, and, as of June 30, 2005, we had anaccumulated deficit of approximately $240.8 million.  The majority of our operating losses haveresulted from costs we incurred developing our *HAP*Technology, in our clinical trials and from administrative costsassociated with operations.  As part ofour *HAP* Technology program, wecontinue to populate our database with *HAP*Marker information for pharmaceutically relevant genes, but we do so only wheninformation that we need is not then currently available in our *HAP* Database.  We expect to dedicate a significant portion ofour resources for the foreseeable future to continue the development of ourproprietary programs and service our proprietary programs and molecular biologyservices customers.  To date, our revenuehas been primarily from licensing and service fees from our agreements withBiogen Idec, Inc., Gene Logic, Inc., Johnson & Johnson PharmaceuticalResearch & Development (J&J PRD), Millennium Pharmaceuticals, Inc.(Millennium), Pfizer, Inc. (Pfizer) and Wayne State University and from themolecular biology services that we offer.

 

**Merger with Clinical Data, Inc.**

 

On June 21, 2005, weentered in to a merger agreement with Clinical Data, Inc. (Clinical Data) and awholly owned subsidiary of Clinical Data, pursuant to which Genaissance wouldbecome a wholly owned subsidiary of Clinical Data in a stock-for-stock mergerto be accounted for as a purchase transaction whereby each one of our common stockholderswould receive 0.065 shares of Clinical Data common stock for each share ofGenaissance common stock held and Genaissance series A preferred stock wouldconvert into a new class of Clinical Data preferred stock.  The transaction is valued at approximately $65.4million, including the assumption of debt, and is expected to close in thefourth quarter of 2005.  The closing ofthe transaction is conditioned upon the approval of the respective stockholdersof both companies and certain other customary items.  Reference is made to the joint proxystatement/prospectus, which forms a part of the Registration Statement on FormS-4 filed by Clinical Data on August 5, 2005, for a full description of thebackground, reasons for and terms of the proposed merger with Clinical Data.

 

**Financing Activities**

 

On April 21, 2005, weentered into a Note and Warrant Purchase Agreement with Xmark Opportunity Fund,Ltd., Xmark Opportunity Fund, L.P. and Xmark JV Investment Partners, LLC(collectively, Xmark), pursuant to which, we issued Notes (collectively, Note)to Xmark in the aggregate principal amount of $4.5 million.  The Note, which is payable in full on April21, 2007, bears interest at 5% and is secured by substantially all of ourassets, excluding, among other assets, our intellectual property.  Under the terms of the Note, we are requiredto prepay the Note upon the occurrence of certain events including the sale ofour assets, as defined.  In addition, weissued Xmark warrants to purchase an aggregate of 2,000,000 shares of ourcommon stock at an exercise price of $2.25 per share.  The price per share is subject to adjustmentin certain circumstances if there is a balance outstanding underthe Note on or after September 18, 2005 and we issue securitiesfor less than $2.25 per share.  Thewarrants also provide for an equitable adjustment to the exercise price andnumber and type of securities purchasable upon exercise of the warrant incertain circumstances, including the proposed merger transaction with ClinicalData.  Concurrent with signing the Note,we terminated our Loan and Security Agreement with Comerica Bank N.A.(Comerica) and repaid all outstanding principal and interest due to Comerica.

 

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**Acquisitions**

 

*Lark Technologies, Inc.*

 

We acquired Lark in astock-for-stock merger that closed on April 1, 2004.  In the merger, each Lark stockholder received1.81 shares of our common stock for each share of Lark common stock held.  Immediately following the closing, the formerLark stockholders held approximately 19.2% of our total outstanding shares,assuming the conversion of our preferred stock and the exercise and conversionof our preferred stock warrant then outstanding.

 

Lark providescontract, GLP-compliant and research sequencing and associated molecularservices to the pharmaceutical, biotechnology and agricultural industries throughits GLP compliant facility in Houston, Texas and its research facility inTakeley, U.K.

 

We recorded thetransaction as a purchase transaction for accounting purposes and allocated thepurchase price of approximately $24.5 million to the assets purchased andliabilities 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 $120,000 perquarter.

 

Our condensedconsolidated financial statements include the results of operations and cashflows of Lark from the closing date. Although Lark is contributing positive operating cash flows, we willstill incur net losses in the foreseeable future as we continue to develop ourproprietary programs.

 

###### **CriticalAccounting Policies and Estimates**

 

Our financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America (GAAP). The preparation of financial statements in accordance with GAAP requiresmanagement to make judgments, assumptions and estimates that affect ourreported assets and liabilities, revenue and expenses, and other informationreported in our financial statements and accompanying footnotes.  We base our estimates on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances, the results of which form our basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from estimates, sometimes materially.  We regard an accounting estimate orassumption underlying our financial statements as a “critical accountingestimate” where:

 

•                  thenature of the estimate or assumption is material due to the level ofsubjectivity and judgment necessary to account for highly uncertain matters orthe susceptibility of such matters to change; and

 

•                  theimpact of the estimates and assumptions on financial condition or operatingperformance is material.

 

Our significant accounting policies are more fullydescribed in Note 3 of the Notes to Consolidated Financial Statements in ourAnnual Report on Form 10-K for the year ended December 31, 2004.  Notall of these significant accounting policies, however, fit the definition of “criticalaccounting estimates.”  We have discussedour accounting policies with the audit committee of our board of directors, andwe believe that our estimates described below fit the definition of “criticalaccounting estimates”:

 

•                  revenuerecognition;

 

•                  valuationof long-lived assets;

 

•                  researchand development expenses; and

 

•                  goodwilland identifiable intangible assets

 

Revenue recognition.  We earn ourrevenues primarily through the licensing of our HAP Technology and by providingmolecular biology services.  We recognizerevenue associated with molecular biology services in accordance with StaffAccounting Bulletin (SAB) No. 104, Revenue Recognition (which supercedes SABNo. 101, Revenue Recognition in Financial

 

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Statements)as the services are performed provided that persuasive evidence of anarrangement exists, the price is fixed and determinable and collectibility isreasonably assured.  In accordance withSAB No. 104 and Emerging Issues Task Force Issue 00-21, we generally recognizelicense fees over the term of the agreement and research fees as the researchis performed.  For agreements withmultiple deliverables, revenue is not recognized unless the fair value of theundelivered elements can be determined and the elements delivered havestand-alone value to the customer. Future milestones and royalties received under these agreements, if any,will be recognized, provided that the milestone is substantive and aculmination of the earnings process has occurred.  Deferred revenue results when considerationis received or amounts are receivable in advance of revenue recognition.  Deferred revenue related to licenseagreements is generally recognized over the license period.  For license agreements, which contain earlytermination provisions, we recognize revenue upon the expiration of thetermination provision for the period from the original license date to the datethe early termination provisions expire.

 

Valuation of long-lived assets. We assess the impairment of long-lived assets whenever events or changesin circumstances indicate that the carrying value of the assets may not befully recoverable.  Factors, which couldtrigger an impairment review, include:

 

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

 

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

 

•                  a significant decrease in the marketvalue of assets.

 

If we determine that thecarrying value of the long-lived assets may not be fully recoverable, basedupon the existence of one or more of the above indicators of impairment, wecompare the carrying value of the asset group to the undiscounted cash flows weexpect to be generated by the group.  Ifthe carrying value exceeds the undiscounted cash flows, an impairment chargemay be needed.  To determine the amountof the impairment charge, we compare the carrying value of the applicable assetgroup to its fair value.  We determinethe fair value of the asset group by discounting expected future cash flowusing a discount rate that we determine to be commensurate with the riskinherent in our current business.  If thefair value is less than the carrying value, such amount is recognized as animpairment charge.  If an impairmentcharge is required in future periods, it could result in a material, non-cashcharge in our consolidated statement of operations.

 

Research anddevelopment expenses. We record research and development expenses when they are incurred.  Research and development expenses include thefollowing major types of costs: salaries and benefits, material and reagentcosts, research license fees, clinical trial expenses, depreciation andamortization of laboratory equipment and leasehold improvements and buildingand utility costs related to research space.

 

Goodwill and identifiable intangible assets. We record business combinations under the provisions of Statement ofFinancial Accounting Standards (SFAS) No. 141, *BusinessCombinations,* and SFAS No. 142, *Goodwilland Other Intangible Assets*. These standards require the use of the purchase method of accounting forbusiness combinations, set forth the accounting for the initial recognition ofacquired intangible assets and goodwill and describe the accounting subsequentto initial recognition. Under the provisions of these standards, goodwill andintangible assets deemed to have indefinite lives are not subject toamortization.  All other intangibleassets are amortized over their estimated useful lives. Goodwill and intangibleassets are subject to annual impairment tests and will also be tested forimpairment between annual tests, if changes in circumstances indicate that thecarrying amount may be impaired.  Thistesting compares carrying values to fair values and, if the carrying value ofthese assets is less than the fair value, an impairment loss is recognized forthe amount of the difference.  Our evaluationof fair value is based on various analyses including undiscounted cash flowprojections.

 

**Results of Operations**

 

***Three Months Ended June 30, 2005 and 2004***

 

License and researchrevenue consists primarily of revenue recognized in connection with thelicensing of our *HAP* Technologyand by providing molecular biology services. License and research revenue decreased to approximately $2.1 million forthe three months ended June 30, 2005 from approximately $2.6 million for thesame period in 2004.  Revenue fromlicensing our *HAP* Technologydecreased approximately $748,000, due mainly to the reduction in the dataprovided under our agreements with Millennium and Pfizer.  Revenue from research genotyping decreasedapproximately $652,000 due mainly to the completion of our project with WayneState University in 2004.  The decreasewas offset by an increase of approximately $466,000 in revenue recognized fromour collaboration with Sciona Inc. (Sciona) during the three months ended June30, 2005.

 

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In addition, during thethree months ended June 30, 2005, we recognized approximately $417,000 inrevenue from our *FAMILION* Test,which we launched in May 2004.

 

Laboratory servicesrevenue consists of revenue recognized from services provided by our GLP-compliantDNA banking and genotyping facility in Morrisville, North Carolina, and GLP-compliantsequencing and related molecular biology services provided by Lark, which weacquired in April 2004.  Laboratoryservices revenue increased to approximately $3.0 million for the three monthsended June 30, 2005 from approximately $2.8 million for the same period in2004.  The increase in laboratoryservices revenue was attributable to an increase in services provided by ourfacility in Morrisville, North Carolina.

 

Cost of laboratoryservices consists of payroll and benefits for personnel, materials and reagentcosts, depreciation and maintenance and facility-related costs incurred inproviding the laboratory services.  The costof laboratory services was constant at approximately $2.0 million for the threemonths ended June 30, 2005 and 2004.  Weexpect the cost of laboratory services to decrease as a percentage of revenuesas our revenues increase because a substantial portion of these costs are fixedcosts for operating these facilities.

 

Research and developmentexpenses consist primarily of payroll and benefits for research and developmentpersonnel, materials and reagent costs, depreciation expense and maintenancecosts for equipment used for *HAP*Marker discovery and research genotyping, technology license fees andfacility-related costs.  We expense ourresearch and development costs as incurred. Research and development costs decreased to approximately $3.0 millionfor the three months ended June 30, 2005 from approximately $6.1 million forthe same period in 2004.  A substantialportion of our research and development expenditures are incurred in developingand conducting our proprietary programs. The following is a breakdown of research and development expenses (inthousands):

 
| ** **                     | ** ** | **Three Months Ended** | ** ** |
|--------------------------------|------------|------------------------|------------|
| ** **                     | ** ** | **June 30,**           | ** ** | **June 30,** | ** ** |
| ** **                     | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                           |       |                   |       |   |   |
| Payroll and  benefits          |       | $                      | 1,380      |   | $ | 2,060 |   |
| Depreciation and  amortization |       | 320                    |       | 1,200 |   |
| Material and  reagent costs    |       | 550                    |       | 1,350 |   |
| Technology  license fees       |       | 160                    |       | 450 |   |
| Repairs and  maintenance       |       | 130                    |       | 150 |   |
| Stock-based  compensation      |       | —                 |       | 90 |   |
| Other                          |       | 433                    |       | 828 |   |
|                           |       |                   |       |   |   |
| Total                          |       | $                      | 2,973      |   | $ | 6,128 |   |

 

The decrease in researchand development expenses for the three months ended June 30, 2005 was primarilyattributable to a decrease of approximately $880,000 in depreciation andamortization, a decrease of approximately $680,000 in payroll and benefits anda decrease of approximately $800,000 in material and reagent costs.  The decrease in depreciation and amortizationwas primarily due to the fact that the majority of our DNA sequencing machinesand the related assets became fully depreciated during the quarter ended June30, 2004.  The decrease in payroll andbenefits was primarily due to the fact that in November 2004, we reduced ourwork force by approximately 10% to align better our operating structure withour current and projected revenues and reduced expenses in certain otherareas.  The majority of the workforcereductions occurred in research and development.  The decrease in materialand reagent costs was primarily due to a decrease in research services providedby our research facility.  The development of our proprietary programswill require us to continue to devote substantial resources to research anddevelopment expenses in the near future. We currently do not have sufficient resources to continue thedevelopment of all of our proprietary programs. Further development of these programs will depend upon our ability tosecure sufficient funds.  See “FactorsAffecting Future Operating Results” for further discussion.

 

Selling, general andadministrative expenses consist primarily of payroll and benefits forexecutive, sales, finance and other administrative personnel, as well asfacility related costs and outside professional fees incurred in connectionwith corporate development, general legal and financial matters.  Selling, general and administrative expensesincreased to approximately $3.9 million for the three months ended June 30,2005 from approximately $3.7 million for the same period in 2004.  The increase was primarily due toprofessional fees of approximately $625,000 incurred in connection with themerger with Clinical Data.

 

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Other income, net increased to approximately $42,000for the three months ended June 30, 2005 from approximately $9,000 for the sameperiod in 2004.  The increase wasprimarily due to a miscellaneous charge incurred in 2004.

 

Interest expense increasedto approximately $411,000 for the three months ended June 30, 2005 fromapproximately $175,000 for the same period in 2004.  The increase was primarily due to the write-offof approximately $123 of deferred finance costs originally recorded inconnection with the Loan and Security Agreement with Comerica in September2003, which was subsequently terminated with all outstanding principal andinterest being paid in April 2005, and the amortization of approximately $141of the debt discount related to the Xmark warrants.

 

Income tax expense decreased to approximately $7,000for the three months ended June 30, 2005 from approximately $36,000 for thesame period in 2004.  We recordedestimated foreign and state taxes of approximately $19,000 and $96,000 in thethree months ended June 30, 2005 and 2004, respectively.  The expense was offset by a net tax benefitfrom the State of Connecticut (the State) as a result of legislation, whichallows companies conducting business in the State to receive cash refunds fromthe State at a rate of 65% of their qualifying research and development taxcredit, as defined, in exchange for foregoing the carryforward of the researchand development tax credit.

 

Equity in loss ofaffiliate represents our percentage interest in the losses of Sciona.  In November 2003, we granted Sciona a licenseto our *HAP*Technology in exchangefor a 37% equity interest (30% on a fully diluted basis).  Under the equity method of accounting, werecorded a loss of $150,000 in the three months ended June 30, 2004.  In September 2004, Sciona closed an equityfinancing, which diluted our holdings to 13% (11% on a fully dilutedbasis).  As a result, we changed ourmethod of accounting for the investment from the equity method to the costmethod, and we no longer record our percentage interest in the results ofoperations of Sciona.  In February 2005,Sciona closed an additional equity financing, which further diluted ourholdings to 9% (7% on a fully diluted basis).

 

During the fourth quarterof 2003, we issued shares of series A redeemable convertible preferred stockand granted a warrant to purchase additional shares of series A preferredstock.  We were required to recognize,over the life of the warrant, a charge of approximately $49,000 for thebeneficial conversion feature embedded in the warrant.  The warrant was exercised on June 30, 2004,and, therefore, we recognized the remaining unamortized beneficial conversioncharge of approximately $40,000 during the three months ended June 30, 2004.  In addition, we recognized a charge of$833,000 representing the Black-Scholes value of the common stock warrantissued in connection with this transaction.

 

***Six Months Ended June 30, 2005and 2004***

 

License and researchrevenue decreased to approximately $4.9 million for the six months ended June30, 2005 from approximately $5.4 million for the same period in 2004.  Revenue from licensing our *HAP* Technology decreased approximately $2.2million, due mainly to the expiration of our agreement with J&J PRD and areduction in the data provided under our agreements with Millennium andPfizer.  The collaboration agreement withJ&J PRD expired in the first quarter of 2004, which accounted forapproximately $600,000 of revenue recognized during the six months ended June30, 2004.  The decrease was offset by an increaseof approximately $920,000 in revenue recognized from our collaboration withSciona during the six months ended June 30, 2005.  In addition, during the six months ended June30, 2005, we recognized approximately $617,000 in revenue from our *FAMILION* Test, which we launched in May2004.

 

Laboratory servicesrevenue increased to approximately $5.7 million for the six months ended June 30,2005 from approximately $3.7 million for the same period in 2004.  The increase was attributable to the increase ofapproximately $1.9 million in revenue from Lark, which is included for a fullsix months in 2005 as opposed to 2004, which only included Lark revenue earnedfrom the date of acquisition, April 1, 2004.

 

The cost of laboratoryservices increased to approximately $4.0 million for the six months ended June30, 2005 from approximately $2.8 million for the same period in 2004.  The increase was due to the inclusion of Larkfor the full six month period in 2005.  Weexpect the cost of laboratory services to decrease as a percentage of revenuesas our revenues increase because a substantial portion of these costs are fixedcosts for operating these facilities.

 

Research and developmentcosts decreased to approximately $6.3 million for the six months ended June 30,2005 from approximately $11.1 million for the same period in 2004.  The following is a breakdown of research anddevelopment expenses (in thousands):

 

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| ** **                     | ** ** | **Six Months Ended** | ** ** |
|--------------------------------|------------|----------------------|------------|
| ** **                     | ** ** | **June 30,**         | ** ** | **June 30,** | ** ** |
| ** **                     | ** ** | **2005**             | ** ** | **2004** | ** ** |
|                           |       |                 |       |   |   |
| Payroll and  benefits          |       | $                    | 2,800      |   | $ | 4,150 |   |
| Depreciation and  amortization |       | 630                  |       | 2,530 |   |
| Material and  reagent costs    |       | 1,330                |       | 1,900 |   |
| Technology  license fees       |       | 350                  |       | 710 |   |
| Repairs and  maintenance       |       | 290                  |       | 280 |   |
| Stock-based  compensation      |       | 10                   |       | 190 |   |
| Other                          |       | 864                  |       | 1,380 |   |
|                           |       |                 |       |   |   |
| Total                          |       | $                    | 6,274      |   | $ | 11,140 |   |

 

The decrease in researchand development expenses for the six months ended June 30, 2005 was primarilyattributable to a decrease of approximately $1.9 million in depreciation andamortization, a decrease of approximately $1.4 million in payroll and benefitsand a decrease of approximately $570,000 in material and reagent costs.  The decrease in depreciation and amortizationwas primarily due to the fact that the majority of our DNA sequencing machinesand the related assets became fully depreciated during the quarter ended June30, 2004.  The decrease in payroll andbenefits was primarily due to the fact that in November 2004, we reduced ourwork force by approximately 10% to align better our operating structure withour current and projected revenues and reduced expenses in certain otherareas.  The majority of the workforcereductions occurred in research and development.  The decrease in materialand reagent costs was primarily due to a decrease in research services providedby our research facility.

 

Selling, general andadministrative expenses increased to approximately $7.2 million for the sixmonths ended June 30, 2005 from approximately $6.0 million for the same periodin 2004.  The increase was primarily dueto an increase of approximately $363,000 due to the inclusion of Lark in ouroperations for the full six month period in 2005.  Amortization of the intangible assetsrecognized from the Lark purchase accounted for an additional $120,000 inexpense for the six months ended June 30, 2005. In addition, we incurred professional fees of approximately $625,000 inconnection with the merger with Clinical Data.

 

Other income, net decreased to approximately $76,000for the six months ended June 30, 2005 from income of approximately $84,000 forthe same period in 2004.  The decreasewas primarily due to a decrease in interest income as a result of higher cash,cash equivalents and short-term investment balances in 2004.

 

Interest expenseincreased to approximately $568,000 for the six months ended June 30, 2005 fromapproximately $355,000 for the same period in 2004.  The increase was primarily due to higher debtbalances in 2005.

 

Income tax (expense) benefit decreased to an expenseof approximately $33,000 for the six months ended June 30, 2005 from a benefitof approximately $13,000 for the same period in 2004.  We recorded estimated foreign and state taxesof approximately $78,000 and $102,000 in the six months ended June 30, 2005 and2004, respectively.  The expense wasoffset by a net tax benefit from the State as a result of legislation, whichallows companies conducting business in the State to receive cash refunds fromthe State at a rate of 65% of their qualifying research and development taxcredit, as defined, in exchange for foregoing the carryforward of the researchand development tax credit.

 

Equity in loss ofaffiliate represents our percentage interest in the losses of Sciona.  In November 2003, we granted Sciona a licenseto our *HAP*Technology in exchangefor a 37% equity interest (30% on a fully diluted basis).  Under the equity method of accounting, werecorded a loss of $300,000 in the six months ended June 30, 2004.  In September 2004, Sciona closed an equityfinancing, which diluted our holdings to 13% (11% on a fully dilutedbasis).  As a result, we changed ourmethod of accounting for the investment from the equity method to the costmethod, and we no longer record our percentage interest in the results ofoperations of Sciona.  In February 2005,Sciona closed an additional equity financing, which further diluted ourholdings to 9% (7% on a fully diluted basis).

 

During the fourth quarterof 2003, we issued shares of series A redeemable convertible preferred stockand granted a warrant to purchase additional shares of series A preferredstock.  We were required to recognize,over the life of the warrant, a charge of approximately $49,000 for thebeneficial conversion feature embedded in the warrant.  The warrant was exercised on June 30, 2004,and, therefore, we recognized the remaining unamortized beneficial conversioncharge of approximately

 

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$46,000 during the sixmonths ended June 30, 2004.  In addition,we recognized a charge of $833,000 representing the Black-Scholes value of thecommon stock warrant issued in connection with this transaction.

 

**Liquidity and Capital Resources**

 

Our liquidityrequirements have historically consisted, and we expect that they will continueto consist, of capital expenditures, working capital, debt service, researchand development expenses, general corporate expenses and expenses related toacquisitions.

 

We have financed ouroperations primarily through the private and public sale of common andpreferred stock, loans, payments under licensing agreements, governmentresearch grants and capital leases.  Frominception through June 30, 2005, we have received aggregate gross proceeds ofapproximately $180.0 million from the issuance of common and preferredstock.  In addition, through June 30,2005, we have received approximately $51.1 million from license and servicefees, royalties and research contracts. We also have received approximately $26.2 million from capital leasefinancing arrangements and approximately $17.7 million from other loans. ThroughJune 30, 2005, we have acquired approximately $45.2 million of property andequipment.  These assets were largelyfinanced through capital lease financing arrangements and other loans.

 

On April 21, 2005, weentered into a Note and Warrant Purchase Agreement with Xmark, pursuant towhich, among other things, we issued the Note to Xmark in the aggregateprincipal amount of $4.5 million.  TheNote, which is payable in full on April 21, 2007, bears interest at 5% and issecured by substantially all of our assets, excluding, among other assets, ourintellectual property.  Under the termsof the Note, we are required to prepay the Note upon the occurrence of certainevents including the sale of our assets, as defined.  In addition, we issued Xmark warrants topurchase an aggregate of 2,000,000 shares of our common stock at an exerciseprice of $2.25 per share.  The price pershare is subject to adjustment in certain circumstances while there is abalance outstanding under the Note on or after September 18,2005 and we issue securities for less than $2.25 per share.  The warrants also provide for an equitableadjustment to the exercise price and number and type of securities purchasableupon exercise of the warrant in certain circumstances, including****the proposed mergertransaction with Clinical Data.****

 

On November 19, 2004, weclosed a private placement with certain institutional and other accreditedinvestors for 3,550,294 shares of our common stock together with warrants topurchase an additional 3,550,294 shares of our common stock at $1.69 pershare.  We received proceeds ofapproximately $5.4 million net of issuance costs of approximately $580,000.

 

We entered into a $5.0million loan and security agreement with Comerica in September 2003, which wassubsequently terminated with all outstanding principal and interest beingrepaid in April 2005 (See “Financing Activities” section above).  Under the terms of the agreement, we wererequired to satisfy certain financial covenants, including a minimum cashbalance and a minimum quick ratio, as defined. Due to the uncertainty surrounding future debt covenant compliance atDecember 31, 2004, we classified the Comerica debt as current in our condensedconsolidated balance sheet as of December 31, 2004.  We have terminated our agreement withComerica and repaid all amounts due there under with the proceeds from ourXmark financing.

 

We have also entered intofinancing agreements (the Agreements) with Connecticut Innovations, Inc., oneof our stockholders, to finance certain leasehold improvements and other costsassociated with our facility expansion in New Haven.  The Agreements provide for payments ofprincipal and interest based on a 120-month amortization, with final balloonpayments due in March 2009 through June 2011. Borrowings under the Agreements are collateralized by the relatedleasehold improvements.  Managementbelieves that we are in compliance with all covenants under the Agreements asof June 30, 2005.  The Agreements do notcontain any cross default provisions.

 

We operate in anenvironment of rapid change in technology and have substantial competition fromcompanies developing genomic-related technologies and offering molecularbiology services.  In addition to thenormal risks associated with a business venture, there can be no assurance thatour technologies and our molecular biology services offerings will besuccessfully used, that we will obtain adequate patent protection for ourtechnologies or that any of our products will be commercially viable.  We have incurred substantial losses to date,have an accumulated deficit of approximately $240.8 million as of June 30, 2005and expect to incur substantial expenditures in the foreseeable future to fundour research, development and commercialization of our products and to maintainour molecular biology services.

 

We believe that ourcurrent cash and cash equivalents balance and the funds generated fromoperations will not be sufficient to fund our expected net losses, debt serviceobligations and capital expenditures for the next twelve months based on ourcurrent activities.  The pending mergerwith Clinical Data would obviate the need for additional liquidity.  However, as

 

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there can be no assurancethat the merger will be consummated in the expected time frame, should themerger not occur, we would be required to review other alternatives to raise capitalincluding, but not limited to, the sale of certain assets or raising private orpublic equity or debt.  There can be noassurance that we will be able to obtain sufficient financing on acceptableterms, if at all.  These circumstancesraise substantial doubt about our ability to continue as a going concern.  These financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

 

***Cash and Cash Equivalents***

 

At June 30, 2005, cash,cash equivalents and short-term investments totaled approximately $4.1 millioncompared to approximately $9.2 million at December 31, 2004.  Our cash reserves are held ininterest-bearing money market accounts.

 

***Cash Flows***

 

Cash used in operationswas approximately $5.7 million in the six months ended June 30, 2005, comparedwith approximately $8.5 million for the same period in 2004.  The cash used in operations for the sixmonths ended June 30, 2005 resulted primarily from a net loss of approximately$7.3 million and a $1.3 million decrease in accrued expenses and deferredrevenue, partially offset by approximately $2.8 million of non-cash charges fordepreciation and amortization expense and stock-based compensation.  The cash used in operations for the sixmonths ended June 30, 2004 resulted primarily from a net loss of approximately$11.5 million and a decrease of approximately $1.3 million in accrued expenses,partially offset by approximately $4.2 million of non-cash charges fordepreciation and amortization expense, stock-based compensation, non-cashresearch and development expense and the loss in the equity of an affiliate.

 

Cash used in investing activitieswas approximately $451,000 in the six months ended June 30, 2005, compared withcash provided by investing activities of approximately $3.5 million for thesame period in 2004.  During the sixmonths ended June 30, 2005, we used approximately $440,000 for the purchase ofproperty and equipment.  During the sixmonths ended June 30, 2004, we used approximately $930,000 for the purchase ofproperty and equipment and received net proceeds of approximately $4.2 millionfrom the maturity of investments in marketable securities.

 

Cash provided byfinancing activities was approximately $1.2 million in the six months ended June30, 2005, compared with approximately $3.9 million for the same period in2004.  During the six months ended June30, 2005, we received approximately $4.5 million in proceeds from long-termdebt.  In addition, we used cash ofapproximately $3.2 million for the repayment of long-term debt andapproximately $104,000 for the payment of preferred stock dividends.  During the six months ended June 30, 2004, wereceived approximately $5.1 million in cash from the sale of common stock andthe exercise of a preferred stock warrant and used cash of approximately $1.1million for the repayment of long-term debt.

 

***Contractual Obligations***

 

In April 2005, we enteredinto a Note and Warrant Purchase Agreement with Xmark, pursuant to which, weissued the Note to Xmark in the aggregate principal amount of $4.5 million (See“Financing Activities” section above). Concurrently, we terminated our Loan and Security Agreement withComerica and repaid all outstanding principal and interest due toComerica.  As such, $2.6 million of long-termdebt, including interest, shown in the contractual obligations table in our2004 Annual Report on Form 10-K (File No. 000-30981) as due in fiscal 2005, isnow due in fiscal 2007.

 

***Short-Term Funding Requirements***

 

We believe that ourcurrent cash and cash equivalents balance and the funds generated fromoperations will not be sufficient to fund our expected net losses, debt serviceobligations and capital expenditures for the next twelve months based on ourcurrent activities.  The pending mergerwith Clinical Data would obviate the need for additional liquidity.  However, as there can be no assurance thatthe merger will be consummated in the expected time frame, should the mergernot occur, we would be required to review other alternatives to raise capital,including, but not limited to, the sale of certain assets or raising private orpublic equity or debt.  There can be noassurance that we will be able to obtain sufficient financing on acceptableterms, if at all.

 

We expect to continue tofinance our operations from cash we received in June 2004 from the sale of ourseries A preferred stock and the related exercise of a warrant to purchaseshares of our series A preferred stock, cash we received in November 2004 fromour private placement of common stock, cash we received from our debt financingin April 2005 and future revenue from our proprietary programs and molecularbiology services customers.  Factorsaffecting our funding requirements are described below.  In particular, if we are unsuccessful inmarketing our proprietary programs and growing our

 

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molecular biologyservices revenue, we may not generate sufficient revenue to sustain ouroperations at planned levels.  We expectto expend substantial funds to conduct research and development activities andother general and administrative activities. Our expenditures for these activities will include required paymentsunder operating leases and long-term debt agreements and licensing, collaborationand service agreements.  Capitalexpenditures are not currently expected to exceed $1.0 million for fiscal 2005and 2006.  We expect to fund our capitalexpenditures through our current cash and cash equivalents reserves and expectour capital expenditures to be for equipment used in our services business andin our research activities.

 

***Long-Term Funding Requirements***

 

In addition to ourshort-term funding requirements, for periods beyond the end of the fiscal yearif the pending merger with Clinical Data is not completed, even if we marketour proprietary programs and grow our molecular biology services revenuesignificantly, we may need to seek additional funding through public or privateequity financings, debt financings or commercial customers.  However, we cannot assure you that we will beable to obtain additional financing or new customers for our molecular biologyservices and our proprietary programs, or generate the increased revenue tosupport our operations.  If we do notreceive additional financing, or additional income, or if we do not receive itas rapidly as we expect, we would spend our existing cash and investmentsecurities more rapidly than we currently plan and will be unable to continueas a going concern.

 

Our cash requirements in boththe short-term and the long-term could vary depending upon a number of factors,many of which may be beyond 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 commercialize molecular tests;

 

•                  howwe finance any clinical trials for our in-licensed compound, if at all;

 

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

 

•                  thecommercialization of intellectual property derived from our proprietaryprograms;

 

•                  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.

 

If our existing resourcesare insufficient to satisfy our liquidity requirements, we may need to selladditional equity or debt securities or seek additional financing through otherarrangements.  Any sale of additionalequity or debt securities may result in additional dilution to our stockholders,and debt financing may involve covenants limiting or restricting our ability totake specific actions, such as incurring additional debt or making capitalexpenditures.  We cannot be certain thatadditional public or private financing will be available in amounts or on termsacceptable to us, if at all.  Inaddition, we cannot incur indebtedness above certain levels or issue anycapital stock or other equity securities having rights, preferences, privilegesor priorities pari passu with or senior to the series A preferred stock withoutthe vote or written consent of holders of at least 66-2/3% of the series Apreferred stock then outstanding.  If weare unable to obtain additional financing, we will be required to delay, reducethe scope of, or eliminate one or more of our planned research, development andcommercialization activities, which could harm our financial condition andoperating results.  In addition, failureto obtain additional capital may preclude us from developing or enhancing ourproducts, taking advantage of future opportunities, growing our business orresponding to competitive pressures.

 

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**Collaborative Research Agreements**

 

In September 2004, weentered into a license, development and cooperation agreement with Merckpursuant to which we acquired an exclusive worldwide license from Merck todevelop and commercialize vilazodone, a small molecule compound.  We believe that previous preclinical andclinical studies of vilazodone provide a basis for further development of theproduct for use in the treatment of depressive illness.  In light ofpublished studies suggesting an association between antidepressant response andgenetics, we intend to evaluate vilazodone in a Phase II clinical trial, whichwould include a pharmacogenomic characterization of patients suffering fromdepression.  We believe that geneticmarkers predictive of drug response can be discovered, which could lead to anovel therapy targeting a population of patients suffering from depression, whowill respond to the drug.  We currentlydo not have sufficient resources to commence this Phase II clinical trial.  We believe that the planned merger withClinical Data fulfills the financing requirements under the agreement.

 

In consideration for therights relating to vilazodone, we agreed to pay Merck an initial license feeand milestone payments upon the achievement of specified development,regulatory and sales milestones.  Under the terms of the agreement, wepaid the initial license fee through the issuance of 369,280 shares of ourcommon stock.  Pursuant to the terms ofthe agreement, Merck is entitled to royalties on all future product sales and ashare of all sub-licensing income from any third party.

 

**Income Taxes**

 

We have not generated anytaxable income, subject to federal taxes, to date and, therefore, have not paidany federal income taxes since inception. On December 31, 2004, we had available unused net operating losscarryforwards of approximately $153.8 million and approximately $140.5 million,which may be available to offset future federal and state taxable income,respectively.  Use of our federal andstate net operating loss carryforwards, which will begin to expire in 2007 and2005, respectively, may be subject to limitations.  The future utilization of these carryforwardsmay be or have been 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 SFAS No. 109, *Accounting forIncome Taxes*.

 

**Off-Balance Sheet Arrangements**

 

During the year endedDecember 31, 2004 and through June 30, 2005, we have not engaged in off-balancesheet activities, including the use of structured finance or specific purposeentities.

 

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**FactorsAffecting Future Operating Results**

 

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

 

### **Risks to Genaissance if theProposed Merger Transaction Is Not Completed**

 

### **If the merger is not completed, our stock price and future business andoperations could be adversely affected.**

 

If the merger is not completed, wemay be subject to the following material risks, among others:

 

•                  Wemay be required to pay Clinical Data a termination fee of up to $1,324,600under certain circumstances;

 

•                  Wemay not be able to meet certain financing obligations under the Merck licensingagreement related to the development and commercialization of vilazodone; and

 

•                  Ourcosts related to the merger, such as legal, accounting and some of the fees ofour financial advisor, must be paid even if the merger is not completed.

 

Further,if the merger agreement is terminated and our board of directors determines toseek another merger or business combination, we may not be able to find apartner willing to pay an equivalent or more attractive price than that whichwould be paid in the merger with Clinical Data.

 

### **Our market price may be negatively impacted if the merger with ClinicalData is not concluded.**

 

On June 20, 2005, we entered intothe merger agreement with Clinical Data. Consequently, we believe our stockprice has begun to take into account the likelihood of the merger beingconcluded.  Failure to consummate thismerger may have a significant negative impact on the trading price of our commonstock. While we are working to complete the merger during the fourth quarter ofcalendar year 2005, the consummation of the merger is subject to approval ofthe transaction by our stockholders and other customary closing conditions,many of which are beyond our control.

 

### **The termination fee and therestrictions on solicitation contained in the merger agreement and the terms ofthe voting agreements may discourage other companies from trying to acquire us.**

 

Until the completion of themerger, and with some exceptions, we are prohibited from initiating or engagingin discussions with a third party regarding some types of extraordinarytransactions, such as a merger, business combination or sale of a materialamount of assets or capital stock. We also agreed to pay a termination fee ofup to $1,324,600 to Clinical Data under certain specified circumstances.  Payment of the termination fee could alsohave a material adverse effect on our financial condition.  In addition, the holder of all of theoutstanding shares of our series A preferred stock entered into an agreementwith Clinical Data in which such holder agreed to vote in favor of the mergerand against any action, agreement, transaction or proposal that would result inany of the conditions to our obligations under the merger agreement not beingfulfilled or that is intended, or would reasonably be expected, to prevent,impede, interfere with, delay or adversely affect the transactions contemplatedby the merger agreement.  Theseprovisions could discourage other companies from trying to acquire us, eventhough those other companies might be willing to offer greater value to ourstockholders than Clinical Data has offered in the merger.

 

**If the merger is notcompleted, we may not be able to obtain financing to fund operations, repaydebt or develop vilazodone, which will negatively impact our value.**

 

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If the merger is notcompleted and we are unable to obtain financing, we will be required to delay,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.

 

We may be forced toseek funds 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 intoa license, development and cooperation agreement with Merck, pursuant to whichwe acquired an exclusive world-wide license to develop and commercializevilazodone, a small molecule compound.  We agreed to pay milestonepayments upon the achievement of specified development, regulatory and salesmilestones and royalties on all future product sales and a share of allsub-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 infinancing or have shown the capacity to fund such levels of research anddevelopment activities in 2005 relating to vilazodone and we believe thatentering into the merger agreement demonstrates the combined company’s capacityto fund such levels. However, if the merger is not completed and we are unableto meet this financing requirement, Merck can terminate the agreement andreacquire the compound.

 

In addition, if theaverage closing price of our common stock at the time of the respectivemilestone payment is below $2.25 per share, we will be required to make themilestone payments to Merck in cash rather than in shares of our commonstock.  If Merck and its affiliates’ aggregate ownership of our commonstock would exceed 19.9% of the number of shares of common stock thenoutstanding, we would also be required to make payments in cash rather than inshares of common stock.  If the merger is not completed, we will need toseek alternate means to finance the development of vilazodone or raiseadditional capital to do so.  We do not currently have sufficientresources to meet our obligations with respect to vilazodone.

 

Anysale of additional equity or debt securities may result in additional dilutionto our stockholders, and such financing may involve covenants limiting orrestricting our ability to take specific actions, such as incurring additionaldebt or making capital expenditures.  We cannot be certain that additionalpublic or private financing will be available in amounts or on terms acceptableor favorable to us, if at all.  In addition, we cannot incur indebtednessabove certain levels or issue any capital stock or other equity securitieshaving rights, preferences, privileges or priorities pari passu with or seniorto our series A preferred stock without the vote or written consent of holdersof at least 66 2/3% of our series A preferred stock then outstanding. Failure to obtain additional capital may preclude us from developing orenhancing our products, taking advantage of future opportunities, growing ourbusiness or responding to competitive pressures.

 

**Risks Related to Our Need for Financing and FinancialResults**

 

**We are an early stagecompany with a history of losses, and we expect to incur net losses for theforeseeable future such that we may never be profitable.**

 

We have incurredsubstantial operating losses in every year since our inception.  As of June 30, 2005, we had generated onlyminimal revenues from our proprietary programs and our molecular biologyservices.  From inception through June30, 2005, we had an accumulated deficit of approximately $240.8 million.  Our losses to date have resulted principallyfrom costs we incurred in the development and conduct of our proprietaryprograms and from general and administrative costs associated 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 significantly higher revenues and attractexternal capital in the form of debt or equity financing, or a third partycollaboration, to fund our spending. Pharmaceutical and biotechnology companies are only beginning to useservices such as ours in their drug and diagnostic development or marketingefforts and, accordingly, they may not choose to use our *HAP* Technology or our molecular biologyservices.  We cannot be certain whetherwe will be able to attract external capital in the form of debt or equityfinancing, or a third party collaboration, because of significant uncertaintieswith respect to our ability to generate revenues from the sale of products andcovenants with existing stockholders.  Asa result, even if we obtain additional financing, we expect to incur additionallosses this year and in future years, and we may never achieve profitability.

 

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**Additional financing maybe difficult to obtain.  Our failure toobtain necessary financing or doing so on unattractive terms could adverselyaffect our ability to fund operations, repay debt and develop vilazodone and,thereby, negatively impact our value.**

 

If we are unable toobtain additional financing, we will be required to delay, reduce the scope of,or eliminate one or more of our planned research, development andcommercialization activities, which could harm our financial condition andoperating results.  In November 2004, wereduced our workforce by approximately 10%, and the majority of the workforcereductions occurred in our research and development department.

 

We may be forced toseek funds 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, inSeptember 2004, we entered into a license, development and cooperationagreement with Merck, pursuant to which we acquired an exclusive world-widelicense to develop and commercialize vilazodone, a small moleculecompound.  We agreed to pay milestonepayments upon the achievement of specified development, regulatory and salesmilestones and royalties on all future product sales and a share of allsub-licensing income from any third party on the commercialization ofvilazodone.  Under the agreement, we wererequired to demonstrate that, by no later than July 22, 2005, we have at least$8.0 million in financing or have shown the capacity to fund such levels ofresearch and development activities in 2005 relating to vilazodone.  Webelieve that our pending merger transaction with Clinical Data satisfies thisrequirement; however, if we have not met this requirement, Merck can terminatethe agreement and reacquire the compound. In addition, if the average closing price of our common stock at thetime of the respective milestone payment is below $2.25 per share, we will berequired to make the milestone payments to Merck in cash rather than in sharesof our common 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 a payment in cash rather than in shares of our commonstock.  We will need to seek alternatemeans to finance the development of vilazodone or raise additional capital todo so.  We do not currently have sufficientresources to meet our obligations with respect to vilazodone.

 

Any sale of additionalequity or debt securities may result in additional dilution to ourstockholders, and such financing may involve covenants limiting or restrictingour ability to take specific actions, such as incurring additional debt ormaking capital expenditures.  We cannotbe certain that additional public or private financing will be available inamounts or on terms acceptable or favorable to us, if at all.  In addition, we cannot incur indebtednessabove certain levels or issue any capital stock or other equity securitieshaving rights, preferences, privileges or priorities *pari passu*with or senior to our series A preferred stock without the vote or writtenconsent of holders of at least 66-2/3% of the series A preferred stock thenoutstanding.  In addition, under theterms of the Note dated April 21, 2005, pursuant to which we issued seniorsecured notes in the aggregate principal amount of $4.5 million in a privateplacement, we cannot incur indebtedness above certain levels or issue anycapital stock with maturity senior to or *pari passu* withthe Note without the written consent of the holders of the Note.  Failure to obtain additional capital maypreclude us from developing or enhancing our products, taking advantage offuture opportunities, growing our business or responding to competitivepressures.

 

**Our redemptionobligations under our series A preferred stock could have a material adverseeffect on our financial condition.**

 

Under the terms of ourseries A preferred stock, we are required, unless the holders of at least66-2/3% of our outstanding series A preferred stock elect otherwise, to redeemall then outstanding shares of our series A preferred stock if one or more ofthe 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;

 

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•                  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 windup, transfer all or substantiallyall of our assets or are party to a merger or other change in controltransaction, in which our stockholders do not own a majority of our outstandingvoting securities after such transaction.

 

If we are required toredeem our series A preferred stock due to any of the foregoing events, we arerequired to pay each holder of our series A preferred stock the originalpurchase price, plus an amount equal to the dividends that would otherwise haveaccrued and been payable on such shares through October 29, 2008 that have nototherwise been paid as of the redemption date. As of June 30, 2005, the aggregate redemption price we would be requiredto pay is approximately $11.1 million. As of June 30, 2005, we had aggregate cash and cash equivalents of approximately$4.1 million.

 

In addition, theholders of at least 66-2/3% of the outstanding shares of our series A preferredstock may elect to require us to redeem all outstanding shares of our series Apreferred stock for the original purchase price, plus all accrued but unpaiddividends as of the redemption date, on either October 29, 2006, 2007 or 2008.

 

A redemption of the series A preferred stock woulddeplete the cash we have available to fund operations, research and productdevelopment, capital expenditures and other general corporate purposes.  In addition, we have incurred net losses inthe past and expect to incur losses in the future, which may impair our abilityto generate the cash required to meet our obligations under our series Apreferred stock.  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.

 

In addition, under the terms of the Note, a redemptionof the series A preferred stock would result in an event of default under theNote.  Upon the occurrence and during thecontinuance of such an event of default, the outstanding principal amount ofthe Note will bear interest at a maximum rate of 15% per annum.

 

**The purchaser of ourseries A preferred stock owns a substantial portion of our capital stock, whichmay afford the purchaser significant influence over our affairs.**

 

As of June 30, 2005,the holder of our series A preferred stock, together with its affiliates, heldor had the right to acquire and/or vote approximately 14% of our outstandingcommon stock, assuming the conversion of series A preferred stock to commonstock and the exercise of a common stock purchase warrant, including shares ofour common stock which the holder previously purchased in the open market.  The series A holder has agreed not to convertits series A preferred stock if such conversion would cause the holder tobeneficially 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 andaffect any change in control of the Company that may be favored by other stockholders.  Additionally, this stockholder couldotherwise exercise significant influence over all corporate actions requiringstockholder approval, including the approval of some mergers and othersignificant corporate transactions, such as a sale of substantially all of ourassets or the defeat of any non-negotiated takeover attempt that mightotherwise benefit the public stockholders. Consequently, this stockholder may approve a transaction that, in itsjudgment, enhances the value of its investment, but which nonetheless maydiverge from the interests of our other stockholders.

 

**The agreements andinstruments governing the rights and preferences of our series A preferredstock impose restrictions on our business and limit our ability to undertakecertain corporate actions, including financings.**

 

Our amended andrestated certificate of incorporation, which we refer to as our charter, andthe series A purchase agreement govern the terms of our series A preferredstock and impose significant restrictions on our business.  These restrictions may limit our ability toobtain additional financing, operate our business and to take advantage ofpotential business opportunities as they arise. Without the consent of the holders of at least 66-2/3% of theoutstanding shares of our series A preferred stock, we cannot:

 

•                  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;

 

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•                  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 our control, including prevailingeconomic, financial and industry conditions, may affect our ability to complywith these restrictions.  In addition,the holder of our series A preferred stock has the right to participate in anyof our future capital raising transactions. The existence of this right may substantially reduce our ability toestablish terms with respect to, or enter into, any financing with partiesother than the series A preferred stockholder. The terms of any additional financing, which we may enter into, mayimpose constraints on our ability to operate our business as we deemappropriate.  These restrictions andcovenants could limit our ability to take advantage of financings, mergers andacquisitions or other corporate opportunities, which could adversely affect ourbusiness and financial condition and your investments in our common stock.

 

**The issuance and sale ofour securities could have the effect of substantially diluting the interests ofour current stockholders.**

 

In connection with our private placement of theNote, we issued Xmark warrants to purchase an aggregate of 2,000,000 shares ofour common stock at an exercise price of $2.25 per share.  While the number of shares subject towarrants is fixed at 2,000,000, the price per share is subject to adjustment incertain circumstances while there is a balance outstanding under the Note on orafter September 18, 2005 and we issue specified securities for less than $2.25per share.  The warrants also provide foran adjustment to the exercise price and type of securities purchasable upon exerciseof the warrant in certain circumstances, including the proposed mergertransaction with Clinical Data.  Inconnection with our private placement in November 2004, we issued warrants topurchase an aggregate of 3,550,294 shares of our common stock at an exerciseprice of $1.69 per share.  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 the exercise of thewarrant, we granted an affiliate of the series A holder a warrant to purchase261,500 shares of our common stock at an exercise price of $4.17 pershare.  Each share of our series Apreferred stock is currently convertible into ten shares of our commonstock.  Consequently, on an as-convertedand as-exercised basis, an aggregate of 4,861,500 shares of our common stockmay be issued to the series A purchaser or its affiliate.  Any issuance of shares of our common stockupon conversion of shares of our series A preferred stock, or upon exercise ofoutstanding warrants, could have the effect of substantially diluting theinterests of our current stockholders, as well as the interests of holders ofour outstanding options and warrants.  Asof June 30, 2005, we had outstanding options and warrants exercisable for anaggregate of 11,321,808 shares of our common stock.

 

Moreover, any sale ofthe shares of our common stock issued upon conversion of the series A preferredstock, 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, for compensatory purposes or in other typesof transactions, we may issue additional equity securities, including optionsand warrants, that could dilute the interests of our current and futurestockholders.

 

**Our operating resultsmay fluctuate significantly, and any failure to meet financial expectations maydisappoint securities analysts or investors and result in a decline of ourcommon stock price.**

 

Our operating resultshave fluctuated in the past and we expect they will fluctuate in thefuture.  These fluctuations could causeour common stock price to decline.  Someof the factors 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;

 

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•                  demandfor, and market acceptance of, our molecular biology services and ourproprietary programs;

 

•                  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 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 and ourmolecular biology services.

 

Due to volatile and unpredictable revenue andoperating expenses, we believe that period-to-period comparisons of our resultsof operations may not be a good indication of our future performance.  It is possible that our operating results maybe below the expectations of securities analysts or investors.  In this event, the market price of our commonstock could fluctuate significantly or decline.

 

**If we are unable tomaintain compliance with NASDAQ’s listing requirements, our common stock couldbe delisted which would negatively impact our liquidity and the ability of ourstockholders to sell their shares.**

 

Our listing on the NASDAQNational Market is conditioned upon our continued compliance with the NASDAQMarketplace Rules, including a rule that requires that the minimum bid priceper share for our common stock not be less than $1.00 for 30 consecutivetrading days.  Given the recent minimumbid price levels for our common stock, we cannot assure you that we will be incompliance with this rule.  If we fail tocomply with this rule, NASDAQ may send us a deficiency notice, and, if we cannotremedy this noncompliance in a manner contemplated by NASDAQ’s rules, includingany applicable grace periods, our common stock could be delisted from theNASDAQ National Market.  Delisting fromthe NASDAQ National Market will result in an acceleration of the Note and anobligation to redeem our series A preferred stock.  In addition, the delisting of our commonstock would likely have a material adverse effect on the trading price, volumeand marketability of our common stock.

 

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**Risks Related to Commercialization and Development**

 

**We currently rely on alimited number of customers for a substantial portion of our revenue.  As a result, our revenues may fluctuate basedon the buying patterns of our customers, and the loss of one major customer orour inability to secure additional significant revenue-producing customers,during a given period, would have a material adverse effect on our business andoperating results.**

 

We are dependent upona limited number of customers for substantially all of our revenue.  In the three months ended June 30, 2005, oneof our customers accounted for 17% of our revenues.  Our reliance on a small number of customerscould cause our revenues to fluctuate from quarter to quarter, based on thebuying patterns of these customers.  Forexample, we revised our guidance for our 2004 annual revenue downward inOctober 2004, primarily as a result of a shift in the timing of certainanticipated contracts and the receipt of samples associated with some of thesecontracts.  If we lose and are not ableto replace customers that provide us with significant revenues, it could have amaterial adverse effect on our revenues and on our business in general andcould cause volatility or a decline in our stock price.  In addition, if any of these customers failsto pay us on a timely basis, or at all, our financial position and results ofoperations could be materially and adversely affected.

 

**To generate significantrevenue, we must obtain additional customers for our molecular biology servicesand our proprietary programs.**

 

Our strategy dependson obtaining additional customers for our molecular biology services andentering into new agreements with pharmaceutical and biotechnology companiesfor our *HAP* Technology and ourother proprietary programs.  Ourcontracts for our molecular biology services and with many of our *HAP* Technology customers are for specificlimited-term projects.  We may not besuccessful in obtaining a sufficient number of new customers for our molecularbiology services, additional customers for our *HAP*Technology, or in obtaining significant customers for our other proprietaryprograms to replace our current customers and projects.  If we are unsuccessful in finding such newcustomers, we may never generate sufficient revenue to sustain ouroperations.  In addition, we expect thatsome of our future *HAP* Technologycollaborations, like some of our current *HAP*Technology collaborations, will be limited to specific, limited-term projectsor that some of these collaborations may not be renewed.  Accordingly, we must continually obtain newcustomers to be successful.  To date, theintegration of pharmacogenomics into drug development and marketing has notachieved widespread market acceptance.

 

**We may need to establishcollaborative relationships in order to develop vilazodone.**

 

In order to satisfyour obligations under our license, development and cooperation agreementrelating to vilazodone, we will likely need to enter into a collaborativerelationship with a third party.  We facesignificant competition in seeking appropriate collaborators.  Moreover, these arrangements are complex tonegotiate and time-consuming to document. We may not be successful in our efforts to identify potentialcollaborators and establish collaborative relationships or other alternativearrangements, especially since we do not have experience with these types ofcollaborations.

 

Reliance oncollaborative relationships poses a number of risks, including the following:

 

•                  wecannot effectively control whether a collaborator will devote sufficientresources to a program or product;

 

•                  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;

 

•                  wemay have difficulty enforcing the contracts, if a collaborator fails toperform;

 

•                  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.

 

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Given these risks,even if we are able to identify a potential collaborator and negotiate andenter into a collaborative arrangement, it is possible that any collaborativearrangement into which we enter may not be successful.  Failure of our efforts could cause us tobreach covenants in our license agreement relating to vilazodone, delay ourdrug development or impair commercialization of vilazodone.  In particular, we were required to have demonstratedto Merck’s satisfaction, by no later than July 22, 2005, that we have the financialresources to fund the anticipated budget for research and developmentactivities relating to vilazodone for 2005. We believe that our proposed merger transaction with Clinical Datasatisfies this requirement; however, we may be required to obtain significantadditional funding or enter into a collaboration arrangement with a third partyto satisfy this and other obligations regarding vilazodone.

 

**Our proprietary programsmay not allow our commercial customers to develop commercial products or toincrease sales of their marketed products.**

 

We developed ourproprietary programs on the assumption that information about gene variationand gene variation associated with drug response may help drug developmentprofessionals better understand the drug response of particular populations andcomplex disease processes.  Although thepharmaceutical and biotechnology industries are increasing their use ofgenomics in analyzing drug response and diseases, we are aware of only twosuccessful drug program applying genomics.

 

We discover *HAP* Markers for pharmaceutically relevantgenes.  This information may not prove tobe superior to genomic variation information discovered by our competitors orto genomic information available in public databases.  Furthermore, pharmaceutical and biotechnologycompanies may not choose our *HAP*Technology over competing technologies.

 

Our *DecoGen* Informatics System may also beless effective than we expect or may not allow our commercial customers or us todetermine a correlation between drug response and genomic variation.  Furthermore, even if our customers or we aresuccessful in identifying such a correlation, our customers may not be able todevelop or sell commercially viable products, nor may our customers be able toincrease the sales of their marketed products using this correlation.  Accordingly, our *HAP* Markers and *HAP*Technology may not improve the development, marketing and prescribing of drugsor the development and marketing of diagnostics developed by our *HAP*Technology customers and customers forour other proprietary programs.

 

**We may be unable todevelop or commercialize our proprietary programs if we cannot establishadditional customers, and we may depend on our customers to develop or toco-develop products.**

 

Part of our currentand future 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 attractnew proprietary program customers, we may never generate sufficient revenue tosustain our operations.

 

Our customers forcertain of our proprietary programs may be responsible for pre-clinical studyand clinical development of therapeutic and diagnostic products and forregulatory approval, manufacturing and marketing of any product or enhancedmarketing claims that result from the application of our proprietary programs.  Our current agreements with these customersallow them significant discretion in pursuing these activities and futureagreements, if any, may allow similar discretion.  We cannot control the amount and timing ofresources that any such current or potential customers will devote to ourprograms or potential products.  Ourcurrent proprietary program arrangements and our future proprietary programarrangements, if any, may also have the effect of limiting the areas of researchor commercialization that we may pursue either alone or with others.  Because part of our revenue could bedependent on the successful commercialization or development of our customers’products, if, for any reason, a proprietary program customer delays or abandonsits development or commercialization of a product developed using our proprietary programs, we may receivereduced royalty or other payments or no royalty or other payments at all.

 

**We invest considerableamounts of time, effort, and money to license our *HAP* Technology and proprietary programs and, if we fail inthese licensing efforts, we may not generate sufficient revenue to sustain ouroperations.**

 

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 achieve market acceptance, we mustcontinue to educate the pharmaceutical and biotechnology industries and the publicin general as to the potential benefits of our *HAP*Technology.  Most importantly, we mustconvince the research and development, clinical and marketing departments ofpharmaceutical and biotechnology companies that our *HAP* Technology can accelerate and improve the processes fordeveloping, marketing and prescribing drugs and for developing and marketingdiagnostics, and that our proprietary programs will be commerciallyviable.  If we fail to gain this

 

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acceptance,we may never generate sufficient revenue to sustain our operations.  We may expend substantial funds andmanagement effort to market our proprietary programs without any resultingrevenue.

 

**If we do notsuccessfully distinguish and commercialize our proprietary programs, we may beunable 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 and drugresponse and to develop products and services based on these discoveries.  We face competition in these areas frompharmaceutical, biotechnology and diagnostic companies, academic and researchinstitutions and government and other publicly funded agencies, both in theUnited States and abroad, most of which have substantially greater capitalresources, research and development staffs, facilities, manufacturing andmarketing experience, distribution channels and human resources than do we.

 

These competitors maydiscover, characterize or develop important technologies applying genomicsbefore our customers or us for our proprietary programs that are more effectivethan those technologies, which our customers or which we develop for ourproprietary programs.  Additionally,these competitors may obtain regulatory approval 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 as Perlegen Sciences and theInternational HapMap Project have developed databases containing gene sequence,genomic variation or other genomic information and are marketing their data topharmaceutical and biotechnology companies or are making their databases freelyavailable to the public.  In addition,numerous pharmaceutical and biotechnology companies, such as GlaxoSmithKlineplc, either alone or in collaboration with our competitors, are developinggenomic research programs that involve the use of information that can be foundin these databases.  Furthermore,companies, such as deCODE genetics, Inc., have technologies for usinggenomic variation in diagnostics and in the drug development process and havecollaborations with companies employing these technologies.

 

Genomic technologieshave undergone, and are expected to continue to undergo, rapid and significantchange.  Our future success will dependin large part on maintaining a competitive position in the genomics field.  Others may rapidly develop new technologiesthat may result in our molecular tests or technologies becoming obsolete beforewe recover the expenses that we incur in connection with the development ofthese products.  Our proprietary programscould become obsolete if our competitors offer less expensive or more effectivedrug discovery and development technologies, including technologies that may beunrelated to genomics.

 

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

 

The market for genetictests is relatively undeveloped.  We aremarketing our *FAMILION* Test tophysicians, who did not previously have a genetic test available for cardiacchannelopathies.  The success of our testdepends on its acceptance by the medical community, patients and third-partypayers as being medically useful.  If weare not able to gain market acceptance for our test, we may not be able togenerate sufficient revenue to help sustain our operations.

 

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**Risks Related to Our Intellectual Property**

 

**If we are unable toprevent others from the unauthorized use of, or are unable to defend their useof, our patents, trade secrets or know how, we may not be able to operate ourbusiness profitably.**

 

Despite our efforts toprotect our proprietary rights, unauthorized parties may be able to obtain anduse information that we regard as proprietary. The issuance of a patent does not guarantee that it is valid orenforceable.  Thus, even if we obtainpatents, they may be challenged, narrowed, invalidated or unenforceable againstthird parties, which could limit our ability to stop competitors from marketingsimilar technologies or products, or limit the length of term of patentprotection we may have for any of our technologies or products.  Changes in patent laws or in interpretationsof patent laws in the United States and other countries may diminish the valueof our intellectual property or narrow the scope of our patent protection.  Because patent applications that were filedprior to November 29, 2000 in the United States are confidential untilpatents issue, third parties may have filed patent applications for technologycovered by our pending patent applications without us being aware of thoseapplications, and our patent applications may not have priority over any patentapplications of others.  We are awarethat there are other firms and individuals who have discovered, or arecurrently 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, someinterest groups 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 thirdparty may sue us for infringing on its patent rights.  Likewise, we may need to resort to litigationto enforce a patent issued to us or to determine the scope and validity ofthird party proprietary rights.  The costto us of any litigation or other proceeding relating to intellectual propertyrights, even if resolved in our favor, could be substantial, and the litigationwould divert our management’s focus from our core business concerns.  Some of our competitors may be able tosustain the costs of complex patent litigation more effectively than we canbecause they have substantially greater resources.  Uncertainties resulting from the initiationand continuation of any litigation could limit our ability to continue ouroperations.

 

We also rely uponunpatented trade secrets and improvements, unpatented know-how and continuingtechnological innovation to develop and maintain our competitive position.  We generally protect this information with reasonablesecurity measures, including confidentiality agreements signed by ouremployees, academic collaborators and consultants that provide that allconfidential information developed or made known to others during the course ofthe employment, consulting or business relationship will be kept confidential,except in specified circumstances. Agreements with employees, consultants and collaborators generallyprovide that all inventions conceived by the individual while employed by usare our exclusive property.  Ifemployees, consultants or collaborators do not honor these agreements, we maynot have adequate remedies for breach. Furthermore, our trade secrets may otherwise become known or beindependently discovered by competitors.

 

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 threatened or commenced against us or any ofour proprietary program customers claiming damages or seeking to enjoincommercial activities relating to the affected test and processes could, inaddition to subjecting us to potential liability for damages, require us or ourcurrent and future customers of our proprietary programs, if any, to obtain alicense in order to continue to manufacture or market the affected test andprocesses.  Any license required underany patent may not be made available on commercially acceptable terms, if atall.  In addition, some licenses may benon-exclusive and, therefore, our competitors may have access to the sametechnology licensed to us.  If we fail toobtain a required license or are unable to design around a patent, we may beunable to market effectively some of our proprietary programs, which couldlimit our profitability and possibly prevent us from generating revenuesufficient to sustain our operations.

 

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**Regulatory Risks**

 

**Regulatory oversight ofour 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 U.S. Food and Drug Administration (FDA) regulation of genetictests.  The Secretary’s AdvisoryCommittee on Genetic Testing, an advisory panel to the Secretary of the U.S.Department of Health and Human Services, has recommended that the FDA expandits regulation of genetic testing to require FDA approval for all new genetictests and labeling of genetic tests.  Ifthe FDA adopts this recommendation, it may require that we, or our customers, applyfor FDA approval as a prerequisite to marketing genetic tests that incorporateour intellectual property.  If the FDAwere to deny any application of this kind, it could adversely affect ourbusiness and we may be unable to generate sufficient revenue to sustain ouroperations.

 

The FDA has twicerequired that a physician must have genomic variation information determinedabout a patient before the doctor prescribes a drug.  In April 2005, the FDA issued guidance thatencourages drug and biologic developers to conduct pharmacogenomic tests duringdrug development and clarified how the FDA will evaluate the resultingdata.  The guidance provides specificcriteria and recommendations on the submission of pharmacogenomic data inconnection with Investigational New Drug Applications, New Drug Applicationsand Biological License Applications.  Theguidance includes information on the type of data needed and how the FDA willor will not use such data in regulatory decisions.  The FDA asked for voluntary submissions ofresearch information in order to gain experience as the field ofpharmacogenomics evolves.  The FDAadvised that the agency would not use information from voluntary reports forregulatory decisions on the drug or biologic, with which the voluntary data isassociated.  In addition, the FDA held aworkshop in April 2005 to discuss its guidance and gain further industrycomment on implications of voluntary data submissions and joint development ofdrug-diagnostic combination products. Our success will depend, in part, on how rapidly the pharmaceutical andbiotechnology industry implements the guidance and, accordingly, the validityof our services as a basis for identifying genomic variation and forcorrelating drug response with genomic variation.  Without this implementation by the pharmaceuticaland biotechnology industry, we may be unable to market effectively any test wemay have, as well as any of our services, and we may not generate sufficientrevenue to sustain our operations.

 

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 and regulations limit the use of ourproducts and services or impose additional costs on our customers, we may beunable to market effectively our proprietary programs, and we may not generatesufficient 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 tests.  In addition, governmental authorities orother entities may call for limits on, or regulation on the use of, genetictests or prohibit testing for genetic predisposition to certain conditions,particularly for those that have no known cure. 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 aresubject to laws and regulations as a provider of information that a doctor canuse to make a therapeutic decision.  Tothe extent that these laws and regulations restrict the sale of our productsand services or impose other costs, we may be unable to provide our productsand services to our customers on terms sufficient to recover our expenses.

 

**If our customers or we delay,do not seek, or do not receive, marketing approval for products developed, ifany, from our proprietary programs, we may receive delayed royalty or otherpayments or no royalty or other payments at all.**

 

Any new drug,biologic, or new drug or biologic indication we or our customers develop usinggenetic markers from our proprietary programs must undergo an extensiveregulatory review process in the United States and other countries before a newproduct or indication of this kind could be marketed.  This regulatory process can take many years,requires substantial expense and is uncertain as to outcome.  Changes in FDA policies and the policies ofsimilar foreign regulatory bodies can prolong the regulatory review of each newdrug or biologic license application or prevent approval of the application.  We expect similar delays and risks in theregulatory review process for any diagnostic product developed by our customersor us, whenever this regulatory review is required.  Even if a product obtains marketingclearance, a marketed product and its manufacturer are subject to continuingreview.  A manufacturer may be forced towithdraw a product from the market if a previously unknown problem with aproduct becomes apparent.  Because ourfuture revenue will be dependent on the successful commercialization ordevelopment of products using genetic markers from our proprietary programs,any delay in obtaining, failing to obtain, or failing

 

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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 our customers areunable to obtain regulatory approval for therapeutic or diagnostic productsdeveloped using our *HAP*Technology or genetic markers from our proprietary programs, the lack ofregulatory approval will diminish the value of our *HAP* Technology and proprietary programs.**

 

To date, none of ourcustomers has developed or commercialized any therapeutic product orcommercialized any diagnostic product using our genetic markers from ourproprietary programs.  We expect to relyon our customers to file applications for regulatory approval and generallydirect the regulatory review process and obtain regulatory acceptance of anyproduct they develop with our genetic markers from our proprietary programs, ifany.  Our customers may not submit anapplication for regulatory review.  Evenif they do submit applications, they may not be able to obtain marketingclearance for any product on a timely basis, if at all.  If our customers fail to obtain requiredgovernmental clearances for any therapeutic or diagnostic product, they willnot be able to market these products.  Asa result, we may not receive royalty or other payments from our customers.  The occurrence of any of these events mayprevent us from generating revenue sufficient to sustain our operations.

 

**If we are unable toobtain reimbursement from health insurers and other organizations for our *FAMILION* Test, our test may be too costlyfor regular use and our ability to generate revenues would be harmed.**

 

Our future revenuesand profitability will be adversely affected if we cannot depend ongovernmental and private third-party payers to defray the cost of our test topatients.  If these entities refuse toprovide reimbursement for our test or provide an insufficient level ofreimbursement, our test may be too costly for general use.  Our profitability may be adversely impactedif we choose to offer our test at a reduced price.  Any limitation on the use of our test or anydecrease in the price of our test, without a corresponding decrease in therelated costs, could have a material adverse effect on our ability to generaterevenues.

 

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**Additional Risks Related to Our Business**

 

**We depend on third-partyproducts and services and limited sources of supply, specifically for ourhigh-throughput genotyping laboratory.**

 

We rely on outsidevendors to supply certain software, products and materials used in ourlaboratories.  Some of these products andmaterials are obtained from a single supplier or a limited group of suppliers.  For example, we have a written agreement withSequenom, Inc., pursuant to which it is contractually the sole provider ofsilicon chips for one-time use on their MassARRAYTM System, which isour primary genotyping platform in our New Haven facility.  Under the terms of the agreement and subjectto specific conditions, we have the authority to reuse these chips shouldSequenom be unable to supply new chips to us. While we believe that we could prepare for reuse the requisite supply ofchips without unreasonable cost or delay, we may be unable to do so.  We have no other written long-term supplyagreements with our suppliers.  Ourreliance on outside vendors generally and a sole or a limited group ofsuppliers in particular involves several other risks, including:

 

•                  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 we fail to maintainour computer hardware, software and related infrastructure, we could experienceloss 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.  Tothe extent that any of these elements malfunction, we will experience reducedproductivity.  We protect our computerhardware through physical and software safeguards.  However, our computer hardware is stillvulnerable to fire, weather, earthquake, or other natural disaster and powerloss, telecommunications failures, physical or software break-ins and similarevents.  In addition, the software andalgorithmic components of our *DecoGen*Informatics System are complex and sophisticated, and as such, could containdata, design or software errors that could be difficult to detect andcorrect.  Users of our system may findsoftware defects in current or future tests. We have developed a proprietary Laboratory Information Management System(LIMS) to operate our facilities. Software defects in the LIMS could adversely effect our operations andhave a significant impact on our ability to generate revenue from thisfacility.  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.

 

**The current labormarkets are very competitive, and our business may suffer if we are not able tohire and retain key personnel.**

 

Our future successdepends on the retention of our key technical, marketing and executivemanagement to assist in formulating our business strategies.  The loss of the services of any of theseindividuals could have a material adverse effect on our product development andcommercialization efforts.  In addition,research, product development and commercialization may require additionalskilled personnel.  Competition forqualified personnel in the technology area is intense, particularly given thecompetition among biotechnology, pharmaceutical and health-care companies,universities and non-profit research institutions for experiencedscientists.  In addition, 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 are unable to attract and retain asufficient number of qualified personnel on acceptable terms, our business,financial condition and results of operations could be seriously harmed.  The inability to retain and hire qualifiedpersonnel could also hinder the future expansion of our business.

 

**Integrationefforts or strategic investments could interrupt our business and our financialcondition could be harmed.**

 

OnApril 1, 2004, we acquired Lark Technologies, Inc.  Our integration activities with respect tothe acquisition are ongoing and entail numerous risks that include thefollowing:

 

•                  difficulties integratingany acquired operations, personnel, technologies or products;

 

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•                  diversion of management’sfocus from our core business concerns;

 

•                  entering markets, in whichwe have no or limited prior experience or knowledge; and

 

•                  any difficulties encountered as aresult of our recent acquisition could adversely affect our business, operatingresults and financial condition.

 

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**Risks Relating toFinancial Reporting**

 

**Under regulationsrequired by the Sarbanes-Oxley Act of 2002, an adverse opinion on internalcontrols could be issued by our independent registered public accounting firm,and this could have a negative impact on our stock price.**

 

Section 404 of the Sarbanes-Oxley Act of 2002requires that we establish and maintain an adequate internal control structureand procedures for financial reporting and assess on an on-going basis thedesign and operating effectiveness of our internal control structure andprocedures for financial reporting. Our independent registered publicaccounting firm is required to audit both the design and operatingeffectiveness of our internal controls and management’s assessment of thedesign and the effectiveness of its internal controls. Although no knownmaterial weaknesses exist at this time, this will be the first year that wehave undergone an audit of our internal controls and procedures of theoperating facilities at our subsidiary, Lark Technologies, Inc., theintegration of which was not required under the assessment of our internalcontrol structure and procedures for the year ended December 31, 2004.  It is possible that material weaknesses couldbe found through our own evaluation, or that of our independent registeredpublic accounting firm. If such weaknesses are found, we may not be able toremediate such weaknesses in time to meet the deadlines imposed by theSarbanes-Oxley Act for compliance with the requirements of Section 404. If wedo not effectively complete our assessment or if our internal controls are notdesigned or operating effectively, our independent registered public accountingfirm may either disclaim an opinion as it relates to management’s assessment ofthe effectiveness of our internal controls or may issue a qualified opinion onthe effectiveness of our internal controls. Any such disclaimer or qualifiedopinion could have a material adverse effect on our stock price.

 

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**Item 3 – Quantitative andQualitative Disclosures About Market Risk.**

 

Our exposure to marketrisk is principally confined to our cash equivalents and investments, all ofwhich have maturities of less than one year.  We have maintained anon-trading investment portfolio of investment grade, liquid debt securitiesthat limit the amount of credit exposure to any one issue, issuer or type ofinstrument.  In view of the nature and mix of our total portfolio, a 10%movement in market interest rates would not have any impact on the total valueof our investment portfolio as of June 30, 2005.

 

**Wemaintain an operating facility in Takeley, England.  If the U.S. dollar weakens relative to aforeign currency, any losses generated in the foreign currency will, in effect,increase when converted into U.S. dollars and vice versa. We do not speculatein the foreign exchange market and do not manage exposures that arise in thenormal course of business related to fluctuations in foreign currency exchangerates by entering into offsetting positions through the use of foreign exchangeforward contracts. We also do not engage in derivative activities.**

 

**Item4 – Controls and Procedures.**

 

**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 as of June30, 2005.  The term “disclosure controlsand procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the ExchangeAct, means controls and other procedures of a company that are designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is recorded, processed,summarized and reported, within the time periods specified in the SEC’s rulesand forms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is accumulated and communicatedto the company’s management, including its principal executive and principalfinancial officers, as appropriate to allow timely decisions regarding requireddisclosure.  Management recognizes thatany controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving their objectives and managementnecessarily applies its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures. Based on the evaluation of our disclosurecontrols and procedures as of June 30, 2005, our chief executive officer andchief financial officer concluded that, as of such date, our disclosurecontrols and procedures were effective at the reasonable assurance level.

 

**Changesin Internals Control Over Financial Reporting**

 

**No changein our internal control over financial reporting (as defined in Rules 13a-15(f)and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended June30, 2005 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.**

 

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**PART II - Other Information**

 

**Item 2 – Unregistered Sales ofEquity Securities and Use of Proceeds.**

 

The following tableprovides information about purchases made by us of our common stock for eachmonth included in our first quarter:

 

**ISSUER PURCHASES OF EQUITY SECURITIES**

 
| **Period**         | ** ** | **(a)  Total Number  of Shares (or  Units)  Purchased** | ** ** | **(b)  Average Price  Paid per Share  (or Unit)** | ** ** | **(c)  Total Number  of Shares (or  Units)  Purchased as  Part of Publicly  Announced  Plans or  Programs** | ** ** | **(d)  Maximum  Number (or  Approximate  Dollar Value)  of Shares (or  Units) that May  Yet Be  Purchased  Under the Plans  or Programs** | ** ** |
|--------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 4/1/2005-4/30/2005 |       | —                                                  |       | —                                            |       | —                                                                                                      |       | —                                                                                                                                    |       |
| 5/1/2005-5/31/2005 |       | 57,130                                                  | (1)        | $                                                 | 0.001      |                                                                                                        | —     |                                                                                                                                      | —     |   |
| 6/1/2005-6/30/2005 |       | —                                                  |       | —                                            |       | —                                                                                                      |       | —                                                                                                                                    |       |
| Total              |       | 57,130                                                  | (1)        | $                                                 | 0.001      |                                                                                                        | —     |                                                                                                                                      | —     |   |

 

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(1)          The57,130 shares are shares of our common stock repurchased pursuant to restrictedstock agreements that we had entered into with certain of our employees.

 

**Item 4 –Submissionof Matters to a Vote of Security Holders.**

 

On May10, 2005, the following proposals were voted and acted upon at our 2005 annualmeeting of stockholders:

 
| **Proposal**                                                                                                                                                                                                                                                  | ** ** | **For**    | ** ** | **Against/Withheld** | ** ** | **Abstentions** | ** ** | **Broker Non-  Votes** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|----------------------|------------|-----------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                                                                    | ** ** | ** ** | ** ** | ** **           | ** ** | ** **      | ** ** | ** **             | ** ** |
| To elect Dr. Jürgen Drews, Mr. Kevin Rakin and Mr.  Christopher Wright to serve as a Class 2 Directors of the Company for the  next three years, except for Mr. Rakin, who will serve for the next two years  and be reclassified as a Class 1 Director: |       |       |       |                 |       |            |       |                   |       |
|                                                                                                                                                                                                                                                          |       |       |       |                 |       |            |       |                   |       |
| • Dr. Jürgen Drews                                                                                                                                                                                                                                  |       | 33,552,956 |       | 881,726              |       | —          |       | n/a                    |       |
| • Mr. Kevin  Rakin                                                                                                                                                                                                                                       |       | 33,698,573 |       | 736,109              |       | —          |       | n/a                    |       |
| • Mr. Christopher Wright                                                                                                                                                                                                                                 |       | 33,698,348 |       | 736,334              |       | —          |       | n/a                    |       |
|                                                                                                                                                                                                                                                          |       |       |       |                 |       |            |       |                   |       |
| To approve an amendment to the Company’s 2000  Amended and Restated Equity Incentive Plan, as amended, increasing the number  of shares of common stock available for issuance under the plan from  7,187,375 shares to 8,187,375 shares                 |       | 12,264,214 |       | 3,262,673            |       | 77,069          |       | 18,830,726             |       |
|                                                                                                                                                                                                                                                          |       |       |       |                 |       |            |       |                   |       |
| To ratify the appointment by the Audit Committee of  the Company’s Board of Directors of PricewaterhouseCoopers LLP as the  Company’s independent auditors for the current fiscal year                                                              |       | 34,372,132 |       | 53,023               |       | 9,527           |       | n/a                    |       |

 

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Inaddition to the Class 2 Directors listed above who were elected at the meeting,the present terms of our remaining Class 1 and Class 3 Directors continuedafter the meeting as follows:

 

•                  Termsexpiring at our 2007 annual meeting of stockholders:  Harry Penner, our Class 1 Director.

 

•                  Termsexpiring at our 2006 annual meeting of stockholders:  Karen Dawes, Joseph Klein III and SethRudnick, our Class 3 Directors.

 

Thefollowing proposals were voted and not acted upon:

 
| **Proposal**                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **For**    | ** ** | **Against/Withheld** | ** ** | **Abstentions** | ** ** | **Broker Non-  Votes** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|----------------------|------------|-----------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** ** | ** ** | ** ** | ** **           | ** ** | ** **      | ** ** | ** **             | ** ** |
| To approve an amendment to the Company’s Certificate  of Designations to the Company’s Certificate of Incorporation, as amended, to  provide that the amount of indebtedness we may incur under our Certificate of  Designations without the vote or written consent of the holder of at least 66  2/3% of the shares of the Company’s outstanding series A preferred stock be  increased from $7.0 million to $9.0 million from and after September 30, 2004 |       | 15,103,793 |       | 433,928              |       | 66,234          |       | 18,830,727             |       |

 

**Item 6 – Exhibits.**

 

SeeIndex to Exhibits attached hereto, which Exhibit Index is incorporated hereinby reference.

 

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**SIGNATURE**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.

 
|                 |   |   |   | GENAISSANCE  PHARMACEUTICALS, INC.                 |
|----------------------|--------|--------|--------|----------------------------------------------------|
|                 |   |   |   |                                               |
|                 |   |   |   |                                               |
|                 |   |   |   | By:                                                |   /s/ Ben  Kaplan |   |
|                 |   |   |   | Ben Kaplan                                         |
| Date: August 9, 2005 |   |   |   | Senior Vice President  and Chief Financial Officer |
|                 |   |   |   | (Principal Financial  and Accounting Officer)      |

 

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**EXHIBITINDEX**

 
| **Exhibit No.** | ** ** | **Description of Document**                                                                                              |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------|
| 10.1*           |       | Form of Restricted  Stock Agreement granted under Genaissance’s 2000 Amended and Restated Equity  Incentive Plan.   |
| 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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*             Indicates a management contract orcompensatory plan.

 

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